Ludwig Erhard Lectures 2004
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Chapter 4: The objective of international
harmonisation: value relevance or accountability?
Introduction
Many scholars take it for granted that the objective of international harmonisation is
to improve the informational efficiency of foreign stock markets. As Hopwood said,
in most international accounting research, The user perspective is taken to be one of
such obviousness that it requires no appeal to conventionally accepted evidence
(1994, p.249). By user-perspective Hopwood means the decision-relevance or
informational perspective which, as we saw in chapter three, says that the aim of
accounting is to help investors value companies. In this chapter we appeal to
conventionally accepted evidence to ask, why do the capital markets want harmonised
accounting? It is not sufficient to simply assume that this is the aim of international
accounting, any more than we can just assume that domestic investors want valuerelevant accounting information. As Holthausen and Watts say,
standard-setting inferences based on a theory that assumes standard setters
consider a high association with stock values a desirable attribute for
accounting earnings are not likely to be useful if the evidence suggests
standard setters do not consider stock valuation association an important
attribute. Simple assertions by authors that standard setters should consider
that attribute desirable are not sufficient for scientific research (2001, p.4).
While there are important differences in international financial reporting, their
significance for users in share valuation is debatable. Many observers believe
accounting differences create a Tower of Babel . However, there is extensive
evidence that the capital markets of developed economies are informationally
efficient (e.g., Choi and Levich, 1990, pp.23-25; Alford, 1993, pp.184, 196). In other
words, accounting differences have not caused domestic investors any insurmountable
problems in valuing shares sufficiently accurately to prevent abnormal transfers of
wealth from trading on past prices (weak-form efficiency), publicly available
accounting information (semi-strong), or even inside information (strong-form). NonAnglo Saxon capital markets have lower liquidity and public disclosure standards, but
we must remember that poor public disclosure does not necessarily impede the flow
of information into stock prices, since the information flow can occur instead via the
trading of informed insiders (Ball, Kothari and Robin, 2000, p.48). US investors
behave as though they believe foreign stock markets are efficient. As Lochner, a SEC
commissioner, pointed out, the failure of most non-US companies to use US GAAP
has not deterred U.S. investors from purchasing foreign securities (1991, p.108).
The problem for those who allege that IAS are a pre-requisite to a well-developed
global securities market is that a well-developed capital market exists already. It has
evolved without uniform accounting standards (Goeltz, 1991, p.86).
To explain the objective of international harmonisation we must distinguish between
informational efficiency and allocational efficiency, that is, between the fair price
for a financial security and its maximum value. A securities market is efficient if
Ludwig Erhard Lectures 2004
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information is widely and cheaply available to investors and all relevant and
ascertainable information is already reflected in security prices (Brealey and Myers,
1984, p.266). The chapter argues that the problem for international investors is not
whether the market price for foreign securities is fair, but whether the expected
returns are as high as possible. As Choi and Levich point out, the international capital
market efficiency of interest to policy makers includes not just confidence in the
accuracy of relative share values, but the confidence to form fully diversified global
portfolios:
Not withstanding this rosy appraisal of international capital markets, two
questions are of concern to policy makers. First, would a common,
harmonized accounting system provide more useful information to market
participants than the diverse systems now in place? Second, even though
financial markets may appear efficient, do diverse accounting systems act as a
nontariff barrier, affecting the capital market decisions of investors and
issuers? (Choi and Levich, 1990, p.34).
The fundamental question is whether, based on their analyses, foreign investors are
confident enough to participate in international markets to the extent required to hold
well-diversified portfolios (Choi and Levich, 1990, p.22). Even though there is clear
evidence that market prices reflect available information [this] does not address the
question of how costly it is for investors to process diverse accounting information
(Choi and Levich, 1990, p.22). We saw in chapter 1 that international diversification
by US and UK investors is below its apparently optimal level. This is consistent with
the hypothesis that without IAS international investors do not expect the returns from
additional investment in foreign securities to cover the increased information
processing costs they would incur to hold foreign management accountable for the
rate of return on capital.
If the international capital markets are informationally efficient, accounting is
useful to investors only as a means of holding management accountable. Only if
investors have confidence that the accounts objectively measure management s
performance are there no accounting barriers to investors allocating their capital to
those firms delivering the highest rates of returns on capital. In this sense, we can
agree with Saudagaran and Meek that
The primary economic rationale in favor of harmonization is that major
differences in accounting practices act as a barrier to capital flowing to the
most efficient uses. Investors are more likely to direct their capital to the most
efficient and productive companies globally if they are able to understand
their accounting numbers (and so, presumably, their economic reality) (1997,
p.137).
The most efficient and productive companies are those with the highest rates of
return on capital. This, we shall argue, is the economic reality of concern to
international investors.
By contrast, the information efficiency objective assumes harmonising accounting
around the Anglo-Saxon model will give investors more value-relevant information,
Ludwig Erhard Lectures 2004
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that is, information with more predictive ability , to increase capital market
efficiency.1 As we saw in chapter 3, the basis of the IASC[ s] conceptual
framework is the value relevance of financial reports (Ali and Hwang, 2000, p.3).
The dominant view is that the objective is to improve the efficiency with which the
markets operate by reducing the diversity that exists among the bases on which
financial accounts are prepared in various countries (Bayless, 1996, p.76; see also,
Zarzeski, 1996, p.18). As Arthur Wyatt, former director of the IASC, put it,
Comparable financial information assists in the quality of the financial
analysis and thereby should increase the efficiency of capital markets. . One
can build a strong case that financial data, presented on a comparable basis
across countries - with the same degree of credibility as local data possesses will increase the efficiency of investment analysis (1991, p.13.9).
To prove that informational efficiency is the real aim of harmonisation, its advocates
must show us, first, that the primary function of accounting in the Anglo-Saxon
capital markets is to help investors value securities.2 In other words, they would have
to show us that Anglo-Saxon accounting plays a major role in security valuation by
providing investors with information having significant predictive-ability or valuerelevance . Second, they would have to show us that restating foreign accounts using
Anglo-Saxon methods improves their value-relevance. We first show that extensive
research has established neither proposition. Then we look at the evidence supporting
the accountability objective of harmonisation.
The value-relevance of accounting
During the 1970s and 1980s scholars attempted to verify the decision-usefulness view
of accounting by establishing a statistical link between economic returns and
accounting earnings, usually called the information content or value-relevance of
accounting. Initially they had little success. Early studies of the information content
of earnings usually found only weak links between earnings and returns, with R2
statistics typically ranging from 2 per cent to 10 per cent (Pope and Rees, 1992,
p.337). Stimulated by Ohlson s work the inclusion of the book value of equity in the
regression equations increased these embarrassingly low R2 statistics (Strong and
Walker, 1993, p.385). Nevertheless, we will see this research has not established
value-relevance as the primary function of accounting, and we conclude, therefore,
that it provides no support for the market efficiency objective of harmonisation.
