The Effect of IFRS and its Enforcement on Earnings Management:

An International Comparison

Lei Cai
Asheq Rahman
Stephen Courtenay

School of Accountancy
Massey University
New Zealand

Version: December 2008

Comments welcome

This paper has benefited from presentations at Massey University and the comments and
suggestions of Paul Dunmore, Jill Hooks, Michael Bradbury, Natasja Steenkamp, Nicholas
Smith, Helen Bishop, and Warwick Stent.

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Abstract

Widespread adoption of International Financial Reporting Standards (IFRS) is expected to

improve accounting quality. IFRS is issued by the International Accounting Standards Board
(IASB), but the IASB has no power to enforce the standards. Many are concerned that
without adequate enforcement mechanisms, the benefits of IFRS adoption will be minimal.
We examine the effect of IFRS and its enforcement on earnings management in financial
reporting using over 100,000 firm-year observations from 2000 to 2006 across 32 countries.
We conduct this examination by using a modified measure of enforcement developed by
Hope (2003). We find that earnings management in IFRS adoption countries has been
decreasing in recent years. The results also show that countries with stronger enforcement
generally have less earnings management.

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1. Introduction

Since 2005, many countries have begun mandatory adoption of International Financial
Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
One aim of IASB is to improve the transparency and comparability of financial reporting
across countries. Comprising a set of high quality financial reporting standards, IFRS
removes many allowable accounting alternatives, and is expected to limit the managements’
discretion to manipulate earnings, thereby improving earnings quality. However, some
research (Pope & Walker, 1999; Ball et al., 2000; Leuz et al., 2003; Soderstrom & Sun, 2007)
is sceptical about the benefits of global accounting harmonisation. Their view is that although
IASB issues IFRS, it has no enforcement power for its standards in practice. While some
countries have mandated the adoption of IFRS, others are yet to follow suit. Moreover,
enforcement mechanisms vary across countries. Without adequate and uniform enforcement,
it may expose IFRS to the risk of adoption in name only.

The purpose of this study is to examine the effect of IFRS adoption and its enforcement on
earnings management. As country-specific institutions beyond accounting standards affect the
characteristics of financial reporting, the topic of IFRS enforcement becomes important. But
previous studies were unable to obtain data for large-sample tests on the effect of IFRS
enforcement. Since mandatory IFRS adoption is becoming fairly common, it is now possible
to conduct empirical tests on how enforcement plays a crucial role towards the effective
implementation of IFRS.

Using a sample on over 100,000 firm-year observations from 32 countries from 2000 to 2006,
we extend the work of Leuz et al. (2003) through modifying Hope’s (2003) comprehensive
measure of enforcement. Our tests show that earnings management in IFRS adopting
countries has been decreasing in recent years. We also find that countries with stronger
standards enforcement generally have less earnings management. The results suggest that
besides accounting standards there are other factors that are also relevant to accounting
quality, and perhaps, it will take longer for IFRS to have a strong impact on financial
reporting. These findings are consistent with the argument that cross-country differences in
accounting quality are likely to remain after IFRS adoption until all institutional differences
are removed. It is important to note that firm reporting incentives are shaped by the
institutional environments of countries (Soderstrom & Sun, 2007).

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A major contribution of this study is that it provides evidence on how IFRS and its
enforcement link with other institutional factors to contribute to earnings quality. The results
demonstrate the importance of IFRS enforcement on the quality of financial reporting to
standard setters, policy makers, and market investors in many countries.

The rest of the paper is organized as follows. The next section begins with a conceptual
framework providing the determinants of accounting quality. Then, the hypothesis is
developed based on this conceptual framework. Section 3 outlines the research design.
Section 4 describes the measures for dependent, independent, and control variables. Section 5
states the sample selection. Section 6 presents the descriptive statistics and empirical analysis.
Finally, the conclusion and the limitations of this study are drawn in section 7.

2. Conceptual framework and hypothesis development

Soderstrom and Sun (2007) provide a schematic framework (see Figure 1) depicting
determinants of accounting quality. They argue that accounting quality after IFRS adoption
hinges on three factors: 1) the quality of the accounting standards; 2) a country’s legal and
political system; and 3) financial reporting incentives from financial market development,
capital structure, ownership structure, and tax system. However, as all these variables may
link and interact with each other, they are difficult to model. Another methodological concern
is the problem of omitted variables, since some other unobserved factors may also affect the
quality of earnings.

[Insert Figure1 here]

According to this framework, improvement of accounting quality rests on at least two factors:
high quality accounting standards and a country’s overall institutional system.

First, the improvement of accounting quality is based upon the premise that IFRS itself is a
set of high quality reporting standards (arrow 1 in Figure 1). Adopting a common set of
accounting standards improves earnings quality through the ease of monitoring and
comparison of financial reports across borders, which puts pressure on management to report
faithfully and truthfully and engage in less earnings management activities (Soderstrom &
Sun, 2007). Consistent with this view, Ewert and Wagenhofer (2005) find that tightening
accounting standards reduces earnings management and improves reporting quality. Similarly,

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Barth et al. (2008) find that firms adopting IFRS have less earnings management, more
timely loss recognition, and more value relevance of earnings, all of which they interpret as
evidence of higher accounting quality. Daske and Gebhardt (2006) also show that disclosure
quality, as perceived by experts, has increased significantly under IFRS.

In contrast, opponents argue that adopting IFRS itself may not improve accounting quality.
For example, Lin and Paananen (2006) examine changes in the patterns of earnings
management activities over time, and suggest that IASB has not been effective in decreasing
overall earnings management activities.

Besides accounting standards, accounting quality is also determined by a country’s overall

institutional system and firms’ incentives for financial reporting (Ball et al., 2000; Ball et al.,
2003). Leuz et al. (2003) perform a cluster analysis using La Porta et al. (1998)’s nine
institutional variables to examine the systematic difference in earnings management across 31
countries. They report less earnings management in countries with stronger investor
protection, since strong protection limits insiders’ ability to acquire private control benefits,
and reduces their incentives to mask firm performance. Similarly, Burgstahler et al. (2007)
examine the relation between earnings management and the interaction among ownership
structure, capital market structure and development, tax system, accounting standards, and
investor protection. They document that strong legal systems are associated with less earning
management. Ding et al. (2007) examine how a country’s legal system, economic
development, the importance of stock markets, and ownership concentration shape the
country’s accounting standards, which in turn affect the country’s quality of financial
reporting. Soderstrom and Sun (2007) argue that cross-country differences in accounting
quality are likely to remain following IFRS adoption, because accounting quality is a function
of the firm’s overall institutional setting. Although conversion to IFRS is likely to improve
earnings quality, it is only one of the determinants. Even after mandatory IFRS adoption,
these country-level institutional variables continue to vary across countries.

In recent years, many researchers argue that the enforcement of accounting standards is as
important as the accounting standards (e.g. Sunder, 1997). Strong IFRS enforcement puts
great pressure on management and auditors to act faithfully and truthfully to comply with the
standards, and contributes to comparability of financial statements across countries (FEE,
2002, 29). Ball et al. (2003) question the quality of financial statements prepared under IFRS,
particularly in the presence of weak enforcement mechanisms. Holthausen (2003) predicts

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that adopting IAS 1 by countries with weak enforcement mechanisms will likely lead to
damaging the perceived quality of the standards, and suggests that it would be useful for the
literature to begin to structure and quantify the country descriptions by developing more
informative tests. Leuz et al. (2003) do not directly study the effect of accounting standards
enforcement, but infer that countries with strong outsider protection are expected to enact and
enforce accounting and securities laws that limit the manipulation of accounting information.
Hope (2003) constructs a comprehensive measure of accounting standards enforcement and
finds that strong enforcement encourages or forces managers to follow the rules. Based on
these arguments, we expect strong enforcement will reduce earnings management. Thus, we
hypothesize:

H: Earnings management is negatively associated with IFRS enforcement.

3. Research design

To understand the effects of global harmonization in accounting standards on earnings

management, several steps are taken. Firstly, we use charts to plot the changes in patterns of
earnings management activities over the sample period to examine the effect of IFRS
adoption on earnings management. Next, we test the mean difference in earnings
management between groups of adoption countries and non-adoption countries, using the U.S.
as a benchmark. Lastly, different to previous studies that use Ordinary Least Squares on
time-series data for the cross-country comparison, we undertake Autoregressions 2 to examine
the impact of IFRS adoption and its enforcement on earnings management. We also control
for other institutional variables.

4. Variables and measurement 3

4.1 Dependent variable: earnings management

Following Burgstahler et al. (2007), we use earnings management as the dependent variable
to represent accounting quality that is particularly responsive to reporting incentives.

