EARNINGS QUALITY AND THE ADOPTION OF IFRS-BASED ACCOUNTING

STANDARDS: EVIDENCE FROM AN EMERGING MARKET

Wan Adibah Wan Ismaila

Keitha Dunstanb
Tony van Zijla

a
School of Accounting and Commercial Law, Victoria University of Wellington
b
School of Business, Bond University, Australia

Keywords: Earnings quality, accounting standards, IFRS, financial reporting, Malaysia

Contact details:

Wan Adibah Wan Ismail

School of Accounting and Commercial Law
Victoria University of Wellington
Wellington, New Zealand
Email address: deb.wanismail@vuw.ac.nz
Phone: +64 21 02630493

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Electronic copy available at: http://ssrn.com/abstract=1566634

 EARNINGS QUALITY AND THE ADOPTION OF IFRS-BASED ACCOUNTING
STANDARDS: EVIDENCE FROM AN EMERGING MARKET

Abstract

This study investigates the differences in earnings quality of Malaysian companies after
the adoption of IFRS-based accounting standards named FRS. We hypothesize that under
the new set of accounting standards, the quality of earnings reported by these companies is
relatively higher. We measure earnings quality using two different proxies; the absolute
value of abnormal accruals and the value relevance of earnings. Using 4010 observations
over a three-year period before and a three-year period after the adoption of the new set of
accounting standards, our study finds that the adoption of FRS is relatively related to
higher reported earnings quality. Specifically, the results shows that (1) the absolute value
of abnormal accrual is significantly lower and (2) the value-relevance of firms earnings is
significantly higher, after the adoption the new set of accounting standards.

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Electronic copy available at: http://ssrn.com/abstract=1566634

Introduction

Many countries have adopted the 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 seems to focus more on the
effect of such adoption in European countries (Callao, Jarne and Laínez, 2007;
Ernstberger and Vogler, 2008; Gjerde, Knivsflå and Sættem, 2008; Jermakowicz, 2004;
Paananen and Lin, 2009; Van der Meulen, Gaeremynck and Willekens, 2007; Van
Tendeloo and Vanstraelen, 2005) and other developed countries such as Australia
(Goodwin, Ahmed and Heaney, 2008; Jeanjean and Stolowy, 2008). This is an important
gap in the literature given the differences that exist between developed and developing
countries. As mentioned by Hofstede and Hofstede (2004), developing countries are
substantially different from developed market in terms of the institutional, organisational
and market aspects of the economy and society. Developing countries has weaker and less
mature capital market (Gibson, 2003; Lins, 2003), limited role of regulatory authorities
(Berghe, 2002), and more concentrated ownership (Claessens, Djankov and Lang, 2000;
Shleifer and Vishny, 1997; Thillainathan, 1998); that leads to greater information
asymmetry. In addition to that, accounting standards in developing markets are different
from those of developed market, which makes it harder for investors to judge the true
performance of a firm in developing financial market and 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 prevalent than those found in developed market.

In late 2004, the Malaysian accounting standard setting body (Malaysian Accounting
Standard Board) announced the adoption of IFRS for Malaysian companies, effective from
January 1, 2006. The standards are named as 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

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due to the excellent reputation, good quality and high credibility. 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 standards 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 are related to share-based payments (FRS2), business combination
(FRS3), property plant and equipment (FRS116), impairment of assets (FRS136),
intangible assets (FRS 138) 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. This is because fair
values are likely to reflect market value; and even in the absence of market value,
determination of fair values normally involves more people including accountants and
managements. Any estimates and judgments made to determine fair value have to be
disclosed and justified accordingly.

Another attribute of IFRS is that it requires greater level of disclosure. For example, FRS
136 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, p. 80), the disclosure system that are founded on high quality standards give
investors confidence in the credibility of financial reporting. As more disclosure is
required, any attempts to manage earnings can easily be detected and reduced by internal
monitoring bodies (board of directors and auditors) in a company.

