Do Corporate Governance Mechanisms Impact on Earnings Quality? Evidence from IFRS Adoption in European Union

Abstract

This study examines the impacts of mandatory adoption of International Financial Reporting Standards (IFRS) and corporate governance on accounting accruals in the UK and Germany. There has been a long debate on whether mandating a single set of high quality accounting standards, i.e. IFRS, leads to higher quality of accounting earnings. Some treat accounting standards as the sole determinant of accounting quality and find higher quality of accounting numbers in IFRS adoption countries; while others show that reporting incentives dominate accounting standards in determining accounting quality. Using hand-collected corporate governance data in companies’ annual reports throughout the sample period 2001-2013, we operationalize reporting incentives by constructing a score that rates the overall effectiveness of a firm’s corporate governance and highlight the following main findings. First, the magnitude of discretionary accruals in our sample has not changed since the 2005 mandatory IFRS adoption; meanwhile, the volatility of accrual residuals estimated by Dechow and Dichev (2002) model has become larger in IFRS adoption period, suggesting lower quality of IFRS accounting numbers. Second, firms with better corporate governance and therefore less earnings management incentive are associated with higher accounting quality, i.e. smaller sizes of discretionary accruals and lower volatilities of accrual residuals. Our results are in line with Ball et al. (2003), suggesting that incentives act as a deciding factor in improving accounting quality.