READ AND SUMMARIZE THE CONCEPT OF DIFFERENCE IN ENFORCEMENT OF ACCOUNTING STANDARDS

Differences in countries institutional settings have long been recognised in accounting research. Countries have been grouped based on political, economic and legal systems, albeit in rudimentary ways (Nobes and Parker, 2006). Mueller (1967) provided an early classification of accounting systems, drawing on political and economic differences between countries. Nobes (1983) extended this work, considering legal system, economic environment, tax law, business practices, professional regulation and public sector accounting enforcement to arrive at a classification of accounting systems. In general there is recognition that a range of factors, captured within a countrys culture and its legal, financing and taxation systems, will affect the output of the financial reporting process. Table 1 provides a list of institutional features that have been considered important and the proxies used to capture them. The broadest classification relates to origin of the legal system (code law or common law), a simple dichotomy that also reflects differences in other aspects such as financing systems. The legal system classification can be further explored by considering specific attributes of the system that provide protection for investors, for example shareholder (or anti-director) rights and creditor rights (La Porta et al., 1998; Djankov et al., 2008). Attributes of the legal setting considered important for investor protection are observance of the rule of law, including judicial efficiency, corruption, risk of expropriation and risk of contract repudiation (La Porta et al., 1998).2 Kaufmann et al. (2010) provide a proxy for rule of law based on perceptions of the extent to which market participants have confidence in and comply with the laws of society. Their proxy is an aggregate indicator based on a wide range of specific components reflecting the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. It is widely used to measure differences between countries. Usually it is referred to as legal setting or legal enforcement, or just enforcement, often without further definition of what is meant by the concept (Byard et al., 2011; and Landsman et al., 2011).

Another sub-classification of legal enforcement is public or private enforcement. La Porta et al.s (2006) proxy for public enforcement summarises self-constructed country-level indices relating to country-specific supervisor characteristics, rulemaking power, investigative powers, orders and criminal sanctions. The proxy for private enforcement summarises country indices relating to the liability standard for companies and managers, for distributors (underwriters) and accountants. It also captures variation in mandatory disclosures such as the prospectus, compensation, shareholders, inside ownership, irregular contracts and transactions. Taking a different approach, Jackson and Roe (2009) proxy for public enforcement activity using resources measures based on the budget and staffing levels of security market regulators. Overall, the approaches to the measurement of enforcement used in most studies do not consider enforcement of accounting standards per se. Studies use legal setting as the proxy for country differences but they do not measure enforcement of accounting standards (as defined above) specifically. Nevertheless many studies conclude that enforcement is an important factor in explaining various capital market and financial reporting outcomes (Daske et al., 2008; Li, 2010; Landsman et al., 2011; Florou and Pope, 2012; and Florou and Kosi, 2013). This missing link, common to almost all international accounting studies, motivated us to develop an index that proxies specifically for the degree of enforcement of financial reporting at the country level. We focus on audit and accounting enforcement because of the importance attached to these activities in improving the quality of financial information available in capital markets.3 Put simply, the theory of efficient markets predicts that share prices reflect all publicly available information. Further, market efficiency implies the information content of the disclosure, not the act of disclosure itself, is more important (Scott, 2006, p. 88). Given the information asymmetry problems between firms managers and their capital providers (Jensen and Meckling, 1976), external auditors are engaged to provide assurance about the quality of information provided by the managers. However, the extent to which auditors can fulfil this role depends on their effectiveness. Mautz and Sharaf (1961) developed a theory of auditing, identifying essential elements of audit practice including evidence, due audit care, fair presentation, independence and ethical conduct. These elements of audit have been incorporated into auditing standards and regulations and promoted through private sector organisations (e.g., professional associations) and government entities (Nobes and Parker, 2006, pp. 46468). The basic proposition underlying the development of standards and requirements for the audit profession has been that improving auditor practice (e.g., through more training, ongoing professional development, resourcing and independence) will improve audit quality.4 Other features that can promote audit quality include monitoring and sanctioning by peers, regulatory agencies and the media, and the threat of litigation against firms for audit failure (Baker et al., 2001; Khurana and Raman, 2004). Van der Plaats (2000) lists several factors that, if present in the institutional setting, will help to ensure an auditors objectivity: (1) exposure to liability; (2) quality assurance system; (3) system of professional disciplinary sanctions; and (4) damage to the brand name of the audit firm. Many studies point to differences between countries in the governance role of auditors, arguably linked to the national legal setting, firm financing and litigation risk (Choi and Wong, 2007). The collapse of Enron and Arthur Andersen led to changes in the US and other countries to improve the quality of audit from 2002 onwards. Key initiatives to increase auditor independence include restricting provision of non-audit services to audit clients, requiring firm audit partner rotation and introducing independent oversight bodies with the power to review audit firms working papers and to take any corrective action deemed necessary (Zhang, 2007; and Hart, 2009). The latter two changes were introduced because they were expected to encourage a more independent and rigorous approach to completing an audit. At the same time, regulators in the EU were engaged in initiatives to strengthen the regulation of the audit profession in Europe, as part of the ECs Financial Services Action Plan, including more public oversight of auditors. Priorities included improving disciplinary sanctions and reinforcing auditor independence and codes of ethics (Dewing and Russell, 2004).5 Accounting standards also have a role in reducing information asymmetry as they provide a means of communication between a firms managers and investors. Financial reports based on accounting standards provide a cost-effective way of providing information to assist investors decision making. Firm managers control the preparation and release of accounting information and their incentives to provide the high quality information demanded by investors will vary with specific contracting relationships, including financing and remuneration (Watts and Zimmerman, 1986). While some theorists argue market forces (arising from markets for finance, corporate control and labour supply) will promote information release, others argue the supply of information will be insufficient without regulatory intervention (Scott, 2006, pp. 38283). Capital market regulators are concerned with not just the supply of information but also its quality or usefulness for investor decision making, because of the link between high quality information and lower information asymmetry, greater market liquidity, and lower cost of capital (Hail and Leuz, 2007). Compliance with accounting standards is seen as a way to promote information with desirable qualitative characteristics including relevance and representational faithfulness (IASB, 2010). While external auditors have a role in providing assurance about the quality of financial information, other entities such as a stock exchange or government body may play a role in promoting or monitoring the accounting information provided in capital markets (Frost et al., 2006). The concept underlying the role of a security market regulator is that the regulator promotes fair and efficient operation of the market and intervenes when necessary to ensure a level playing field, which also means promoting compliance with the rules regulating behaviour of market participants (CESR, 2003). Increasingly, accounting standards are seen as part of the set of requirements with which listed companies must comply (Berger, 2010).

