Setting the Bar: Earnings Management During a Change in Accounting Standards

Abstract

This paper examines the impact of the accounting flexibility offered by IFRS 1 during the 2005 mandatory adoption of IFRS in the European Union. Same year reconciliations between local GAAP and IFRS are used on a sample of 1,635 European firms to determine the nature and extent of their use in managing earnings and earnings changes under IFRS. We posit and find that firms with negative Local GAAP earnings were more likely to report positive Local GAAP-to-IFRS earnings reconciliations, while firms with large positive earnings under Local GAAP were more likely to report negative Local GAAP-to-IFRS earnings reconciliations. Subsequently, in reporting periods following the adoption of IFRS, firms that reported positive (negative) reconciliations were more likely to show a decrease (an increase) in earnings. Finally, while we find no evidence of stock markets reacting to earnings management during the IFRS transition, we find strong evidence in support of CEOs managing earnings reconciliations to increase their compensation.

Keywords: IFRS, Earnings Quality, Earnings Management, Compensation