Value relevance research starts from the tautology that the market value of a firm s
equity is the sum of the book value3 of its net assets plus the present value of its
expected residual income . Residual income is the excess earnings over the required
return on its net assets. The economic value of expected residual earnings is what
accountants call internal goodwill. Value-relevance research exploits this tautology
1
Note that market efficiency does not mean that the market has perfect forecasting ability, only that
prices reflect all available information (Brealey and Myers, 1984, p.271).
2
We saw in chapter 3 that the IASC s Framework for the Preparation and Presentation of Financial
Statements assumes this is the aim of accounting.
3
From the traditional perspective, book value is replacement cost.
Ludwig Erhard Lectures 2004
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to re-write the dividend valuation model using accounting numbers. The dividend
valuation model is:
Pt =
R- Et[dt+ ]
=1
Pt = share price at time t.
R = 1 + required return on equity.
dt+ = the dividend to be paid at year-end t + .
Et[.] = expectations at year-end t.
To re-write this equation with accounting numbers, we define earnings as the annual
clean surplus . This means earnings equals all changes in the book value of equity
(other than capital injections and distributions) including all movements of reserves
(e.g., foreign currency translation differences, asset revaluations, goodwill write-offs):
xt = yt - yt-1 + dt
xt = earnings in the year end t.
yt = book value of equity capital at year-end t.
yt-1 = book value of equity capital at year-end t-1.
dt = the dividend paid at year-end t.
We define residual income for year t as earnings for year t less a capital charge based
on the opening book value of equity:
xta = xt - (R - 1) yt-1
xta = yt + dt - Ryt-1
dt = Ryt-1 + xta - yt
All this says is that dividends equals the normal increase in equity (i.e., normal
income) plus the abnormal or residual income less the closing equity. Substituting
this expression for dividends in the dividend valuation model produces:
Pt = yt +
Et[xat+ ]R=1
This says the market value of a firm is the sum of the book value of its equity and the
present value of expected clean surplus residual income.
Thus, if the market knows the book value of equity and can forecast expected
earnings and, therefore, the clean surplus residual income, it can deduce the expected
dividends and value the firm whatever methods of accounting management uses.
Consider the following example:4
A company raises £1m cash in equity at the end of t = 0.
The company immediately communicates to the market the expectation that this £1m will
all be used to buy inventory during year 1:
4
From Rees (1995, pp.230-231).
Ludwig Erhard Lectures 2004
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The company will sell half of the inventory in year 1 for £0.6m;
The company will sell half of the inventory in year 2 for £0.6m
It will earn no other income and pay no taxes.
It will distribute all cash balances at the year end.
Assuming a cost of capital of 10%, according to the dividend capitalisation model the value of the firm
at t0 is:
P0 = £0.6m/1.1 + £0.6m/[1.1]2
= £1.0413m.
We can derive this valuation from the forecast accounts based on the forecast events regardless of the
methods used. Consider the following three accounting bases:
1. Historical cost accounting where the closing stock at the end of year 1 = £0.5m.
2. Valuing closing stock at zero at the end of year 1.
3. Valuing closing stock at £2m at the end of year 1.
1. Stock @ t=1 = £0.5m:
Cash
Inventory
Equity
-----------------------------------------------------------------£m
£m
£m
Initial capital
+1.0
-1.0
Purchases
-1.0
+1.0
Sales
+0.6
-0.6
Cost of sales
-0.5
+0.5
Profit/Dividends
-0.1
+0.1
Dividends/cash
-0.5
+0.5
-----------------------------------------------------------------BS end 1
0.0
0.5
0.5
==================================================================
Sales
+0.6
-0.6
Cost of sales
-0.5
+0.5
Profit/Dividends
-0.1
+0.1
Dividends/cash
-0.5
+0.5
-----------------------------------------------------------------BS end 2
0.0
0.0
0.0
==================================================================
According to the accounting valuation model:
Et[xat+ ]R-
P t = yt +
=1
£0.1m - [£1m x 0.1]
£0.1m - [£0.5m x 0.1]
= £1m + ------------------- + --------------------1.1
1.12
= £1.0413.
2. Stock @ t=1 = £0.0m:
Cash
Inventory
Equity
------------------------------------------------------------------£m
£m
£m
Initial capital
+1.0
-1.0
Purchases
-1.0
+1.0
Sales
+0.6
-0.6
Cost of sales
-1.0
+1.0
Dividends
-0.6
+0.6
------------------------------------------------------------------BS end 1
0.0
0.0
0.0
===================================================================
Sales
+0.6
-0.6
Cost of sales
0.0
+0.0
Profit/Dividends
-0.6
+0.6
-------------------------------------------------------------------
Ludwig Erhard Lectures 2004
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BS end 2
0.0
0.0
0.0
====================================================================
-£0.4m - [£1m x 0.1]
£1m + ------------------- +
1.1
£0.6m - [£0.0m x 0.1]
--------------------1.12
= £1.0413.
3. Stock @ t=1 = £2.0m:
Cash
Inventory
Equity
-------------------------------------------------------------------£m
£m
£m
Initial capital
+1.0
-1.0
Purchases
-1.0
+1.0
Sales
+0.6
-0.6
Revaluation
+1.0
-1.0
Dividends
-0.6
+0.6
-------------------------------------------------------------------BS end 1
0.0
+2.0
-2.0
====================================================================
Sales
+0.6
-0.6
Cost of sales
2.0
+2.0
Profit/Dividends
-0.6
+0.6
-------------------------------------------------------------------BS end 2
0.0
0.0
0.0
====================================================================
£1.6m - [£1m x 0.1]
-£1.4m - [£2.0m x 0.1]
£1m + ------------------- + ---------------------1.1
1.12
= £1.0413.
Many researchers have estimated Ohlson s model in the following forms to assess the
value relevance of accounting :
Either,
Pt = a0 + a1bj,t + a2xj,t + ,jt
Or, a statistically more valid formulation (Brown et al. 1999),5 as
xj,t
xj,t
Rj,t = a0 + a1 ------- + a2 ------- + ,jt
pj,t-1
pj,t-1
Where:
Pt = share price at time t.
a0 = the intercept.
a1, a2 = regression coefficients.
bj,t = the book value of the equity of firm j at time t.
xj,t = reported earnings of firm j at time t.
xj,t = the change in the reported earnings of firm j from time t-1 to t.
,jt = an error term.
5
Regressions of the levels of prices against levels of the book value of equity and earnings can lead to
spuriously high R-squares because companies with large nominal share values tend also to have large
values for the book values of equity and earnings per share.
