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Earnings quality and the adoption of IFRS‐

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Article in Asian Review of Accounting · May 2013

DOI: 10.1108/13217341311316940

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IFRS-based
Earnings quality and the accounting
adoption of IFRS-based standards
accounting standards
Evidence from an emerging market 53
Wan Adibah Wan Ismail and Khairul Anuar Kamarudin
Faculty of Accountancy, Universiti Teknologi Mara, Segamat, Johor, Malaysia
Tony van Zijl
School of Accounting and Commercial Law, Victoria University of Wellington,
Wellington, New Zealand, and
Keitha Dunstan
School of Business, Bond University, Gold Coast, Australia

Abstract
Purpose – This study aims to investigate the differences in earnings quality of Malaysian companies
after the adoption of IFRS-based accounting standards named FRS.
Design/methodology/approach – It is hypothesize that under the new set of accounting standards,
the quality of earnings reported by these companies is relatively higher. Specifically, the study tests
whether the level of earnings management is significantly lower after the adoption of IFRS, and
reported earnings is more value relevant during the IFRS period. This study uses a large sample of
4,010 observations over a three-year period before and a three-year period after the adoption of the new
set of accounting standards.
Findings – The results show that IFRS adoption is associated with higher quality of reported
earnings. It is found that earnings reported during the period after the adoption of IFRS is associated
with lower earnings management and higher value relevant.
Originality/value – The results of this study contribute additional evidence to the literature on
earnings quality and the impact of IFRS adoption. As most of the existing studies on earnings
quality and IFRS have been conducted on data from the U.S and European countries, this study fills a
gap in the existing literature by studying the effect of adoption of IFRS on earnings quality in an
emerging market.
Keywords Earnings quality, Accounting standards, IFRS, Financial reporting, Malaysia
Paper type Research paper

Introduction
Many countries have adopted international financial reporting standards (IFRS) as
their primary standards for the preparation of corporate accounts. Despite this
widespread adoption, little research has directly addressed the impact of IFRS
adoption on the quality of financial reporting in an emerging market. Current studies
seem to focus more on the effect of such adoption in European countries (Callao and
Jarne, 2010; Callao et al., 2007; Chen et al., 2010; Daske and Gebhardt, 2006; Devalle
et al., 2010; Ernstberger and Vogler, 2008; Gjerde et al., 2008; Iatridis and Rouvolis,
2010; Jermakowicz, 2004; Kaserer and Kingler, 2008; Paananen and Lin, 2009;
Tsalavoutas and Evans, 2010; Van der Meulen et al., 2007; Van Tendeloo and Asian Review of Accounting
Vol. 21 No. 1, 2013
Vanstraelen, 2005) and other developed countries such as Australia (Clarkson et al., pp. 53-73
r Emerald Group Publishing Limited
2011; Goodwin et al., 2008; Jeanjean and Stolowy, 2008). This is an important gap in the 1321-7348
literature given the differences that exist between developed and developing countries. DOI 10.1108/13217341311316940
ARA As mentioned by Hofstede and Hofstede (2004), developing countries are substantially
21,1 different from developed markets in terms of the institutional, organisational and
market aspects of the economy and society. Developing countries have weaker and less
mature capital markets (Gibson, 2003; Lins, 2003), limited regulatory enforcement
(Berghe, 2002) and more concentrated ownership (Claessens et al., 2000; Shleifer
and Vishny, 1997; Thillainathan, 1998); that arguably leads to greater information
54 asymmetry. In addition, accounting standards in developing markets are typically
different from those of developed markets, which makes it harder for investors to
judge the true performance of a firm in a developing financial market and thus make
rational investment decision (Rashid and Islam, 2008). Better accounting standards
could increase the quality of financial statements in these countries. Thus, the impact
of the adoption of IFRS in developing countries could be more significant than is
found in developed markets.
In late 2004, the Malaysian accounting standard setting body (Malaysian
Accounting Standard Board (MASB)) announced the adoption of IFRS for
Malaysian companies, effective from 1 January 2006. The standards are named
financial reporting standards (FRS)[1]. The adoption of this new set of accounting
standards in Malaysia provides a setting to study the effect of IFRS-based
accounting standards on the quality of earnings in a developing country. The
introduction of IFRS in Malaysia is viewed as an advantage to the country due to
excellent reputation, good quality and high credibility of the standards. According
to Ball (2006):
IFRS promise more accurate, comprehensive and timely financial statement information,
relative to the national standards they replace for public financial reporting in most of the
countries adopting them, Continental Europe included. To the extent that financial statement
information is not known from other sources, this should lead to more-informed valuation in
the equity market, and hence lower risk to investors.

