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According to the Conceptual Framework for Financial Reporting (also known as the IFRS Framework), which was approved by the International Accounting Standards Board (IASB) in September 2010, the financial statements are supposed to serve certain objectives and are characterised by specific attributes, the qualitative characteristics. This framework is the revised version of the formerly known ''Framework for the Preparation and Presentation of Financial Statements''. The main objective of the aforementioned framework is to "provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about buying, selling or holding equity or debt instruments and providing or settling loans or other forms of credit" (www.ifrs.org). The financial statements' qualitative characteristics that make them valuable to users are the Relevance and the Faithful Representation (reliability). There are also four supplementary qualitative characteristics: comparability, verifiability, timeliness and understandability.
The choice of earnings as an indicator of performance allows for the involvement of managers. This involvement can have both costs and benefits. There is a benefit to users of financial statements when managers use their discretion properly to portray the inner information they possess - thanks to their direct occupation with business issues - to the extent allowed by the competitive dynamics of the the industry in which the firm operates. On the contrary, there is a cost for users when managers manipulate earnings and, therefore, the financial statements for self serving purposes. This is what is called earnings management, namely, the selection of accounting patterns, on behalf of the managers, in order to attain specific goals (Scott, 1997). As it is understood, earnings management affects negatively the qualitative characteristics and reduces the informativeness of financial statements. Occasionally, it is so pervasive that does not permit the accomplishment of financial statements' major objective. The International Financial Reporting Standards (IFRS), which is a "set of principles-based accounting standards developed by the International Accounting Standards Board (IASB)" (www.ifrs.com), aims primarily at convergence with respect to the patterns used for financial reporting across various countries and facilitation of transborder investment analysis. Apart from this, it also aims at contstraining the degree of earnings management exercised, which renders the financial statements valueless and misleading.
This section describes the motivation of the current study. The issue of earnings management and its association with the IFRS has been examined in various contexts within and outside European countries and the existing literature on this subject is voluminous. The purpose of this study is to investigate if and how the degree of earnings management fluctuated during the past decade in two European countries, Italy and Portugal. The analysis probes how the transition from domestic generally accepted accounting principles (GAAP) to the adoption of IFRS affected earnings management. Taking for granted the significance of auditors in the limitation of earnings management, this study also focuses on the role of BIG 4 in deterring earnings management. The reason for choosing these particular countries is the peculiarity of their regulatory framework and, specifically, the prevalence of code-law in these two countries. As Leuz, Nanda & Wysocki (2003) confirm, code law is liable for a higher degree of earnings management compared to the Anglo-Saxon institutional framework. These countries' immature and deficient capital market plus the weak safeguard of the shareholders' benefits (La Porta, Shleifer & Vishny, 2000) makes the investigation of the effectiveness of the IFRS and BIG 4 audit quality even more challenging. To the best of my knowledge, there have not been any previous studies examining the joint effects of these two factors on earnings management under this specific framework. In this sense, this empirical research is authentic and singular and can reach to inferences that are expected to be of value to researchers, investors, professional accountants and the IASB experts.
1.3 REsearch question and sub-questions
. The research concerns a sample of public (listed) companies which belong to the non-financial sector from two European countries that have an influential role in the economic activity of Europe as a whole and have adopted IFRS. In addition, the time period examined will be divided into two groups: The first is prior to the passage and adoption of International Financial Reporting Standards (IFRS), from 1999-2004 and the other will concern the period after the transition from local GAAP to IFRS, 2005-2010 as from 2005 compliance with IFRS became mandatory. This distinction is made in order to ascertain whether this transition impacted the degree of earnings management.
Moreover, I aim to distinguish companies that were audited by BIG 4 audit firms and those that were audited by other audit firms. The reason for doing this is because I want to know if the rumoured higher audit quality provided by BIG 4 has indeed an effect on earnings management. Specifically, I want to know whether it reduces the degree of earnings manipulation at a higher extent than other audit firms. Therefore, the main research question will be formulated as follows:
"What is the impact of IFRS and the BIG 4 audit quality on earnings management?"
This main research question will be broken into smaller sub-questions, the answer of which will lead to the answer of the main question, step by step. These sub-questions are the following:
What does earnings management mean? Why is it used and by who?
What does IFRS mean? Which are their objectives? How do they impact earnings management?
Which audit firms are the BIG 4? Do they limit earnings management? Are they more effective than other audit firms in mitigating earnings management?
The structure of this study consists, except for the first chapter which pertains to introductory information, the motivation of the empirical research, the statement of the research question and sub-questions, of two more major parts, each of which is, in turn, separated into smaller sections.
The first part concerns the theory that surrounds the concepts mentrioned above, that is, earnings management, BIG 4, and International Financial Reporting Standards (IFRS). This is the theoretical part. Particularly, the second chapter of this part, the "THEORETICAL FRAMEWORK" includes explanations of all these components and of the relevant theories that have been developed and are thought to have an effect on the degree of earnings management. The third chapter, the "LITERATURE REVIEW" summarizes the findings of various prior scientific studies with respect to the incentives that encourage the engagement in earnings management, as well as the role of IFRS in mitigating it. Moreover, the "LITERATURE REVIEW" part will enclose BIG 4 characteristics, their effectiveness and their differences from other audit firms. The final section (fourth chapter) of the theoretical part is the development of "HYPOTHESES" stemming from the research questions.
