The Effects of IFRS Adoption on Observed Earnings Smoothing Properties: The Confounding Effects of Changes in Timely Gain and Loss Recognition

Abstract

The observed smoothing of earnings (i.e. negative contemporaneous correlation between accruals and cash flows) is the joint product of the role of accruals in smoothing out transitory fluctuations in operating cash flows (noise reduction role) and the role of accruals in providing timely gain and loss recognition (contracting role). These two roles of accruals have opposite effects on earnings smoothing properties. We demonstrate that failing to control for changes in timely gain and loss recognition as firms shift to IFRS can lead to erroneous inferences regarding the effects of IFRS adoption on earnings smoothing, and consequently on researcher’ conclusions about how IFRS adoption has affected accounting quality. Our results are consistent with IFRS adoption resulting in a change in the contracting role rather than the noise reduction role of accruals. A decrease in timely loss recognition, an increase in timely gain recognition, and a net decrease in asymmetric timely loss recognition are what drives the change in observed smoothing of earnings.