Detecting Earnings Management

Introduction

As of January 1st, 2005 it is mandatory for listed companies in the European Union to report according to International Financial Reporting Standards (IFRS). IFRS is in general considered to be a high quality standard, which should contribute to an improved quality of annual reports. But if this is also the case in practice, is still a subjective matter. If the level of earnings management is used as a measure of this quality, it remains uncertain if the extent of earnings management decreases after the introduction of the IFRS.

Therefore the aim of this study is to investigate whether the adoption of the IFRS will result in a decrease in earnings management.

The European commission presented numerous reasons for authorizing one set of accounting standards, namely: IFRS, across the European Union. The Commission required a single set of high quality financial reporting standards that are internationally accepted (compared to the different domestic standards that were then used). The key targets of this unification were firms listed on financial markets. Furthermore the Commission wanted to contribute to the efficient and cost-effective functioning of the capital market by ensuring transparency and comparability of financial reporting (Gassen 2006). The goal was to protect investors and maintain (or increase) confidence in financial markets. The Commission also wanted to increase competitiveness globally of the overall EU economy. And lastly the European Union intended to increase the accounting quality of all financial statements of their member countries. One measure to determine this, is the degree of earnings management. Furthermore it is also possible that value relevance or earnings conservatism determine the accounting quality. Accounting quality is the value that users give to the accounting information.

Companies can apply earnings management to meet the expectations of the society. Earnings management could be defined as follows: "when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers" (Healy and Wahlen 1999)

As mentioned before, this research investigates whether the adoption of IFRS leads to a decrease in earnings management within Dutch listed-companies. When reviewing previous research on this topic it is find that Aussenegg et al. (2008) reveals in their study, that earnings management is lower for companies who use IFRS/IAS[1] compared to companies who use local GAAP. However this only applies for German legal origin countries and French origin countries in the France/Benelux area. Nevertheless in their results a distinction is made between German legal origin - and French origin countries. This brings us to another factor besides the reporting standard, which explains differences in financial reporting, also the development of a country's legal system influences financial reporting. Two categories of legal systems can be distinguished, namely common law and code law. Generally it is known that common-law countries, like the US and the UK, have a very strong legal system with a high degree of investors' protection along with a heavy penalty rate. Code-law countries, such as Germany, Japan and Greece, are the other way around (a less stringent legal system with low investor protection and rather low penalty ratios). This factor will be taken briefly in consideration in chapter three of this paper.

Another recent study from a Dutch researcher F. de Beest (2008) provided results that indicated an increase in earnings management in the Netherlands after the introduction of the IFRS. He studied the affect of the accounting standards, the legal system as well as the financial system, on the degree of earnings management after the implementation of IFRS. Besides the Netherlands he also included the UK and Germany into his study.

Problem definition

A lot of research has been done on this specific topic, however most of them were cross-country studies, no study could be found that focused specifically on companies in the Netherlands. Previously it is mentioned that no clear conclusion could be made from prior research to which legal system the Netherlands belongs to, though most of the studies cluster their results into these two different legal systems. Thus providing a study of exclusively Dutch-listed companies provides readers with a clear view of the impact of the IFRS on the degree of earnings management within Dutch-listed companies. Another disadvantage of the previous literature on this topic is the fact that those studies are based on data gathered from companies in their IFRS implementation phase. For instance the paper of Capkun et al. (2000) concluded that earnings management is present during the transition to IFRS. Since their research is based on data gathered during the transition period, these results must be taken with caution. Given that after the transition period F. de Beest (2008) did a research based on data gathered from the period 2003 (before the mandatory implementation of IFRS) and 2007, whereas his results indicate an increase in earnings management in the Netherlands. Based on these contradictory results this study is centered solely on the Dutch-listed companies, to determine which result will hold. This leads to the following research question:

What is the influence on earnings management due to the transfer from the Dutch GAAP to IFRS, within Dutch listed companies?

The following sub questions are stated in order to answer the problem definition:

  • What are the main differences between the Dutch GAAP and the IFRS?
  • What is the meaning of earnings management?
  • What are the effects of the introduction of IFRS on earnings management shown by prior empirical research?
  • What proxy is used to measure earnings management?
  • What is the method of the empirical part of this master thesis?
  • What is the association between the introduction of IFRS and the level of earnings management?
  • What are the conclusions of this master thesis?

As followed by Jones (1991) earnings management in empirical literature is generally measured with the so-called 'accrual-models'. These models are based on the accrual principle, under which revenue is recognized (recorded), when earned, and expenses are recognized when incurred. In order to measure these accruals a distinction is made between discretionary and non-discretionary accruals. This difference depends on the influence the manager has to adjust to this particular accrual. Hence a discretionary accrual is a non-obligatory expense, such as an estimated bonus for management that is still to be realized but is recorded in the account books. Thus this is questioned to a great degree of subjectivity and is open to manipulation. A non-discretionary accrual is an obligatory expense that has yet to be realized but is already recorded in the account books. An example is an upcoming bill or next month's salary. Consequently this type of accruals' subjectivity cannot be questioned. Within the accrual-models, earnings management will be determined by the difference between the estimated accruals (based on information from previous years) and the actual accruals.

Relevance of the study

A few years ago, the IASB developed a new set of high quality accounting

standards for European listed companies. Since January 2005 listed companies in the European Union are obligated to report their consolidated financial statements according to the new International Financial Reporting Standards (IFRS). For the IASB the implementation of IFRS is meant to deliver a higher quality of financial statements in terms of comparability and transparency. Since the level of earnings management is a key indicator of earnings quality, it is expected that this would decline after implementing IFRS.

This thesis will therefore assist in the knowledge of the influence of IFRS on the occurrence of earnings management.

Previous research has been done on this specific topic, however most of them were cross-country studies. No study could be found that focused specifically on companies in the Netherlands. Thus providing a study of exclusively Dutch-listed companies gives readers a clear view of the impact of the IFRS on the degree of earnings management within Dutch-listed companies.

This information can be useful for stakeholders of firms within the Netherlands that report their financial statements according to IFRS.

Because earnings management is known to decrease the value of financial statements for decision - making, it is also useful for Investors who will be able to distinguish the value of financial statements.

Lastly, regulators can also profit from the results of this thesis, because it will give an indication to what extent their objectives have been met.

Chapter Outline

The remainder of this paper is as followed: in the next chapter, background information is provided on the Dutch GAAP and the IFRS, here the differences between the two standards are made clear. Chapter 3 discusses the relation between accruals, cash flows and earnings together with the definitions of accruals quality and earnings quality. Also earnings management with its definitions, motives, strategies and methods are presented in this chapter. In Chapter 4 a literature review of prior empirical research is given on earnings management and the effects of IFRS on earnings management shown by prior research. Chapter 5 describes the proxy that is used to detect earnings management.

Chapter 6 contains the development of the hypothesis, the statistical methods and models that will be used, a description of the sample and the limitations to the sample. Chapter 7 describes the descriptive statistics of all variables of the linear regression, the results of the modified Jones model and the results of the linear regression. Finally a summary and a conclusion of this thesis is given in chapter 8.

Chapter 2 : IFRS & Dutch GAAP

Introduction

In the previous chapter it is mentioned that this research studies a possible relationship between the level of earnings management and the transition from Dutch GAAP to IFRS. In order to study this relationship it is important to examine the different backgrounds of the IFRS and the Dutch GAAP to account for the differences between these accounting standards. This chapter discusses the sub question provided in the previous chapter (1.2):

What are the main differences between the Dutch GAAP and the IFRS?

Paragraph 2.2 provides background information and the reason for introducing IFRS, paragraph 2.3 provides information about the Dutch GAAP. Lastly a comparison is made between these accounting standards and the main differences are discussed.

International Financial Reporting Standards (IFRS)

As already mentioned, since January 1st, 2005 listed companies in the European Union are required by the European Commission's 'IAS Regulation' (EC 2002) to report their financial statements according to International Financial reporting standards (IFRS) or International Accounting standards (IAS). The IASB is empowered to develop and approve IFRS. One of the aims of the IASB was to develop, a single set of high quality, understandable and enforceable global accounting standards that require high quality (which are in the interest of the public), transparent and comparable information in financial statements and other financial reporting to help participants in the world's capital markets and other users to make economic decisions (www.iasplus.com). This should result in higher accounting quality because management's opportunistic discretion in determining accounts is limited. The main purpose of this requirement is to seek harmonization across member countries and a better functioning of the internal market (Gassen, 2006). The goal of European economic integration and development is to enhance the freedom for corporations and multinational enterprises to become more international and to do business and compete within a common framework of law, taxation, and financial resources (Tilli, 2006).

