Transcript No Slide Title

Financial Reporting Incentives: Law, Politics and Corporate Discipline
Professor Robert Bushman
The Forensic Accounting Distinguished Professor
Kenan-Flagler Business School
University of North Carolina at Chapel Hill
Remarks prepared for:
International Conference on Corporate Governance in Asia and China
Shanghai, China
March 2005
Bushman 2005
1
The Role of Financial Systems
Functional View (Ross Levine, JEL (1997))
Facilitate trading and pooling of risk
Allocate resources
Monitor managers and exert corporate control
Mobilize savings
Facilitate the exchange of goods and services
Implemented via a range of institutional configurations that
achieve varying degrees of functional efficiency
Bushman 2005
2
Financial systems must deal with the ways in which suppliers of finance to
corporations assure themselves of getting a return on their investment
Investment
Management
Financiers
Return
How can investors be assured that managers will choose the right projects, exert sufficient
effort, adequately disclose relevant information, and ultimately repay investors?
Bushman 2005
3
Financial Accounting Numbers as Governance Mechanism
Lawrence Summers, Former Secretary of the Treasury and now President
of Harvard University (Interview for PBS website Commanding Heights, 04/24/01)
“Transparency is good because, as someone once said,
‘conscience is the knowledge that someone's watching,’
and it discourages bad behavior.”
“If you look at the history of the American capital market,
there's probably no innovation more important than the idea
of generally accepted accounting principles.”
More to it than just rules!!!
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4
The U.S. Configuration: A Web of Institutions & Mechanisms
Investment
Governance Mechanisms
Contracts
Class Action Suits
-compensation
-debt
-venture capital
The Media
Sarbanes-Oxley
Management
Legal
Protection
-voting rights
-election of board
-minority rights
-duty of loyalty
-bankruptcy
Large
Investors
-large s’holder
-takeover/LBO
-large creditor
Financiers
Financial Accounting and
Other Information
Criminal Justice
SEC
GAAP
Audit
Audit
Committee
Return
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Economies as a Web of Inter-related Institutions
Economic Performance
Financial Development
Legal Regime
Political Regime
•Markets/Banks
•Corporate Transparency
The availability of firm-specific information to those outside publicly traded firms
Corporate Reporting
Source of contractible
variables to support :
Private Sector Information
•Info Processing
•Searching, gathering,
validating info
Dissemination
Compensation, debt contracts,
etc
Bushman 2005
6
The Press as a Watchdog for Accounting Fraud (Gregory S. Miller, 2003, SSRN)
SEC Accounting and
Auditing Enforcement
Releases:
AAERs generally represent
egregious violations of the SEC
standards.
While accounting fraud is a
primary reason for an AAER,
they also frequently include
illegal insider trading, violations
of SEC requirements by auditing
firms and other illegal acts. Only
AAER that include a substantial
accounting fraud are included
here.
Bushman 2005
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Actual Financial Reporting Outcomes Shaped by Institutional Structure
Financial Development
Corporate Reporting
•Formal rules and standards
•Managers’ reporting incentives
•Regulators’ incentives
•Value of contractible variables
•Disciplining effect on behavior
Legal Regime
Political Regime
Private Sector Information
Dissemination
Bushman 2005
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What Determines Corporate Transparency?
Bushman, Piotroski and Smith, Journal of Accounting Research 2004
Empirical Framework
CORPORATE REPORTING
PRIVATE INFORMATION
ACQUISITION & COMMUNICATION
INFORMATION
DISSEMINATION
Financial disclosures (DISCL):
Financial analysts
Media channels:
Segments, R&D, Capital Expenditures,
Accounting Policies, Subsidiaries
(NANALYST)
Penetration
(MEDIA)
Governance disclosures (GOVERN)
Major Shareholders, Management,
Board, Director& officer pay, Director
and officer shareholdings
Accounting principles (MEASURE):
Consolidation, Reserves
Timeliness of disclosures (TIME)
Frequency of reporting
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Underlying Structure of Corporate Transparency
Factor analyzed underlying the measures of firm-specific information environments
Isolate two distinct factors underlying country-level transparency:
Financial transparency: interpreted as a relative measure of availability of financial
information to those outside the firm due to the disclosure, interpretation, and
dissemination of financial information by firms, financial analysts, and media
Governance transparency: interpreted as a relative measure of availability of
information for outside investors to hold officers and directors accountable.
