The Effect of Managerial Ability on Earnings Quality in ...

1 Proceedings of the Third Middle East conference on Global Business, Economics, Finance and banking (ME15 Dubai October conference ), ISBN - 978-1-63102-286-9 16-18 October, 2015 Paper ID: DF523 1 The Effect of Managerial Ability on Earnings Quality in the Pre and Post IFRS Adoption Periods Weitzu Chen, Department of Accountancy, National Taipei University, Taiwan. E-mail: Chia-Wei Tai, Department of Accountancy, National Taipei University, Taiwan. E-mail: _____ Abstract This study examines the Effect of Managerial Ability on providing financial information. Generally, compared with ones with inferior Ability in making judgments and estimates, managers with superior Ability provide informative reports with Earnings of higher Quality to investors due to their better knowledge of firms conditions and prospects.

2 Managers with superior Ability have no need to manipulate Earnings through discretionary accruals. In addition, due to many accounting treatments in international financial reporting standards (IFRS) based on fair value measurements, the purpose of fair value accounting is to increase the information transparency for investors to make a better decision. Based on aforementioned assumptions of Managerial Ability and fair value accounting, this study investigates the Effect of Managerial Ability on the preparation of financial information in the pre- and post-IFRS adoption periods.

3 For this study, we extract data from Global Compustat to examine that the Effect of Managerial Ability in the UK listed firms on firm's Earnings Quality in the pre- and post- IFRS adoption periods. We focus on the UK listed firms because the UK has the largest capital market in the European Union (EU). Based on our evidence, we find that Earnings Quality is negatively associated with Managerial Ability in the pre-IFRS adoption period. In addition, managers of superior Ability are associated with better Earnings Quality in the post-IFRS adaption period. Compared empirical findings between the pre- and post-IFRS adoption periods, our results imply that Managerial Ability in making judgments and estimates affects Earnings Quality primarily due to fair value accounting in the IFRS.

4 Overall, fair value accounting in the post-IFRS adoption period can mitigate Managerial Ability in manipulating Earnings . _____ Keywords: Managerial Ability ; fair value; international financial reporting standards (IFRS). JEL Classification: M41, N24 Proceedings of the Third Middle East conference on Global Business, Economics, Finance and banking (ME15 Dubai October conference ), ISBN - 978-1-63102-286-9 16-18 October, 2015 Paper ID: DF523 2 1. Introduction There are many sources of firm value. Among others, Managerial skill is the most important factor in the human capital of a firm.

5 Previous research (Demerjian, Lev, and McVay 2012) has shown that the characteristics of managers including Ability , talent, reputation, and style can affect economic outcomes. Therefore, Managerial abilities are important for research and practical applications in the fields of economics, finance, accounting, and management. More capable managers have stronger professional knowledge related to the firm, enabling them to make better judgments and decisions. In addition, more capable managers show a more flexible understanding and application of accounting standards .

6 Therefore, the financial reporting of managers to investors varies according to the intentions and choices of managers. Although it is obviously difficult to capture how the intentions and choices of managers are used to manipulate the Quality of financial reporting , when compared to less capable managers, more capable managers show better understanding of the industry and the overall economic environment, as well as the Ability to apply accounting standards more flexibly, and therefore have a significant influence on the Quality of information. Better Earnings Quality can be used to appropriately reflect the firm s current operating performance through financial reports.

7 Furthermore, it can enable better decision-making on the distribution of Earnings from the perspective of investors (Dechow et al. 2010). More capable managers are able to better allocate resources, and create a positive impact on the Quality of financial reporting . Related research on the Quality of financial reporting including Earnings forecasts also provides strong evidence for the impact of the Ability of managers on financial reporting . Trueman (1986) points out Ability of managers to anticipate future changes in the firm s economic environment and to adjust the firm s production plan accordingly is valuable for investors because managers with stock incentive compensation have incentives to voluntarily release Earnings forecasts as signals to markets.

8 Therefore, compared to firms that do not release Earnings forecasts, firms that release Earnings forecasts have higher firm value. That is, Earnings forecasts include useful signals about the Ability of managers, increasing the value of Earnings information in forecasts. The Ability of managers inevitably affects the accuracy and relevance of financial reporting . Therefore, more capable managers have a better understanding of a firm s overall economic environment and future development. In addition, managers play a key role in the distribution of firm resources, and therefore also influence the development of firms as well.

9 Proceedings of the Third Middle East conference on Global Business, Economics, Finance and banking (ME15 Dubai October conference ), ISBN - 978-1-63102-286-9 16-18 October, 2015 Paper ID: DF523 3 In addition, Managerial Ability has a significant influence on the accuracy and relevance of financial reporting (Baik, Farber, and Lee 2011). However, it is not easy to observe the Ability of managers. Therefore, this study adopts the data envelopment analysis (DEA) method developed by Demerjian, Lev, and McVay (2012) to estimate Managerial Ability . This study uses DEA to estimate firm efficiency, and then uses a regression model to estimate the portion of company efficiency that is attributable to the efficiency of managers.

10 This measure is used as a proxy for the Ability of managers. In addition to influence of Managerial Ability on financial reporting , many studies related to accounting and management research investigate whether managers use accounting methods and discretionary power to influence Earnings reports, so called Earnings management. At the same time, the preparation of financial reports is regulated by accounting standards . Currently, there is a global trend toward the adoption of the international financial reporting standards (IFRS). Different countries in the world have gradually moved from their local standards to fully adopted or incorporated IFRS.