Audit Quality On Earnings Management Accounting Essay

Harmonizing to the Conceptual Framework for Financial Reporting ( besides known as the IFRS Framework ) , which was approved by the International Accounting Standards Board ( IASB ) in September 2010, the fiscal statements are supposed to function certain aims and are characterised by specific properties, the qualitative features. This model is the revised version of the once known ”Framework for the Preparation and Presentation of Financial Statements ” . The chief aim of the aforesaid model is to “ supply fiscal information about the coverage entity that is utile to bing and possible investors, loaners and other creditors in doing determinations about purchasing, selling or keeping equity or debt instruments and supplying or settling loans or other signifiers of recognition ” ( ) . The fiscal statements ‘ qualitative features that make them valuable to users are the Relevance and the Faithful Representation ( dependability ) . There are besides four auxiliary qualitative features: comparison, verifiability, seasonableness and comprehensibility.

The pick of net incomes as an index of public presentation allows for the engagement of directors. This engagement can hold both costs and benefits. There is a benefit to users of fiscal statements when directors use their discretion decently to portray the interior information they possess – thanks to their direct business with concern issues – to the extent allowed by the competitory kineticss of the the industry in which the house operates. On the contrary, there is a cost for users when directors manipulate net incomes and, hence, the fiscal statements for ego helping intents. This is what is called net incomes direction, viz. , the choice of accounting forms, on behalf of the directors, in order to achieve specific ends ( Scott, 1997 ) . As it is understood, net incomes direction affects negatively the qualitative features and reduces the informativeness of fiscal statements. Occasionally, it is so permeant that does non allow the achievement of fiscal statements ‘ major aim. The International Financial Reporting Standards ( IFRS ) , which is a “ set of principles-based accounting criterions developed by the International Accounting Standards Board ( IASB ) ” ( ) , aims chiefly at convergence with regard to the forms used for fiscal coverage across assorted states and facilitation of transborder investing analysis. Apart from this, it besides aims at contstraining the grade of net incomes direction exercised, which renders the fiscal statements valueless and misleading.

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1.2 Motivation

This subdivision describes the motive of the current survey. The issue of net incomes direction and its association with the IFRS has been examined in assorted contexts within and outside European states and the bing literature on this topic is voluminous. The intent of this survey is to look into if and how the grade of net incomes direction fluctuated during the past decennary in two European states, Italy and Portugal. The analysis probes how the passage from domestic by and large accepted accounting rules ( GAAP ) to the acceptance of IFRS affected net incomes direction. Taking for granted the significance of hearers in the restriction of net incomes direction, this survey besides focuses on the function of BIG 4 in discouraging net incomes direction. The ground for taking these peculiar states is the distinctive feature of their regulative model and, specifically, the prevalence of code-law in these two states. As Leuz, Nanda & A ; Wysocki ( 2003 ) confirm, codification jurisprudence is apt for a higher grade of net incomes direction compared to the Anglo-Saxon institutional model. These states ‘ immature and lacking capital market plus the weak precaution of the stockholders ‘ benefits ( La Porta, Shleifer & A ; Vishny, 2000 ) makes the probe of the effectivity of the IFRS and BIG 4 audit quality even more ambitious. To the best of my cognition, there have non been any old surveies analyzing the joint effects of these two factors on net incomes direction under this specific model. In this sense, this empirical research is reliable and remarkable and can make to illations that are expected to be of value to research workers, investors, professional comptrollers and the IASB experts.

1.3 REsearch inquiry and sub-questions

. The research concerns a sample of public ( listed ) companies which belong to the non-financial sector from two European states that have an influential function in the economic activity of Europe as a whole and have adopted IFRS. In add-on, the clip period examined will be divided into two groups: The first is prior to the transition and acceptance of International Financial Reporting Standards ( IFRS ) , from 1999-2004 and the other will concern the period after the passage from local GAAP to IFRS, 2005-2010 as from 2005 conformity with IFRS became compulsory. This differentiation is made in order to determine whether this passage impacted the grade of net incomes direction.

Furthermore, I aim to separate companies that were audited by BIG 4 audit houses and those that were audited by other audit houses. The ground for making this is because I want to cognize if the rumoured higher audit quality provided by BIG 4 has so an consequence on net incomes direction. Specifically, I want to cognize whether it reduces the grade of net incomes use at a higher extent than other audit houses. Therefore, the chief research inquiry will be formulated as follows:

“ What is the impact of IFRS and the BIG 4 audit quality on net incomes direction? ”

This chief research inquiry will be broken into smaller sub-questions, the reply of which will take to the reply of the chief inquiry, measure by measure. These sub-questions are the undermentioned:

What does net incomes direction mean? Why is it used and by who?

What does IFRS intend? Which are their aims? How do they impact net incomes direction?

Which audit houses are the BIG 4? Do they restrict net incomes direction? Are they more effectual than other audit houses in extenuating net incomes direction?


The construction of this survey consists, except for the first chapter which pertains to introductory information, the motive of the empirical research, the statement of the research inquiry and sub-questions, of two more major parts, each of which is, in bend, separated into smaller subdivisions.

The first portion concerns the theory that surrounds the constructs mentrioned above, that is, net incomes direction, BIG 4, and International Financial Reporting Standards ( IFRS ) . This is the theoretical portion. Particularly, the 2nd chapter of this portion, the “ THEORETICAL FRAMEWORK ” includes accounts of all these constituents and of the relevant theories that have been developed and are thought to hold an consequence on the grade of net incomes direction. The 3rd chapter, the “ LITERATURE REVIEW ” summarizes the findings of assorted anterior scientific surveies with regard to the inducements that encourage the battle in net incomes direction, every bit good as the function of IFRS in extenuating it. Furthermore, the “ LITERATURE REVIEW ” portion will envelop BIG 4 features, their effectivity and their differences from other audit houses. The concluding subdivision ( 4th chapter ) of the theoretical portion is the development of “ HYPOTHESES ” stemming from the research inquiries.

