Financial Reporting Quality in International Settings A Comparative Study of The USA Japan Thailand France and Germany - 2010 - The International Journal PDF

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The International Journal of Accounting 45 (2010) 1 34
Financial reporting quality in international settings: A

comparative study of the USA, Japan, Thailand,
France and Germany
Asheq Rahman a,, Jira Yammeesri b , Hector Perera c
a
School of Accountancy, Massey University, Auckland, New Zealand
b
School of Accountancy, University of the Thai Chamber of Commerce, Bangkok, Thailand
c
Department of Accounting and Finance, Macquarie University, Sydney, Australia
Abstract
The purpose of this study is to show the importance of the business contexts of individual
countries to understand corporate accounting practices in international settings. Using data from five
countries, we show that while agency theory constructs are effective in explaining accounting
practices in corporate settings that have a strong agency orientation, such as that of the United States,
it is necessary to go beyond such constructs to understand accounting practices in other corporate
settings. Given the variety of international business settings, we use a generic theory, institutional
theory. To conduct this examination into cross-country accounting practices, we focus on an
earnings quality measure based on accrual accounting practices, the abnormal accruals component of
accounting earnings. We provide evidence to support the view that with varying business settings we
are likely to see diversity in accounting practices that result in different levels of accruals or accruals
based earnings quality.
2010 University of Illinois. All rights reserved.
Keywords: Agency theory; Financial reporting quality; USA; Japan; Thailand; France; Germany
1. Introduction
Agency theory is frequently used by researchers to explain accounting practices in

country-specific studies. It explains accounting practices in corporate settings that have a
Corresponding author. Tel.: +64 9 414 0800.

