Legal Regime and Financial Reporting Quality

This article uses the Canadian environment, where French civil law (FCL) in the province of Quebec coexists with common law (CL) in the Rest of Canada (denoted as bijural), to test the thesis of the neutrality of the legal system with regard to financial reporting quality (FRQ). This single‐country design allows for a better control over other factors that influence FRQ. The FCL environment appears to encourage firms to publish accounting data of better quality due to the greater liability risk faced by auditors and corporate directors under that regime. These findings, based on 10 years of data and seven attributes of FRQ, are robust to different matching procedures and model specifications. This research contributes to the current debates in Canada as to whether financial market regulation under FCL and CL jurisdictions should be unified under a single CL national securities regulator. At the broader level, the results support claims that a more in‐depth understanding of the implementation of civil law and CL is needed rather than gross generalization about the two systems. These results especially call into question that CL regimes are unambiguously superior to civil law regimes in encouraging high‐quality financial reports.     

Strategic Tax and Financial Reporting Decisions: Theory and Evidence*

This paper examines the effect of book‐tax differences on the probability that a transaction is audited and the probability that additional taxes are collected. It constructs a stylized model in which the taxpayer reports both financial accounting income and taxable income. The government observes both reports before deciding whether to conduct an audit. The analysis of the equilibrium yields two hypotheses. First, the probability that the government will audit a transaction is higher if the transaction generates a positive book‐tax difference (e.g., an expenditure that is deducted for tax purposes but capitalized for financial reporting purposes) than if the transaction generates no book‐tax difference. Second, conditional on being selected for audit, transactions with and without book‐tax differences are equally likely to have detected understatements of tax liability. These hypotheses are tested using Internal Revenue Service (IRS) data from the Coordinated Examination Program. The empirical tests are consistent with the predictions of the strategic tax compliance model.     

企业财务报告质量问题及其治理对策

近年来,一些企业采用编造、变造、伪造等手法粉饰财务报告,以失真的财务信息误导企业利益相关者的行为十分普遍,严重扰乱了经济秩序,动摇了投资者的信心,对我国经济造成严重损害。本文对该问题产生的原因进行了分析,并根据财务报告应＂客观、充分地反映会计主体的财务状况、经营成果和现金流量,为利益相关者提供有用的财务信息＂的要求提出了治理对策。     

Managing Insurance Company Financial Statements to Meet Regulatory and Tax Reporting Goals*

This study investigates the extent to which property-casualty insurers select levels of loss reserves, net capital gains, and net stock transactions to meet solvency and tax reporting goals. Insurer solvency is reflected in financial measures known as IRIS (Insurance Regulatory Information System) ratios. IRIS ratios are generally enhanced by underestimating loss reserves, accelerating the realization of capital gains, postponing the realization of capital losses, issuing stock, and cutting dividends. Taxable income is reduced by reporting higher reserves and lower net capital gains on investments. We use simultaneous equations to model the three discretionary choices individually, while controlling for potential tradeoffs among the decisions. During the sample period of the study (1990-95), there is a shift in the regulatory environment that we argue tends to reduce incentives to meet IRIS goals. Specifically, risk-based capital (RBC) requirements were adopted in 1994. Although IRIS ratios continued to be used for solvency screening, their effect is expected to be diluted in the post-RBC period. Our results provide qualified support for this claim. Evidence of the phenomenon is stronger when the choice variables are net capital gains and stock transactions, and weaker when loss reserves are considered. Two of the three discretionary choices affect taxable income: loss reserves and capital gains. We find that tax incentives are significantly associated with the loss reserve estimate throughout the sample period. In contrast, our results are only weakly consistent with the view that capital gains are timed to achieve tax relief.     

JIT Adoption: The Effects of LIFO Reserves and Financial Reporting and Tax Incentives*

Using matched samples of JIT adopters and nonadopters, we examine the association of JIT adoption with firms' financial reporting and tax incentives, earnings‐management histories, and LIFO reserve levels. We find evidence that adoption decisions are influenced by the interaction of firms' LIFO reserves with their income smoothing, debt covenant, and tax incentives. We also find that adoption is less likely for firms historically engaging in high degrees of earnings management, particularly when such firms have no substantial LIFO reserves. Our study extends earlier research demonstrating a relation between inventory valuation method and year‐end inventory transactions, and documents a relation between earnings‐management incentives and a fundamental supply‐chain design choice.     

