International Accounting Research and Some Thoughts on China

1. International Accounting Research and Some Thoughts on China Robert M. Bushman University of North Carolina August 2005

2. Broad relation between institutions, incentives, financial reporting practices and economic outcomes • Institutions Economic Outcomes Levine 1997; Rajan and Zingales 1998 Bekaert, Harvey and Lundblad 2002 Demirguc-Kunt and Maksimovic 1998 Wurgler 2000; Beck and Levine 2002

3. Broad relation between institutions, incentives, financial reporting practices and economic outcomes • Institutions Economic Outcomes Levine 1997; Rajan and Zingales 1998 Bekaert, Harvey and Lundblad 2002 Demirguc-Kunt and Maksimovic 1998 Wurgler 2000; Beck and Levine 2002 Incentives Watts and Zimmerman 1986 Ball Kothari and Robin 2000 Bushman and Smith 2001 Ball Robin and Wu 2003 Leuz, Nanda and Wysocki 2003 Bushman Piotroski and Smith 2004 Bushman and Piotroski 2005 Revealed Accounting Practices

4. Measuring Timely Loss Recognition Practices:Ball, Kothari and Robin (2000) • Following Basu (1997), prior cross-country studies measure differences in timely loss recognition practices using variations of the following model: • NIj,k,t = α0 +α1NEGj,k,t+ β1RETj,k,t + β2NEGj,k,t*RETj,k,t + εj,k,t, • where NEG=1 if RET < 0. • Primary measures of economy-level TLR practices: • Timely loss recognition(BKR_TIME) is measured as β1 + β2 • Incremental timely loss recognition (BKR_INCR) is measured as β2. Good News Sensitivity Incremental Bad News Sensitivity

5. From Bushman and Piotroski (Forthcoming JAE) Legal Institutions: Mapping of + and –Economic Income into Accounting NI Weak public enforcement of securities laws Strong public enforcement of securities laws Low judicial system quality High judicial system quality

6. From Bushman and Piotroski (Forthcoming JAE) Political Regimes: Mapping of + and –Economic Income into Accounting NI Low SOE High SOE Low SOE High SOE Common Law Countries Code Law Countries

7. Broad relation between institutions, incentives, financial reporting practices and economic outcomes • Institutions Economic Outcomes Levine 1997; Rajan and Zingales 1998 Bekaert, Harvey and Lundblad 2002 Demirguc-Kunt and Maksimovic 1998 Wurgler 2000; Beck and Levine 2002 Incentives Watts and Zimmerman 1986 Ball Kothari and Robin 2000 Ball Robin and Wu 2003 Bushman and Piotroski 2005 Leuz, Nanda and Wysocki 2003 Bushman Piotroski and Smith 2004 Revealed Accounting Practices But, so what???

8. Broad relation between institutions, incentives, financial reporting practices and economic outcomes • Institutions Economic Outcomes Levine 1997; Rajan and Zingales 1998 Bekaert, Harvey and Lundblad 2002 Demirguc-Kunt and Maksimovic 1998 Wurgler 2000; Beck and Levine 2002 Incentives ? Watts and Zimmerman 1986 Ball Kothari and Robin 2000 Ball Robin and Wu 2003 Bushman and Piotroski 2005 Leuz, Nanda and Wysocki 2003 Bushman Piotroski and Smith 2004 Revealed Accounting Practices Governance Mechanism

9. For example: Consider the relation between institutions, timely loss recognition (TLR) practices and economic outcomes • Institutions Investment Efficiency Wurgler 2000 Beck and Levine 2002 Ball Kothari and Robin 2000 Pope and Walker 1999 Ball Robin and Wu 2003 Lang Raedy and Yetman 2003 Ball and Shivakumar 2005 Buijink Coppens and Peek 2004 Bushman and Piotroski 2005 Ball Robin and Sadka 2005 ? Timely Loss Recognition Practices Governance Mechanism

10. The Influence of TLR Practices on Capital Allocation Efficiency Prior research identifies inefficiencies in the capital allocation process when firms are faced with a deterioration in investment opportunities. • Inefficient exit from poor performing projects. • Economists have long recognized the importance of efficient exit for the productivity and economic vitality of an economy. • Schumpeter (1942): Ideas about “creative destruction.” • Jensen (1993): Problems associated with designing control systems that lead managers to exit from activities where exit is warranted by economic realities. • Managers pursuing, ex ante, negative NPV projects. • Jensen (1986): Free cash flow problem  managers have the potential to over-invest in declining industries. • Other explanations include: Empire building; perquisite consumption; principal-agent problems; the sunk-cost phenomenon; and escalation of commitment.

11. Link between Timely Loss Recognition Practices and Capital Allocation Timely accounting recognition of economic losses (TLR) should influence capital allocation through its impact on exit decisions and project selection decisions e.g., Ball (2001) and Ball and Shivakumar (2005). • Decreases ex ante likelihood that managers undertake negative NPV projects. • Impact of poor economic performance influences earnings (and therefore explicit and implicit employment contracts) sooner. • Timely accounting recognition of economic losses promotes early intervention through its impact on contracting activities.

12. Relation between TLR and Capital Allocation • Governance Mechanism Economic Outcomes Observables Timely withdrawal of capital from failing projects Greater Elasticity of Investment in Declining Industries TLR practices Avoidance of negative NPV projects

13. Relation between TLR and Capital Allocation An array of financial reporting practices and governance choices Timely withdrawl of capital from failing projects Greater Elasticity of Investment in Declining Industries Country- level institutions TLR practices Avoidance of negative NPV projects

14. Bushman, Piotroski and Smith (2005) Hypothesis: Economic Impact of TLR practices on capital allocation Primary hypothesis: Firms in countries characterized by more timely accounting recognition of economic losses respond more quickly to a deterioration in investment opportunities by reducing the flow of capital to new investments and by withdrawing capital from losing projects than firms in countries with less timely loss recognition practices.

15. Research Design: Measurement of elasticity of gross investment to value added • Estimates of the elasticity of gross investment to value added at the country level are drawn from Wurgler (2000) dataset. • Estimated from the following model: ln (Ijkt/Ijkt-1) = α + ηkln(Vjkt/Vjkt-1) + ε • Estimates of ηk are influenced by country-level adjustment costs resulting from financing, technological, political and agency cost frictions. • Estimates of ηk can be separated into the elasticity of investment for industries with increasing value added (η+) and decreasing value added (η-). • Wurgler notes that the difference (η- - η+) can be viewed as an inverse measure of the severity of the control problem in a country. • (η- - η+) captures managers propensity to downsize investments in declining sectors relative to their willingness to invest in industries with strong opportunities. • Differencing technique removes structural, economy-level effects (e.g., adjustment costs) that symmetrically influence the general level of investment elasticity. • Our hypotheses predict that (η- - η+) will be increasing in TLR if timely loss recognition promotes efficient exit and better project selection (i.e., influences η-).

16. Table 2: Correlation matrix

17. Table 2: Correlation Matrix

18. Table 4: The impact of TLR practices on the difference in elasticity of investment between declining and growing industries, (η--η+)k, after controlling for financial development in an economy and alternative governance/investor protection mechanisms • Panel A: TLR measures based on Ball Kothari and Robin non-linear earnings-returns estimations

19. Distribution of Realized Stock Returns across TLR regimes