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EARNINGS QUALITY AND THE ADOPTION OF IFRS-BASED ACCOUNTING STANDARDS: EVIDENCE FROM AN EMERGING MARKET

Wan Adibah Wan Ismail a Keitha Dunstan b Tony van Zijl a

a School of Accounting and Commercial Law, Victoria University of Wellington b School of Business, Bond University, Australia

Keywords: Earnings quality, accounting standards, IFRS, financial reporting, Malaysia

Contact details:

Wan Adibah Wan Ismail School of Accounting and Commercial Law Victoria University of Wellington Wellington, New Zealand Email address: deb.wanismail@vuw.ac.nz Phone: +64 21 02630493

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ElectronicElectronic copycopy availableavailable at:at: http://ssrn.com/abstract=1566634http://ssrn.com/abstract=1566634

EARNINGS QUALITY AND THE ADOPTION OF IFRS-BASED ACCOUNTING STANDARDS: EVIDENCE FROM AN EMERGING MARKET

Abstract

This study investigates the differences in earnings quality of Malaysian companies after the adoption of IFRS-based accounting standards named FRS. We hypothesize that under the new set of accounting standards, the quality of earnings reported by these companies is relatively higher. We measure earnings quality using two different proxies; the absolute value of abnormal accruals and the value relevance of earnings. Using 4010 observations over a three-year period before and a three-year period after the adoption of the new set of accounting standards, our study finds that the adoption of FRS is relatively related to higher reported earnings quality. Specifically, the results shows that (1) the absolute value of abnormal accrual is significantly lower and (2) the value-relevance of firms earnings is significantly higher, after the adoption the new set of accounting standards.

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ElectronicElectronic copycopy availableavailable at:at: http://ssrn.com/abstract=1566634http://ssrn.com/abstract=1566634

Introduction

Many countries have adopted the International Financial Reporting Standards (IFRS) as their primary standards for the preparation of corporate accounts. Despite this widespread adoption, little research has directly addressed the impact of IFRS adoption on the quality of financial reporting in an emerging market. Current studies seems to focus more on the effect of such adoption in European countries (Callao, Jarne and Laínez, 2007; Ernstberger and Vogler, 2008; Gjerde, Knivsflå and Sættem, 2008; Jermakowicz, 2004; Paananen and Lin, 2009; Van der Meulen, Gaeremynck and Willekens, 2007; Van Tendeloo and Vanstraelen, 2005) and other developed countries such as Australia (Goodwin, Ahmed and Heaney, 2008; Jeanjean and Stolowy, 2008). This is an important gap in the literature given the differences that exist between developed and developing countries. As mentioned by Hofstede and Hofstede (2004), developing countries are substantially different from developed market in terms of the institutional, organisational and market aspects of the economy and society. Developing countries has weaker and less mature capital market (Gibson, 2003; Lins, 2003), limited role of regulatory authorities (Berghe, 2002), and more concentrated ownership (Claessens, Djankov and Lang, 2000; Shleifer and Vishny, 1997; Thillainathan, 1998); that leads to greater information asymmetry. In addition to that, accounting standards in developing markets are different from those of developed market, which makes it harder for investors to judge the true performance of a firm in developing financial market and make rational investment decision (Rashid and Islam, 2008). Better accounting standards could increase the quality of financial statements in these countries. Thus, the impact of the adoption of IFRS in developing countries could be more prevalent than those found in developed market.

In late 2004, the Malaysian accounting standard setting body (Malaysian Accounting Standard Board) announced the adoption of IFRS for Malaysian companies, effective from January 1, 2006. The standards are named as Financial Reporting Standards (FRS) 1 . The adoption of this new set of accounting standards in Malaysia provides a setting to study the effect of IFRS-based accounting standards on the quality of earnings in a developing country. The introduction of IFRS in Malaysia is viewed as an advantage to the country

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due to the excellent reputation, good quality and high credibility. According to Ball

(2006):

IFRS promise more accurate, comprehensive and timely financial statement information, relative to the national standards they replace for public financial reporting in most of the countries adopting them, Continental Europe included. To the extent that financial statement information is not known from other sources, this should lead to more-informed valuation in the equity market, and hence lower risk to investors.

The major change in accounting standards in Malaysia as a consequence of the adoption of

IFRS is the use of fair value accounting. Among others, the extensive use of fair value

occurs in the standards are related to share-based payments (FRS2), business combination

(FRS3), property plant and equipment (FRS116), impairment of assets (FRS136),

intangible assets (FRS 138) and investment properties (FRS140). The movement towards

fair value accounting from historical-cost accounting is expected to result in financial

statements that are more relevant, timely, credible and transparent. This is because fair

values are likely to reflect market value; and even in the absence of market value,

determination of fair values normally involves more people including accountants and

managements. Any estimates and judgments made to determine fair value have to be

disclosed and justified accordingly.

Another attribute of IFRS is that it requires greater level of disclosure. For example, FRS

136 on Impairment of Assets requires more disclosure on goodwill and other intangibles,

particularly in relation to allocation of goodwill to cash generating units, key assumptions

used to measure recoverable amounts and impairment testing. Increased level of disclosure

in corporate financial reports could affect the quality of reported earnings. According to

Levitt (1998, p. 80), the disclosure system that are founded on high quality standards give

investors confidence in the credibility of financial reporting. As more disclosure is

required, any attempts to manage earnings can easily be detected and reduced by internal

monitoring bodies (board of directors and auditors) in a company.