1
IAS was issued by the International Accounting Standards Committee (IASC) which became IASB in 2001.
IASB revised IAS and adopted IFRS. In this paper, the terms of IFRS and IAS are interchangeable.
2
As the data are collected over sequential periods of time, the presence of autocorrelated residuals violates the
assumption of linear regression. The autoregression is an extension of ordinary least squares regression analysis,
specifically designed for time series. It accounts for first-order autocorrelated residuals and provides reliable
estimates of both goodness-of-fit measures and significance levels of chosen predictor variables.
3
Table 1 summarizes the measures for dependent, independent and control variables used in this paper.

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Earnings management is defined as “the managers use their judgement 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 & Wahlen, 1999, 371). The
distortion of firm’s financial reporting masks the true performance and may mislead the users.
Lower (higher) earnings management indicates higher (lower) quality of financial reporting.

Leuz et al. (2003) develop four country-level measures of earnings management to capture
various dimensions along which insiders exercise the discretion to manipulate earnings,
namely, 1) accruals, 2) the correlation between changes in accounting accruals and operating
cash flows, 3) the magnitude of accruals, and 4) small loss avoidance. The first two capture
the degree of smoothing, while the other two measure the discretion in reported earnings.
Initially, we compute all these measures in our sample. We find that the second and fourth
measures are not suitable for our study, because one year’s change in accruals may relate to
changes in operating cash flows in several subsequent years (for the second measure), and the
small loss avoidance (the fourth measure) cannot be used for a country in a given year that
has a small number of firms in the sample. They only suit the analysis when pooling the
firm-level data in a relatively long time period, and with a large sample size. We employ only
the first and third measures: accounting accruals and magnitude of accruals. They are
sufficient to capture the two dimensions of earnings management discussed below. The result
is consistent with Leuz et al. (2003) 4 .

1) Smoothing measure: accruals

Earnings smoothing is defined as “an attempt on the part of the firm’s management to reduce
abnormal variations in earnings to the extent allowed under sound accounting and
management principles” (Beidleman, 1973, 653). To capture the degree of earnings
smoothing, the first earnings management measure (EM1) in Formula 1 is a country’s median
ratio 5 of the firm-level standard deviation of operating earnings divided by the firm-level
standard deviation of cash flow from operations. The scaling by cash flow from operations
controls for differences in the variability of economic performance across firms. A low value

4
We test the correlation between the aggregate earnings management score calculated by Leuz et al. (2003)’s
four measures and the aggregate score based on our two measures, and find a positive Spearman’s correlation
(=0.676, p<0.01).
5
We use the median ratio to allow for direct firm size comparisons across countries, and to avoid extreme
values.

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indicates that management exercises accounting discretion to smooth reported earnings.

EM1 = Median (StdDev (Operating Income) / StdDev (Cash Flow from Operations)) (1)

Cash flow from operations is computed by subtracting the accruals from operating income
because information of firms’ cash flows is not always available in some countries, as in (2):

Cash Flow from Operations = Operating Income – Accruals (2)

Following Dechow et al. (1995) accruals are calculated as in (3):

Accrualsiititt= (ΔCAiititt– ΔCashit) – (ΔCLiititt- ΔSTDiititt- ΔTPit) – Depiititt (3)

Where:

ΔCAiittit= change in total current assets,

ΔCashiititt= change in cash / cash equivalents;

ΔCLiititt= change in total current liabilities,

ΔSTDiittit= change in short-term debt included in current liabilities,

ΔTPiititt= change in income taxes payable, &

Depiititt= depreciation and amortization expense, for firm i in year t.

2) Discretion measure: the magnitude of accruals

The second earnings management measure (EM2) captures the magnitude of accruals. It is
used as a proxy for management discretion in reported earnings. It is computed as a country’s
median ratio of the absolute value of firms’ accruals divided by the absolute value of firms’
cash flows from operations in a fiscal year (see Formula 4). A larger value is interpreted as
higher earnings management.

EM2 = Median (|Accruals|/|Cash Flow from Operations|) (4)

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Finally, to reduce measurement error, we combine EM1 and EM2 into an aggregate earnings
management measure (EM12) 6 (see Formula 5). High values of EM12 suggest high levels of
earnings management.

EM12 = (- 1) * EM1 + EM2 (5)

We reverse the direction of EM1 by multiplying it by -1, because the lower it is the higher is
the earnings management.

[Insert Table 1 here]

4.2 Independent variables: IFRS Enforcement

Ball et al. (2003) and Soderstrom and Sun (2007) argue that accounting standards alone do
not determine the quality of financial reporting. Country-level enforcement factor is likely to
have a powerful influence on earnings management, especially after mandatory IFRS
adoption. However, the enforcement of accounting standards is very difficult to measure and
quantify, as it takes different forms in different countries. To develop a good measure of
enforcement, we start from the following definitions:

“Enforcement” is defined by the European Federation of Accountants (FEE) as “a system to

whenever possible prevent, and hereafter identify and correct, material errors or omissions in
the application of IFRS in financial information and other regulatory statement issued to the
public” (FEE, 2002, 31). The Committee of European Securities Regulators (CESR) defines
“enforcement” as “the combination of supervision and sanctioning in cases of
non-compliance with the rules”.

An overall enforcement system for accounting standards has two sides: internal and external.
On the internal side within the adoption firms, IFRS is enforced by accountants through
preparing the financial reports, internal auditors through internal audits, and audit
committee/board/AGM through corporate governance. On the external side, IFRS is enforced
by external auditors, national IFRS enforcement bodies, financial market regulators and the
press. An efficient and effective enforcement has six aspects: 1) Self-enforcement through the
preparation of financial statements; 2) Statutory audit of financial statements; 3) Approval of

6
This aggregate measure is positively and significantly correlated with the component extracted from principal
component analysis of EM1 and EM2 (not tabulated).

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financial statements; 4) Institutional oversight system; 5) Court: sanctions/complaints; and 6)

Public and Press reactions (FEE, 2001, 8). FEE (2001) provides that large differences in legal
environments can be used to explain part of the differences in enforcement mechanisms,
which relate to the institutional oversight systems. Further, FEE (2001) observes that the
enforcement of accounting standards differs significantly across countries, even nonexistent
in some countries.

The above statements indicate that the country-level measure of enforcement can be based on
legal factors and the institutional oversight system. To capture these factors, we modify
Hope’s (2003) comprehensive measure of enforcement 7 , by aggregating four country-level
factors: 1) insider trading law, 2) judicial efficiency, 3) rule of law, and 4) shareholder
protection. This aggregate measure assigns equal weights to each variable. It is consistent
with the result obtained from factor analysis if one score is extracted.

The first element of enforcement, insider trading laws, may deter insiders from manipulating
earnings to profit from trading in the firm’s stock (Hope, 2003). Beneish and Vargus (2002)
provide evidence that insider trading is associated with earnings management. Aboody et al.
(2005) find that privately informed traders earn greater profits when trading stocks with high
earnings quality risk factors. In our study, we use the aggregate insider trading law index
developed by Beny (2005), which equals the sum of (1) tipping, (2) tippee, (3) damages, and
(4) criminal or the sum of scope and sanction. It ranges from 0 to 4, with 0 indicating the
least restrictive insider trading legal regime and 4 indicating the most restrictive insider
trading legal regime.

The second and third elements, judicial efficiency and rule of law, are sourced from La Porta
et al. (1998). Judicial efficiency indicates the efficiency and integrity of the legal environment
as it affects business, while rule of law assesses a country’s law and order tradition (La Porta
et al., 1998). As explained by Hope (2003), although a country’s judicial system might be
functioning well without enforcement of accounting standards, generally standards
enforcement is strongly associated with a strong judicial system, and only in countries with
strict rules of law, accounting regulations tend to be effective. Both judicial efficiency and
rule of law range from 0 to 10, with lower scores for less efficiency and less tradition for law
7
We exclude audit spending in Hope’s (2003) measure mainly based on 2 reasons. First, Hope (2003, 242)
realizes that audit spending is not a perfect measure of the audit quality, as it covers only the top 10 audit firms.
Second, although audit spending contributes to part of the country-level enforcement, whether including it or not
does not affect the result of analysis.

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and order.

The inclusion of the above legal variables8 is consistent with Schipper’s (2005) argument that
enforcement power resides in the security exchanges and courts where firms are listed.
However, because the security exchanges in most IFRS adoption countries require audit
reports to state compliance with IFRS or have similar requirements such as compliance with
“ IFRS as adopted by EU”, “NZ FRS”, or “Hong Kong FRS” (Deloitte’s IAS Plus Website,
2008), we do not code this basic requirement into the measure of a country’s IFRS
enforcement mechanisms.

