What Happened to Accounting Quality in Eastern Europe after the

Communists Retired Early?

Kozminski University3 Feb 2015

Frederick LindahlGeorge Washington University

Hannu SchadéwitzSatu-Päivi KantolaUniversity of Turku

2

“Landscape” of eastern Europe

• from: autocratic communist rule

• from: planned socialist economy

• to: democracy

• to: free markets

More than half of today’s eastern EU countries were not even countries at the time that communism fell!

Research domain

3

Laws and markets

1990:• No functioning stock markets• No large-scale private enterprises • No legal institutions to govern capitalist markets• Little private wealth• No judiciary or lawyers trained in capitalist law• Little trust by citizens in fairness of legal system

Research domain

4

Laws and markets

During 1990s, early 2000s• Privatization of state enterprises• Attract foreign investors (FDI)• Establish stock markets

Research domain

5

Laws and markets

During 1990s, early 2000s• Privatization of state enterprises• Attract foreign investors (FDI)• Establish stock markets• Development of laws for free markets:

Communist law Common law (help from World Bank)

Civil law (anticipation of EU) EU law, through regulations and

directives

Research domain

6

Baltic countries German/Swedish legal influence; Soviet republics; eurozone

Visegràd countries German legal influence; more autonomy under communism; industrialized; sophisticated manufacture

Southern countries German/French/Ottoman legal influence; lower GDP; late joiners

clustersResearch domain

7

Baltic countries -- Estonia -- Latvia -- Lithuania

Visegràd countries -- Czech Rep -- Hungary -- Poland -- Slovakia

Southern countries -- Bulgaria -- Croatia -- Romania -- Slovenia

ClustersResearch domain

8

Main elements of study

Research question: What is the state of reporting in formerly communist countries in Europe?• Law– How does the law affect accounting quality?

• Methods– New measurement of earnings quality

• Findings

Research

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Law

• Law– How does the law affect accounting quality?

Legal system corporate governance financial reporting

Research: law

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Laws and accounting

• Previous research– With accounting quality as the dependent variable,

insert a dummy for “common” or “civil” law.– Alternatively, insert the country score from LLSV (98).

• Limitations– LLSV rely on ADRI, that has nothing to do with financial

reporting• “One share, one vote”• Right to call shareholders meeting, …

– All eastern EU countries are civil law; conceivably they are not all the same.

Research: law

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Law

• Law– How does the law affect accounting quality?

Legal system corporate governance financial reporting

Research: law

12

Laws and accounting

Conditions that create demand for financial reporting• Providers of capital separate from managers• Foreign investors want accountability• Cost of capital considerations

Research: law

13

Laws and accounting (2)

Activities that fulfill demand for financial reporting• Establishment of securities laws• Establishment of independent securities

regulators• Increasing trust in legal systems– “Trust in legal institutions and legal certainty are

preconditions for a working market economy”– (Fogelklou 2003)

– Slow: in 2005, only in Estonia did more than 50% of citizens think the judiciary was not corrupt.

Research: law

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Eastern European Union

• Forces toward improved quality in corporate governance– Transnationalization (EU, WTO, treaties, IMF)–Global markets (major stock exchanges)– IFRS

• Forces against–National legal culture–Corruption, lack of professionalism–Distrust of legal system

Research: law

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Hypothesis

• Periods–1990-1995 Transition: Period of emerging

from communism: privatizing, etc.–1995-2000 Consolidation: Period of

adapting to western civil law and preparing for EU–2000-2005 Accession: Introduction to EU,

adapting to all EU conditions, including IFRS –2005-2010 Integration: EU members

• Hypothesis: earnings quality improves

Research: law

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Baltic countries -- Estonia -- Latvia -- Lithuania

Visegràd countries -- Czech Rep -- Hungary -- Poland -- Slovakia

Southern countries -- Bulgaria -- Croatia -- Romania -- Slovenia

Clusters

2

1

3

Research: law

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Measuring accounting quality

• Methods rely on abnormal accruals– Unsuitable for international comparisons, because

accrual rules differ among accounting standards• Methods that rely on stock returns– Unsuitable for international comparisons, because

capital markets not fully developed (efficiency, synchronous trading)

• Methods that rely on discontinuities

Research methods

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Measurement of quality

• Burgstahler & Dichev (1997): too many small gains compared with small losses–Robust to accounting systems differences–Robust to different capital market conditions– Few, if any, alternative explanationsGood measure for international comparison

Research methods

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Burgstahler-Dichev (97)

• Burgstahler & Dichev (1997): too many small gains compared with small losses– Assumes “smooth” distribution– Choice of bin width arbitrary

These are inherent weaknesses

Research methods

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c0

Research methods

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Censored normal distribution

Y = c if Y* ≤ c andY = Y* if Y* > c

Y is defined as observed values, and c is the censoring point.

