Firm Incentives, Institutional Complexity and the Quality of 'Harmonized' Accounting Numbers

In this paper, we investigate how firm reporting incentives and institutional factors affect accounting quality in firms from 26 countries. We exploit a unique multicountry setting where firms are required to comply with the same set of international reporting standards. We develop an approach of cross-country comparisons allowing for differences between firms within a country and we investigate the relative importance of country- versus firm-specific factors in explaining accounting quality. We find that financial reporting quality increases in the presence of strong monitoring mechanisms by means of ownership concentration, analyst scrutiny, effective auditing, external financing needs, and leverage. Instability of business operations, existence of losses, and lack of transparent disclosure negatively affect the quality of accounting information. At the country level, we observe better accounting quality for firms from regulatory environments with stronger institutions, higher levels of economic development, greater business sophistication, and more globalized markets. More importantly, we find that firm-specific incentives play a greater role in explaining accounting quality than countrywide factors. This evidence suggests that institutional factors shape the firm's specific incentives that influence reporting quality. Our findings support the view that the global adoption of a single set of accounting standards in isolation is not likely to lead to more comparable and transparent financial statements unless the institutional conditions and the firm-specific reporting incentives also change.

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title: Corporate Ownership Around the World
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title: Who Cares About Auditor Reputation?
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title: Fees Paid to Audit Firms, Accrual Choices, and Corporate Governance
abstract: We examine the relation between the fees paid to auditors for audit and non‐audit services, and the choice of accrual measures for a large sample of firms. Using our pooled sample, we find that the ratio of non‐audit fees to total fees has a positive relation with the absolute value of accruals similar to Frankel, Johnson, and Nelson [2002]. However, using latent class mixture models to identify clusters of firms with a homogenous regression structure reveals that this positive association only occurs for about 8.5% of the sample. In contrast to the fee ratio results, we find consistent evidence of a negative relation between the level of fees (both audit and non‐audit) paid to auditors and accruals (i.e., higher fees are associated with smaller accruals). The latent class analysis also indicates that this negative relation is strongest for client firms with weak governance. Overall, our results are most consistent with auditor behavior being constrained by the reputation effects associated with allowing clients to engage in unusual accrual choices.

title: The role of accounting and auditing in corporate governance and the development of financial markets around the world
abstract: For a sample of 31 countries, we document that financial disclosures are more transparent and national accounting standards require timelier (accrual based) reporting in countries with stronger investor protection. These countries also spend more on auditing enforcement and the Big Five accounting firms audit proportionately more companies in these countries. These results indicate that higher quality accounting standards and the enforcement of such standards through higher quality auditing are more likely to exist in corporate governance in countries with strong investor protection. Higher quality accounting and auditing are also positively associated with financial market development in countries whose legal systems are conducive to the protection of investors. However, we are unable to find systematic evidence that higher quality accounting and auditing alone—independent of a country's underlying investor protection regime—affects the development of financial markets.

title: Litigation Risk and the Financial Reporting Credibility of Big 4 versus Non‐Big 4 Audits: Evidence from Anglo‐American Countries
abstract: Prior research suggests that Big 4 auditors provide higher quality audits in the U.S. in order to protect the firm's brand name reputation and to avoid costly litigation. In this study, we examine whether the perceived higher quality of a Big 4 audit is related to auditor litigation exposure or to reputation concerns. Specifically, we utilize an estimable proxy for financial reporting credibility—the ex ante cost of equity capital—to examine whether Big 4 auditors are perceived as providing higher quality audits (relative to non‐Big 4 auditors) in the U.S., and in the less litigious (but economically similar) environments in other Anglo‐American countries during the 1990–99 period. We find that a Big 4 audit is associated with a lower ex ante cost of equity capital for auditees in the U.S. but not in Australia, Canada, or the U.K. Our findings suggest that it is litigation exposure rather than brand name reputation protection that drives perceived audit quality.

