Abstract
In this study, we show that the exposure of European firms across European capital markets is associated with significant constraints in financial reporting discretion. By exploiting the variation in the regulatory environment in this setting, we are able to demonstrate that incentives for reducing financial reporting discretion stem from a form of legal bonding within Europe, in the sense of the exposure to at least one capital market with better regulation than the firm’s origin. Furthermore, we provide evidence for the presence of reputational bonding in cases where the firm is exposed to capital markets with weaker regulation than the regulation in its home jurisdiction. We corroborate the evidence on reputational bonding by extending this investigation to circumstances that are likely to trigger managers’ engagement with more transparency even in the absence of strong legal regulations, such as stock exchange consolidation and geographical proximity.
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Notes
- 1.
In this regard, exposure may capture formal cross-listings as well as cases where the trading has been initiated without the involvement of the issuer. Although the latter case might work against our hypothesis of legal or reputational bonding, we are able nevertheless to report findings here that are consistent with bonding. Future research could investigate further the implications of the differences between those two kinds of exposure.
- 2.
The research question addressed in this study draws parallels with prior research on the differential demand for accounting information between public and private firms (Ball and Shivakumar 2005). On one hand, exposure in public equity markets entails the presence of outsider ownership, which relies heavily on financial reporting for evaluating and monitoring the firm. The presence of outsider investors imposes a threshold of financial reporting information quality which public firms need to exceed in order to convince outsiders to buy or continue to hold their shares. In this spirit, the discussion in Burgstahler et al. (2006) implies that outsider investors may be reluctant to supply capital to firms exhibiting poor information quality, where this does not enable the assessment of economic performance. On the other hand, financial reporting information quality is less of a concern among private firms whereby, for typically concentrated ownership structures, information necessary for evaluating and monitoring the firm may be more accessible through private channels.
- 3.
The idea that local investors have an information advantage is also consistent with Malloy ’s (2005) finding that geographically proximate analysts are more accurate than other analysts.
- 4.
The term ‘home bias’ is used to describe the tendency of investors to overweight portfolios with firms domiciled in their home countries and underweight portfolios with firms located outside of their home countries.
- 5.
Similar results concerning the impact of the mandatory adoption of IFRS are also reported by Florou and Pope (2012).
- 6.
Subsequent research admits that this concept of legal bonding in the US might not be entirely realistic. For instance, Siegel (2005) argues that the recovery of damages awarded to shareholders by US courts is contingent upon the size of the assets held by the firm in the US.
- 7.
It is also an open question to which extent European stock exchanges enforce their own jurisdiction’s requirements on foreign firms who formally cross-list in their stock markets.
- 8.
Euronext established two voluntary sections of the integrated stock market on which firms could choose to list by pre-committing themselves to enhanced financial reporting quality and corporate governance i.e., quarterly financial reports beginning in 2004; international accounting standards, or a reconciliation of existing information with those standards, beginning in 2004; financial documents in English beginning in 2002; scheduling of at least two meetings annually for analysts; description of corporate governance policy in the annual report; announcement of a schedule for publications and meetings beginning in 2002; publication of key financial information on their websites beginning in 2002 Pownall et al. (2012).
- 9.
The statistics reported in Pownall et al. (2012), Table 9 do not suggest that internationally exposed firms dominate the Euronext segments. Therefore, we argue that we capture a relationship that is not fully addressed in their study.
- 10.
- 11.
An alternative approach is to examine indices of similarity between accounting standards (see Bae et al. 2008). However, the case of internationally accepted accounting standards captures a similar concept here, as their use is assumed to enhance the comparability of financial reporting information.
- 12.
Ayers et al. (2011) also note that their findings in the domestic US market should have similar implications for cross-border investment. The present study contributes by testing this conjecture explicitly.
- 13.
Peasnell , Pope , and Young (2005) justify modeling the working capital accrual instead of the total accrual by pointing out that changes in depreciation policy cannot be made very frequently without attracting adverse attention and that modeling other long-term accruals such as environmental liabilities and pension obligations is far too complex. Note that, in the European setting examined here, depreciation policy is anyway often not left to managers to determine and is, instead, guided by tax rules.
- 14.
Here, the focus is on the type of earnings management that would be obvious to an investor for whom a reduction in discretion would signal a commitment to greater reporting integrity. In fact, evidence suggests that the manipulation of accruals is perceived by the managers themselves as the most common indicator of earnings misrepresentation Dichev et al. (2013). Unlike Cohen et al. (2008) and others, we do not attempt to investigate ‘real earnings management’, which has a less than obvious effect on current and future financial statements. In the pre-IFRS European context of this study, taking such an approach would present significant problems associated with identifying real earnings management (Roychowdhury 2006). First, given that the availability of cash flow statements was more limited across Europe at that time (LaFond 2005), there are major data reliability and completeness issues, and second there is considerable variation with respect to certain critical accounting rules, such as expensing and capitalizing intangibles including R&D: see Stolowy and Jeny-Cazavan (2001) for a discussion on this topic.
- 15.
Following other authors, the model employed here includes a constant as an additional control for heteroskedasticity not alleviated by using assets as the deflator, and to mitigate problems stemming from an omitted size (scale) variable.
- 16.
Wysocki (2004) employs the correlation between earnings management indicators and similar jurisdiction-specific institutional environment factors (disclosure and private–public enforcement indicators).
- 17.