The junction with IFRS has led to a lot of uncertainty. It is also a difficult and major task for all European companies. It requires joint effort in each country by the government, stock market regulators, financial statement preparers, standard setters and the accounting profession (Nobes, 2001). Special attention must also go to every user of the financial information. They should take great care to understand which treatments of accounting standards, which alternative standards, have been applied in preparing the relevant financial statements (Nobes, 2001).

"To change the requirements appears to be quite difficult task, but to guarantee a high quality of implementation would be a much more difficult challenge" (Nobes, 2001). To ensure a proper implementation of the IFRS, accountants and auditors must have a great degree of knowledge on all standards and treatments of the IFRS. However, in addition to all the uncertainty, difficulties and criticism, a lot of companies share the opinion that the move towards the IFRS will eventually lead to some benefits (Mazars, 2005). However, in this study of Mazars, (2005), the greatest support for IFRS comes from "Mediterranean" countries like Spain and Italy. One of the reasons that countries, like the United Kingdom and the Netherlands, do not notice the advantages of the new accounting principles is perhaps due to the fact that the local accounting standards of these countries do not show major differences with IFRS (Mazars, 2005). Overall, there is still a lot of skepticism among companies on IFRS, as a consequence of major changes in international accounting. Major changes like this will always bring skepticism, nevertheless the expectation is, that after a few years, the real advantages of IFRS will become clear by everyone and the skepticism will disappear.

Dutch Generally Accepted Accounting Principles (Dutch GAAP)

"Dutch GAAP" is used to specify the whole body of authoritative accounting literature. The Netherlands accounting rules are based on a legal framework, the Netherlands Civil Code (CC), the framework and the Guidelines on Annual Reporting (GARs) from the Dutch Accounting Standards Board (DASB). There are limited circumstances within an enterprise that may be accepted from not acting in accordance with the Civil Code (KPMG, 2006).

Dutch accounting is described as being more subjective and less rule-oriented than the Continental model[2]. However Dutch company law also codifies reporting requirements, for example, one aspect of the Dutch GAAP is the Civil Code; Book 2 (CC) stipulates most of the legal framework for financial reporting by companies.

The Annual Reporting Guidelines spread by the Council on Annual Reporting are intended to have an impact on accounting practice. But it is neither mandatory for companies to adhere to these guidelines nor obligatory for auditors to qualify their reports if the guidelines are not followed. For example one aspect of the Dutch GAAP is that accounting policy changes occur frequently and that the diversity of adopted accounting principles is high (Vergoossen, 1997). Additionally, Dorsman et al. (2003) state a widespread use of discretionary accounting by Dutch firms in an attempt to improve the accuracy of qualitative earnings forecasts.

Dutch GAAP vs. IFRS

When compared to the IAS, Hoogendoorn (1995) and Van Rooijen (2002) explain that Dutch GAAP proposes flexibility in areas relating to foreign currency translation, classification of extraordinary items, intangible fixed assets ( for example: research and development costs) and the use of provisions[3].

Furthermore there are a lot of key items recognized that agree to managerial discretion within Dutch GAAP (Van Rooijen, 2002).

These are (1) tangible fixed assets including financial fixed assets, (2) intangible fixed assets (expenses related to share issues, R & D, intangible rights, and goodwill), (3) current assets (i.e., stocks, work in progress, accounts receivable, and securities), (4) provisions (pension, taxation, and other provisions), (5) shareholder's equity, (6) accounting policy changes, and (7)extraordinary items.

The items mentioned are not a thorough list of all discretionary items of the Dutch financial reporting system; however, they represent the major areas of flexibility offered by Dutch GAAP in comparison to IAS. Therefore Dutch GAAP holds a single position in international accounting systems. It combines the managerial discretion of Anglo-Saxon[4] accounting with the codified accounting rules of the Continental European model.

Ding et al. (2007) investigated the differences between domestic accounting standards (DAS) and International Accounting Standards (IAS), and included the Netherlands in their sample. Ding et al. (2007) indicate a positive and significant correlation between absence and earnings management (Absence measures the extent to which the rules regarding certain accounting issues are missing in Domestic Accounting Standards (DAS) but are covered in IAS). When the absence score is high, room for earnings management is created. This means that companies will be likely to take advantage of the accounting discretion to manage earnings when the accounting regulation environment is not sophisticated. The results of the research of Ding et al. (2007) indicate that in 2001 the absence score for Dutch companies is low, which means that there aren't many rules regarding certain accounting issues missing in Dutch GAAP that are covered in IAS. This indicates that the Dutch reporting requirements and practices are in many ways similar to the IAS. Nobes and Parker (2000) and Radebough and Grady (1997) also found that the Dutch reporting requirements and practices are in many ways similar to those used in the United Kingdom and the United States. So this could signify that there is less room for earnings management when reporting under Dutch GAAP. This would also imply that the mandatory transition (as of January 1, 2005) from Dutch GAAP to IFRS would not significantly change the absence level since there isn't a big difference in accounting standards when reporting under Dutch GAAP or IFRS. However when reporting under the Dutch Financial Reporting guidelines, it is neither mandatory for companies to adhere to these guidelines nor obligatory for auditors to qualify their reports if the guidelines are not followed.

Summary

The sub question of this chapter as described in paragraph 1.2 is :

What are the main differences between the Dutch GAAP and the IFRS?

In paragraph 2.1 the International Financial Reporting Standards (IFRS) is discussed. Since January 1st, 2005, listed companies in the European Union are required to report their financial statements according to IFRS. The reason for developing these accounting standards by the International Accounting Standards Board (IASB) was to enforce a single set of high quality, understandable global standards to improve harmonization across member countries and for better functioning of the internal market (Gassen, 2006). Even though the IASB had good intentions, there was a lot of skepticism, uncertainty and criticism among companies on the IFRS, because the IFRS brings with it major changes in international accounting. Nevertheless it is expected that after a few years the move to IFRS will show its advantages (Mazars, 2005).

Paragraph 2.2 discusses the Dutch Generally Accepted Accounting Principles ( Dutch GAAP). Which describes Dutch accounting as being more subjective and less rule - oriented. Paragraph 3.2 provides the key items which offer more flexibility compared to IFRS: (1) tangible fixed assets including financial fixed assets, (2) intangible fixed assets (expenses related to share issues, R & D, intangible rights, and goodwill), (3) current assets (i.e., stocks, work in progress, accounts receivable, and securities), (4) provisions (pension, taxation, and other provisions), (5) shareholder's equity, (6) accounting policy changes, and (7) extraordinary items. In this paragraph results are also found by Ding et. Al 2007, that the Dutch reporting requirements and practices are in many ways similar to the IAS. This could signify that there is less room for earnings management when reporting under Dutch GAAP.

The purpose of this chapter was to identify the main differences between Dutch GAAP and IFRS. This in order to examine on which items these two accounting standards differ from each other to create an idea whether managers could have more incentives to practice earnings management under Dutch GAAP compared to IFRS. This chapter shows that Dutch GAAP is in many ways similar to the IFRS. This would imply that the mandatory transition (as of January 1, 2005) from Dutch GAAP to IFRS would not significantly change the absence level since there isn't a big difference in accounting standards when reporting under Dutch GAAP or IFRS.

Earnings management

Introduction

In the previous chapters it is said that the purpose of this master thesis is to research the subject: whether the level of earnings management has changed since the mandatory transition to IFRS. In order to understand earnings management it is necessary to understand the terms accruals, accruals quality and earnings quality. Therefore in this chapter the following sub question is discussed:

What is the meaning of earnings management?

First of all for a better understanding of the term "earnings management" the relation between accruals, cash flows and earnings are discussed in paragraph 3.2. In paragraph 3.2.2., the definitions of accruals quality and earnings quality are given. And lastly in paragraph 3.3, 3.3.1 and 3.3.2., earnings management with its definitions, motives, strategies and methods will be discussed.

Relation between accruals, cash flows and earnings

Under the basis of cash accounting, revenues are recognized when cash is received and expenses are recognized when cash is paid. When a company prepares its financial statements on the basis of cash accounting, then earnings equal the cash flow mutation:

One benefit that cash based accounting provides, is that the system is easier and cheaper to maintain. Because most of the sales are cash sales, it is not necessary to maintain an inventory, or to maintain customer accounts or returns. However, because firms undertake economic transactions on a continual basis, cash accounting cannot report the full economic consequence of the transactions undertaken in a given period. So when financial statements are prepared on the basis of the cash accounting method, there is a possibility that the financial statements may not provide a fair view of the company's financial situation.

