Accounting Abroad: Keeping 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. Recent research argues that the
top priority for reform should be restoring the rights of
affected shareholders and lenders to sue managers and auditors
for false or misleading reporting.
The Enron scandal brought unprecedented attention to the
U.S. accounting system and the topic of financial reporting
and disclosure. While Enron may have been 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, University of Chicago Graduate School
of Business professor Ray Ball looks at the limitations of
existing theories on financial reform in developing countries.
Studying how reforms work in developing countries also helps
to calibrate the comparative strengths and weaknesses of the
U.S. system. In "Infrastructure Requirements for an Economically
Efficient System of Public Financial Reporting and Disclosure,"
Ball outlines the necessary reforms that many previous accounting
theorists have ignored.
In Germany, China, Germany, 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
"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 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.
In 1993, under German code-law rules, DaimlerChrysler reported
income of DM615 million. 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
DM1.839 billion. 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
These requirements are important features of common-law systems,
and many countries are trying to move closer to this model
of public disclosure.
"In terms of financial reporting quality, common law
wins hands down," says Ball.
Standards Alone Are Not Enough
The futility of implementing standards without changing incentives
can be seen in China, Hong Kong, Malaysia, Singapore, and
Thailand. 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
The accounting systems of Asian countries, for example, must
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
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
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," says Ball.
Ball is skeptical of the European Parliament's 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,"
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.