Effects of firm-level incentives and the mandatory IFRS adoption on Latin American firms’ earnings management practices

This paper investigates the effects of four proxies for firm-level incentives and the mandatory adoption of IFRS on real activities manipulation (RAM) and accrual-based earnings management (AEM) in Latin American countries. The results show that growth potential and the standard of corporate governance are negatively associated with the level of RAM. Financial leverage is negatively (positively) associated with the level of RAM (AEM). The status of listing on US stock exchanges is negatively associated with the level of AEM. For the effect of IFRS adoption, the level of AEM in the post-adoption period is higher than in the pre-adoption period. For firms with low growth potential, a low standard of corporate governance, high financial leverage and listing on domestic stock exchanges, their level of AEM in the post-adoption period is higher than in the pre-adoption period. These findings imply that (i) firm-level incentives shape firms’ RAM and AEM when the enforcement of law is weak. (ii) Firms use AEM to adjust the additional level of RAM at the end of financial year, rather than treating them as substitutes. (iii) The debt covenant hypothesis explains firms’ choices of AEM and RAM better than the control hypothesis. (iv) The mandatory adoption of IFRS does not necessarily reduce the level of AEM and RAM. An implication of these findings is that Latin American regulators and the IASB need to be aware of the role of firm-level incentives in the process of IFRS adoption, besides the improvement of law enforcement.