Given the emphasis on the use of fair value and greater disclosure requirements prescribed under the new accounting standards, we conjecture that there would be some impact of the adoption of the new standards on the quality of earnings reported by companies in Malaysia. To examine the effect of IFRS adoption on earnings quality, we test whether (1) the level of earnings management is significantly lower after the adoption of IFRS, and (2) reported earnings is more value relevant during IFRS period. Our study covers a short period of three years before (MASB period) and after the event (IFRS period). This is to ensure that changes of earnings quality observed are not due to changes in other institutional factors, such as the change in legal institutions and stock exchange listing requirements. Since there is no other change in the country’s financial reporting environment during the studied period, we assume that the potential country-level factor that could affect firm’s earnings quality during the period is the adoption of IFRS, other than firm’s idiosyncratic factors.

Our results show that earnings quality is relatively higher after the adoption of the new IFRS-based accounting standards. Firstly, we find that the absolute value of abnormal accruals, which is the inverse measure of earnings quality, is significantly lower during FRS period. The fact that the IFRS-based earnings quality outperforms MASB earnings quality holds after controlling for firm specific factors such as firm size, leverage, growth and profitability. Secondly, our results also show that reported earnings are more value relevant during IFRS period, as compared to MASB period. This implies that the decision made by the Malaysian accounting standard setting body to adopt IFRS gives significant benefits to the country’s financial reporting, in terms of lower amount of earnings management and more value relevant of earnings.

This study has several contributions. First, the results of this study provide additional evidence to the literature on earnings quality and the impact of IFRS adoption. As most of the existing studies on earnings quality and IFRS have been conducted on data from the U.S and European countries, this study fills the gap in the existing literature by concentrating on adoption of IFRS and earnings quality in an emerging market. Secondly, the results of this study can assist in understanding the impact that the introduction of IFRS standards bring to the quality of financial reporting in Malaysia and identify issues that

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may assist regulators and standard setters in shaping future policy. In addition to that,

similar to Zhou et al. (2009), our empirical evidence, which suggests that the adoption of

IFRS improves the quality of financial reporting, could encourage regulators and standard

setters in other emerging markets to move forward in adopting the standards.

Overview of Malaysia Financial Reporting Environment

The International Accounting Standards (IAS) issued by the International Accounting

Standards Board (IASB) has become the model for Malaysian accounting standards since

1978. The country’s professional accounting body 2 at that time reviewed and adapted IAS

according to local needs. There was no regulatory mechanism to enforce the compliance to

these standards as mandatory, until an important change in the country’s financial

reporting system took place in 1997 (Saleh, Iskandar and Rahmat, 2005).

In 1997, the Financial Reporting Act 1997 (FRA 1997) was enacted. This regulatory

reform is a response to rapid economic development and globalization of commercial

market that had demanded the country to upgrade its accounting practice (Fadzly and

Ahmad, 2004). The Parliamentary Act sets out the first formal accounting framework for

Malaysia. It established two bodies, the Malaysian Accounting Standards Board (MASB)

and the Financial Reporting Foundation (FRF) 3 . Under the FRA 1997, accounting

standards issued by MASB have legal standing for both public and non-listed companies.

The MASB, together with the FRF make up the new framework for financial reporting in

Malaysia. This new framework comprises an independent standard-setting structure with

representation from all relevant parties in the standard-setting process, including preparers,

users, regulators and the accountancy profession. Section 7 of the FRA 1997, states the

functions of MASB as follows:

(a) to issue new accounting standards as approved accounting standards; (b) to review, revise or adopt existing accounting standards as approved accounting standards; (c) to issue statements of principles for financial reporting; (d) to

2 The Malaysian Institute of Certified Public Accountants (MICPA). 3 FRF is a trustee body who watch over MASB's performance, financial and funding arrangements. It acts as a sounding board for the MASB. For instance, the FRF would be the first to review MASB’s technical pronouncements before it goes out to the public.

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sponsor or undertake development of possible accounting standards; (e) to conduct such public consultation as may be necessary in order to determine the contents of accounting concepts, principles and standards; (f) to develop a conceptual framework for the purpose of evaluating proposed accounting standard; (g) to make such changes to the form and content of proposed accounting standards as it considers necessary; and (h)to perform such other function as the Minister may prescribe by order published in the Gazette.

With the power provided under the Act, MASB had reviewed, revised and adopted

existing accounting standards; and issued new standards as approved accounting standards

known as MASB standards. By the end of 2004, the Board has produced a total of 97

technical pronouncements, comprising 33 Standards, 1 Interpretation Bulletin, 1 Foreword,

2 Statement of Principles (SOPs), 2 Technical Releases, 1 Discussion Paper, 5 Draft SOPs,

and 52 Exposure Drafts.

A number of regulating bodies, including the Securities Commission, the Central Bank of

Malaysia and the Companies Commission of Malaysia are responsible to enforce the

compliance of MASB standards over their respective jurisdictions. In the case of non-

compliance with the approved accounting standards, the regulators have the power to

direct the company to take the necessary rectifying actions, or make necessary

announcements with respect to the non-compliance or required corrections. For publicly

listed companies, there are also penalties for such offence.

The country’s financial reporting system moved a step forward when MASB decided to

adopt IFRS. MASB announced its adoption of IFRS at the end of 2004. As the first step,

MASB standards were renamed Financial Reporting Standards (FRS) in line with

International Financial Reporting Standards (IFRS) in 2005. FRS 1 to 8 are labelled to

standards that are newly introduced by IASB and issued by MASB. Thus, IFRS 1 to 8 are

named as FRS 1 to 8 in Malaysia. FRS with 100 prefix corresponds to its equivalent IAS,

an FRS with 200 prefix denotes a locally developed standard with no equivalent

international standard and FRS with i prefix denotes an Islamic financial reporting

standard.