Finally, Hung (2001), Ball et al. (2000), and Leuz et al. (2003) infer that countries with strong
outsider protection are expected to enact and enforce accounting rules and securities laws that
limit earnings manipulation. Thus, in weak shareholder protection environments, managers
are more likely to violate accounting standards to manipulate earnings. Hence, the fourth
element, shareholder protection used in this paper is the same measure as La Porta et al.
(1998)’s anti-director rights index. It is an aggregate measure of minority shareholder rights,
ranging from 0 to 6, where 0 indicates the weakest investor protection and 6 indicates the
strongest investor protection.

4.3 Control variables

To isolate the relationship between earnings management, IFRS adoption and enforcement
mechanism, we control for other country-level institutional factors provided in the schematic
framework of Soderstrom and Sun (2007). These factors also affect the quality of financial
reporting.

4.3.1 IFRS

To measure the extent of IFRS adoption, we use Bae et al’s (2008) 9 summary score of
difference between local GAAP and IFRS (GAAPDiff) to indicate how each country’s local
accounting standards differ from IAS. This measure ranges from 0 to 21, with higher values
for more discrepancies between each country’s local GAAP and IFRS.
8
They represent the legal and political system factors in the schematic framework of Soderstrom and Sun
(2007). Even though accounting enforcement is conceptually different to legal enforcement, they are strongly
connected.
9
Bae et al. (2008) develop two measures of differences in accounting standards for 1,176 country pairs based
on an international survey of generally accepted accounting principles in 2001. We use their first measure that
involves identifying a list of 21 important accounting rules.

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We create two indicator variables to control for IFRS adoption on earnings management. First,
‘Voluntary IFRS adoption’ takes the value of 1 for a given country in fiscal years ending on
or after the announcement date of mandatory IFRS reporting, but before the date of
mandatory IFRS adoption, and 0 otherwise. Second, ‘Mandatory IFRS adoption’ takes the
value of 1 for a given country in years ending on or after the mandatory IFRS adoption date,
and 0 otherwise (see Table 4 Panel A for the announcement and adoption dates).

4.3.2 Financial market development

We control for financial market development, because the demand for financial information
from market participants may provide incentives for firms to improve the quality of financial
reporting. Many (Leuz et al., 2003; Burgstahler et al., 2007; Djankov et al., 2008) find that
firms in countries with large and highly developed equity markets engage in less earnings
management, as financial markets can screen out firms with less informative earnings.

We use four alternative indicators of financial market development. The first is the logarithm
of annual GDP per capita in 2004 US$, because La Porta et al. (1999) find that economic
development is generally associated with greater financial market development and better
institutions and law enforcement capabilities. The second is the annual growth of GDP per
capita, and the third is market liquidity, because Levine and Zervos (1998) and Atje and
Jovanovic (1993) find that market liquidity is positively associated with economic growth,
and Huddart et al. (1999) find that high liquidity lowers the costs of capital, in turn motivates
firms to make earnings more informative. The fourth variable is the ratio of stock market
capitalization to GDP. Shleifer and Wolfenzon (2002) argue that public firms tend to be larger,
and more prevalent in countries with better shareholder protection. Given that all these
indicators represent the same variable, the degree of a country’s financial market
development, they cannot be used in the same regression as they will cause multicollinearity
problems.

4.3.3 Ownership Structure

We control for ownership structure by using ownership concentration in La Porta et al. (1998).
Firms in countries with concentrated ownership have less demand for financial reporting and
more earnings management. Soderstrom and Sun (2007) provide that controlling shareholders
have incentives to smooth earnings, as they not only have access to firms’ information but

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also have incentives to hide their exploitation of the wealth of minority shareholders. Both
theory (Shleifer & Wolfenzon, 2002) and prior evidence (La Porta et al., 1998; La Porta et al.,
1999; etc.) show that ownership concentration is lower in countries with better investor
protection. Leuz et al. (2003) find that firms in countries with relatively dispersed ownership,
strong investor protection and large stock markets exhibit lower levels of earnings
management than insider countries with relatively concentrated ownership, weak investor
protection, and less developed stock markets.

4.3.4 Capital structure

There are two ways that the capital structure can affect the level of earnings management.
First, an important incentive for earnings management is to reduce the likelihood of violating
debt covenants (Healy & Wahlen, 1999). In theory, when firms have more debt, managements
have more incentives not to breach the covenants by engaging in earnings manipulation
(Watts & Zimmerman, 1978). Soderstrom and Sun (2007) argue that banks demand less
financial reporting than do shareholders because banks have private access to firm
management. Ali and Hwang (2000) find that price leads earnings more in bank-based
economies than in market-based economies, which in turn lowers accounting quality in bank
financed firms.

In contrast, a counter argument shows that firms in countries with more public debt or bank
debt tend to have less earnings management, because creditors such as banks have more
monitoring power in countries with high creditor protection.

We use a country’s median ratio of total long-term debt and total assets (LT Debt / TA) as the
proxy of the capital structure10 , where total long-term debt in the Global Vantage database
represents all interest-bearing obligations due after the current operating cycle.

4.3.5 Tax system

We control for the effect from taxation on earnings management, since prior studies find that
firms in countries with high tax-book conformity and high tax rates have more earnings
management (Ali & Hwang, 2000; Guenther & Young, 2000; Burgstahler et al., 2007). First,
firms have strong incentives to manipulate earnings in countries with a close link between tax

10
Bank debt is not available in the Global Vantage database.

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and financial accounting rules. We use Hung’s (2001) tax-book conformity to represent the
extent to which a country’s financial accounting standards depart from tax rules. A value of 1
means there is substantial divergence between financial reporting and tax rules, and 0
otherwise. Second, high tax rates increase the incentive to reduce taxable earnings and hide
profits in financial reporting (Soderstrom & Sun, 2007). Since the actual tax rates are not
easy to compare across countries, we use a country’s median ratio of total income taxes to
total assets (Total taxes / TA) obtained from Global Vantage database to reflect the tax burden
of the country.

5. Sample selection

The sample is obtained from the Global Vantage: Industrial Research, Industrial Research
Issue, Industrial Active, and Industrial Active Issue datasets. Following previous research
(Leuz et al. 2003; Lin & Paananen, 2006), we exclude financial service firms such as banks
and financial institutions because it is difficult and problematic to compute discretionary
accruals. We also exclude utility companies because, as they are regulated, they have
different incentives to manage earnings from companies in unregulated industries. To ensure
sufficient observations in any given country and year for computing EM1 and EM2, each
country must have at least 30 firm observations in each year. We also exclude firm-year
observations with missing financial data that is necessary for computing EM1 and EM2. For
example, EM1 requires calculation of the standard deviation of operating earnings and
standard deviation of cash flow. It means each firm must have income statement and balance
sheet information for at least 5 consecutive years. We obtain data from 1996 for computing
the consecutive 5 years standard deviations of EM1 in year 2000. Finally, for extending the
work of Leuz et al. (2003), the sample period for the analyses was taken from 2000 to 2006 11 .

This paper should only be viewed as providing preliminary evidence, since only 2 years data
are included after mandatory adoption of IFRS in 2005. A limitation here is that the effect of
IFRS adoption may not appear entirely in such a relatively short time period.

Table 2 shows the sample distribution by country and fiscal year. The final sample consists of
102,636 firm-year observations, across 32 countries for the fiscal years 2000 - 2006.

11
The sample period of Leuz et al. (2003) study is from 1990 to 1999. Data in the Global Vantage database are
only available up to 2006 for most countries at the time of this study.

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[Insert Table 2 here]

6. Descriptive statistics and empirical analysis

6.1 Descriptive statistics for earnings management

Table 3 provides descriptive statistics for the two individual earnings management measures
in Panel A and Panel B respectively, as well as their aggregate measure in Panel C. The
countries are grouped into mandatory IFRS adoption countries and non-adoption countries,
according to whether they switched to IFRS in 2005. The U.S. is used as a benchmark and is
not included in either group. While the U.S. is yet to adopt IFRS, prior studies have found
high quality earnings due to high quality accounting standards and strong regulatory
arrangements. The signs in the heading of the panels indicate (+) for more earnings
management and (-) for less earnings management.

[Insert Table 3 here]

Moving to Panel D of Table 3, EM1 and EM2 are correlated with a spearman correlation
coefficient of -0.41 at a highly significance level (p < 0.01), suggesting that EM1 and EM2
capture somewhat distinct aspects of earnings management.

