Financial Reporting Incentives: Law, Politics and Corporate Discipline Professor Robert Bushman

1. Financial Reporting Incentives: Law, Politics and Corporate Discipline Professor Robert Bushman The Forensic Accounting Distinguished Professor Kenan-Flagler Business School University of North Carolina at Chapel Hill Remarks prepared for: International Conference on Corporate Governance in Asia and China Shanghai, China March 2005 Bushman 2005

2. The Role of Financial Systems Functional View (Ross Levine, JEL (1997)) Facilitate trading and pooling of risk Allocate resources Monitor managers and exert corporate control Mobilize savings Facilitate the exchange of goods and services Implemented via a range of institutional configurations that achieve varying degrees of functional efficiency Bushman 2005

3. Financial systems must deal with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment How can investors be assured that managers will choose the right projects, exert sufficient effort, adequately disclose relevant information, and ultimately repay investors? Bushman 2005

4. Financial Accounting Numbers as Governance Mechanism Lawrence Summers, Former Secretary of the Treasury and now President of Harvard University (Interview for PBS website Commanding Heights, 04/24/01) “Transparency is good because, as someone once said, ‘conscience is the knowledge that someone's watching,’ and it discourages bad behavior.” “If you look at the history of the American capital market, there's probably no innovation more important than the idea of generally accepted accounting principles.” More to it than just rules!!! Bushman 2005

5. The U.S. Configuration: A Web of Institutions & Mechanisms Class Action Suits The Media Sarbanes-Oxley Criminal Justice Bushman 2005

6. Economies as a Web of Inter-related Institutions Economic Performance Financial Development Legal Regime Political Regime • Markets/Banks • Corporate Transparency The availability of firm-specific information to those outside publicly traded firms Corporate Reporting Source of contractible variables to support : Compensation, debt contracts, etc Dissemination • Private Sector Information • Info Processing • Searching, gathering, • validating info Bushman 2005

7. The Press as a Watchdog for Accounting Fraud (Gregory S. Miller, 2003, SSRN) SEC Accounting and Auditing Enforcement Releases: AAERs generally represent egregious violations of the SEC standards. While accounting fraud is a primary reason for an AAER, they also frequently include illegal insider trading, violations of SEC requirements by auditing firms and other illegal acts. Only AAER that include a substantial accounting fraud are included here. Bushman 2005

8. Actual Financial Reporting Outcomes Shaped by Institutional Structure Financial Development Legal Regime Political Regime Dissemination Private Sector Information • Corporate Reporting • Formal rules and standards • Managers’ reporting incentives • Regulators’ incentives • Value of contractible variables • Disciplining effect on behavior Bushman 2005

9. What Determines Corporate Transparency? Bushman, Piotroski and Smith, Journal of Accounting Research 2004 Empirical Framework PRIVATE INFORMATION ACQUISITION & COMMUNICATION INFORMATION DISSEMINATION CORPORATE REPORTING Financial disclosures (DISCL): Segments, R&D, Capital Expenditures, Accounting Policies, Subsidiaries Financial analysts Media channels: (NANALYST) Penetration (MEDIA) Governance disclosures (GOVERN) Major Shareholders, Management, Board, Director& officer pay, Director and officer shareholdings Accounting principles (MEASURE): Consolidation, Reserves Timeliness of disclosures (TIME) Frequency of reporting Bushman 2005

10. Underlying Structure of Corporate Transparency Factor analyzed underlying the measures of firm-specific information environments Isolate two distinct factors underlying country-level transparency: Financial transparency: interpreted as a relative measure of availability of financial information to those outside the firm due to the disclosure, interpretation, and dissemination of financial information by firms, financial analysts, and media Governance transparency: interpreted as a relative measure of availability of information for outside investors to hold officers and directors accountable. Q: How do financial and governance transparency factors vary with countries’ legal/judicial regimes and political economies? Bushman 2005

11. DISCL : Segments, R&D, Capital Expenditures, Accounting Policies, Subsidiaries GOVERN: Major Shareholders, Management, Board, Director& officer pay, Director and officer shareholdings MEASURE: Consolidation, Discretionary Reserves TIME: Frequency of reporting Bushman 2005

12. Corporate transparency and legal/judicial regimes Theory emphasizes role of verifiable information in contract design and governance more generally. Principal-agent models assume existence of a perfect court system. e.g., Jensen & Meckling (1976), Holmstrom (1979) Suggests that mechanisms allowing low cost, effective enforcement of private contracting arrangements are complements with systems that produce contractible information signals. Financial accounting supplies a rich set of such variables. In the absence of a viable judicial system, alternative relationship-based arrangements and private enforcement mechanisms may arise which are less reliant on public information Bushman 2005

13. For Governance: British > German > French & Scandinavian > French Same basic ordering as LaPorta et al. (1998) find for investor protections For Financial: No significant relation with legal origin!! Bushman 2005

14. Political Variables Powerful, centralized governments constrain financial development to maintain power and capture wealth. States directly owning enterprises may suppress information to hide expropriation activities by politicians and cronies. However, a benevolent government may use state ownership to directly govern firms, obviating the need for public information. Politicians may exploit regulatory powers to impose costs of entry on start-up firms to benefit politically connected incumbents by shielding economic rents from competition. As propensity of State to expropriate wealth from firms increases, firms may limit disclosure of financial information to hide wealth. Also, unprofitable firms may voluntarily disclose more to keep the government away or governments may mandate higher transparency to aid in identifying assets to expropriate. Autocracy State-owned enterprises State ownership of banks Barriers to entry Risk of Expropriation Bushman 2005