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Researchers usually take the regression R2 as a measure of the value relevance of
the accounting numbers. On this basis, research in the US and Europe shows that
this relation is weak, suggesting that reported earnings do not provide good summary
measures of the value-relevant events that have been incorporated in stock prices
during the reporting period [as] R-squares are relatively low (Dumontier and
Raffournier, 2002, p.131), usually in the range 20% to 30% for US and non-US
companies (e.g., Ali and Hwang, 2000, Table 3, p.12).
However, even these correlations do not prove that the release of accounting numbers
themselves causes any changes in forecast earnings and hence share prices. As
accounting numbers reflect real world events, correlations between accounting and
share prices could reflect the correlation between share prices and the underlying real
world events which accounting reports reflect. But, if (as in our example) the market
can forecast the real world events underlying its forecast of the accounts, including
the dividend, why would it bother to use the accounts to value the firm as it could do
so directly? As Walker concludes,
Potentially the most destructive criticism of the Ohlson approach is that it
does not explain why firms bother to report earnings and book values in the
first place. Ever since Beaver and Demski s (1979) seminal paper, this line of
criticism has dogged all approaches to financial accounting based on notions
of income measurement.
In particular, [that] neo-classical economics has
failed to develop a theory of income measurement in which there is an
endogenous demand for some form of income measurement (1997, pp.352,
342).
Beaver and Demski restated the well-known fact that income measurement only has
an unambiguous interpretation as an increment to economic value in a wholly
unrealistic certain world with perfect and complete markets. In the real world of
uncertainty and imperfect and incomplete markets the case for accrual accounting to
improve the predictive abilities of investors is unclear. In the real world, to forecast
dividends and value shares investors need information about the real world, in
particular management s state-contingent production plans . They must combine
their knowledge of management s plans with other information to form beliefs about
future states of the world and their implications for the dividends expected from
particular firms. It is unclear whether, or if so how, accrual accounting provides this
information (Beaver and Demski, 1979, pp.43-45). Although Ohlson claims to
integrate the income measurement approach that assumes that investors use
accounting information to value companies with the information perspective that says
that accounting provides data about the real world that investors use for valuation, in
fact, as Walker says, The Ohlson models assume that accounting numbers reflect an
underlying reality that is directly observed by the market (1997, p.352). As
Dumontier and Raffornier say,
association studies do not infer any causal connection between accounting
figures and stock prices. They do not even presume that market participants
use accounting data in their valuation process. They only posit that if
accounting data are good summary measures of the events incorporated in
Ludwig Erhard Lectures 2004
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security prices, they are value-relevant because their use might provide a value
of the firm that is close to its market value (2002, p.128).
In short, Ohlson s model tells us nothing about the role of accounting in the real
world, only that it is to some extent correlated with share prices. Not surprisingly, the
huge value-relevant literature has made virtually no contribution to setting accounting
standards. Holthausen and Watts are scathing in their criticism of this literature:
Barth et al summarize what the have learned from the research on the value
relevance of fair value as the basis of accounting. They conclude that various
fair value estimates of pension assets and liabilities and fair values of debt
securities, equity securities, bank loans, derivatives, non-financial intangible
assets (R&D, capitalized software, advertising, brands, patents and goodwill)
and tangible long-lived assets are value relevant. They also conclude that
some estimates are not value relevant. These conclusions amount to the
finding that the literature has documented that the listed items are correlated
with equity values than other items. However, it is difficult to derive
standard-setting inferences from these findings without descriptive theories of
accounting and standard setting to interpret them (2001, p.65).6
To write helpful standards we must understand accounting and its role. As Walker
concludes,
what we really want to know is why do we have financial reporting systems
that supply measures of income (earnings) and value (book value)? Perhaps
one cannot hope to explain the basic features of the financial reporting unless
one starts from the proposition that that capitalist owners value measures of
return on capital (Walker, 1997, p.352).
In traditional accounting, capitalist owners value the accounting rate of return because
it provides an objective basis for holding management accountable for the rate of
return on capital. As we shall see, research on the usefulness of accounting to the
international capital markets is consistent with the accountability hypothesis.
First, however, we show that although there is some evidence that Anglo-Saxon
accounting has more value-relevance within Anglo-Saxon capital markets than
foreign GAAP has in foreign capital markets (Ali and Hwang, 2000), there is little
evidence that the value relevance of their accounts to Anglo-Saxon investors would
increase if foreign firms used Anglo-Saxon GAAP. This undermines the hypothesis
that investors demand international harmonisation to improve the value relevance of
non-Anglo Saxon GAAP and thereby increase the informational efficiency of the
international capital markets (hereafter, the efficiency hypothesis ).
The value-relevance of non-Anglo-Saxon GAAP
6
Barth et al (2001) is a reply to Watts in the same issue of the journal. They admit that Because
usefulness is not a well-defined concept in accounting research, value relevance studies typically do
not and are not designed to assess the usefulness of accounting amounts , and that Academic
researchers are the intended consumers of value relevance research (pp.78-79)!
Ludwig Erhard Lectures 2004
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If Anglo-Saxon GAAP has predictive-ability we should expect the accounts of foreign
firms that report using non-Anglo Saxon GAAP would consistently have significantly
less value-relevance than Anglo-Saxon restatements. The SEC s 20-F requirement
that to have their shares traded in the US foreign firms must restate their accounts to
US GAAP provides a test of the likely value-relevance of internationally harmonised
accounts. Several studies have investigated whether US GAAP restatement releases
have value-relevance. Saudagaran and Meek summarise the results:
(1) non-US GAAP accounting information has value relevance; (2)
restatement information seems to have some (though not overwhelming) value
relevance, but evidence on the general direction of relevance is mixed; (3)
such value relevance as exists seems to vary by country of domicile, or
perhaps system of accounting. In other words, the restatement may be more
important for some countries than it is for others (1997, p.152).
Bhusan and Lessard (1992) surveyed the opinions of US and UK international
investment fund managers. They found that while professional investors thought
international harmonisation useful , it was not essential as they relied on local
accounts and local valuation.
Meek (1993) examined 26 firms from five countries. He found no significant
relationship between the equivalent 20-F earnings and security prices. He concluded
the market had already impounded the information contained in the 20-F
reconciliation before the company released them (usually three months after the
foreign earning announcement). Amir et al (1993) studied 101 firms from 20
countries. They observed that 20-F earnings and shareholders equity reconciliations
were not value relevant even for specific items (e.g., goodwill, asset revaluations, and
taxes). Amir et al question the relevance of 20-F reconciliations as they argue a
careful investigator could reconstruct US GAAP for themselves. Consistent with this,
McQueen s (1993) analysis suggests that levels of both [foreign] reported earnings
and foreign earnings reconciled to a US GAAP basis are significantly associated with
securities returns (Choi and Levich, 1997, p.6.15), but the relationships were small
and not robust (Pownall and Schipper, 1999, p.266).