Figure 2 shows the general trends of aggregated earnings management through three charts.
Chart 1 for IFRS adoption countries shows a pattern of decreasing earnings management in
most IFRS adoption countries. However, the sudden increase in 2005 might be due to
changes in accounting figures resulting from the change in accounting standards, rather than
real increase in earnings management. In the adoption group, the levels of earnings
management still vary largely across countries, even after mandatory adoption in 2005.
Australia, Sweden, and South Africa have the lowest earnings management, while Portugal,
Philippines, and Italy have the highest in 2006. In Chart 2 there are no particular patterns in
non-adoption countries, suggesting that adoption of IFRS does reduce earnings management.
In the non-adoption group, United States, Canada, and New Zealand have the lowest earnings
management, while Taiwan, Indonesia, and Malaysia have the highest. This is inconsistent
with the evidence in Brown and Higgins (2001) that U.S. firms are more likely to engage in
income smoothing.

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Chart 3 provides a comparison of the average earnings management between the two groups
using U.S. as a benchmark. It shows that earnings management begins to decrease in 2002 for
IFRS adoption group, because most counties began their voluntary adoptions at that time.
However, the mean difference between the two groups is not obvious. Also, we note that the
average earnings management of the non-adoption group is even lower than the adoption
group. A possible explanation is that some countries in the adoption group had high levels of
earnings management before switching to IFRS, and reduced it through the adoption of IFRS.
Additionally, a selection bias may exist in this study, because there are only 10 non-adoption
countries in this study, which may not be representative of the population of non-adoption
countries.

[Insert Figure 2 here]

6.2 Institutional characteristics

Table 4 presents the country-by-country data for institutional variables used in this study. In
Panel A, the aggregate earnings management pooled over 1990-1999 (EM90-99) is drawn
from Leuz et al. (2003) and recalculated based on the two measures used in our study.
EM00-06 is the median of aggregate earnings management pooled over 2000-2006 for each
given country. EM05-06 is the median of aggregate earnings management pooled over 2005
and 2006 to represent the effect of mandatory IFRS adoption. Consistent with the earnings
management score for years 1990-1999 (EM90-99) from Leuz et al. (2003), earnings
management for years 2000-2006 (EM00-06) and its subsample (EM0506) for year 2005 and
2006 show that countries such as United States, Australia, Sweden, and Canada have the
lowest scores, while Portugal, Austria, and Philippines have the highest. The accounting
standards difference index shows that, Singapore, South Africa and Untied Kingdom have the
smallest scores, while Greece, Spain, Finland and Portugal have the largest difference. The
official IFRS announcement and adoption dates are used for coding the IFRS indicator
variables (also see Table 1).

Panel B provides details of the factors included in the enforcement measure and the mean
adjusted enforcement. Consistent with Hope’s (2003) measure, countries such as United
States, Canada, New Zealand, Australia and United Kingdom have the highest enforcement
scores, while Indonesia, Philippines, Pakistan, and Thailand have the lowest. The mean
adjusted enforcement is used to interact with the indicator variables of IFRS adoption for the

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 16

regression tests later.

Panel C shows the data for other control variables. First, for the financial market development
measures 12 , Hong Kong, Switzerland, South African and United States have the largest stock
market capitalization and market liquidity ratios, while New Zealand, Indonesia, and Pakistan
have the lowest. Second, for the ownership structure, United States, Taiwan, and United
Kingdom show the smallest ownership concentration, while Greece, Belgium, and Indonesia
have the largest ownership concentration. Third, for capital structure, United States, South
Africa, and Netherlands have the lowest median ratio of long-term debt to total assets pooled
over 2000-2006 13 , while Singapore, Austria, and Pakistan have the largest. Lastly, United
States, United Kingdom, and Canada have the lowest median ratio of total taxes to total
assets pooled over 2000-2006, while Sweden, Singapore have the largest.

[Insert Table 4 here]

6.3 Bivariate correlations

Table 5 reports the Spearman correlation coefficients between pooled aggregate earnings
management and various institutional variables. The proxy for accounting standards is
positively correlated with earnings management (0.466) at a highly significant level (p <
0.01), suggesting that the quality of accounting standards is useful to improve accounting
quality. Consistent with H1, enforcement is negatively correlated with earnings management
(-0.554) at a highly significant level (p < 0.01). Of the control variables, earnings
management has significant correlation with stock market capitalization 14 , ownership
concentration, and tax-book conformity, Although the correlations between earnings
management and both pooled median ratio of long-term debt to total assets and pooled
median ratio of total taxes to total assets are not significant in the bivariate correlations, their
annual measures are reported at highly significant levels in the Autoregressions. Stock market
capitalization is negatively correlated with earnings management (-0.381, p < 0.05),
ownership concentration is positively correlated with earnings management (0.592, p < 0.01),
and tax-book conformity is also positively correlated with earnings management (0.477, p <

12
The annual data for Log of GDP and GDP growth are not reported here, but used as alternative measures in
the autogressions.
13
In this section, we use the median ratio of long-term debt to total assets, and the median ratio of total taxes to
total assets pooled over the sample period. In the Autoregressions, we use the annual data for these variables.
14
Other financial market development measures (provided in Table 1) are not significant (not tabulated).

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 17

0.01). Consistent with prior research, the results suggest that firms in countries such as
United States, Canada, and Australia with high quality of accounting standards, strong
enforcement, large and highly developed equity markets, less concentrated ownership, and
low tax-book conformity engage in less earnings management. We also note that enforcement
has significant correlations with stock market capitalization (0.424, p < 0.05), ownership
concentration (-0.452, p < 0.01) and tax-book conformity (-0.487, p < 0.05). This is
consistent with the intuition that strong enforcement is associated with a developed stock
market, low ownership concentration and less tax-book conformity.

[Insert Table 5 here]

6.4 Autoregressions 15

Because we have multi-year pooled data, we use autoregressions for our multivariate tests.
Autoregression modifies the ordinary least-square regression specifically for time series
analysis. The analysis from autocorrelations shows that in this study the data of earnings
management collected over several years exhibit first-order autocorrelation of the residuals
(not tabulated here).

Table 6 provides results of the autoregressions for the relations between each country’s
annual median of aggregate earnings management and IFRS and its enforcement.

Model 1 (in Column 1) is the basic regression:

EM12=α+β1*GAAPDiff+β2*VoluntaryAdoption+β3*MandatoryAdoption+ β4*Enforcement

Model 2 (in Column 2) includes the control variables:

EM12=α+β1*GAAPDiff+β2*VoluntaryAdoption+β3*MandatoryAdoption+
β4*Enforcement+β5*MarketLiquidity+β6*OwnershipConcentration+β7*LTDebt/TA+
β8*TotalTaxes/TA

Consistent with the univariate results of Table 5, Model 1 in Table 6 shows that IFRS
adoption and its enforcement explains a substantial portion (adjusted R square = 0.249) of the
variation in earnings management. The proxy for the quality of accounting standards is

15
Autoregression is also called as auto-regressive regression.

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 18

positively (t = 3.246) and significantly (p < 0.01) related to earnings management, confirming
that the quality of accounting standards is relevant to earnings quality. Both voluntary IFRS
adoption and mandatory adoption indicator variables are significant. We note that the effect
of mandatory adoption (p < 0.01) is more significant than voluntary adoption (p < 0.05). The
coefficient on the enforcement variable is negatively (t = -5.433) related to earnings
management at a highly significant level (p < 0.01).

The results are robust after controlling for other institutional variables (Model 2, Table 6)
with an adjusted R square of 0.364. Both IFRS adoption and enforcement remain significant.
Consistent with prior research, earnings management is positively associated with ownership
concentration (t = 4.420, p < 0.01), and negatively associated with both the proxies for capital
structure (t = -2.370, p < 0.05) and tax rate (t = -4.063, p < 0.01). However, market liquidity
is positively associated with earnings management (t = 2.189, p < 0.05). This is inconsistent
with the findings in Huddart et al. (1999) that high liquidity is associated with more
informative earnings. A possible explanation is that firms in order to lower their cost of
capital in high liquidity markets may manipulate earnings.

Earnings management is significantly related with Hung’s (2001) tax-book conformity index
in the correlations table. However, similar to the finding in Leuz et al. (2003), this tax
variable is not significant in our study (not tabulated).

We also re-run the autoregression by replacing market liquidity with other three alternative
financial market development measures (provided in Table 1), but none of them are
significant (not tabulated), suggesting that a country’s economic performance reflected in the
GDP may not have direct connection with a country’s earnings quality.

Finally, we add interaction terms, mean adjusted enforcement*voluntary IFRS adoption and
mean adjusted enforcement*mandatory IFRS adoption, to the autoregressions (not tabulated).
However, neither of these two interaction variables is significant while the results for other
variables are similar to those reported in Table 6, suggesting that enforcement is important for
earnings quality, regardless of whether IFRS is adopted or not.