The second part of the study constitutes the quantitative analysis and is divided in the following parts: The fifth chapter, "SAMPLE DESCRIPTION" which describes the selected sample and the data collected to conduct the research. Then, the sixth chapter "RESULTS", which presents the results of the analysis and their interpretation. Last but not least, the seventh chapter, "CONCLUSION" provides an overview of the findings and overall recommendations about the course of earnings management.
2. THEORETICAL FRAMEWORK
In this chapter I will firstly analyse the concepts of Earnings Management, IFRS and BIG 4 and subsequently I will cite the theoretical framework that has evolved so far and provides various perspectives about the reasons why managers resort to earnings manipulation. These theories are the Stakeholder-Agency Theory, the Catering Theory, the Prospect Theory and the Institutional Theory and last but not least, the Positive Accounting Theory.
2.1 EARNINGS MANAGEMENT, IFRS & BIG 4
First of all, I have to aknowledge that in addition to the aforementioned wording of Scott (1997), about what constitutes earnings management, there are other definitions as well. One of these definitions as stated by Schipper (1989) is the "purposeful intervention in the external financial reporting process with the intent of obtaining some private gain". An alternative wording was made by Healy and Wahlen (1999) which defines earnings management as the "use of judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting judgments". Another definition given by Ayres (1994) is "the intentional structuring of reporting or production/investment decisions around the bottom line impact". Usually, earnings management is adopted by high level executives who have the authority to influence the financial reporting process. Conceptually, the kinds of earnings management are classified into two fundamental categories, regardless of the means that are used in each of them. The first one is the real earnings management category, such as the cut in R&D costs or the premature recognition of revenues, and the second one is the accruals-based earnings management (Cohen, Dey and Lys, 2007).
Regarding the IFRS, they were formerly known as International Accounting Standards and currently they are composed of 41 discrete International Accounting Standards, issued in various dates over the past years. At the moment, the adoption of IFRS is extensive in a variety of countries across the world, among which is Australia, Canada, India and Japan and either allow or require the preparation of financial statements according to the IFRS. Starting from 2005, the implementation of IFRS became obligatory for all public listed companies within the European Union. Until then, it was optional. The implications of this regime will be demonstrated later on, in the literature review section.
As far as audit firms are concerned, they are separated into two categories worldwide. The first one is referred as the "BIG 4" and the other one as the "Second - Tier Audit firms" (Khurana, Boone & Raman, 2010). Initially, there were eight big audit companies known as the BIG 8, which were gradually transformed, through mergers and due to the termination of Arthur Andersen audit firm, to the contemporary BIG 4. In the aggregate, these four accounting firms are Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers. In order to illustrate their magnitude, more than three quarters of all listed US companies are audited by the BIG 4 (GAO-03-864).
2.2.1 Positive Accounting Theory
The Positive Accounting Theory was initially developed by Watts & Zimmerman (1978) and was also called ''Contracting Theory'' by Scott (1997). The emphasis of this theory is in organisations' contract-based motives to exercise their discretion with respect to accounting practices. The main assumption on which it stands is that managers behave logically to affect the upshot arising from covenants in which the organisation has engaged, for their own personal interest.
In this sense, they distinguish three hypotheses. These are the bonus plan hypothesis, the debt covenant and the political costs hypothesis. The first is linked to managers' intention to maximize their personal financial condition. Due to the fact that usually the concept of ''financial condition'' coherent with the achievement of certain targets, clarified in contractual terms and simultaneously based on accounting numbers (usually earnings), managers are apt to manipulate these figures. The second implies that managers, depending on their judgement, they behave in such a way to avoid sanctions and negative implications for the firm and theirselves due to potential infringement of contracts with other parties. The likelihood of using manipulation techniques is positively related to the likelihood of contract infingement. The third one supports the notion that managers prefer to intentionally underestimate earnings in order to avoid unfavourable consequnces that would occur in case of flourishing accounting numbers, such as tax payments and subsequent inevitable negotiations with labor unions for raising wages.
2.2.2 Stakeholder-Agency Theory
The Stakeholder-Agency Theory is built on the notion that when someone, kwon as "the prinicipal" hires another person, namely, "the agent", to provide some kind of operation in favor of "the principal'' and grants him with the respective authorisation, there is an agency connection between the two (Jensen and Meckling, 1976). The implicit hypothesis is that the ownership and the management are distinguished within an organisation. To some extent, the interests of both coincide but occasionally there is a deviation, high enough to encourage managers to engage in earnings management. There are two significant elements with respect to the Stakeholder-Agency Theory: The motives of managers for earnings management and the information asymmetry between the two sides. The motives of managers are related to: the accomplishment of settled contracts with respect to accounting figures, (either compensation/bonus or debt contracts), the compliance with regulations and/or the avoidance of undesired regulatory sanctions and implications, as well as the expectations developed by the capital markets regarding the firm's future prospects. (Healy and Wahlen, 1999). The agency problem usually arises when there is misalignement of executives' and shareholders interest and intention and there is also the appropriate potentiality for the executives. Consequently, the in-depth monitoring of the managers behaviour and actions, which is required on behalf of the owners, plus the divergence in the actions of the former and the original interest of the latter are considered as agency costs (Hill and Jones, 1992). As a result, earnings management is a kind of agency cost as well.
