Ebook The Importance of Reporting Incentives: Earnings Management in European Private and Public Firms
In this paper, we examine the role of incentives stemming from capital market pressures and legal institutions to report earnings that accurately reflect a firm’s economic performance. Reporting incentives have been given little attention in the international accounting debate. Much of the discussion has focused on accounting standards per se, which are viewed as the primary input for high quality accounting (e.g., Levitt, 1998). Consistent with this view, several countries have adopted or plan to adopt International Financial Reporting Standards (IFRS) in an attempt to improve accounting quality. Similarly, harmonization efforts within the European Union (EU) have largely focused on eliminating differences in accounting standards across countries (e.g., Van Hulle, 2004).
Accounting standards generally grant substantial flexibility to firms. Measurements are often based on private information and the application of standards involves judgment. Corporate insiders can use the resulting discretion in reporting to convey information about the firm’s economic performance, but they may also abuse discretion when it is in their interest. For this reason, reporting incentives are likely to play an integral role in determining the informativeness of reported accounting numbers. While this general insight is not new (e.g., Watts and Zimmerman, 1986), it is often overlooked in international standard setting. As Ball (2001) notes, the global debate focuses too much on the standards and too little on the role of institutional factors and market forces in shaping firms’ incentives to report informative earnings.
To empirically illustrate the importance of reporting incentives, we examine a setting in which incentives to report about economic performance differ substantially across sets of firms and countries, although standards are formally harmonized and largely held constant. We hypothesize that raising capital in public markets rather than from private sources and the institutional environment in which a firm operates have a systematic influence on its incentives to report earnings that reflect economic performance. Both factors shape the way in which information asymmetries between firms and the key financing parties are resolved, i.e., the role earnings play in the process, which in turn affects the properties of reported earnings (see also Ball et al., 2000).
International settings are especially powerful along the incentive dimension because they offer much variation in institutional features and market forces. However, it is difficult to isolate the effects of reporting incentives on earnings quality when accounting standards vary across countries. The European setting provides a unique opportunity to overcome these difficulties. As accounting regulation in the EU is not based on having publicly traded securities but depends on a firm’s legal form, private limited companies face the same accounting standards as publicly traded corporations. This feature allows us to study reporting incentives and demand for information created by public debt and equity markets, while holding accounting standards constant. At the same time, the European setting provides variation in institutional factors across countries, which allows us to examine their role in shaping earnings quality for both private and public firms.
Ideally, our analysis would be based on measures that directly capture the extent to which firms use discretion to make earnings more informative about economic performance. However, the use of discretion and the resulting informativeness of earnings are difficult to measure because true economic performance is unobservable. Moreover, we do not have stock prices for private firms, which generally serve as a benchmark for economic performance. We therefore focus on the pervasiveness of earnings management as an inverse proxy for the extent to which reported earnings reflect a firm’s true economic performance. We believe that this proxy offers several advantages. First, earnings management is an important dimension of accounting quality and in the extreme unlikely to be informative. Second, earnings management proxies should be particularly responsive to the use of discretion and firms’ reporting incentives, making our tests more powerful. Third, there is an extensive literature offering various earnings management proxies (see Healy and Wahlen, 1999).
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