E-mail address: a.r.rahman@massey.ac.nz (A. Rahman).
0020-7063/$ - see front matter 2010 University of Illinois. All rights reserved.
doi:10.1016/j.intacc.2010.01.001
2 A. Rahman et al. / The International Journal of Accounting 45 (2010) 134
strong agency orientation as it is based on the notion of separation among ownership, debt,
and management. For example, studies focused on the United States usually support the
agency argument that certain firm and board features, and good quality accounting1 and
auditing are the bases for better firm performance. However, in international settings,
similar studies have often produced contradictory results. For example, Gabrielsen,
Gramlich, and Plenborg (2002) find that managerial ownership (an agency variable) has
different effects on the information content of earnings and discretionary accruals in
Denmark from that in the United States. Further, in a review of audit independence,
discretionary accruals, and earnings-informativeness studies, Rainsbury (2007) finds that in
many non-U.S. settings agency monitoring mechanisms such as board of directors,
accounting arrangements, and audit quality do not relate to discretionary accruals and
earnings informativeness in the same manner as they do in the US setting.
Agency theory originated in the environment of growth of large modern corporations in
Anglo-American countries. It mainly focuses on exogenous factors that relate to financing.
However, the business settings internationally are diverse in characteristics. The purpose of
this study is to emphasize the need to go beyond the agency theory constructs to explain
accounting practices in international settings and to propose the use of a generic and all-
encompassing theory, institutional theory, which is applicable to all international settings,
with or without strong agency orientation. Institutional theory allows for the examination of
all exogenous and endogenous factors that affect corporate practices.
We do not see, however, agency theory and institutional theory as mutually exclusive.
Rather, we see agency theory as a theory that is applicable to an institutional setting where
the agency relationships among ownership, debt, and management are clearly explicable. In
other words, agency theory constructs are better applicable to explaining corporate actions
in settings where there is clear separation among ownership, debt, and management. On the
other hand, institutional theory is a more general theory that calls for an appreciation of any
form of institutional arrangement prevailing in business.
Institutional influences on accounting have been observed in the extant literature. For
example, Ball (1995) and Nobes (1998) contend that accounting systems and the level of
market transparency are functions of the nature of the legal systems and financing of firms
in a country. This view has been broadly assessed in terms of whether a country has a code-
law or a common-law legal origin, or whether a country has a debt-based or an equity-based
capital market (Ball, Kothari, & Robin, 2000; Ali & Hwang, 2000; Ball, Robin, & Wu,
2003). However, it only provides a general understanding of how accounting is related to
law and finance and lacks appreciation of the specific nature of country settings and their
influence on accounting practices in international settings. For example, Ball et al. (2003)
find that the timeliness of accounting income in four East Asian common-law countries is
similar to the timeliness of accounting income in code-law countries, suggesting that there
are other factors affecting accounting income.
The financial and organizational settings of countries are far more complex than what the
legal and financing dichotomies reflect. For East Asian countries, Fan and Wong (2002)
find that concentrated ownership and the associated pyramidal and cross-holding structures
1
For the purposes of this study, accounting quality is defined as the extent to which accounting indicators are
reliable measures of firm performance.
A. Rahman et al. / The International Journal of Accounting 45 (2010) 134 3
create agency conflicts between controlling owners (insiders) and outside investors,
whereby, controlling owners report accounting information for self-interest purposes. Their
explanations of high concentration and tightly controlled hierarchies suggest that firms in
East Asia do not display separation of ownership and control. In addition, finance and
management literatures suggest that there are systematic variations between countries with
regard to organization of firms, which in turn affect managerial and market behavior
(Gilson & Roe, 1993; Shishido, 1999). These firm-level idiosyncrasies that exist across
many firms in a country often arise from country level institutional idiosyncrasies. For
example, in the case of countries with weak shareholder protection, major shareholders tend
to attempt to protect their own interests at the expense of other shareholders through
majority ownership or other control measures.
Using samples of firm-year observations from the United States, Japan, Thailand,
France, and Germany, we show that because institutional variables such as organizational
structures, ownership structures, nature of debt, and regulations vary systematically
between countries, the agency variables of equity and debt affect accounting quality in each
country differently. In this regard, we find that the agency expectations of how financing
affects accounting quality hold only in certain settings. In other settings, the effects of
financing variables depend on the nature of the institutional variables. We use a broad
accounting-practice variable, the level of abnormal accruals, to assess accounting quality in
each country. We partition debt into long-term and short-term components, as these
components are likely to have different influences on abnormal accruals.
The United States is chosen as one of the sample countries because the institutional
setting of its firms resembles the setting depicted in agency theory, which suggests a clear
demarcation between the interests of equity providers, creditors and managers. Most of the
prior literature dealing with financing and accounting issues is based on the agency
framework. Japan is chosen because its business setting is dominated by a unique business
form called the keiretsu. The keiretsu is a group of firms interrelated through debt and
equity financing by a central keiretsu bank, cross-shareholdings between keiretsu member
firms and operating links between the keiretsu firms. Thailand also provides a unique
business setting with its family-owned businesses and high short-term debt dependence.
France has its own idiosyncrasies with firms having high blockholder concentration and
high debt financing complemented by regulations that require better disclosure when debt
levels are higher. Germany also has high block ownership in firms, but has less debt
financing than France, and its debt financiers participate in the governance of firms and are
heavily protected by bankruptcy laws.
An important contribution of this study is that it provides insights into how organi-
zational, financial, and regulatory factors that are peculiar to a country interact and affect
accounting practices. Such insights can help policy makers and external users of financial
information understand how firms in different countries may adopt international financial
reporting standards (IFRS). Researchers can also benefit as our study cautions them of
about the use of agency theory constructs where the institutional settings of the firms and
their environments are different from the settings depicted in the agency theory literature.
The remainder of the paper is organized into five sections. The second section lays down
the theoretical basis of the study. The third section develops the hypotheses. The fourth section
specifies the research design. The fifth section provides the results. The sixth section presents a
discussion and an analysis of the results. The final section includes the conclusions, limitations
and implications of this study.
2. Theoretical basis
Agency theory was developed by Berle and Means (1932) for a corporate setting with a
clear separation between ownership and control. Its central issue is how to resolve the
conflict between owners, managers, and debt holders over the control of corporate
resources through the use of contracts (Simerly & Li, 2000). An unambiguous separation of
ownership and control of firms is not common in many countries. Agency theory doesn't
take into consideration corporate environments that have no discernible separation between
ownership and control, nor does it consider that managers might have to make choices from
a perspective other than maximizing wealth for stockholders.
According to Simerly and Li (2000), organizations match the demands of their
environment with management and organizational systems in order to survive and succeed.
They argue that management and organizational systems most appropriate for any given
firm will be a product of the specific set of environmental contingencies being faced by the
firm. Similarly, the choice of capital structure is less a matter of predefined alternatives and
more a search for alternatives in a complex and uncertain environment in which the firm
exists. The choice of managerial and organizational systems and the capital structure, in turn,
affects accounting practices of firms within a particular corporate environment. Prior studies
have shown that various forms of organizational and capital structures exist outside the
Anglo-American countries (Fan & Wong, 2002; Nagano, 2003; Booth, Aivazian,
Demirguc-Kunt, & Maksimovic, 2001; Antoniou, Guney, & Paudyal, 2008). This suggests
that there is a need for a more generic theoretical model to explain accounting behavior
across countries.
Institutional theory offers a generic framework to analyze corporate practices. It
provides insights into how an organization functions in its environment, and allows for an
explanation of the relationship between organizational practices and its environment. Its
premise is that organizations adopt or adapt to institutional norms and rules to gain stability
and enhance survival prospects. Through the processes of adoption and adaptation the
institutional norms and rules impact the positions, policies, programs, and procedures of