2.2.3 Catering Theory
The Catering theory is a relatively new theory that was developed by Simpson, Rajgopal and Shivakumar (2007). This theory provides a new framework about what triggers earnings management. The point of departure is that investors search for and prefer stocks which are characterised by positive earnings surprises. The additional value they place on this kind of stocks denotes their positive outlook concerning their future progress. This tendency of investors is unstable, stems from their instinct and feelings and varies over time. Managers try to cater to the needs and preferences of investors by artificially enlarging the abnormal accruals thus engaging in earnings management activities. This comes at the expense of the costs that the firms bear in the long term, while accruals tend to revert. In addition, abnormal accruals are subject to higher possibility of detection by investors which is translated into deterioration of the firm's fame and subsequent difficulties in raising capital. The robustness of this theory is more conspicuous in little and unstable firms.
2.2.4 Prospect Theory
The Prospect Theory was firstly formulated by Kahneman and Tversky (1979) and stems from the science of psychology. These two researchers attempt to explain the behaviour of investors and how they evaluate potential profits or losses. Particularly, they claim that they employ heuristics to evaluate an organisation and that they "derive value from gains and losses with respect to a reference point rather than from absolute levels of wealth". One such absolute benchmark is the null earnings. On top of this, they state that the implications of reporting a slight loss will be far more significant compared to the respective implications of a report which signifies a profit of the same absolute value. This means that the magnitude of the impact is uneven when referring to profits than when referring to losses. As a result, managers are prone to utilise earnings management techniques in order to achieve the expectations of investors. Furthermore, the Prospect Theory was used as a building 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 approaches there is ambiguity about the exact definition of Institutional Theory. Remarkably, there are seven extant approximations 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 attributes wich are common in all the aforementioned theories. Consistent with North (1990), the social structure is comprised of institutions and organisations. In this context, institutions impose limitations, either endorsed or unofficial, in an attempt to control for the acts of corporations. However, at the same time, they create possibilities for wealth creation and materialisation of profits and the organisations set their behaviour according to these. The institutions can alter positively or negatively the economic effectiveness. The combination of the incentives and the opportunities provided by the institutions can spur managers to manipulate earnings. This effect is considered to be moderated in societies in which there are explicit, severe and enforceable laws, the "rule-based" societies. On the contrary, in societies where there are not dominant or adequately enforced laws, known as the "relation - based" societies this effect is more pronounced (Li, Park & Li, 2004).
3. LITERATURE REVIEW
This chapter summarizes the findings of a great volume of prior published researches that refer to earnings management, the incentives and other factors that promote it. Also, the role of IFRS together with the advantages and drawbacks that are involved in them are analysed. Additionally, this section deals with references to the BIG 4 audit firms, their attributes and their differentiation compared to the rest audit firms.
3.1 DETERMINANTS & INFLUENTIAL FACTORS OF EARNINGS MANAGEMENT
There have been plenty of assertions about the provenance of earnings management and the parameters that prompt the utilisation of the corresponding means. The study of Healy & Wahlen (1998) is a landmark with respect to these assertions and indicates that there are three basic categories of incentives. The first is relative to capital market issues, such as the managers' will to meet the expectations of financial analysts. The second refers to contractual relations in both lending and management's reward terms. In the case of the former, earnings management patterns were used to eliminate the possibility of breaking a contract and subsequenlty suffering the respective negative implications. In the case of the latter, it was used to boost the accounting figures that, under specific circumstances, would ensure the growth of managers' personal wealth, just like bonuses.
Zeghal and Othman (2006) draw upon previous studies and they briefly refer to motives such as the remuneration of managers, the adherence to debt covenants and regulations, the aversion for reporting losses and the attainment of the analysts'forecasts. Apart from that, they also define a triptych of motives categorised as follows: i) Firm attributes such as the size, the industry in which it operates and the degree of executives' ownership ii) Contextual factors (avoidance of losses) and iii) Conjectural factors (income smoothing). They suggest that the implementation of IFRS is not identical across all countries, while the domestic authorities of each country are mainly responsible for this purpose. As a consequence, the level of earnings management also varies. To account for the inherent social and economic differences which impact the accounting practices they add value by developing the "Earnings Management Motives (EMM)" model. Specifically they focus on the methods of financing, either equity or debt based, the scheme of corporate governance and the legal environment under which the firms operate. They recommend that the companies which are subject to legislation that ties tax to financial reporting and are financed through equity are more prone to manage earnings.
SUN Wensheng & SUN Jie (2008) examine the issue from a different perspective. Except for the known economic factors that influence earnings management they also mention ethical elements as determinant factors. They believe that the ethical standars (or their absence) that dominate a firm and the degree to which this is made explicit to its employees can accordingly constrain (or allow) earnings management practices. Of course, there are conceptual differences of what is or is not allowed and considered as "earnings management" varies depending on one's personal characteristics. Relative to this point of view is the Kaplan's (2001) theory who states that individuals characterize as less unethical a behaviour which is to their own benefit. That is, managers are more lenient in judging actions that can be deemed earnings management, compared to shareholders.