Alford, et al (1993) compared the information content and timeliness of accounting
earnings in 17 countries using the US as the benchmark. They do find differences,
but some of them are inconsistent with the market efficiency hypothesis. Their
finding that the information content and timeliness of accounts to the capital markets
in Denmark, Germany, Italy, Singapore and Sweden, was either less timely or less
value relevant than US GAAP earnings is consistent with the efficiency hypothesis.
However, they also find that accounts in Australia, France, Netherlands, and the UK
are more informative and timely accounts than US companies, which is highly
unlikely. Given the size, liquidity, extensive requirements for timely disclosures
effectively policed by the SEC this result would puzzle many US observers (at least),
and is not explained by the authors . In addition, data questions, such as whether
earnings is defined consistently across sample countries, also obscure the results.
Cautious interpretations are in order (1997, p.149). Significantly, the results for
Belgium, Canada, Hong Kong, Ireland, Norway, South Africa and Switzerland are
not conclusive (Alford, et al, 1993, p.213). That is, it was not possible to conclude
Ludwig Erhard Lectures 2004
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that these countries systems of accounting were or were not more or less value
relevant than US GAAP.
Harris, Lang and Moller (1994) compared the correlations between accounting
earnings and stockholders equity to share prices and returns using Ohlson s approach
for German and US companies on their home stock exchanges. These researchers
find the explanatory power (R2) of earnings for stock market returns is similar for
both German and US companies (around 10%). Harris, Lang and Moller conclude,
contrary to the notion that accounting data are essentially meaningless for German
corporations that these data are associated with stock price levels and returns.
Further, the explanatory power of earnings for returns in Germany is comparable to
that in the United States, which suggests that German earnings are not as garbled as is
often perceived. However, the explanatory power of shareholder s equity for price is
significantly lower in German than in the United States (1994, p.207). The
conclusion that German stockholders equity is significantly less correlated with
returns than US stockholders equity is consistent with the efficient markets objective.
However, they also found that the market valued German earnings at a higher
multiple than US earnings, as an efficient capital market should given the
conservative nature of German accounting. Saudagaran and Meek conclude:
Arguably, the most surprising aspect of these results is that German GAAP
earnings are just as value relevant as U.S. GAAP earnings. Differences
between the two countries in the importance of capital markets as a source of
finance, the fundamental purpose of accounting, and particularly German
income smoothing practices would lead one to expect lower explanatory
power for German companies (1997, p.149).
In other words, this finding is inconsistent with the efficient markets objective. Also
inconsistent is the finding of Joos and Lang (1994) who found that while UK
accounting is more investor-oriented than France or Germany their R-squares were
higher than those for the UK. Also inconsistent with the efficient market objective is
the conclusion of Hall, Hamao and Harris (1994) that over the period they studied
(1980s) there is little evidence of any relation between market returns and accounting
earnings in Japan, even though the Japanese capital markets were informationally
efficient over this period. Clearly, as they conclude, investors in Japanese capital
markets relied heavily on other , non-accounting, information in valuing Japanese
securities. However, first, it is not clear that investors elsewhere rely on accounting
information most of which the market anticipates, or they are reacting to the real
world data they reflect. Second, investors in all capital markets rely heavily on nonaccounting data (Dumontier and Raffournier, 2002, pp.137-139).
Understanding the role of accounting in market valuation in any country depends
crucially on that nation s institutional framework, involving the purpose and practice
of accounting and the capital market microstructure (Saudagaran and Meek, 1997,
p.149). In other words, it is necessary to understand how the market makers obtain
the information they use to value shares. As these sources differ across countries, not
surprisingly the associations between market returns and accounting, its value
relevance, differ systematically across countries according to institutional differences,
particularly the differences between the market or shareholder-focused economies
Ludwig Erhard Lectures 2004
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and the Continental or code-law or bank-dominated economies (Pownall and
Schipper, 1999, p.272; Ali and Hwang, 2000). In market systems, with numerous
investors with no direct access to value relevant information, investors rely heavily on
financial accounting disclosures. In bank-oriented systems, by contrast, banks are
insiders with direct access to value relevant information (e.g., Berglof, 1990). Not
surprisingly, therefore, Ali and Hwang find,
Using financial accounting data from manufacturing firms in 16 countries for
1986-1995,
that the value relevance of financial reports is lower for
countries where the financial systems are bank oriented rather than market
oriented; where accounting practices follow the Continental model as opposed
to the British-American model; where tax rules have a greater influence on
financial accounting measures; and where spending on auditing services is
relatively low (2000, p.20).7
Thus, even the remarkable case of Japan provides no grounds for harmonisation in the
name of improving capital market efficiency. Studies have repeatedly found the
Japanese capital market is efficient.
Bandyopadhyay et al (1994) study 20-F reconciliations from a sample of Canadian
firms. They found no evidence that the reconciliations were value relevant in the US.
Harris, a leading researcher in value-relevance, admitted in an open forum discussion
of allowing foreign access to US capital markets on the basis of IAS, the evidence
was inconclusive. [W]e have not been able to isolate a market reaction on an
aggregate basis to the release of the 20F disclosures given that other accounting
information exists (Bayless, 1996, p.91). For example, Frost and Pownall s study of
Smithkline Beecham plc (SK) found that U.S. investors do not appear to be confused
by U.S./U.K. GAAP differences, and in fact use information about U.K. GAAP
earnings in their valuations of SK (1996, p.38). Chan and Seow (1996) studied 45
firms 20-F adjustments and found better associations between foreign GAAP and
market returns than US GAAP. In contrast, Barth and Clinch s (1996) find a negative
relationship with market returns, for Canadian reconciliations, and a positive
relationship for changes in reconciliations. Their results differ year by year.
Gornik-Tomaszewski and Rozen conclude U.S. capital market participants are able
to interpret foreign GAAP earnings and promptly infer from them U.S. GAAP
earnings (1999, p.550). This, as they say,
may be interpreted as empirical evidence of semi-strong efficiency of capital
markets in an international context.
[M]arket participants have apparently
developed a coping mechanism in dealing with accounting diversity.
They
seem to utilize other sources of information, such as previous years
reconciliations and interim reports (Gornik-Tomaszewski and Rozen, 1999,
pp.550-551).
7
Ali and Hwang find that these factors are all closely related, with only one underlying construct, but
they were unable to label the construct (2000, p.2). In chapter five we label the underlying construct
capital market orientation , the extent to which the capital markets dominate industrial and
commercial enterprise.