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Since the country still use some of its local accounting standards, the adoption of IFRS

announced in 2004 is actually a change from MASB standards to FRS. However, as at

January 2006 Malaysia FRS are close to word-for-word with IFRS issued by IASB, except

for some standards that are not yet made effective, which is IFRS 7, Financial Instrument:

Disclosures, and IFRS 8, Operating Segments. FRS also includes one Islamic accounting

standard and four local standards, which are not dealt in IFRS. The local standards are

FRS201 2004 Property Development Activities, FRS202 2004 General Insurance Business,

FRS203 2004 Life Insurance Business, and FRS204 2004 Accounting for Aquaculture.

Compliance with these FRS is mandatory, as stated in the Financial Reporting Act 1997

(Section 26D). Thus, in this paper, we consider FRS as IFRS-based standards, and use the

term interchangeably. The IFRS-based standards adopted by the Malaysian Accounting

Standards Board were made effective from 1 January 2006. Therefore, the earliest

financial statements reported by Malaysian companies under the mandated FRS are dated

31 December 2006.

Association between Earnings Quality and Accounting Standards

Studies analyzing managerial discretion in accounting regimes argue that the degree of

latitude in accounting standards plays some role in determining the quality of financial

reports (e.g. Dye and Sunder, 2001; Goncharov and Zimmermann, 2006). Dye and Sunder

(2001, p. 256) claim that:

Lax IASB standards allow firms more opportunity to manage their earnings, making financial reports less useful to investors…Broad standards create more ambiguities and enhance chances that opportunistic, if not illegal, accounting treatments are blessed by generally accepted accounting principles.

Supporting Dye and Sunder’s argument, Goncharov and Zimmermann (2006, p. 4) state

that:

The accounting standards provide different (amounts of) accounting choices, and therefore their application may results in earnings of different quality. As every accounting choice has its costs and these costs increase with the frequency accounting choice is exercised, earnings management is expected to

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be more widely spread under lax regimes that leave sufficient space for making judgments.

The notion that different accounting standards are associated with different levels of

earnings quality is also evidenced in previous studies. By systematically modelling the

effects of tightening accounting standards, Ewert and Wagenhofer (2005) conclude that

higher earnings quality can be achieved by having stricter accounting standards that limit

the number of accounting choices and prescribe clearer rules. In particular, their results

confirm that tighter accounting standards increase earnings quality measured by the

variability of reported earnings and the association between reported earnings and market

price reactions.

Goncharov and Zimmermann (2006) investigate whether the level of earnings

management differs between consolidated accounts of German companies prepared under

three different accounting standards; German GAAP, IAS and US GAAP. Their findings

show that the level of earnings management for firms that report their results under US

GAAP is significantly lower, while the level of earnings management under German

GAAP and IAS is roughly equal. Based on the evidence, they conclude that the different

accounting choices embedded in different accounting standards influence the level of

earnings management.

Using a broad sample, Barth, Landsman and Lang (2008) examine the accounting quality

of firms in 21 countries that adopted IAS between the year 1994 and 2003. The study

compares several accounting quality metrics for firms that apply IAS to those for a

matched sample of firms that do not. The results of the study shows that companies

applying IAS exhibit higher accounting quality in terms of less income smoothing, less

management of earnings towards a target, more timely recognition of losses, and higher

association of accounting information with share prices and returns. In addition, those

firms also display an improvement in accounting quality between the pre and post IAS

adoption periods.

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In line with the evidence shown in previous studies that different accounting standards is

associated with different level of earnings quality, we conjecture that the adoption of

IFRS-based accounting standards has some impacts on the quality of earnings reported by

Malaysian companies. Due to greater disclosure requirements and greater emphasis on the

use of fair value in the new standards, we posit that earnings quality has significant

positive association with the adoption of IFRS-based accounting standard in Malaysia. In

other words, our study tests whether earnings quality after the introduction of IFRS-based

accounting standards is better relative to the quality of earnings before the introduction of

the new standard. We measure earnings quality in terms of lower level of earnings

management and higher value relevance of earnings.

The extant literatures on earnings management suggest that earnings management exists

due to the important roles and functions played by the reported earnings number.

According to Vander Bauwhede (2001), managers may be inclined to manage earnings due

to the existence of the firm’s explicit and implicit contracts, the firm’s relation with capital

markets, the need for external financing, the political and regulatory environment or

several other specific circumstances. For example, earnings numbers are normally

included in management compensation and bonus contracts, debts covenants, management

buyouts, proxy contest, valuation of initial public offerings (IPOs), labour union

negotiations, and lobbying on accounting standards and regulations.

Davidson, Stickney and Weil (1985) define earnings management as the process of taking

deliberate steps within the constraint of generally accepted accounting practice to bring

about a desired level of reported earnings. Similarly, Healy and Wahlen (1999, p. 368)

note that:

Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some shareholders about the underlying economic performance of the company, or to influence contractual outcomes that depends on reported accounting numbers.

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According to above the definitions, it is clear that earnings management becomes possible

due to the discretion given to managers when preparing financial reports. However, it is

limited within the boundaries allowed under a particular set of accounting standards. Thus,

any changes in the extent of managerial discretion allowed under the accounting standards

may also change the amount of earnings management.

Zheng (2003) claim that the purpose of earnings management, as stated in Healy and

Wahlen (1999)’s definitions indicates that managed earnings is of lower quality than

unmanaged earnings. The greater the departure of reported earnings from what it should,

the lower the quality of earnings. Consistently, previous studies on earnings quality (e.g.

Barth et al., 2008; Chen, Dhaliwal and Trombley, 2007; Van Tendeloo and Vanstraelen,

2005) often use the term ‘earning quality’ to denote the absence of earnings management.