In summary, the autoregression results are consistent with our hypothesis. In other words,
enforcement reduces earnings management and improves earnings quality.

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 19

[Insert Table 6 here]

7. Conclusion and limitations

Although accounting standards have now been harmonized in many countries, the lack of
uniformity and comparability in the enforcement of accounting standards across borders
reduces the benefits of IFRS adoption to improve accounting quality, which is of concern to
accounting standard setters, regulators, and investors. This concern is extended into this study
to investigate the effect of enforcement of IFRS on the differences in earnings management
through a multinational sample from 32 countries.

The findings show that, although both voluntary and mandatory adoption of IFRS can reduce
earnings management, strong enforcement is an effective factor for reducing earnings
management. The results are robust after controlling for a country’s financial market
development, ownership structure, capital structure, and tax system. These findings highlight
the importance of accounting enforcement in the role of financial reporting quality for
standard setters and policy makers. Future improvement in accounting quality should focus
on the enforceability of IFRS.

Our findings are subject to several limitations. Firstly, an assumption of this study is that a
country’s institutional settings do not vary over a relatively short period of time, as changing
a country’s overall institutional infrastructure is difficult and costly (Soderstrom & Sun, 2007,
37). A potential problem is that some measures such as enforcement and ownership
concentration, obtained from studies conducted several years ago are being used in this study.
However, these variables may have changed over time. For example, some countries have
substantially renewed their enforcement systems to support the adoption of IFRS. Secondly, a
methodological concern is the issue of omitted and unobserved factors at both the country
level and the firm level which may affect the earnings management. Thirdly, we acknowledge
that many institutional factors link and interact with each other, adding noise to the models. It
is difficult to fully control for the potential impact of these institutional factors and
disentangle them from the direct effect of enforcement on earnings management. Thus, we
suggest research on the differences in earnings quality between countries arising from
firm-level variables. Fourthly, this study can only provide some preliminary evidence, as the
effect of IFRS may not appear in merely two years after mandatory IFRS adoption. Finally,
we have not identified which aspects of enforcement have the greatest effect on earnings

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management.

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 21

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Figure 2: Patterns of Earnings Managements

Chart 1
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Earnings Management of Adoption Countries

0.6

AUS
AUT
BEL
0.4
CHE
DEU
DNK
ESP
0.2
FIN
FRA
Aggregate EM

GBR
GRC
0
HKG
90-99 2000 2001 2002 2003 2004 2005 2006
IRL
ITA
NLD
-0.2 NOR
PHL
PRT
SGP
-0.4 SWE
ZAF

-0.6
Year
 26

Chart 2

Earnings Management of non-adoption Countries

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0.4

0.3

0.2

0.1 CAN
IDN
IND
0.0
Aggregate EM

JPN
90-99 2000 2001 2002 2003 2004 2005 2006
KOR
-0.1 MYS
NZL
-0.2 PAK
THA
TWN
-0.3 USA

-0.4

-0.5

-0.6
Year
 27

Chart 3

Earnings Management Comparison bebween 2 Groups

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0.1

0
90-99 2000 2001 2002 2003 2004 2005 2006

-0.1
Aggregate EM

-0.2
IFRS Adoption Group
Non-Adoption Group
USA
-0.3

-0.4

-0.5

-0.6
Year
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Table 1: Description of variables

Variable Measure Description Data Source
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Dependent variable

EM1 captures the degree of insiders' smoothing. It is the

country's median ratio of the firm-level 5-year standard
deviations of operating income and operating cash flow (both
1) Accruals (EM1) scaled by lagged total assets). The cash flow from operations is Global Vantage (2008)
equal to operating income minus accruals, where accruals are
calculated as in Equation 1. Lower values indicate less earnings
management.
Earnings Management
EM2 is a proxy for the extent to which insiders exercise
discretion in reporting earnings. It is a country's median ratio of
2) Magnitude of accruals
the absolute value of firms' accruals scaled by the absolute Global Vantage (2008)
(EM2)
value of firms' cash flow from operations. Higher values indicate
more earnings management.

Aggregate earnings EM12 is the aggregate score that is equal to EM2 minus EM1.
Global Vantage (2008)
management (EM12) Higher values imply more earnings management.
 29

Independent variables
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The aggregate Insider trading law index equals the sum of (1)
Tipping, (2) Tippee, (3) Damages, and (4) Criminal or
equivalently, the sum of Scope and Sanction. It ranges from 0 to
1) Insider trading law Beny (2005)
4, with 0 representing the most lax insider trading legal regime
and 4 representing the most restrictive insider trading legal
regime.
Assessment of the efficiency and integrity of the legal
2) Judicial efficiency environment as it affects business. Scale from 0 to 10; with La Porta et al. (1998)
lower scores, lower efficiency levels.

Enforcement Assessment of the law and order tradition in the country

produced by country risk rating agency International Country
3) Rule of law La Porta et al. (1998)
Risk (ICR). Scale from 0 to 6; with lower scores for less tradition
for law and order.
It is an aggregate measure of (minority) shareholder rights and
4) Anti-director rights /
ranges from 0 to 6, where 0 signifies the weakest investor La Porta et al. (1998)
shareholder protection
protections and 5 signifies the strongest investor protection.
A comprehensive measure of the enforcement of accounting
standards equals to the aggregate score by assigning equal
Aggregate enforcement
weights to above 4 country-level variables. High values stand
for strong enforcement.
 30

Control variables
The summary score of how domestic GAAP differs from IAS on
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GAAP Diff 21 key accounting dimensions. High values stand for more Bae et al. (2008)
discrepancies between local GAAP and IFRS.
A dummy variable takes the value of 1 for a given country in Deloitte's IAS Plus website
Voluntary IFRS adoption
years of voluntary IFRS adoption and 0 otherwise. (2008)
IFRS

Mandatory IFRS A dummy variable takes the value of 1 for a given country in Deloitte's IAS Plus website
adoption years after mandatory IFRS adoption and 0 otherwise. (2008)

Log of GDP Logarithm of annual GDP per capita in 2004 US$. Global financial data (2008)
GDP growth Annual growth rate of per capita GDP. Global financial data (2008)
It equals to the total value of market trading as a percentage of
a country's GDP for 2007. This indicator complements the
Financial market Market liquidity World Bank (2008)
market capitalization ratio by showing whether market size is
development matched by trading.
The ratio of stock market capitalization to gross domestic
Stock market product in 2007. Market capitalization (also known as market
World Bank (2008)
capitalization to GDP value) is the share price times the number of shares
outstanding.
It is measured as the median percentage of common share
Ownership owned by the top 3 shareholders in the ten largest privately
Ownership structure La Porta et al. (1998)
Concentration owned non-financial firms in a given country. High values stand
for high ownership concentration.
 31

It is the country's median ratio of total long-term debt and total

Capital Structure LT Debt / TA assets, where total long-term debt represents interest-bearing Global Vantage (2008)
obligations due after the current operating cycle.
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The Tax-book conformity index shows the convergence

Tax-book conformity between tax reporting and financial accounting. It equals 1 for
Hung (2001)
index countries with high tax-book conformity and equals 0 for
countries with low conformity.
Tax
It is the country's median ratio of total income taxes and total
assets, where total income taxes represents all taxes imposed
Total Taxes / TA Global Vantage (2008)
on income by local, provincial/state, national, and foreign
governments.
 32

Table 2: Sample distribution by country and fiscal year

The sample is selected from Industrial Research, Industrial Research Issue, Industrial Active, and
Industrial Active Issue Files in the Global Vantage database. The final sample consists of 102,636
firm-year observations, across 32 countries for the fiscal years 2000 to 2006. In selecting, we use the
following criteria: 1) utility and financial companies are excluded, as they are under different
incentives for earnings management; 2) each country must have at least 30 firms observation in each
year for reliability reason; and 3) the sample only contains firms with necessary data to compute the 2
measures of earnings management.