Through their own research, Hutchinson & Leung (2007), support the inference that the level of earnings management varies disproportionately with that of the managers' ownership. This means that the augmentation of ownership from minor levels to higher ones restricts earnings management, while, in higher levels of ownership it is more profound. They also examine some features that make earnings management more intense. Concretely, they prove it is more pervasive in little firms, in firms whose operations show unsteady trends - in order to satisfy earnings smoothings purposes - , in low growth firms as well as in firms which engage in cutting edge technologies, due to the need for protection from the prevailing uncertainty, and finally, in firms with insignificant participation of institutional owners.
Cheng & Warfield (2005) initially define two forms of equity motives for managers stemming from "stock based compensation and stock ownership". They corroborate that managers seek to get rid of the shares they own by selling them, in order to moderate the risk they are subject to and disentangle from the firm's risks. In this regard, they are propelled to use earnings management so as to influence the formulation process of stock pirces, which actually means to inflate the prices of the stocks they aim to sell and take advantage of this premium. Their findings substantiate the positive alignment between the executives' stock related incentives and earnings management.
To sum up, we note that there are numerous perspectives through which incentives and factors can affect an individual's behaviour and spark earnings management. Now that they are specified, the next section will refer to another critical point, the consequences, both positive and negative involed in IFRS.
3.2 CONSEQUENCES FROM THE ADOPTION OF IFRS
This section is divided in three parts, namely, the IFRS and how they relate to accrual accounting as well as voluntary and mandatory adoption, the consequences from the adoption of IFRS on earnings quality and finally, the profits and drawbacks they have incurred.
3.2.1 IFRS, Accrual Accounting, Voluntary and Mandatory Adoption
As mentioned, the adoption of IFRS became obligatory for publicly listed companies within Europe since the fiscal year 2005. One of the changes that this adoption dictated was the emphasis on the use of accrual accounting. As stated: "Accrual basis means a basis of accounting under which transactions and other events are recognized when they occur (and not only when cash or its equivalent is received or paid). Therefore, the transactions and events are recorded in the accounting records and recognized in the financial statements of the periods to which they relate." (ifac.org). This practice enables the financial reports to depict a more complete and superior picture of the real economic circumstances that dominate a firm. This is feasible while the financial statements do not only mention the current cash expenses and revenues, but they also mention the expenses to be paid in the future and the revenues to be received as well. Apart from that, a lot of firms decided to operate and report under the IFRS before they were mandated to do so (starting from 1st January 2005). This was a tempting point for research and previous studies probed the reasons for this choice and documented its results with respect to earnings management.
Dumontier & Raffournier (1998) made a preliminary research about what urges the companies to adopt the IFRS voluntarily. Specifically, they examined the case of Switzerland and they cocluded that firms adopted the IFRS in order to profit from this option. Due to the peculiarity of Switzerland's accounting regulatory framework, which permits numerous alternative reporting choices, firms would have reasons to report under the IFRS for the following reasons: users of financial statements outside Switzerland were not accustomed to its domestic accounting practices and the acquisition of necessary information is not easy through alternative sources. Also, adoption of IFRS signals more extensive disclosures, as it contains explicit and more severe rules. Last but not least, the foreign markets and the political costs they impose was another reason for this choice.
Leuz, Daske, Hail & Verdi (2008) also conducted another research about the effects of the sharp adoption of accrual accounting and the voluntary adoption IFRS. They examined the changes in terms of liquidity, cost of capital and valuation of companies. Initially, they partition their sample in mandatory and voluntary adopters to account for the effects of this change. Their inferences suggest that the firms which were obliged to comply with the IFRS revealed higher liquidity amelioration compared to those which had in advance adopted the IFRS voluntarily. On the contrary, the former firms experienced an increase in the cost of capital. Moreover, because of the differentiation in the implementation of the IFRS across countries and the room they leave for applying personal discretion, the significance of the capital market effects varies depending on the severity of their infliction. However, one weakness identified in their paper is that these effects might not be exclusively charged to the IFRS application, but in changes in other factors such as the audit practices, the corporate governance structure and the level of compliance with the IFRS. Finally, they prove that the greater the deviation of national accounting principles from the international standards and the beforehand lack of congruence, the greater the importance and size of this transition is. In the same line of reasoning, Ipino & Parbonetti (2011), underpin these arguments and provide new insights by documenting the replacement of accrual-based with real earnings management techniques in the aftrermath of mandatory IFRS adoption. Not only do they demonstrate the replacement of the former with the latter when the legislative framework is severe, they also demonstrate that the real earnings managements worsens the firms performance and prospects at a greater extent. Thus, the standard-setters' effort to improve the quality of earnings through the IFRS are rendered void unwittingly. Another research conducted by Guenther, Gegenfurtner, Kaserer & Achleitner (2009), investigates the qualitative characteristics and the differences between mandatory and voluntary IFRS adopters and compares the results for these two groups. Particularly, they find that mandatory adopters were more emphatically characterized by smaller size as well as increased external and bank shareholding. In addition, they note a drop in the extent of income smoothing for early adopters. Regarding the results, the IFRS induced the expansion of conservative practices for mandatory and voluntary groups.
