Earnings management and derivatives reporting: evidence from the adoption of IFRS standards in Europe

ABSTRACT

Although the new IFRS standards are considered an improvement for financial transparency, derivatives reporting remains subject to criticism by professional observers due to its complexity. Indeed, derivatives reporting could easily be used for earnings management. In this article, we analyse half a dozen earnings management proxies before and after the mandatory adoption of a battery of IFRS standards in 2013 and 2014 by European firms. Among others, IFRS 13 and IFRS 11 featured impactful requirements for the financial reporting of listed companies. Our results show that following the adoption of these standards, earnings management has faded except for firms using derivatives. These results suggest that the 2013–2014 IFRS standards package has improved the accounting quality of European-listed firms but that the flexibility and lack of guidance in the new standards regarding derivatives reporting are used by managers to manage earnings.

KEYWORDS:

• IFRS
• accounting quality
• earnings management
• derivatives reporting

JEL CLASSIFICATION:

• G30
• M41
• K22

Acknowledgments

We thank Janel Siemplensky and the participants of the annual meetings of the Association Française de Comptabilité (AFC), May 16-17, 2018; Association Française de Finance (AFFI), May 22-24, 2018; and ISG Lab workshop, 18 October 2017 for their constructive comments.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ https://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-by-jurisdiction/european-union/.

² Using firm-level changes in reporting incentives, actual reporting behaviours and the external reporting environment around IAS/IFRS adoption periods, Daske et al. (2013) classify firms into ‘label’ and ‘serious’ adopters.

³ Note that in line with Choi, Mao, and Upadhyay (2015), Barton (2001) and Pincus and Rajgopal (2002), we do not investigate how managers manipulate the reporting of derivatives but whether calling upon derivatives in current activities (for risk hedging) has an impact on earnings management.

⁴ The Stoxx Europe 600 contains the 600 largest-capitalization companies in Europe spread across 17 countries (https://www.stoxx.com/index-details?symbol=SXXP).

⁵ The ICB list is available at http://www.ftserussell.com/financial-data/industry-classification-benchmark-icb.

⁶ Dechow, Ge, and Schrand (2010) provide an extensive review of proxies used for earnings management.:

⁷ It should be mentioned that in Capkun, Collins, and Jeanjean (2016), when 0%<EOA<1% the variable SPR is given the value of 1. Regarding SPC, Lo, Ramos, and Rogo (2017) use thresholds of 0.4%, 0.5% or 0.6% of the year-to-year changes in earnings on assets.

⁸ We also allocated a dummy variable to the top 50% of the ranking to check for robustness. The results remain unchanged. Coefficients are not significant when we use the top 25%. This could be due to the size of the database or the fact that having derivatives could trigger earnings management behaviour following the IFRS adoptions regardless of the relative amount of derivatives in companies’ financial statements.

Additional information

Funding

This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.