The major change in accounting in Malaysia as a consequence of the adoption

of IFRS is the use of fair value accounting. Among others, the extensive use of
fair value occurs in the standards related to share-based payments (FRS2),
business combination (FRS3), property plant and equipment (FRS116), impairment
of assets (FRS136), intangible assets (FRS138) and investment properties (FRS140).
The movement towards fair value accounting from historical-cost accounting is
expected to result in financial statements that are more relevant, timely, credible
and transparent.
Another attribute of IFRS is that it requires more extensive disclosure. For example,
FRS136 on impairment of assets requires more disclosure on goodwill and other
intangibles, particularly in relation to allocation of goodwill to cash generating units,
key assumptions used to measure recoverable amounts and impairment testing.
Increased level of disclosure in corporate financial reports could affect the quality of
reported earnings. According to Levitt (1998), the disclosure systems that are founded
on high-quality standards give investors confidence in the credibility of financial
reporting. If more disclosure is required, any attempt to manage earnings can more
easily be detected and reduced by internal monitoring bodies (board of directors and
auditors) in a company.
Given the emphasis on the use of fair value and greater disclosure requirements
prescribed under the new accounting standards, we conjecture the adoption of the new
standards would have a favourable impact on the quality of earnings reported by
companies in Malaysia. To examine the effect of IFRS adoption on earnings quality, we IFRS-based
test whether the level of earnings management is significantly lower after the adoption accounting
of IFRS, and reported earnings is more value relevant during the IFRS period. Our
study covers the two time periods, three years before adoption (MASB period) and standards
three years after the adoption (IFRS period). Since there was no other change in the
country’s financial reporting environment during the period studied, we assume
that the potential country-level factor that could affect firm’s earnings quality during 55
the period was the adoption of IFRS.
Our results show that earnings quality is higher after the adoption of the new
IFRS-based accounting standards. First, we find that the absolute value of
abnormal accruals, which is the inverse measure of earnings quality, is significantly
lower during the IFRS period. IFRS-based earnings quality outperforms
MASB earnings quality holds after controlling for firm-specific factors such as
firm size, leverage, growth and profitability. Second, our results also show that
reported earnings are more value relevant during the IFRS period, as compared to the
MASB period. This implies that the decision made by the Malaysian accounting
standard setting body to adopt IFRS resulted in significant benefits for the
country’s financial reporting, in terms of less earnings management and more value
relevant earnings.
This study makes several contributions. First, the results of this study contribute
additional evidence to the literature on earnings quality and the impact of IFRS
adoption. As most of the existing studies on earnings quality and IFRS have been
conducted on data from the USA and European countries, this study fills a gap in the
existing literature by studying the effect of adoption of IFRS on earnings quality in an
emerging market. Second, the results of this study can assist in understanding the
impact of the introduction of IFRS standards on the quality of financial reporting
in Malaysia and identify issues that may assist regulators and standard setters in
shaping future policy. In addition to that, similar to Zhou et al. (2009), our empirical
evidence, which suggests that the adoption of IFRS improves the quality of financial
reporting, could encourage regulators and standard setters in other emerging markets
to move forward in adopting the standards.

Overview of Malaysia financial reporting environment

The standards issued by the International Accounting Standards Board (IASB)
have been the model for Malaysian accounting standards since 1978. The
country’s professional accounting body[2] at that time reviewed and adapted IAS[3]
according to local needs. There was no regulatory mechanism to enforce compliance
with these standards until the Financial Reporting Act 1997 (FRA 1997) was enacted
(Saleh et al., 2005).
This regulatory reform was in response to the rapid economic development
and globalisation of commercial markets that had demanded the country upgrade
its accounting practices (Fadzly and Ahmad, 2004). The Parliamentary Act sets out
the first formal accounting framework for Malaysia. It established two bodies, the
MASB and the Financial Reporting Foundation (FRF)[4]. Under the FRA 1997,
accounting standards issued by MASB have legal standing for both public and
non-listed companies.
The MASB, together with the FRF make up the new framework for financial
reporting in Malaysia. This framework comprises an independent standard-setting
structure with representation from all relevant parties in the standard-setting process,
ARA including preparers, users, regulators and the accountancy profession. According to
21,1 Section 7 of the FRA 1997, the functions of MASB includes:
(a) to issue new accounting standards as approved accounting standards; (b) to review, revise
or adopt existing accounting standards as approved accounting standards; (c) to issue
statements of principles for financial reporting; (d) to sponsor or undertake development of
possible accounting standards; (e) to conduct such public consultation as may be necessary
56 in order to determine the contents of accounting concepts, principles and standards;
(f) to develop a conceptual framework for the purpose of evaluating proposed accounting
standard; (g) to make such changes to the form and content of proposed accounting standards
as it considers necessary; and (h) to perform such other function as the Minister may
prescribe by order published in the Gazette.
The MASB has reviewed, revised and adopted existing accounting standards, and
issued new standards as approved accounting standards named as MASB standards.
At the end of 2004, the Board had produced a total of 97 technical pronouncements,
comprising 33 standards, one interpretation bulletin, one foreword, two statement
of principles (SOPs), two technical releases, one discussion paper, five draft SOPs and
52 exposure drafts.
A number of regulatory bodies, including the Securities Commission, the Central
Bank of Malaysia and the Companies Commission of Malaysia are responsible for
enforcement of compliance with MASB standards. In the case of non-compliance with
the approved accounting standards, the regulators have the power to direct the
company to take the necessary rectifying actions, or make announcements with
respect to the non-compliance. For publicly listed companies, there are also penalties
for such offence.
The country’s financial reporting system moved a step forward when MASB
decided to adopt IFRS. MASB announced its adoption of IFRS at the end of 2004. As
the first step, MASB standards were renamed FRS in line with IFRS in 2005. The
change of name from MASB standards to FRS in 2005 did not actually change the
content of the standards. The adoption of IFRS was made effective from 1 January
2006. Although the standards are named as FRS, they are virtually identical to the
IFRS issued by the IASB. However, two standards, which are the IFRS 7, financial
instrument: disclosures and IFRS 8, operating segments, have not been adopted. FRS
also includes one Islamic accounting standard and four local standards, on topics
which are not addressed in IFRS. The local standards are FRS2012004 Property
Development Activities, FRS2022004 General Insurance Business, FRS2032004 Life
Insurance Business and FRS2042004 Accounting for Aquaculture. Compliance with
these FRS is mandatory, as stated in the Financial Reporting Act 1997 (Section 26D).
Thus, in this paper, we consider FRS as IFRS-based standards, and use the term
interchangeably. The IFRS-based standards adopted by the MASB were made effective
from 1 January 2006. Therefore, the earliest financial statements reported by
Malaysian companies under the mandated FRS are dated 31 December 2006.
Note that similar to Barth et al. (2008), this current study examines the effect of IFRS
adoption, which reflects the combined effect of the change in accounting standards
including its application, interpretation, enforcement, litigation and other features of
financial reporting system.