The accrual basis of accounting (IAS 1.27) is described by the International Accounting Standards Board as, "The effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis informs users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making decisions". This citation by the International Accounting Standards Board describe that under the accrual basis of accounting revenues are recorded when they are earned and expenses are recorded when they incur. Under the accrual basis, earnings can be divided in two components

Earnings = Cash Flows + Accruals

One benefit that cash based accounting provides, is that the system is easier and cheaper to maintain. Because most of the sales are cash sales, it is not necessary to maintain an inventory, or to maintain customer accounts or returns. However, because firms undertake economic transactions on a continual basis, cash accounting cannot report the full economic consequence of the transactions undertaken in a given period. So when financial statements are prepared on the basis of the cash accounting method, there is a possibility that the financial statements may not provide a fair view of the company's financial situation. On the other hand under the accrual basis of accounting the financial statements are a better reflection of the financial situation of the company because the financial statements also show the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future in terms of accruals.

Earnings management

The purpose of financial statements is to provide information on the financial position and the results of a company. There are a lot of different users who base their decisions on this information. However, because of the flexibility within the accounting standards, there are possibilities to manipulate the figures in the annual report to the discretion of management. According to various literature, there are a variety of definitions on the theory of earnings management.

Definitions

There are several definitions for earnings management; consider the following definitions from the academic literature:

Schipper (1989) defined earnings management as follows: "a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process).

A second commonly used definition is given by Healy and Wahlen (1999), they define earnings management as: "Earnings management occurs when management use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers."

In this definition explicit reference is made to the deliberate intervention of management in the financial reporting process. Dechow and Skinner (2000) state that this aspect of deliberation has to be clearly present in order to speak of earnings management. Most of the accounting standards offer great discretion when choosing between different accounting methods, as a result that interventions are difficult to distinguish from the right implementations and rules. Only when discretion offered by accounting standards is being used for opportunistic behavior by management it is called earnings management (Heemskerk and Van der Tas 2006).

Generally, it can be concluded from these definitions, that earnings management is considered as relatively negative. Manipulation outside the law and standards constitutes fraud. The activities covered by the term "earnings management" (income smoothing, big bath accounting) or generally "creative accounting" normally remain within the law (Stowoly and Breton 2000). For this study the definition of earnings management given by Healy and Wahlen (1999) will be used.

Motives, Methods & Strategies

Motives

According to Dye (1988) and Schipper (1989) manipulating accounts is a managerial activity. They state that other players (such as analysts and investors) in the field influence managers' decisions to manipulate accounts. When management exercises earnings management to mislead stakeholders, this does not mean that the company does not act in conformity with generally accepted accounting principles. A distinction is made between management that manage earnings within the limits of generally accepted accounting principles and management that act outside the limits of generally accepted accounting principles. When management manages earnings within the limits of GAAP this is called earnings management but when management act outside the limits of GAAP this is considered to be fraudulent financial reporting (Dechow and Skinner, 2000). This paragraph describes some incentives for management to manage earnings and the strategies and tools management use to manage earnings.

Many authors in the past have studied motivations to manage earnings; several have been identified ranging from the managers' incentive to manipulate earnings to influencing the actions of other stakeholders (such as suppliers, employees, consumers and government). Management of a company has in certain situations incentives to manipulate the figures in the annual reports and therefore they also influence the actions of the stakeholders. That is why the actions of the management lead to economic consequences. Management could have the incentive of creating shareholder value by maximizing firm value (by maximizing future cash flows), but management could also act in their own self interest by maximizing their own wealth. An advantage of a higher firm value is that this could lead to a higher share price, better credit conditions and lower tax assessments ( Hoogendoorn, 2004).

Within this view of motivation, a distinction could be made between the opportunistic perspective and on the other hand the signaling perfective (Schipper, 1989). The opportunistic perspective is the way managers seek to mislead investors and other users of the financial statements for their own benefit. These motives could be derived from the capital market, compensation contracts and regulation. On the other hand there is the signaling perspective, at time that managers have privilege information about feature earnings they will take the opportunity to signal their confidence in the level of those future earnings (Scott, 1997). They could do this by selecting alternative accounting methods to give a better impression of the financial status of the company. Subsequently we will give an overview of findings by previous studies about these motives.

  • Capital market. In general the motives of the capital market are derived from the attempts to influence the stock prices and to profit from them. To be more specific, motives concerning the capital markets includes amongst other underestimating operating profits preliminary to a management buy-out (DeAngelo, 1998). Also overestimating the profits during a period of an initial flotation on the stock market (Teoh et al.1998; Mulford and Comisky, 2002). At last to present more smoothed earnings because they are being associated with limited risks and with that a lower return on equity (Goel and Thakor, 2003; Bitner and Dolan, 1998).
  • Contracts. A lot of research has been done in the past about motives for earnings management regarding contracts. According to Positive Accounting Theory, compensation contracts as well as loan terms prominently are the most common motives for earnings management (Watts and Zimmerman, 1987). This could include maximizing bonuses (Healy, 1986; Dechow and Sloan, 1991) or complying with the terms of liquidity and solvability in loan contracts (Richardson et al., 2002; Sweeney, 1994; DeFond and Jiamalyo, 1994).
  • Regulation. Motives for managing earnings could derive from existing regulation with as goal to avoid certain industry specific rules, to get around investigations of regulatory bodies or to achieve tax benefits (Healy and Wahlen 1999)
  • Signaling. In this perspective it is asserted that managers make certain choices to put together the financial statements in order to provide investors with information about the firm (Deegan 2000). Subrmanyam (1996) claims that firms imply to present the financial status better in this way than according the regular methods. Scott (1997) confirms this by stating that along this way managers try to signal their confidence in the firms' profit to the shareholders and other users of the financial statements.

Strategies & Methods

There are two methods for managing earnings (Heemskerk &Van der Tas), these are:

  1. Changes in accounting estimates, accruals management
  2. Real earnings management

Accruals management point out the discretion managers apply when selecting certain accounting methods and estimating numbers. Real earnings management indicate intentionally planning economic events in order to manipulate a company's financial results.

Not only does management apply methods for managing earnings, they can also apply different strategies. Five different strategies to manipulate earnings are discussed by Hoogendoorn, (2004). The first strategy management could apply is: profit maximization. This strategy is applicable when a company is somewhat profitable. Management could then report a high profit, which could enhance a company's reputation. However, high profits can cause high political costs so this is not always positive. Another potential strategy that could be used by management is, profit minimization. This could be used by activating costs as soon as possible and returns as late as possible

The third strategy managers could apply, is: loss maximization, also called "big bath accounting". This strategy can be used if a company endures loss within a specific period, without the risk of losing its continuity. For example, when specific targets or bonuses are not met, management will maximize losses during this period. This is done to improve future profitability and achieve future targets and bonuses. An example for a situation when this strategy could be used is: restructuring or a CEO-change. However it is important that a company does not lose its continuity so loss maximization cannot be practiced for a longer period. The fourth strategy that could be used to manipulate earnings is: loss minimization which is the opposite of the previous strategy discussed namely: loss maximization. Loss minimization can be applied when a company has to deal with long term losses. In this case management should try to achieve profits or aim to maintain the losses as low as possible. Lastly, the fifth strategy is a mixture of the previous discussed strategies. This strategy is called: income smoothing and is used by management of steady companies. The reason management uses this type of strategy is to smooth the earnings and achieve a stable risk profile. This could have a positive effect on the company's reputation and could also reduce fluctuations in share prices. The way this strategy is applied is during profitable years, the profit will be weakened and the "profit reserve" that is resolved from this weakening will be used in more weak years (with losses) in order to stabilize the level of profit.

These Motives, Methods and Strategies are all made possible by the existence of information asymmetry between management and stakeholders. The information asymmetry is related to the principal - agent problem, which is derived from the agency theory.

This theory could be defined as "a contract under which one or more than one person (principals) engage another person (agent) to perform some service on their behalf which involves delegating some decision making authority to the agent."(Jensen and Meckling, 1976). In this case the stakeholders are the principals and the management is the agent. Both parties are in it to maximize their utilities. That is why management (the agent) will not always act in the interests of the principal. The agents will act in their own self-interest in order to maximize their own wealth. Deciding on the accounting choices is one of the ways management act in their own self-interest.

Summary

The sub question of this chapter as described in paragraph 1.2 is :

What is the meaning of earnings management?

Paragraph 3.2 described the relation between accruals, cash flows and earnings. Under the basis of cash accounting, revenues are recognized when cash is received and expenses are recognized when cash is paid. Under the accrual basis of accounting revenues are recorded when they are earned and expenses are recorded when they incur. Paragraph 3.3 describes some definitions of earnings management and also the motives, methods and strategies used to practice earnings management. From the definitions it is concluded that earnings management is to be considered as relatively negative. The definition used for earnings management in this study is the one by Healy and Wahlen (1999): "Earnings management occurs when management use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accountin gnumbers." Furthermore the motives, strategies and methods are discussed in this paragraph. Managers have different motives to manipulate accounts. A distinction is made between management that manage earnings within the limits of generally accepted accounting principles and management that act outside the limits of generally accepted accounting principles. When management manage earnings within the limits of GAAP this is called earnings management but when management act outside the limits of GAAP this is considered to be fraudulent financial reporting (Dechow and Skinner, 2000). The strategies discussed in this paragraph are Changes in accounting estimates and real earnings management, furthermore managers can practice profit maximization, profit minimization, loss maximization, loss minimization and income smoothing. Lastly it is discussed that these Motives, Methods and Strategies are all made possible by the existence of information asymmetry between management and stakeholders .

