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Enforcement of accounting standards: how effective is the German two-tier system in detecting earnings management?

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Abstract

Within the European Union, the IAS-Regulation has harmonized applicable accounting standards for consolidated financial statements of capital market oriented companies by requiring IFRS since 2005. Regarding enforcement of financial reporting, the IAS-Regulation offered only small guidance for EU member states which led to the implementation of different enforcement systems. Currently, harmonization efforts are taken, in particular by the European Securities and Markets Authority, to establish a cross-jurisdictional accounting enforcement regime. This paper contributes to the discussion of standardized EU-wide enforcement mechanisms by assessing the effectiveness of the current German two-tier enforcement system in detecting earnings management. Using a unique data set provided by the German capital market authority, we find that the German enforcement system is effective in detecting earnings management, but shows weak ability in constraining earnings management in years following error releases.

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Notes

  1. The Consultation Paper is available for download at http://www.esma.europa.eu/system/files/2013-1013_consultation_paper_-_guidelines_on_enforcement_of_financial_information.pdf.

  2. The German two-tier structure has already been a blueprint for the implementation of the Austrian enforcement system in 2013, see http://www.oepr-afrep.at.

  3. In 2013, the two directives were converged to one single directive 2013/34/EU.

  4. As an exemption, entities applying certain third country GAAP (e.g. US-GAAP) were allowed to convert to IFRS until 2007.

  5. Recital 16 of the IAS-Regulation also states: “A proper and rigorous enforcement regime is key to underpinning investors’ confidence in financial markets”.

  6. The extracts from EECS’s database of enforcement decisions are available at www.esma.europa.eu.

  7. The annual examination areas of emphasis are available for download at www.frep.info.

  8. DAX, MDAX, SDAX and TecDAX are indices which are part of the Prime Standard of the Frankfurt Stock Exchange. The DAX consists of the 30 largest companies listed on the Frankfurt Stock Exchange, the MDAX of the 50 largest companies following the DAX and the SDAX of the 50 largest companies following the MDAX. The TexDAX consists of the 30 largest companies from the technology sector listed on the Frankfurt Stock Exchange. See for a comprehensive description http://deutscheboerse.com/dbag/dispatch/de/kir/gdb_navigation/home.

  9. According to Principle 21 of CESR Standard No. 1 on Financial Information—Enforcement of Standards on Financial Information (2003), “[e]nforcers should periodically report to the public on their activities providing at least information on the enforcement policies adopted and decisions taken in individual cases including accounting and disclosure matters.”.

  10. The annual activity reports are available for download via www.frep.info. See also in comparison e.g. the report of the UK enforcement institution FRRP: http://www.frc.org.uk/images/uploaded/documents/FRRP%20Annual%20Report%202011%20final.pdf.

  11. For criticism with regard to this study and its findings and conclusions see Barth and Israeli (2013).

  12. However, most of these studies are based on the assumptions that non-discretionary accruals stay constant over time and discretionary accruals have a mean of zero, which both can lead to considerable errors in measurement if these assumptions do not hold. Another point of criticism besides the simplified assumptions is the disregard of firm-specific characteristics like company size, cash flows or growth.

  13. See for advantages of the cash-flow-statement based approach (in comparison to the balance-sheet approach) Collins and Hribar (2002).

  14. However, as a robustness check, we ran our analysis also after excluding disclosure or unintentional errors; see Sect. 8.3.

  15. Therefore, our enforcement investigation data conforms to a large extent with the official statistics published in the FREP’s annual activity reports (see also Table 1).

  16. Information about which variables have been hand-collected and which variables have been obtained from DATASTREAM is provided in Sect. 7.4.

  17. Regarding this result, as well as all other t tests in this chapter, we also perform Wilcoxon rank-sum tests (Mann–Whitney U tests) in order to check our results for robustness. In general, the results did not change.

  18. Data for the construction of the error dummies has been provided by the BaFin. All data for the control variables with the exception of BIGFOUR was obtained from DATASTREAM. Auditor data, i.e. the BIGFOUR dummy, was hand-collected from the published financial statements. Also, information about the error releases (i.e., type of the errors, number of individual errors) was hand-collected.

  19. In order to increase the readability of Table 12 with regard to the direction of the coefficient signs, we use absolute values of negative discretionary accruals.

  20. Running the regression models without including LOSSAVOID or LARGE_LOSSES as control variables does not alter the results.

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Acknowledgments

We thank two anonymous referees for their helpful comments and suggestions. Moreover, we thank the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin, Federal Financial Supervisory Authority) for providing us with internal data on completed investigations by the German accounting enforcement system. We also appreciate the helpful comments on various versions of this paper by Inder K. Khurana and Ole-Kristian Hope during a new scholar concurrent session at the 2011 AAA Annual Meeting in Denver, USA, as well as by participants at the 2011 JIAR conference in Xiamen, China, the 2012 AAA Annual Meeting in Washington, USA, the 2013 AAA International Accounting Section Midyear Meeting in Savannah, USA, and the 2014 EAA Annual Congress in Tallinn, Estonia.

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  1. Chair of Auditing and Corporate Governance, Goethe-University Frankfurt, Grüneburgplatz 1, 60323, Frankfurt/Main, Germany

    Hans-Joachim Böcking, Marius Gros & Daniel Worret

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  1. Hans-Joachim Böcking
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Correspondence to Marius Gros or Daniel Worret.

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Böcking, HJ., Gros, M. & Worret, D. Enforcement of accounting standards: how effective is the German two-tier system in detecting earnings management?. Rev Manag Sci 9, 431–485 (2015). https://doi.org/10.1007/s11846-014-0159-z

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