                                                                                                                                                                                    
1
In this paper, we use the term FRS, IFRS-based and IFRS interchangeably.

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Given the emphasis on the use of fair value and greater disclosure requirements prescribed
under the new accounting standards, we conjecture that there would be some impact of the
adoption of the new standards on the quality of earnings reported by companies in
Malaysia. To examine the effect of IFRS adoption on earnings quality, we test whether (1)
the level of earnings management is significantly lower after the adoption of IFRS, and (2)
reported earnings is more value relevant during IFRS period. Our study covers a short
period of three years before (MASB period) and after the event (IFRS period). This is to
ensure that changes of earnings quality observed are not due to changes in other
institutional factors, such as the change in legal institutions and stock exchange listing
requirements. Since there is no other change in the country’s financial reporting
environment during the studied period, we assume that the potential country-level factor
that could affect firm’s earnings quality during the period is the adoption of IFRS, other
than firm’s idiosyncratic factors.

Our results show that earnings quality is relatively higher after the adoption of the new
IFRS-based accounting standards. Firstly, we find that the absolute value of abnormal
accruals, which is the inverse measure of earnings quality, is significantly lower during
FRS period. The fact that the IFRS-based earnings quality outperforms MASB earnings
quality holds after controlling for firm specific factors such as firm size, leverage, growth
and profitability. Secondly, our results also show that reported earnings are more value
relevant during IFRS period, as compared to MASB period. This implies that the decision
made by the Malaysian accounting standard setting body to adopt IFRS gives significant
benefits to the country’s financial reporting, in terms of lower amount of earnings
management and more value relevant of earnings.

This study has several contributions. First, the results of this study provide 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 the gap in the existing literature by
concentrating on adoption of IFRS and earnings quality in an emerging market. Secondly,
the results of this study can assist in understanding the impact that the introduction of IFRS
standards bring to the quality of financial reporting in Malaysia and identify issues that

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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 International Accounting Standards (IAS) issued by the International Accounting

Standards Board (IASB) has become the model for Malaysian accounting standards since
1978. The country’s professional accounting body2 at that time reviewed and adapted IAS
according to local needs. There was no regulatory mechanism to enforce the compliance to
these standards as mandatory, until an important change in the country’s financial
reporting system took place in 1997 (Saleh, Iskandar and Rahmat, 2005).

In 1997, the Financial Reporting Act 1997 (FRA 1997) was enacted. This regulatory
reform is a response to rapid economic development and globalization of commercial
market that had demanded the country to upgrade its accounting practice (Fadzly and
Ahmad, 2004). The Parliamentary Act sets out the first formal accounting framework for
Malaysia. It established two bodies, the Malaysian Accounting Standards Board (MASB)
and the Financial Reporting Foundation (FRF)3. 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 new framework comprises an independent standard-setting structure with
representation from all relevant parties in the standard-setting process, including preparers,
users, regulators and the accountancy profession. Section 7 of the FRA 1997, states the
functions of MASB as follows:

(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
                                                            
2
The Malaysian Institute of Certified Public Accountants (MICPA).
3
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.

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 sponsor or undertake development of possible accounting standards; (e) to
conduct such public consultation as may be necessary 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.

With the power provided under the Act, MASB had reviewed, revised and adopted
existing accounting standards; and issued new standards as approved accounting standards
known as MASB standards. By the end of 2004, the Board has produced a total of 97
technical pronouncements, comprising 33 Standards, 1 Interpretation Bulletin, 1 Foreword,
2 Statement of Principles (SOPs), 2 Technical Releases, 1 Discussion Paper, 5 Draft SOPs,
and 52 Exposure Drafts.