Introduction

In this chapter a few empirical studies which examine the effect on earnings management within the region or that are similar to the region on which this study is based on, will be observed. This leads to the third sub question given in paragraph 1.2:

What are the effects of the introduction of IFRS on earnings management shown by prior empirical research?

In the paragraph 4.2 the studies of Ashbaugh (2001) and Dumontier and Raffournier (1998) look at the reasons for voluntary adoption of the IFRS before the mandatory adoption in 2005. In the paragraph 4.3 the impact of the mandatory transition to IFRS will be discussed based on studies by Van Tendeloo and Vanstraelen (2005), Leuz et al. (2003), Aussenegg et al. (2008) and Ferdy van Beest (2008).

Reasons for the voluntary implementation of the IFRS

There were several firms that voluntarily complied with the IFRS before the mandatory adoption of January 1st, 2005. Since this was not mandatory it is rather appealing to consider why firms adopt the IFRS and what the main advantages were for these particular firms. The adoption of IAS was introduced in order to reduce information asymmetry. Several researches investigated the economic consequences of the voluntary adoption of several firms and stated that there was indeed a sign of lower earnings management, because of the reduction of information asymmetry.

One research (Ashbaugh, 2001) investigated why Non - U.S. firms voluntarily report financial information prepared in accordance with IFRS or US - GAAP (United States Generally Accepted Accounting Principles). He stated the following reasons for conforming to IFRS instead of Local GAAP: firstly, the evidence presented point out that the main driver of voluntarily taking on the IFRS is the number of foreign listings and the higher degree of disclosure and information consistency in relation to local GAAP.

Firms are also more likely to disclose IFRS financial information when US-GAAP entails more disclosures and restricts accounting measure methods in relation to the policies of their local GAAP. Overall, non-US firms select increasingly strict sets of accounting standards when the expected benefits exceed the expected cost.

Another research (Dumontier and Raffournier, 1998) also investigated why companies voluntarily comply with IAS. In Switzerland it is possible to use IAS or some other set of accounting standards similar to national regulation for the preparation of consolidated financial statements. Because of their low national accounting regulation Swiss companies have a broad choice of alternative accounting policies. This gives them the opportunity to act in accordance with IAS or other accounting standards like foreign GAAP or local GAAP. There are several reasons for firms to adopt the IAS (Dumontier and Raffournier, 1998) First, for companies with a larger share from foreign users, reporting under IAS is more usable than reporting under Swiss GAAP. Out of the country users are not used to the Swiss accounting rules and cannot access other sources of information easily. Second, reporting under IAS facilitates admission on foreign stock exchange and let firms free from preparing financial statements consistent with domestic accounting rules. Third, compliance with IAS means an increase of disclosure, because the Swiss GAAP is less strict in relation to IAS for valuation rules in addition to disclosure requirements. Finally political costs and pressures from outside markets have an important effect in reporting under IAS (Dumontier and Raffournier, 1998).

The effects of the change to IFRS on earnings management shown by prior empirical research

A number of studies have dedicated their research on the influence of IFRS on earnings management for firms that voluntarily or obligatory adopt the IFRS. It is rather remarkable that there are especially many papers contributed to earnings management in German firms. This could be because German firms were allowed to follow IFRS prior to 2005. As mentioned before, in 2002, the European Union (EU) decided that EU listed companies are required to use IFRS (International Reporting Standards) starting from January 1st 2005. Prior to this requirement, there were specific Domestic Generally Accepted Accounting principles (GAAP) which are now replaced by the IFRS for listed companies. It is expected that this should have harmonization between companies and a higher quality of financial reporting as outcome. Because a high quality financial report contains more timely and relevant information, it is an important instrument to help reduce the information asymmetry. The mandatory transition from domestic GAAP to IFRS caused a lot of researchers to raise questions concerning the transparency that IFRS is supposed to give. One of the main goals of IFRS is to increase transparency and thus among others reduce earnings management.

One research examined, (Van Tendeloo and Vanstraelen 2005), studies whether the adoption of IFRS is associated with lower earnings management in Germany (A code law country with low investor protection rights). This is examined by a comparison between German companies that adopted the IFRS and German companies reporting under German generally accepted accounting principles (GAAP). In this study it is noticeable that under German GAAP, the use of so-called hidden reserves is allowed. Hidden reserves can be generated by building up unjustified provision, recognizing excessive depreciation of assets or setting aside certain profits in tax-free reserves (Van Tendeloo and Vanstraelen 2005). It is suggested that IFRS-adopters do not present different earnings management behavior in relation to companies reporting under German GAAP when they make use of hidden reserves. However the results also suggest that without the usage of hidden reserves to manage earnings, IFRS- adopters turn more to discretionary accruals to manage their earnings, which indicates that the adoption of IFRS does not considerably reduce earnings management. The results also suggest that companies that have adopted IFRS are more appointed with earnings smoothing. This can be explained by the allowed use of hidden reserves which can facilitate earnings smoothing. However the increase in earnings smoothing with the adoption of the IFRS is considerably reduced when one of the Big 4 audit firm audits the firm. This is because Big 4 audit firms are assumed to provide higher audit quality than other firms. The authors indicate that there are several studies (DeFond and Jiambalvo 1991, 1994; Becker et al. 1998; Gore et al. 2001), which indicate that being audited by a Big 4 audit firm, does impose a constraint on earnings management. Van Tendeloo and Vanstraelen (2005) expect that the adoption of high quality standards (IFRS) has a larger effect on the reduction of earnings management when a Big 4 audit firm audits companies.

After investigating this part, it can be concluded that the adoption of IFRS does not impose a significant constraint on earnings management, but it increases earnings management. Leuz et al. (2003) states that in code law countries with low investor protection the magnitude of earnings management is on average higher than in common-law countries with high investor protection rights. Since Germany is a code law country where the adoption of IFRS increases the level of earnings management, we want to investigate this for the Netherlands. Shown by previous empirical literature it is not clear to which legal system the Netherlands belongs to, since it shows similarities to both the common law and code law system. However the Netherlands leans more towards a code law country because of its strong capital market, but the corporate governance shows signs of a common law country.

Aussenegg et al. (2008) examined how the transition from local GAAP to IAS/IFRS of companies that are publicly traded on the European stock exchange, affects earnings management. It is important to utter that everything stated in this paper must be taken with caution because this is still the first draft of the paper. Aussenegg et al. (2008) found that earnings management is lower for companies who use IFRS/IAS compared to companies who use local GAAP. However this average result does not comply with all the countries they analyzed. This lower earnings management level for IFRS/IAS adopters only applied for German legal origin countries (Austria, Germany and Switzerland) and French origin countries in the France/Benelux area (Belgium, France and the Netherlands). There was no change in earnings management found for English legal origin countries (U.K. and Ireland) and Scandinavian legal origin countries (Denmark, Finland, Norway and Sweden). According to the authors this could be because these counties already have lower earnings management levels prior to IFRS/IAS adoption compared to the rest of Europe. La Porta et al. (1998) also document that English and Scandinavian legal origin countries have the highest rated (local) accounting standards, whereas the corresponding rating of German and French legal origin countries is significantly lower. Aussenegg et al. (2008) also found that the volatility of earnings management over time is higher for firms that use IFRS/IAS than for firms that prepare their financial statements in accordance with domestic GAAPs. Furthermore they say that time period and firm size has no effect on earnings management. Suggested by the results is that growth firms are more likely to engage in earnings management. This also applies for firms with higher financial leverage. Additionally they find that firms with more cash flows from operations are less likely to engage in earnings management. Firms with higher cash flows are less risky, and therefore can reach targets more easily (on average). Finally it is concluded that different measures seem to capture different dimensions of earnings management. The research done by Aussenegg et al. (2008) is partly similar to this research, because they also examine the impact of the transition to IFRS on earnings management. From their findings it can be concluded that earnings management is lower for companies who use IFRS/IAS compared to companies who use local GAAP. This lower earnings management level for IFRS/IAS adopters, does only apply for German legal origin countries and French origin countries in the France/Benelux area (which includes the Netherlands). However there is no change in earnings management found for English legal origin countries and Scandinavian legal origin countries. These findings are meaningful to this research because it could now be suggested that the transition from Dutch GAAP to IFRS would decrease the level of earnings management. However their sample includes observations from the period 1995-2005, so this only concerns firms before the mandatory adoption of IFRS. And this research also aims to investigate what the impact on earnings management is after the mandatory adoption of IFRS.