Association between earnings quality and accounting standards

Studies analysing managerial discretion in accounting regimes argue that the degree of
latitude in accounting standards plays some role in determining the quality of financial
reports (e.g. Dye and Sunder, 2001; Goncharov and Zimmermann, 2006). Dye and IFRS-based
Sunder (2001) claim that: accounting
Lax IASB standards allow firms more opportunity to manage their earnings, making standards
financial reports less useful to investors [y] Broad standards create more ambiguities and
enhance chances that opportunistic, if not illegal, accounting treatments are blessed by
generally accepted accounting principles.
Supporting Dye and Sunder’s argument, Goncharov and Zimmermann (2006) state 57
that:
The accounting standards provide different (amounts of) accounting choices, and therefore
their application may results in earnings of different quality. As every accounting choice has
its costs and these costs increase with the frequency accounting choice is exercised, earnings
management is expected to be more widely spread under lax regimes that leave sufficient
space for making judgments.
The notion that different accounting standards are associated with different levels of
earnings quality is also evidenced in previous studies. By systematically modelling the
effects of tightening accounting standards, Ewert and Wagenhofer (2005) conclude that
higher earnings quality can be achieved by having stricter accounting standards
that limit the number of accounting choices and prescribe clearer rules. In particular,
their results confirm that tighter accounting standards increase earnings quality
measured by the variability of reported earnings and the association between reported
earnings and market price reactions.
Goncharov and Zimmermann (2006) investigate whether the level of earnings
management differs between consolidated accounts of German companies prepared
under three different accounting standards; German GAAP, IAS and US GAAP. Their
findings show that the level of earnings management for firms that report their results
under US GAAP is significantly lower, while the level of earnings management
under German GAAP and IAS is roughly equal. Based on the evidence, they conclude
that the different accounting choices embedded in different accounting standards
influence the level of earnings management.
Using a broad sample, Barth et al. (2008) examine the accounting quality of firms in
21 countries that adopted IAS between the year 1994 and 2003. The study compares
several accounting quality metrics between firms that apply IAS and a matched
sample of firms that do not. The results of the study shows that companies applying
IAS exhibit higher accounting quality in terms of less income smoothing, less
management of earnings towards a target, more timely recognition of losses and
higher association of accounting information with share prices and returns. In
addition, those firms also display an improvement in accounting quality between the
pre- and post-IAS adoption periods.
A more recent study by Bova and Pereira (2012) investigates whether IFRS
compliance improve a firm’s information environment in Kenya. The study argues that
higher-quality accounting standards, IFRS, lead to higher-quality financial reporting
and transparency. This is because IFRS limits managerial discretion and imposes
greater disclosure requirements compared to domestic GAAP. The study found that
public, rather than private, firms exhibit greater compliance to IFRS and relates to
higher share turnover. The evidence signifies the importance of economic incentives
and capital market benefits in ensuring IFRS compliance in Kenya.
In line with the evidence shown in previous studies that different accounting
standards are associated with different levels of earnings quality, we conjecture that
ARA the adoption of IFRS-based accounting standards has an impact on the quality of
21,1 earnings reported by Malaysian companies. Due to the greater disclosure requirements
and greater emphasis on the use of fair value in the new standards, we posit that
earnings quality has significant positive association with the adoption of IFRS-based
accounting standard in Malaysia. In other words, our study tests whether earnings
quality after the introduction of IFRS-based accounting standards is higher than the
58 quality of earnings before the introduction of the new standards. We measure
higher earnings quality as a lower level of earnings management and higher value
relevance of earnings.
The extant literature on earnings management suggest that earnings management
exists due to the important roles and functions played by the reported earnings
number. According to Vander Bauwhede (2001), managers may be inclined to manage
earnings due to the existence of the firm’s explicit and implicit contracts, the firm’s
relation with capital markets, the need for external financing, the political
and regulatory environment or several other specific circumstances. For example,
earnings numbers are normally included in management compensation and bonus
contracts, debts covenants and are relevant to management buyouts, proxy contest,
valuation of initial public offerings, labour union negotiations and lobbying on
accounting standards and regulations.
Davidson et al. (1985) define earnings management as the process of taking
deliberate steps within the constraint of generally accepted accounting practice
to bring about a desired level of reported earnings. Similarly, Healy and Wahlen
(1999) note that:
Earnings management occurs when managers use judgment in financial reporting and in
structuring transactions to alter financial reports to either mislead some shareholders about
the underlying economic performance of the company, or to influence contractual outcomes
that depend on reported accounting numbers.
According to above definitions, it is clear that earnings management becomes possible
due to the discretion given to managers when preparing financial reports. However,
it is limited to the boundaries permitted under a particular set of accounting standards.
Thus, any changes to the extent of managerial discretion allowed under the accounting
standards may also change the amount of earnings management.
Zheng (2003) claims that the purpose of earnings management, as stated in
Healy and Wahlen’s (1999) definition, indicates that managed earnings is of lower
quality than unmanaged earnings. The greater the departure of reported earnings
from what it should be, the lower the quality of earnings. Consistently, previous
studies on earnings quality (e.g. Barth et al., 2008; Chen et al., 2007; Van Tendeloo and
Vanstraelen, 2008) often use the term “earning quality” to denote the absence of
earnings management. In addition, Levitt (1998) mentioned that when earnings
management is on the rise, the quality of financial reporting is on the decline. Given the
changes in disclosure requirement and the extent of managerial discretion allowed
under the IFRS-based accounting standard, we develop the following hypothesis:

H1. The extent of earnings management is lower after the adoption of IFRS-based
accounting standards.