Country 2000 2001 2002 2003 2004 2005 2006 Total

Australia AUS 664 801 899 1,000 1,060 1,131 1,148 6,703
Austria AUT 83 82 71 64 65 61 59 485
Belgium BEL 102 100 91 92 91 92 80 648
Canada CAN 453 424 412 424 419 409 381 2,922
Switzerland CHE 176 180 176 170 174 173 159 1,208
Germany DEU 675 666 597 573 569 586 547 4,213
Denmark DNK 138 133 132 123 114 111 102 853
Spain ESP 116 113 106 104 105 102 94 740
Finland FIN 116 114 109 107 107 107 100 760
France FRA 616 612 585 583 570 567 515 4,048
United Kingdom GBR 1,202 1,239 1,271 1,265 1,303 1,390 1,397 9,067
Greece GRC 68 73 81 84 86 89 69 550
Hong Kong HKG 114 123 130 140 162 172 170 1,011
Indonesia IDN 190 194 207 216 211 198 179 1,395
India IND 299 393 474 603 650 679 698 3,796
Ireland IRL 57 57 53 54 57 60 60 398
Italy ITA 180 193 190 184 191 198 196 1,332
Japan JPN 2,928 3,202 3,285 3,326 3,357 3,475 3,544 23,117
Korea KOR 179 227 241 253 254 300 299 1,753
Malaysia MYS 574 592 603 635 674 698 675 4,451
Netherlands NLD 168 164 153 149 144 141 125 1,044
Norway NOR 146 143 126 120 129 134 128 926
New Zealand NZL 63 68 68 84 84 82 79 528
Pakistan PAK 42 42 31 33 36 37 37 258
Philippines PHL 98 99 100 109 103 103 86 698
Portugal PRT 40 38 37 36 36 34 32 253
Singapore SGP 305 344 354 371 420 426 416 2,636
Sweden SWE 259 255 266 260 259 255 234 1,788
Thailand THA 258 250 253 263 286 279 267 1,856
Taiwan TWN 192 223 263 762 934 949 1,078 4,401
United States USA 2,960 2,763 2,624 2,517 2,406 2,264 2,094 17,628
South Africa ZAF 131 152 178 186 177 176 170 1,170
13,592 14,059 14,166 14,890 15,233 15,478 15,218 102,636

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Table 3: Country scores for earnings management measures

EM1 in Panel A is the earnings smoothing measure, which is the country’s median ratio of the
firm-level standard deviations of operating income and operating cash flow, both scaled by lagged total
assets. EM2 in Panel B is the earnings discretion measure, which is the country’s median ratio of the
absolute value of accruals and the absolute value of the cash flow from operations. EM12 in Panel C is
the aggregate earnings management score, which is equal to EM2 minus EM1. The sign in the heading
indicates where higher scores for the respective measure represent more earnings management (+) or
less earnings management (-). Panel D reports the spearman’s correlation and significance level
between EM1 and EM2.

Panel A: Earnings smoothing measure: EM1 σ(OpInc) /σ(CFO) (-)

2000 2001 2002 2003 2004 2005 2006
IFRS Adoption Group
Australia AUS 0.678 0.732 0.731 0.784 0.859 0.849 0.871
Austria AUT 0.361 0.342 0.360 0.463 0.456 0.424 0.467
Belgium BEL 0.363 0.440 0.416 0.481 0.497 0.487 0.503
Switzerland CHE 0.426 0.613 0.677 0.708 0.788 0.685 0.750
Germany DEU 0.429 0.478 0.528 0.555 0.619 0.549 0.553
Denmark DNK 0.579 0.543 0.537 0.581 0.555 0.604 0.597
Spain ESP 0.372 0.432 0.467 0.426 0.455 0.460 0.401
Finland FIN 0.560 0.627 0.725 0.763 0.823 0.716 0.728
France FRA 0.422 0.424 0.470 0.530 0.547 0.501 0.507
United
Kingdom GBR 0.663 0.684 0.722 0.722 0.699 0.668 0.630
Greece GRC 0.403 0.525 0.435 0.372 0.404 0.541 0.613
Hong Kong HKG 0.579 0.553 0.584 0.656 0.609 0.590 0.496
Ireland IRL 0.673 0.820 0.755 0.688 0.714 0.520 0.542
Italy ITA 0.364 0.500 0.498 0.498 0.505 0.489 0.491
Netherlands NLD 0.376 0.553 0.582 0.601 0.667 0.671 0.645
Norway NOR 0.690 0.717 0.742 0.698 0.721 0.682 0.690
Philippines PHL 0.685 0.572 0.537 0.540 0.462 0.529 0.463
Portugal PRT 0.337 0.412 0.401 0.358 0.298 0.384 0.350
Singapore SGP 0.524 0.540 0.603 0.598 0.673 0.643 0.601
Sweden SWE 0.648 0.767 0.812 0.847 0.890 0.827 0.804
South Africa ZAF 0.622 0.621 0.662 0.692 0.681 0.712 0.733

Mean 0.512 0.566 0.583 0.598 0.615 0.597 0.592

Median 0.524 0.553 0.582 0.598 0.619 0.590 0.597
Std. Dev. 0.132 0.127 0.134 0.136 0.158 0.126 0.135
Min 0.337 0.342 0.360 0.358 0.298 0.384 0.350
Max 0.690 0.820 0.812 0.847 0.890 0.849 0.871

Non-adoption Group
Canada CAN 0.722 0.813 0.787 0.780 0.774 0.778 0.830
Indonesia IDN 0.523 0.517 0.641 0.576 0.606 0.553 0.574
India IND 0.670 0.616 0.717 0.663 0.649 0.597 0.601
Japan JPN 0.445 0.457 0.471 0.486 0.506 0.536 0.542
Korea KOR 0.450 0.520 0.471 0.515 0.559 0.587 0.650
Malaysia MYS 0.604 0.629 0.550 0.531 0.521 0.538 0.560
New Zealand NZL 0.587 0.484 0.456 0.602 0.609 0.608 0.765
Pakistan PAK 0.353 0.636 0.601 0.529 0.541 0.566 0.480
Thailand THA 0.583 0.565 0.558 0.582 0.595 0.570 0.610
Taiwan TWN 0.620 0.554 0.601 0.465 0.694 0.644 0.571

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 34

Mean 0.556 0.579 0.585 0.573 0.605 0.598 0.618

Median 0.585 0.560 0.580 0.553 0.601 0.578 0.588
Std. Dev. 0.113 0.102 0.109 0.093 0.083 0.071 0.106
Min 0.353 0.457 0.456 0.465 0.506 0.536 0.480
Max 0.722 0.813 0.787 0.780 0.774 0.778 0.830

Benchmark
United States USA 0.797 0.853 0.863 0.846 0.842 0.798 0.772

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 35

Panel B: Earnings discretion measure:EM2 │Acc│/│CFO│ (+)

2000 2001 2002 2003 2004 2005 2006
IFRS Adoption Group
Australia AUS 0.493 0.432 0.428 0.409 0.380 0.328 0.334
Austria AUT 0.550 0.728 0.702 0.733 0.618 0.651 0.407
Belgium BEL 0.638 0.674 0.684 0.575 0.481 0.576 0.427
Switzerland CHE 0.447 0.553 0.580 0.529 0.452 0.430 0.350
Germany DEU 0.662 0.695 0.764 0.749 0.628 0.645 0.511
Denmark DNK 0.485 0.590 0.630 0.592 0.486 0.517 0.540
Spain ESP 0.479 0.518 0.567 0.543 0.549 0.538 0.481
Finland FIN 0.410 0.555 0.575 0.565 0.551 0.500 0.478
France FRA 0.493 0.605 0.571 0.515 0.501 0.530 0.443
United Kingdom GBR 0.456 0.516 0.507 0.504 0.495 0.449 0.438
Greece GRC 0.779 0.616 0.527 0.450 0.525 0.575 0.376
Hong Kong HKG 0.626 0.611 0.607 0.628 0.530 0.523 0.592
Ireland IRL 0.373 0.470 0.456 0.435 0.412 0.449 0.380
Italy ITA 0.571 0.598 0.612 0.649 0.561 0.594 0.610
Netherlands NLD 0.477 0.472 0.625 0.649 0.509 0.481 0.367
Norway NOR 0.657 0.592 0.696 0.685 0.571 0.578 0.504
Philippines PHL 0.859 0.670 0.796 0.697 0.704 0.605 0.612
Portugal PRT 0.568 0.594 0.714 0.578 0.651 0.612 0.515
Singapore SGP 0.652 0.781 0.793 0.646 0.646 0.613 0.589
Sweden SWE 0.396 0.459 0.558 0.503 0.397 0.348 0.358
South Africa ZAF 0.483 0.507 0.356 0.391 0.320 0.395 0.277

Mean 0.550 0.583 0.607 0.573 0.522 0.521 0.456

Median 0.493 0.592 0.607 0.575 0.525 0.530 0.443
Std. Dev. 0.126 0.092 0.117 0.104 0.097 0.093 0.098
Min 0.373 0.432 0.356 0.391 0.320 0.328 0.277
Max 0.859 0.781 0.796 0.749 0.704 0.651 0.612