A number of regulating bodies, including the Securities Commission, the Central Bank of
Malaysia and the Companies Commission of Malaysia are responsible to enforce the
compliance of MASB standards over their respective jurisdictions. 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 necessary
announcements with respect to the non-compliance or required corrections. 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 Financial Reporting Standards (FRS) in line with
International Financial Reporting Standards (IFRS) in 2005. FRS 1 to 8 are labelled to
standards that are newly introduced by IASB and issued by MASB. Thus, IFRS 1 to 8 are
named as FRS 1 to 8 in Malaysia. FRS with 100 prefix corresponds to its equivalent IAS,
an FRS with 200 prefix denotes a locally developed standard with no equivalent
international standard and FRS with i prefix denotes an Islamic financial reporting
standard.

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Since the country still use some of its local accounting standards, the adoption of IFRS
announced in 2004 is actually a change from MASB standards to FRS. However, as at
January 2006 Malaysia FRS are close to word-for-word with IFRS issued by IASB, except
for some standards that are not yet made effective, which is IFRS 7, Financial Instrument:
Disclosures, and IFRS 8, Operating Segments. FRS also includes one Islamic accounting
standard and four local standards, which are not dealt 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 Malaysian Accounting
Standards Board 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.

Association between Earnings Quality and Accounting Standards

Studies analyzing 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 Sunder
(2001, p. 256) claim that:

Lax IASB standards allow firms more opportunity to manage their earnings,
making financial reports less useful to investors…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, p. 4) state
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

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 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, Landsman and Lang (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 for firms that apply IAS to those for 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.

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In line with the evidence shown in previous studies that different accounting standards is
associated with different level of earnings quality, we conjecture that the adoption of
IFRS-based accounting standards has some impacts on the quality of earnings reported by
Malaysian companies. Due to 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 better relative to the quality of earnings before the introduction of
the new standard. We measure earnings quality in terms of lower level of earnings
management and higher value relevance of earnings.

The extant literatures 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, management
buyouts, proxy contest, valuation of initial public offerings (IPOs), labour union
negotiations, and lobbying on accounting standards and regulations.

Davidson, Stickney and Weil (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, p. 368)
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 depends on reported
accounting numbers.

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According to above the definitions, it is clear that earnings management becomes possible
due to the discretion given to managers when preparing financial reports. However, it is
limited within the boundaries allowed under a particular set of accounting standards. Thus,
any changes in the extent of managerial discretion allowed under the accounting standards
may also change the amount of earnings management.

Zheng (2003) claim that the purpose of earnings management, as stated in Healy and
Wahlen (1999)’s definitions indicates that managed earnings is of lower quality than
unmanaged earnings. The greater the departure of reported earnings from what it should,
the lower the quality of earnings. Consistently, previous studies on earnings quality (e.g.
Barth et al., 2008; Chen, Dhaliwal and Trombley, 2007; Van Tendeloo and Vanstraelen,
2005) 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:

Ha1: 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 value relevance of
earnings to measure earnings quality (e.g. Cheng, Hsieh and Yip, 2007; Lang, Raedy and
Wilson, 2006; Lang, Raedy and Yetman, 2003; Leuz, Nanda and Wysocki, 2003). These
studies relate earnings directly to stock prices or market returns. The association (the slope
coefficient or the explanatory power of the model) between earnings and stock market
performance suggests that earnings are both relevant and reliable to investors (Barth,
Beaver and Landsman, 2001). In the existing studies, earnings are considered to be higher
in quality if it is more value relevant. As claimed by Bao and Bao (2004, p. 1533):

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

11 
 
 impaired, then the association between firm value and reported earnings should also
be impaired.

Based on the prior studies that considered more value relevant earnings as that of high
quality, we set our second hypothesis as follows:

Ha2: 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 study that examines 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 (2009)’s study that examine the adoption
of IFRS in Germany. However, in Germany the adoption of IFRS is made voluntary for
two years before it is made compulsory. Thus, the initial year of IFRS adoption for the
companies in the country varies.