The 2nd portion of the survey constitutes the quantitative analysis and is divided in the undermentioned parts: The 5th chapter, “ SAMPLE DESCRIPTION ” which describes the selected sample and the informations collected to carry on the research. Then, the 6th chapter “ RESULTS ” , which presents the consequences of the analysis and their reading. Last but non least, the 7th chapter, “ CONCLUSION ” provides an overview of the findings and overall recommendations about the class of net incomes direction.

Chapter 2


In this chapter I will foremost analyze the constructs of Earnings Management, IFRS and BIG 4 and later I will mention the theoretical model that has evolved so far and provides assorted positions about the grounds why directors resort to net incomes use. These theories are the Stakeholder-Agency Theory, the Catering Theory, the Prospect Theory and the Institutional Theory and last but non least, the Positive Accounting Theory.


First of all, I have to aknowledge that in add-on to the aforesaid diction of Scott ( 1997 ) , about what constitutes net incomes direction, there are other definitions as good. One of these definitions as stated by Schipper ( 1989 ) is the “ purposeful intercession in the external fiscal coverage procedure with the purpose of obtaining some private addition ” . An alternate diction was made by Healy and Wahlen ( 1999 ) which defines net incomes direction as the “ usage of judgement in fiscal coverage and in structuring minutess to change fiscal studies to either misdirect some stakeholders about the implicit in economic public presentation of the company, or to act upon contractual results that depend on reported accounting judgements ” . Another definition given by Ayres ( 1994 ) is “ the knowing structuring of coverage or production/investment determinations around the bottom line impact ” . Normally, net incomes direction is adopted by high degree executives who have the authorization to act upon the fiscal coverage procedure. Conceptually, the sorts of net incomes direction are classified into two cardinal classs, irrespective of the agencies that are used in each of them. The first 1 is the existent net incomes direction class, such as the cut in R & A ; D costs or the premature acknowledgment of grosss, and the 2nd 1 is the accruals-based net incomes direction ( Cohen, Dey and Lys, 2007 ) .

Sing the IFRS, they were once known as International Accounting Standards and presently they are composed of 41 distinct International Accounting Standards, issued in assorted day of the months over the past old ages. At the minute, the acceptance of IFRS is extended in a assortment of states across the universe, among which is Australia, Canada, India and Japan and either let or necessitate the readying of fiscal statements harmonizing to the IFRS. Get downing from 2005, the execution of IFRS became obligatory for all public listed companies within the European Union. Until so, it was optional. The deductions of this government will be demonstrated subsequently on, in the literature reappraisal subdivision.

Equally far as audit houses are concerned, they are separated into two classs worldwide. The first 1 is referred as the “ Large 4 ” and the other one as the “ Second – Tier Audit houses ” ( Khurana, Boone & A ; Raman, 2010 ) . Initially, there were eight large audit companies known as the BIG 8, which were bit by bit transformed, through amalgamations and due to the expiration of Arthur Andersen audit house, to the modern-day BIG 4. In the sum, these four accounting houses are Deloitte & A ; Touche, Ernst & A ; Young, KPMG and PricewaterhouseCoopers. In order to exemplify their magnitude, more than three quarters of all listed US companies are audited by the BIG 4 ( GAO-03-864 ) .

2.2 Theory

2.2.1 Positive Accounting Theory

The Positive Accounting Theory was ab initio developed by Watts & A ; Zimmerman ( 1978 ) and was besides called ”Contracting Theory ” by Scott ( 1997 ) . The accent of this theory is in administrations ‘ contract-based motivations to exert their discretion with regard to accounting patterns. The chief premise on which it stands is that directors behave logically to impact the upshot arising from compacts in which the administration has engaged, for their ain personal involvement.

In this sense, they distinguish three hypotheses. These are the fillip program hypothesis, the debt compact and the political costs hypothesis. The first is linked to directors ‘ purpose to maximise their personal fiscal status. Due to the fact that normally the construct of ”financial status ” coherent with the accomplishment of certain marks, clarified in contractual footings and at the same time based on accounting Numberss ( normally net incomes ) , directors are disposed to pull strings these figures. The 2nd implies that directors, depending on their opinion, they behave in such a manner to avoid countenances and negative deductions for the house and theirselves due to possible violation of contracts with other parties. The likeliness of utilizing use techniques is positively related to the likeliness of contract infingement. The 3rd one supports the impression that directors prefer to deliberately underestimate net incomes in order to avoid unfavorable consequnces that would happen in instance of booming accounting Numberss, such as revenue enhancement payments and subsequent inevitable dialogues with labour brotherhoods for raising rewards.

2.2.2 Stakeholder-Agency Theory

The Stakeholder-Agency Theory is built on the impression that when person, kwon as “ the prinicipal ” hires another individual, viz. , “ the agent ” , to supply some sort of operation in favour of “ the principal ” and grants him with the several mandate, there is an bureau connexion between the two ( Jensen and Meckling, 1976 ) . The inexplicit hypothesis is that the ownership and the direction are distinguished within an administration. To some extent, the involvements of both coincide but on occasion there is a divergence, high plenty to promote directors to prosecute in net incomes direction. There are two important elements with regard to the Stakeholder-Agency Theory: The motivations of directors for net incomes direction and the information dissymmetry between the two sides. The motivations of directors are related to: the achievement of settled contracts with regard to accounting figures, ( either compensation/bonus or debt contracts ) , the conformity with ordinances and/or the turning away of unsought regulative countenances and deductions, every bit good as the outlooks developed by the capital markets sing the house ‘s future chances. ( Healy and Wahlen, 1999 ) . The bureau job normally arises when there is misalignement of executives ‘ and stockholders involvement and purpose and there is besides the appropriate potency for the executives. Consequently, the in-depth monitoring of the directors behaviour and actions, which is required on behalf of the proprietors, plus the divergency in the actions of the former and the original involvement of the latter are considered as bureau costs ( Hill and Jones, 1992 ) . As a consequence, net incomes direction is a sort of bureau cost as good.