organizations (Scott, 2004).
One common question addressed in institutional theory is what makes organizations
so similar in a country? Meyer and Rowan (1977) and DiMaggio and Powell (1983)
observe that business practices arise mainly from three types of pressures in an institutional
environment, coercive, mimetic and normative. Coercive pressure comes from govern-
mental regulations; mimetic pressure happens when organizations embrace the system of
the existing institutions in their field; and normative pressure occurs when organizational
administrators intuitively follow the conventional practices. They conclude that rational
individuals make their organizational structures, functions, and operations increasingly
homogeneous not necessarily to increase efficiency but to meet social expectations or to be
socially acceptable.
Institutional theorists point out that all social systems, hence all organizations, exist in an
institutional environment that defines social reality and that, just as with technical environments,
institutional environments are enormously diverse, and variable over time (Scott, 2001).
Institutional Theory proposes that organizations are affected by common understandings of
what is appropriate and, fundamentally, meaningful behavior (Zucker, 1983, p.105).
Accordingly, Institutional Theory advocates that organizational structures and processes are
moderated by the institutional environment (Lincoln, Hanada, & McBride, 1986, p.340).
Institutional theory, therefore, is capable of explaining organizational behavior in any
setting, whereas, agency theory deals with the setting of separation between ownership and
control. In other words, institutional theory can explain why businesses have similar
organizational structures and cultural elements within a particular socio-cultural setting,
even though they are separate entities, and, in turn, can explain why the features of an
organization in a particular setting are different from those of another. Agency theory is a
theory of a particular institutional setting, the setting where ownership is separate from
control, whereas institutional theory is a generic theory intended to identify and explain the
features of organizations in any setting. From these features arise the actions of
organizational actors, which include accounting, control, and other review practices of
organizations (Scott, 2004). This is consistent with Zucker (1983) who points out that the
institutional setting exogenous to the firm and the endogenous setting within the firm
coexist. Likewise, one can argue that firm-specific practices, such as accounting practices,
are continuously responding to or are influencing the institutional setting of the firm.
3. Hypotheses development
Prior literature in international financial accounting has linked the quality of accounting
parameters to the nature of country level institutional arrangements. Ball et al. (2000), Ali
and Hwang (2000) and Ball et al. (2003) attribute the differences in institutional systems to
the legal origin of, and the nature of corporate finance in a country. Their evidence suggests
that in countries where companies depend more on debt finance than on equity finance, or
in countries which have code law (compared to common law), the quality of accounting in
companies is relatively inferior. Leuz, Nanda, and Wysocki (2003) also provide similar
conclusions in their study on earnings management across countries.
The broadly framed analyses based on country level legal or financing variables have
limited explanatory power. There exists a variation in accounting quality within the broad
groups of countries. For example, Ball et al. (2003) find that the East Asian common-law
countries do not have levels of accounting conservatism similar to those of the other
common-law countries. Leuz et al. (2003) find that common-law countries like Singapore
and Hong Kong have high, aggregate earnings-management scores similar to those of code-
law countries such as Germany and Japan. Additionally, Graham and King (2000) find that
methods of differentiating accounting practices of countries using accounting-regulation
differences also lead to inconclusive results. On the other hand, country-specific studies,
such as Fan and Wong (2002) provide interesting country-based explanations, but they
cannot typify differences of accounting practices between countries because they do not
attempt to draw comparisons.
An examination of variations in accounting practices between countries requires scrutiny
of features specific to a country rather than the broad features, and an evaluation of how the
specific features cause accounting practices to be different across countries. It is important to
6
Table 1
Institutional settings and the role of external financial reporting in the USA, Japan, Thailand, France and Germany.
Country Institutional arrangements Role of main Usefulness Intent Effect of
financiers in of external and monitoring
Organization Regulation Financing components' proportion of
monitoring the firm financial capacity of quality
total assets (Avg. 1994 to 2005)
reports to of major of external
major financiers financial
financiers to reports
monitor (effect on
external |AA|) a
financial
reporting
quality
USA Public 1. Corporate law and accounting Public equity 0.564 External High High Positive
rules have equity focus (negative)
2. Accounting has no tax focus Long-term public (bond) debt 0.182 External High High Positive
(negative)
Private short-term (bank) debt 0.042 Minimal external Low Minimal None
A. Rahman et al. / The International Journal of Accounting 45 (2010) 134
Japan Keiretsu Corporate law and accounting rules Bank and group equity 0.459 Internal Low Minimal Negative
have equity focus (US based) (positive)
2. Accounting has tax focus Long-term bank debt 0.124 Internal Low Minimal Negative
(positive)
Private short-term (bank) Debt 0.157 Internal Low Minimal Negative
(positive)
Thailand Family 1. Corporate law and accounting rules Private equity 0.470 Internal Low Minimal None
are generally weak, but improving after Private long-term debt 0.153 Internal Low Minimal None
Asian financial crisis
2. Accounting has tax focus Private short-term (bank) debt 0.234 Internal and External High High Positive
(negative)
France Blockholder 1. Corporate law and accounting rules Bank and block equity 0.308 Internal Low Minimal Negative
have creditor and social focus (positive)
2. Accounting has tax focus Private long-term debt 0.152 External High High Positive
(negative)
Private short-term (bank) debt 0.105 External High High Positive
(negative)
Germany Blockholder 1. Corporate law and accounting Bank and block equity 0.332 Internal Low Minimal Negative
rules have creditor and employee focus (positive)
2. Auditing requirements are graduated Private long-term debt 0.121 Internal Low Minimal None
by firm size.
3. Accounting has tax focus Private short-term (bank) debt 0.088 Internal Low Minimal None
a
|AA| = absolute value of abnormal accruals. High abnormal accrual means low earnings quality.
7
note that the reporting incentives of firms are shaped by institutional environments of
countries (Soderstrom & Sun, 2007). Accordingly, we adopt the precepts of institutional
theory and examine how the different institutional settings of firms in five countries bring
about different accounting practices in these countries. The countries chosen are the United
States, Japan, Thailand, France, and Germany.
USA: The U.S. institutional setting of firms has been intricately captured through
extensive agency theory-based research literature (Eisenhardt, 1989). The U.S. firms bear
the hallmarks of a Berle and Means setting, whereby, due to the separation between
ownership and control, clear observations can be made about the relations among equity,
debt, and management (see Table 1). Furthermore, U.S. capital-market financing is equity
based (Ball, 1995; Nobes, 1998). Tables 1 and 2 show that between 1994 and 2005 57.1% of
U.S. corporate financing came from widely dispersed public equity.
Williamson (1988) argues that different financing arrangements, i.e., debt and equity, result
in different governance structures. He explains that debt has its own governance rules
specified by its financial contract, which reduce uncertainties for the debt providers. Equity
has weak contractual governance mechanisms, which could create uncertainties for the equity
holder. Therefore, equity holders would expect better quality accounting for monitoring of
firm performance. In this respect, equity holders expect earnings to be of higher quality so that
they can receive their due share of firms' surpluses for the year. This is the main reason why
public equity providers would demand high quality accounting practices, internal control, and
external audit. The U.S. market has experienced over time many coercive regulatory measures
in the form of securities laws and stock exchange regulations to protect the interests of the
equity providers. Therefore, we hypothesize for U.S. firms that:
H1a. There is a positive association between external reporting quality and the level of
common equity.
Debt in the U.S. market is mainly long-term public debt in the form of bonds
(Limpaphayom, 1999). Table 1 shows that between 1994 and 2005, on average, 18.2% of
Table 2
Sample firm-year observations.
Period USA Japan Thailand France Germany
1994 105 23 87 158 252
1995 1020 24 115 230 283
1996 1074 1045 122 295 324
1997 1110 1171 147 396 392
1998 1154 1237 222 392 426
1999 1182 1289 215 398 466
2000 1230 2785 205 446 570
2001 1265 3059 193 538 604
2002 1290 3161 204 499 637
2003 1305 3216 227 451 535
2004 1310 3255 246 464 565
2005 1317 3329 259 437 498
Total 13,362 23,594 2242 4704 5552
U.S. corporate financing came from long-term debt. Long-term debt in the U.S., e.g., bonds, is
issued publicly and managed by financial institutions in the interest of the debt providers. This
arrangement provides for robust monitoring of firms by external financiers, and accounting is
often the chosen device for monitoring. In an agency setting such as that of the U.S., where
most financing is from public equity providers, managers (agents) tend to favor equity holders
(principals) through higher earnings and dividends. In this setting, the public long-term debt
providers tend to secure their debts with long-term assets. The long-term debt contracts also