In addition, Levitt (1998) mentioned that when earnings management is on the rise, the

quality of financial reporting is on the decline. Given the changes in disclosure

requirement and the extent of managerial discretion allowed under the IFRS-based

accounting standard, we develop the following hypothesis:

H a1 : The extent of earnings management is lower after the adoption of IFRS-

based accounting standards.

Earnings that are high in quality should also be more value relevant. In other words, high

quality earnings should have greater ability to explain market value of companies. A

number of studies that examine the quality of financial reporting use value relevance of

earnings to measure earnings quality (e.g. Cheng, Hsieh and Yip, 2007; Lang, Raedy and

Wilson, 2006; Lang, Raedy and Yetman, 2003; Leuz, Nanda and Wysocki, 2003). These

studies relate earnings directly to stock prices or market returns. The association (the slope

coefficient or the explanatory power of the model) between earnings and stock market

performance suggests that earnings are both relevant and reliable to investors (Barth,

Beaver and Landsman, 2001). In the existing studies, earnings are considered to be higher

in quality if it is more value relevant. As claimed by Bao and Bao (2004, p. 1533):

Theoretically, if quality of earnings is improved, then the association between firm value and reported earnings should also be improved. If quality of earnings is

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impaired, then the association between firm value and reported earnings should also be impaired.

Based on the prior studies that considered more value relevant earnings as that of high

quality, we set our second hypothesis as follows:

H a2 : The value relevance of earnings is higher after the adoption of IFRS-based

accounting standards.

Our study is different from previous studies on earnings quality and IFRS. To the best of

our knowledge, this study is among the early empirical study that examines the effect of

mandatory adoption of IFRS on earnings quality of companies over time in a developing

country. Our study is closest to Paananen and Lin (2009)’s study that examine the adoption

of IFRS in Germany. However, in Germany the adoption of IFRS is made voluntary for

two years before it is made compulsory. Thus, the initial year of IFRS adoption for the

companies in the country varies.

The common approach of existing studies that examine the impact of IFRS adoption on

earnings quality is by comparing earnings quality of IFRS adopters and non-IFRS adopters

in a particular country during the period when companies are given the option of adopting

IFRS or adhering to local GAAPs or other accounting standards (e.g. Christensen, Lee and

Walker, 2007; Van der Meulen et al., 2007; Van Tendeloo and Vanstraelen, 2005; Zhou et

al., 2009). According to Zhou et al., when the adoption of accounting standards is

voluntary, the results of the study could be subject to self-selection bias. This is evidenced

in Paananen and Lin (2009) where most of the early adopters of IFRS are the companies

that previously have higher quality of financial reporting. Our study is free from the self-

selection bias as we examine the effect of IFRS in a setting where the adoption of IFRS is

made mandatory. There is no period for voluntary adoption of IFRS in Malaysia.

Therefore, the effect of adopting IFRS can be captured evenly for all companies in the

sample as all companies are required to adopt IFRS starting from 1 January 2006.

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Model specification

Earnings management models We examined the difference between earnings quality after the adoption of FRS in Malaysia by looking at the extent of earnings management and value relevance of earnings. To measure the level of earnings management, we calculated the absolute value of abnormal accrual using Jones (1991) model, modified by Dechow, Sloan and Sweeney (1995), by running the following regression, by year and industry based on the General Industry Classification Code (GICS):

TACCR

it

= a

(1/

ASSETS

it

1

)

+ b ΔREV

(

it

− ΔREC

it

)

+ cPPE

it

+ ε

it

(1)

where TACCR it is the total accruals for firm i in year t, ASSETS it-1 is total assets for firm i in year t-1, ΔREV it is measured by revenues in year t less revenues in year t-1 for firm i,

ΔREC it is measured by receivables in year t less receivables in year t-1 for firm i, PPE it is

the gross property, plant, and equipment for firm i in year t and ε it is the error term firm i in year t.

In regression (1), the total accruals (TACCR it ) 4 , change in revenue (REV it ), change in receivables (REC it ), and gross property, plant and equipment (PPE it ) are each scaled by previous year total assets (ASSETS it-1 ). We followed Kothari, et al., (2005) that deflate the variables with assets for the purpose of mitigating heteroscedasticity in residuals. In this model, normal accruals is estimated based on the change in net revenue and PPE of firms in the same industry. The residual generated from this regression is the abnormal accruals of firms, that is the amount of accruals above or below the normal accruals. We used the absolute value of the residual (ABACDEC) to measure the extent of earnings management, which is the extent of departure of total accrual from normal accrual (or the departure of reported earnings from normal earnings). High absolute value of abnormal accrual indicates low earnings quality.

4 Total accruals are calculated by deducting the cash flows from operations (CFO) from net income (NI).

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To ensure robustness of the abnormal accrual estimation, we also calculate the absolute value of abnormal accrual using Kasnik (1999) model, which is slightly different from Dechow, et al (1995) model. Based on the evidence that cash flows from operations are negatively associated with total accruals, Kasnik (1999) added the change in operating cash flows, to Dechow et al. (1995) model. We use the following model to estimate the absolute value of abnormal accrual based on Kasznik (1999) model:

TACC

it

= a

(1/

ASSETS

it

1

)

+ b ΔREV

(

it

− ΔREC

it

)

+ cPPE

it

+ dΔCFO

it

+ ε

it

(2)

where ΔCFO is the change in cash flows from operation 5 for firm i in year t, and all other variables are as previously defined. We labelled the absolute value of abnormal accrual estimated using Kasnik (1999) model as ABACKAS. Then, we estimate the OLS regression using equation (3) to test our first hypothesis of whether the extent of earnings management is lower after the adoption of FRS.