Earnings that are high in quality should also be more value relevant. In other words,
high-quality earnings should have greater ability to explain market value of
companies. A number of studies that examine the quality of financial reporting use IFRS-based
value relevance of earnings to measure earnings quality (e.g. Cheng et al., 2007; Lang accounting
et al., 2003, 2006; Leuz et al., 2003). These studies relate earnings directly to stock prices
or market returns. The association (the slope coefficient or the explanatory power of standards
the model) between earnings and stock market performance suggests that earnings
are both relevant and reliable to investors (Barth et al., 2001). In the existing studies,
earnings are considered to be higher in quality if it is more value relevant. As claimed 59
by Bao and Bao (2004):
Theoretically, if quality of earnings is improved, then the association between firm value and
reported earnings should also be improved. If quality of earnings is impaired, then the
association between firm value and reported earnings should also be impaired.
Based on these prior studies, our second hypothesis is as follows:

H2. The value relevance of earnings is higher after the adoption of IFRS-based
accounting standards.

Our study is different from previous studies on earnings quality and IFRS. To the best of
our knowledge, this study is among the early empirical studies that examine the effect of
mandatory adoption of IFRS on earnings quality of companies over time in a developing
country. Our study is closest to Paananen and Lin’s (2009) study that examined the
adoption of IFRS in Germany. However, in Germany the adoption of IFRS was voluntary
for two years before it was made compulsory. Thus, the initial year of IFRS adoption for
companies in Germany varies according to whether they adopted early or not.
The common approach of existing studies that examine the impact of IFRS
adoption on earnings quality is to compare the earnings quality of IFRS adopters and
non-IFRS adopters in a particular country during the period when companies were
given the option of adopting IFRS or adhering to local GAAPs or other accounting
standards (Christensen et al., 2007; Van der Meulen et al., 2007; Van Tendeloo and
Vanstraelen, 2005; Zhou et al., 2009). According to Zhou et al. (2009), when the adoption
of accounting standards is voluntary, the results of the study could be subject to self-
selection bias. This is evidenced in Paananen and Lin’s (2009) study where most of the
early adopters of IFRS were the companies that previously had higher quality of
financial reporting. Our study is free from the self-selection bias as we examine the
effect of IFRS in Malaysia where the adoption of IFRS was mandatory and there was
no prior period during which firms could voluntarily adopt IFRS. Therefore, the effect
of adopting IFRS can be captured evenly for all companies in the sample as all
companies are required to adopt IFRS starting from 1 January 2006.

Model specification
Earnings management models
We examined the change in earnings quality after the adoption of FRS in Malaysia by
looking at the extent of earnings management and value relevance of earnings. To
measure the level of earnings management, we calculated the absolute value of
abnormal accruals using the Jones (1991) model, as modified by Dechow et al. (1995),
by running the following regression, by year and industry based on the General
Industry Classification Code:

TACCRit ¼ að1=ASSETSit1 Þ þ bðDREVit  DRECit Þ þ cPPEit þ eit ð1Þ

ARA where TACCRit is the total accruals for firm i in year t, ASSETSit1 is total assets for
21,1 firm i in year t1, DREVit is measured by revenues in year t less revenues in year
t1 for firm i, DRECit is measured by receivables in year t less receivables in year t1
for firm i, PPEit is the gross property, plant and equipment for firm i in year t and eit is
the error term firm i in year t.
In regression (1), the total accruals (TACCRit)[5], change in revenue (DREVit),
60 change in receivables (DRECit) and gross property, plant and equipment (PPEit) are
each scaled by previous year total assets (ASSETSit1). We followed Kothari et al.
(2005) who deflate the variables by total assets for the purpose of mitigating
heteroscedasticity of the residuals. In this model, normal accruals is estimated based
on the change in net revenue and PPE of firms in the same industry. The residual
generated from this regression is the abnormal accruals of firms, that is the amount
of accruals above or below the normal accruals. We used the absolute value of the
residual (ABACDEC) to measure the extent of earnings management, which is the
extent of departure of total accrual from normal accrual (or the departure of reported
earnings from normal earnings). High absolute value of abnormal accrual indicates
low earnings quality.
To ensure robustness of the abnormal accrual estimation, we also calculate the
absolute value of abnormal accrual using the Kasznik (1999) model, which is a
variation on the Dechow et al. (1995) model. Based on the evidence that cash flows from
operations are negatively associated with total accruals, Kasznik (1999) added the
change in operating cash flows, to the Dechow et al. (1995) model. We use the following
model to estimate the absolute value of abnormal accruals, as based on the Kasznik
(1999) model:

TACCit ¼ að1=ASSETSit1 Þ þ bðDREVit  DRECit Þ

ð2Þ
þ cPPEit þ dDCFOit þ eit

where DCFO is the change in cash flows from operation[6] for firm i in year t, and all
other variables are as previously defined. We labelled the absolute value of abnormal
accrual estimated using Kasznik (1999) model as ABACKAS. We then estimate the
OLS regression of Equation (3) to test our first hypothesis of whether the extent of
earnings management is lower after the adoption of FRS:

ABACi;t ¼ b0 þ b1 LEVERAGEi;t þ b2 SIZEi;t

þ b3 PROFITABILITYi;t þ b4 GROWTHi;t ð3Þ
þ b5 IFRSi;t þ ei;t

where ABACi, t is the absolute value of abnormal accrual for firm i in year t. ABACi, t
represents either ABACDECi, t which is the absolute abnormal accrual from the
Dechow et al. (1995) model or ABACKASit, which is the absolute value of abnormal
accrual from the Kasznik (1999) model. SIZEi, t is the natural logarithm of total
assets for firm i in year t, ROAi, t is the return on assets ratio for firm i in year t,
LEVERAGEi, t is the total debt divided by total assets for firm i at the end of fiscal
year t, GROWTHi, t is the share price divided by book value per share for firm i at the
end of fiscal year t and IFRSi, t is a dummy variable given a value of 1 if the financial
statement is prepared under FRS, 0 otherwise; for firm i in year t.
 In the above model, we include four control variables, firms size (SIZEi, t), profitability IFRS-based
(ROAi, t), leverage (LEVERAGEi, t) and growth (GROWTHi, t), that could also influence accounting
the extent of earnings management practices. According to Johnson et al. (2002), these
variables can affect financial reporting quality in terms of the level of sophistication of standards
the financial reporting system and in terms of management incentives to manipulate
earnings. For example, larger and more mature companies are more likely to have more
sophisticated financial reporting systems. Therefore, managers of these companies may 61
have more opportunity to manipulate earnings. Also, it would be harder for an external
auditor to detect earnings manipulation in a more sophisticated accounting system.
Other than that, previous studies on financial reporting quality have found certain
conditions that may provide incentives for earnings manipulation, such as a firm’s
financial condition (Burgstahler and Dichev, 1997; Dechow et al., 1996; Saleh and Ahmed,
2005) and the tightness of debt constraints (Carlson and Bathala, 1997; DeFond and
Jiambalvo, 1994; Jaggi and Lee, 2002; Sweeney, 1994).

Value relevance models

To test our second hypothesis, we compare the value relevance of earnings during the
period before and after the adoption of IFRS-based accounting standards in Malaysia.
We employ two widely used models, which are the price-earnings model and the
return-earnings model, to examine the value relevance of earnings during the two
periods. We follow the price-earnings model as used by Ohlson (1995) and Burgstahler
and Dichev (1997), where prices are regressed on both earnings and the book value
of equity. According to Ohlson (1995), the value of firm’s equity can be expressed
as a function of its earnings and book value, as follows:

Pi;t ¼ a0 þ a1 EPSi;t þ a2 BVPSi;t þ ei;t ð4Þ

where Pi, t is the price of a share of firm i three months after fiscal year-end t, EPSi, t is
the earnings per share of firm i during the year t, BVPSi, t is the book value per share of
firm i at the end of year t and ei, t represents other value relevant information of firm i
for year t. The value relevance of earnings and book value is represented by the
coefficient of these variables. The coefficient of earnings depends on how well a firm’s
earnings can explain stock prices. According to Ohlson and Zhang (1998), the ability
of earnings to explain stock prices can be influenced by its ability to reflect future
earnings. They explain that the relative weight of earnings as compared to book value
may vary depending on the permanence of earnings. However, the combined weights
of earnings and book value should remain unchanged, for different accounting
methods unless the accounting choice has an economic impact. Therefore, other than
looking at the coefficient of earnings, we compare the R2 values of the model to
examine whether the joint coefficient of earnings and book value after the adoption of
IFRS are more value-relevant and have higher quality. Our approach is similar to
Cheng et al. (2007) and Van der Meulen et al. (2007), wherein higher R2 of the model
signals higher value relevance of earnings and book value.
We further extend our analysis by running a regression on the following extended
model, which include IFRS adoption as a dummy variable, and its interaction with
earnings and book value:
Pi;t ¼ a0 þ a1 EPSi;t þ a2 BVPSi;t þ a3 EPSi;t IFRS
ð5Þ
þ a4 BVPSi;t IFRS þ ei;t
ARA In this model, all variables are as previously defined. The coefficient of the interaction
21,1 variables EPS  IFRS, a3, indicates whether the adoption of IFRS has a significant
influence on the value relevance of earnings.
To ensure the robustness of our result, we also performed further analysis of the
value relevance of earnings using the return-earnings model introduced by Easton
and Harris (1991). The approach of using return earnings to examine the value
62 relevance of earnings is widely used in existing studies (e.g. Gul, 2006; Gul et al., 2002;
Loftus and Sin, 1997; Warfield and Wild, 1992; Warfield et al., 1995). The return-
earnings model is as follows:

RETi;t ¼ a0 þ a1 E=Pi;t1 þ ei;t ð6Þ

where RETi, t is holding returns for a 12-month period before the financial year end for
firm i in year t, E/Pi, t1 is the earnings per share at the financial year end divided by
the closing price 12 months previously for firm i in year t and all other variables are as
previously defined. The regression is run separately, for the period before and after the
adoption of IFRS. Similar to the value-relevance analysis using the price-earnings
regression, the coefficient of E/Pt1 and the R2 of the model are examined to compare
the ability of earnings to explain stock returns between the two periods. To test
whether there is any significant difference between the value relevance of earnings
before and after IFRS adoption using the return-earnings model, we include interaction
variables and other control variables, as shown below:

RETi;t ¼ a0 þ a1 E=Pi;t1 þ a2 IFRSi;t þ a3 E=Pi;t1 IFRSi;t

þ a4 E=Pi;t1 RISKi;t þ a5 E=Pi;t1 GROWTHi;t ð7Þ
þ a6 E=Pi;t1 TDTAi;t þ ei;t

where RISKi, t is the b for firm i in year t, GROWTHi, t equals the share price divided by
book value per share for firm i at the end of fiscal year t, TDTAi, t is the total debt
divided by total assets for firm i in year t and all other variables are as previously
defined. The coefficient of the interaction variable of E/Pt1  IFRS, a3, captures the
influence of IFRS on the value-relevance of earnings.