The common approach of existing studies that examine the impact of IFRS adoption on
earnings quality is by comparing earnings quality of IFRS adopters and non-IFRS adopters
in a particular country during the period when companies are given the option of adopting
IFRS or adhering to local GAAPs or other accounting standards (e.g. Christensen, Lee and
Walker, 2007; Van der Meulen et al., 2007; Van Tendeloo and Vanstraelen, 2005; Zhou et
al., 2009). According to Zhou et al., 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 (2009) where most of the early adopters of IFRS are the companies
that previously have higher quality of financial reporting. Our study is free from the self-
selection bias as we examine the effect of IFRS in a setting where the adoption of IFRS is
made mandatory. There is no period for voluntary adoption of IFRS in Malaysia.
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.

12 
 
Model specification

Earnings management models

We examined the difference between 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 accrual using Jones (1991) model, modified by Dechow, Sloan and Sweeney
(1995), by running the following regression, by year and industry based on the General
Industry Classification Code (GICS):
TACCRit = a (1 / ASSETS it −1 ) + b(ΔREVit − ΔREC it ) + cPPE it + ε it (1)

where TACCRit is the total accruals for firm i in year t, ASSETSit-1 is total assets for firm i
in year t-1, ΔREVit is measured by revenues in year t less revenues in year t-1 for firm i,
ΔRECit is measured by receivables in year t less receivables in year t-1 for firm i, PPEit is
the gross property, plant, and equipment for firm i in year t and εit is the error term firm i in
year t.

In regression (1), the total accruals (TACCRit)4, change in revenue (∆REVit), change in
receivables (∆RECit), and gross property, plant and equipment (PPEit) are each scaled by
previous year total assets (ASSETSit-1). We followed Kothari, et al., (2005) that deflate the
variables with assets for the purpose of mitigating heteroscedasticity in 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.

                                                            
4
Total accruals are calculated by deducting the cash flows from operations (CFO) from net income (NI).

13 
 
To ensure robustness of the abnormal accrual estimation, we also calculate the absolute
value of abnormal accrual using Kasnik (1999) model, which is slightly different from
Dechow, et al (1995) model. Based on the evidence that cash flows from operations are
negatively associated with total accruals, Kasnik (1999) added the change in operating
cash flows, to Dechow et al. (1995) model. We use the following model to estimate the
absolute value of abnormal accrual based on Kasznik (1999) model:

TACC it = a (1 / ASSETS it −1 ) + b(ΔREVit − ΔREC it ) + cPPE it + dΔCFOit + ε it

(2)
where ΔCFO is the change in cash flows from operation5 for firm i in year t, and all other
variables are as previously defined. We labelled the absolute value of abnormal accrual
estimated using Kasnik (1999) model as ABACKAS. Then, we estimate the OLS regression
using equation (3) to test our first hypothesis of whether the extent of earnings
management is lower after the adoption of FRS.
ABACi ,t = β 0 + β 1 LEVERAGEi ,t + β 2 SIZE i ,t + β 3 PROFITABILITYi ,t + β 4 GROWTH i ,t
+ β 5 IFRS i ,t + ε i ,t
(3)
where ABACi,t is the absolute value of abnormal accrual for firm i in year t. ABACi,t
represents either (1) ABACDECi,t which is the absolute abnormal accrual from the
Dechow, et al, (1995) model, or (2) 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
(ROAi,t), leverage (LEVERAGEi,t) and growth (GROWTHi,t), that could also influence the
extent of earnings management practices. According to Johnson et al. (2002), these

14 
 
variables can affect financial reporting quality in terms of the level of sophistication of 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 system. Therefore, managers in these companies may
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, Sloan and Sweeney, 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 = α 0 + α 1 EPSi ,t + α 2 BVPSi ,t + ε i ,t (4)

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 εi,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 the
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
                                                                                                                                                                                    
5
Cash flows from operation is obtained from the Statement of Cash Floww
15 
 
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
results in economic impact. Therefore, other than looking at the coefficient of earnings, we
compare the R-squared 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 at al.
(2007), wherein higher R-squared 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 = α 0 + α 1 EPSi ,t + α 2 BVPSi ,t + α 3 EPSi ,t * IFRS + α 4 BVPSi ,t * IFRS + ε i ,t (5)