Q: How do financial and governance transparency factors vary
with countries’ legal/judicial regimes and political economies?
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DISCL :
Segments, R&D, Capital Expenditures, Accounting Policies, Subsidiaries
GOVERN:
Major Shareholders, Management, Board, Director& officer pay,
Director and officer shareholdings
MEASURE: Consolidation, Discretionary Reserves
TIME:
Frequency of reporting
Bushman 2005 11
Corporate transparency and legal/judicial regimes
Theory emphasizes role of verifiable information in contract design and
governance more generally.
Principal-agent models assume existence of a perfect court system.
e.g., Jensen & Meckling (1976), Holmstrom (1979)
Suggests that mechanisms allowing low cost, effective enforcement of private
contracting arrangements are complements with systems that produce
contractible information signals. Financial accounting supplies a rich set of
such variables.
In the absence of a viable judicial system, alternative relationship-based
arrangements and private enforcement mechanisms may arise which are less
reliant on public information
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For Governance: British > German > French & Scandinavian > French
Same basic ordering as LaPorta et al. (1998) find for investor protections
For Financial:
No significant relation with legal origin!!
Bushman 2005 13
Political Variables
Powerful, centralized governments constrain financial development to maintain
power and capture wealth.
States directly owning enterprises may suppress information to hide
expropriation activities by politicians and cronies. However, a benevolent
government may use state ownership to directly govern firms, obviating the need
for public information.
Politicians may exploit regulatory powers to impose costs of entry on start-up
firms to benefit politically connected incumbents by shielding economic rents
from competition.
As propensity of State to expropriate wealth from firms increases, firms may
limit disclosure of financial information to hide wealth. Also, unprofitable firms
may voluntarily disclose more to keep the government away or governments may
mandate higher transparency to aid in identifying assets to expropriate.
Autocracy
State-owned enterprises
State ownership of banks
Barriers to entry
Risk of Expropriation
Bushman 2005 14
Table 4 (continued)
Panel B: Relation between corporate transparency factors and political and legal / judicial regimes
log(GNP)
Predict:
+
Legal / Judicial Regime
Protection Efficiency
Legal
of Patent
of Judicial
Origin
Rights
System
+
+
Dependent variable: FACTOR1 (Financial)
0.279
0.004
(0.042)
(0.983)
-
Autocracy
-
Political Economy
StateStateowned
Cost of
owned
Enterprises
Entry
Banks
?
?
Low Risk of
Expropriation
?
Adj. R2
n
-0.006
(0.924)
0.075
(0.265)
-
-
-
0.283
(0.026)
0.667
43
0.155
(0.275)
0.066
(0.728)
-
-0.011
(0.856)
-
-0.078
(0.037)
-
-
0.274
(0.016)
0.695
44
0.310
(0.020)
-0.017
(0.940)
-
-0.033
(0.611)
-
-
-0.009
(0.902)
-
0.222
(0.058)
0.657
44
0.275
(0.031)
0.084
(0.671)
-
-0.022
(0.714)
-
-
-
-0.681
(0.068)
0.191
(0.089)
0.686
44
0.083
(0.353)
-
-
-
0.213
(0.201)
0.369
43
Dependent variable: FACTOR2 (Governance)
-0.194
-0.699
0.201
(0.284)
(0.013)
(0.032)
-0.244
(0.220)
-0.664
(0.017)
-
0.175
(0.042)
-
-0.027
(0.591)
-
-
0.193
(0.215)
0.366
44
-0.181
(0.290)
-0.760
(0.017)
-
0.174
(0.045)
-
-
0.035
(0.709)
-
0.182
(0.234)
0.364
44
-0.236
(0.159)
-0.553
(0.041)
-
0.180
(0.030)
-
-
-
-0.851
(0.087)
0.134
(0.366)
0.410
44
Bushman 2005 15
Properties of Financial Accounting: Conservatism & Governance
Conservatism: asymmetric accounting recognition of economic gains and losses.