2.2.3 Catering Theory

The Catering theory is a comparatively new theory that was developed by Simpson, Rajgopal and Shivakumar ( 2007 ) . This theory provides a new model about what triggers net incomes direction. The point of going is that investors search for and prefer stocks which are characterised by positive net incomes surprises. The extra value they place on this sort of stocks denotes their positive mentality refering their hereafter advancement. This inclination of investors is unstable, stems from their inherent aptitude and feelings and varies over clip. Directors try to provide to the demands and penchants of investors by unnaturally enlarging the unnatural accumulations therefore prosecuting in net incomes direction activities. This comes at the disbursal of the costs that the houses bear in the long term, while accumulations tend to return. In add-on, unnatural accumulations are capable to higher possibility of sensing by investors which is translated into impairment of the house ‘s celebrity and subsequent troubles in raising capital. The hardiness of this theory is more conspicuous in small and unstable houses.

2.2.4 Prospect Theory

The Prospect Theory was foremost formulated by Kahneman and Tversky ( 1979 ) and stems from the scientific discipline of psychological science. These two research workers attempt to explicate the behavior of investors and how they evaluate possible net incomes or losingss. Particularly, they claim that they employ heuristics to measure an administration and that they “ derive value from additions and losingss with regard to a mention point instead than from absolute degrees of wealth ” . One such absolute benchmark is the void net incomes. On top of this, they province that the deductions of describing a little loss will be far more important compared to the several deductions of a study which signifies a net income of the same absolute value. This means that the magnitude of the impact is uneven when mentioning to net incomes than when mentioning to losingss. As a consequence, directors are prone to use net incomes direction techniques in order to accomplish the outlooks of investors. Furthermore, the Prospect Theory was used as a edifice block for the evolvement of the similar subsequent Transaction Cost theory and the Distribution of Reported Earnings theory.

2.2.5 Institutional Theory

Due to several different attacks there is ambiguity about the exact definition of Institutional Theory. Unusually, there are seven extant estimates among which the Normative theory, the Rational Choice theory, the Historical Institutionalism theory and the Empirical Institutionalism theory ( Peters, 2000 ) . However, the Institutional Theory is based upon certain properties wich are common in all the aforesaid theories. Consistent with North ( 1990 ) , the societal construction is comprised of establishments and administrations. In this context, establishments impose restrictions, either endorsed or unofficial, in an effort to command for the Acts of the Apostless of corporations. However, at the same clip, they create possibilities for wealth creative activity and materialization of net incomes and the administrations set their behavior harmonizing to these. The establishments can change positively or negatively the economic effectivity. The combination of the inducements and the chances provided by the establishments can spur directors to pull strings net incomes. This consequence is considered to be moderated in societies in which there are expressed, terrible and enforceable Torahs, the “ rule-based ” societies. On the contrary, in societies where there are non dominant or adequately implemented Torahs, known as the “ relation – based ” societies this consequence is more marked ( Li, Park & A ; Li, 2004 ) .

Chapter 3


This chapter summarizes the findings of a great volume of anterior published researches that refer to net incomes direction, the inducements and other factors that promote it. Besides, the function of IFRS together with the advantages and drawbacks that are involved in them are analysed. Additionally, this subdivision deals with mentions to the BIG 4 audit houses, their properties and their distinction compared to the remainder audit houses.


There have been plenty of averments about the birthplace of net incomes direction and the parametric quantities that prompt the use of the corresponding agencies. The survey of Healy & A ; Wahlen ( 1998 ) is a landmark with regard to these averments and indicates that there are three basic classs of inducements. The first is comparative to capital market issues, such as the directors ‘ will to run into the outlooks of fiscal analysts. The 2nd refers to contractual dealingss in both loaning and direction ‘s wages footings. In the instance of the former, net incomes direction forms were used to extinguish the possibility of interrupting a contract and subsequenlty enduring the several negative deductions. In the instance of the latter, it was used to hike the accounting figures that, under specific fortunes, would guarantee the growing of directors ‘ personal wealth, merely like fillips.

Zeghal and Othman ( 2006 ) pull upon old surveies and they briefly refer to motivations such as the wage of directors, the attachment to debt compacts and ordinances, the antipathy for coverage losingss and the attainment of the analysts’forecasts. Apart from that, they besides define a triptych of motivations categorised as follows: I ) Firm attributes such as the size, the industry in which it operates and the grade of executives ‘ ownership two ) Contextual factors ( turning away of losingss ) and three ) Conjectural factors ( income smoothing ) . They suggest that the execution of IFRS is non indistinguishable across all states, while the domestic governments of each state are chiefly responsible for this intent. As a effect, the degree of net incomes direction besides varies. To account for the built-in societal and economic differences which impact the accounting patterns they add value by developing the “ Earnings Management Motives ( EMM ) ” theoretical account. Specifically they focus on the methods of funding, either equity or debt based, the strategy of corporate administration and the legal environment under which the houses operate. They recommend that the companies which are capable to statute law that ties revenue enhancement to fiscal coverage and are financed through equity are more prone to pull off net incomes.

SUN Wensheng & A ; SUN Jie ( 2008 ) examine the issue from a different position. Except for the known economic factors that influence net incomes direction they besides mention ethical elements as deciding factors. They believe that the ethical standars ( or their absence ) that dominate a house and the grade to which this is made expressed to its employees can consequently restrain ( or let ) net incomes direction patterns. Of class, there are conceptual differences of what is or is non allowed and considered as “ net incomes direction ” varies depending on 1 ‘s personal features. Relative to this point of position is the Kaplan ‘s ( 2001 ) theory who states that persons characterize as less unethical a behavior which is to their ain benefit. That is, directors are more indulgent in judging actions that can be deemed net incomes direction, compared to stockholders.