In this model, all variables are as previously defined. The coefficient of the interaction
variables EPS*IFRS, α3, 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 another analysis on value
relevance of earnings using return-earnings models introduced by Easton and Harris
(1991). The approach of using return-earnings to examine the value relevance of earnings
is widely used in existing studies (e.g. Gul, Lynn and Tsui, 2002; Gul, Tsui and Dhaliwal,
2006; Loftus and Sin, 1997; Warfield and Wild, 1992; Warfield, Wild and Wild, 1995).
The return-earnings model is as follows:

RETi ,t = α 0 + α 1 E / Pi ,t −1 + ε i ,t (6)

where RETi,t is holding returns for a 12-month period before the financial year end for firm
i in year t, E/Pi,t-1 is the earnings per share at the financial year end divided by the closing
price 12 months previously 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

16 
 
IFRS. Similar to the value-relevance analysis using the price-earnings regression, the
coefficient of E/Pt-1 and the R-squared 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 return-earnings model, we include interaction variables and other control
variables, as shown below:

RETi ,t = α 0 + α 1 E / Pi ,t −1 + α 2 IFRS i ,t + α 3 E / Pi ,t −1 * IFRS i ,t + α 4 E / Pi ,t −1 * RISK i ,t

+ α 5 E / Pi ,t −1 * GROWTHi ,t + α 6 E / Pi ,t −1 * TDTAi ,t + ε i ,t
(7)

where RISKi,t is the beta for firm i in year t, GROWTHi,t equals to 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/Pt-1*IFRS, α3, captures the influence of
IFRS on the value-relevance of earnings.

Data and Sample Selection

Our data are collected from 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 Jan 1 2006, the first annual report prepared using
the new standard dated 31 December 2006. Thus, we classify our data based on financial
year end of each firm. For example, data from annual report dated 31 December 2006 to
30 December 2007 is considered as 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. 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
maximize our observations. For the first hypothesis, relating to analysis on the effect of
FRS adoption on earnings management, most of the missing data is because of

17 
 
unavailability of cash flows from operations data, which are required to calculate total
accrual. For this analysis, our sample comprises 4010 firm-year observations as in Table 1.
For value relevance models, we exclude data with missing market prices. To control for
potential outliers, we remove 0.5% top and bottom of each variables used in the study. The
total observations for value relevance analysis are 2663.

[Table 1 and 2 is about here]

Table 1 presents descriptive statistics of 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) with those using Kasnik (ABACKAS).
The mean and median of ABACDEC (ABACKAS) is 0.849 (0.618) and 0.076 (0.064)
respectively. Table 2 reports the correlation matrix between 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 3 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, which are run based on model (3), include other
determinants of earnings management practices such as the firm’s size (SIZE), profitability
(PROFITABILITY), growth (GROWTH) and leverage (LEVERAGE). 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).

[Table 3 is about here]

From the table, the coefficient of the dummy variable IFRS, β1, is significant at 1% level
with a t-statistics of -28.353. This result suggests that the adoption of IFRS-based
accounting standards is significantly associated with lower level of earnings management.
In other words, the level of reported earnings’ departure from normal earnings is lower
after the adoption of the new standard, suggesting that earnings quality is higher after the

18 
 
adoption of IFRS. Panel B of Table 3 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 absolute value of abnormal accruals.
Consistently, the coefficient of the dummy variable IFRS, β1, shows a significant negative
association with the absolute value of abnormal accruals using Kasnik (1999) model
(ABACKAS) at 1% level with a t-statistics of -28.477.

Our analyses on the value relevance of earnings are presented in Table 4 and Table 5.
Table 4 shows the results using the price-earnings model, as discussed in Section 5.
Differences between MASB and IFRS-based earnings with regard to value relevance are
reflected in the differences in model (4)’s coefficient for EPS, α1, and R-squared 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, α3, indicates whether there is a significant difference in the value
relevance of earning between the two periods.

