Accounting Abroad-How to Keep Managers and Auditors In Line
Reforming Financial Reporting in Developing Nations Research by Ray Ball
How do you improve the quality of financial reporting in countries
switching from a planned to a market economy? Conventional wisdom
suggests these countries should simply adopt high-quality accounting
standards and high-quality reporting and disclosure will follow.
The European Parliament recently took this approach, but it
has not worked in other countries. The top priority for reform
should be restoring the rights of affected shareholders and
lenders to sue managers and auditors for false or misleading
The Enron scandal has brought unprecedented attention to the
U.S. accounting system and the topic of financial reporting
and disclosure. While Enron may be news here, in many countries
Enron-style accounting is the norm. A reflex response has been
for governments and Securities and Exchange Commission-type
organizations to tighten their regulation of accounting standards,
despite the evidence that regulation decreases financial reporting
Public financial reporting refers to financial statements issued
by firms with publicly traded shares. An efficient financial
reporting and disclosure system is crucial to a country's development
of economically efficient public corporations and public securities
markets, as well as the development of the economy.
In a recent study, Ray Ball, Eli B. and Harriet B. Williams
Professor of Accounting at the University of Chicago Graduate
School of Business, looks at the limitations of existing theories
on financial reform in developing countries. The paper, "Infrastructure
Requirements for an Economically Efficient System of Public
Financial Reporting and Disclosure," outlines the necessary
reforms that many previous accounting theorists have ignored.
Studying how reforms work in developing countries also helps
to calibrate the comparative strengths and weaknesses of the
In Germany, China, Japan, and several other countries, it is
common practice for managers and auditors to disguise both gains
and losses when preparing financial statements. Such methods
result in low-quality financial statements and economic inefficiency.
For systems with low-quality financial reporting, previous studies
have argued that mandating international accounting standards
will be the cure for bringing the accounting practices of these
nations up to par.
Ball argues that focusing on standards is merely "window
dressing," and the real problems lie with the accounting
practices ingrained within the system. "The quality of
a country's financial reporting system is determined by the
incentives of those preparing the financial statements-the managers
and the auditors. Improve the incentives and better accounting
standards will follow," says Ball.
While Ball advocates widespread reform, he recognizes the difficulty
of implementing such a large degree of change. The accounting
infrastructure cannot be changed independently of the wider
economic, legal, and political infrastructure. However, as a
first step he recommends that developing countries liberalize
the rules governing stockholder and lender litigation. An effective
system of private litigation does more to improve practice than
laws imposed by governments; litigation constitutes an important
incentive for managers and auditors to follow the rules.
"It's important to look at issues that one takes for granted
in one's own economy, issues that are so fundamental that they're
not even taught," says Ball.
Common Law vs. Code Law
There are two broad categories of accounting systems: 1) the
market-oriented common-law system, used by Australia, Canada,
the United Kingdom, the United States, and others; and 2) the
planning-oriented code-law system used by France, Germany, Japan,
and several other Asian countries.
In the common-law system, accounting standards originate by
becoming commonly accepted standards of practice and are enforced
privately through civil litigation. In the United States, for
example, professional auditors determine the accounting standards
by which all must abide. These standards are referred to as
U.S. Generally Accepted Accounting Principles (GAAP). Common-law
systems typically place greater emphasis on public information
than code-law systems.
One of the main strengths of common-law systems is that economic
losses are quickly included in published financial statements.
Timely loss recognition means that managers who become aware
of decreases in expected future cash flows from long-term investments
will incorporate that information quickly into accounting income
as one-time losses. The system encourages managers to take action
to improve investments and strategies that are losing money,
and thus make the company more efficient. Guiding the enforcement
of timely loss recognition is the threat of shareholder litigation.
In a code-law system, the government writes and enforces the
accounting code, with violations carrying criminal penalties.
Countries that use a code-law system rely more on private than
public information. There is no fundamental presumption that
transactions must be at arm's length in an open market, and
therefore informed by public disclosure.
Code-law accounting gives managers considerable discretion
in making various accounting estimates. For example, in good
years managers can reduce reported income by overestimating
expenses, by underreporting revenues, and even by transferring
funds to hidden reserves. These techniques "put income
in the bank" for the future. In bad years, they can increase
reported income by reverting to normal accounting estimates,
"taking income out of the bank."