In the extreme : “anticipate no profit, but anticipate all losses.
Three alternative theories of conservatism (Watts (2003):
Contracting
- Part of efficient contracting design between the firm and various parties.
- Constrains opportunistic behavior and offsets managerial biases with its asymmetrical
verifiability requirement that on average defers earnings and understates net assets.
- Timely incorporation of losses leads managers to address losses more quickly.
- Makes leverage and dividend restrictions bind more quickly
Shareholder litigation
- Overstating the firm’s profits and net assets is more likely to generate costly litigation
against the firm than understating them.
Regulation
- Regulators are more likely to be punished for firms overstating profits and net assets than
for understating them.
Bushman 2005 16
Asymmetric Accounting Recognition of Economic Gains and Losses
Good news
Economic Eventst
Defer
Economic incomet ? Reported Earningst
Bad news
Accelerate
Question 1: What institutions influence accounting conservatism?
Question 2: Through what channels do specific institutions influence conservatism?
Question 3: Do certain institutions influence only a specific dimension of accounting
conservatism (i.e., timely loss recognition versus deferral of gains)
Bushman 2005 17
Empirical Approach
Following Basu (1997), measure accounting conservatism proxying for
economic income with returns (also use non-price model):
NIi,j,t = α0 +α1NEGi,j,t + β1RETi,j,t + β2NEGi,j,t*RETi,j,t + εi,j,t,
where NEG=1 if RET < 0.
2 captures the incremental speed of bad news recognition in earnings
relative to the speed of good news recognition.
If 2 0, then 1 captures the speed of good news recognition, 3 the
incremental speed of bad news recognition relative to good news
recognition, and
1+2 the speed of bad news recognition.
Bushman 2005 18
Evidence on the role of institutions: Ball Robin and Wu (2003)
Figure 1
How Accounting Income Incorporates Economic Gains and Losses:
Code-law, Common-law and East Asia Groups
Sensitivity of accounting income to positive and negative fiscal-year stock return
(proxies for economic gains and losses), estimated as slope coefficients in a
pooled piecewise linear regression of accounting income on return. Large slope
coefficients indicate timely incorporation of current economic gains and losses.
Small coefficients indicate gradual incorporation over time.
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Common
Economic Gains
Code
East Asia
Hong Kong, Malaysia,
Singapore and Thailand.
Economic Losses
Source: Ball, Kothari and Robin (2000, Table 2), Ball, Robin and Wu (2000a, Table 2).
Bushman 2005 19
Bushman an Piotroski (2005): “Financial Reporting Incentives for Conservative
Accounting: The Influence of Legal and Political Institutions”
Forthcoming Journal of Accounting and Economics
NI = Intercept + 1RET + 2RET*CCD + 3NEG*RET + 4NEG*RET*CCD + 
= Intercept + [1+ 2*CCD]*RET +
Total coefficient on RET
(good news) in countries
that possess characteristic
CCD, where 2 is the
incremental coefficient for a
CCD country relative to a
non-CCD country.
[3 + 4*CCD]*NEG*RET + .
Coefficient on NEG*RET
(bad news) in countries with
characteristic CCD, where 4
is the incremental coefficient
for a CCD country relative to
a non-CCD country.