title: The association between financial accounting measures and real economic activity: a multinational study
abstract: We investigate how cross-country differences in financial accounting standards affect the relation between financial accounting earnings and real economic value-relevant events that underlie those earnings. Based on previous research and economic theory we hypothesize that, because of differences in legal systems and the demand for accounting information, differences in legal protection for external shareholders, and differences in the degree of tax conformity in our sample countries, accounting earnings in the UK and the US will be more closely related to underlying economic activity than will accounting earnings in France and Germany. Empirical results are generally consistent with our hypothesis.

title: The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors
abstract: This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that t...

title: An empirical evaluation of accounting income numbers
abstract: Accounting theorists have generally evaluated the usefulness of accounting practices by the extent of their agreement with a particular analytic model. The model may consist of only a few assertions or it may be a rigorously developed argument. In each case, the method of evaluation has been to compare existing practices with the more preferable practices implied by the model or with some standard which the model implies all practices should possess. The shortcoming of this method is that it ignores a significant source of knowledge of the world, namely, the extent to which the predictions of the model conform to observed behavior. It is not enough to defend an analytical inquiry on the basis that its assumptions are empirically supportable, for how is one to know that a theory embraces all of the relevant supportable assumptions? And how does one explain the predictive powers of propositions which are based on unverifiable assumptions such as the maximization of utility functions? Further, how is one to resolve differences between propositions which arise from considering different aspects of the world? The limitations of a completely analytical approach to usefulness are illustrated by the argument that income numbers cannot be defined substantively, that they lack "meaning" and are therefore of doubtful utility.' The argument stems in part from the patchwork development of account-

title: Earnings Management to Avoid Earnings Decreases and Losses
abstract: Anecdotal evidence and recent research suggest there are incentives to avoid earnings decreases and losses. This paper provides systematic evidence that firms increase reported earnings to achieve these goals. Specifically, using all available observations on the annual industrial and research Compustat database for the years 1976-1994, cross-sectional distributions of scaled annual earnings changes and earnings are bell-shaped and fairly smooth except in the regions near zero. For both earnings changes and levels distributions, there is a trough immediately to the left of zero and a peak immediately to the right of zero which are inconsistent with the overall shape of the remainder of the distribution, i.e., the frequencies of small decreases in earnings and small losses are unusually low and the frequencies of small increases in earnings and small positive income are unusually high. Exploring the methods of earnings management, we find evidence that two components of earnings, cash flow from operations and changes in working capital, are used to achieve the manipulation of earnings. Finally, we present two theories about the motivation for avoidance of earnings decreases and losses. We find that the main results of this paper are consistent with both prospect theory and managerial opportunistic behavior motivated by stakeholder use of earnings-related heuristics.

title: Information Asymmetry, Corporate Disclosure and the Capital Markets: A Review of the Empirical Disclosure Literature
abstract: Corporate disclosure is critical for the functioning of an efficient capital market. Firms provide disclosure through regulated financial reports, including the financial statements, footnotes, management discussion and analysis, and other regulatory filings. In addition, some firms engage in voluntary communication, such as management forecasts, analysts? presentations and conference calls, press releases, internet sites, and other corporate reports. Finally, there are disclosures about firms by information intermediaries, such as financial analysts, industry experts, and the financial press.

title: Law, Finance and Firm Growth
abstract: We investigate how differences in legal and financial systems affect firms' use of external financing to fund growth. We show that in countries whose legal systems score high on an efficiency index, a greater proportion of firms use long-term external financing. An active, though not necessarily large, stock market and a large banking sector are also associated with externally financed firm growth. The increased reliance on external financing occurs in part because established firms in countries with well-functioning institutions have lower profit rates. Government subsidies to industry do not increase the proportion of firms relying on external financing.

title: Industry costs of equity
abstract: Estimates of the cost of equity for industries are imprecise. Standard errors of more than 3.0% per year are typical for both the CAPM and the three-factor model of Fama and French (1993). These large standard errors are the result of(i) uncertainty about true factor risk premiums and (ii) imp ecise estimates of the loadings of industries on the risk factors. Estimates of the cost of equity for firms and projects are surely even less precise.

