Measuring Country Differences in Enforcement of Accounting Standards: An Audit and Enforcement Proxy

Abstract

In this paper we present an index designed to capture differences between countries in relation to the institutional setting for financial reporting, specifically the auditing of financial statements and the enforcement of compliance with each country's accounting standards. The use of a common set of standards such as International Financial Reporting Standards (IFRS) aims, in broad terms, to promote the comparability and transparency of financial statements and to improve the quality of financial reporting. However, the effectiveness of IFRS adoption may be hampered by differences, across countries, in the institutional setting in which financial reporting occurs. Studies of outcomes from adopting IFRS use a range of legal system proxies to capture these country differences, but the proxies are deficient in that they seldom focus explicitly on factors that affect how compliance with accounting standards is promoted through external audit and the activities of independent enforcement bodies. To address this deficiency, we calculate measures of the quality of the public company auditors' working environment (AUDIT) and the degree of accounting enforcement activity (ENFORCE) by independent enforcement bodies. We do this for 51 countries for each of the years 2002, 2005 and 2008, using publicly available data provided by the International Federation of Accountants (IFAC), the World Bank and the national securities regulators. Preliminary tests suggest our indices have additional explanatory power (over more general legal proxies) for country-level measures of economic and market activity, financial transparency and earnings management. 1 2 BROWN, PREIATO AND TARCA will prove useful to researchers and other interested parties who require country-level measures that focus on the degree of enforcement of financial reporting practices.

The Effect of Mandatory IFRS Adoption on Conditional Conservatism in Europe

“…Ahmed et al (2013) highlight that the increase discretion and flexibility permitted by IFRS could prevent financial reporting quality from increasing despite strong enforcement. Third, we use a more recent index measuring the quality of the auditing environment and the strength of accounting enforcement activity (Brown et al, 2014). First, we control for the potential effect of shifts in unconditional conservatism and cost of capital on conditional conservatism, whereas Ahmed et al (2013) use a control group mainly composed of US and Japanese firms.…”

“…Legal rules may remain ineffective without proper enforcement (Burgstahler et al, 2006). Brown et al (2014) propose an index designed to capture institutional differences between countries that are relevant for financial reporting, in particular the quality of the auditing working environment and of the enforcement of compliance with accounting standards. The influence of law enforcement is supported by numerous studies dealing with various aspects of accounting quality.…”

“…The influence of law enforcement is supported by numerous studies dealing with various aspects of accounting quality. We therefore rely on the index suggested by Brown et al (2014). Daske et al (2008) document that the increase in liquidity and equity valuations following the mandatory adoption of IFRS is restricted to countries with strict enforcement regimes.…”

“…To study the effect of public enforcement on conditional conservatism surrounding the adoption of IFRS (H2), we use the audit and enforcement index developed by Brown et al (2014). Therefore, equation (6) becomes:…”

“…5 Various measures have been used to capture conditional conservatism in the literature (see Ryan, 2006). 6 Next, we explore if the strength of enforcement led to a change (or lack of a change) in the degree of conditional conservatism after the adoption of IFRS in 2005 using a recent index measuring the quality of the auditing environment and the strength of accounting enforcement activity (Brown et al, 2014). Our measure includes controls for the effects of shifts in unconditional conservatism and cost of capital after the adoption of IFRS.…”