Y* is the reference distribution of unmanaged earnings.

Research methods

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Hypothesis test

p1 = estimated value of small lossesP2 = observed frequency of small losses

Test statistic: p2/p1Null hypothesis p2 = p1; i.e., test statistic =

1

Research methods

23

Hypothesis tests apply to:

• H1: there is no earnings management in eastern EU in 2005 (accession)

• H2: accounting quality has not improved from 2005 to 2010.

• H3: accounting quality– Visegràd > Baltic– Baltic > southern– Visegràd > southern

Research methods

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Data

• Years of interest:–1995–2000–2005 –2010

• Compustat database of financial reports

Research findings

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2000, all east countries

BUL 0 CRO 3CZE 2

EST 5 HUN 6 LAT 1

LTU 1 POL 40ROM 0

SLV 6 SVK 2

Compustat

Research findings

Eliminating firms with sales < $50,000.

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1995, all east countries

N=4

Compustat

Research findings

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2005, all east countries, n=279

-0.15-0.14

-0.13-0.12

-0.11-0.1

-0.0899999999999999

-0.0799999999999999

-0.0699999999999999

-0.0599999999999999-0.05

-0.04-0.03

-0.02

-0.00999999999999998 00.01

0.020.03

0.040.05

0.060.07

0.080.09 0.1

0.110.12

0.130.14

0.150

3

6

9

12

15

18

Change in Earnings Interval

Freq

uenc

y

Research findings: Hypothesis 1: no earnings management.

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“new method”

p1 = estimated value of small lossesP2 = observed frequency of small losses

Test statistic: p2/p1Null hypothesis p2 = p1; i.e., test statistic = 1

Test statistic = 0.431; standard error = 0.148 Null hypothesis rejected at p < 0.01,

for year 2005.

Research findings: Hypothesis 1: no earnings management.

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2010 West East Total Chi-square (probability)

Small losses 41 6 47 Small gains 110 44 154 All other 1924 404 2328 13.2Total 2075 454 2529 (p=0.001)

Research findings: Hypothesis 1: no more earnings management in the east than in the west

Null hypothesis rejected at p = 0.001

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“New method” comparison with western EU

p1 = estimated value of small losses, 2005p2 = observed frequency of small losses, 2005

q1 = estimated value of small losses, 2010q2 = observed frequency of small losses, 2010

Test statistic: (q2/q1) – (p2/p1) = 0.056standard error: 0.182

Null hypothesis not rejected at p = 0.05

Research findings: Hypothesis 2: accounting quality not improving

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-0.15-0.13

-0.11

-0.0899999999999999

-0.0699999999999999-0.05

-0.03

-0.009999999999999980.01

0.030.05

0.070.09

0.110.13

0.1506

1218

Change in Earnings Interval

Freq

uenc

y

-0.15-0.13

-0.11

-0.0899999999999999

-0.0699999999999999-0.05

-0.03

-0.009999999999999980.01

0.030.05

0.070.09

0.110.13

0.1506

1218

Change in Earnings Interval

Freq

uenc

y

-0.15-0.13

-0.11

-0.0899999999999999

-0.0699999999999999-0.05

-0.03

-0.009999999999999980.01

0.030.05

0.070.09

0.110.13

0.1506

1218

Change in Earnings Interval

Freq

uenc

y2005

“Peel the onion”:

clusters

Baltic

Visegràd

southern

Research findings: Hypothesis 3: no cluster differences

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Contributions and conclusions

• Analysis of 20 years of eastern European legal history gives basis for cross-sectional and time series hypotheses of earnings quality.

• Data show evidence of earnings management, perhaps declining (work in progress).– Evidence of more earnings management in

eastern than in western Europe.• A new method of analyzing data gives better

statistical evidence to support results.