Ludwig Erhard Lectures 2004
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Davis-Friday and Rivera (2000) assess the relationship between market prices and
Mexican and US GAAP earnings and equity. They find no significant relationship
between the [Mexican] ADR price and net income and equity reconciliations from
Mexican to US GAAP. [Their] results call into question once again the validity and
usefulness of the SEC s required reconciliations to US GAAP (Davis-Friday and
Rivera, 2000, p.113). Their results also call into question the efficient market
objective.
Conclusions
There is no case for harmonisation around the Anglo-Saxon model if the purpose is to
improve the informational efficiency of the capital markets. As Choi and Levich
conclude, the conventional wisdom behind the quest for a harmonized set of
international accounting standards appears to be twofold (1997, p.6.23). First, that
mandatory accounting standards are necessary, and second, that harmonisation is a
necessary part of developing large, well-functioning international financial markets
(Choi and Levich, 1997, p.6.23). There is, as they say, empirical evidence that
contradicts both , and at best the capital markets case for harmonization remains an
empirical issue (Choi and Levich, 1997, p.6.23). The best we can say after extensive
empirical research is that The results are mixed, with coefficient estimates and Rsquares varying across empirical specifications, years and sample firms domiciles
(Pownall and Schipper, 1999, p.266). Certainly, as Pownall and Schipper conclude,
the Form 20-F reconciliation literature provides some evidence that for non-U.S.
firms that list in the U.S., both U.S. and non-U.S. GAAP accounting measures are
value-relevant for U.S. (and other) investors (Pownall and Schipper, 1999, p.268).
Therefore, if the objective is value relevance, full harmonisation is not necessarily a
good idea. As Pownall and Schipper put it, the academic research literature poses the
following question for securities commissioners and standard setters worldwide:
What is the best way to trade off the comparability benefits and benefits from
economies of oversight and enforcement, obtainable from using a single set of
financial statements worldwide, against the potential noncomparability costs
of inappropriately imposing worldwide standards on events and transactions
that are inherently noncomparable because of cross-jurisdictional institutional
differences? Faced with this cost-benefit trade-off, some regulators and
standard setters may find it preferable to maintain (at least some) countryspecific reporting differences that capture qualitative, institution-driven
differences in similar-seeming events and transactions, coupled with
reconciliations for firms wishing to report in several jurisdictions (Pownall
and Schipper, 1999, pp.278-279).
In other words, recent levels of diversity in international accounting are consistent
with an efficient international capital market. How is this possible? From the
traditional perspective the purpose of accounting is to hold management accountable
for the capital they control, not to provide investors with data for economic valuation.
Accounts merely provide investors with a steady state model of the realised surplus
for the period and the capital recoverable. While accounts do contain data that may
be more or less useful in valuing shares, for valuation investors must interpret this
data in the light of their beliefs and the vast amount of additional and alternative
Ludwig Erhard Lectures 2004
13
information available. From this point of view, the existence of capital market
efficiency implies that most differences in international accounts are insignificant for
the purpose of share valuation. That is, international differences in accounting are
either irrelevant, or sophisticated investors can see through them or compensate by
using alternative information to produce share values.
It certain appears to be true that, In shareholder-focused economies (common-law
countries), earnings [or information correlated with earnings] are used by
shareholders to determine share value and compensate managers, while in
stakeholder-focused economies (code-based countries), earnings are used more for
determining current payouts to government (via taxation), to shareholders (via
dividends), and to managers and employees (via wages and bonuses) (Pownall and
Schipper, 1999, p.273). However, it does not follow that code-country stock markets
would be more efficient if its companies used IAS or US GAAP and investors relied
more on these accounts and less on their current sources of value-relevant
information. The fact that investors in shareholder-focused economies make more
use of accounts or information correlated with accounting information to value shares
than investors in code-based economies does not mean share valuation is the purpose
of harmonisation.
If we cannot justify the international harmonisation of accounting in the name of
value-relevance, why are the world s leading stock markets and the IASB determined
it will happen? In what follows we argue the evidence supports the accountability
objective.
Accountability to the international capital markets?
From the accountability perspective the purpose of accounts, whether national or
international, is to motivate management to take decisions in the interests of the
providers of equity.8 As Lowenstein puts it,
The financial disclosure system, while intended to permit investors and
creditors to make rational decisions, and so to make markets fair and efficient,
in fact it has the quite independent effect of forcing managers to confront
disagreeable realities in detail and early on, even when those disclosures may
have no immediate market consequences.
[G]ood disclosure has been a
most efficient and effective mechanism for inducing managers to manage
better.
Alas, it is an insight that is lost on most financial economists, who
instead rely on stock prices as the measure of corporate performance (1996,
pp.1335-1336; 1342-1343).
This independent effect , management s accountability for the capital it controls and
the profits or losses it makes, appears to explain the superior statistical performance
of Ohlson s book value model over the earnings models. In traditional accounting net
assets represents the capital estimated to be recoverable. Implicit, therefore, in the
inclusion of an asset on the balance sheet, is the verified estimate that management
8
We assume the providers of credit either share the same interests as equity or are able to look after
their interests where they differ.
Ludwig Erhard Lectures 2004
14
will recover the capital and expects to earn at least the required return from its
ordinary operations. This is consistent with Walker s view that
The key to understanding why accounting book values might yield superior
explanatory performance turns on the fact that reported book values reflect the
rational investment choices of firms, and assessments by the firm (and its
accountants) of capital expenditures that can be booked as assets. A
fundamental feature of accruals accounting is that it classifies expenditures
into revenues and capital. To the extent that the currently booked capital
expenditures have positive net present a truncated equation based on
earnings and book values will tend to produce a better statistical fit than the
truncated dividend series.
In other words, accounting numbers provide a
better association with market values because, somehow, managers have been
motivated to adopt investments with value (1997, p.346).
Ohlson s value-relevance approach assumes management makes maximum NPV
investments. Traditional accounting explains why management maximizes NPV. It
assumes accountability for the rate of return on capital is the purpose of financial
reporting - that is, accountability for the maximum sustainable residual income. If
management maximizes NPV it will maximize sustainable residual income, and vice
versa. Thus, the accountability perspective explains the statistical results of Ohlson s
value relevance approach. It explains why we find reasonably high correlations
between accounting numbers and share prices.
The traditional accountability perspective is also consistent with the findings of other
research on international capital markets and financial reporting. In particular, with
research seeking to explain (a) voluntary disclosure to the international capital
markets, (b) listing behaviour, (c) management s behavioural responses to
international diversity in accounting, (d) differences in apparent income smoothing in
different accounting jurisdictions, and (e) emerging evidence of a governance
premium .