SIZE

ABAC

,

i t

=

β

0

+

β

1

LEVERAGE

,

i t

+

β

2

+

β

3

PROFITABILITY

,

i t

+

β

4

GROWTH

,

i t

,

i t

+

β

5

IFRS

,

i t

+

ε

,

i t

(3)

where ABAC i,t is the absolute value of abnormal accrual for firm i in year t. ABAC i,t represents either (1) ABACDEC i,t which is the absolute abnormal accrual from the Dechow, et al, (1995) model, or (2) ABACKAS it , which is the absolute value of abnormal accrual from the Kasznik (1999) model. SIZE i,t is the natural logarithm of total assets for firm i in year t, ROA i,t is the return on assets ratio for firm i in year t, LEVERAGE i,t is the total debt divided by total assets for firm i at the end of fiscal year t, GROWTH i,t is the share price divided by book value per share for firm i at the end of fiscal year t, and IFRS i,t is a dummy variable given a value of 1 if the financial statement is prepared under FRS, 0 otherwise; for firm i in year t.

In the above model, we include four control variables, firms size (SIZE i,t ), profitability (ROA i,t ), leverage (LEVERAGE i,t ) and growth (GROWTH i,t ), that could also influence the extent of earnings management practices. According to Johnson et al. (2002), these

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variables can affect financial reporting quality in terms of the level of sophistication of the financial reporting system and in terms of management incentives to manipulate earnings. For example, larger and more mature companies are more likely to have more sophisticated financial reporting system. Therefore, managers in these companies may have more opportunity to manipulate earnings. Also, it would be harder for an external auditor to detect earnings manipulation in a more sophisticated accounting system. Other than that, previous studies on financial reporting quality have found certain conditions that may provide incentives for earnings manipulation, such as a firm’s financial condition (Burgstahler and Dichev, 1997; Dechow, Sloan and Sweeney, 1996; Saleh and Ahmed, 2005) and the tightness of debt constraints (Carlson and Bathala, 1997; DeFond and Jiambalvo, 1994; Jaggi and Lee, 2002; Sweeney, 1994).

Value relevance models

To test our second hypothesis, we compare the value relevance of earnings during the period before and after the adoption of IFRS-based accounting standards in Malaysia. We employ two widely used models, which are the price-earnings model and the return- earnings model, to examine the value relevance of earnings during the two periods. We follow the price-earnings model as used by Ohlson (1995) and Burgstahler and Dichev (1997), where prices are regressed on both earnings and the book value of equity. According to Ohlson (1995), the value of firm’s equity can be expressed as a function of its earnings and book value, as follows:

P

,

i t

= α + α

0

1

EPS

i t

,

+ α

2

BVPS

i t

,

+ ε

i t

,

(4)

where P i,t is the price of a share of firm i three months after fiscal year-end t, EPS i,t is the earnings per share of firm i during the year t, BVPS i,t is the book value per share of firm i at the end of year t, and ε i,t represents other value relevant information of firm i for year t. The value relevance of earnings and book value is represented by the coefficient of the variables. The coefficient of earnings depends on how well a firm’s earnings can explain stock prices. According to Ohlson and Zhang (1998), the ability of earnings to explain stock prices can be influenced by its ability to reflect future earnings. They explain that the

relative weight of earnings as compared to book value may vary depending on the permanence of earnings. However, the combined weights of earnings and book value should remain unchanged, for different accounting methods unless the accounting choice results in economic impact. Therefore, other than looking at the coefficient of earnings, we compare the R-squared values of the model to examine whether the joint coefficient of earnings and book value after the adoption of IFRS are more value-relevant and have higher quality. Our approach is similar to Cheng, et al. (2007) and Van der Meulen at al. (2007), wherein higher R-squared of the model signals higher value relevance of earnings and book value.

We further extend our analysis by running a regression on the following extended model, which include IFRS adoption as a dummy variable, and its interaction with earnings and book value:

P

,

i t

= α + α

0

1

EPS

,

i t

+ α

2

BVPS

,

i t

+ α

3

EPS

i t

,

*

IFRS

+ α

4

BVPS

,

i t

*

IFRS

+ ε

i t

,

(5)

In this model, all variables are as previously defined. The coefficient of the interaction variables EPS*IFRS, α 3 , indicates whether the adoption of IFRS has a significant influence on the value relevance of earnings.

To ensure the robustness of our result, we also performed another analysis on value relevance of earnings using return-earnings models introduced by Easton and Harris (1991). The approach of using return-earnings to examine the value relevance of earnings is widely used in existing studies (e.g. Gul, Lynn and Tsui, 2002; Gul, Tsui and Dhaliwal, 2006; Loftus and Sin, 1997; Warfield and Wild, 1992; Warfield, Wild and Wild, 1995). The return-earnings model is as follows:

RET

,

i t

=α +α /

0

1

E

P

,

i t

1

+ε

,

i t

(6)

where RET i,t is holding returns for a 12-month period before the financial year end for firm i in year t, E/P i,t-1 is the earnings per share at the financial year end divided by the closing price 12 months previously firm i in year t, and all other variables are as previously defined. The regression is run separately, for the period before and after the adoption of

16

IFRS. Similar to the value-relevance analysis using the price-earnings regression, the coefficient of E/P t-1 and the R-squared of the model are examined to compare the ability of earnings to explain stock returns between the two periods. To test whether there is any significant difference between the value relevance of earnings before and after IFRS adoption using return-earnings model, we include interaction variables and other control variables, as shown below:

RET

i t

,

=

α +α

0

1

+α /

5

E

E

/

P

i t

,

P

i t

,

1

+α

2

IFRS

i t

,

1

*

GROWTH

i t

,

+α

3

E

+α /

6

E

/

P

,

i t

P

i t

,

1

1

*

IFRS

i t

,

*

TDTA

i t

,

+α

4

+ε

i t

,

E

/

P

,

i t

1

*

RISK

,

i t

(7)

where RISK i,t is the beta for firm i in year t, GROWTH i,t equals to the share price divided by book value per share for firm i at the end of fiscal year t, TDTA i,t is the total debt divided by total assets for firm i in year t, and all other variables are as previously defined. The coefficient of the interaction variable of E/P t-1 *IFRS, α 3 , captures the influence of IFRS on the value-relevance of earnings.