The Impact of Financial and Tax Reporting Incentives on Option Grants to Canadian CEOs*

This study explores the effects of financial and tax reporting incentives on options granted to chief executive officers in Canada. Extant studies with a similar objective (Yermack 1995; Matsunaga 1995) explore predominantly nonqualified U.S. option grants that are deductible to the extent that the options are in the money at the time of exercise. In contrast, Canadian firms do not get a tax deduction for their stock option grants at any time. In both countries, no expense is recorded for financial reporting purposes. As a result, the financial reporting and tax reporting trade‐off is more pronounced in the Canadian setting of this study compared with the U.S. setting. We measure option granting behavior as the ratio of the Black‐Scholes value of stock option grants to the sum of cash compensation and the value of stock option grants. Using a sample of 806 firm‐year observations during the period 1993‐95, we find that observed option grants are significantly correlated with proxies for short‐run financial reporting incentives. We also find evidence that option granting behavior is correlated with proxies for tax incentives.     

The Association between the Legal and Financial Reporting Environments and Forecast Performance of Individual Analysts*

We test the ability of analyst characteristics to explain relative forecast accuracy across legal origins (common law versus civil law). Common‐law countries generally have more effective corporate governance mechanisms, including stronger investor protection laws and inputs provided through higher‐quality financial reporting systems. In this type of environment, we predict that analysts with superior ability and resources in common‐law countries will more consistently outperform their peers because appropriate market‐based incentives exist. In civil‐law countries, where the demand for earnings information is reduced because of weaker corporate governance mechanisms and lower‐quality financial reporting, we predict that analysts with superior ability will less consistently provide superior forecasts. Results are consistent with our expectations and suggest an association between legal and financial reporting environments and analysts' forecast behavior.     

The Difference between Earnings and Operating Cash Flow as an Indicator of Financial Reporting Fraud*

This paper examines the relation between earnings and operating cash flow to derive and test an indicator of financial statement fraud. Accrual measurement concepts indicate that financial statement fraud should be associated with high levels of earnings relative to operating cash flow. We demonstrate that the excess of earnings over operating cash flow is extreme in most fraud cases in years immediately prior to the fraud discovery based on a sample of 56 fraud cases from 1978 to 1991. We compare the distribution of the earnings minus operating cash flow variable for fraud firms with that for a sample of 60,453 firm-years for firms listed on COMPUSTAT. We test a logistic regression model in which the discovery/nondiscovery of fraud is the dependent variable, and earnings minus operating cash flow is the explanatory variable. Other control variables are included in the model based on prior studies. Results are consistent with expectations derived from accrual measurement theory. We then examine the predictive ability of the model using our sample of fraud firms and a sample of nonfraud firms in the same four-digit SIC code industries. Observations for the fraud firms are for the fiscal year prior to the discovery of fraud. Observations for the nonfraud firms are for the same fiscal years as the fraud firms in the same industries. The predictive ability of the model, including the excess of earnings over operating cash flow, is substantially higher than the predictive ability of the model omitting this variable. We conclude that the earnings-operating cash flow relation provides important information for those interested in identifying financial statement fraud, especially when considered in conjunction with other factors associated with fraud risk.     

Evolving Financial Reporting Practices: A Comparative Study of the Nordic Countries' Harmonization Efforts*

Abstract. In the 1960s, a group of culturally similar countries—the Nordic countries—cooperated in harmonizing their companies acts, including their accounting requirements. They even issued a Nordic proposal for new companies acts, intended to be enacted as new laws in each of the Nordic countries. The purpose of the paper is to study this harmonization effort and to suggest future research to enhance our understanding of diverse financial reporting practices. The paper shows that accounting harmonization in this context was difficult, even though the prerequisites for success were excellent. Future research should explore the experiences of accounting harmonization in other contexts. Résumé. Dans les années 60, un groupe de pays de même parenté culturelle — les pays nordiques — ont collaboré à l'harmonisation de leurs lois sur les sociétés ainsi que de leurs exigences en matière comptable. Ils ont même produit une Proposition des pays nordiques relative à de nouvelles lois sur les sociétés, qui devaient être sanctionnées dans chacun des pays participants. Les auteurs ont ici pour but d'analyser cet effort d'harmonisation et de suggérer d'éventuels travaux de recherche qui nous amèneraient à mieux comprendre différentes pratiques en matière d'information financière. Les auteurs expliquent que l'harmonisation comptable, dans ce contexte, s'est révélée difficile, même si les préalables au succès étaient excellents. Les travaux de recherche à venir devraient porter sur l'analyse des expériences d'harmonisation comptable dans d'autres contextes.     