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16. Properties of Financial Accounting: Conservatism & Governance • Conservatism: asymmetric accounting recognition of economic gains and losses. • In the extreme : “anticipate no profit, but anticipate all losses. • Three alternative theories of conservatism (Watts (2003): • Contracting • - Part of efficient contracting design between the firm and various parties. • - Constrains opportunistic behavior and offsets managerial biases with its asymmetrical • verifiability requirement that on average defers earnings and understates net assets. • - Timely incorporation of losses leads managers to address losses more quickly. • - Makes leverage and dividend restrictions bind more quickly • Shareholder litigation • - Overstating the firm’s profits and net assets is more likely to generate costly litigation against the firm than understating them. • Regulation • - Regulators are more likely to be punished for firms overstating profits and net assets than • for understating them. Bushman 2005

17. Asymmetric Accounting Recognition of Economic Gains and Losses Bushman 2005

18. Empirical Approach Following Basu (1997), measure accounting conservatism proxying for economic income with returns (also use non-price model): NIi,j,t = α0 +α1NEGi,j,t + β1RETi,j,t + β2NEGi,j,t*RETi,j,t + εi,j,t, where NEG=1 if RET < 0. 2 captures the incremental speed of bad news recognition in earnings relative to the speed of good news recognition. If 20, then 1 captures the speed of good news recognition, 3 the incremental speed of bad news recognition relative to good news recognition, and 1+2 the speed of bad news recognition. Bushman 2005

19. Evidence on the role of institutions: Ball Robin and Wu (2003) Hong Kong, Malaysia, Singapore and Thailand. Bushman 2005

20. Bushman an Piotroski (2005): “Financial Reporting Incentives for Conservative Accounting: The Influence of Legal and Political Institutions” Forthcoming Journal of Accounting and Economics NI = Intercept + 1RET + 2RET*CCD + 3NEG*RET + 4NEG*RET*CCD +  = Intercept + [1+ 2*CCD]*RET + [3 + 4*CCD]*NEG*RET + . Total coefficient on RET (good news) in countries that possess characteristic CCD, where 2 is the incremental coefficient for a CCD country relative to a non-CCD country. Coefficient on NEG*RET (bad news) in countries with characteristic CCD, where 4 is the incremental coefficient for a CCD country relative to a non-CCD country. NEG is an indicator variable equal to one if RET is less than zero, zero otherwise CCD is an indicator variable reflecting country-level differences in various legal, political and financial institutions Bushman 2005

21. Results Legal: 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 Bushman 2005

22. Results Political: Mapping of + and –Economic Income into Accounting NI Low SOE High SOE Low SOE High SOE Common Law Countries Code Law Countries Bushman 2005

23. Timely Exit and Timely Accounting Recognition of Economic Losses: International Evidence Bushman, Piotroski and Smith (2005) The importance of efficient exit for the productivity and economic vitality of an economy has long been recognized, dating back to at least Schumpeter’s (1942) ideas about creative destruction. The issue of managers pursuing losing projects has long been recognized: Perquisite consumption, empire building, the free cash flow problem, the Pain Avoidance Model, the principal-agent problem, the sunk cost phenomenon and escalation of commitment. We investigate whether firms in countries whose accounting regimes are characterized by more timely recognition of economic losses tend to withdraw capital from losing projects relatively faster than firms in countries with less timely loss recognition. Bushman 2005

24. The Story: Incentives for early exit from losers Ball (2001): Important criterion for economically efficient public financial reporting is the timely incorporation into the published financial statements of adverse information about future cash flows. Since lenders and borrowers contract on the financial reports through accounting-based covenants, timely recognition of losses enable lenders to receive more timely signals of deteriorating performance through a tightening of covenants or triggering of covenant violations, and thus promotes early intervention. If economic losses are charged against income, there is no incremental income penalty to actual abandonment, reducing the incentives of managers to prolong losing investments and strategies. Decreases ex ante likelihood that managers undertake negative-NPV projects. Bushman 2005

25. Return distribution in countries with low & high speed of bad news recognition Bushman 2005

26. Use measures from Wurgler (JFE ('00)) to measure investment behavior Panel of gross investment and value-added for 65 countries, 28 industries, 33 years ln [Ijct / Ijct-1 ] = c + c * ln [Vjct / Vjct-1] + jct Ijct = investment in industry j, country c, year t Vjct = value added of industry j, country c, year t c = value added elasticity of country c = efficiency of project selection in country c Also: c+ = estimated value added elasticity for each country c separately for industry-year observations reflecting increasing value added c– = estimated value added elasticity for each country c separately for industry-year observations reflecting decreasing value added Bushman 2005

27. Results from Bushman et al. (2005) The elasticity of new investment to increasing value added is unrelated to speed of bad news recognition c+ c– • The elasticity of new investment to decreasing value added is • positively related to speed of bad news recognition • Capital is withdrawn faster from shrinking sectors in countries with timely accounting recognition of bad news Bushman 2005