(a) Voluntary disclosure:
The importance of accountability to the international capital markets could explain
why those European and Japanese companies who came to these markets to raise
capital in the 1960s and 1970s voluntarily disclosed substantial additional
information. For example, in 1969 Most found that when comparing financial
statements of listed U.S. and European chemical companies, a skilled analyst could
compare their accounts. In 1973 Choi showed that companies that sought to borrow
on the eurobond market adapted their financial reports to best international practice.
Choi rationalised this finding by claiming that Increased firm disclosure tends to
improve the subjective probability distributions of a security s expected return
streams in the mind of an individual investor by reducing the uncertainty , that
increased disclosure had value-relevance. However, it is also consistent with the
demand from the international capital markets for increased accountability. In 1976
Barrett examined both the extent of financial statement disclosures, and the
comprehensiveness of the net income figure, for 103 companies in the US, Japan, UK,
France, Germany, Sweden and Holland, in 1963 and 1972. The companies chosen
Ludwig Erhard Lectures 2004
15
had the largest market capitalisations in their domestic stock markets in 1972. Barratt
studied their English-Language accounts to view the financial reporting practices of
the sample companies through the eyes of an internationally-oriented investor
(Barrett, 1976, p.11). The results were as follows:
Disclosure: Barrett constructed a weighted scoring index for the disclosure of 17
items of information (covering financial history, segments, capital expenditure,
depreciation, funds flow, stocks, price-level, marketable securities, currency
translation, tax, margins):
US
UK
Japan
Sweden
Holland
Germany
France
All Companies
Average Disclosure Indices
1963
1972
53
72
48
73
41
56
29
58
43
57
40
52
24
44
41
59
Source: Barrett (1976), p.15.
Barrett s work showed that US companies were better on operating details and UK
companies were better on segmental data and capital expenditure plans.9
Comprehensiveness: Barrett measured this as (a) the extent of consolidation and (b)
the comprehensiveness of income statement for 1963 and 1972:
% Companies Consolidating All Significant Subsidiaries
1963
1972
US
67
87
UK
100
100
Japan
42
64
Sweden
71
93
Holland
88
100
Germany
20
86
France
0
50
All Companies
54
83
Source: Barrett (1976), p.17.
In 1972 only US companies made significant use of equity accounting, although the
average percentage of companies reporting equity in associates had increased from
9% in 1963 to 34% in 1972 (Barrett, 1976, p.18).
Inclusiveness of Net Income: In 1963 53% of companies passed all noncapital items (e.g., accrued liabilities, extraordinary items) through the income
statement. In 1972 61% did. Only the US had 100% in both years, and the
UK provided sufficient supplementary data to achieve similar results. When
supplementary disclosures were included, 62% of companies provided a
comprehensive net income figure in 1963, and 66% in 1972.
9
Note that the authors did not consider alternative sources of information (e.g. the detailed individual
French company accounts produced according to the Plan Comptable) in scoring the disclosures.
Ludwig Erhard Lectures 2004
16
Barrett concluded:
While the overall level of financial disclosure steadily improved throughout
the 1963 to 1973 period, there was still a wide variance between the overall
level of disclosure of American and British firms on the one hand, and the
firms from the other five countries. In addition,...the American and British
firm s financial statements were considerably more comprehensive.... These
results were certainly consistent with the general belief that there is a link
between the quality of financial reporting practice and the degree of efficiency
of national equity markets (1976, p.24).
These results are also consistent with the hypothesis that while all these national
equity markets were efficient , whereas the American and British firms were fully
accountable to their capital markets, the firms of the other countries were not.
Meek and Gray (1989) studied 28 Continental European firms listed on the London
Stock Exchange, who exceeded its disclosure requirements through a wide range of
voluntary disclosures. Choi and Levich say, These results suggest that firms have
found it in their interest to provide additional accounting disclosures in the hope of
improving their share prices, reducing the cost of their funds, and competing with
other firms for capital in the international market (1997, p.6.14). However, it does
not automatically follow that these benefits to firms accrue from the improved valuerelevance of their accounts. While not probed by these researchers, this evidence is
also consistent with the hypothesis that the benefits from additional disclosure arise
from the increased accountability they signal to the market. As Saudagaran and Meek
say, an unresearched question is, for example, whether, and if so how, restatement
disclosures affect the way companies are managed. For example, there is anecdotal
evidence that Daimler-Benz changed its management practices in response to
reporting U.S. GAAP earnings (Saudagaran and Meek, 1997, p.153).
(b) Listing behaviour:
The research of Biddle and Saudagaran (1991), Saudagaran and Biddle (1992, 1995)
on the listing choices of 450 firms from eight countries provides further evidence
consistent with the accountability objective. Their evidence is consistent with the
explanation that over the 1980s and early 1990s the required levels of disclosure of
foreign stock exchanges compared to their domestic disclosures strongly influenced
firms who choose to obtain a listing on a foreign stock exchange. These studies found
that, after taking other factors into account, companies were indifferent across
exchanges with levels of disclosure that were less than domestic levels.10 However,
companies were progressively less likely to list on exchanges with higher disclosure
levels.11 Scholars usually rationalise this behaviour as an aversion by some firms to
the large expenses required in foreign listings requiring greater disclosures.
10
Firm size, foreign sales, foreign investment, and foreign employees, industry, geographic location,
exports, importance of domestic stock market as a proportion of GDP.
11
While Gray and Roberts (1997) study of listing decisions into London in 1994 questions the
generality of this finding, their companies were not typical of all foreign companies. Those listing
tended to be large, came from countries with relatively important stock markets and had high needs for
capital as measured by the level of domestic investment over the country of origin s GNP.
Ludwig Erhard Lectures 2004
However, it is also consistent with the hypothesis that the major
management is the increased accountability entailed.
17
cost
for
For example, as Saudagaran and Biddle note, Managements in certain countries such
as Germany and Japan strongly oppose quarterly reporting on philosophical grounds,
arguing that it adversely affects their ability to take actions that are in the long term
interests of their firms (1992, p.373). These countries have therefore largely avoided
listing in the US. From the accountability perspective, management should take
decisions in the long-term interests of investors, to produce the maximum sustainable
return on capital, not in the interests of their firms! Glaum and Mandler (1996) give
us evidence consistent with the accountability view in their survey of the opinions of
the senior management of top listed German companies and German university
professors about the desirability of adopting 13 accounting US regulations. In general
these US regulations would have shifted German accounting towards traditional
Anglo-Saxon accounting. Glaum and Mandler found:
almost every single US-GAAP regulation was opposed by the corporate
managers. The professors assessment were more differentiated . A second,
related, observation is equally striking: all suggestions for the adaptation of
German accounting to current US-practices were judged less favorably by the
managers than by the professors (1996, p.226).
Their explanation for this difference is consistent with German managers not wanting
to face increased accountability to shareholders:
One purpose of financial accounting is to oblige management to render an
account at regular intervals to the owners of the company with regard to the
financial results of their decision-making.