Non-adoption Group
Canada CAN 0.383 0.435 0.470 0.448 0.399 0.402 0.383
Indonesia IDN 0.634 0.577 0.740 0.826 0.674 0.666 0.629
India IND 0.445 0.395 0.450 0.432 0.386 0.451 0.489
Japan JPN 0.567 0.528 0.600 0.550 0.500 0.462 0.446
Korea KOR 0.526 0.498 0.460 0.425 0.454 0.563 0.531
Malaysia MYS 0.747 0.754 0.675 0.638 0.664 0.622 0.612
New Zealand NZL 0.417 0.478 0.418 0.347 0.389 0.387 0.344
Pakistan PAK 0.409 0.393 0.270 0.426 0.505 0.247 0.356
Thailand THA 0.644 0.591 0.533 0.527 0.523 0.540 0.531
Taiwan TWN 0.568 0.782 0.653 0.585 0.592 0.607 0.905

Mean 0.534 0.543 0.527 0.520 0.509 0.495 0.523

Median 0.546 0.513 0.501 0.488 0.502 0.501 0.510
Std. Dev. 0.120 0.136 0.141 0.139 0.107 0.129 0.167
Min 0.383 0.393 0.270 0.347 0.386 0.247 0.344
Max 0.747 0.782 0.740 0.826 0.674 0.666 0.905

Benchmark
United States USA 0.406 0.506 0.467 0.419 0.362 0.340 0.330

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 36

Panel C: Aggregate measure: EM2-EM1 (+)

2000 2001 2002 2003 2004 2005 2006
IFRS Adoption Group
Australia AUS -0.185 -0.300 -0.303 -0.375 -0.479 -0.522 -0.537
Austria AUT 0.189 0.387 0.342 0.270 0.162 0.228 -0.060
Belgium BEL 0.275 0.234 0.267 0.094 -0.016 0.089 -0.075
Switzerland CHE 0.021 -0.060 -0.097 -0.178 -0.336 -0.255 -0.400
Germany DEU 0.233 0.216 0.236 0.194 0.009 0.096 -0.042
Denmark DNK -0.093 0.047 0.093 0.011 -0.068 -0.087 -0.057
Spain ESP 0.107 0.086 0.101 0.118 0.094 0.078 0.080
Finland FIN -0.151 -0.072 -0.149 -0.198 -0.273 -0.216 -0.250
France FRA 0.072 0.181 0.100 -0.015 -0.046 0.030 -0.064
United Kingdom GBR -0.207 -0.168 -0.215 -0.218 -0.204 -0.219 -0.193
Greece GRC 0.377 0.092 0.092 0.078 0.121 0.034 -0.238
Hong Kong HKG 0.047 0.057 0.023 -0.028 -0.079 -0.066 0.096
Ireland IRL -0.300 -0.350 -0.299 -0.253 -0.302 -0.070 -0.163
Italy ITA 0.206 0.097 0.114 0.151 0.056 0.105 0.119
Netherlands NLD 0.101 -0.081 0.042 0.048 -0.158 -0.190 -0.278
Norway NOR -0.033 -0.125 -0.046 -0.012 -0.149 -0.104 -0.187
Philippines PHL 0.174 0.098 0.259 0.157 0.242 0.076 0.149
Portugal PRT 0.231 0.183 0.314 0.220 0.353 0.228 0.164
Singapore SGP 0.129 0.241 0.191 0.048 -0.028 -0.030 -0.012
Sweden SWE -0.252 -0.308 -0.254 -0.343 -0.492 -0.479 -0.446
South Africa ZAF -0.139 -0.114 -0.307 -0.302 -0.361 -0.317 -0.457

Mean 0.038 0.016 0.024 -0.025 -0.093 -0.076 -0.136

Median 0.072 0.057 0.092 0.011 -0.068 -0.066 -0.075
Std. Dev. 0.191 0.199 0.213 0.195 0.228 0.206 0.208
Min -0.300 -0.350 -0.307 -0.375 -0.492 -0.522 -0.537
Max 0.377 0.387 0.342 0.270 0.353 0.228 0.164

Non-adoption Group
Canada CAN -0.340 -0.377 -0.317 -0.332 -0.376 -0.375 -0.446
Indonesia IDN 0.112 0.060 0.099 0.250 0.068 0.113 0.055
India IND -0.225 -0.221 -0.267 -0.231 -0.263 -0.145 -0.112
Japan JPN 0.122 0.070 0.129 0.064 -0.007 -0.075 -0.096
Korea KOR 0.075 -0.021 -0.011 -0.089 -0.105 -0.024 -0.119
Malaysia MYS 0.143 0.125 0.126 0.107 0.143 0.085 0.052
New Zealand NZL -0.170 -0.006 -0.038 -0.255 -0.220 -0.221 -0.422
Pakistan PAK 0.056 -0.244 -0.331 -0.103 -0.036 -0.319 -0.124
Thailand THA 0.061 0.026 -0.025 -0.056 -0.072 -0.030 -0.079
Taiwan TWN -0.051 0.227 0.052 0.120 -0.102 -0.037 0.333

Mean -0.022 -0.036 -0.058 -0.053 -0.097 -0.103 -0.096

Median 0.059 0.010 -0.018 -0.072 -0.087 -0.056 -0.104
Std. Dev. 0.168 0.187 0.181 0.187 0.156 0.162 0.226
Min -0.340 -0.377 -0.331 -0.332 -0.376 -0.375 -0.446
Max 0.143 0.227 0.129 0.250 0.143 0.113 0.333

Benchmark
United States USA -0.390 -0.347 -0.396 -0.427 -0.480 -0.458 -0.441

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 37

Panel D: Correlations between EM1 & EM2

The table presents Spearman correlation and 2-tailed significance level between EM1 and
EM2.

EM2
Spearman's rho EM1 Correlation Coefficient -.410(**)
Sig. (2-tailed) .000
N 224

** Correlation is significant at the 0.01 level (2-tailed).

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 38

Table 4: Institutional characteristics

Panel A: Earnings Management and IFRS Adoption
EM90-99 is the pooled aggregate earnings management over 1990-1999, drawn from Leuz et al. (2003)
and recalculated based on the 2 earnings management measures used in this study. EM00-06 is the
pooled median of aggregate earnings management over 2000-2006, and EM05-06 is the pooled median
of aggregate earnings management over 2005-2006. Difference between local GAAP and IFRS is the
summary score of how domestic GAAP differs from IAS on 21 key accounting dimensions, sourced
from Bae et al. (2008). Higher values stand for more discrepancies between local GAAP and IFRS.
IFRS announcement and adoption dates are used to code the two IFRS adoption dummy variables in
Table 1.
Difference Adoption of
between Announcement Mandatory
Country EM90-99 EM00-06 EM05-06
local GAAP of Mandatory IFRS
and IFRS IFRS Reporting Reporting
Australia -0.175 -0.421 -0.529 4 4/07/2002 31/12/2005
Austria 0.438 0.230 0.084 12 4/06/2002 31/12/2005
Belgium 0.151 0.131 0.007 13 4/06/2002 31/12/2005
Canada -0.171 -0.367 -0.411 5 n.a. n.a.
Switzerland 0.074 -0.190 -0.328 12 11/11/2002 31/12/2005
Germany 0.338 0.132 0.027 11 4/06/2002 31/12/2005
Denmark -0.033 -0.022 -0.072 11 4/06/2002 31/12/2005
Spain -0.025 0.093 0.079 16 4/06/2002 31/12/2005
Finland -0.038 -0.214 -0.233 15 4/06/2002 31/12/2005
France 0.018 0.024 -0.017 12 4/06/2002 31/12/2005
United Kingdom -0.177 -0.205 -0.206 1 4/06/2002 31/12/2005
Greece 0.306 0.070 -0.102 17 4/06/2002 31/12/2005
Hong Kong 0.101 0.010 0.015 3 10/09/2004 31/12/2005
Indonesia 0.025 0.093 0.084 4 n.a. n.a.
India -0.014 -0.198 -0.129 8 n.a. n.a.
Ireland -0.236 -0.235 -0.117 6 4/06/2002 31/12/2005
Italy 0.142 0.112 0.112 12 4/06/2002 31/12/2005
Japan 0.007 0.016 -0.085 9 n.a. n.a.
Korea 0.286 -0.076 -0.071 6 n.a. n.a.
Malaysia 0.009 0.106 0.068 8 n.a n.a
Netherlands -0.011 -0.071 -0.234 4 4/06/2002 31/12/2005
Norway -0.157 -0.092 -0.146 7 4/06/2002 31/12/2005
New Zealand n.a, -0.212 -0.321 3 n.a. n.a.
Pakistan 0.005 -0.165 -0.221 4 n.a. n.a.
Philippines -0.167 0.192 0.113 10 2/10/2003 31/12/2005
Portugal 0.343 0.245 0.196 13 4/06/2002 31/12/2005
Singapore 0.172 0.059 -0.021 0 7/12/2000 31/12/2005
Sweden -0.155 -0.386 -0.462 10 4/06/2002 31/12/2005
Thailand 0.069 -0.022 -0.055 4 n.a. n.a.
Taiwan 0.215 0.054 0.148 6 n.a. n.a.
United States -0.454 -0.422 -0.450 4 n.a. n.a.
South Africa -0.346 -0.311 -0.387 0 20/05/2003 31/12/2005

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 39

Panel B: Enforcement
See Table 1 for the description for the four components of enforcement. Judicial efficiency, rule of law,
and anti-director rights are sourced from La Porta et al. (1998). Insider trading laws index is sourced
from Beny (2005). Enforcement is the aggregate score by assigning equal weights to above four
variables. The results are consistent with those computed from factor analysis. High values stand for
strong enforcement. Mean adjusted enforcement is used for interaction with IFRS adoption indication
variables.