Data and Sample Selection

Our data are collected from Thompson One Banker database from 2002 to 2009. We identify each firm’s financial year end and extract the firm’s data for the period of three years before the adoption of IFRS and three years after the adoption of IFRS. Since the adoption of IFRS is made effective from Jan 1 2006, the first annual report prepared using the new standard dated 31 December 2006. Thus, we classify our data based on financial year end of each firm. For example, data from annual report dated 31 December 2006 to 30 December 2007 is considered as data for the first year of FRS adoption.

Following previous research on earnings management and value relevance of earnings (Callao et al., 2007; Van Tendeloo and Vanstraelen, 2005; Vander Bauwhede, 2001), we exclude all financial institutions and utility companies from our sample. We impose data restriction on the sample, such as the availability of accounting variables and market variables. We end up having two separate samples to test our hypotheses in order to maximize our observations. For the first hypothesis, relating to analysis on the effect of FRS adoption on earnings management, most of the missing data is because of

17

unavailability of cash flows from operations data, which are required to calculate total accrual. For this analysis, our sample comprises 4010 firm-year observations as in Table 1. For value relevance models, we exclude data with missing market prices. To control for potential outliers, we remove 0.5% top and bottom of each variables used in the study. The total observations for value relevance analysis are 2663.

[Table 1 and 2 is about here]

Table 1 presents descriptive statistics of the main variables used in the study. The table shows that there is not much difference between the absolute value of abnormal accruals calculated using Dechow, et al’s model (ABACDEC) with those using Kasnik (ABACKAS). The mean and median of ABACDEC (ABACKAS) is 0.849 (0.618) and 0.076 (0.064) respectively. Table 2 reports the correlation matrix between variables included in the regression. The correlation matrix shows that the Pearson (Spearman) correlations between ABACDEC or ABACKAS and the other variables used in the model are relatively small and do not exceed 0.285 (0.465).

Empirical Results

Table 3 presents the results of the ordinary least square regressions used to test the relationship between earnings quality, measured by the absence of earnings management, and IFRS adoption. The regressions, which are run based on model (3), include other determinants of earnings management practices such as the firm’s size (SIZE), profitability (PROFITABILITY), growth (GROWTH) and leverage (LEVERAGE). Panel A of the table reports the results from estimating the model using the absolute value of abnormal accrual based on Dechow, et al. (1995).

[Table 3 is about here]

From the table, the coefficient of the dummy variable IFRS, β 1 , is significant at 1% level with a t-statistics of -28.353. This result suggests that the adoption of IFRS-based accounting standards is significantly associated with lower level of earnings management. In other words, the level of reported earnings’ departure from normal earnings is lower after the adoption of the new standard, suggesting that earnings quality is higher after the

18

adoption of IFRS. Panel B of Table 3 reveals that a similar association between IFRS adoption and earnings management is observed as before, suggesting that the inference is robust to the use of alternative estimation for absolute value of abnormal accruals. Consistently, the coefficient of the dummy variable IFRS, β 1 , shows a significant negative association with the absolute value of abnormal accruals using Kasnik (1999) model (ABACKAS) at 1% level with a t-statistics of -28.477.

Our analyses on the value relevance of earnings are presented in Table 4 and Table 5. Table 4 shows the results using the price-earnings model, as discussed in Section 5. Differences between MASB and IFRS-based earnings with regard to value relevance are reflected in the differences in model (4)’s coefficient for EPS, α 1 , and R-squared between the pre-IFRS sample and the post-IFRS sample. Further, to determine whether the difference between the value relevance of earnings during the two periods is significant, we refer to the results from estimation of model (5). The coefficient of the interaction variable EPS*IFRS, α 3 , indicates whether there is a significant difference in the value relevance of earning between the two periods.

[Table 4 and 5 is about here]

As shown in Table 4, the coefficient of EPS from the price-earnings regression before and after IFRS adoption is 4.139 and 5.199, respectively. Both coefficients are significant at 1% level with a t-value of 19.039 (pre-IFRS) and 20.660 (post-IFRS). These results suggest that earnings reported during the IFRS period has higher weight compared to earnings reported in pre-IFRS period. Similarly, the R-squared shows that the joint coefficient of earnings and book value during the IFRS period is relatively higher, 41.4% for the pre-IFRS period and 47.5% for the post-IFRS period. Thus, assuming prices are good indicators of share value, it seems that IFRS-based earnings explain more variation in the share value movement. The higher value relevance of earnings during the post IFRS period is confirmed by further analysis using model (5). The result shows that the interaction variable, EPS*IFRS is positively significant at 1% level with t-statistics 3.214.

The examination of value relevance of earnings during the two different periods using return-earnings regressions, as in model (6) and (7), produces qualitatively similar results.

19

The results are shown in Table 5. We found that the ability of earnings in explaining returns is relatively higher during the period of IFRS adoption. The coefficient of E/P t-1 during the period before and after IFRS adoption is 0.995 and 2.104, and both are significant at 1% level with t-statistics of 6.463 and 16.489 respectively. Consistently, the interaction variables, E/P t-1 *IFRS is positively significant at 1% level with t-statistics of 6.058. Our examination on the value relevance of earnings using return-earnings regression suggests that the main finding of this study is not sensitive to model specification issues.

