Accounting Abroad—How to Keep Managers and Auditors in Line

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 reporting.

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 quality.

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 U.S. system.

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 time.

"You can't regulate an economy very effectively if there are incentives in the economy to act against the way you regulate," says Ball.

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," says Ball.

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."