[Table 4 and 5 is about here]

As shown in Table 4, 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% 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 higher weight compared to
earnings reported in pre-IFRS period. Similarly, the R-squared shows that the joint
coefficient of earnings and book value during the IFRS period is relatively higher, 41.4%
for the pre-IFRS period and 47.5% for the post-IFRS period. Thus, assuming prices are
good indicators of share value, it seems that IFRS-based earnings explain more variation in
the share value movement. 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% level with t-statistics 3.214.

The examination of value relevance of earnings during the two different periods using
return-earnings regressions, as in model (6) and (7), produces qualitatively similar results.

19 
 
The results are shown in Table 5. We found that the ability of earnings in explaining
returns is relatively higher during the period of IFRS adoption. The coefficient of E/Pt-1
during the period before and after IFRS adoption is 0.995 and 2.104, and both are
significant at 1% level with t-statistics of 6.463 and 16.489 respectively. Consistently, the
interaction variables, E/Pt-1*IFRS is positively significant at 1% level with t-statistics of
6.058. Our examination on 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 high quality of earnings, in terms of lower level of
earnings management practices and higher value relevance of earnings numbers. Our
results confirm that IFRS adoption is associated with better quality of reported earnings.
Specifically, we found that earnings reported during the period after the adoption of IFRS
is associated with lower amount of earnings management. Using both, price-earnings and
return-earnings models, our findings also shows 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
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 environment so that the impact
of IFRS adoption in different environment can be revealed. Other than that, the consistent
changes in the level of absolute abnormal accruals 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 give better valuation for earnings that has lower level of earnings
management. Future research can investigate this issue. Furthermore, additional studies
can also consider other attributes of earnings quality such as earnings conservatism,
predictability, comparability, persistence and timeliness.

20 
 
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 Table 1: General descriptive statistics on observations and sample firms

Panel A: Descriptive Statistics for testing Hypothesis 1 (n= 4010)

Variables Mean Median SD Minimum Maximum Q1 Q3

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 Hypothesis 2 (n=2663)

Variables Mean Median SD Minimum Maximum Q1 Q3

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/Pt-1 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

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/Pt-1 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 beta.

25 
 
 Table 2: Pearson (below diagonal) and Spearman (above diagonal) Correlation Matrix
Panel A: Sample for Earnings Management Analysis
ABACDEC ABACKAS SIZE PROFITABILITY GROWTH LEVERAGE
ABACDEC .723** -.077** -.020 .042** .039*
ABACKAS .764 ** -.093** -.021 .036* .007
SIZE -.034 * -.015 .273** .115** -.005
PROFITABILITY -.024 .010 .285** .465** -.028
GROWTH -.019 -.021 .105** .252** .000
LEVERAGE .076 ** -.066** .200** -.107** -.021
N=4010

Panel B: Sample for Value Relevance Analysis

P BVPS EPS RET E/Pt-1 TDTA GROWTH RISK
P .635** .645** .275** .259** -.237** .123** -.108**
BVPS .514** .552** -.022 .231** -.209** .037 -.063**
EPS .622** .482** .213** .789** -.249** .251** -.024
RET .103** -.046* .078** .397** -.063** .173** .031
E/Pt-1 .108** .119** .607** .294** -.141** .306** .064**
TDTA -.145** -.141** -.208** -.004 -.128** .039* .147**
GROWTH -.008 -.014 -.003 .132** .055** -.024 .059*
RISK -.088** -.026 -.032 .088** .061** .162** .032
N=2663

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/Pt-1 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 beta.

26 
 
Table 3: OLS regressions of absolute value of abnormal accruals on IFRS and other additional determinants variables.