3.2.2 The implications of IFRS on earnings quality
As far as the effects on the quality of reported earnings and accounting numbers as a whole under the IFRS are concerned, no definitive inferences can be extracted while results are conflicting and inconclusive. Ball (2001) suggests that the international standards ameliorate the quality of financial reporting in general. On the other hand, Paananen (2008) highlights the deterioration of the quality of financial reporting because of international standards. After having taken a closer look at the case of Sweden, she discovered strengthening of income smoothing techniques and overdue detection of losses. Of course this is an isolated incident and it would be risky to generalise these findings for all IFRS adopters. A recent scientific study of Houqe, Zijl, Dunstan & Karim (2011) innovates suggesting that 'earnings quality is a joint function of investor protection and the quality of accounting standards, as proxied by IFRS'. This actually implies that none of these two components is adequate enough to ensure the amelioration of the informativeness and quality of financial reports on its own. It is only the combination of these two that allows for such an improvement. The 'investor protection' concept is approximated by variables like the legal and regulatory envirnonment. A unanimous research of Sonderstrom & Sun (2007), conjencture that the IFRS do not equally enhance the quality of financial reports as this is dependent on country-specific characteristics. Furthermore, each firm prepares its official accounting and financial information in accordance with its needs and motives. Through these motives the quality of reports is influenced either negativley or positively in correlation with the discretion allowed by the country's regulations and laws and its political system too. This actually means that the appropriateness and the robustness of accounting standards is not the only crucial aspect that determines accounting quality.
3.2.3 Advantages and disadvantages from the adoption of IFRS
The last paragraphs of this part are devoted to the advantages and disadvantages arising for the implementation of IFRS. Nobes (2004) scrutinizes the international standards and stresses the importance of the existence of the suitable principles that should be embodied in the explicit rules. Of course he admits the advantages of these rules, as mentioned in the 1.1 section but he also adds that the necessity for them exists due to the absence of such principles. Apart from that, he suggests that this is the reason why there is enough space for discretionary accounting treatments and as a consequence, earnings management. His main contribution is that he makes clear the categories of accounting that are subject to such limitations-distortions and proposes modifications and the right principles for their improvement such as the correct definition of balance sheet items (assets). These categories relate to Leasing, Finacial Assets, Post-employment Benefits, Subsidiaries, Equity issues and Government Grants. Finally, he concludes that the inclusion of the right principles could both diminish the bulk of standards and improve the quality of reporting at the same time supporting in general a principles-based apporach. Paul & Burks ("Journal of Finance and Accountancy") point out the negative and positive effects of the transition for US GAAP to IFRS, some of which can be generalised for the rest of the countries that have adopted the IFRS too. For example, as benefits they consider the lowering in costs for enterprises, especially for making investments abroad, the fact that more hierarchical management layers will be preoccupied with the financial reports thus reducing the possibility of mistakes and earnings management attempts and the elasticity of rules which, if used appropriately, leads to revelation of more in-depth and useful information. Couto, Cordeiro & Silva (2009) investigated the case of Portugal and found that although the initial intention of the implementation of the IFRS was purely to improve the quality of financial reporting, it triggered some discrepancies in the short run. These refer to individual elements of the Balance Sheet as well as the Income Statement. However, they did not record an absolute trend in these alterations.
Right at the commencement of the IFRS implementation, Ball (2005), founded on a theoretical level his opinion about the consequences of this twist. He categorized the advantages into direct and indirect and noted that the latter could prove more profitable than the former. In the first category he sets the cost reduction as well as the elimination of prior arbitrary assessments made by analysts in order to homogenize international financial reports. In addition, he sets the enhancement of the position of minor investors in comparison with the major and most skillest ones, because they would both derive their information from the same sources and he also puts emphasis on the "Efficient Market Hypothesis (EMH)", stating that stock prices would reflect with a greater preciseness the available information. Regarding the second category, he illustrates the managers would be more cautious when deciding about the realisation of investments, if they are aware of the fact that they are closely observed and they would, therefore, act in the interest of shareholders more and more. Another subject that he goes through is the "fair value accounting". Although he admits that this method, as promoted by the IFRS, can be useful and informative, he also juxtaposes the argument that it can render the prediction of future earnings very difficult, considering the potential estimation errors included in it. This is why he doubts the merit that this practice could breed.
As far as the drawbacks of the implementation of IFRS are concerned, they consist of the irregular and unequal implementation of standards among the countries that have adopted them. He first makes a distinction between the homogeneity of reporting standards and the real reporting activity, which may vary even under the same reporting regulation (IFRS). Then, he explains that although the standards are common internationally, the degree of their diversified implementation is attributed to "political and economic reasons". This actually means that the cross-country differences in monitoring, enforcement bodies and either common or code-law status are deterministic factors that shape the level of inconsistency. As a consequence, investors are tricked, while left to perceive financial statements of companies from different countries as equally reliable.
3.3 EARNINGS MANAGEMENT & THE ROLE OF AUDITORS: BIG 4 & OTHERS
This section grapples with the previous studies that bring to the surface the prominence of the auditors with respect to the influence they can exert in order to restrain earnings management attempts, pinpointing especially the BIG 4's activity.