Lastly studied is a paper (Ferdy van Beest 2008) on "if the level of earnings management has decreased after the introduction of IFRS". So, whether the financial reporting quality has increased since the introduction of IFRS, for listed companies. This study also investigated if there is an interaction effect, because the study is done for three different countries, before and after the mandatory introduction of the IFRS, namely: if there is a relationship between the introduction of the IFRS, the countries legal system and the financial system in terms of earnings management. The results show that measured on the basis of accruals, the quality of the annual reports in the Netherlands, Germany and England have decreased after the introduction of the IFRS and that the level of earnings management has increased after the introduction of the IFRS. Next to the accounting standards as explanation for earnings management, the legal and financial system can also be of influence on the level of earnings management according to this study. Legal systems indicate the code law countries (low investor protection) and common law countries (high investor protection), financial system of a country indicates a bipartition between bank- oriented countries and market- oriented companies. The results indicate that an increase in the power of a legal system leads to a decrease in earnings management. At the same time results show that a cluster of shares in a bank-oriented system leads to more earnings management. However the author indicates that the results of the financial system for 2007 are not significant, so the results can be based on chance. Furthermore results show that there are signs for an interaction effect. In this study, the legal system shows an interaction with the introduction of the IFRS, which shows an additional contribution to explain the level of earnings management. Therefore in Germany (code law country) the introduction of the IFRS has a more negative effect on earnings management in relation to England (common law country). Finally the financial system did not seem to have an additional interaction-effect.

This research done by (Ferdy van Beest 2008) is also quite similar to this research, because his paper also studies the influence on earnings management after the introduction of IFRS, namely: if the level of earnings management has decreased after the introduction of IFRS. From his findings it can be concluded that the level of earnings management has increased after the introduction of the IFRS. These findings are rather contradicting in relation to the findings of Aussenegg et al. (2008), who found that earnings management is lower for companies who use IFRS/IAS compared to companies who use local GAAP. This may be because Ferdy van Beest (2008) examined companies in 2003 and 2007, which includes companies before and after the mandatory adoption of IFRS, and on the other hand Aussenegg et al. (2008) sample included observations of companies from 1995-2005, which does only include companies who have voluntarily adopted the IFRS.

These papers research the Netherlands together with other companies. Within these researches the results are rather contradictory. Some studies say that earnings management decreases after the mandatory implementation of IFRS in the Netherlands however other studies state the exact opposite. There are a lot of factors that influence these results, for example the use of years in which comparisons are made or the different countries that are studied. Therefore this will be further investigated and a comparison will be made with these papers to see if there are similarities within the results or if this research displays a different outcome.

Summary

The sub question of this chapter as described in paragraph 1.2 is :

What are the effects of the introduction of IFRS on earnings management shown by prior empirical research?

Paragraph 4.1 describes the reasons firm voluntarily implemented the IFRS. It is described that the overall reason non-US firms select increasingly strict sets of accounting standards is when the expected benefits exceed the expected cost. Also Dumontier and Raffournier, 1998 give several reasons firms adopt IFRS. First, for companies with a larger share from foreign users, reporting under IAS is more usable than reporting under local GAAP. Second, reporting under IAS facilitates admission on foreign stock exchange and let firms free from preparing financial statements consistent with domestic accounting rules. Third, compliance with IAS means an increase of disclosure, because often the local GAAP is less strict in relation to IAS for valuation rules in addition to disclosure requirements. Finally political costs and pressures from outside markets have an important effect in reporting under IAS. In the second part of this chapter, paragraph 4.3 the effects of the change to IFRS on earnings management shown by prior research. The results shown in this paragraph are rather contradictory. Some studies say that earnings management decreases after the mandatory implementation of IFRS in the Netherlands however other studies state the exact opposite. It is also said that there are a lot of factors that influence these results, for example the use of years in which comparisons are made or the different countries that are studied. In chapter 6 this will be further investigated and in chapter 8 ( the conclusion) a comparison will be made with these papers to see if there are similarities within the results or if this research displays a different outcome.

Chapter 5 : Proxy for detecting earnings management

Introduction

The empirical part of this master thesis examines the association between earnings management and the introduction of IFRS. Chapter 3 provided a definition for earnings management together with the motives, methods and strategies for applying this instrument. In this chapter two different proxies for measuring earnings management are discussed by investigating the relationship between the transition to IFRS and the absolute value of the discretionary accruals, it can be determined to what degree accruals are used for managing earnings as a result of the IFRS. This chapter provides an answer to the fourth sub question provided in paragraph 1.2:

What proxy is used to measure earnings management?

In paragraph 5.2 the Jones model is discussed, followed by paragraph 5.3, which discusses the Modified Jones model.

The Jones Model

A commonly used method to determine the level of earnings management is to investigate the indicator for accrual management. In order to achieve this, different steps need to be followed through. First of all it has to be determined which part of the total accrual is a result from the firm's economic performance (non-discretionary accruals) and those that result from managers' exercise of discretion (discretionary accruals). The last one is open for manipulation and therefore, the one that will be used as a proxy for determining earnings management. Within the accrual-models, earnings management will be determined by the difference between the estimated accruals (based on information from previous years) and the actual accruals.

Previous research has developed several accrual based models (Healy (1985); DeAngelo (1986); Jones (1991)) which enabled researchers to detect earnings management. According to Healy (1985) total accruals consist of a discretionary accrual component (DAt) and a non-discretionary accrual component (NDAt). The difference between the non discretionary accrual component and the discretionary accrual component is that management is able to influence the discretionary accrual component. Non-discretionary accruals are adjustments of company's cash flows, which are authorized by accounting standard setting organizations (i.e. International Accounting Standards Board). Discretionary accruals are adjustments of cash flows which are selected by management. This means that discretionary accruals, allows management to transfer earnings between periods. However neither the discretionary accrual component nor the non-discretionary accrual component is directly detectable from the annual report (Aljifri, 2007). So the accrual models have to estimate the discretionary - and non-discretionary accrual components. It is expected that a companies working capital requirements depend on sales, whereas its depreciation accruals depends on the level of property, plant and equipment (Bernard and Skinner, 1996). The variables REV and PPE are added to control for normal (non-discretionary) accruals. All variables are scaled by lagged total assets to make them comparable among firms and over time. So if this model distracts non-discretional accruals from total accruals, it is easy to move these to the second period, the test (event) period. In this period, the difference between total accruals and non-discretionary accruals is expected to be the amount of discretionary accruals, and the measurement of earnings management.

The Jones model assumes that companies with high discretionary accruals are connected with high intentional errors (i.e. earnings management). As mentioned before, this affects the quality of accruals. A disadvantage of the Jones model is the presence of the so-called type-I error in tests. This means that some normal accruals were erroneously identified as discretionary accruals. This leads to the incorrect conclusion that earnings management is applied. Another limitation of the Jones model is declared by Jones herself, namely that all revenues are supposed to be non-discretionary. Dechow Sloan and Sweeney (1995) provide a solution in their modified Jones model.

The Modified Jones Model

Dechow, Sloan and Sweeney (1995) do not agree with the assumption of the Jones Model that discretion is not exercised on revenues. Dechow et. al assume that all changes in credit sales in the event period result from earnings management, while Jones (1991) assumes that all revenues are supposed to be non-discretionary. Companies can engage in earnings management by posting revenues that belong to the next period in the current period, or the other way around. Jones (1991) doesn't correct for this fact. The assumption that all changes in credit sales in the event period result from earnings management, is also made because it is easier for managers to manage earnings by applying discretion over the recognition of credit sales compared to the recognition of cash sales. That is why Dechow et. al. include a extra variable to the second period of the Jones model, namely Accounts Receivable ((p.199): (? AR; ? REC), which results in the following regression:

The Modified Jones Model is quite similar to the original Jones Model. However like the Jones Model there are also limitations to the Modified Jones Model. Some limitations are also similar to the Jones Model. For instance a limitation of the Modified Jones Model is that it treats some discretionary accruals as nondiscretionary and some nondiscretionary accruals as discretionary (Bernard and Skinner, 1996). Because it is not possible to directly observe from an annual report whether an accrual exists of a discretionary or non-discretionary component, all discretionary accrual models, measure a discretionary component and a non-discretionary component. And since it is not possible to measure these components perfectly, there are some errors in the discretionary accrual models. Sometimes some gains and losses and other special items (i.e. lawsuits) are identified by the Jones Model as discretionary when in fact they are necessarily discretionary. This is an example of when components are identified by the Jones Model as discretionary when they are nondiscretionary. As said earlier the Jones Model also identifies items as nondiscretionary when they are discretionary. For example the Jones Model assumes that revenues are nondiscretionary. However Hoogendoorn ( 2004) describes that not all revenues are nondiscretionary, because management is able to position transactions in order to manage earnings. He describes that management is able to increase revenues when a profitable contract is completed just before the end of the financial year.