Summary and Conclusion

In this study, we examine the impact of IFRS adoption on the quality of reported earnings. We focused on two attributes of high quality of earnings, in terms of lower level of earnings management practices and higher value relevance of earnings numbers. Our results confirm that IFRS adoption is associated with better quality of reported earnings. Specifically, we found that earnings reported during the period after the adoption of IFRS is associated with lower amount of earnings management. Using both, price-earnings and return-earnings models, our findings also shows that earnings reported during the period after IFRS adoption is more value relevant.

Our results are based on Malaysian data, where some IFRS standards are yet to be implemented. However, the results are of significant benefit for local standard setters as well as for other emerging countries that have similar capital market and institutional characteristics. More research could be conducted in other environment so that the impact of IFRS adoption in different environment can be revealed. Other than that, the consistent changes in the level of absolute abnormal accruals and the value relevance of earnings during the period before and after the adoption of IFRS in Malaysia suggest that there is a possibility that investors give better valuation for earnings that has lower level of earnings management. Future research can investigate this issue. Furthermore, additional studies can also consider other attributes of earnings quality such as earnings conservatism, predictability, comparability, persistence and timeliness.

20

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24

Table 1: General descriptive statistics on observations and sample firms

Panel A: Descriptive Statistics for testing Hypothesis 1 (n= 4010)

Variables

Mean

Median

SD

Minimum

Maximum

Q1

Q3

ABACDEC

0.849

0.076

2.108

0.000

19.733

0.032

0.235

ABACKAS

0.618

0.064

1.652

0.000

15.966

0.025

0.165

SIZE

18.875

18.807

1.511

9.306

24.251

17.964

19.727

PROFITABILITY

4.232

4.661

11.127

-163.059

84.849

1.386

8.536

GROWTH

1.255

0.840

2.146

-53.870

36.730

0.520

1.380

LEVERAGE

0.397

0.061

1.278

0.000

9.814

0.004

0.189

Panel B: Descriptive Statistics for testing Hypothesis 2 (n=2663)

 

Variables

Mean

Median

SD

Minimum

Maximum

Q1

Q3

P

1.503

0.921

1.976

0.200

26.250

0.535

1.700

BVPS

1.621

1.274

1.617

0.010

25.500

0.799

1.915

EPS

0.098

0.066

0.204

-0.773

1.509

0.010

0.170

RET

0.188

-0.005

1.103

-1.000

25.667

-0.241

0.300

E/P t-1

0.061

0.072

0.204

-1.997

2.270

0.014

0.134

TDTA

21.372

20.026

16.906

0.000

84.889

5.651

33.767

RISK

0.972

0.910

0.672

-1.751

3.747

0.483

1.379

GROWTH

1.106

0.765

1.384

0.132

31.481

0.502

1.240

ABACDEC and ABACKAS are the absolute value of abnormal accruals estimated using Dechow, et al. (1995) model and Kasznik (1999) model respectively. SIZE is the natural logarithm of total assets. PROFITABILITY is the return on assets ratio. GROWTH equals to the share price divided by book value per share at the end of fiscal year. LEVERAGE is total long term debt divide by total assets at fiscal year end. P is closing price per share at the financial year end. BVPS is the book value per share. EPS is earnings per share. RET is holding returns for a 12-month period before the financial year end. E/P t-1 is earnings per share at the financial year end divided by the closing price 12 months previously. TDTA is total debt to total assets. RISK is measured by firm’s beta.

25

Table 2: Pearson (below diagonal) and Spearman (above diagonal) Correlation Matrix

Panel A: Sample for Earnings Management Analysis

 

ABACDEC

ABACKAS

SIZE

PROFITABILITY

GROWTH

LEVERAGE

ABACDEC

.723**

-.077**

-.020

.042**

.039*

ABACKAS

.764 **

-.093**

-.021

.036*

.007

SIZE

-.034 *

-.015

.273**

.115**

-.005

PROFITABILITY

-.024

.010

.285**

.465**

-.028

GROWTH

-.019

-.021

.105**

.252**

.000

LEVERAGE

.076 **

-.066**

.200**

-.107**

-.021

N=4010

Panel B: Sample for Value Relevance Analysis

 
 

P

BVPS

EPS

RET

E/P t-1

TDTA

GROWTH

RISK

P

.635**

.645**

.275**

.259**

-.237**

.123**

-.108**

BVPS

.514**

.552**

-.022

.231**

-.209**

.037

-.063**

EPS

.622**

.482**

.213**

.789**

-.249**

.251**

-.024

RET

.103**

-.046*

.078**

.397**

-.063**

.173**

.031

E/P t-1

.108**

.119**

.607**

.294**

-.141**

.306**

.064**

TDTA

-.145**

-.141**

-.208**

-.004

-.128**

.039*

.147**

GROWTH

-.008

-.014

-.003

.132**

.055**

-.024

.059*

RISK

-.088**

-.026

-.032

.088**

.061**

.162**

.032

N=2663

ABACDEC and ABACKAS are the absolute value of abnormal accruals estimated using Dechow, et al. (1995) model and Kasznik (1999) model respectively. SIZE is the natural logarithm of total assets. PROFITABILITY is the return on assets ratio. GROWTH equals to the share price divided by book value per share at the end of fiscal year. LEVERAGE is total long term debt divide by total assets at fiscal year end. P is closing price per share at the financial year end. BVPS is the book value per share. EPS is earnings per share. RET is holding returns for a 12-month period before the financial year end. E/P t-1 is earnings per share at the financial year end divided by the closing price 12 months previously. TDTA is total debt to total assets. RISK is measured by firm’s beta.