3.3.1 Audit quality & the usefulness of auditors
First of all, the quality of audit determines to a high level how valuable the financial statements are. With the term "audit quality" is meant the "the joint probability that the external auditor detects an anomaly in financial statements, and then reveals it to the users of these statements" (DeAngelo, 1981). Of course, this is just a brief description and as it is understood, it contains components such as the auditor's fame, the existence or not of an audit committee inside an organisation, as well as the degree to which it is free of managerial influence and the duration of the auditor's occupation by the firm. The audit committee has a double role both in the surveillance during the formulation of financial reports and the conduct of audit procedures. Moreover, in case the auditors discover suspicious financial anomalies, the audit committee shall safeguard their right and possibility to mention these anomalies to administrative layers above the ones that might have induced them and, thus, discharge them from any managerial stress to conceal potential abuses. The significance of all these components of "audit quality" is supported by prior literature and was proven by Piot & Janin (2005). The importance of auditors in deterring earnings management is also underlined by Healy & Wahlen (1998) but they clarify that the audit process is not flawless and it is probable that failures can occur which foster the application of earnings management practices.
Nelson, Elliott & Tarpley (2000) aided by executives of one of the BIG 5 audit firms who participated in the research, probed the activity of auditors and the state under which they manage to restrain earnings management. They recorded what they called "Earnings Management Attempts (EMA)" and based on these, they concluded that the auditors were more hesitant or inefficient to demand from the firm to restate its financial statements or to forestall earnings management in the following situations: i) there is not adequate proof of erroneous financial statements, because of ambiguous legislation ii) the magnitude of the errors detected was insignificant because as they say auditors' main task is to "identify and require adjustment of material misstatements, and many EMAs could be considered misstatements, so it is reasonable that auditors would be less likely to waive misstatements that they consider materia." iii) the audited company is sizeable, as there is a positive relation of the auditors' salary and the magnitude and reputation of the firm they audit. As a consequence, auditors have the incentive to circumvent improprieties that cause inconveniences to the firms, under the fear of losing their customer. iv) EMAs that lessen the income of the present year.
3.3.2 BIG 4 vs "Second - Tier" firms
Lately, except for the known BIG 4 audit firms, other notable audit firms have come to the fore and act as their deputies. This could be expected, because in the passage of time, the volume of tasks that need to be performed by the auditors has been multiplied. Francis, Maydew & Sparks (1999) have documented the supremacy of BIG 6 (subsequently BIG 4) against the rest audit firms in detecting and confining earnings management attempts. This inference is extracted from the lower degree of abnormal accruals found in enterprises that are audited by one the BIG 6. As a result, the financial statements of BIG 4 clients are more representative of the genuine condition of the firm and are of higher quality. Apart from these, they also document the BIG 6's higher expenditures for acquiring in depth audit specialization and improve their practices in general. Supportive of these findings is the research conducted by Becker, Defond, Jiambalvo & Subramanyam (1998). Also, DeFond and Jiambalvo (1993), prove the effectiveness of bigger audit firms to object to the force of managers and issue the proper audit opinion.
However, the study of Boone, Khurana & Raman (2010) opposes to these pretensions. Firstly, they support that there is some degree of resembelance between the two derived from their common concern of suffering lawsuits and status damage, as side effects of poor audits. Nevertheless, they admit that they differ in the degree of reliance on their major clients. This practically means that the BIG 4 are more resistant and can discard more easily high levels of managerial coercion. Afterwards, they find that there are no considerable discrepancies between the audit quality that both of them offer using as a benchmark the ease with which the audit firm is eager to compile an ominous statement. Nonetheless, the most important aspect of their study refers to the perspective of investors who view the financial statements that are audited by one of the BIG 4 as superior even though the results of the research do not justify this behaviour. Except for the fame of the BIG 4 that affects the investors' point of view, this is also explained by the reasoning that in case of an audit default, and keeping in mind the BIG 4's prosperous financial condition, they will have better chances to gain large amounts of compensation.
The study of Francis & Yu (2009) proceeded one step further. They illustrated that there is a fluctuation across each of the BIG 4 audit firms, with respect to the quality of audit they provide, which is proportionate to the stature of the regional bureau in which they operate. They support the previously mentioned argument that just like bigger audit firms, greater bureaus within the same company are less contingent on single clients too. This happens because the supervision is stronger in these bureaus and do not easily permit audit misrepresantations and because the relative impact of losing a customer, even a major one is lesser compared to another relatively small bureau. In addition, the bigger a bureau is, the deeper the expertise of the auditors working in it. It is important to note that this characteristic is not transferable because it is developped based on each bureau and its customers. This is attributed principally to the numerous customers and colleagues who mutually exchange their business knowledge and experience through their interpersonal relationship and improve their skills.
3.4 EARNINGS MANAGEMENT LITERATURE REVIEW
This part of the literature review makes a retrospect in the most important past studies about earnings management. The senior studies dealt mainly with two categories of incentives, - those that stem from the need to comply with rules and regulations and those that stem from the need to abide by the agreed covenants, referring to them as the main causes of earnings management. Dechow & Skinner (2000) state that: "as stock market valuations increased during the 1990s, especially in conjunction with the increased importance of stock-based compensation, managers have become increasingly sensitive to the level of their firms' stock prices and their relation to key accounting numbers. Consequently, their incentives to manage earnings to maintain and improve those valuations have also increased, which arguably explains why earnings management has received so much recent attention". The last decade though, the concept of accrual accounting attracted the researchers' attention as a leading contributor in earnings management practices. As Dechow & Dichev (2002) punctuate, when an economic transaction takes place, it is quite possible that the respective cash inflows or outflows associated with it, will not occur at that same time, but at a later point in time. The answer to this problem, in order to provide a complete view of the aggregate economic activity, is the use of accrual accounting, which aligns the moment that the transaction is recorded with that of the occurrence of the economic effects resulting from it. It is logical that this procedure requires personal evaluation of these transactions. Since these evaluations are not always either reliable or honest, it is expected that occasionally assessment errors will occur which distort the accruals quality. As a consequence, such false estimations could be considered as earnings management attempts, when made purposefully. Furthermore, Dechow & Dichev prove that there is an inverse relationship between the accruals quality and the size of this kind of errors.