While reviewing previous studies it is evident that for determining earnings management the use of discretionary accruals is most commonly used as an estimation[5]. Therefore in this study, discretionary accruals will be used as a proxy for detecting earnings management. To test the hypotheses it is necessary to use a tool to detect these discretionary accruals before and after the introduction of the IFRS. Several competing models are used in previous studies; however for this study it is important to study event-years. In their paper Dechow et al. (1995) evaluate alternative accrual-based models for detecting earnings management. This evaluation involves comparisons of specification and power of commonly used test statistics across the measures of discretionary accruals, which are generated by the models. The models studied are Healy (1985); DeAngelo (1986); Jones (1991), the Modified Jones model and the industry model. The results of the paper of Dechow et al. (1995) imply that all the models considered, show to produce reasonably well-specified tests for a random sample of event-years. However the authors found that a modified version of the model developed by Jones (1991) provides the most powerful tests of earnings management.

Summary

The sub question of this chapter as described in paragraph 1.2 is :

What proxy is used to measure earnings management?

This chapter discusses two models namely: the Jones model and the Modified Jones Model. The Modified Jones Model is quite similar to the original Jones Model. However both models have their limitations. While reviewing previous studies it is evident that for determining earnings management the use of discretionary accruals is most commonly used as an estimation. Therefore in this study, discretionary accruals will be used as a proxy for detecting earnings management. The results of the paper of Dechow et al. (1995) imply that all the models considered, show to produce reasonably well-specified tests for a random sample of event-years. However the authors found that a modified version of the model developed by Jones (1991) provides the most powerful tests of earnings management. Therefore for this research the modified Jones model will be used for estimating the non-discretionary accruals. this will be done in the next chapter.

Chapter 6: Hypotheses development & Research Design

Introduction

Chapter 4 described empirical research that examines the effect on earnings management after the implementation of IFRS. The previous chapter discussed two proxies to measure earnings management and found that the modified jones model provides the most powerful tests of earnings management. This chapter provides an answer to the fifth sub question described in paragraph 1.2:

What is the method of the empirical part of this master thesis?

First of all in paragraph 6.2. and 6.2.1. the development of the hypotheses of this research is presented. Paragraph 6.3 describes the sample of this research. Paragraph 6.4 discusses the statistical methods that will be used to research the relation between the introduction of IFRS and the effect this had on the level of earnings management. Paragraph 6.4.1 provides the model variables that will be used for the statistical methods. Finally paragraph 6.5 provides a summary of this chapter.

Hypothesis 1

The main purpose of this paper is to examine whether the adoption of high quality standards is associated with high financial reporting quality, since the transition from Dutch GAAP to IFRS. For the first hypothesis it is important to state that under the International Accounting Standards Committee Foundation Constitution, one of the objectives of the IASB is "to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world's capital markets and other users make economic decisions". A higher accounting quality is associated with less earnings management, more timely loss recognition and higher value relevance (Barth et. al, 2008). If the level of earnings management is used as a measure of this financial reporting quality, it is questioned whether companies that have adopted IFRS engage significantly less in earnings management compared to companies reporting under domestic GAAP.

Therefore the first hypothesis is:

H1: Earnings Management will decrease in the Netherlands after the introduction of IFRS because IFRS is considered to be of higher quality compared to Dutch GAAP..

Expectations

Since there is not very much research done within this field in the Netherlands and most of the researches are first or incomplete drafts which give contradictory results. The predictions on this is that not much difference is expected in the level of earnings management within Dutch companies after the introduction of IFRS. According to Ding et al. (2007) there is no big difference between the Dutch GAAP and the IFRS. This indicates that the Dutch reporting requirements and practices are in many ways similar to the IAS. So this could suggest that there is less room for earnings management when reporting under Dutch GAAP. This would also imply that the transition from Dutch GAAP to IFRS would not significantly change the amount of earnings management practiced since there isn't a big difference in accounting standards when reporting under Dutch GAAP or IFRS.

Apart from the primary hypothesis one additional hypothesis dealing with the relation between earnings management and firm specific characteristics is investigated.

Hypothesis 2

Because of the transition from Dutch GAAP to IFRS it is expected that the amount of earnings management will decrease. This indicates a decrease in earnings smoothing. Firms with higher cash flows from operations are less risky (a lower probability of non-payment) resulting in the accomplishment of certain targets more easily on average (Aussenegg, 2008). This creates a lower need to smooth earnings within these firms, which results in managers having lower incentives to manage earnings. However when cash flows are extremely high, managers have incentives to smooth earnings in order to create a more stable risk profile. This could influence the amount of discretionary accruals whether or not IFRS is implemented. Therefore it is necessary to control for this effect.

Therefore the second hypothesis is:

H2: After the transition from Dutch GAAP to IFRS, firms use less "accruals" as an instrument for earnings smoothing which results in less earnings management even when controlling for operating cash flows.

Expectations

The expectations for this hypothesis are that after the implementation of IFRS firms with high cash flows use less accruals to smooth earnings. According to previous research Dechow et. al (1995) and McNichols (2000) firms with strangely high earnings have positive reactions to earnings that include an accrual component and firms with strangely low earnings have negative reactions to earnings that include an accrual component. So firms with high earnings tend to have high cash flows and firms with low earnings tend to have low cash flows.

Sample selection

The sample for this study will consist of data from listed companies in the Netherlands for the periods 2000 - 2003 and 2007; consequently before and after the introduction of the IFRS. This way a comparison can be made to determine if the introduction of the IFRS has an influence on the level of earnings management. The period 2000-2003 is chosen, because in later years (2004-2006) many companies already voluntarily adopted the IFRS and there are a lot of other factors like implementation issues which could also have an influence on earnings management in these periods, which is why these periods are excluded. The data that will be used should include information about the companies' accruals. The samples will be attained from the database of Thomson one Banker. This database consists of financial information of all Dutch listed companies. This data will be used to compute the relevant accruals. In the second appendix a list of these companies is provided. Companies that voluntarily adopted IFRS in the year 2000-2003 (before the year 2005) will be excluded from the sample selection. This is because Dutch law does not accept some IFRS standards. If companies that voluntarily adopt IFRS are included a distinction must be made between the standards that are applied according to IFRS and the standards that are applied according to Dutch GAAP, which makes detecting earnings management more difficult. All figures that will be included in the analysis are from companies that comply with IFRS as of January 1st, 2005 and that followed Dutch GAAP before this transition. Companies with missing data are also excluded from the sample, because for superior analysis it is better if all the required data is available. The final sample consists of 255 financial statements of Dutch listed companies in the Netherlands within three industries (Manufacturing, Wholesale trade and Services) relating to the period 2000-2003 and 2007. These three industries are chosen, because there is a required minimum per industry of 6 firms to make a regression analysis. The sample showed 28 firms in manufacturing, 14 in Services and 9 in Sales. For the other industries the number of firms was below 6, so these are also excluded from the sample. The final sample consists of 51 firms spread over these three industries. In the sample (just like in previous researches) financial institutions ( SIC 60-67) are excluded because financial institutions have specific accounting requirements, which are different than those of the industrial and commercial companies.

Data sources

As already mentioned in section 6.3, the Thomson One Banker Databases are used, in particular the Worldscope database, to obtain the data. In table 1, the variables are enumerated as mentioned in section 6.4 connecting them to de Worldscope database terms.

Statistical Methods

Subparagraph 6.3.1 displays the modified Jones model which helps to separate the discretionary accruals from the non-discretionary accruals, which are needed for the linear regression analysis. With these discretionary accruals, subparagraph 6.3.2 describes the linear regression analysis that enables this research to examine the effect of the implementation of IFRS on earnings management after controlling for several effects.

Separating Non-discretionary accruals from Discretionary accruals

A regression analysis will be used to determine if the level of discretionary accruals has increased as a result of the implementation of the IFRS. Therefore it is necessary to divide the total accruals into non-discretionary and discretionary accruals. To test the hypotheses it's necessary to use a tool to detect these discretionary accruals before and after the introduction of the IFRS.

Total accruals

As previously mentioned, the Modified Jones Model will be used to determine the discretionary accruals. This model attempts to separate the discretionary accruals from the non-discretionary accruals based on a regression analysis. A linear relationship is assumed between the non-discretionary accruals and the presumed explaining variables like: changes in debtors, sales and tangible assets. The discretionary accruals are equalized to the part of the total accruals that cannot be explained by the previous variables and are therefore generated from intentional modifications by management.

Modified Jones Model:

Linear regression

With help from a regression analysis, the first hypothesis can be tested.