[C]urrent German accounting
rules leave management wide discretion for accounting policy and, in
particular, for the smoothing of profits.
The differing attitudes of managers
and professors may be explained, at least partly, by the managers negative
attitude towards closer scrutiny of their decision-making by the capital
markets (Glaum and Mandler, 1996, p.226).
Not surprisingly, many major firms did not wish to list in the US under SEC rules.
Also consistent with the accountability objective is Saudagaran and Biddle s finding
that Japanese managements were unhappy about the segment reporting a US listing
would have required. Japanese companies complain that these disclosures put them
at a competitive disadvantage relative to other Japanese companies that are not listed
in the U.S. (Saudagaran and Biddle, 1992, p.373). Competition is essential for
accountability to holders of diversified portfolios. To produce the maximum
sustainable residual income from all companies requires management teams to
compete with other firms to earn abnormal returns. To hold management accountable
for the performance of its segments requires objective and comparable accounting
information relative to its competitors. Clearly, disclosure of segment results could
intensify competition in Japan, could make the management of US listed Japanese
Ludwig Erhard Lectures 2004
18
companies more accountable to the product market, but it would certainly make them
more accountable to investors.12
In countries such as Germany and Japan, the law currently sanctions if not encourages
conservative accounting. The statutory audits of Germany and Japan only attest to
conformity with the law. Thus, German and Japanese managers may not have sought
a listing in the US or UK because they require auditors to attest whether the
statements are either fair according to US GAAP or are true and fair according to
UK GAAP. Consistent with the accountability objective is the view of Robert
Bayless, chief accountant of the Division of Corporate Finance for the US Securities
and Exchange Commission, who argued for retaining the requirement to translate
foreign accounts to US GAAP or to equivalent IAS. In his view, A particular danger
to an efficient market and to investor confidence in that market could arise if one of
the competing accounting and reporting systems is of lower quality than the other
because it is more susceptible to management s discretionary selection of the methods
and its disclosure rules are less rigorous than the other system (Bayless, et al, 1996,
p.88). This is the real problem with conservative accounting - the discretion it gives
management to manipulate the accounts and thereby become unaccountable to
investors for their performance as accounts are not comparable. As Jim Leisenring
said, This debate is about how much flexibility is acceptable (Bayless, et al, 1996,
p.90).
(c) Management behaviour and accounting diversity:
Choi and Levich (1991, 1996) use the results of opinion surveys to discuss the effects
of accounting diversity on the behaviour of major categories of participants in the
international capital market. Choi and Levich find accounting diversity does have
effects on behaviour. They conducted an opinion survey during 1988 and 1989 of 52
institutional investors, companies, underwriters, regulators, and debt raters. They
found that international accounting diversity was seen as having a detrimental effect
on the ability of participants in the international capital markets to reach their classic
financial objectives - earning the highest risk-adjusted rate of return on their
investments and incurring the lowest cost of capital conditional on the risks of their
strategies (Choi and Levich, 1991, p.7.2). Half of their respondents thought
international diversity affected their capital market decisions . Only 24% of
investors claimed to be able to fully understand international accounting principles
and practices, and said diversity had no effects on their capital market decisions.
More than 50% of them said they had difficulty in comparing international
accounts.13 While most attempted to standardise accounts, this did not eliminate the
problem of diversity. Some imposed a higher risk premium, simply avoided
international investment, or avoided accounting data in their investment decisions
placing more weight on non-accounting information. Those investors with problems
saw international accounting standards as the solution - those in favour thought it
12
Another suggestive example is the frequently cited influence of the U.S. Foreign Corrupt Practices
Act, requiring the disclosure of bribes [?], as a reason for not listing in the US. Many foreign firms
believe that these regulations adversely affect their global competitiveness and contradict established
business practice (Saudagaran and Biddle, 1992, p.114). Not having to report bribes allows
management discretion to consume some of all of these expenses themselves.
13
International security underwriters (who often bring new companies to the international markets)
also found diversity troublesome.
Ludwig Erhard Lectures 2004
19
would not only make life easier for analysts, but would enlarge investor interests in
international markets (Choi and Levich, 1997, p.6.18). Choi and Levich repeated
their survey in 1996, tailoring it to European investors and companies. While a much
smaller number cited accounting differences and the quality of financial reporting as
significant barriers to pan-European investments, over half said a change in
European accounting reports would make them more likely to consider pan-European
investments (Choi and Levich, 1997, p.6.19)! How can we explain this apparent
contradiction? Choi and Levich offer two comments from their investor respondents
that are for them very different interpretation[s] of why accounting changes might
matter for investors (1997, p.6.20):
All analysts recognize that earnings figures are manipulated, so they will conduct their
fundamental analysis on a relative basis. Either relative to earlier years, or relative to other
firms in the same country. The desire for accounting standardization is computer driven
growing from a desire to mechanise the analysis of firms (Choi and Levich, 1997, pp.6.1920).
Again, [the impact of accounting harmonization] depends on the firm. If Nestle decides to
issue in US GAAP, it will not affect us, since we feel we already know a great deal about
Nestle and the outlook for the firm. On the other hand, if a smaller firm (he mentions one)
makes an accounting change, it could be a signal of a cultural change within the firm. For
small and mid cap firms, this accounting change could be important as a signal (Choi and
Levich, 1997, pp.6.20).
From the accountability perspective we can resolve the apparent contradiction. We
resolve the problem if diversity of accounting was not a critical problem for valuing
European companies and therefore was not a barrier to investment, but, as many
European companies were not accountable to their investors their rate of return on
capital did not justify investing in them. Both comments are consistent with this
interpretation. The desire to mechanise the comparison of accounts is consistent with
the critical role this plays in holding management accountable for financial
performance. Similarly, the change in culture signalled by the change to AngloSaxon accounting is the improved accountability it affords. As Choi and Levich
comment, whether firms are managed for shareholders or debt holders, whether
firms are managed for profit maximization and wealth maximization or some other
less transparent target (1997, p.6.20), such as balancing stakeholder interests. The
managers of such European companies may well want to change their accounts to
signal their acceptance of primary accountability to shareholders. This could, as Choi
and Levich imply, be costly to these firms as firms cannot alter their accounting
reporting practices for free (1997, p.6.20). The costs of accountability to
shareholders they identify could be high, they imply, even though they are
unquantifiable political costs: For many European firms, there is not a tradition of
external, or financial reporting versus tax reporting. A second set of accounting
reports could add a layer of confusion. And some may value secrecy and hold
allegiance to debt holders (1997, p.6.20). As we shall see in the following chapters,
one stakeholder group in particular, the workforce, may well feel confused . That is,
may focus on the higher profits in international accounts described as fair and
ignore the lower, more conservative, profits reported in domestic accounts, the
traditional focus of wage negotiations in these countries.