Panel A: Regression results of absolute value of abnormal accrual estimated using Dechow, et al (1995) model
ABACDECi,t = β0 + β1IFRSi,t +β2SIZEi,t +β3PROFITABILITYi,t +β4GROWTHi,t + β5LEVERAGEi,t + εi,t

Variable (Constant) IFRS SIZE PROFITABILITY GROWTH LEVERAGE

Coeff. 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
Adj. R2 0.172
F-Stats 167.715 ***
N 4010

Panel B: Regression results of absolute value of abnormal accrual estimated using Kasnik (1999) model
ABACKASi,t = β0 + β1IFRSi,t +β2SIZEi,t +β3PROFITABILITYi,t +β4GROWTHi,t + β5LEVERAGEi,t + εi,t

Variable (Constant) IFRS SIZE PROFITABILITY GROWTH LEVERAGE

Coeff. 1.863 *** -1.412 *** -0.019 0.002 -0.017 -0.230 ***
T-value 6.03 -28.477 -1.132 0.742 -1.505 -11.996
VIF 1.076 1.090 1.152 1.069 1.077
Adj. R2 0.172
F-Stats 167.299 ***
N 4010

Notes: ***, **, * represents statistical significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test). 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.

27 
 
Table 4: OLS regressions on value relevance of earnings using price-earnings models.
Pooled Sample Pre IFRS Post IFRS Pooled Sample
(Basic Model) (Basic Model) (Basic Model) (Extended Model)
Variable Coeff. T-value Coeff. T-value Coeff. T-value Coeff. T-value
(Constant) .486 *** 12.038 .574 *** 12.324 .353 *** 4.724 .574 *** 11.361
EPS 4.715 *** 29.606 4.139 *** 19.039 5.199 *** 20.660 4.139 *** 17.550
BVPS .340 *** 16.924 .343 *** 15.779 .344 *** 8.201 .343 *** 14.545
IFRS -.221 ** -2.593
EPS*IFRS 1.060 *** 3.214
BVPS*IFRS .001 .032
2
Adj. R 0.446 0.414 0.475 .449

F-Stats 1071.788 *** 530.058 *** 528.809 *** 434.739 ***

N 2663 1497 1166 2663

Basic Model: Pi ,t = α 0 + α 1 EPS i ,t + α 2 BVPSi ,t + ε i ,t

Extended Model: Pi ,t = α 0 + α 1 EPS i ,t + α 2 BVPSi ,t + α 3 EPS i ,t * IFRSi ,t + α 4 BVPSi ,t * IFRSi ,t + ε i ,t

Notes: ***, **, * represents statistical significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test). 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.

28 
 
Table 5: OLS regressions on value relevance of earnings using return-earnings models
Pre IFRS Post IFRS Extended Model
Variable Coeff. T-value Coeff T-value Coeff T-value   
(Constant) .106 *** 3.607 .067 ** 2.192 .071 *** 2.841
E/Pt-1 .995 *** 6.463 2.104 *** 16.489 .242 1.135
IFRS -0.044 -1.169
E/Pt-1*IFRS 1.086 *** 6.058
E/Pt-1*RISK 1.249 *** 10.871
E/Pt-1*GROWTH .455 *** 8.073
E/Pt-1*TDTA -0.042 *** -8.578
Adj. R2 0.03 0.19 0.19
F-Stats 41.776 *** 271.895 *** 86.527 ***
N 1497 1166 2663
  

Basic Model: RETi ,t = α 0 + α 1 E / Pi ,t −1 + ε i ,t

Extended Model:
RETi ,t = α 0 + α 1 E / Pi ,t −1 + α 2 IFRSi ,t + α 3 E / Pi ,t −1 * IFRSi ,t + α 4 E / Pi ,t −1 * RISK i ,t + α 5 E / Pi ,t −1 * GROWTHi ,t + α 6 E / Pi ,t −1 * TDTAi ,t + ε i ,t

Notes: ***, **, * represents statistical significance at 0.01, 0.05 and 0.10 levels, respectively (two-tailed test). RET is holding returns for a 12-
month period before the financial year end. E/Pt-1 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 beta. 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.

29