Through their ain research, Hutchinson & A ; Leung ( 2007 ) , back up the illation that the degree of net incomes direction varies disproportionately with that of the directors ‘ ownership. This means that the augmentation of ownership from minor degrees to higher 1s restricts net incomes direction, while, in higher degrees of ownership it is more profound. They besides examine some characteristics that make net incomes direction more intense. Concretely, they prove it is more permeant in small houses, in houses whose operations show unsteady tendencies – in order to fulfill net incomes smoothings intents – , in low growing houses every bit good as in houses which engage in cutting border engineerings, due to the demand for protection from the predominating uncertainness, and eventually, in houses with undistinguished engagement of institutional proprietors.

Cheng & A ; Warfield ( 2005 ) ab initio define two signifiers of equity motivations for directors stemming from “ stock based compensation and stock ownership ” . They corroborate that directors seek to acquire rid of the portions they own by selling them, in order to chair the hazard they are capable to and extricate from the house ‘s hazards. In this respect, they are propelled to utilize net incomes direction so as to act upon the preparation procedure of stock pirces, which really means to blow up the monetary values of the stocks they aim to sell and take advantage of this premium. Their findings substantiate the positive alliance between the executives ‘ stock related inducements and net incomes direction.

To sum up, we note that there are legion positions through which inducements and factors can impact an person ‘s behavior and spark net incomes direction. Now that they are specified, the following subdivision will mention to another critical point, the effects, both positive and negative involed in IFRS.


This subdivision is divided in three parts, viz. , the IFRS and how they relate to accrual accounting every bit good as voluntary and compulsory acceptance, the effects from the acceptance of IFRS on net incomes quality and eventually, the net incomes and drawbacks they have incurred.

3.2.1 IFRS, Accrual Accounting, Voluntary and Mandatory Adoption

As mentioned, the acceptance of IFRS became obligatory for publically listed companies within Europe since the financial twelvemonth 2005. One of the alterations that this acceptance dictated was the accent on the usage of accrual accounting. As stated: “ Accrual footing means a footing of accounting under which minutess and other events are recognized when they occur ( and non merely when hard currency or its equivalent is received or paid ) . Therefore, the minutess and events are recorded in the accounting records and recognized in the fiscal statements of the periods to which they relate. ” ( ) . This pattern enables the fiscal studies to picture a more complete and superior image of the existent economic fortunes that dominate a house. This is executable while the fiscal statements make non merely advert the current hard currency disbursals and grosss, but they besides mention the disbursals to be paid in the hereafter and the grosss to be received every bit good. Apart from that, a batch of houses decided to run and describe under the IFRS before they were mandated to make so ( get downing from 1st January 2005 ) . This was a alluring point for research and old surveies probed the grounds for this pick and documented its consequences with regard to net incomes direction.

Dumontier & A ; Raffournier ( 1998 ) made a preliminary research about what urges the companies to follow the IFRS voluntarily. Specifically, they examined the instance of Switzerland and they cocluded that houses adopted the IFRS in order to gain from this option. Due to the distinctive feature of Switzerland ‘s accounting regulative model, which permits legion alternate coverage picks, houses would hold grounds to describe under the IFRS for the undermentioned grounds: users of fiscal statements outside Switzerland were non accustomed to its domestic accounting patterns and the acquisition of necessary information is non easy through alternate beginnings. Besides, acceptance of IFRS signals more extended revelations, as it contains expressed and more terrible regulations. Last but non least, the foreign markets and the political costs they impose was another ground for this pick.

Leuz, Daske, Hail & A ; Verdi ( 2008 ) besides conducted another research about the effects of the crisp acceptance of accrual accounting and the voluntary acceptance IFRS. They examined the alterations in footings of liquidness, cost of capital and rating of companies. Initially, they partition their sample in compulsory and voluntary adoptive parents to account for the effects of this alteration. Their illations suggest that the houses which were obliged to follow with the IFRS revealed higher liquidness betterment compared to those which had in progress adopted the IFRS voluntarily. On the contrary, the former houses experienced an addition in the cost of capital. Furthermore, because of the distinction in the execution of the IFRS across states and the room they leave for using personal discretion, the significance of the capital market effects varies depending on the badness of their imposition. However, one failing identified in their paper is that these effects might non be entirely charged to the IFRS application, but in alterations in other factors such as the audit patterns, the corporate administration construction and the degree of conformity with the IFRS. Finally, they prove that the greater the divergence of national accounting rules from the international criterions and the beforehand deficiency of congruity, the greater the importance and size of this passage is. In the same line of logical thinking, Ipino & A ; Parbonetti ( 2011 ) , underpin these statements and supply new penetrations by documenting the replacing of accrual-based with existent net incomes direction techniques in the aftrermath of compulsory IFRS acceptance. Not merely do they show the replacing of the former with the latter when the legislative model is terrible, they besides demonstrate that the existent net incomes directions worsens the houses public presentation and chances at a greater extent. Therefore, the standard-setters ‘ attempt to better the quality of net incomes through the IFRS are rendered null inadvertently. Another research conducted by Guenther, Gegenfurtner, Kaserer & A ; Achleitner ( 2009 ) , investigates the qualitative features and the differences between compulsory and voluntary IFRS adoptive parents and compares the consequences for these two groups. Particularly, they find that compulsory adoptive parents were more decidedly characterized by smaller size every bit good as increased external and bank shareholding. In add-on, they note a bead in the extent of income smoothing for early adoptive parents. Sing the consequences, the IFRS induced the enlargement of conservative patterns for compulsory and voluntary groups.