Carvajal and Elliot (2009) identify three essential elements in securities regulation: the legal framework, the supervision programme and the enforcement programme.6 IOSCO7 principles relating to enforcement call for securities market regulators to have comprehensive inspection, investigation and surveillance powers (principle 8), and comprehensive enforcement powers (principle 9); and for the regulatory system to ensure effective and credible use of inspection, investigation, surveillance and enforcement powers and the implementation of an effective compliance program (IOSCO, 2003). The extent to which a government (or private sector) entity is involved in supervision and enforcement of accounting information requirements varies between countries according to the predominant social and political views on the role and importance of a regulator. In theory, a more active regulator will promote the quality of financial reporting information by encouraging and assisting firms to provide the required information, identifying cases where suitable information has not been provided and taking action to ensure defective reporting is corrected. Carvajal and Elliot (2009) argue that non-compliance is a serious matter, as the credibility of the system relies on effective discipline with the probability of real consequences for failure to obey the law (p. 1). Similarly, Leuz (2010) states the benefits of regulation will not materialise unless the rules are properly implemented and enforced. The experience of the US Securities and Exchange Commission (SEC), an active regulator of financial reporting, indicates firms respond to regulatory initiatives to promote compliance with accounting standards and that fines and penalties, as well as likely adverse share price reaction, appear to provide strong incentives for compliance (Dechow et al., 1996; Nobes and Parker, 2006, p. 178). Hitz et al. (2012) report that accounting enforcement actions under the structure introduced in Germany from 2005 are associated with unfavourable market reactions for firms receiving sanctions. Ernstberger et al. (2012) find evidence of higher accounting quality (less earnings management) and positive market outcomes (relating to liquidity and valuation) for German firms under the new regime. Christensen et al. (2013) report that benefits of IFRS (measured by changes in proxies for market liquidity) occurred in countries that increased their accounting enforcement activity at the time of adoption of IFRS in 2005. The above discussion singles out the importance of the activities of auditors and enforcement bodies in promoting the quality of financial information. In addition, studies have highlighted a widespread reliance on external auditors to help achieve high quality financial reporting (FEE, 2001; World Bank, 2011) despite substantial differences between the capabilities and capacities of audit firms (e.g., Big 4 and non-Big 4) and variation in the intensity of audit activity across countries (Khurana and Raman, 2004; and Choi and Wong, 2007). Other reports point to the important role of independent enforcement bodies and argue that, absent enforcement, high quality financial reporting is unlikely to be achieved (SEC, 2002; CESR, 2003). For these reasons we have focused on measurable country differences in relation to audit and enforcement activities. In each of 51 countries for which we could obtain sufficient data, we measure the audit environment by considering the presence or absence of a number of factors that are likely to affect the skills and training of auditors and their incentives to carry out their role effectively, as discussed earlier in this section. We include factors relating to audit licencing, training and oversight as well as levels of audit fees and litigation risk. In relation to enforcement bodies, we focus on the activities of security market regulators (and other bodies) with respect to monitoring and reviewing company financial statements and sanctioning companies for non-compliance with accounting standards. Our data are hand-collected from public sources, including IFACs surveys of member compliance, the World Banks Review of Standards and Codes (ROSC) reports, and from annual reports and websites of security market regulators and auditing oversight bodies (IFAC, 2011; World Bank, 2011). There have been many changes in the audit and accounting enforcement environment since mandatory adoption of IFRS began in 2005. Capturing these changes presents a challenge to researchers as existing proxies are often aged and static (e.g., many of the La Porta et al. (1998) measures derive from data from the 1980s1990s) or do not significantly change over time (e.g., see Chen et al.s 2010 report on the Kaufmann et al. proxies). Examples of changes in the audit environment include the introduction of auditor rotation and auditor oversight bodies following the collapse of Arthur Andersen in 2001 and the passage of the SarbanesOxley Act in the US in 2002. Although other countries may not have experienced corporate collapses on the same scale as those in the US, many followed the US lead in introducing new rules and structures to improve auditor independence and oversight, particularly from 200304. Similarly, in many countries the activities of enforcement bodies changed with the introduction of IFRS, for example the UK and Germany (FRRP, 2005; Ernstberger et al., 2012; Hitz et al., 2012; Christensen et al., 2013). A contributing factor was the promulgation of CESR Standard No. 1, which required all European Union (EU) members to have an independent enforcement body responsible for review of financial reporting, beginning 2005 (CESR, 2003). Our index aims to capture salient aspects of the environment in which auditors carry out their work and to measure the activities of enforcement bodies during the period 200208. We explain the construction of the index in the next section.