1: Earnings Management will decrease in the Netherlands after the introduction of IFRS because IFRS is considered to be of higher quality compared to Dutch GAAP..

This will examine if there is a relation between the rate of occurrence of the discretionary accruals and the transition to IFRS. In this regression analysis exogenous variables are included, not only the IFRS will be included, but the industry and the size of the firm as well ( in order to control for size effects the variable lnassets is included in the regression formula).

Linear regression 2

With help from the second linear regression, hypothesis 2 can be tested:

H2: After the transition from Dutch GAAP to IFRS, firms use less "accruals" as an instrument for earnings smoothing which results in less earnings management even when controlling for operating cash flows.

The second hypothesis will examine if there is a relationship between the amount of cash flows and the level of earnings management. When cash flows are high it is assumed that there is less incentive for earnings management, which would give a decrease in discretionary accruals whether or not IFRS is implemented. Thus this hypothesis examines if the amount of operating cash flows significantly influences the level of earnings management.

This regression uses Total Accruals as the independent variable rather than discretionary accruals ( Van Tendeloo and Vanstraelen, 2005). Because the discretionary accruals are used as measure for earnings management. Now the correlation between accruals and operating cash flow are examined as a measure for earnings smoothing.

Model Variables

The independent variable of interest of this study is (1) whether the company has adopted IFRS or not (IFRS).

To examine if there is a correlation between accruals and operating cash flow (OPCF), the interaction variable 'IFRS*OPCF' is included (hypothesis 2).

As seen in earlier in this research, managers have different reasons to manage earnings. In order to control for these differences in incentives to practice earnings management the following variables are included:

First, to control for the size of the company, the natural logarithm of total assets (LNASSETS) is included.

According to the political costs hypothesis the potential government supervision increases as firms become larger and more profitable. This results in a higher probability that firms would prefer downward earnings management ( Watts and Zimmerman, 1990, Young, 1999).

The second control variable included is operating cash flow scaled by lagged total assets. Dechow et. al. (1995) and Young (1999) report negative non-discretionary accruals to occur in periods where cash flows are extremely positive and positive non-discretionary accruals in periods where cash flows are extremely negative. For the decrease/increase of reported income in the related period a part of the cash flows is attributed to the discretionary accruals. To control for this the cash flows from operations are included as a control variable in the third formula (5.9). Furthermore, to control for industry effects on earnings management industry dummies (INDUSTRY) are included. Finally a dummy variable (DumDutch) is included in order to control for the Dutch listed companies that used a different accounting standard than the Dutch GAAP ( U.S. GAAP or other international accounting standards) prior to the mandatory implementation of the IFRS.

Summary

The sub question of this chapter as described in paragraph 1.2 is :

What is the method of the empirical part of this master thesis?

In paragraph 6.2 the two hypothesis of this research are illustrated. The first hypothesis is : Earnings Management will decrease in the Netherlands after the introduction of IFRS because IFRS is considered to be of higher quality compared to Dutch GAAP. Because operating cash flow can also influence the level of earnings management, this has to be controlled for, therefore the second hypothesis described in this paragraph is : After the transition from Dutch GAAP to IFRS, firms use less "accruals" as an instrument for earnings smoothing which results in less earnings management even when controlling for operating cash flows. The expectation for the first hypothesis are that the transition from Dutch GAAP to IFRS would not change the amount of earnings management practiced since there isn't a big difference in accounting standards when reporting under Dutch GAAP or IFRS. The expectation for the second hypothesis is The expectations for this hypothesis are that after the implementation of IFRS firms with high cash flows use less accruals to smooth earnings. In paragraph 6.3 the final sample of this study is displayed. The final sample consists of 255 financial statements of Dutch listed companies in the Netherlands within three industries (Manufacturing, Wholesale trade and Services) relating to the period 2000-2003 and 2007. This way a comparison can be made to determine if the introduction of the IFRS has an influence on the level earnings management. The period 2000-2003 is chosen, because in later years (2004-2006) many companies already voluntarily adopted the IFRS and there are a lot of other factors like implementation issues which could also have an influence on earnings management in these periods, which is why these periods are excluded. After discussing the sample in paragraph 3, paragraph 6.4 describes the statistical method used for this research. First of all the modified jones model is used to estimate the amount of the non- discretionary accruals. Second the discretionary accruals are calculated by formula (5.7). After estimating the discretionary accruals, the first hypothesis is tested with help of a linear regression, followed by the second hypothesis which is also tested with help of a linear regression. Finally the model variables of this study are illustrated in the last subparagraph.

Chapter 7 : Results

Introduction

In the previous chapter the method of the empirical part of this paper is discussed. This chapter will examine the 6th sub question given in paragraph 1.2,

What is the association between the introduction of IFRS and the level of earnings management?

Paragraph 7.2 will discuss the descriptive statistics of this research. Paragraph 7.3 describes the results of the applied modified Jones model to determine the discretionary accruals. Paragraph 7.4 describes the results of this thesis after controlling for several differences in incentives for earnings management. Finally a summary of this chapter is given in paragraph 7.5.

Descriptive statistics ( Comparison before- and after the mandatory implementation of IFRS)

As already mentioned the final sample of this research contains 51 companies. This paragraph describes the descriptive statistics for this sample. The descriptive statistics are presented in table 2. When looking at table 2.1, it can be noticed that all earnings management metrics have a lower mean values in magnitude after the implementation of IFRS compared to the years before.This could indicate a decrease in discretionary accruals, which indicates a decrease in earnings management after the mandatory implementation of IFRS. Also the total accruals lagged by total assets has a negative value in both the years before IFRS and in 2007. when comparing the previous years with the year 2007 there is a decrease in the mean value of the total accruals. This could indicate stricter rules under IFRS compared to Dutch GAAP concerning total accruals.

F

urthermore when looking at table 2.2, it is noticeable that there is a decrease in the magnitude of the mean values of the absolute discretionary accruals, from the years before the implementation of the IFRS and after the mandatory implementation of the IFRS. This also indicates a decrease in earnings management. 7.3. Results of the discretionary accruals

First of all the indicators that estimate the discretionary accruals are approached with help from a regression analysis. The results of this regression are presented in table 3. This table shows a very low R Square of 0.038 The table also shows an F-value of 1.266. It is noticeable that for the dummy variable for companies that used other accounting standards then Dutch GAAP before the mandatory implementation of IFRS, the relation with the total accruals is significantly negative.

Regression results hypothesis 1

After the approach to calculate the non-discretionary accruals in the previous paragraph. The discretionary accruals ( Total accrual minus the non-discretionary accruals) can be analysed. First of all the first hypothesis is tested with help of the second regression formula. The results of this regression are presented in table 4. Even though the regression formula is significant ( F = 4,382; P= 0,000). The adjusted R Square is relatively low (adjusted R Square = 0,066). The results show that the implementation of the IFRS insignificantly negatively affect the amount of discretionary accruals. This shows that the mandatory implementation of IFRS has no effect on the level of earnings management. The t-value is negative as expected but the significance is very weak so there is no relation between the level of earnings management and the implementation of IRFS.

Regression results hypothesis 2

In the previous paragraph the first hypothesis is tested. The results showed that there is no significant relationship between the mandatory adoption of the IFRS and the level of earnings management. In this paragraph the second hypothesis will be tested with help from the third formula. The results are presented in table 5.

The results show an R Square that is negative. This means there is no indirect effect of operating cash flow on the total accruals during the year 2007 after the mandatory IFRS implementation. The negative insignificant effect in the previous paragraph is not influenced by the cash flows from operations. This means the amount of cash flows has no effect on the accruals after the implementation of IFRS. So After the transition from Dutch GAAP to IFRS, firms use less "accruals" as an instrument for earnings smoothing which results in less earnings management even when controlling for operating cash flows.

Summary

The sub question of this chapter as described in paragraph 1.2 is :

What is the association between the introduction of IFRS and the level of earnings management?

Paragraph 7.2 describes the descriptive statistics of this research. The results in the descriptive table show a decrease in earnings management when comparing companies before the mandatory adoption of the IFRS and after the mandatory adoption of IFRS. In paragraph 7.3 the results of the modified Jones model are discussed. The indicators that estimate the discretionary accruals are approached with help from a regression analysis. The results of this regression are presented in table 3. This table shows a very low R Square of 0.038 The table also shows an F-value of 1.266. Paragraph 7.4 show the results of the first hypothesis which also answer the sub question of this chapter. The results show that the implementation of the IFRS insignificantly negatively affect the amount of discretionary accruals. This shows that the mandatory implementation of IFRS has no effect on the level of earnings management. Finally the results of the second hypothesis are discussed in paragraph 7.5 show that there is no indirect effect of operating cash flow on the total accruals during the year 2007 after the mandatory IFRS implementation.

