Financial Reporting Incentives for Conservative Accounting: The Influence of Legal and Political Institutions

Abstract

In this paper, we explore how reported accounting numbers are shaped by the institutional structure of the country in which firms are domiciled. We seek deeper understanding into the nature of financial reporting incentives created by an economy's institutional structure. We focus on financial reporting incentives related to accounting conservatism. To this end, we empirically analyze relations between key characteristics of economy-level institutions and one dimension of accounting conservatism, the asymmetric recognition of economic gains and losses into earnings. We also provide evidence on channels through which specific institutions manifest their influence on observed conservatism. Channels investigated include the use of accounting numbers in designing debt and compensation contracts, in supporting securities-related litigation, in motivating the behavior of public-sector regulators, and in mediating the relations between politicians and private sector business firms.

We document that firms in countries with strong judicial systems reflect bad news in earnings faster than firms in countries with weak judicial systems. We show that higher judicial quality and higher usage of public bonds or more diffuse ownership structures leads to more conservatism. Also, strong public enforcement aspects of securities law (but not private enforcement) slows recognition of good news in earnings relative to firms in countries with weak public enforcement. Finally, firms in countries with common law legal origin combined with high risk of expropriation by the state and high state ownership of enterprises speed the recognition of good news and slow the recognition of bad news relative to firms in countries with less political involvement. This result is reversed in countries with civil law legal origin and high risk of expropriation and high state ownership of enterprises. Thus, firms appear to adjust their financial reporting in response to the nature of the State's involvement.

Keywords: Financial reporting, political and legal institutions, conservatism, incentives

JEL Classification: D82, F02, G15, H11, K22, M41, M44, O57