Burgstahler & Dichev (1997) advert to two of the most ordinary purposes for which earnings manipulation is employed. These are the companies' intent to shy away from announcing either a decline in earnings or negative earnings (loss). Given the fact that stakeholders fixate on the attainment of financial goals, expressed in pure accounting figures, both cases provide the motivation to managers to do so, due to high expenses they would have to suffer in business dealings with them in the opposite case. In the first condition, as the duration of sequential raises in earnings is prolonged, the strength of motivation is enhanced. However, this inference does not hold for the second condition. Overall, earnings manipulation is more widespread for
loss aversion compared to declines in earnings.
The study of Degeorge, Patel & Zeckhauser (1999) could be characterised as the sequel of Burgstahler & Dichev as they also underscore the role of accomplishing the benchmarks that have been set. Except for the two already mentioned ones, they also refer to the need for achieving the analysts' previsions. Both studies find that when earnings management occurs, it is higly probable to notice reported figures that merely reach the targets and highly improbable to see respective figures that merely miss the targets. Another contribution of their research is that they classify the three benchmarks according to their magnitude and the caution given to them by managers. Most important is ranked the statement of positive earnings, then, the statement of earnings which exceed a benchmark, such as previous year's earnings, and least important is the attainment of analysts' previsions.
Dechow & Skinner (2000) report the difference in earnings management perspectives between the regulatory bodies and the academic community. Specifically, academics are more reassuring about the importance of earnings management and the damage it can incur to the related parties, compared to regulatory bodies which are more worried about it. The authors admit that this happens due to the inadequacy of research techniques used by academics to detect earnings management, the deviation regarding the importance they attribute to various species of managers' motives for earnings management and, last but not least, the existing discrepancy about how reasonably the members of capital markets behave. Broadly, they argue that academics undervalue the significance of market-related motives. The authors' phrase: "our natural tendency to assume investor rationality has caused us to ignore capital market incentives for earnings management" is indicative of this. On top of this, they face difficulties in the calculation of earnings management levels and they rely on investors' ability to identify and confront earnings management. Regulators from their side, see a fraction of earnings management as necessary evil because of the freedom provided to managers. Also, they do not assume that investors are always adequately reasonable when making decisions. Contrariwise, they are convinced that they cannot perceive earnings manipulation at a timely basis and this inability is amplified by the fact that the access to useful information is quite expensive.
Cohen, Dey & Lys (2007) found a diachronic and gradual increment of the aggregate level of earnings management. Prior to the previous decade's scandals, like Enron, a drop in earnings management associated with the manipulation of accruals was observed, but the authors assert that this did not happen exclusively because of the modification in the SOX legislation. Perhaps other causes led to this change too, like the prudence shown by auditors in the wake of recent scandals. In fact this drop confessed an exchange, not a decline, between real and accruals earnings management, as the practices that belong to the category of real earnings management showed an upward drift. This kind of practices are thought to be more expensive for the firm but are more favourable for the managers as they are not easily tracked. They also wonder about the results of regulations in limiting earnings management: "some argue that these frauds occurred after 70 years of ever-increasing securities regulation" implying indirectly that plurality of laws might prove ineffective.
Cohen & Zarowin (2008) relied on the previous study and developped it, documenting the consequences of both real and accruals earnings management for the firms employing it. Regardless of which of the two was used, they found corroborative evidence that earnings management impacted the firm as follows: the level of investments was augmented in the relative years of earnings manipulation and was shrinked afterwards. Moreover, the joint effect of these practices was stronger than that of just a single of them. Apart from this, the implications incurred by the firm were of similar magnitude irrespective of the species of earnings management.
4. HYPOTHESES DEVELOPMENT
This chapter is concerned with the formulation of the two hypotheses, the soundness of which is tested subsequently through the statistical analysis.
The main objective of the IFRS is to reinforce the credibility of financial information that investors need in the decision making process about the allocation of their funds. In this sense, they encourage and compel the firms that abide by them to reveal as much relevant information as possible. This makes the concealment of earnings management more expensive for the firms. On the other hand though, as the IFRS do not lean on absolutely explicit rules but, rather, constitute a set of regulations based on principles there is a need for personal involvement and valuation. Under these circumstances, if managers misappropriate the privileges of their position they can provoke opposite results of the intended. In general, prior research by Ball (2001) has shown that the implementation of IFRS instead of the local generally accepted accounting principles (GAAP) has enhanced the quality of information provided, but there are also studies such as Paananen (2008) and Sonderstrom & Sun (2007) that doubt the effectiveness of IFRS in the limitation of earnings management and consider it inadequate. Italy and Portugal are code-law countries. This actually implies that in these countries there is inferior security of the interests of shareholders, financing is acquired from individual investors and the necessity of financial reports is not so imperative. Rather the focus is on other issues, such as tax considerations. In political frameworks like these, the efficacy of international standards is controversial. This is the reason why investigating the consequences of IFRS is of interest in these two countries. The first hypothesis is established on the above discussion:
H1: "Earnings management will decrease after the transition from local GAAP to IFRS."