title: A Survey of Corporate Governance
abstract: This article surveys research on corporate governance, with special attention to the importance of legal protection of investors and of ownership concentration in corporate governance systems around the world. CORPORATE GOVERNANCE DEALS WITH the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. How do the suppliers of finance get managers to return some of the profits to them? How do they make sure that managers do not steal the capital they supply or invest it in bad projects? How do suppliers of finance control managers? At first glance, it is not entirely obvious why the suppliers of capital get anything back. After all, they part with their money, and have little to contribute to the enterprise afterward. The professional managers or entrepreneurs who run the firms might as well abscond with the money. Although they sometimes do, usually they do not. Most advanced market economies have solved the problem of corporate governance at least reasonably well, in that they have assured the flows of enormous amounts of capital to firms, and actual repatriation of profits to the providers of finance. But this does not imply that they have solved the corporate governance problem perfectly, or that the corporate governance mechanisms cannot be improved. In fact, the subject of corporate governance is of enormous practical impor

title: Debt covenant violation and manipulation of accruals
abstract: This paper examines the abnormal accruals of a sample of 94 firms that reported debt covenant violations in annual reports. We expect debt covenant restrictions to influence accounting choices in the year preceding and the year of violation. Time-series and cross-sectional models are used to estimate ‘normal’ accruals. In the year prior to violation, both models indicate that ‘abnormal’ total and working capital accruals are significantly positive. In the year of violation, there is evidence of positive abnormal working capital accruals after controlling for management changes and auditor going concern qualifications.

title: ACCOUNTING STANDARDS AND VALUE RELEVANCE OF FINANCIAL STATEMENTS: AN INTERNATIONAL ANALYSIS
abstract: Using 17,743 firm-year observations of industrial companies in 21 countries from 1991 to 1997, this paper finds that the use of accrual accounting (versus cash accounting) negatively affects the value relevance of financial statements in countries with weak shareholder protection. This negative effect, however, does not exist in countries with strong shareholder protection. These findings are consistent with the belief that shareholder protection improves the effectiveness of accrual accounting, and suggest the importance of considering shareholder protection when formulating accounting policies related to accruals.

title: Expected Earnings Growth and the Cost of Capital: An Analysis of Accounting Regime Change in the European Financial Market
abstract: This study focuses on the relation between the cost of equity capital and earnings expectations when the properties of accounting that determine earnings vary across different regulatory regimes. More particularly, it addresses the European setting where different types of GAAP regime have continued to function in the presence of the gradual harmonization of the underlying legal framework, and where the adoption of internationally recognized accounting standards by certain firms has anticipated the requirement for International Financial Reporting Standards. On the basis of estimates of the cost of equity that are implied by analysts’ earnings forecasts, the article provides evidence that financial market integration may have already contributed to mitigating the economic consequences of accounting diversity, and that switching to IFRS could have a short lived impact on capital markets. Moreover, based on firm level transparency and disclosure rankings provided by Standard and Poor's, it is shown how the quality of financial reporting conditions the implied cost of equity under different GAAP.

title: THE EFFECTS OF ACCOUNTING DIVERSITY - EVIDENCE FROM THE EUROPEAN-UNION
abstract: In this paper, we investigate the financial statement effects of differences in accounting measurement practice in France, Germany, and the United Kingdom (U.K.). We find evidence of significant differences in financial ratios and the stock market valuation of accounting data. The differences do not appear to be explained by the composition of the sample or by macroeconomic factors; they are predictable, given crosscountry differences in reporting philosophies, and they are present for the components of net income which one would expect based on differences in accounting practice. The differences across countries appear largely unaffected by legislation enacted in response to the European Union (EU) directives, which were intended to create an integrated set of reporting standards to serve as a basis for cross-listing and facilitate cross-border investment.1 This research provides descriptive evidence, from a capital markets perspective, on how cross-country differences in measurement practices affect the comparability of the resulting accounting data. Europe provides a relevant context to examine this issue for several reasons. First,