The notorious example of DaimlerChrysler illustrates the problem
of poor-quality financial reporting in code-law countries. Under
German code-law rules, DaimlerChrysler reported 1993 income
of 615 million deutsch marks. When it listed its stock on the
New York Stock Exchange, the company was required to file financial
reports complying with U.S. GAAP, and disclosed a loss of 1.839
billion deutsch marks. Under German rules, DaimlerChrysler had
been able to hide the loss, which was only revealed as a result
of listing in a common-law country.
Given these two systems, what are the requirements for an economically
efficient system of financial reporting? Ball suggests the following:
1. Make sure there are enough professionally trained auditors
to certify the quality of financial statements, and keep auditors
independent of managers.
2. Separate the systems of public financial reporting and corporate
income taxation as much as possible, so that tax objectives
do not distort financial information.
3. Reform the structure of corporate ownership and governance
to achieve an open-market process with a genuine demand for
reliable public information.
4. Establish a system for setting and maintaining high-quality,
independent accounting standards.
5. Establish an effective, independent legal system for detecting
and penalizing fraud, manipulation, and failure to comply with
standards of accounting and other disclosure. Include provisions
for private litigation by stockholders and lenders who are adversely
affected by incomplete financial reporting and disclosure.
These requirements are important features of common-law systems,
and many countries are trying to move closer to this model of
public disclosure. "If you look at the differences between
code law and common law in terms of financial reporting quality,
common law wins hands down," says Ball.
"Enron turned out to invert many of the strengths of the
common-law system, because the company did not report its losses
in a timely manner, and also reported profits before they were
realized," says Ball. "The reason reaction to Enron
has been so strong is that the company acted against the basic
tenets of the U.S. system."
Standards Alone Are Not Enough
The futility of implementing standards without changing incentives
can be seen in Hong Kong, Malaysia, Singapore, Thailand, and
China. Each country implemented common-law accounting standards,
but did not implement the substantial institutional changes
required to make these standards effective. In each case, new
standards did not result in better-quality financial reporting.
Even in common-law systems, managers have great temptation
to manipulate numbers on financial reports. Managers have a
personal interest in the information disclosed, because of the
potential for promotions, bonuses, stock, and other benefits.
In some code-law systems, there is additional political and
cultural pressure to "smooth" income and losses over
"You can't regulate an economy very effectively if there
are incentives in the economy to act against the way you regulate,"
The accounting systems of Asian countries must also contend
with cultural factors that emphasize family networks and personal
ties. As a result of the emphasis on personal connections, auditors
in Asia have little positive incentive to produce objective
evaluations, nor do they have litigation-induced pressure.
Under Chinese law, firms with foreign shareholders prepare
two sets of financial statements. The first set is prepared
under Chinese accounting rules, audited by Chinese auditors.
The problems here are similar to those of Enron, namely that
the auditors often have close ties to the management. The second
set of statements is prepared according to International Accounting
Standards (IAS), and audited by a Big Five accounting firm.
However, Ball finds that despite the supposed improvement in
standards, the IAS statements show no real improvement in quality
in terms of reflecting economic losses.
"People are people-if you sit down to an audit in a culture
that emphasizes harmony and long-term relationships, and you
don't have the fear of stockholder litigation hanging over you,
you will behave differently than you would if you were doing
the audit under the same alleged standards in New York City,"
Ball is skeptical of the European Parliament's recent legislation
requiring European companies to report under IAS by 2005. "They
have not removed the pressures on European managers to hide
losses and underreport large profits, nor have they provided
shareholders and lenders with significant rights to protect
themselves against that type of behavior," says Ball.
The First Step-A System of Private Litigation
According to Ball, private litigation rights are the single
most essential requirement for an efficient disclosure system.
Without a system for penalizing inadequate financial disclosure
and reporting, other institutional changes are doomed to fail.
The emphasis on private litigation also means that the ideal
role of the government is limited. "In the long term, politicians
are not good at understanding financial reporting, and the more
they keep out of it, the better," says Ball.
Though effective accounting reform has yet to take place in
any of the developing nations, U.S. business executives evaluating
investments abroad can check whether those companies have cross-listed
their stocks in jurisdictions where there are penalties for
not following the rules.
Responding to Enron
Enron has revealed an aberration in common-law accounting practices,
but such cases are rare and they are effectively dealt with
by private-sector mechanisms. "A lot of people are saying
that we should lose faith in our accounting system because of
Enron, but I think that's misplaced," says Ball. "We
will learn lessons from Enron, and ours will remain a high-quality
financial reporting system. Provided, of course, that the political
process keeps out of it."
Ray Ball is Eli B. and Harriet B. Williams Professor of
Accounting at the University of Chicago Graduate School of Business.