New research argues that culture has a particularly important role in earnings management post-IFRS adoption due primarily to the flexibility IFRS creates for financial statement preparers.
Research by: Terry Mason, Assistant Professor of Accounting
Joe Ugrin, Associate Professor of Accounting
Anna Emley, Federal Reserve Bank of Kansas City (former Kansas State Student) NOTE: The views expressed in this article do not necessarily reflect the views and opinions of the Federal Reserve Bank of Kansas City or the Federal Reserve system.
International Financial Reporting Standards (IFRS) is a set of accounting rules that aim to create a common financial reporting platform worldwide with the goal of bringing “transparency, accountability and efficiency to financial markets around the world”. The International Accounting Standards Board (IASB) governs IFRS, and its mission is to serve “the public interest by fostering trust, growth and long-term financial stability in the global economy” through trusted financial data. IFRS is becoming the replacement for Generally Accepted Accounting Principles (GAAP) in much of the world. The European Union for example, has required that listed firms in member states use IFRS since 2005 and member countries of the European Economic Association that are not members of the EU have complied with this directive. IFRS has not been adopted in the United States, but the Securities and Exchange Commission has allowed foreign firms that trade on U.S. equity markets to file IFRS-based financial statements since 2007.
IFRS is a principles-based approach to standard setting that offers guidelines for preparing financial statements, while GAAP is a rules-based approach that provides a rigid set of detailed standards and clear-cut guidance for creating financial statements. There has been considerable debate over whether or not firms benefit from the adoption of IFRS. Proponents of IFRS have pushed for countries to adopt IFRS instead of GAAP to increase comparability and reduce reconciliation costs. Convergence would allow for easier comparison between corporations in different countries, as well as allow multi-national companies the ability to use one accounting standard company-wide.
Research has shown that the adoption of IFRS can indeed increase financial statement comparability. However, others believe the adoption of IFRS will be problematic. They suggest the adoption of IFRS will:
- Create an unnecessary burden on small companies that lack significant international operations and will incur costs associated with adopting IFRS that outweigh the benefits.
- Cause a loss of the quality that GAAP provides
- Result in increased earnings management because of the flexibility inherent in the principles-based IFRS.
Research coauthored by Terry Mason, assistant professor of accounting, Joe Ugrin, associate professor of accounting, and former Kansas State student Anna Emley argues that culture has a particularly important role in earnings management post-IFRS adoption due primarily to the flexibility IFRS creates for financial statement preparers. IFRS creates an environment that is conducive to earnings management and some cultures are more likely to take advantage of the IFRS environment.
Results of their research show a post-IFRS increase in earnings management for firms based in cultures that are more uncertainty avoidant, individualistic, short-term oriented, and indulgent. In cultures where uncertainty avoidance is high, firms appear to aim to keep earnings and profit predictable and stable and may use the flexibility of IFRS to do so. Cultures that are more short-term oriented may use the flexibility created by IFRS to gain quick results, improve the bottom line, and stabilize earnings with little regard for future negative effects of poor earnings quality. Individualistic cultures are more likely to manage earnings because the increased discretion and flexibility in the accounting standards post-IFRS reduces the likelihood that firms would be reprimanded if they are reported for managing earnings.
Takeaways
- Regulators may need to consider the effects of culture and introduce additional mechanisms to account for culture’s effects. Regulators in countries that are attempting to adopt or conform to IFRS, such as the United States, should be aware of cultural tendencies that could lead to more earnings management and, thus, lower financial reporting quality.
- In industry, multinational firms may need to consider these effects on intracompany transactions between countries and recording of financial results by managers in different countries.
- Practitioners may need to consider these effects when consulting and auditing financial statements for multinational or international firms where IFRS is in use.
- Researchers may need to consider culture when examining corporate behavior and control for culture in studies that include information related to firms from different countries.
More Information
Ugrin, Joseph, Mason, Terry W., and Emley, Anna. (2017). “Culture’s Consequence: The Relationship Between Cultural Dimensions and Income-Increasing Earnings Management After IFRS Adoption in the European Union,” Advances in Accounting, volume 37, pp. 140-151.
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