26

Table 3: OLS regressions of absolute value of abnormal accruals on IFRS and other additional determinants variables.

Panel A: Regression results of absolute value of abnormal accrual estimated using Dechow, et al (1995) model

ABACDEC i,t = β 0 + β 1 IFRS i,t +β 2 SIZE i,t +β 3 PROFITABILITY i,t +β 4 GROWTH i,t + β 5 LEVERAGE i,t + ε i,t

Variable

(Constant)

IFRS

SIZE

PROFITABILITY

GROWTH

LEVERAGE

Coeff. T-value VIF Adj. R 2 F-Stats

2.657 ***

-1.794 ***

-0.04 *

-0.003

-0.012

-0.061 **

6.737

-28.353

-1.904

-1.107

-0.813

-2.481

1.076

1.090

1.152

1.069

1.077

0.172

167.715 ***

N

4010

Panel B: Regression results of absolute value of abnormal accrual estimated using Kasnik (1999) model

ABACKAS i,t = β 0 + β 1 IFRS i,t +β 2 SIZE i,t +β 3 PROFITABILITY i,t +β 4 GROWTH i,t + β 5 LEVERAGE i,t + ε i,t

Variable

(Constant)

IFRS

SIZE

PROFITABILITY

GROWTH

LEVERAGE

Coeff. T-value VIF Adj. R 2 F-Stats

1.863 ***

-1.412 ***

-0.019

0.002

-0.017

-0.230 ***

6.03

-28.477

-1.132

0.742

-1.505

-11.996

1.076

1.090

1.152

1.069

1.077

0.172

167.299 ***

N

4010

Notes: ***, **, * represents statistical significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test). ABACDEC is the absolute value of abnormal accrual estimated using Dechow, et al. (1995) model. ABACKAS is the absolute value of abnormal accrual estimated using Kasznik (1999) model. SIZE is the natural logarithm of total assets. PROFITABILITY is the return on assets ratio. GROWTH equals to the share price divided by book value per share at the end of fiscal year. LEVERAGE is total long term debt divide by total assets at fiscal year end. IFRS is 1 if the financial statement is prepared under FRS, 0 otherwise.

27

Table 4: OLS regressions on value relevance of earnings using price-earnings models.

Pooled Sample

Pre IFRS

Post IFRS

Pooled Sample

(Basic Model)

(Basic Model)

(Basic Model)

(Extended Model)

Variable

Coeff.

T-value

 

Coeff.

T-value

Coeff.

T-value

Coeff.

T-value

(Constant)

.486 ***

 

12.038

 

.574 ***

12.324

.353 ***

4.724

.574 ***

11.361

EPS

4.715 ***

29.606

4.139 ***

19.039

5.199 ***

20.660

4.139 ***

17.550

BVPS

.340 ***

16.924

.343 ***

15.779

.344 ***

8.201

.343 ***

14.545

IFRS

-.221 **

-2.593

EPS*IFRS

1.060 ***

3.214

BVPS*IFRS

.001

.032

Adj. R 2

0.446

 

0.414

0.475

.449

F-Stats

1071.788 ***

 

530.058 ***

 

528.809 ***

434.739 ***

N

Basic Model:

P

,

i t

2663

=α +α

0

1

EPS

,

i t

+α

2

BVPS

,

i t

+ε

,

i t

1497

1166

2663

Extended Model:

P

i t

,

=α +α

0

1

EPS

i t

,

+α

2

BVPS

,

i t

+α

3

EPS

,

i t

*

IFRS

,

i t

+α

4

BVPS

i t

,

*

IFRS

i t

,

+ε

i t

,

Notes: ***, **, * represents statistical significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test). P is the closing price of a share of firm i at the financial year-end. EPS is the earnings per share of firm during the year. BVPS is the book value per share at the end of the year. IFRS is a dummy variable given a value of 1 if the financial statement is prepared under FRS, 0 otherwise.

28

Table 5: OLS regressions on value relevance of earnings using return-earnings models

Pre IFRS

Post IFRS

Extended Model

Variable

 

Coeff.

 

T-value

Coeff

T-value

Coeff

T-value

(Constant)

 

.106 ***

 

3.607

.067 **

2.192

.071 ***

2.841

E/P t-1

.995 ***

6.463

2.104 ***

16.489

.242

1.135

IFRS

 

-0.044

-1.169

E/P

t-1 *IFRS

1.086 ***

6.058

E/P

t-1 *RISK

1.249 ***

10.871

E/P

t-1 *GROWTH

 

.455 ***

8.073

E/P

t-1 *TDTA

-0.042 ***

-8.578

Adj. R 2

 

0.03

 

0.19

0.19

F-Stats

 

41.776 ***

 

271.895 ***

86.527 ***

N

1497

 

1166

2663

Basic Model:

RET

,

i t

=α +α /

0

1

E

P

,

i t

1

+ε

,

i t

Extended Model:

RET

i t

,

=α +α /

0

1

E

P

i t

,

1

+α

2

IFRS

i t

,

+α /

3

E

P

,

i t

1

*

IFRS

,

i t

+α /

4

E

P

,

i t

1

*

RISK

,

i t

+α /

5

E

P

i t

,

1

*

GROWTH

i t

,

+α /

6

E

P

i t

,

1

*

TDTA

i t

,

+ε

i t

,

Notes: ***, **, * represents statistical significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test). RET is holding returns for a 12- month period before the financial year end. E/P t-1 is the earnings per share at the financial year end divided by the closing price 12 months previously. IFRS is a dummy variable given a value of 1 if the financial statement is prepared under FRS, 0 otherwise. RISK is measured by firm’s beta. GROWTH equals to the share price divided by book value per share at the end of fiscal year. TDTA is total debt to total assets.

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