Chapter 8 : Summary and Conclusion

Summary

The previous chapter discussed the empirical results of this paper. This chapter will discuss the last sub question of this thesis:

What are the conclusions of this master thesis?

First of all the conclusions of this research are described in paragraph 8.2 and 8.3, paragraph 8.2 describes the theoretical part of this thesis and paragraph 8.3. describes the empirical part of this research. Finally the limitations of this study are discussed in paragraph 8.4

Theoretical part of the thesis

Chapter 1 illustrates the introduction of this research, chapter 2,3,4 and 5 concern the theoretical part of this thesis and chapter 6 and 7 concern the empirical part. The literature study is focused on the situation in the Netherlands, because the empirical research studies Dutch stock listed companies within the Netherlands. The literature study also focuses on the European situation, because most of the studies concerning the effect of earnings management due to the introduction of IFRS focused on countries within Europe.

Chapter 2 discusses the differences between the Dutch GAAP and the IFRS. Since January 1st, 2005, listed companies in the European Union are required to report their financial statements according to IFRS. The reason for developing these accounting standards by the International Accounting Standards Board (IASB) was to enforce a single set of high quality, understandable global standards to improve harmonization across member countries and for better functioning of the internal market (Gassen, 2006). After discussing the IFRS, the Dutch GAAP is examined. Dutch accounting is described as being more subjective and less rule - oriented. However results found by Ding et. Al 2007, that the Dutch reporting requirements and practices are in many ways similar to the IAS. This could signify that there is less room for earnings management when reporting under Dutch GAAP.

Chapter 3 discusses the meaning of earnings management. The definition used for earnings management in this study is the one by Healy and Wahlen (1999): "Earnings management occurs when management use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accountin gnumbers." Also the motives, strategies and methods are discussed. Managers have different motives to manipulate accounts. Furthermore it is said that these Motives, Methods and Strategies are all made possible by the existence of information asymmetry between management and stakeholders .

Chapter 4 discusses the effects of the introduction of IFRS on earnings management shown by prior empirical research. First of all the reasons for firms to voluntarily implement the IFRS are provided. The overall reason non-US firms select increasingly strict sets of accounting standards is when the expected benefits exceed the expected cost. Furthermore the effects of the change to IFRS on earnings management shown by prior empirical research is provided. The results shown in this paragraph are rather contradictory. Some studies say that earnings management decreases after the mandatory implementation of IFRS in the Netherlands however other studies state the exact opposite.

Chapter 5 discusses what proxy is used to measure earnings management. This chapter discusses two models namely: the Jones model and the Modified Jones Model. The Modified Jones Model is quite similar to the original Jones Model. However both models have their limitations. The results of the paper of Dechow et al. (1995) imply that all the models considered, show to produce reasonably well-specified tests for a random sample of event-years. However the authors found that a modified version of the model developed by Jones (1991) provides the most powerful tests of earnings management. Therefore for this research the modified Jones model is used for estimating the non-discretionary accruals.

Empirical part of the thesis

Chapter 6 and 7 describe the empirical part of this thesis. Chapter 6 describes the development of the hypotheses, the sample of this research, the statistical methods that will be used to research the relation between the introduction of IFRS and the effect this had on the level of earnings management and the model variables that will be used for the statistical method. Chapter 7 describes the descriptive statistics of this research, the results of the applied modified Jones model to determine the discretionary accruals and the results of this thesis after controlling for several differences in incentives for earnings management.

Chapter 6 first illustrates the two hypothesis of this research. The first hypothesis is : Earnings Management will decrease in the Netherlands after the introduction of IFRS because IFRS is considered to be of higher quality compared to Dutch GAAP. Because operating cash flow can also influence the level of earnings management, this has to be controlled for, therefore the second hypothesis described in this paragraph is : After the transition from Dutch GAAP to IFRS, firms use less "accruals" as an instrument for earnings smoothing which results in less earnings management even when controlling for operating cash flows. The expectation for the first hypothesis are that the transition from Dutch GAAP to IFRS would not change the amount of earnings management practiced since there isn't a big difference in accounting standards when reporting under Dutch GAAP or IFRS. The expectation for the second hypothesis is The expectations for this hypothesis are that after the implementation of IFRS firms with high cash flows use less accruals to smooth earnings. Furthermore the final sample of this study is displayed. The final sample consists of 255 financial statements of Dutch listed companies in the Netherlands within three industries (Manufacturing, Wholesale trade and Services) relating to the period 2000-2003 and 2007. This way a comparison can be made to determine if the introduction of the IFRS has an influence on the level earnings management. The period 2000-2003 is chosen, because in later years (2004-2006) many companies already voluntarily adopted the IFRS and there are a lot of other factors like implementation issues which could also have an influence on earnings management in these periods, which is why these periods are excluded. After discussing the sample the statistical method used for this research is described. First of all the modified Jones model is used to estimate the amount of the non- discretionary accruals. Second the discretionary accruals are calculated by formula (5.7). After estimating the discretionary accruals, the first hypothesis is tested with help of a linear regression, followed by the second hypothesis which is also tested with help of a linear regression. Finally the model variables of this study are illustrated.

Chapter 7 first describes the descriptive statistics of this research. The results in the descriptive table show a decrease in earnings management when comparing companies before the mandatory adoption of the IFRS and after the mandatory adoption of IFRS. Furthermore the results of the modified Jones model are discussed. The indicators that estimate the discretionary accruals are approached with help from a regression analysis. The results of this regression are presented in table 3. This table shows a very low R Square of 0.038 The table also shows an F-value of 1.266. With help from the first regression the results of the first hypothesis which also answer the sub question of this chapter are displayed. The results show that the implementation of the IFRS insignificantly negatively affect the amount of discretionary accruals. This shows that the mandatory implementation of IFRS has no effect on the level of earnings management. Finally the results of the second hypothesis are discussed and these show that there is no indirect effect of operating cash flow on the total accruals during the year 2007 after the mandatory IFRS implementation. These results are consistent with the expectations of the hypothesis.

Previous studies predicted that not much difference is expected in the level of earnings management within Dutch companies after the introduction of IFRS.

According to Ding et al. (2007) there is no big difference between the Dutch GAAP and the IFRS. The results of the research of Ding et al. (2007) indicate that in 2001 the absence score for Dutch companies is low, which means that there aren't many rules regarding certain accounting issues missing in Dutch GAAP that are covered in IAS and that companies are not likely to take advantage of the accounting discretion to manage earnings when the accounting regulation environment is not sophisticated. This indicates that the Dutch reporting requirements and practices are in many ways similar to the IAS. So this could suggest that there is less room for earnings management when reporting under Dutch GAAP. This would also imply that the transition from Dutch GAAP to IFRS would not significantly change the amount of earnings management practiced since there isn't a big difference in accounting standards when reporting under Dutch GAAP or IFRS.

When comparing the results of this thesis to previous studies, it can observed that the results are contradictory. The research done by Aussenegg et al. (2008) is partly similar to this research, because they also examine the impact of the transition to IFRS on earnings management. From their findings it can be concluded that earnings management is lower for companies who use IFRS/IAS compared to companies who use local GAAP. Whereas in this thesis it is found that the mandatory implementation of IFRS shows no effect on earnings management. However the sample of Aussenegg et al. (2008) includes observations from the period 1995-2005, so this only concerns firms before the mandatory adoption of IFRS. In contrast to this master thesis which looks at companies before the mandatory adoption of IFRS and after the mandatory adoption of IFRS to determine the change in the level of earnings management.

Another research done by Ferdy van Beest (2008) show that measured on the basis of accruals, the quality of the annual reports in the Netherlands, Germany and England have decreased after the introduction of the IFRS and that the level of earnings management has increased after the introduction of the IFRS. Next to the accounting standards as explanation for earnings management, the legal and financial system can also be of influence on the level of earnings management according to this study. However the author indicates that the results of the financial system for 2007 are not significant, so the results are based on chance. So this could explain why his study found these results.

Limitations

The previous paragraph described the conclusions for this master thesis. However there are several limitations to be considered when drawing conclusions based on the results of this research. A few limitations are mentioned in this paragraph

A limitation of this study is that the estimation of earnings management with discretionary accruals is only a extremely indirect approach to earnings management. It cannot be determined if it really was earnings management in all cases that influenced the discretionary accruals. And above all earnings management could also have been practiced in other ways rather than with discretionary accruals.

Furthermore another limitation of this research is the limited dataset. This because the mandatory adoption is rather recent and to control for implementation issues, the year 2007 is chosen, but for the years 2008 and 2009 very limited data was available. And for decent analysis a series of years is necessary.

Finally the years chosen before the mandatory adoption of IFRS are 4 years and after the mandatory adoption is chosen for 1 year. This could also have some interference in the results. Which could also cause the results to be less accurate.

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