Insider Mean
Judicial Rule of Anti-director
Country trading Enforcement adjusted
efficiency Law rights
laws enforcement

Australia 10 10 3 4 27.00 4.87

Austria 9.5 10 2 2 23.50 1.37
Belgium 9.5 10 3 0 22.50 0.37
Canada 9.25 10 4 5 28.25 6.12
Denmark 10 10 3 2 25.00 2.87
Finland 10 10 3 3 26.00 3.87
France 8 8.98 4 3 23.98 1.85
Germany 9 9.23 3 1 22.23 0.10
Greece 7 6.18 2 2 17.18 -4.96
Hong Kong 10 8.22 3 5 26.22 4.09
India 8 4.17 2 5 19.17 -2.97
Indonesia 2.5 3.98 2 2 10.48 -11.66
Ireland 8.75 7.8 3 4 23.55 1.42
Italy 6.75 8.33 3 1 19.08 -3.06
Japan 10 8.98 2 4 24.98 2.85
Korea 6 5.35 4 2 17.35 -4.79
Malaysia 9 6.78 2 4 21.78 -0.35
Netherlands 10 10 3 2 25.00 2.87
New Zealand 10 10 3 4 27.00 4.87
Norway 10 10 1 4 25.00 2.87
Pakistan 5 3.03 1 5 14.03 -8.11
Philippines 4.75 2.73 2 3 12.48 -9.66
Portugal 5.5 8.68 3 3 20.18 -1.96
Singapore 10 8.57 3 4 25.57 3.44
South Africa 6 4.42 2 5 17.42 -4.72
Spain 6.25 7.8 3 4 21.05 -1.09
Sweden 10 10 3 3 26.00 3.87
Switzerland 10 10 3 2 25.00 2.87
Taiwan 6.75 8.52 3 3 21.27 -0.86
Thailand 3.25 6.25 3 2 14.50 -7.64
United
10 8.57 3 5 26.57
Kingdom 4.44
United States 10 10 4 5 29.00 6.87

Mean 8.15 8.02 2.75 3.22 22.14 0.00

Std. Dev. 2.23 2.30 0.76 1.39 4.77 4.77

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 40

Panel C: Other Controls

See Table 1 for the description for the control variables (Log of GDP and GDP growth are not
tabulated). LT Debt / TA 00-06 and Total Taxes / TA 00-06 in this table are pooled median for each
country over 2000-2006.

The ratio of the

Total value Total
stock market
traded as a LT Debt / TA Ownership Tax-book Taxes /
Country capitalization
percentage of 00-06 (%) Concentration Conformity TA 00-06
to GDP for
GDP in 2007 (%) (%)
2007 (%)
Australia 158 161 0.679 0.28 0 0.000
Austria 60.7 32.2 11.436 0.51 n.a. 0.972
Belgium 86.1 57 14.074 0.62 1 1.100
Canada 164.9 124.1 14.472 0.24 0 0.604
Switzerland 306.7 427.9 13.020 0.48 1 1.199
Germany 63.9 102 6.064 0.5 1 0.988
Denmark 90.2 78.6 12.913 0.4 0 1.187
Spain 125.9 207.3 13.034 0.5 1 1.153
Finland 150.1 220.9 15.808 0.34 1 1.810
France 108.2 133.4 10.737 0.24 1 1.463
United
141.5 378.5 3.420 0.15 0 0.800
Kingdom
Greece 73.6 42.1 12.316 0.68 n.a. 1.526
Hong Kong 562.4 443.6 3.647 0.54 0 0.603
Indonesia 48.9 26.1 8.254 0.62 n.a. 1.123
India 155.4 94.6 19.700 0.43 n.a. 1.250
Ireland 56.5 53.6 6.841 0.36 0 0.584
Italy 50.9 109.8 10.879 0.6 1 1.543
Japan 101.8 148.4 8.361 0.18 1 1.489
Korea 115.9 203.5 6.583 0.23 n.a. 1.323
Malaysia 180.2 83 3.835 0.52 n.a. 0.895
Netherlands 126.8 239.1 12.807 0.31 0 1.432
Norway 93.6 123.5 20.006 0.31 0 0.580
New Zealand 36.7 16.7 17.135 0.51 0 1.898
Pakistan 48.9 70 5.798 0.41 n.a. 3.378
Philippines 71.6 20.3 2.962 0.51 n.a. 0.371
Portugal 60.1 65.6 24.434 0.59 n.a. 0.746
Singapore 219.1 238.1 4.099 0.53 0 0.873
Sweden 137.8 218 8.077 0.28 1 1.015
Thailand 79.8 44 5.963 0.48 n.a. 0.689
Taiwan 188.8 332 7.023 0.14 n.a. 0.602
United States 144.4 308.5 15.097 0.12 0 1.438
South Africa 300.3 153.4 3.970 0.52 0 2.881

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 41

Table 5: Correlations
The table presents Spearman correlations and 2-tailed significance levels between the following measures. EM00-06 is the pooled median of aggregated earnings
management for each country over 2000-2006. LT Debt / TA 00-06 and Total Taxes / TA 00-06 are also pooled measures. See Table 1 for other variables.

Stock LT Debt / Total Taxes /

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GAAP Diff Enforcement Ownership Tax-book

Spearman’s rho market TA 00-06 TA 00-06
Concentration Conformity
Cap
EM 00-06 Correlation
.466(**) -.554(**) -.381(*) .592(**) -.047 .477(*) -.115
Coefficient
Sig. (2-tailed) .007 .001 .032 .000 .799 .029 .533
GAAP Diff Correlation
-.237 -.249 .205 .457(**) .821(**) .144
Coefficient
Sig. (2-tailed) .192 .170 .260 .009 .000 .433
Enforcement Correlation
.424(*) -.452(**) .185 -.487(*) -.144
Coefficient
Sig. (2-tailed) .016 .009 .311 .025 .432
Correlation
Stock market Cap -.295 -.180 -.222 -.185
Coefficient
Sig. (2-tailed) .102 .325 .332 .311
Ownership Correlation
-.007 .127 .062
Concentration Coefficient
Sig. (2-tailed) .971 .582 .736
LT Debt / TA 00-06 Correlation
.143 .297
Coefficient
Sig. (2-tailed) .536 .098
Correlation
Tax-book Conformity .352
Coefficient
Sig. (2-tailed) .118

** Correlation is significant at the 0.01 level (2-tailed).

* Correlation is significant at the 0.05 level (2-tailed).
 42

Table 6: Autoregressions
The table presents coefficients (t statistic) and Significance levels from autoregressions with the
aggregate earnings management as the dependent variable (see Table 1).The Prais-Winsten estimation
method is used. Model 1 (in Column 1) is the basic regression. Model 2 (in Column 2) includes some
other control variables.

Model 1. Aggregate Model 2. Aggregate Earnings

Earnings Management Management
(EM12) (EM12)
Constant 3.415 (**) 0.327
Sig. 0.001 0.744
GAAPDiff 3.246 (**) 3.516 (**)
Sig. 0.001 0.001
Voluntary Adoption -1.995 (*) -2.944 (**)
Sig. 0.047 0.004
Mandatory Adoption -4.333 (**) -5.128 (**)
Sig. 0.000 0.000
Enforcement -5.433 (**) -3.200 (**)
Sig. 0.000 0.002
Market Liquidity 2.189 (*)
Sig. 0.030
Ownership Concentration - 4.420 (**)
Sig. 0.000
LT Debt / TA - -2.370 (*)
Sig. 0.019
Total Taxes / TA - -4.063 (**)
Sig. 0.000
R 0.516 0.624
Adjusted R Square 0.249 0.364
Durbin-Watson 2.184 2.226

** Correlation is significant at the 0.01 level.

* Correlation is significant at the 0.05 level.

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