have other means of controlling opportunistic behavior by managers. The long-term debts
issued publicly are monitored by trustees, who expect managers to focus on activities that are
necessary to ensure debt repayments (Simerly & Li, 2000). Trustees use debt covenant, often
based on accounting numbers in their trust deeds, to monitor firms. Companies failing to meet
debt covenant requirements are likely to be declared insolvent. Trustees monitor financial
reports of borrowing firms to ensure that earnings are not manipulated. The presence of the
monitoring pressures could be regarded as normative pressures. While legal provisions to
protect creditor rights are present, the U.S. has a system of financial institutions designed to
protect the interests of the debt providers, which obligates companies to provide good quality
accounting information. Accordingly, we also hypothesize for U.S. firms that:
H1b. There is a positive association between external reporting quality and the level of
long-term debt.
As for short-term debts in the U.S., these are often secured against unencumbered
physical assets of the business or guarantees from principals. The interest and repayment
arrangements are tied to the operating cash cycle of firms. Lenders normally charge a higher
base rate of interest and favor businesses that have strong management, steady growth
potential, and reliable projected cash flow (McGuire & Dow, 2002). Given the short-term
nature of such debts and the more secure features, including private monitoring devices,
these debts require less public scrutiny through periodic reporting. Furthermore, U.S. public
corporations have low levels of short-term debts. Table 1 shows that between 1994 and
2005, only 4.2% of U.S. corporate financing came from short-term debt. Finally, we
hypothesize for US firms that:
H1c. There is no association between external reporting quality and the level of short-term debt.
Japan: Agency theory has had limited results in explaining the Japanese organizational
system (McGuire & Dow, 2009). Most Japanese firms are located in organizational groups
called keiretsu. The keiretsu firms are governed by a main bank and are generally financed
through both debt and equity. The companies of a keiretsu have cross-holdings in other firms
within the kereitsu. They also often have vertical and horizontal integration of business
activities with firms within the kereitsu (McGuire & Dow, 2002). Institutional theory can be
applied to explain the evolution of keiretsu organizations. Institutional theory views that
pressures for legitimacy drive firms to maintain structures, processes, and procedures although
they may depart from what would otherwise be dictated by economic rationality. Institutional
forces have traditionally supported keiretsus. Keiretsus are congruent with broader Japanese
cultural values toward cooperation and collectivism (McGuire & Dow, 2009). We use the
institutional analysis of keiretsus to assess the nature of their accounting practices.
In a collectivistic society such as Japan's, keiretsu has been a very successful business
form.2 The interdependencies of keiretsus have led to efficient business practices such as
just in time manufacturing. The keiretsu companies are known to weather the pressures
of business cycles collectively, and takeovers are not often the means of correcting
inefficiencies (Gilson & Roe, 1993). In times of crisis, keiretsu main banks may intervene
in the operations of a company to ensure its continued existence (Gilson & Roe, 1993).
Keiretsu interrelated ownership also acts as a safeguard against hostile takeovers (Shishido,
1999) and collapses (McGuire & Dow, 2009). Although these safety nets are known to be
important for the effective operation of keiretsu form, it has also been regarded as the
reasons for the Japanese banks' lack of action against nonperforming loans (Herr &
Miyazaki, 1999). The banks' involvement in both debt and equity make their agency
relationship with companies complex, particularly in times of corporate failures. In other
words, the members of keiretsus are not distinct entities, but are parts of a wider family of
firms (Gilson & Roe, 1993; McGuire & Dow, 2009). The banks themselves and other
keiretsu partners own substantial amounts (23%42%) of shares in the keiretsu member
firms (McGuire & Dow, 2009). The monitoring by the debt providers of managers working
in the interest of equity providers, as in the Berle and Means agency setting, is likely to fail
in keiretsus. Also, keiretsu partners help weaker firms level-off their losses (McGuire &
Dow, 2009). To make matters more complex, keiretsu firms also have operational
relationships with firms of other keiretsus. Such relationships can further stifle the
relevance of accounting information as these firms are likely to have inside information.
Inside information by both the keiretsu partners and the outside affiliates lowers the
relevance of publicly disclosed earnings information.
Japanese companies have been facing challenging circumstances since the early 1990s
(Gilson & Roe, 1993; McGuire & Dow, 2009). Since most investors and investees are
members of the same group of firms and their operations are linked, the investors' demands
for high quality accounting information can be relaxed when the investee firms face
difficult circumstances such as a recessionary conditions.
The main keiretsu banks and kereitsu partners have private knowledge of the activities
of the keiretsu firms (McGuire & Dow, 2009). A large source of corporate finance in Japan
is debt. Table 1 shows that on average 28.1% of the financing between 1994 and 2005 came
from debt, 12.4% of which was long-term debt and 15.7% was short-term debt. Most of
those debts are acquired from the keiretsu main banks (Gilson & Roe, 1993; Shishido,
1999; Miyajima & Arikawa, 2002; Nagano, 2003). Additionally, equity in Japanese firms
often comes from keiretsu sources. Since both equity and debt sources are within the
kereitsu, debt and equity financiers have private access to information about firms within
the keiretsus on an ongoing basis (McGuire & Dow, 2002). Therefore, such financiers rely
less on public information of the firm's earnings and have little reason to monitor the
quality of accounting information in external reports.
In sum, the norm in Japan is that keiretsus are grounded in the idea of group value
maximization rather than maximization of individual interests. Keiretsus have an internal
2
Korea, another collectivistic society, has similar arrangements called chaebols. Chaebols were similarly
successful in the initial phases of development in Korea.
monitoring mechanism that reduces the need for outside monitoring. Also, in recent years
the main keiretsu banks, which are both equity and debt providers, have been demanding
higher rents for their participation and support in providing finance to firms (McGuire &
Dow, 2009). The absence of appropriate market-monitoring mechanisms may lead to the
use of methods of accounting that enhance key accounting numbers such as earnings.
Additionally, profit smoothing to allow firms to deal with the effects of economic
downturns has been an issue in keiretsus (McGuire & Dow, 2009). Leveling is done either
through real-earnings manipulation or through earnings management. Japan has
experienced slow or negative economic growth since the early 1990s. This has increased
the pressure on firms to provide higher earnings and, at the same time, deplete the firms'
capacity to manage real earnings. In these circumstances, firms with higher equity and debt
financing would tend to use higher abnormal accruals to prop up their earnings. This is
likely to motivate them to inflate their earnings using abnormal accruals, especially when
they are facing unfavorable economic conditions and the outside financiers do not have
strong monitoring capacity in a keiretsu-dominant setting. Therefore, we hypothesize for
Japanese firms that:
H2a. There is a negative association between external reporting quality and the level of
equity.
H2b. There is a negative association between external reporting quality and the level of
long-term debt.
H2c. There is a negative association between external reporting quality and the level of
short-term debt.
Thailand: Thailand has an emerging capital market with an emerging regulatory system.
Its institutional setting prior to the Asian financial crisis (AFC) of 1997 was summed up by
the former prime minister of Thailand, Anand Panyarachun, in the following manner:
In our rush to catch up with the West, the lessons we learned from the West and
from our past were incomplete. While the West had evolved checks and balances
to curb the excesses of capitalism, in our exuberance to reap the fruits of capitalism
the need for such mechanisms was unheeded. While transparency and accountability
had long been pillars of public governance in the West, in Asia the webs of power
and money remain largely hidden from public viewWe created a hybrid form of
capitalism where patronage was put to the service of profit-maximization, indeed a
recipe for unbalanced and unsustainable development. (ADB, 1999 p. i)
Because of Thailand's weak judicial and regulatory system, Thai companies are
generally closely owned by families (Alba, Claessens, & Djankov, 1998; Jyoti,
Bunkanwanicha, Pramuan, & Yupana, 2006). Also, Thailand does not have an active
long-term debt market, and as a result, Thai companies have had a high propensity to rely
on short-term debt, even if it is for long-term assets. In the period prior to the AFC, large
amounts of short-term debt were acquired by companies from foreign sources making
themselves vulnerable to risks of currency value fluctuation (Dollar & Hallward-
Drlemeler, 2000). Explaining the risk created by such debt, Limpaphayom (1999) states
that:
In the prelude to the 1997 crisis, short-term private debt obligations grew to about
60% of total private sector debts. The majority of these debts were not properly
hedged. As a result, Thai corporations were collectively overexposed to exchange
rate risks. The fixed exchange rate policy, coupled with financial liberalization and
deregulation in the absence of an effective regulatory and supervisory system,
magnified the impact of these problems on the economy when the crisis hit. (p. 229).
Limpaphayom (1999) explains the borrowing situation in the following manner:

Companies generally issued short-term debt instruments like promissory notes or
bills of exchange. Investors had limited knowledge of debt instruments. A turning
point of the corporate debt market was the enactment of the SEA (Securities and
Exchange Act) of 1992, which encouraged limited companies and public companies
to issue debt instruments. Four years after the passage of the SEA, the size of the
corporate debt market rose to Bhat 132.9 billion. (p. 225).
In post-AFC Thailand, regulatory measures were put in place to improve accounting

practices and attention was paid by both local and foreign regulators on the excessive use of
short-term foreign debt to finance long-term projects. According to Metzger (2004), the
SEC of Thailand reviewed the accounting principles and practices for listed companies to
bring them in line with international best practices. Tougher requirements were put in place
for improving financial reporting (including disclosure of external liabilities and off-
balance-sheet liabilities). Further, all listed companies were required to establish audit
committees comprised of independent directors.
While regulatory shortcomings and short-term debt have been highlighted in the
literature explaining the accounting practices in Thailand recently, a major feature that is
likely to drive accounting in that country is family control. Family control and long-term
debts from banks related to families is a dominant feature of Thai corporate finance and
governance arrangements (Jyoti et al., 2006). With the dominance of closely held family
firms, we expect neither the level of equity nor the level of long-term debt to have any
significant effect on the quality of externally related financial information. Ball et al. (2003)
point out that more extensive family or other networks reduce the demand for accounting
transparency and timely public disclosure. The family-controlled firms, they believe, have a
preference for internal funds and bank loans over public equity and debt because the
families do not want to lose control over their businesses. This they argue reduces the
expected costs arising from stockholder and creditor litigation concerning alleged losses
arising from untimely disclosure.
Ball et al. (2003) further explain that the predominance of networked family business
groups is due to less developed capital, labor, and product markets. These groups, they argue,
are alternative contracting systems with low contracting costs for insiders. They also contend
that another factor that reduces the need for public disclosure in Southeast Asian countries is
the prominence of banks as suppliers of capital. To strengthen family control, the banks are
often controlled by the families that control the family groups (Bunkanwanicha, Gupta, &
Wiwattanakantan, 2007; Bertrand, Johnson, & Schoar, 2004). Therefore, we hypothesize for
Thai firms that:
H3a. There is no association between external reporting quality and the level of equity.
H3b. There is no association between external reporting quality and the level of long-term debt.
Table 1 confirms that, relative to the U.S. firms, Thai firms have higher levels of short-
term bank debt (23.4% of total assets as compared to 4.2% for the U.S. for the years 1994 to
2005). Excessive use of short-term debt for long-term activities receives close attention
from commentators and financiers (Metzger, 2004). Long-term debt is scarce in Thailand
(Alba et al., 1998). For the period 1994 to 2005, 15.3% of the total assets have been
financed using long-term debt as compared to 23.4% for short-term debt (Table 1). Since
short-term debt continues to be significant financing source and it has been receiving
considerable scrutiny, we expect such a source to influence the quality of external reporting
of Thai firms. It is likely that Thai firms that have higher short-term debt produce better
quality external information. Therefore, we also hypothesize for Thai firms that:
H3c. There is a positive association between external reporting quality and the level of
short-term debt.
France: France's institutional setting is made up of firms that have high blockholder
concentration in company shares countered by regulations that have a creditor and social
focus. According to Van der Elst (2004), more than 70% of French companies have at least
one blockholder holding over 25% of the company's shares and more than half of the
companies have a majority shareholder (holding above 50% of shares). Additionally, while
French firms are known to have high levels of debt relative to equity (more than a 2 to 3
ratio of debt to equity as opposed to about one-third for the U.S., Table 1), they have
significant amounts of reserves and provisions that are under the control of the blockholders
of shares. While the requirements to provide for provisions and reserves can counteract
against opportunistic behavior of the blockholders, the ability to be opportunistic can
increase with the level of equity financing. The level of equity gives control to the insiders
to manage earnings opportunistically to attract minority shareholders and expropriate their
wealth, and also allows the insiders to monitor their interests in the firm.
France has a conservative approach to regulating business activities, including
accounting. It follows a codified regulatory system whereby its accounting system is part
of a wider national code. At the business level, this code tends to safeguard the interests of
the creditors and the society at large. The accounting rules, within the codified business
rules, demands conservative practices. Moreover, corporate accounting in France is closely
associated with French taxation procedures. This provides fewer opportunities for
manipulating accounting numbers. In spite of the conservative measures, because of the
presence of blockholders, control can be established by insiders to manage earnings
opportunistically. Since blockholding is quite common in companies of all sizes, the
tendency to manage earnings will be higher in firms with higher levels of equity (larger
equity firms are likely to have more minority shareholders). In this respect Goyer (2003)
notes that French companies maintain various practices such as earnings management that
effectively disenfranchise minority shareholders, allowing them to raise capital without

losing control of the firm. Therefore, we hypothesize for French firms that:
H4a. There is a negative association between external reporting quality and the level of
equity.
Debt financing is a major source of company financing. As shown in Table 1 about 25%
of financing of French firms is directly from debt. Banks are allowed to hold company
shares and be represented on a company's board. Although such arrangements should result
in internal monitoring of company activities and finances, which should not require better
quality external reporting, the French regulatory system requires better accounting
disclosures to protect the interests of the creditors and debt providers. Furthermore, the
larger the firm the greater is the stringency of the auditing requirements. In France, the debt
providers are regarded as an external source of funds, whereas the equity providers are
regarded as own funds (Friderichs, Paranque, & Sauve, 1999). To protect the interests of
the debt providers, the French laws also require significant amounts of provisions and
reserves, and requires a better accounting practices when the debt levels are high (Friderichs
et al., 1999). There seems to be no distinction made between long-term and short-term debt.
Likewise, we also hypothesize for French firms that:
H4b. There is a positive association between external reporting quality and the level of
long-term debt.
H4c. There is a positive association between external reporting quality and the level of
short-term debt.
Germany: In Germany, at the outset the accounting institutional setting looks similar to
that of France. However, it has its own peculiarities as well. Blockholding of shares is very
high and prevalent across firms of all sizes. Among the Western European countries, its
blockholder control is second only to France. The most important blockholders are other
business enterprises followed by families and then the large banks (Schmidt, 2003).
German companies have blockholder concentration in excess of 50%, giving the
blockholders veto rights (Schmidt, 2003; Van der Elst, 2004). Such a capacity allows
controlling shareholders to manage earnings opportunistically if the level of equity is higher
relative to other forms of financing. This is perhaps why German firms with higher
blockholder concentration report higher earnings (Schmidt, 2003). It can be argued that
when insiders control the firm they are in a position to manage earnings to portray a better
performance profile of the firm. Accordingly, we hypothesize for German firms that:
H5a. There is a negative association between external reporting quality and the level of equity.
Unlike in France, the amount of debt relative to equity is low and debt providers maintain
ownership and board representation in Germany (Friderichs et al., 1999). Germany has a two
tier system of governance with two governing boards. The overall governing board is the
supervisory board which has representation from shareholders, employees and debt holders
(also known as co-determination: Schmidt, 2003). The second board, the management board,
conducts the day-to-day activities of the firm (Schmidt, 2003; Altana, 2008). The presence of
debt providers in the supervision of the firm and their ability to be a significant part of
ownership enables them to have private access to company information. German bankruptcy
legislation guarantees creditor protection interests (Friderichs et al., 1999). Protection of the
debt provider is also an important goal of the German legal arrangements.
Furthermore, historically German law has provided for stricter audit requirements (Shiobara
& Inoue, 2001). Within Germany, the supervisory board, not the management board, is
responsible for auditing (Leuz & Wstemann, 2003). As supervisory boards often have
members who are debt providers, such external audits are expected to highlight the interests of
the debt providers. Given their capacity to monitor internally, the presence of regulations, and
the low level of debt relative to equity, German debt providers have little need for to use external
financial reports to monitor firms. Likewise, we also hypothesize for German firms that:
H5b. There is a no association between external reporting quality and the level of long-
term debt.
H5c. There is a no association between external reporting quality and the level of short-
term debt.
Akin to the explanations of institutional theory, we note varying pressures in the financial
reporting processes across different countries, not all of which resemble the classic agency
relationships discussed in the agency theory literature. Agency theory assumes a separation
between managerial control, ownership/equity, and debt; and because equity and long-term
debt are generally publicly held in agency settings, e.g., the U.S. S&P1500 firms, we expect
better quality reporting for higher levels of equity and long-term debt. For non-U.S. settings, we
argue that specific organizational, ownership, and regulatory arrangements create different
pressures from those of the U.S. These pressures alter the role of financing sources as monitors
of earnings quality, giving rise to a different set of associations between earnings quality and
forms of financing.
4. Research design
4.1. Research model
An effective way for management to influence reported earnings subtly is to manipulate

accounting policies relating to abnormal accruals. Users of financial reporting data can be
misled into interpreting reported accounting earnings as equivalent to economic profitability
(Fields, Lys, & Vincent, 2001, p. 279). However, accruals can also inform the investors
about future cash flows as they require assumptions and estimates of future cash inflows and
outflows. Estimating accruals requires managerial judgment and prudent accounting
allocations. Callen and Segal (2004) find that accruals are a driver of current stock returns.
Studies such as Francis, LaFond, Olsson, and Schipper (2004) and Boonlert-U-Thai, Meek,
and Nabar (2006), among others, use accruals quality to study earnings quality and view
earnings to be of higher quality if accruals quality is high. Several models of accruals quality
have been developed since Jones (1991). We choose the relatively simple modified Jones
model as stated in Kothari, Leone, and Wasley (2005) without the performance control. We
make this choice for two reasons. First, we have data constraints for Japan, Thailand, France,
and Germany, so a simple model would lead to a better sample size as it would have fewer
variables leading to fewer missing observations. Second, the abnormal accruals of the modified
Jones model provides a reasonable indication of the nature of accounting practice and policy
choice of a firm, and is broad enough to capture the effects of institutional influences on
accounting practice. Haw, Hu, Hwang, and Wu (2004) argue that absolute abnormal accruals
using the Jones (1991) model captures the insiders' tendency to both overstate reported income
to conceal resource diversion and to understate income in good performance years to create
reserves for poor-performance periods in the future. According to them, this measure also
avoids conceptual ambiguity associated with benchmark measures. Benchmark measures, they
believe, do not consider whether the observed results are achieved through income
management, expectations management, or improvement in operations. They further argue
that the unsigned abnormal accrual is the most appropriate measure of earnings management
because it captures the net effect of both income-increasing and income-decreasing abnormal
accrual estimations. Income-increasing abnormal accruals represent management of current-
period income, while income-decreasing abnormal accruals indicate intentions of future
earnings management or a reversal of previous period earnings management. Since we are
interested only in accounting-based earnings management, we use absolute abnormal accruals
as a broad proxy to capture the quality of financial reporting practices.
To compute abnormal accruals, we first determine a firm's total accruals for the year as
the difference between operating cash flows and net income. Then we separate the
abnormal component of total accruals in the following manner:
TAat = Aat1 = a + 1 1 = Aat1 + 2 REVat = Aat1 + 3 PPEat = Aat1 + at

