A Comparison of Between-Country Measures of Legal Setting and Enforcement of Accounting Standards

Abstract

Academics and practitioners agree that the enforcement of accounting standards has an important role in promoting high quality financial reporting and favourable capital market outcomes. Researchers have used a range of proxies to capture differences between countries in the extent of enforcement, usually based on aspects of the legal system or laws in place, rather than the activities of auditors and independent enforcement bodies. We assess the merits of eight proxies that have been used to distinguish between countries’ institutional settings, including three recently-available indices (AUDIT, ENFORCE and their summation, AETOTAL) that focus specifically on auditing and accounting enforcement. We examine firms’ information environments, represented by the error in analysts’ consensus forecasts and the extent of disagreement among analysts, as indicated by forecast dispersion. For financial years ending from 2003 to 2009, we construct a sample of 357,034 firm-month observations on the errors and dispersion of analysts’ earnings forecasts for 10,769 firms domiciled in those 39 countries, where a variety of accounting standards have been followed and institutional settings have varied. While the results for forecast dispersion are equivocal, those for forecast accuracy are clear. AETOTAL has the strongest association with forecast accuracy, and AUDIT, ENFORCE and AETOTAL have additional explanatory power in models including more general legal enforcement (‘rule of law’) measures. We conclude accounting enforcement may be more important in securing favourable economic outcomes than has been realised, because researchers commonly have used noisier, more general legal proxies for enforcement that understate its marginal effects.