Setting the Bar: Earnings Management During a Change in Accounting Standards

This study examines how European Union firms used the flexibility of IFRS 1 during the 2004/2005 mandatory transition from Local GAAPs to IFRS to set their 2004 reconciliated IFRS earnings. More precisely, we analyze earnings reconciliations published during the 2004/2005 mandatory transition from Local GAAPs to IFRS in Europe, a period during which firms had to disclose earnings both under the old GAAP and IFRS. Our sample is comprised of 1,635 firms from the nine countries subject to IFRS 1 where early adoption of IFRS was not allowed. We posit and find that firms with negative Local GAAP earnings are more likely to report positive Local GAAP-to-IFRS earnings reconciliations, while firms with large positive earnings under Local GAAP are more likely to report negative Local GAAP-to-IFRS earnings reconciliations. We also find firms that increase (decrease) their first benchmark IFRS earnings are more likely to show a decrease (increase) in earnings in subsequent reporting periods. Markets returns are associated with meeting or beating last year earnings only if managers set the bar high in the previous period, consistent with compensation related factors to this IFRS transition earnings management. Overall, this evidence is consistent with firms using the flexibility of IFRS1 and resulting reconciliations to manage their earnings.