DOES IFRS LIMIT THE EARNINGS MANAGEMENT?: MRIGANC MISHRA

 

INTRODUCTION- WHAT IS IFRS?

The International Financial Reporting Standards (IFRS) is a set of common rules so that financial statements can be consistent, transparent and comparable around the world.[1] The financial information of businesses are to be reported using the same set of rules. This would ensure a proper and organised uniformity in the financial reporting, barring any fraudulent manipulation.[2] Apart from preventing the manipulation of data, the rationale behind these set of rules is that it makes it easier to compare and contrast the financial result[3] of companies/organisations.

The IFRS has become universal financial reporting language as it is currently used by 166 (85%) (out of 195) countries in Africa, America, Europe, Middle East and Asia, and Oceania.[4] USA, however, does not follow the IFRS framework, for they follow the Generally Accepted Accounting Principles (GAAP). These are standards adopted by the U.S. Securities and Exchange Commission (SEC), and they are a collection of commonly followed accounting rules and standards for financial reporting.[5] Similar to the IFRS, the rationale behind GAAP is to ensure that financial reporting is transparent and consistent from one organisation to another.[6]

EARNINGS MANAGEMENT:-

Earnings Management is the use of accounting techniques, to produce financial statements that present an overly positive view of the company’s business activities and financial position.[7] It is not to be confused with illegal activities and document tampering. These types of activities involve misrepresenting financial results. The management is under a lot of pressure by the investors and creditors, who want to see a steady growth and stability in the profits of the company. Therefore, they manipulate the company’s accounting practices to meet financial expectations, and simultaneously keep the stock price up.

EFFECT OF IFRS ON EARNINGS MANAGEMENT:-

In theory, IFRS adoption is supposed to limit the opportunistic management in undertaking Earnings Management, and increase the quality of disclosed information.[8] IFRS improves the market infrastructure, decreases information processing costs, increases reporting quality and thus, attracts foreign investments.[9]

Over the years, there have been several attempts to answer the hypothesis- does IFRS limit the Earnings Management of an organisation? Many empirical studies have shown that the incidence of earnings management decreased after IFRS was adopted.[10] However, there are some authors and researchers, who argue that the pervasiveness of Earnings Management behaviour in some countries (Australia, France and UK) have not been reduced after the mandatory adoption of IFRS.[11] A study conclusively proved that the Accounting quality has declined over time, even after the adoption of IFRS, in Germany.[12] Thus, an unambiguous and lucid answer fails to come into the picture.

There are several reasons for different findings of these research, the major reason being cross-country differences in accounting quality. These differences persist, because accounting quality is also a function of the firm’s overall institutional setting- which includes the legal and political system of the country in which the firm resides.[13] Moreover, a lack of study into the effect of IFRS adoption on the developed and developing countries separately, is also a reason for different conclusions.

INDIAN CONTEXT:-

Research in the Indian sub-context have shown that along with IFRS, adoption of high-quality governance mechanisms in firms (for example- an independent board of directors) are associated with low levels of Earnings Management. The Banking System in India, however, has been seen to engage in Earnings Management- low profitability banks in India adopt Earnings Management techniques to under provide their loan loss provisions and understate their gross NPAs to boost capital adequacy norms.[14] Similarly, an international comparison also reported high levels of Earnings Management in Indian Banking System.[15]

The reason for the prevalence of Earnings Management in the Indian Banking System, is that high earning banks have a positive ‘Return to Risk’ ratio, while the low earning banks have a negative ratio. Therefore, the management of low earning banks is compelled to indulge in these practices.

In developing countries (eg- India), a simple practice of strengthening the protection of investors, and achieving greater transparency in accounting reports can substantially reduce the banks’ incentives to manage earnings. Along with this, stringent enforcement of laws can effectively counter Earnings Management.

CONCLUSION:-

Demystifying the relationship between Earnings Management and IFRS is not an easy task. An intensive research, taking into account the different factors, becomes necessary to provide a fair conclusion. There is a wide spectrum of discrepancy between the theoretical application of the adoption of IFRS, and the actual prevalent practices followed by firms of different countries. In theory, IFRS reduces the Earnings Management of firms, however, the practicality paints a different picture. 

A standard conclusion throughout all the countries following IFRS is next to impossible, for a market research requires a research into separate countries, continents and regions.  Emerging markets, financial positions of nations, effect of institutionalisation of the firms in a particular country, and the structure of business organisations are also some of the factors that need to be taken into consideration. In the end, the main objective of the firms/organisations should be transparency in the financial reports and protection of investors, and refraining from managing earnings.  

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[1] Barclay Palmer, “International Financial Reporting Standards (IFRS)”, (last visited on 25^th August, 2020, 9:44pm) (https://www.investopedia.com/terms/i/ifrs.asp)

[2] Steven Bragg, “What is IFRS?”, (last visited on 25^th August, 2020, 9:59pm) (https://www.accountingtools.com/articles/what-is-ifrs.html)

[3] Id.

[4] Shivaji Borhade, Munadhil Abd Aljabar Alsalim, Ali Omer Mohammed, “Convergence of IFRS in Global Accounting System: Where do SAARC Countries stand for?”, (2018).

[5] CFA Institute, “US GAAP: Generally Accepted Accounting Principles”, (last visited on 26^th August, 2020, 2:56pm) (https://www.cfainstitute.org/en/advocacy/issues/gaap)

[6] Id.

[7] Alicia Tuovila, “Earnings Management”, (last visited on 26^th August, 2020, 10:50pm)( https://www.investopedia.com/terms/e/earnings-management.asp#:~:text=Earnings%20management%20is%20the%20use,judgments%20in%20following%20these%20principles.)

[8] Volume 55, Fathiah Rahmaningtyas, Aria Farah Mital, “IFRS Adoption, Earnings Management and Investor Protection in Several Asian Countries”, (IAC 2017).

[9] Volume 8 Issue 3, Mohammad Tariq Hasan, Dr. Azhar Abdul Rahman, “IFRS Adoption and Earnings Management: A Review and Justification of Earnings Management Model for Developing Countries”, (2017).

[10] Supra

[11] Jeanjean T., Stolowy H., ”Do Accounting Standards matter? An exploratory analysis of Earnings Management before and after IFRS adoption”, Journal of accounting and public policy, (2008).

[12] Paananen M., Lin H., “The development of accounting quality of IAS and IFRS over time: The case of Germany”, Journal of International Accounting Research, (2009).

[13] Supra.

[14] Volume 4, Titas Rudra, “Does IFRS Influence Earnings Management? Evidence from India”, Journal of Management Research, 2012.

[15] Shen C H., Chih H L., “Investor Protection, prospect theory, and earnings management: An International comparison of the Banking Industry”, Journal of Banking and Finance, (2005).