NEG is an indicator variable equal to one if RET is less than zero, zero otherwise
CCD is an indicator variable reflecting country-level differences in various legal,
political and financial institutions
Bushman 2005 20
Results Legal: Mapping of + and –Economic Income into Accounting NI
NI
NI
RET
-RET
+RET
Low judicial system quality
RET
-RET
+RET
Weak public enforcement of
securities laws
High judicial system quality
Strong public enforcement of
securities laws
Bushman 2005 21
Results Political: Mapping of + and –Economic Income into Accounting NI
NI
NI
RET
-RET
+RET
RET
-RET
+RET
Low SOE
Low SOE
High SOE
High SOE
Common Law Countries
Code Law Countries
Bushman 2005 22
Timely Exit and Timely Accounting Recognition of Economic Losses:
International Evidence
Bushman, Piotroski and Smith (2005)
The importance of efficient exit for the productivity and economic vitality
of an economy has long been recognized, dating back to at least
Schumpeter’s (1942) ideas about creative destruction.
The issue of managers pursuing losing projects has long been recognized:
Perquisite consumption, empire building, the free cash flow problem, the
Pain Avoidance Model, the principal-agent problem, the sunk cost
phenomenon and escalation of commitment.
We investigate whether firms in countries whose accounting regimes are
characterized by more timely recognition of economic losses tend to
withdraw capital from losing projects relatively faster than firms in
countries with less timely loss recognition.
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The Story: Incentives for early exit from losers
Ball (2001): Important criterion for economically efficient public financial
reporting is the timely incorporation into the published financial statements of
adverse information about future cash flows.
Since lenders and borrowers contract on the financial reports through
accounting-based covenants, timely recognition of losses enable lenders to
receive more timely signals of deteriorating performance through a
tightening of covenants or triggering of covenant violations, and thus
promotes early intervention.
If economic losses are charged against income, there is no incremental
income penalty to actual abandonment, reducing the incentives of managers
to prolong losing investments and strategies.
Decreases ex ante likelihood that managers undertake negative-NPV
projects.
Bushman 2005 24
[-0
to
.9 -0
.9
0
[-0 to 0)
.8 -0
.8
0
[-0 to 0)
.7
0.
0
7
[-0 to 0)
.6 -0
.6
0
[-0 to 0)
.5
0 0 .5
[-0 to 0)
.4 -0
.4
0
[-0 to 0)
.3
0.
0
3
[-0 to 0)
.2 -0
.2
0
[-0 to - 0)
.1 0.1
0
0
[0 to 0 )
.0
0 .00
[0 to 0 )
.1
0 .10
[0 to 0 )
.2
0 .20
[0 to 0 )
.3
0 .30
[0 to 0 )
.4
0 .40
[0 to 0 )
.5
0 .50
[0 to 0 )
.6
0 .60
[0 to 0 )
.7
0 .70
[0 to 0 )
.8
0 .80
[0 to 0 )
.9
0 .90
to
)
1.
00
)
³1
.0
0
.0
0
[-1
Proportion of Returns in Range
Return distribution in countries with low & high speed of bad news recognition
Density Functions
0.12
0.1
0.08
0.06
low speed of bad news recog.
high speed of bad news recog.
0.04
0.02
0
Return Range
Bushman 2005 25
Use measures from Wurgler (JFE ('00)) to measure investment behavior
Panel of gross investment and value-added for 65 countries, 28 industries, 33 years
ln [Ijct / Ijct-1 ] = c + c * ln [Vjct / Vjct-1] + jct
Ijct
Vjct
c
= investment in industry j, country c, year t
= value added of industry j, country c, year t
= value added elasticity of country c
= efficiency of project selection in country c
Also:
c+ = estimated value added elasticity for each country c separately for
industry-year observations reflecting increasing value added
c– = estimated value added elasticity for each country c separately for
industry-year observations reflecting decreasing value added
Bushman 2005 26
Results from Bushman et al. (2005)
c+
c–
The elasticity of new investment to increasing value added is
unrelated to speed of bad news recognition
The elasticity of new investment to decreasing value added is
positively related to speed of bad news recognition
Capital is withdrawn faster from shrinking sectors in
countries with timely accounting recognition of bad news
Bushman 2005 27