The Effect of IAS/IFRS Adoption on Earnings Management (Smoothing): A Closer Look at Competing Explanations

Prior research provides mixed evidence on whether the transition to IAS/IFRS deters or contributes to greater earnings management (earnings smoothing). The dominant explanation for the conflicting results is self-selection. Early voluntary adopters had incentives to increase the transparency of their reporting in order to attract outside capital, and, therefore, earnings management (smoothing) went down after adoption, while those firms that waited until IFRS adoption became mandatory in EU countries lacked incentives for transparent reporting leading to increases in earnings management (smoothing) after IFRS adoption. We argue that IAS/IFRS standards changed substantially from the early voluntary adoption period to the mandatory adoption year (2005). Compared to earlier IAS/IFRS standards and many countries’ domestic GAAP standards, we maintain that the IFRS standards that went into effect in 2005 provide greater flexibility of accounting choices because of vague criteria, overt and covert options, and subjective estimates that are allowed under these principle-based standards. We argue that this greater flexibility coupled with the lack of clear guidance on how to implement these new standards has led to greater earnings management (smoothing). Consistent with this view, we find an increase in earnings management (smoothing) from pre-2005 to post-2005 for Early Adopters and Late Adopters in countries that allowed early IAS/IFRS adoption, and for Mandatory Adopters in countries that did not allow early IFRS adoption. Our major findings hold after eliminating firms more likely to have mechanically-induced increases in earnings smoothing properties as a result of IFRS adoption and across countries with and without concurrent improvements in enforcement of accounting standards. We also find that firms from countries with less (more) local GAAP flexibility exhibit greater (less) evidence of increases in earnings smoothing following mandatory adoption of IFRS standards in 2005. Collectively, our results suggest that the increased flexibility of new IAS/IFRS standards and lack of clear guidance in implementing these standards are major factors that explain earnings management (smoothing) changes around IFRS adoption.