Ludwig Erhard Lectures 2004
20
Choi and Lee (1991) and Lee and Choi (1992) find that UK, German and Japanese
companies pay more on average for US acquisitions. They also find a relationship
with these countries more flexible treatments of purchased goodwill compared to the
US where management must capitalise and amortise it over not more than 40 years.
This is particularly the British option of writing off purchased goodwill against
reserves. This allowed British companies to report higher earnings than under US
GAAP (Weetman and Gray, 1990), and a higher rate of return on capital (Bryer,
1995). As Choi and Levich say, while there are no economically substantive
differences arising from the British treatment of goodwill, Conventional wisdom
says that differences in accounting treatment for goodwill provide an incentive for
British companies to offer more than U.S. acquirors for a U.S. target because future
earnings need not be reduced by the higher price paid (1997, p.6.15). Conventional
wisdom , the views of most non-academic commentators, was right, and fully
consistent with the accountability perspective. From the traditional viewpoint the
absence of the US requirement to amortise goodwill did give the managers of British
companies a competitive advantage . That is, British managers could pay more for
their US acquisitions because they were not accountable for the cost whereas US
managers were. Choi and Lee s analysis showed that the differing goodwill
accounting treatments does explain the larger British merger premia; that British
managers with the most flexibility, paid the most: higher premiums paid by UK
acquirors do appear to be associated with not having to amortize goodwill to
earnings . As they conclude, consistent with the accountability perspective, This
finding suggests that national differences in accounting do impact managerial
behaviour in the market for corporate control (1997, p.6,16). Choi and Lee repeat
their analysis for German and Japanese companies, also active acquirors of US
companies. Goodwill is deductible from taxable income in Germany and Japan
(unlike the US and UK). For these countries they also found higher merger premia
compared with those paid by US acquirors. Although relative tax benefits partly
accounted for the results, Regression analysis again showed that goodwill
accounting does explain merger premiums (Choi and Levich, 1997, p.6.16).
Germany allowed the most favourable accounting treatment and these companies paid
higher premia than Japanese acquirors.14
(d) Smoothing earnings
As Pownall and Schipper say, a consistent result is earnings of firms in some
countries are smoother than are earnings of firms in other countries (1999, p.276).
They reference evidence showing, for example, that For three-quarters of th[eir]
variables, Australian firms standard deviations are the highest of the seven countries
[studied], and Japanese firms standard deviations are the lowest . Another study
finds evidence consistent with both German and French firms managing their
earnings to a greater degree than do U.S. firms (Pownall and Schipper, 1999, p.277).
Other work is consistent with greater earnings management in the UK compared to
the US. These differences are consistent with different levels of accountability
demanded by different accounting systems. Whether the differences result from
differences in rules or differences in the way management operationalises them is, as
14
Dunne and Rollins (1992) and Dunne and Ndubiza (1995) report similar results. See, however, the
criticisms of Nobes and Norton (1997) which are cutting but not fundamental. See the reply in Lee
and Choi (1997).
Ludwig Erhard Lectures 2004
21
Pownall and Schipper say, a fruitful area of academic inquiry (1999, p.279). We
look in some detail and differences in rules in following chapters.
(e) The governance premium
If investors do not get objective accounts, we might expect them to nevertheless pay
more for companies that guarantee their accountability to shareholders in other ways.
According to research by McKinsey, the consulting firm, the World Bank and the
Institutional Investor magazine, just such a governance premium exists:
Investors will pay large premiums for companies with effective boards of
directors, particularly in countries where financial reporting is poor.
[For
example, I]nvestors were prepared to pay premiums of up to 30 per cent for
companies that had a majority of independent outside directors (Financial
Times, June 20 2000).
Investors also favoured companies where directors held significant shareholdings,
paid themselves in share options, and subjected themselves to formal evaluation.
While in the US and UK investors will pay around 18 per cent more than the average
for well governed companies, in Asia and Latin America they will pay much more. In
Indonesia, Venezuela and Colombia they will pay 27 more, and in Thailand and
Malaysia 25 per cent more. As Mr Coombs of McKinsey said:
In Asia and Latin America, where financial reporting is both limited and of
poor quality, investors prefer not to put their trust in figures alone. They
believe their investments will be better protected by well-governed companies
that respect shareholder rights. In Europe and the US, where accounting
standards are higher, the relative performance of corporate governance is
lower (Financial Times June 20 2000).
Consistent with the accountability hypothesis, Classen et al (2002) find that
concentrated control in East Asia diminishes firm value indicating low levels of
accountability, whereas in wealthy Western countries, La Porta et al (2002) find that
firm s with higher concentrations of ownership by controlling owners increased
value. With less accountability, high concentrations of ownership is dangerous to
minorities because management can divert wealth to the owners; with effective
accountability, high concentrations of ownership means the controlling owner s
incentive to increase wealth also benefits the minority.
Conclusions
The evidence available suggests the international harmonisation of accounting is
unnecessary to improve the efficiency of the international capital markets. That is, to
provide international investors with more useful information for investment decisionmaking. Choi and Levich say we can safely assume that most managements have
favorable intentions toward shareholders and wealth maximization (1997, p.6.20).
If we can assume this, as firms can choose to provide additional disclosure and
translations to Anglo-Saxon GAAP, it follows that firms that do this have weighed the
Ludwig Erhard Lectures 2004
22
additional costs and benefits to investors and that in their particular environments an
optimal level of financial reporting currently exists:
Given that corporate issuers have a natural incentive to provide accounting
information that attracts foreign investors and that both issuers and investors
have developed a variety of mechanisms to facilitate communication, the
burden to issuers in having to comply with yet another layer of mandated
accounting and reporting requirements is likely to outweigh the benefits to the
wider market (Choi and Levich, 1997, p.6.24).
However, if the favourable intentions of continental European and Japanese
managements towards shareholders cannot be assumed - the starting point of the
accountability perspective - then it cannot be assumed that the potential costs of
international harmonisation outweigh the potential benefits to international investors.
This, at least, provides a coherent explanation for the unswerving drive of the
international capital markets, the accounting profession and the IASB for IAS.
We argued in this chapter that the evidence is consistent with the accountability
hypothesis. That is, that the purpose of international harmonisation is to improve the
accountability of the managements of firms from countries that allow or promote
conservative accounting - to abolish or significantly reduce the income-smoothing it
currently allows their managements. In chapter 5 we reinforce this conclusion with
evidence that the cause of this difference in international accounting is different
systems of corporate governance . Many argue that the cause of differences in
corporate governance is differences in culture . However, we argue different
systems of corporate governance are the product of differences in the historical
development of the capital markets that create different systems of accountability.
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