3.2.2 The deductions of IFRS on net incomes quality

Equally far as the effects on the quality of reported net incomes and accounting Numberss as a whole under the IFRS are concerned, no unequivocal illations can be extracted while consequences are conflicting and inconclusive. Ball ( 2001 ) suggests that the international criterions ameliorate the quality of fiscal coverage in general. On the other manus, Paananen ( 2008 ) highlights the impairment of the quality of fiscal coverage because of international criterions. After holding taken a closer expression at the instance of Sweden, she discovered beef uping of income smoothing techniques and delinquent sensing of losingss. Of class this is an stray incident and it would be hazardous to generalize these findings for all IFRS adoptive parents. A recent scientific survey of Houqe, Zijl, Dunstan & A ; Karim ( 2011 ) innovates proposing that ‘earnings quality is a joint map of investor protection and the quality of accounting criterions, as proxied by IFRS ‘ . This really implies that none of these two constituents is equal plenty to guarantee the betterment of the informativeness and quality of fiscal studies on its ain. It is merely the combination of these two that allows for such an betterment. The ‘investor protection ‘ construct is approximated by variables like the legal and regulative envirnonment. A consentaneous research of Sonderstrom & A ; Sun ( 2007 ) , conjencture that the IFRS do non every bit heighten the quality of fiscal studies as this is dependent on country-specific features. Furthermore, each house prepares its official accounting and fiscal information in conformity with its demands and motivations. Through these motivations the quality of studies is influenced either negativley or positively in correlativity with the discretion allowed by the state ‘s ordinances and Torahs and its political system excessively. This really means that the rightness and the hardiness of accounting criterions is non the lone important facet that determines accounting quality.

3.2.3 Advantages and disadvantages from the acceptance of IFRS

The last paragraphs of this portion are devoted to the advantages and disadvantages originating for the execution of IFRS. Nobes ( 2004 ) scrutinizes the international criterions and stresses the importance of the being of the suited rules that should be embodied in the explicit regulations. Of class he admits the advantages of these regulations, as mentioned in the 1.1 subdivision but he besides adds that the necessity for them exists due to the absence of such rules. Apart from that, he suggests that this is the ground why there is adequate infinite for discretional accounting interventions and as a effect, net incomes direction. His chief part is that he makes clear the classs of accounting that are capable to such limitations-distortions and proposes alterations and the right rules for their betterment such as the right definition of balance sheet points ( assets ) . These classs relate to Leasing, Finacial Assets, Post-employment Benefits, Subsidiaries, Equity issues and Government Grants. Finally, he concludes that the inclusion of the right rules could both decrease the majority of criterions and better the quality of describing at the same clip back uping in general a principles-based apporach. Paul & A ; Burks ( “ Journal of Finance and Accountancy ” ) point out the negative and positive effects of the passage for US GAAP to IFRS, some of which can be generalised for the remainder of the states that have adopted the IFRS excessively. For illustration, as benefits they consider the lowering in costs for endeavors, particularly for doing investings abroad, the fact that more hierarchal direction beds will be preoccupied with the fiscal studies therefore cut downing the possibility of errors and net incomes direction efforts and the snap of regulations which, if used suitably, leads to disclosure of more in-depth and utile information. Couto, Cordeiro & A ; Silva ( 2009 ) investigated the instance of Portugal and found that although the initial purpose of the execution of the IFRS was strictly to better the quality of fiscal coverage, it triggered some disagreements in the short tally. These refer to single elements of the Balance Sheet every bit good as the Income Statement. However, they did non enter an absolute tendency in these changes.

Right at the beginning of the IFRS execution, Ball ( 2005 ) , founded on a theoretical degree his sentiment about the effects of this turn. He categorized the advantages into direct and indirect and noted that the latter could turn out more profitable than the former. In the first class he sets the cost decrease every bit good as the riddance of anterior arbitrary appraisals made by analysts in order to homogenise international fiscal studies. In add-on, he sets the sweetening of the place of minor investors in comparing with the major and most skillest 1s, because they would both deduce their information from the same beginnings and he besides puts accent on the “ Efficient Market Hypothesis ( EMH ) ” , saying that stock monetary values would reflect with a greater clearcutness the available information. Sing the 2nd class, he illustrates the directors would be more cautious when make up one’s minding about the realization of investings, if they are cognizant of the fact that they are closely observed and they would, hence, act in the involvement of stockholders more and more. Another topic that he goes through is the “ just value accounting ” . Although he admits that this method, as promoted by the IFRS, can be utile and enlightening, he besides juxtaposes the statement that it can render the anticipation of future net incomes really hard, sing the possible appraisal mistakes included in it. This is why he doubts the virtue that this pattern could engender.

Equally far as the drawbacks of the execution of IFRS are concerned, they consist of the irregular and unequal execution of criterions among the states that have adopted them. He foremost makes a differentiation between the homogeneousness of coverage criterions and the existent coverage activity, which may change even under the same coverage ordinance ( IFRS ) . Then, he explains that although the criterions are common internationally, the grade of their diversified execution is attributed to “ political and economic grounds ” . This really means that the cross-country differences in monitoring, enforcement organic structures and either common or code-law position are deterministic factors that shape the degree of incompatibility. As a effect, investors are tricked, while left to comprehend fiscal statements of companies from different states as every bit dependable.


This subdivision grapples with the old surveies that bring to the surface the prominence of the hearers with regard to the influence they can exercise in order to keep net incomes direction efforts, nailing particularly the BIG 4 ‘s activity.

