Institutional differences in EU countries and their relationship with earnings management differences

Abstract

PurposeThe paper seeks to highlight the differences among EU countries in a series of institutional factors (e.g. enforcement, securities regulation, investor protection and ownership concentration) in order to test whether these differences are associated with the European variability in earnings management practices and, as a result, in the quality of financial information.Design/methodology/approachThe approach is to use cluster analysis and regression analysis.FindingsThe results of the study confirm the main hypothesis in that earnings management practices are significantly lower in those EU countries with an institutional framework more favourable to a high quality of financial reporting (i.e. in those countries with a higher level of enforcement of the rules, stricter securities regulation, lower ownership concentration and a higher degree of investor protection).Research limitations/implicationsThe study presents the limitations typical from cross‐country studies. Moreover, the results should be interpreted cautiously as earnings management is difficult to measure. Future research should explore further the theoretical relations among institutional factors and earnings management practices by taking into consideration potential endogeneity issues.Practical implicationsThe results of the study suggest that a single EU financial market should be based not only on a harmonization of financial reporting standards (such as the International Reporting Financing Standards issued by the International Accounting Standards Board) but also on a harmonization of enforcement rules, investor protection mechanisms, and securities regulation.Originality/valueThe main contribution is to justify from an empirical point of view the necessity of the recent EU convergence regulatory initiatives in the areas of shareholder protection, enforcement and securities regulation to facilitate the construction of the pan‐European stock market.