Data and sample selection

Our data was collected from the Thompson One Banker database from 2002 to 2009.
We identify each firm’s financial year end and extract the firm’s data for the period of
three years before the adoption of IFRS and three years after the adoption of IFRS.
Since the adoption of IFRS is made effective from 1 January 2006, the first annual
report prepared using the new standard is dated 31 December 2006. Thus, we classify
our data based on financial year end of each firm. For example, data from annual
reports dated 31 December 2006 to 30 December 2007 are considered to be data for the
first year of FRS adoption.
Following previous research on earnings management and value relevance of
earnings (Callao et al., 2007; Van Tendeloo and Vanstraelen, 2005; Vander Bauwhede,
2001), we exclude all financial institutions and utility companies from our sample, thus
ensuring greater homogeneity of the firms included in the sample. We impose data
restriction on the sample, such as the availability of accounting variables and market
variables. We end up having two separate samples to test our hypotheses in order to
maximise our observations. For the first hypothesis, relating to analysis on the effect IFRS-based
of FRS adoption on earnings management, most of the missing data is caused by the accounting
unavailability of cash flows from operations data, which is required to calculate total
accruals. For this analysis, our sample comprises 4,010 firm-year observations as in standards
Table I. For value relevance models, we exclude data with missing market prices. To
control for potential outliers, we removed the 0.5 per cent top and bottom of each
variables used in the study. The total number of observations for the value relevance 63
analysis was 2,663.
Table I presents descriptive statistics for the main variables used in the study. The
table shows that there is not much difference between the absolute value of abnormal
accruals calculated using Dechow et al.’s model (ABACDEC) and those calculated
using the Kasznik model (ABACKAS). The mean and median of ABACDEC
(ABACKAS) is 0.849 (0.618) and 0.076 (0.064), respectively. Table II reports the
correlation matrix between the variables included in the regression. The correlation
matrix shows that the Pearson (Spearman) correlations between ABACDEC or
ABACKAS and the other variables used in the model are relatively small and do not
exceed 0.285 (0.465).

Empirical results
Table III presents the results of the ordinary least square regressions used to test the
relationship between earnings quality, measured by the absence of earnings
management and IFRS adoption. The regressions based on model (3), include other
determinants of earnings management practices such as the firm’s size (SIZE),

Variables Mean Median SD Minimum Maximum Q1 Q3

Panel A: descriptive statistics for testing H1 (n ¼ 4,010)

ABACDEC 0.849 0.076 2.108 0.000 19.733 0.032 0.235
ABACKAS 0.618 0.064 1.652 0.000 15.966 0.025 0.165
SIZE 18.875 18.807 1.511 9.306 24.251 17.964 19.727
PROFITABILITY 4.232 4.661 11.127 163.059 84.849 1.386 8.536
GROWTH 1.255 0.840 2.146 53.870 36.730 0.520 1.380
LEVERAGE 0.397 0.061 1.278 0.000 9.814 0.004 0.189
Panel B: descriptive statistics for testing H2 (n ¼ 2,663)
P 1.503 0.921 1.976 0.200 26.250 0.535 1.700
BVPS 1.621 1.274 1.617 0.010 25.500 0.799 1.915
EPS 0.098 0.066 0.204 0.773 1.509 0.010 0.170
RET 0.188 0.005 1.103 1.000 25.667 0.241 0.300
E/Pt1 0.061 0.072 0.204 1.997 2.270 0.014 0.134
TDTA 21.372 20.026 16.906 0.000 84.889 5.651 33.767
RISK 0.972 0.910 0.672 1.751 3.747 0.483 1.379
GROWTH 1.106 0.765 1.384 0.132 31.481 0.502 1.240
Notes: ABACDEC and ABACKAS are the absolute value of abnormal accruals estimated using
Dechow et al. (1995) model and Kasznik (1999) model, respectively; SIZE is the natural logarithm of
total assets; PROFITABILITY is the return on assets ratio. GROWTH equals to the share price
divided by book value per share at the end of fiscal year; LEVERAGE is total long-term debt divide by
total assets at fiscal year end; P is closing price per share at the financial year end; BVPS is the book Table I.
value per share; EPS is earnings per share; RET is holding returns for a 12-month period before the General descriptive
financial year end; E/Pt1 is earnings per share at the financial year end divided by the closing price statistics on observations
12 months previously; TDTA is total debt to total assets. RISK is measured by firm’s b and sample firms
 64
21,1

matrix
ARA

Table II.

diagonal) correlation
and Spearman (above
Pearson (below diagonal)
Panel A: sample for earnings management analysis
ABACDEC ABACKAS SIZE PROFITABILITY GROWTH LEVERAGE
ABACDEC 0.723** 0.077** 0.020 0.042** 0.039*
ABACKAS 0.764** 0.093** 0.021 0.036* 0.007
SIZE 0.034* 0.015 0.273** 0.115** 0.005
PROFITABILITY 0.024 0.010 0.285** 0.465** 0.028
GROWTH 0.019 0.021 0.105** 0.252** 0.000
LEVERAGE 0.076** 0.066** 0.200** 0.107** 0.021
n ¼ 4,010
Panel B: sample for value relevance analysis
P BVPS EPS RET E/Pt1 TDTA GROWTH RISK
P 0.635** 0.645** 0.275** 0.259** 0.237** 0.123** 0.108**
BVPS 0.514** 0.552** 0.022 0.231** 0.209** 0.037 0.063**
EPS 0.622** 0.482** 0.213** 0.789** 0.249** 0.251** 0.024
RET 0.103** 0.046* 0.078** 0.397** 0.063** 0.173** 0.031
E/Pt1 0.108** 0.119** 0.607** 0.294** 0.141** 0.306** 0.064**
TDTA 0.145** 0.141** 0.208** 0.004 0.128** 0.039* 0.147**
GROWTH 0.008 0.014 0.003 0.132** 0.055** 0.024 0.059*
RISK 0.088** 0.026 0.032 0.088** 0.061** 0.162** 0.032
n ¼ 2,663
Notes: ABACDEC and ABACKAS are the absolute value of abnormal accruals estimated using Dechow et al. (1995) model and Kasznik (1999) model,
respectively; SIZE is the natural logarithm of total assets; PROFITABILITY is the return on assets ratio; GROWTH equals to the share price divided by book
value per share at the end of fiscal year; LEVERAGE is total long-term debt divide by total assets at fiscal year end; P is closing price per share at the financial
year end; BVPS is the book value per share; EPS is earnings per share; RET is holding returns for a 12-month period before the financial year end; E/Pt1 is
earnings per share at the financial year end divided by the closing price 12 months previously; TDTA is total debt to total assets; RISK is measured by
firm’s b. **,*significance at 0.05 and 0.10 levels, respectively
Variable Constant IFRS SIZE PROFITABILITY GROWTH LEVERAGE

