Mandatory Disclosures and Earnings Management: Evidence from IFRS Adoption

Abstract

We examine how changes in mandatory disclosure requirements affect firms’ earnings management practices. Drawing on Ewert and Wagenhofer 2005, we predict that if the increase in mandatory disclosures reduces accrual-based earnings management firms will rely more on real earnings management. We test this prediction using the event of mandatory adoption of International Financial Reporting Standards (IFRS) among UK public firms. We find that after IFRS adoption firms disclose significantly more information in annual reports. Using mediation analysis we document that the increase in the amount of disclosures is a mechanism through which IFRS reduces accrual-based earnings management. Finally, we demonstrate that after IFRS adoption firms rely significantly more on real earnings management. Analysis of earnings management practices around IFRS adoption among firms with a specific incentive to manage earnings (among firms issuing equity) shows similar results. However, comparing earnings management among public and private firms, we find that the substitution between accrual-based and real earnings management around IFRS adoption occurs only among public firms. Overall, our results show that the initiatives towards restricting accrual-based earnings management can lead to a more costly way of managing earnings and thus can have adverse consequences to firm value. Obtained evidence also sheds light on the mechanism through which the adoption of accounting standards can impact earnings management activities of a firm.