Model 1
where:
TAat total accruals for firm a in year x (income before tax less cash flow from
operations)
REVat revenues for firm a in year x less revenues for year (x 1)
PPEat gross property, plant and equipment for firm a in year x
Aat 1 total assets for firm a in year t 1
at a residual term that captures abnormal accruals.
The inclusion of REVat and PPEat is to account for normal accruals of current assets
and liabilities and the normal aspect of amortization and depreciation expenses that is
dependent on the firm's investment in capital assets, respectively. The residual, i.e., at, is
an estimate of the abnormal accrual of year x for firm a.
Following Kothari et al. (2005), we compute abnormal accruals by year and industry. For
industry, we use single digit Global Industry Classification Standard (GICS) codes instead of
two digit GICS codes used by Kothari et al. (2005) because Thailand, France, and Germany
had too few companies within several two digit codes in some years. Dropping these
companies would reduce the already small sample sizes for each year for these countries, and
would make the samples of these countries different in industry composition from those of the
U.S. and Japan. We identify the following industries: Consumer Discretionary, Consumer
Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials,
Telecommunication, and Utilities. Computation by year is needed to control for
macroeconomic fluctuations that affect firm growth and performance, and computation by
industry is needed because product and cash flow cycles are different in different industries.
Firms having longer product and cash flow cycles are likely to have higher accruals allowing
managers more leeway for manipulating the accruals.
To test the hypotheses, we model the relation between absolute abnormal accruals (|AAt|)
or financial reporting quality and the independent variables in the following manner:
lg j AAt j = + 1 lgEQUITYt + 2 lgLT DEBTt + 3 lgST DEBTt + 4 lgRETt

+ 5 RET SIGN t + 6 lgSIZE t + 7 lgGRWT H t Model 2
where:
lg|AA| log of absolute abnormal accruals (|ax| of Model 1). A higher value means lower
earnings quality. A positive (negative) association with |AA| means a negative
(positive) association with earnings quality.
lgEQUITY log of the ratio common shareholder equity by total assets
lgLT_DEBT log of the ratio long-term debt by total assets
lgST_DEBT log of the ratio short-term debt by total assets
lgRET log of the ratio absolute value of prior-year market return
RET_SIGN sign of prior-year market return
lgSIZE log of end-of-year market value
lgGRWTH log of the ratio market value of equity to book value of equity.
All measures for the above variables are from Global Vantage. lg|AA| is the dependent
variable for all of our hypotheses. lgEQUITY, lgLTDA2A, and lgST_DEBT are the
independent variables. All other variables are control variables. lgRET and RET_SIGN are
employed to control for market-based influences that provide incentives for firms to manage
their earnings. Market euphoria has often been cited as a reason for firms to provide
overestimated earnings numbers to make firm performance impressive relative to other firms
in the market. The return that is used for lgRET is the prior-year return of a firm. In a euphoric
market, firms are likely to attempt to meet the earnings expectation of the market set in the
prior-year returns. Alternatively, they could attempt to improve the current year returns by
enhancing current-year earnings when the previous year returns are low. The magnitude and
sign of annual returns are separated because the absolute value of returns has to be used due
to the use of the absolute value of abnormal accruals as the dependent variable.
lgSIZE captures the effects of missing variables that are related to firm size, e.g.,
corporate governance arrangement arising from the use of better auditors in larger firms.
lgGRWTH is used to control for the influence of growth on abnormal accruals.3 Firms that
3
Growth in the form of REV has been considered while computing |AA| in Model 1. However, REV
captures only short-term growth and not long-term future growth generated by current operations.
have high market value relative to book value are considered as growth firms. They are
likely to have high positive abnormal accruals due to high revenues or high negative
abnormal accruals due to large accrued expenses for probable positive NPV projects.
4.2. Sample and data collection
Our data consist of firm-year observations from 1994 to 2005. We have five samples,
one for the US S&P1500 firms and one each for Japanese, Thai, French, and German firms.
Data were collected from Compustat for the US firms and from Global Vantage for firms in
the other four countries. We collected all firm-year data available from these two databases
for computing our variable measures for the eleven years. In all, we have 13,362 firm-year
observations for US firms, 23,594 for Japanese firms, 2242 for Thai firms, 4704 for French
firms and 5552 for German firms (Table 2). We use S&P1500 firms for the U.S. because
they represent small-cap, mid-cap and large-cap firms, thereby providing a broad sample of
firms with agency settings as depicted in the agency theory literature.
A summary of the sample by countries and years is provided in Table 2. We took all
firm-year observations since 1994. Samples were small for 1994 due to a lack of data. In
particular, cash flow information was absent for many Japanese firms for both 1994 and
1995. According to S&P, the publishers of COMPUSTAT, and GLOBAL VANTAGE,
many Japanese companies did not report depreciation and amortization numbers until 1995.
Cash flow from operations cannot be computed without depreciation and amortization
numbers. Because of the small number of firms for Thailand, France, and Germany, we
reduced the required number of firms for each GICS-year group for computing |AA| to only
five. The required number in most U.S. studies is 15.
5. Results
5.1. Descriptive statistics
The trends of median |AA| of all firms, positive |AA| firms, and negative |AA| firms and
the proportion of firms in these three categories of all five countries for the years 1994 to
2005 are charted in Figs. 15. For the U.S., Fig. 1a shows that the median |AA|s for all firms
are higher in years 1999 to 2000 than 2002 to 2004. The years 2000 and 2001 are regarded
as the dot.com crash years and SarbanesOxley Act was enacted in 2002 and came into
effect in 2004. However, by 2005 the median |AA| started to rise again, which perhaps is a
precursor to the 2008 crash. The median |AA| of the U.S. positive |AA| firms is at a similar
level for all years, while for negative |AA| firms the |AA| dropped slightly after the dot.com
crisis, but then went to similar levels as in 2004 and 2005.
Fig. 1b shows that the number of firms having negative |AA|s exceeds those having
positive |AA|s in the period prior to 2000. This situation is reversed for a brief period in
1999 and 2000. After 2000 the number of negative |AA| firms far exceeds the number of
positive |AA| firms.
Overall, although Fig. 2a and b show that the median |AA|s for all Japanese firms and the
proportion of Japanese firms with positive |AA| were rising gradually, the negative |AA|
medians were declining. The trend was smooth and remained unaffected by the Asian
Fig. 1. a. USA median abnormal accruals. b. USA proportion of companies engaging in positive or negative
abnormal accruals.
financial crisis of 1997 or the US market crash of 200001. This suggests that Japanese
firms do not aggressively manipulate their |AA|s to adapt to market circumstances as the
Thai and US firms do. Additionally, Fig. 2b shows that the number of firms having positive
|AA|s consistently exceeds the number of firms having negative |AA|s in each of the years,
irrespective of the business climate.
Fig. 3a shows that unlike Japanese companies, Thai companies have different |AA|s under
different business circumstances. The median |AA| for all Thai firms and Thai firms with
positive |AA| are relatively higher for the crisis years of 19972002. This observation is
further confirmed by Fig. 3b, which shows that the number of firms having positive |AA|
exceeds the number with negative |AA|s in the 19972002 period. Thailand took a series of
Fig. 2. a. Japan median abnormal accruals by years. b. Japan proportion of companies engaging in positive or
negative abnormal accruals.
steps to improve the state of corporate governance, e.g., it improved the securities law, adopted
IFRS, and increased audit requirements. However, it seems that these actions narrowed the gap
only in 2003. The overall |AA| is reduced in 2003 and the number of firms with positive |AA| is
almost equal to the number of firms with negative |AA|.
The French sample resembles the Japanese sample in one way. Its overall median |AA| is
positive for all the years in our distribution (Fig. 4a), but it is not as steady as the Japanese
sample's |AA| and it peaks in 2002 and 2004. Also, like the Japanese and the Thai firms, the
number of firms having positive |AA| in France is higher than those having negative |AA|,
but the divergence far exceeds that of Japan and Thailand (Fig. 4b).
Fig. 3. a. Thailand median abnormal accruals by years. b. Thailand proportion of companies engaging in
positive or negative abnormal accruals.
As for the German firms, there was a large earnings-management bulge between 2001
and 2005 after a brief period of reduction in 1998 and 1999 (Fig. 5a). The median overall |
AA| peaked in 2003. The same behavior is reflected in Fig. 5b, which shows a swell in the
gap between the number of positive and negative |AA| firms between 2000 and 2004, with
the peak difference occurring in 2003.
Generally, we note that the median |AA|s of firms in the Japanese, Thai French, and
German subsamples are above zero in most years, but it is below zero for most of the years
in the U.S. subsample. Also, the number of firms with negative |AA| far exceeds that with
positive |AA|, in almost all years, while the situation is reversed in Japan, Thailand, France,
and Germany. On whole, the U.S. firms have more conservative accounting practices
Fig. 4. a. France median abnormal accruals by years. b. France proportion of companies engaging in positive
or negative abnormal accruals.
compared to Japanese and Thai firms, a point raised in Ball et al. (2003), and perhaps this
arises from the monitoring influences in an agency setting.
Table 3 provides statistics of how the assets of firms are financed in each of the five
countries under investigation. While the proportion of equity, long-term debt and short-
term debt to assets vary across the 12 years in each country and vary between countries, the
general pattern for each of the items of financing remains similar across time within a
country. For the U.S. S&P1500 sample, equity is the dominant financing source (overall
median = 57.1%), with long-term debt as a distant second (overall median = 15.2%) source
of financing. Short-term debt in the U.S. is a very small source of finance (overall
median = 1.3%). Recall that much of the long-term debt and equity in the U.S. are from
Fig. 5. a. Germany median abnormal accruals by years. b. Germany proportion of companies engaging in
positive or negative abnormal accruals.
public debt sources, so putting them together, we can say that much of the financing of U.S.
firms comes from public sources.
Equity financing of firms in Japan (overall median = 44.5%) is much lower than that of
U.S. firms (overall median = 57.1%), and short-term debt in Japan (overall median = 12.3%)
is a larger source of financing than long-term debt (overall median = 9.2%). The pattern of
financing of Thai firms is similar to that of Japanese firms. Their equity financing has an
overall median of 48%. It is followed by short-term debt (overall median = 16.1%) and then
long-term debt (overall median = 6.7%). The proportion of debt relative to equity in these
countries is higher than that of the U.S. Again recall that most of the long-term financing
arrangements in Japan and Thailand, equity and long-term debt, are from private sources.
France and Germany are very similar to each other in terms of financing. Both have far
less equity financing than the other three countries (France's overall median = 34.2% and
Table 3
Median Equity to Assets, LT_Debt to Assets and ST_Debt to Assets by Years.
Country Financing 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Overall
USA Equity 0.603 0.589 0.596 0.579 0.559 0.539 0.534 0.538 0.553 0.567 0.599 0.594 0.571
LT_Debt 0.126 0.132 0.132 0.141 0.156 0.166 0.166 0.17 0.167 0.167 0.156 0.14 0.152
ST_Debt 0.020 0.017 0.015 0.013 0.015 0.017 0.014 0.014 0.01 0.009 0.008 0.008 0.013
Japan Equity 0.376 0.402 0.381 0.392 0.385 0.403 0.466 0.476 0.492 0.502 0.526 0.539 0.445
LT_Debt 0.136 0.118 0.106 0.099 0.096 0.103 0.088 0.079 0.075 0.071 0.068 0.06 0.092
ST_Debt 0.123 0.13 0.135 0.142 0.142 0.137 0.128 0.123 0.122 0.114 0.095 0.084 0.123
Thai Equity 0.545 0.493 0.46 0.344 0.369 0.425 0.456 0.484 0.527 0.533 0.567 0.56 0.480
LT_Debt 0.046 0.085 0.086 0.116 0.061 0.061 0.073 0.064 0.05 0.046 0.054 0.062 0.067
ST_Debt 0.203 0.222 0.228 0.267 0.238 0.169 0.14 0.1 0.081 0.095 0.096 0.089 0.161
France Equity 0.313 0.325 0.350 0.344 0.360 0.352 0.369 0.341 0.341 0.342 0.336 0.332 0.342
LT_Debt 0.122 0.116 0.116 0.114 0.099 0.098 0.095 0.108 0.114 0.110 0.101 0.103 0.108
ST_Debt 0.076 0.083 0.073 0.057 0.063 0.060 0.063 0.071 0.068 0.067 0.063 0.064 0.067
Germany Equity 0.265 0.272 0.267 0.277 0.289 0.372 0.406 0.381 0.354 0.352 0.362 0.386 0.332
LT_Debt 0.119 0.114 0.135 0.129 0.120 0.108 0.104 0.114 0.123 0.129 0.124 0.135 0.121
ST_Debt 0.080 0.086 0.080 0.086 0.085 0.087 0.089 0.100 0.101 0.102 0.087 0.070 0.088
EQUITY = ratio of common shareholder equity by total assets.
LT_DEBT = ratio of long-term debt by total assets.
ST_DEBT = ratio of short-term debt by total assets.
Germany's = 33.2%). Equity is followed by long-term debt (France's = 10.8% and

