1. What Happened to Accounting Quality in Eastern Europe after the Communists Retired Early? Kozminski University 3 Feb 2015 Frederick Lindahl George Washington University Hannu Schadéwitz Satu-Päivi Kantola University 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 2

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 3

4. Laws and markets During 1990s, early 2000s Privatization of state enterprises Attract foreign investors (FDI) Establish stock markets Research domain 4

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 5

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 clusters Research domain 6

7. Baltic countries -- Estonia -- Latvia -- Lithuania Visegràd countries -- Czech Rep -- Hungary -- Poland -- Slovakia Southern countries -- Bulgaria -- Croatia -- Romania -- Slovenia Clusters Research domain 7

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 8

9. Law – How does the law affect accounting quality? Legal system corporate governance financial reporting Research: law 9

10. 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 10

11. Law – How does the law affect accounting quality? Legal system corporate governance financial reporting Research: law 11

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 12

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 13

14. 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 14

15. 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 15

16. Baltic countries -- Estonia -- Latvia -- Lithuania Visegràd countries -- Czech Rep -- Hungary -- Poland -- Slovakia Southern countries -- Bulgaria -- Croatia -- Romania -- Slovenia Clusters 2 2 1 1 3 3 Research: law 16

17. 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 17

18. 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 explanations Good measure for international comparison Research methods 18

19. 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 19

20. c 0 Research methods 20

21. Censored normal distribution Y = c if Y* ≤ c and Y = 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 21

22. Hypothesis test p1 = estimated value of small losses P2 = observed frequency of small losses Test statistic: p2/p1 Null hypothesis p2 = p1; i.e., test statistic = 1 Research methods 22

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 23

24. Data Years of interest: – 1995 – 2000 – 2005 – 2010 Compustat database of financial reports Research findings 24

25. 2000, all east countries BUL 0CRO 3CZE 2 EST 5HUN 6 LAT 1 LTU 1POL 40ROM 0 SLV 6SVK 2 Compustat Research findings Eliminating firms with sales < $50,000. 25

26. 1995, all east countries N=4 Compustat Research findings 26

27. 2005, all east countries, n=279 Research findings: Hypothesis 1: no earnings management. 27

28. “new method” p1 = estimated value of small losses P2 = observed frequency of small losses Test statistic: p2/p1 Null 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. 28

29. 2010WestEastTotal Chi-square (probability) Small losses41647 Small gains11044154 All other1924404232813.2 Total20754542529(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 29

30. “New method” comparison with western EU p1 = estimated value of small losses, 2005 p2 = observed frequency of small losses, 2005 q1 = estimated value of small losses, 2010 q2 = observed frequency of small losses, 2010 Test statistic: (q2/q1) – (p2/p1) = 0.056 standard error: 0.182 Null hypothesis not rejected at p = 0.05 Research findings: Hypothesis 2: accounting quality not improving 30

31. 2005 “Peel the onion”: clusters Baltic Visegràd southern Research findings: Hypothesis 3: no cluster differences 31

32. 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. 32