We investigate how cross-country differences in financial accounting standards affect
the relation between financial accounting earnings and real economic value-relevant
events that underlie those earnings. Based on previous research and economic theory we
hypothesize that, because of differences in legal systems and the demand for accounting
information, differences in legal protection for external shareholders, and differences in
the degree of tax conformity in our sample countries, accounting earnings in the UK and
the US will be more closely related to underlying economic activity than will accounting
earnings in France and Germany. Empirical results are generally consistent with our
hypothesis.
This study investigates how cross-country differences in legal systems and the
demand for accounting information, differences in legal protection for external
shareholders, and differences in the degree of tax conformity affect the relation
between financial accounting earnings and real economic value-relevant events
that underlie those earnings.1 We investigate how well a measure of aggregate
financial accounting performance (return on assets) reflects real economic activity
in five industrialized countries with different financial accounting principles:
France, Germany, Japan, the UK, and the US. These five countries are chosen
because they represent the principal types of accounting standard setting regimes
throughout the world, and they are highly influential in the development of
international accounting standards (Choi et al., 1999). If different accounting
principles are employed to measure a company's performance, the reported
results will be different even though the underlying economic activity may be the
same. For example, in 1993 Daimler-Benz reported DM615 million net income
under German GAAP, but a DM1,839 million net loss under US GAAP. However,
it is not apparent ex ante which GAAP measure better refects real economic events.
We rely on previous research and economic theory to develop hypotheses
about differences in the relation between financial accounting earnings and real
economic activity across countries. Our hypotheses are based on four sets of
measures. First, following Ball et al. (2000), we look to the origin of the legal
systems in our sample countries to classify the countries as following either
a code-law or common-law legal tradition. We expect that the shareholder
orientation of accounting standards in common-law countries, which focuses on
resolution of information asymmetry, will result in accounting standards that
reflect underlying economic events in a timely manner. Alternatively, the stakeholder
orientation of code-law countries, where the focus is on developing a
measure of corporate income that can be divided up by the government, creditors,
employees, managers, and shareholders, is expected to weaken the relation
between financial accounting earnings and real economic value-relevant events.
Second, we consider how well a country's legal system protects external
investors (La Porta et al., 1997). We adopt three measures from La Porta et al.:
the index of antidirector rights, the ratio of external capitalization to GNP,
and the ratio of aggregate market capitalization to sales.2 Strong external
shareholder protections usually lead to a large number of shareholders who
demand information about form economic performance on a timely basis because
they do not have direct access to internal information. In such an
environment a cost-e!ective way to reduce information asymmetry between
managers and investors is through financial accounting. Thus, we expect countries
having strong legal protections for external shareholders will more likely
have accounting standards that require earnings on a timely basis, and these
more timely earnings will better reflect underlying economic activity.
Third, we consider whether a country's capital markets are &bank-oriented' or
&market-oriented' (Ali and Hwang, 2000). In bank-oriented countries, capital
needs of businesses are supplied by a few banks, while in market-oriented
countries financing is provided by many different investors. Because large banks
have access to private company information about form performance, there is
expected to be a lower demand for public value-relevant financial reports in
bank-oriented countries (Ali and Hwang, 2000). We therefore expect that the
relation between financial accounting performance and real economic activity
will be lower in bank-oriented countries.
Fourth, we look at the extent of conformity between a country's financial
accounting rules and its tax accounting rules. If financial and tax accounting
must conform, financial accounting information may di!er from underlying
economic activities because forms attempt to minimize taxable income. Therefore,
we expect that those countries in which financial accounting earnings are
measured independently of taxable income will be more likely to have earnings
that reflect underlying economic events contemporaneously.
We hypothesize that, because of the di!erences discussed above, accounting
earnings in the UK and the US will be more closely related to underlying
economic activity than will accounting earnings in France and Germany. We
expect the relation for Japan to be higher than those for France and Germany,
but lower than those for the UK and the US. Our examination is conducted at
the aggregate (i.e., country) level because real economic activity, such as the
gross domestic product (GDP) and the gross national product (GNP), is usually
measured at the aggregate level. The measure of real economic activity we use is
the economic growth rate, equal to the percentage change in a country's real
GDP, and the accounting measure of performance is the cross-sectional average
return on assets (although we also investigate the robustness of our results using
alternative measures of economic activity and accounting performance). Our
results are generally consistent with our expectations. We find that the association
between aggregate return on assets and the economic growth rate is high
in the UK and the US, and low in France and Germany. The association is also
high in Japan. In fact, our results show that the association in Japan is higher
than that in the UK, although the difference is not statistically significant.
These results make an important contribution to research in international
accounting by providing evidence that the association between financial
accounting earnings and real economic activity in a country is related in
predictable ways to the legal and economic systems that underlie financial
accounting standard setting and the demand for financial accounting information.
The high association for the UK and the US and the low association for
France and Germany are consistent with expectations that accounting earnings
in common-law countries, countries with legal systems that protect external
shareholder rights, countries with market-oriented financial systems, and countries
where financial accounting rules are independent of tax rules better reflect
underlying economic activity.
The paper is organized as follows. Section 2 develops hypotheses, Section
3 discusses the research design and sample, Section 4 presents empirical results,
and Section 5 concludes the paper.
In this study we investigate how cross-country differences in financial accounting
standards affect the relation between financial accounting earnings
and real economic value-relevant events that underlie those earnings. We
develop hypotheses about factors afecting the relation between accounting
earnings and real economic activity across countries. Our hypotheses are based
on four sets of measures. First, following Ball et al. (2000), we look to the origin
of the legal systems in our sample countries to classify the countries as following
either a code-law or common-law legal tradition. Second, we consider how well
a country's legal system protects external investors (La Porta et al., 1997). Third,
following Ali and Hwang (2000) we look at a country's debt/asset ratio to
classify countries as being either bank-oriented or market-oriented. Fourth, we
look at the extent of conformity between a country's financial accounting rules
and its tax accounting rules.
We hypothesize that, because of differences in legal systems and the demand
for accounting information in our sample countries, accounting earnings in the
UK and the US will be more closely related to underlying real economic activity
than will accounting earnings in France and Germany. We measure accounting
earnings in a country as cross-sectional average return on assets, and real economic
activity as the percentage change in real GDP. Our results are generally
consistent with our expectations. We find that the association between aggregate
return on assets and the percentage change in GDP is high in the UK and
the US, and low in France and Germany. The association is also high in Japan.
These results make an important contribution to research in international
accounting by providing evidence that the association between financial accounting
earnings and real economic activity in a country is related in predictable
ways to the legal and economic systems that underlie financial accounting
standard setting and the demand for financial accounting standards. The high
association for the UK and the US and the low association for France and
Germany are consistent with expectations that accounting earnings in common-
law countries, countries with legal systems that protect external shareholder
rights, countries with market-oriented (rather than bank-oriented)
capital markets, and countries where financial accounting rules are independent
of tax rules better reflect underlying economic activity.