Applying a Heckman procedure is also inappropriate, considering that the classification of a particular firm as internationally exposed in a given year is not independent from the classification of the same firm in prior years. Indeed, unless there is an explicit delisting, it is very difficult to ascertain when the international exposure ceases to exist. Given the nature of our data, which encompass the strict concept of cross-listing, once we classify a firm as internationally exposed, this classification remains for the period examined here. This sampling assumption should work against our predictions; in other words, if we look for the impact of international exposure where it has ceased to exist, the association should be nonsignificant.
- 18.
While Hail and Leuz (2009) advocate the used of fixed firm effects, we employ random firm effects in order to accommodate the influence of institutional environment of the home market of the firm.
- 19.
For instance, anticipation and planning of internationalisation may encourage a firm to refrain from financial reporting discretion for a few years before the event in order to present a satisfactory record to prospective foreign investors. More recent research reveals that firms may be found to be involuntarily traded in a foreign jurisdiction (Brüggemann et al. 2012; Brüggemann et al. 2012), and the extent to which less financial reporting discretion has attracted this type of trading without the issuer’s involvement is an open question.
- 20.
More specifically, a propensity score is estimated by matching firms in terms of analyst following, ownership structure, leverage, auditor, size, net operating assets, foreign sales, reporting losses, Tobin’s Q, change in equity, change in leverage, country and industry affiliations, and time. The matching addresses only firms that are traded across Europe and firms that are strictly locally traded during the period covered by the study. The logistic regression which underlies the estimation of the propensity score yields an R2 of 42 %.
- 21.
Roosenboom and Van Dijk (2009) examine the economic benefits of cross-listing in the eight major stock exchanges in the US, the UK, continental Europe, and Japan; Abdallah and Goergen (2008) examine the determinants of cross-listing choice drawing upon 19 markets. More to the point, Cabán-Garcia (2009) examines a sample of 13 European jurisdictions and finds that the foreign regulatory requirements have little or no effect on the reported earnings of European firms cross-listed in European exchanges.
- 22.
The impact of US and other overseas exposure is addressed separately with discrete dummy variables that are included with the other control variables.
- 23.
Alternatively, the coefficient on LEGAL BONDING could be considered as the incremental effect of being exposed to at least one market whose regulatory environment is stronger than the home market’s.
- 24.
It is important to note that the disclosure variable that we discuss here refers to disclosure regulation and not voluntary disclosure scores (e.g., CIFAR scores, S&P Transparency, and Disclosure scores, etc).
- 25.
The disclosure requirements index averages the scores of six areas of disclosure: delivering the prospectus, insiders' compensation, ownership structure, inside ownership, irregular contracts, and related-parties transactions. The liability standard index captures the existence of liability rules thus enabling investors to recover from losses caused by wrong or omitted information. It combines the scores of liability standards for the issuers and directors, distributors, and accountants. The private enforcement index combines the sub-indices of disclosure requirements and liability standard. The public enforcement index comprises sub-indices on the characteristics and investigative powers of the market supervisor as well as on the existence of criminal and noncriminal sanctions for securities laws violations (Gaban-Garcia 2009).
- 26.
The IAS and US GAAP variables take the value of 1 if the firm is said to report under the respective standards according to Worldscope. The criterion is also used for classifying firms as reporting under IAS in Daske et al. (2013). The latter argue that relevant information on the Worldscope database may be subject to errors; if this is so, then this could work against confirming the hypothesis here.
- 27.
This information is taken from Sarkissian and Schill (2004).
- 28.
Since lagged accounting data are necessary for the calculation and estimation of the net accrual, we also employ accounting data from 1994 in order to carry out the estimation for 1995.
- 29.
For instance, in the initial sample of firm-year observations for which an estimate of the discretionary net accrual is feasible, there are 14,220 missing observations for analyst following, 14,298 for the item Percentage of Foreign Sales, 10,928 for the item Percentage of Closely Held Shares and 4,420 for the item Accounting Standards Followed. An alternative approach might arbitrarily add zeros where this item is missing (e.g., analyst following, foreign sales). However, by avoiding this approach, we may bias the sample toward including firms whose information environment is more homogeneous.
- 30.
A similar source of information for identifying exposure to foreign capital markets has been employed in studies that assess earnings quality in an international setting (e.g., the NUMEX variable in Barth et al., 2008) without much further justification or analysis.
- 31.
Sarkissian and Schill (2009) find that valuation gains related to cross-listing tend to be transitory and concentrated mostly before the cross-listing event. The database compiled for this study contains exposures whose initiation took place before 1995, and the impact of these early cross-listings may be outdated. It is an open question how and whether this might affect the inferences drawn here regarding financial reporting, and whether it is likely to bias against finding a significant relation between foreign capital market exposure and discretion in financial reporting.
- 32.
While here we apply a random firm effects model using a GLS approach, we also add year dummies in order to capture cross-sectional dependence in the regressions’ residuals.
- 33.
Given that most of these variables exhibit significant correlation between them, here we also check for possible multicollinearity effects by means of estimating a Variance Inflation Factor.
- 34.
Such an effect cannot be observed in the context of the mainstream cross-listing in the US research, since US regulation is always deemed to be of the highest standard to-date.
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Dargenidou, C., Jaafar, A., McLeay, S. (2014). Regulation, Bonding and the Quality of Financial Statements. In: Di Pietra, R., McLeay, S., Ronen, J. (eds) Accounting and Regulation. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-8097-6_9
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