PREDICTIONS ABOUT THE LIKELY MANAGERIAL BEHAVIOR IN TERMS OF

EARNINGS MANAGEMENT.

Accounting is based on a pragmatic approach, where accounting concepts and theories

are based upon utility. A theory useful under this approach is positive accounting theory, which

attempts to explained observed phenomena, describing ‘what is?’ rather than ‘what it should be’

(normative theory). Within the lifespan of a business, corporate executives, i.e., managers, are

under the pressures of attaining their targeted earnings, thus in response managers utilize

fraudulent practices to benefit the business, influence stakeholders or for their own personal gain.

Positive Accounting Theory & Agency Theory

Positive theory indicates managers engage in earnings management driven by self-

interest and opportunity to increase wealth. Agency theory is a positive accounting theory that

focuses on the conflicts of interest that occur between stakeholders due to differences in their

goals and incentives. Both theories suggest management has incentives to control reported

earnings to achieve their own objectives, obtaining bonuses and influencing stock prices.

Accounting information is crucial in reducing agency cost. Managers will manipulate and

misstate financial statements to increase profits, lower the companies cost of capital and improve

reported income effects. Under reporting standards, such as IFRS 9 can be manipulated to

produce the desired the result.

IFRS 9

IFRS 9 specifies how an entity should classify and measure financial assets, financial
liabilities, and some contracts to buy or sell non-financial items (IFRS, 2017). Replacing IAS 39,
due to criticism on its complexity and inconsistencies on how entities manage their risks and
businesses. IAS 39 also, defers the recognition of credit losses on losses and receivables. The
international accounting standards board (IASB) detailed one of the objectives of IFRS 9 is to
reduce earnings management. IFRS 9 is considered a major improvement in addressing the
potential for earnings management compared to IAS 39. Including stricter requirements for
classification and measurement of financial instruments and the change in handling impairment
of assets from the incurred loss model to the expected credit loss model. The standard is not a
positive accounting theory as it does not explain why stakeholders make certain decisions based
on self-interest or other factors. It is not a full proof standard, IFRS 9 can create incentives for
managers to engage in earnings management to achieve certain financial reporting outcomes.
IFRS 9 was meant to disclose new measures to enhance transparency and provide shareholders
with accurate complete information for decision making. However, since the implementation of
the standard, it is evident, the standard is no different compared to IAS 39 in terms of preventing
earnings management. There is evidence the standard is prone to abuse, where management

Under IFRS 9, management has a certain amount of discretion to determine the level of
impairment of financial assets, through assessments on cash flows, economic conditions, and
other factors. Management utilizes this, coupled with their authority and resources to commit
earnings management without being caught. Below, details few of the instances of earnings
management occurring from managerial behaviors.

All financial instruments are initially measured at fair value plus or minus, in the case of
a financial asset or financial liability, not at fair value through profit or loss, transaction cost
(IFRS 9, n.d., 5.1.1). Managers can classify financial instruments to be held at maturity to avoid
fair value fluctuations and can also classify them as ‘available for sale’ to take advantage of
unrealized gains. IFRS 9 (n.d.) (5.2.1), states ‘an entity can measure financial assets using
amortized cost or fair value through other comprehensive income, or fair value through profit
and loss.’ Managers may increase or decrease the amortization of a premium or discount, thereby
affecting the interest income recognized for the period impacting earnings.

Additionally, managers can engage in earnings management through engineering the

allowance for expected credit losses (ECL). With the exception or originated credit impaired
financial assets, expected credit losses are required to be measured through a loss allowance at an
amount equal to conform to IFRS 9, passages 5:5.3 and 5:5.5 (Deloitte, 2014). Managers can
understate or overstate ECL to increase reported profits or reduce reported profits respectively.
This can adversely affect the debt-to-equity ratio or return on asset ratio.

Hedge accounting is used to manage the risk exposure of an entity. Hedge accounting
under IFRS 9 can be manipulates by managers through delaying or accelerating the gains or
losses on hedging instruments to smooth earnings. Managers may also utilize market risks, such
as interest rates and selectively apply hedge accounting to certain financial instruments which
can recognize gains or delay the recognition of losses.

In this regard, it can be said IFRS 9 is not most suitable standard to combat earnings
management. IFRS 9 is an international accounting standard (IAS), generally more principle-
based, which creates opportunities for earnings management, compared to other standards, such
as ASPE (Accounting Standards for Private Enterprises), which can limit opportunities for
earnings management due to its prescriptive approach. Additionally, the agency theory fails to
consider there is the possibility that managers will not act for their own self-interests. Managers
may be fully satisfied with their position within an entity and will not be tempted to engage in
earnings management. It is the question of ethics, ‘Is every single manager engaging in unethical
practices as earnings management’.

The IASB are aware of the manipulation of the standard to commit earnings
management, but it is evident in the recent years there has been no intention to revise the
standard to combat this issue. Moreover, the extent to which managers will engage in earnings
management under IFRS 9 can be limited through the level of monitoring and control
mechanism in place. There is a need for awareness on the short-term benefits of earnings
management and the long-term risks associated with it.