R&D Reporting Biases and Their Consequences*

The immediate expensing of research and development (R&D) expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm's life. We therefore ask the following questions: (1) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitaliza‐tion? (2) What are the capital‐market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early life‐cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current generally accepted accounting principles. Our empirical analysis, covering the period 1972‐2003, generally supports the analytical predictions. In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa. This evidence is consistent with behavioral finance arguments about investor cognitive biases.     

Accounting Accruals and Auditor Reporting Conservatism*

Accounting accruals are managers' subjective estimates of future outcomes and cannot, by definition, be objectively verified by auditors prior to occurrence. This causes audits of high-accrual firms to pose more uncertainty than audits of low-accrual firms because of potential estimation error and a greater chance that high-accrual firms have undetected asset realization and/or going concern problems that are related to the high level of accruals. One way that auditors can compensate for this risk exposure is to lower their threshold for issuing modified audit reports, an action that will increase modified reports and, therefore, lessen the likelihood of failing to issue a modified report when appropriate. We call this auditor reporting conservatism and test if high-accrual firms in the United States, are more likely to receive modified audit reports for asset realization uncertainties and going concern problems. Empirical results for a large sample of U.S. publicly listed companies support the hypothesis that auditors are more conservative, that is, more likely to issue both types of modified audit reports for high-accrual firms. Further analyses show that income-increasing accruals are somewhat more likely to result in reporting conservatism than income-decreasing accruals, and that only the Big Six group of auditors show evidence of reporting conservatism. These findings add to our understanding of the audit report formation process and the potentially important role played by accounting accruals in that process.     

Audit‐Firm Tenure and the Quality of Financial Reports*

This study examines whether the length of the relationship between a company and an audit firm (audit‐firm tenure) is associated with financial‐reporting quality. Using two proxies for financial‐reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit‐firm tenures of four to eight years, short audit‐firm tenures of two to three years are associated with lower‐quality financial reports. In contrast, we find no evidence of reduced financial‐reporting quality for longer audit‐firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit‐firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases.     

The Association Between Auditor Changes and Reporting Lags*

Abstract. This paper examines audit report lags and earnings announcement lags for a sample of firms that switched auditors. We investigate whether audit report and earnings announcement lags are associated with the timing of auditor changes in relation to firms' fiscal year-ends. It is hypothesized that firms which replace their auditor early (late) in the fiscal year do so for positive (negative) reasons and experience shorter (longer) reporting lags. Conflicts over reporting issues can be difficult to resolve and consequently lead to reporting delays. In other cases, clients may be more concerned about adhering to customary reporting practices or improving reporting timeliness. These are likely to be considerations in auditor realignment decisions and are predictably reflected in the timing of the auditor change. Résumé. Les auteurs s'intéressent aux décalages dans la production des rapports des vérificateurs et dans la publication des bénéfices, pour un échantillon d'entreprises ayant changé de vérificateurs. Ils se demandent si ces décalages sont reliés au choix du moment du changement de vérificateurs par rapport à la date de clôture de l'exercice. Selon leur hypothèse, les entreprises qui remplacent leurs vérificateurs tôt (tard) dans l'exercice le font pour des raisons positives (négatives), et les décalages enregistrés dans la production de l'information sont plus courts (plus longs). Les conflits touchant les questions relatives à l'information à fournir peuvent être difficiles à résoudre et, en conséquence, conduire à des retards dans la publication de l'information. Dans d'autres cas, les entreprises clientes peuvent être davantage préoccupées par le respect des méthodes coutumières de présentation de l'information ou par l'accélération de la publication de l'information. Ces facteurs sont susceptibles d'entrer en ligne de compte dans les décisions de réorientation des vérificateurs, et il est à prévoir qu'ils se refléteront dans le choix du moment du changement de vérificateurs.     

