Abstract

We investigate the earnings management potential of allowing non-U.S. cross-listed firms to choose International Financial Reporting Standards (IFRS) reporting following the Securities and Exchange Commission's (SEC's) elimination of the IFRS-to-U.S.-GAAP reconciliation requirement in 2007. We also investigate whether differences exist between earnings management strategies for firms whose filing choice is most likely attributable to the SEC's regulatory change (i.e., firms that switched to IFRS voluntarily from local standards after the elimination) and those for firms that adopted U.S. GAAP voluntarily after the elimination. We find evidence of simultaneity and substitution between discretionary accruals and real activities manipulation (i.e., abnormal production costs and discretionary expenditures) for the two test samples of IFRS adopters and U.S. GAAP adopters. Nevertheless, in contrast to strategies for voluntary IFRS adopters after the elimination, our findings from additional analyses reveal that simultaneous (before the balance sheet date) and sequential (after the balance sheet date) decision processes (i.e., recognizing discretionary accruals and real activities manipulation in order to achieve expected earnings targets) co-exist in firms voluntarily adopting IFRS prior to the regulatory change, and that mandatory IFRS adopters do not manage earnings through discretionary accruals and discretional expenditures simultaneously. We also provide evidence that executives' reporting incentives, which include "big bath", income smoothing, and debt covenant restrictions, appear to affect the trade-off decision between discretionary accruals and real activities manipulation. However, the existence and tightness of accounting-based debt covenants seem to play a minor role in this decision for firms that switched to IFRS voluntarily after the elimination. Our empirical results underscore the importance of incorporating reporting incentives and earnings management strategies when examining the effects of regulatory changes in accounting standards.  

Keywords

discretionary accrualsreal activities manipulationreconciliation requirement