Panel A: regression results of absolute value of abnormal accrual estimated using Dechow et al. (1995) model
Coefficient 2.657*** 1.794*** 0.04* 0.003 0.012 0.061**
t-value 6.737 28.353 1.904 1.107 0.813 2.481
VIF 1.076 1.090 1.152 1.069 1.077
Adjusted R2 0.172
F-statistics 167.715***
n 4,010
Model: ABACDECi, t ¼ b0 þ b1IFRSi, t þ b2SIZEi, t þ b3PROFITABILITYi, t þ b4GROWTHi, t þ b5LEVERAGEi, t þ ei, t
Panel B: regression results of absolute value of abnormal accrual estimated using Kasznik (1999) model
Coefficient 1.863*** 1.412*** 0.019 0.002 0.017 0.230***
t-value 6.030 28.477 1.132 0.742 1.505 11.996
VIF 1.076 1.090 1.152 1.069 1.077
Adjusted R2 0.172
F-statistics 167.299***
n 4,010
Model: ABACKASi, t ¼ b0 þ b1IFRSi, t þ b2SIZEi, t þ b3PROFITABILITYi, t þ b4GROWTHi, t þ b5LEVERAGEi, t þ ei, t
Notes: ABACDEC is the absolute value of abnormal accrual estimated using Dechow et al. (1995) model; ABACKAS is the absolute value of abnormal accrual
estimated using Kasznik (1999) model; SIZE is the natural logarithm of total assets; PROFITABILITY is the return on assets ratio; GROWTH equals to the
share price divided by book value per share at the end of fiscal year; LEVERAGE is total long-term debt divide by total assets at fiscal year end; IFRS is 1 if the
financial statement is prepared under FRS, 0 otherwise. ***,**,*significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test)
IFRS-based

IFRS and other additional

accounting

abnormal accruals on
absolute value of
OLS regressions of

determinants variables
Table III.
65
standards
ARA profitability (PROFITABILITY), growth (GROWTH) and leverage (LEVERAGE) as
21,1 controls. Panel A of the table reports the results from estimating the model using the
absolute value of abnormal accrual based on Dechow et al. (1995).
The table shows that the coefficient on the dummy variable IFRS, b1, is significant
at the 1 per cent level with a t-statistic of 28.353. This result suggests that the
adoption of IFRS-based accounting standards is significantly associated with lower
66 level of earnings management. In other words, the extent of reported earnings’
departure from normal earnings is lower after the adoption of the new standard,
suggesting that earnings quality is higher after the adoption of IFRS. Panel B of
Table III reveals that a similar association between IFRS adoption and earnings
management is observed as before, suggesting that the inference is robust to the use of
alternative estimation for the absolute value of abnormal accruals. Consistently, the
coefficient of the dummy variable IFRS, b1, shows a significant negative association
with the absolute value of abnormal accruals using the Kasznik (1999) model
(ABACKAS) at 1 per cent level with a t-statistics of 28.477.
Our analyses of the value relevance of earnings are presented in Tables IV and V.
Table IV shows the results using the price-earnings model. Differences between MASB
and IFRS-based earnings, with regard to value relevance, are reflected in the
differences in model (4)’s coefficient for EPS, a1 and R2 between the pre-IFRS sample
and the post-IFRS sample. Further, to determine whether the difference between
the value relevance of earnings during the two periods is significant, we refer to
the results from estimation of model (5). The coefficient of the interaction variable
EPS  IFRS, a3, indicates whether there is a significant difference in the value
relevance of earning between the two periods.
As shown in Table IV, the coefficient of EPS from the price-earnings regression
before and after IFRS adoption is 4.139 and 5.199, respectively. Both coefficients are
significant at 1 per cent level with a t-value of 19.039 (pre-IFRS) and 20.660 (post-IFRS).
These results suggest that earnings reported during the IFRS period has greater value
relevance compared to earnings reported in pre-IFRS period. Similarly, the R2 shows
that the joint coefficient of earnings and book value during the IFRS period is relatively
higher, 41.4 per cent for the pre-IFRS period and 47.5 per cent for the post-IFRS period.
Thus, it seems that IFRS-based earnings explain more of the variation in share values.
The higher value relevance of earnings during the post-IFRS period is confirmed by
further analysis using model (5). The result shows that the interaction variable,
EPS  IFRS is positively significant at 1 per cent level with t-statistics 3.214.
Examination of the value relevance of earnings during the two different periods
using return-earnings regressions, as in models (6) and (7), produces qualitatively
similar results. The results are shown in Table V. We found that the ability of earnings
in explaining returns is relatively higher during the period of IFRS adoption. The
coefficient of E/Pt1 during the period before and after IFRS adoption is 0.995 and
2.104, and both are significant at 1 per cent level with t-statistics of 6.463 and 16.489,
respectively. Consistently, the interaction variable, E/Pt1  IFRS is positively
significant at 1 per cent level with t-statistics of 6.058. Our examination of the value
relevance of earnings using return-earnings regression suggests that the main finding
of this study is not sensitive to model specification issues.