Discretion in Financial Reporting: The Voluntary Disclosure of Compensation Peer Groups in Proxy Statement Performance Graphs*

We examine the 49 Standard & Poor's (S&P) 500 firms that voluntarily disclosed in their 1993 proxy statements, the composition of the comparison group used by each board's compensation committee to set executive compensation policies. We hypothesize that the net benefits of this disclosure are largest when (1) there is a high degree of stakeholder concern about compensation, (2) compensation policies are defensible, and (3) corporate governance is strong. Consistent with our stakeholder concern prediction, disclosing firms have higher compensation levels and are more apt to have received prior shareholder proposals about executive compensation. Contrary to this prediction, we find a negative association between financial press coverage of compensation policies and the probability of disclosure. Additionally, the disclosure decision is unrelated to the defensibility of compensation policies and the firm's corporate governance profile. Industry-adjusted firm performance, managerial entrenchment, CEO tenure, institutional holdings, and compensation committee independence variables are insignificant. We also compare the financial performance and compensation practices of compensation peers to two yardsticks — performance and pay practices at the sample firms and the corresponding S&P industry index firms. The compensation levels of compensation peers exceed those of the firms in the corresponding S&P industry indexes. Because (1) compensation levels and performance sensitivities at sample firms are more similar to those at compensation peers than to those at S&P industry index firms, and (2) the superior financial performance and higher performance sensitivities of disclosing firms justify high pay, this evidence suggests that the compensation peers of disclosing firms are an appropriate comparison group.     

银行业跨国并购的协同效应与金融服务贸易自由化

20世纪90年代以来,随着金融全球化的不断深入和发展,金融业发生了席卷全球的第三次银行并购浪潮,银行业跨国并购活动大量出现,这既给我国金融服务贸易自由化创造了机遇也带来了挑战。本文分析了银行跨国并购的协同效应及其对我国金融服务贸易自由化影响。     

International Accounting Standards for Line-of-Business Reporting and Oligopoly Competition*

Abstract. This article presents a model in which the impact of international accounting standards on product market competition can be assessed. Formulating the choice of disclosure rules as the first stage in a multistage game between countries and representative incumbent and entrant firms, we establish conditions under which an enforceable international standard to require line-of-business (LOB) reporting could lead to strict improvement in the expected national welfare of participating countries over the equilibrium that would otherwise be attained. Additional results consider the effects of changes in certain model assumptions and the addition of tariffs as further trade policy instruments. Résumé. Les auteurs proposent un modèle permettant d'évaluer l'incidence des normes comptables internationales sur la concurrence, sur les marchés de produits. Ils posent d'abord le choix des règles de présentation de l'information comme étant la première étape d'un jeu à multiples épisodes entre les pays et entre les sociétés en place représentatives du secteur et les nouvelles venues. Ils établissent ensuite les conditions dans lesquelles l'application possible d'une norme internationale exigeant la publication d'information sectorielle pourrait mener à une stricte amélioration de la prospérité nationale attendue des pays participants, au-delà du niveau d'équilibre qui serait autrement atteint. Les auteurs s'intéressent entre autres, dans leurs travaux, aux répercussions de la modification de certaines hypothèses du modèle et de l'introduction des tarifs douaniers à titre d'instruments de la politique d'échange.     

Business Strategy,Financial Reporting Irregularities,and Audit Effort

This study examines whether clients' business strategies are a factor in determining the occurrence of financial reporting irregularities and the level of audit effort. We use the organizational strategy theory of Miles and Snow to develop a comprehensive measure of business strategy using publicly available data. We find that Miles and Snow's Prospector strategy is more likely to be involved in financial reporting irregularities and generally requires greater audit effort. The business strategy measure also appears to capture client business risk and provides incremental explanatory power beyond the individual measures of client complexity or risk used in traditional audit fee models. We contribute to the literature by constructing a replicable business strategy measure and identifying organizational business strategy as an important ex ante determinant of financial reporting irregularities and levels of audit effort. Our results suggest that investigating how audits can be improved to reduce financial reporting irregularities among Prospector clients is an important area for audit practice and future research.