Germany's = 12.1%) and then short-term debt (France's = 6.7% and Germany's = 8.8%).
Additionally, recall that debts in France and Germany are financed mainly by banks.
Our statistics confirm that the U.S. market is more equity-based than the markets in
Europe and Asia, and with equity and long-term debt being more from public sources,
managers of U.S. firms are more likely to be pressured by outside financiers to provide
good quality external reports compared to managers in Europe and Asia.
The summary of the descriptive statistics for all variables used in the multivariate
analysis using Model 2 are provided in Table 4. The descriptive statistics of the U.S.
suggest that while the median for all firms (Fig. 1a) is around the zero mark and relative to
the other countries quite stable and low, the mean of |AA| (0.033) is higher than those of
other countries. The mean |AA|s of Japan, Thailand, France, and Germany are 0.011, 0.019,
0.021 and 0.034, respectively. Most of the independent variables, in particular SIZE and
GROWTH, have positive skewness. This is not unusual as there are fewer large firms and
high-growth firms in smaller markets like Thailand, France, and Germany. To be consistent
Notes for Table 4

|AA| = absolute abnormal accruals (|ax| of Model 1).
RET = ratio of absolute value of prior-year market return.
RET_SIGN = sign of prior-year market return.
SIZE = market value of equity.
GRWTH = ratio of market value of equity to book value of equity.
Table 4
Descriptive statistics.
Percentile
Mean Std. Dev. 5 25 75 95 99
USA
|AA| 0.033 0.070 0.000 0.010 0.040 0.100 0.220
EQUITY 0.783 0.176 0.480 0.660 0.950 1.000 1.000
LT_DEBT 0.180 0.158 0.000 0.030 0.290 0.460 0.620
ST_DEBT 0.037 0.070 0.000 0.000 0.040 0.150 0.340
RET% 36.513 273.024 1.000 1.000 41.450 121.150 294.060
SIZE ($ m) 6895.361 23,471.070 130.499 502.425 4152.454 27,028.012 108,719.476
GRWTH 2.798 65.342 0.420 0.910 2.560 6.160 11.870
Japan
|AA| 0.011 0.015 0.000 0.000 0.010 0.030 0.060
EQUITY 0.378 0.193 0.080 0.230 0.510 0.720 0.820
LT_DEBT 0.099 0.099 0.000 0.020 0.140 0.290 0.440
ST_DEBT 0.171 0.132 0.010 0.070 0.250 0.420 0.570
RET% 38.867 59.433 1.900 10.500 47.350 116.560 260.680
SIZE ( m) 92,462.555 452,873.438 1310.878 4388.979 43,891.385 391,127.154 1,315,870.334
GRWTH 1.614 5.726 .292 .570 1.641 4.226 11.032
Thailand
|AA| 0.019 0.025 0.000 0.010 0.020 0.050 0.130
EQUITY 0.531 0.213 0.200 0.370 0.690 0.900 0.950
LT_DEBT 0.119 0.149 0.000 0.000 0.200 0.430 0.600
ST_DEBT 0.172 0.158 0.000 0.040 0.270 0.500 0.610
RET% 51.602 107.659 2.170 11.320 51.480 160.000 528.320
SIZE (B m) 10,559.440 43,716.341 183.000 543.000 3909.000 38,958.000 249,774.000
GRWTH 2.396 13.795 0.390 0.760 1.910 4.820 15.330
France
|AA| 0.021 0.039 0.000 0.010 0.020 0.050 0.140
EQUITY 0.373 0.179 0.110 0.240 0.480 0.690 0.850
LT_DEBT 0.132 0.117 0.000 0.040 0.190 0.360 0.490
ST_DEBT 0.092 0.083 0.000 0.030 0.130 0.250 0.370
RET% 38.244 71.787 2.100 11.120 46.960 97.560 219.360
SIZE ( m) 2427.574 9019.960 6.596 36.622 874.870 11,476.733 45,059.986
GRWTH 3.145 24.944 0.510 1.030 2.820 7.130 19.390
Germany
|AA| 0.034 0.073 0.000 0.010 0.040 0.090 0.320
EQUITY 0.371 0.217 0.070 0.210 0.510 0.790 0.920
LT_DEBT 0.105 0.125 0.000 0.000 0.160 0.350 0.540
ST_DEBT 0.090 0.109 0.000 0.010 0.130 0.320 0.470
RET% 38.079 55.520 1.820 9.850 49.350 102.690 244.140
SIZE ( m) 1977.999 7470.745 6.660 33.200 567.972 10,641.864 35,712.168
GRWTH 4.825 51.735 0.400 1.020 2.880 7.890 28.820
in manner, we normalize the distributions between years and between countries we use log
transformation to reduce skewness.
The distribution of the means of EQUITY, LT_DEBT and ST_DEBT in Table 4 are
generally in line with the distribution of medians of these variables in Table 3. This
confirms that equity is the main financing variable in all five countries, but it is used far
more heavily in the U.S. than in any of the other four. Also, as shown in Table 3, ST_DEBT
exceeded LT_DEBT in Japan and Thailand, and the opposite was the case in the U.S.,
France, and Germany. The mean of RET was very similar for the U.S. (36.5%), Japan
(38.9%), France (38.2%) and Germany (38.1%), whereas it was very high in Thailand
(51.6). Because Thailand is an emerging market, its firms need to provide higher returns in
order to attract investors. The mean of SIZE for U.S. firms was much larger than those of
the other four countries. If converted to a single currency, the mean of the U.S. firms would
be two to three times of the means of firms in the other four countries. The mean of
GRWTH was the highest in Germany (4.825) and the lowest in Japan (1.614). France
(3.145), the USA (2.798) and Thailand (2.396) ranged in the middle of the distribution.
5.2. Bivariate analysis
The bivariate correlations are computed for all the variables of Model 2 for all five
countries. We report the statistics for only the correlations between |AA| and the
independent variables (see Table 5). High collinearity is noted between some of the
independent variables. However, VIFs computed during the multivariate analyses are all
largely below 2. Only in the case of France is a high VIF found two variables (lgGRWTH
and lgRET). We drop lgGRWTH from our regressions on France. Growth in the form of
REV has been considered to a degree while computing |AA| in Model 1.
5.3. Multivariate analyses
Our multivariate tests are based on Model 2. The results of the tests are shown in Table 6,
with one panel for each country. The tests are conducted separately for each country. We
Table 5
Bivariate correlation between |AA| and the independent variables (**pb0.01; *pb0.05).
USA Japan Thailand France Germany
EQUITY .072** .046** .076* 0.017 .070**
LT_DEBT .068** .114** 0.001 0 .038**
ST_DEBT .029** .080** .133** 0.004 0.021
RET .062** .055** .084** .037* .093**
SIZE .020* .036** .145** .036* .054**
GRWTH .031** .041** .102** .033* 0.01
RET = ratio of absolute value of prior-year market return.
SIZE = market value of equity.
GRWTH = ratio of market value of equity to book value of equity.
conduct tests in three stages. The first stage uses the whole sample for a country, the second
stage tests for negative and for positive AA firms of a country, and the third stage (results
not tabulated) tests all firms in a country by separate years. For the first two stages, since the
data are in a time series format with unequal panels, we use autoregressive regressions. For
the third stage tests, since the data are for single years, we use OLS. We also run White's
heteroskedastic tests on all our single-year and combined-year samples and find that for
single years the White's heteroskedasticity test chi-squares are mostly not significant.
However, for multiple year OLS tests, the White's heteroskedasticity test chi-squares are
mostly significant. The heteroskedasticity is, therefore, most likely arising from the
autocorrelation between years. So, we use the autoregressive regression for the tests of the
first two stages of analyses.
USA: The results for U.S. firms are shown in panel A of Table 6. The results of the U.S.
All Firms & All Years test yield strong support for H1b. LgLT_DEBT has a significant
negative association with lg|AA| (p b 0.01), in other words, a significant positive association
with earnings quality. An interesting matter to note is that lgST_DEBT also has a
significant negative association (p b 0.01) with lg|AA|, in other words, a significant positive
association with earnings quality. LgEQUITY has a significant negative association with
lg|AA| (p b 0.01) for the Positive AA firms, and a significant positive association (p b 0.01)
with lg|AA| for Negative AA firms. This suggests that lgEQUITY has a weak association
with lg|AA| for the All Firms & All Years test. These results suggest that Positive AA
firms tend to lower their AA or have better earnings quality when their equity levels are
high. When they have Negative AA they tend to have higher magnitudes of AA with
higher equity levels, presumably signaling the intention of taking a bath. On the whole
lgLT_DEBT has the most consistent set of results. It has significant negative associations
(p b 0.01) with lg|AA| for all three regressions for the U.S. sample. LgST_DEBT has a
significant negative association only for Positive AA regressions (p b 0.01). The single-year
regressions also have lgLT_Debt negatively associated with lg|AA| in most years (results not
tabulated). Overall, for the U.S., lgLT_Debt can be regarded as having strong monitoring
capabilities and equity acts as a deterrent against positive AA. This is consistent with agency
theory predictions.
Japan: The results for the Japanese firms are shown in panel B of Table 6. The results of
the All Firms & All Years test yield strong support for H2a, H2b and H2c. LgEQUITY,
lgLT_DEBT and lgST_DEBT have significant positive association (p b 0.01) with lg|AA|,
in other words a significant negative association with earnings quality. These results are
also supported in many of the annual regressions (results not tabulated). Overall, for Japan
equity and debt do not play much of a monitoring role, in fact, they can be regarded as
having a strong influence on earnings management.
Thailand: The results for the Thai firms are shown in panel C of Table 6. The results
show some support for H3c. LgST_DEBT has significant associations with lg|AA| in the
regression of All Firms & All Years and in the negative AA firms (p b 0.05). However, only
three of the 11 single-year regressions had similar results (results not tabulated).4 Overall,
4
A point to note about separate year regressions is that for countries like Thailand, France, and Germany the
annual samples were small. This could partly be the reason for the low associations.
28
Table 6
Auto-regressive Regression results (dependent variable lg|AA|).
Panel A: USA Panel B: Japan Panel C: Thailand Panel D: France Panel E: Germany
(1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3) (1) (2) (3)
All firms & All Negative Positive All firms & All Negative Positive AA All firms & All Negative Positive All firms & All Negative Positive All firms & All Negative Positive
Years AA AA Years AA Years AA AA Years AA AA Years AA AA
N 13,362 7314 6030 23,594 9521 14,055 2242 953 1273 4704 1532 3156 5552 2089 3445
R_Sq 0.055 0.072 0.08 0.037 0.046 0.06 0.021 0.013 0.057 0.026 0.04 0.033 0.178 0.131 0.156
Intercept 57.55 41.7 38.4 86.35 55.66 61.61 14.86 9.18 11.92 83.25 36.14 73.08 45.14 24.03 39.53
lgEQUITY 0.74 6.48 4.05 15.93 11.37 9.63 0.01 1.36 1.3 3.68 3.18 3.14 7.81 2.85 8.37
lgLT_DEBT 9.04 5.07 2.75 18.97 11.88 15.16 0.62 1.04 1.52 5.32 1.94 6.28 1.37 3.04 1.08
lgST_DEBT 3.7 1.63 2.55 9.66 5.33 7.2 2.11 1.7 1.15 4.03 1.73 4.53 0.45 2.37 1.47
lgRET 9.54 8.12 6.06 4.73 3.27 2.96 0.99 0.04 1.14 5.97 4.12 2.04 4.99 4.39 1.9
RET_SIGN 10.04 5.64 9.04 0.34 1.75 2.86 0.46 0.13 0.97 4.88 5.16 0.75 6.09 3.58 5.1
lgSIZE 11.76 10.94 5.39 13.89 2.4 19.73 6.29 0.95 8.16 1.85 2.22 0.8 19.08 11.1 16.07
lgGRWTH 12.92 0.68 18 18.08 13.73 11.02 4.04 2.25 2.75 . . . 8.41 3.71 8.28
DurbinWatson 2.007 1.998 2.006 1.99 2.005 2.025 2.035 1.986 1.988 2.037 1.988 2.015 2.251 2.097 2.067
AA = abnormal accruals (|ax| of Model 1).