Also, in the relative previous studies of Healy & Wahlen (1998), DeAngelo, (1981), Piot & Janin (2005) the importance of auditors is generally accepted and recognized with respect to the prevention as well as the detection and the restriction of earnings management. The inferences of these studies are considered the point of departure of the current research. Taking this for granted, plus the managers' motives to resort to earnings management practices and the auditors' intention to contribute to financial statements that are free from intentional or unintented errors, unbiased, transparent, revealing and representative of the true financial condition and economic activity of a firm we proceed to the next stage: the studies of Francis, Maydew & Sparks (1999) and Becker, Defond, Jiambalvo & Subramanyam (1998) find evidence that advocate the view of BIG 6 (subsequently BIG 4) being more effective in minimizing earnings management compared to "Second-Tier" audit firms. However, Boone, Khurana & Raman (2010) oppose to this perception and do not find considerable dissimilarities between the two categories of audit firms, regarding the quality of audit they provide. Because of the ability of bigger auditors to controvert the pressure imposed by managers, the higher degree of specialization and the need to preserve their reputation I state the second hypothesis as follows:
H2: "The BIG 4 audit firms constrain earnings management at a higher extent compared to "Second-Tier" audit firms"
5. RESEARCH DESIGN AND DATA
This chapter discusses the research methodology that is followed to test the two hypotheses mentioned in section 4 and describes the data that was collected for this reason. It is divided into two sub-categories. The first one presents the model that is used to ascertain the degree of earnings management applied in public firms of Italy and Portugal and explains the function of the related variables. The second specifies the sample that is used for this research.
5.1 RESEARCH DESIGN
According to Beneish (2001), the methods applied by researchers in order to track earnings management practices are sorted into three main classes. The first one examines the disruptions in the flow of earnings. The second one deals with particular accruals, the manipulation of which is thought to possess explanatory power of earnings management, such as forecasts for bad debts. The last one relies on the computation of discretionary accruals and their separation from non-discretionary, after having computed total accruals. The last category of earnings management recognition process involves various estimation models the most known of which are the following: the DeAngelo Model, the Healy Model, the Jones and the Modified Jones Model and the Industry Model. These models are assessed in Dechow, Sloan, and Sweeney (1995).
The current empirical research focuses on event-years. In agreement with a considerable number of recent prior studies, the model used in this empirical research is the prevalent Modified Jones Model as presented in Dechow, Sloan, and Sweeney (1995). The function of this model is based on the distinction between the discretionary and non-discretionary accruals. The dependent variable is discretionary accruals division. The discretionary part is an indication of possible earnings management and as a consequnce it lowers the quality of financial statements. Therefore, keeping in mind its negative association with the quality of earnings, higher level of discretionary accruals signals contingent earnings management activity. The reasons for selecting this particular model for estimating the degree of earnings management is that has been proven as the most robust among the rest models of the same category, it is effective when applied in a random pattern and it also moderates the Jones Model propensity to underestimate the degree of earnings management when this is applied to revenues.
The structure of the model and the three requisite stages which I will go through to test the two hypotheses are the following:
The first stage consists of the calculation of the aggregate (total) accruals through the equation:
Î¤At / (At-1) = b1*(1/At-1) + b2*(Î”REVt / At-1) + b3*(PPEt / At-1) + Îµt
In this equation the symbols mentioned above denote the following:
TA = the aggregate (total) accruals in year t
At-1 = the total assets in year t - 1
Î”REVt = revenues in year t minus revenues in year t - 1
PPEt = the gross property, plant and equipment in year t
b1 , b2 , b3 = estimates of the parameters Î²1 , Î²2 , Î²3 (explained below) originating from the process of ordinary least squares (OLS)
Îµt = residuals of the equation
The second stage involves the computation of the non-discretionary accruals with the use of the following equation:
NDAt / (At-1) = Î²1*(1/At-1) + Î²2*[(Î”REVt - Î”RECt) / At-1] + Î²3*(PPEt /At-1)
The new variables included are:
NDAt = non-discretionary accruals in year t and
âˆ†RECt which denotes the difference of net receivables between years t and t-1
Î²1 , Î²2 , Î²3 which are firm-related parameters
In the final stage we deduct the NDAt from the TAt and the result gives us the discretionary accruals (DA), which is the index of earnings management we ask for:
Î¤At / (At-1) - NDAt = DA
The absolute magnitude of the last equation depicts the extent of earnings management and given its inverse association with the quality of financial reporting, a higher value means less qualitative earnings.
As far as the first hypothesis is concerned, after having performed the relative regressions and found the aggregate, non-discretionary and discretionary accruals, I classify the results on an annual basis, from 2000 to 2009, thus providing the opportunity to compare the relative trends and variations of earnings management for the first (200-2004) and the second period (2005-2009) of the overall sample period. The results are presented in the next chapter.
Regarding the test of the second hypothesis, I interpret the results that I have found but this time I differentiate the disctinction of the sample to those firms that were audited by one of the BIG 4 and to those that were audited by any other audit firm. Similarly, the consolidated results are presented in the following chapter.