Aurora Borealis
1 May 2013 CFA Institute Journal Review

Firm Incentives, Institutional Complexity and the Quality of “Harmonized” Accounting Numbers (Digest Summary)

  1. Michal Szudejko

Investigating whether reporting incentives and institutional factors affect accounting quality, the authors determine that the global adoption of a single set of accounting standards is insufficient to increase the comparability and transparency of financial statements.

What’s Inside?

The authors assess whether reporting incentives and institutional factors, when analyzed with multicountry adoption of a homogenous set of accounting standards, affect the quality of financial reporting. Using linear regression to investigate the issue, they conclude that firm-specific factors have greater explanatory power of accounting quality than country-level factors. Furthermore, their results indicate that the global harmonization of accounting standards ought to be accompanied by implementing modifications to or reforms of institutional environments and systems. Lastly, by altering firm-specific conditions, managers might be able to reduce the impact on reporting quality of such institutional and systemic influences.

How Is This Research Useful to Practitioners?

According to the authors, financial reporting quality is positively influenced by such strong monitoring mechanisms as ownership concentration, analyst scrutiny, effective auditing, external financing needs, and leverage. They also observe negative relationships between accounting quality and instability of business operations, existence of losses, and lack of transparent disclosures. At the country level, increased quality of financial statements is encouraged and supported by the institutionalization of more rigorous reporting standards and requirements, a higher level of economic development, greater business sophistication, and globalization. More importantly, firm-specific factors have greater explanatory power than country-level factors with regard to accounting quality, which supports the notion that increasing the comparability and transparency of financial statements on a global level must involve not only the harmonization of accounting standards but also changes to the institutional conditions and firm-specific reporting incentives.

The authors begin with prior empirical work on the topic but depart from previous researchers by keeping accounting standards constant in their study. They allow for a variation only within the design of the International Financial Reporting Standards (IFRS) themselves. They also investigate the nature of country-specific impact on the accounting quality—in particular, whether this impact is direct or indirect via an influence on the firm-specific reporting incentives.

The results have value for both policymakers and firm managers. The former can take steps to improve accounting quality through adopting reforms in institutional systems, leading to modifications in business conditions at the firm level. Firm managers can mitigate the influence of institutional conditions through the manipulation of firm-specific factors (e.g., through adopting applicable corporate social responsibility standards). In addition, the accounting standards bodies should consider that unification of accounting standards worldwide may not yield homogenous results in terms of comparability and transparency of financial statements because country- and firm-specific settings can distort the desired outcome of harmonization.

How Did the Authors Conduct This Research?

The authors’ sample consists of nonfinancial firms in 26 countries that adopted IFRS by 2005. The data span fiscal years 2006 and 2007, resulting in 7,854 firm-year observations. The authors make several exclusions from the dataset, including the top and bottom 1% of the distribution of stock price returns and earnings and firm years with negative book value or equity or missing data. They do not restrict the sample to companies whose fiscal year-end is in December. The data are from multiple sources, including Worldscope, Datastream, I/B/E/S, and several sources for country-level conditions.

The accounting quality is assessed using two proxies. The first proxy is based on the market value and captures the relevance of earnings announcements to stock market investors. The second proxy is an accounting measure and shows how earnings are affected by managers’ accrual choices. The selection of these particular proxies is backed by the literature.

The factor that distinguishes the authors’ study from previous research is their selection of companies from countries that already adopted IFRS as an accounting framework. This choice enables them to produce a clearer picture of how accounting quality is affected by the institutional conditions and firm-level reporting incentives. But because IFRS allows for a certain degree of interpretation of accounting events, there is still some bias in the research methodology.

The authors’ primary research tool is linear regression. They develop three models to test against each proxy of financial reporting quality. The first model examines the relationships between accounting quality and firm-level factors; the second model examines the relationships between accounting quality and country-specific factors; and the third model examines both firm- and country-level factors and their interaction with accounting quality.

Abstractor’s Viewpoint

The principal innovation the authors deliver is their research procedure. The sample’s construction allows them to keep the influence of accounting standards more or less constant, which considerably helps them understand the influence of the two other groups of factors (namely, firm- and country-specific factors) on the quality of reporting. The authors’ other important contributions are the assessment of the relative strength of those factors and the indication of chain relationships between those factors and accounting quality. They translate their findings into clear recommendations for policymakers and firm managers, thus increasing the overall usefulness of the article.

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