lg|AA| = log of absolute abnormal accruals (|ax| of Model 1). A higher value means lower earnings quality. A positive (negative) association with |AA| means a negative (positive) association with earnings quality.
lgEQUITY = log of the ratio common shareholder equity by total assets.
lgLT_DEBT = log of the ratio long-term debt by total assets.
lgST_DEBT = log of the ratio short-term debt by total assets.
lgRET = log of the ratio absolute value of prior-year market return.
RET_SIGN = sign of prior-year market return.
lgSIZE = log of end of year market value.
lgGRWTH = log of the ratio market value of equity to book value of equity.
Signifies p b 0.05.
Signifies p b 0.01.
in Thailand short-term debt plays a monitoring role on earnings quality (H2c), albeit a weak
role.
France: The results for the French firms are shown in panel D of Table 6. As block
holding in France is strong, we expected a negative effect from equity on earnings quality
(positive effect on lg|AA|), i.e., H4a. However, our results are in the reverse direction in that
we find a significant negative association between lgEQUITY and lg|AA| in the All Firms
& All Years regression and the regressions for Negative and Positive AA regressions
(p b 0.01). Similar results are seen in four single-year regressions (results not tabulated).
H4b and H4c are both supported. Both lgLT_DEBT and lgST_DEBT have significant
negative associations with lg|AA|. The negative association spills over to the Negative and
Positive AA firms regressions and the single-year regressions (results not tabulated).
Overall, both equity and debt plays a role in monitoring earnings quality in French firms.
The reason for equity having a positive effect could be that large debt holders, like banks,
are also equity holders. So, the positive influence of debt on earnings quality is shared with
equity.
Germany: The results for the German firms are shown in panel E of Table 6. The results
of the All Firms & All Years test and the Negative and the Positive AA tests provide strong
support for H5a. LgEQUITY has a significant positive association with lg|AA| (p b 0.01).
Five of the single-year regressions also provide support at the p b 0.01 or p b 0.05 levels
(results not tabulated). Overall, financing sources do not play much of a monitoring role for
earnings quality in Germany. On the contrary, larger amounts of equity lead to poorer
quality earnings.
Among the control variables, lgSIZE and lgGRWTH have the most consistent results.
LgSIZE has a significant negative association with lg|AA| for most samples and sub-
samples across all countries, whereas lgGROWTH is positively associated with lg|AA| for
most samples and subsamples. LgRET generally has a significant positive association with
lg|AA| (p b 0.01) for most samples. Conversely, RET_SIGN has a significant negative
association with lg|AA| (p b 0.01). The results of lgRET and RET_SIGN put together
suggest that the magnitude of returns influences the quality of earnings and, when the
immediate past year returns are negative, firms tend to manage their current-year earnings
upwards, perhaps to influence share prices.
6. Analysis and discussion
In the section on hypotheses development we identify key features in the institutional

settings of our sample countries. We argue that these features can cause idiosyncrasies in
how agency variables, equity and debt, affect accounting quality within a country. In this
respect, we explain that the influence of these features for the monitoring of firms by the
main financiers and assessing the quality of external financial reports of firms vary by
country. We draw a set of three hypotheses for each country to predict the effects of equity,
long-term debt and short-term debt on accounting earnings quality.
Our results are generally in line with the predictions made in our hypotheses. We find
that the financing variables, equity, long-term debt, and short-term debt, do not play the
same role in monitoring earnings across all our sample countries. The results for U.S. firms
generally coincide with the predictions of agency theory that higher levels of equity and
long-term debt, which are predominantly public in nature, are associated with better quality
earnings, suggesting that long-term-debt holders monitor the quality of earnings. For
Thailand, results suggest that short-term debt is the only financing source with a positive
association with the quality of earnings.
Japan has one of the most unique arrangements for the operation of firms among our five
countries. They have the keiretsu form of governance where equity and debt are closely
held by insiders. As predicted in H2a, H2b, and H2c, neither of the financing sources play
an earnings quality-monitoring role. They are negatively associated with earnings quality.
The nature of keiretsu is that its members collectively attempt to achieve its overall
operational goals. Accounting choices may be used opportunistically to meet these goals. In
France, while debts are more of the private type, strong creditor protection laws seem to
boost the strength of the level of debt in explaining the quality of earnings. This may also be
the reason for the positive association between equity and earnings quality. Germany's
blockholder based equity seems to have a negative association with the quality of earnings,
suggesting that insider influence lowers the quality of earnings.
Our results suggest that the constructs of agency theory do not explain accounting
behavior in non-U.S. settings. For Japan, Thailand, and Germany, the presumption that
debt arrangements can mitigate agency problems does not seem to hold. In contrast, our
results for the U.S. S&P1500 firms show that in strong institutional and higher public-
investor settings, debt mitigates agency problems and ensures reporting of better quality
earnings.
Overall, we find countries have different institutional arrangements at the firm and
country level, and these arrangements moderate the effects of the basic financing variables
on accounting quality. In other words, the Berle and Means perspective of agency relations
among equity, debt, and management is not universally applicable for explaining the
quality of earnings of firms. From an institutional theory perspective, we find that firms
respond to pressures of their environment in producing their accounting numbers. These
pressures differ among countries and, therefore, firms conduct accounting to suit their
particular needs. As a corollary, we may add that agency theory itself is an institutional
theory for a particular institutional setting.
7. Conclusions
We investigate how the different institutional settings of five countries affect the relation
between financing arrangements of equity, long-term debt and short-term debt, and the
quality of accrual-based earnings. We find that in the classic agency setting of the U.S.
S&P1500 firms, the agency theory predictions of how accruals-based earnings would
behave stand. However, for settings in the other four countries the relations vary based on
the features of each setting.
In developing our predictions we argue that variations in the settings lead to different
needs and circumstances for the financiers, which in turn affect the way financiers monitor
the quality of earnings or, in some countries, the way they influence the managers to report
earnings opportunistically. We use institutional theory to explain accounting patterns,
which does not presuppose a particular setting in all countries and allows for an
appreciation of a country setting before making any predictions about accounting practices
of firms within the setting. This flexibility makes it possible for researchers to use the theory
to provide a better understanding of the accounting practices prevalent in a country.
We recognize that this study has its share of limitations. First, we use only five countries.
Future studies may include countries with other unique features, such as China for its state
owned enterprises, Singapore for its government influences, and Malaysia for its Islamic
markets. Second, our study does not examine the relation between the specific features of
equity (such as block, institutional and bank) and abnormal accruals. These variables would
further refine the results. For Japan, results could be further refined by identifying keiretsu
membership.5 Third, although the research design of this study follows the precepts of
Institutional Theory examining the actual features of a firm's setting and not
superimposing the features of another setting as the benchmark of investigation it does
not involve a comprehensive use of the institutional theory methodology. Future studies can
attempt to identify institutional pressures by their specific nature, i.e., coercive, mimetic and
normative, on the quality of accounting information in international settings. Finally, we
have focused only on a broad measure of accounting practice in this study, earnings quality
based on accruals. Future studies may focus on specific practices such as fair value
accounting and accounting for derivatives.
The results of this study have important implications for international policy makers,
investors, and researchers. The results suggest that accounting plays varying roles in
different countries due to the idiosyncrasies of the institutional settings of the countries.
Prior studies relating accounting quality to financing and legal origin have dichotomized
the relationships into debt and equity-based financing relationships and code and common-
law relationships. Our study shows that there is a need to venture beyond these dichotomies
to gain a better understanding of the associations between accounting quality and firm
features in different countries.
Furthermore, agency theory studies provide limited explanations about accounting
practices in settings where corporate structures do not bear strong agency features. These
studies may not fully appreciate how and why accounting information is used in such
settings. Most major investors in such settings, such as the families controlling Thai firms,
the keiretsu banks in Japan, or the blockholders of France and Germany, would rely on
private information available to them because of their controlling interests in firms. Those
who are not privy to inside information are likely to be misled by the accruals-based
information disclosed through the published accounting statements. A policy implication of
our findings, therefore, is that an outright implementation of International Financial
Reporting Standards may not necessarily benefit global investors, as the needs of the users
and preparers of accounting information within countries may vary from the needs of the
global investors.
Acknowledgements
The Accounting & Finance Association of Australia and New Zealand and the School of
Accountancy, Massey University, for financial support; Jonathan Higgs and Sim Loo for
5
Prior studies have found it difficult to identify keiretsu membership of firms (Douthett & Jung, 2001). Firms
could also be associated with keiretsus without any apparent membership (Flath, 1993).
research assistance; and Rashad Abdel-Khalik, Mike Bradbury, Paquita Davis and Sue
Wright, and participants at the Illinois International Accounting Symposium, University of
Hawai at Mnoa, Honolulu, Hawaii, 79 June, 2007; Macquarie University Seminar
Series, 2007; Massey University Seminar Series, 2007; Thai Chamber of Commerce
Conference, Bangkok, March, 2008; Accounting & Finance Association of Australia and
New Zealand (AFAANZ) Conference, 59 July, 2007; American Accounting Association
Conference, Anaheim, 36 August 2008.
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The International Journal of Accounting 45 (2010) 1 34

Financial reporting quality in international settings: A

Agency theory is frequently used by researchers to explain accounting practices in

Corresponding author. Tel.: +64 9 414 0800.

Limpaphayom (1999) explains the borrowing situation in the following manner:

In post-AFC Thailand, regulatory measures were put in place to improve accounting

effectively disenfranchise minority shareholders, allowing them to raise capital without

4.1. Research model

An effective way for management to influence reported earnings subtly is to manipulate

TAat = Aat1 = a + 1 1 = Aat1 + 2 REVat = Aat1 + 3 PPEat = Aat1 + at

lg j AAt j = + 1 lgEQUITYt + 2 lgLT DEBTt + 3 lgST DEBTt + 4 lgRETt

4.2. Sample and data collection

5.1. Descriptive statistics

Germany's = 33.2%). Equity is followed by long-term debt (France's = 10.8% and

Notes for Table 4

5.2. Bivariate analysis

5.3. Multivariate analyses

AA = abnormal accruals (|ax| of Model 1).

6. Analysis and discussion

In the section on hypotheses development we identify key features in the institutional

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