Summary and conclusion

In this study, we examine the impact of IFRS adoption on the quality of reported
earnings. We focused on two attributes of higher quality of earnings, lower level of
 Pooled sample Pooled sample
(basic model) Pre-IFRS (basic model) Post-IFRS (basic model) (extended model)
Variable Coefficient t-value Coefficient t-value Coefficient t-value Coefficient t-value

Constant 0.486*** 12.038 0.574*** 12.324 0.353*** 4.724 0.574*** 11.361

EPS 4.715*** 29.606 4.139*** 19.039 5.199*** 20.660 4.139*** 17.550
BVPS 0.340*** 16.924 0.343*** 15.779 0.344*** 8.201 0.343*** 14.545
IFRS 0.221** 2.593
EPS  IFRS 1.060*** 3.214
BVPS  IFRS 0.001 0.032
Adjusted R2 0.446 0.414 0.475 0.449
F-statistics 1,071.788*** 530.058*** 528.809*** 434.739***
n 2,663 1,497 1,166 2,663
Basic model: Pi, t ¼ a0 þ a1EPSi, t þ a2BVPSi, t þ ei, t
Extended model: Pi, t ¼ a0 þ a1EPSi, t þ a2BVPSi, t þ a3EPSi, t  IFRSi, t þ a4BVPSi, t  IFRSi, t þ ei, t
Notes: P is the closing price of a share of firm i at the financial year-end; EPS is the earnings per share of firm during the year; BVPS is the book value per
share at the end of the year; IFRS is a dummy variable given a value of 1 if the financial statement is prepared under FRS, 0 otherwise. ***,**significance at
0.05 and 0.10 levels, respectively (two-tailed test)
IFRS-based
accounting

using price-earnings
relevance of earnings
OLS regressions on value

models
Table IV.
67
standards
 68
21,1

models
ARA

Table V.

relevance of earnings
using return-earnings
OLS regressions on value
Pre-IFRS Post-IFRS Extended model
Variable Coefficient t-value Coefficient t-value Coefficient t-value

Constant 0.106*** 3.607 0.067** 2.192 0.071*** 2.841

E/Pt1 0.995*** 6.463 2.104*** 16.489 0.242 1.135
IFRS 0.044 1.169
E/Pt1  IFRS 1.086*** 6.058
E/Pt1  RISK 1.249*** 10.871
E/Pt1  GROWTH 0.455*** 8.073
E/Pt1  TDTA 0.042*** 8.578
Adjusted R2 0.030 0.190 0.190
F-statistics 41.776*** 271.895*** 86.527***
n 1,497 1,166 2,663
Basic model: RETi, t ¼ a0 þ a1E/Pi, t1 þ ei, t
Extended model: RETi, t ¼ a0 þ a1E/Pi, t1 þ a2IFRSi, t þ a3E/Pi, t1  IFRSi, t þ a4E/Pi, t1  RISKi, t þ a5E/Pi, t1  GROWTHi, t þ a6E/Pi, t1  TDTAi, t þ ei, t
Notes: RET is holding returns for a 12-month period before the financial year end; E/Pt1 is the earnings per share at the financial year end divided by the
closing price 12 months previously; IFRS is a dummy variable given a value of 1 if the financial statement is prepared under FRS, 0 otherwise; RISK is
measured by firm’s b; GROWTH equals to the share price divided by book value per share at the end of fiscal year; TDTA is total debt to total assets.
***,**significance at 0.05 and 0.10 levels, respectively (two-tailed test)
earnings management practice and higher value relevance of earnings. Our results IFRS-based
confirm that IFRS adoption is associated with higher quality of reported earnings. accounting
Specifically, we found that earnings reported during the period after the adoption of
IFRS is associated with lower earnings management. Using both price-earnings and standards
return-earnings models, our findings also show that earnings reported during the
period after IFRS adoption is more value relevant.
Our results are based on Malaysian data, where some IFRS standards are yet to be 69
implemented. However, the results are of significant benefit for local standard setters
as well as for other emerging countries that have similar capital market and
institutional characteristics. More research could be conducted in other environments
so that the impact of IFRS adoption in different environments can be revealed. Other
than that, the consistent change in the level of earnings management and the value
relevance of earnings during the period before and after the adoption of IFRS in
Malaysia suggest that there is a possibility that investors can more accurately value
shares when there is a lower level of earnings management. Future research can
investigate this issue further. Furthermore, additional studies can also consider other
attributes of earnings quality such as earnings conservatism, predictability,
comparability, persistence and timeliness.
Notes
1. In this paper, we use the term FRS, IFRS-based and IFRS interchangeably.
2. The Malaysian Institute of Certified Public Accountants.
3. The standards issued by the International Accounting Standards Committee, the
predecessor body to the IASB were called International Accounting Standards (IAS). The
IASB adopted these standards and the full set of old and new standards is commonly
referred to as IFRS.
4. FRF is a trustee body who watch over MASB’s performance, financial and funding
arrangements. It acts as a sounding board for the MASB. For instance, the FRF would be the
first to review MASB’s technical pronouncements before it goes out to the public.
5. Total accruals are calculated by deducting the cash flows from operations (CFO) from
net income.
6. CFO is obtained from the statement of cash flow.
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Corresponding author
73
Wan Adibah Wan Ismail can be contacted at: wadibah@johor.uitm.edu.my

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