3.3.1 Audit quality & A ; the utility of hearers

First of wholly, the quality of audit determines to a high degree how valuable the fiscal statements are. With the term “ audit quality ” is meant the “ the joint chance that the external hearer detects an anomalousness in fiscal statements, and so reveals it to the users of these statements ” ( DeAngelo, 1981 ) . Of class, this is merely a brief description and as it is understood, it contains constituents such as the hearer ‘s celebrity, the being or non of an audit commission inside an administration, every bit good as the grade to which it is free of managerial influence and the continuance of the hearer ‘s business by the house. The audit commission has a dual function both in the surveillance during the preparation of fiscal studies and the behavior of audit processs. Furthermore, in instance the hearers discover leery fiscal anomalousnesss, the audit commission shall safeguard their right and possibility to advert these anomalousnesss to administrative beds above the 1s that might hold induced them and, therefore, dispatch them from any managerial emphasis to hide possible maltreatments. The significance of all these constituents of “ audit quality ” is supported by anterior literature and was proven by Piot & A ; Janin ( 2005 ) . The importance of hearers in discouraging net incomes direction is besides underlined by Healy & A ; Wahlen ( 1998 ) but they clarify that the audit procedure is non unflawed and it is likely that failures can happen which foster the application of net incomes direction patterns.

Nelson, Elliott & A ; Tarpley ( 2000 ) aided by executives of one of the BIG 5 audit houses who participated in the research, probed the activity of hearers and the province under which they manage to keep net incomes direction. They recorded what they called “ Earnings Management Attempts ( EMA ) ” and based on these, they concluded that the hearers were more hesitating or inefficient to demand from the house to repeat its fiscal statements or to prevent net incomes direction in the undermentioned state of affairss: I ) there is non equal cogent evidence of erroneous fiscal statements, because of equivocal statute law two ) the magnitude of the mistakes detected was undistinguished because as they say hearers ‘ chief undertaking is to “ place and necessitate accommodation of stuff misstatements, and many EMAs could be considered misstatements, so it is sensible that hearers would be less likely to relinquish misstatements that they consider materia. ” three ) the audited company is ample, as there is a positive relation of the hearers ‘ wage and the magnitude and repute of the house they audit. As a effect, hearers have the inducement to besiege impropernesss that cause incommodiousnesss to the houses, under the fright of losing their client. four ) EMAs that lessen the income of the present twelvemonth.

3.3.2 BIG 4 V “ Second – Grade ” houses

Recently, except for the known BIG 4 audit houses, other noteworthy audit houses have come to the bow and act as their deputies. This could be expected, because in the transition of clip, the volume of undertakings that need to be performed by the hearers has been multiplied. Francis, Maydew & A ; Sparks ( 1999 ) have documented the domination of BIG 6 ( later BIG 4 ) against the remainder audit houses in observing and restricting net incomes direction attempts. This illation is extracted from the lower grade of unnatural accumulations found in endeavors that are audited by one the BIG 6. As a consequence, the fiscal statements of BIG 4 clients are more representative of the echt status of the house and are of higher quality. Apart from these, they besides document the BIG 6 ‘s higher outgos for geting in deepness audit specialisation and better their patterns in general. Supportive of these findings is the research conducted by Becker, Defond, Jiambalvo & A ; Subramanyam ( 1998 ) . Besides, DeFond and Jiambalvo ( 1993 ) , prove the effectivity of bigger audit houses to object to the force of directors and publish the proper audit sentiment.

However, the survey of Boone, Khurana & A ; Raman ( 2010 ) opposes to these pretenses. First, they support that there is some grade of resembelance between the two derived from their common concern of enduring cases and position harm, as side effects of hapless audits. However, they admit that they differ in the grade of trust on their major clients. This practically means that the BIG 4 are more immune and can fling more easy high degrees of managerial coercion. Afterwards, they find that there are no considerable disagreements between the audit quality that both of them offer utilizing as a benchmark the easiness with which the audit house is eager to roll up an baleful statement. However, the most of import facet of their survey refers to the position of investors who view the fiscal statements that are audited by one of the BIG 4 as superior even though the consequences of the research do non warrant this behavior. Except for the celebrity of the BIG 4 that affects the investors ‘ point of position, this is besides explained by the logical thinking that in instance of an audit default, and maintaining in head the BIG 4 ‘s comfortable fiscal status, they will hold better opportunities to derive big sums of compensation.

The survey of Francis & A ; Yu ( 2009 ) proceeded one measure further. They illustrated that there is a fluctuation across each of the BIG 4 audit houses, with regard to the quality of audit they provide, which is proportionate to the stature of the regional agency in which they operate. They support the antecedently mentioned statement that merely like bigger audit houses, greater agency within the same company are less contingent on individual clients excessively. This happens because the supervising is stronger in these agencies and do non easy allow audit misrepresantations and because the comparative impact of losing a client, even a major one is lesser compared to another comparatively little agency. In add-on, the bigger a agency is, the deeper the expertness of the hearers working in it. It is of import to observe that this feature is non movable because it is developped based on each agency and its clients. This is attributed chiefly to the legion clients and co-workers who reciprocally exchange their concern cognition and experience through their interpersonal relationship and better their accomplishments.


This portion of the literature reappraisal makes a retrospect in the most of import yesteryear surveies about net incomes direction. The senior surveies dealt chiefly with two classs of inducements, – those that stem from the demand to follow with regulations and ordinances and those that stem from the demand to stay by the agreed compacts, mentioning to them as the chief causes of net incomes direction. Dechow & A ; Skinner ( 2000 ) province that: “ as stock market ratings increased during the 1990s, particularly in concurrence with the increased importance of stock-based compensation, directors have become progressively sensitive to the degree of their houses ‘ stock monetary values and their relation to identify accounting Numberss. Consequently, their inducements to pull off net incomes to keep and better those ratings have besides increased, which arguably explains why net incomes direction has received so much recent attending ” . The last decennary though, the construct of accrual accounting attracted the research workers ‘ attending as a taking subscriber in net incomes direction patterns. As Dechow & A ; Dichev ( 2002 ) punctuate, when an economic dealing takes topographic point, it is rather possible that the several hard currency influxs or escapes associated with it, will non happen at that same clip, but at a ulterior point in clip. The reply to this job, in order to supply a complete position of the aggregative economic activity, is the usage of accrual accounting, which aligns the minute that the dealing is recorded with that of the happening of the economic effects ensuing from it. It is logical that this process requires personal rating of these minutess. Since these ratings are non ever either dependable or honest, it is expected that on occasion assessment mistakes will happen which falsify the accumulations quality. As a effect, such false appraisals could be considered as net incomes direction efforts, when made purposefully. Furthermore, Dechow & A ; Dichev prove that there is an reverse relationship between the accumulations quality and the size of this sort of mistakes.

Burgstahler & A ; Dichev ( 1997 ) advert to two of the most ordinary intents for which net incomes use is employed. These are the companies ‘ purpose to shy away from denoting either a diminution in net incomes or negative net incomes ( loss ) . Given the fact that stakeholders fixate on the attainment of fiscal ends, expressed in pure accounting figures, both instances provide the motive to directors to make so, due to high disbursals they would hold to endure in concern traffics with them in the opposite instance. In the first status, as the continuance of consecutive rises in net incomes is prolonged, the strength of motive is enhanced. However, this illation does non keep for the 2nd status. Overall, net incomes use is more widespread for

loss antipathy compared to diminutions in net incomes.

The survey of Degeorge, Patel & A ; Zeckhauser ( 1999 ) could be characterised as the subsequence of Burgstahler & A ; Dichev as they besides underscore the function of carry throughing the benchmarks that have been set. Except for the two already mentioned 1s, they besides refer to the demand for accomplishing the analysts ‘ previsions. Both surveies find that when net incomes direction occurs, it is higly likely to notice reported figures that simply reach the marks and extremely unlikely to see several figures that simply miss the marks. Another part of their research is that they classify the three benchmarks harmonizing to their magnitude and the cautiousness given to them by directors. Most of import is ranked the statement of positive net incomes, so, the statement of net incomes which exceed a benchmark, such as old twelvemonth ‘s net incomes, and least of import is the attainment of analysts ‘ previsions.

Dechow & A ; Skinner ( 2000 ) describe the difference in net incomes direction positions between the regulative organic structures and the academic community. Specifically, faculty members are more reassuring about the importance of net incomes direction and the harm it can incur to the related parties, compared to regulative organic structures which are more disquieted about it. The writers admit that this happens due to the insufficiency of research techniques used by faculty members to observe net incomes direction, the divergence sing the importance they attribute to assorted species of directors ‘ motivations for net incomes direction and, last but non least, the bing disagreement about how moderately the members of capital markets behave. Broadly, they argue that faculty members undervalue the significance of market-related motivations. The writers ‘ phrase: “ our natural inclination to presume investor reason has caused us to disregard capital market inducements for net incomes direction ” is declarative of this. On top of this, they face troubles in the computation of net incomes direction degrees and they rely on investors ‘ ability to place and face net incomes direction. Regulators from their side, see a fraction of net incomes direction as necessary immorality because of the freedom provided to directors. Besides, they do non presume that investors are ever adequately sensible when doing determinations. Contrariwise, they are convinced that they can non comprehend net incomes use at a timely footing and this inability is amplified by the fact that the entree to utile information is rather expensive.

Cohen, Dey & A ; Lys ( 2007 ) found a historical and gradual increase of the aggregative degree of net incomes direction. Prior to the old decennary ‘s dirts, like Enron, a bead in net incomes direction associated with the use of accumulations was observed, but the writers assert that this did non go on entirely because of the alteration in the SOX statute law. Possibly other causes led to this alteration excessively, like the prudence shown by hearers in the aftermath of recent dirts. In fact this bead confessed an exchange, non a diminution, between existent and accumulations net incomes direction, as the patterns that belong to the class of existent net incomes direction showed an upward impetus. This sort of patterns are thought to be more expensive for the house but are more favorable for the directors as they are non easy tracked. They besides wonder about the consequences of ordinances in restricting net incomes direction: “ some argue that these frauds occurred after 70 old ages of ever-increasing securities ordinance ” connoting indirectly that plurality of Torahs might turn out uneffective.

Cohen & A ; Zarowin ( 2008 ) relied on the old survey and developped it, documenting the effects of both existent and accumulations net incomes direction for the houses using it. Regardless of which of the two was used, they found collateral grounds that net incomes direction impacted the house as follows: the degree of investings was augmented in the comparative old ages of net incomes use and was shrinked afterwards. Furthermore, the joint consequence of these patterns was stronger than that of merely a individual of them. Apart from this, the deductions incurred by the house were of similar magnitude irrespective of the species of net incomes direction.

Chapter 4


This chapter is concerned with the preparation of the two hypotheses, the soundness of which is tested later through the statistical analysis.

The chief aim of the IFRS is to reenforce the credibleness of fiscal information that investors need in the determination devising procedure about the allotment of their financess. In this sense, they encourage and compel the houses that abide by them to uncover as much relevant information as possible. This makes the privacy of net incomes direction more expensive for the houses. On the other manus though, as the IFRS do non tilt on perfectly expressed regulations but, instead, represent a set of ordinances based on rules there is a demand for personal engagement and rating. Under these fortunes, if directors misappropriate the privileges of their place they can arouse opposite consequences of the intended. In general, anterior research by Ball ( 2001 ) has shown that the execution of IFRS alternatively of the local by and large accepted accounting rules ( GAAP ) has enhanced the quality of information provided, but there are besides surveies such as Paananen ( 2008 ) and Sonderstrom & A ; Sun ( 2007 ) that doubt the effectivity of IFRS in the restriction of net incomes direction and see it inadequate. Italy and Portugal are code-law states. This really implies that in these states there is inferior security of the involvements of stockholders, funding is acquired from single investors and the necessity of fiscal studies is non so imperative. Rather the focal point is on other issues, such as revenue enhancement considerations. In political models like these, the efficaciousness of international criterions is controversial. This is the ground why look intoing the effects of IFRS is of involvement in these two states. The first hypothesis is established on the above treatment:

H1: “ Earnings direction will diminish after the passage from local GAAP to IFRS. ”

Besides, in the comparative old surveies of Healy & A ; Wahlen ( 1998 ) , DeAngelo, ( 1981 ) , Piot & A ; Janin ( 2005 ) the importance of hearers is by and large accepted and recognized with regard to the bar every bit good as the sensing and the limitation of net incomes direction. The illations of these surveies are considered the point of going of the current research. Taking this for granted, plus the directors ‘ motivations to fall back to net incomes direction patterns and the hearers ‘ purpose to lend to fiscal statements that are free from knowing or unintented mistakes, indifferent, crystalline, uncovering and representative of the true fiscal status and economic activity of a house we proceed to the following phase: the surveies of Francis, Maydew & A ; Sparks ( 1999 ) and Becker, Defond, Jiambalvo & A ; Subramanyam ( 1998 ) happen grounds that advocate the position of BIG 6 ( later BIG 4 ) being more effectual in minimising net incomes direction compared to “ Second-Tier ” audit houses. However, Boone, Khurana & A ; Raman ( 2010 ) oppose to this perceptual experience and make non happen considerable unsimilarities between the two classs of audit houses, sing the quality of audit they provide. Because of the ability of bigger hearers to oppose the force per unit area imposed by directors, the higher grade of specialisation and the demand to continue their repute I province the 2nd hypothesis as follows:

H2: “ The BIG 4 audit houses constrain net incomes direction at a higher extent compared to “ Second-Tier ” audit houses ”

Chapter 5


This chapter discusses the research methodological analysis that is followed to prove the two hypotheses mentioned in subdivision 4 and depict the information that was collected for this ground. It is divided into two sub-categories. The first one presents the theoretical account that is used to determine the grade of net incomes direction applied in public houses of Italy and Portugal and explains the map of the related variables. The 2nd specifies the sample that is used for this research.


Harmonizing to Beneish ( 2001 ) , the methods applied by research workers in order to track net incomes direction patterns are sorted into three chief categories. The first one examines the breaks in the flow of net incomes. The 2nd one trades with peculiar accumulations, the use of which is thought to possess explanatory power of net incomes direction, such as prognosiss for bad debts. The last one relies on the calculation of discretional accumulations and their separation from non-discretionary, after holding computed entire accumulations. The last class of net incomes direction acknowledgment procedure involves assorted appraisal theoretical accounts the most known of which are the undermentioned: the DeAngelo Model, the Healy Model, the Jones and the Modified Jones Model and the Industry Model. These theoretical accounts are assessed in Dechow, Sloan, and Sweeney ( 1995 ) .

The current empirical research focuses on event-years. In understanding with a considerable figure of recent anterior surveies, the theoretical account used in this empirical research is the prevalent Modified Jones Model as presented in Dechow, Sloan, and Sweeney ( 1995 ) . The map of this theoretical account is based on the differentiation between the discretional and non-discretionary accumulations. The dependent variable is discretional accumulations division. The discretional portion is an indicant of possible net incomes direction and as a consequnce it lowers the quality of fiscal statements. Therefore, maintaining in head its negative association with the quality of net incomes, higher degree of discretional accumulations signals contingent net incomes direction activity. The grounds for choosing this peculiar theoretical account for gauging the grade of net incomes direction is that has been proven as the most robust among the remainder theoretical accounts of the same class, it is effectual when applied in a random form and it besides moderates the Jones Model leaning to undervalue the grade of net incomes direction when this is applied to grosss.

The construction of the theoretical account and the three necessity phases which I will travel through to prove the two hypotheses are the undermentioned:

The first phase consists of the computation of the sum ( entire ) accumulations through the equation:

I¤At / ( At-1 ) = b1* ( 1/At-1 ) + b2* ( I”REVt / At-1 ) + b3* ( PPEt / At-1 ) + Iµt

In this equation the symbols mentioned above denote the followers:

TA = the sum ( entire ) accumulations in twelvemonth T

At-1 = the entire assets in twelvemonth T – 1

I”REVt = grosss in twelvemonth T subtraction grosss in twelvemonth T – 1

PPEt = the gross belongings, works and equipment in twelvemonth T

b1, b2, b3 = estimations of the parametric quantities I?1, I?2, I?3 ( explained below ) arising from the procedure of ordinary least squares ( OLS )

Iµt = remainders of the equation

The 2nd phase involves the calculation of the non-discretionary accumulations with the usage of the undermentioned equation:

NDAt / ( At-1 ) = I?1* ( 1/At-1 ) + I?2* [ ( I”REVt – I”RECt ) / At-1 ] + I?3* ( PPEt /At-1 )

The new variables included are:

NDAt = non-discretionary accumulations in twelvemonth T and

a?†RECt which denotes the difference of net receivables between old ages t and t-1

I?1, I?2, I?3 which are firm-related parametric quantities

In the concluding phase we deduct the NDAt from the TAt and the consequence gives us the discretional accumulations ( DA ) , which is the index of net incomes direction we ask for:

I¤At / ( At-1 ) – NDAt = DA

The absolute magnitude of the last equation depicts the extent of net incomes direction and given its reverse association with the quality of fiscal coverage, a higher value means less qualitative net incomes.

Equally far as the first hypothesis is concerned, after holding performed the comparative arrested developments and found the sum, non-discretionary and discretional accumulations, I classify the consequences on an one-year footing, from 2000 to 2009, therefore supplying the chance to compare the comparative tendencies and fluctuations of net incomes direction for the first ( 200-2004 ) and the 2nd period ( 2005-2009 ) of the overall sample period. The consequences are presented in the following chapter.

Sing the trial of the 2nd hypothesis, I interpret the consequences that I have found but this clip I differentiate the disctinction of the sample to those houses that were audited by one of the BIG 4 and to those that were audited by any other audit house. Similarly, the amalgamate consequences are presented in the undermentioned chapter.


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