Investor Protection Laws, Accounting and Auditing Around the World

Abstract

Recent research documents that common law countries have stronger investor protection laws and more developed financial markets than civil law countries (La Porta et al., 1997, 1998). This line of inquiry is extended in our study to examine if variations in legal systems also affect accounting and auditing. For a sample of 31 countries, we document that national accounting standards are more timely (accrual-based) and transparent in common law countries, which is consistent with a greater role played by the public disclosure of accrual-based accounting information in corporate governance in these countries. There is also greater demand for auditing as an enforcement mechanism when accounting is more timely and transparent. We also examine if causality could run from high-quality accounting and auditing to the development of financial markets. La Porta et al. (1998) conjecture that high-quality accounting could mitigate the negative effect of weak investor protection on the development of financial markets. Specifically, we examine if those civil law countries that have more timely and transparent accounting, and more auditing, also have more developed financial markets relative to other civil law countries. We find little support that this is case, which raises questions about the rationale for the international harmonization of accounting and the work of the International Accounting Standards Committee, absent fundamental changes in investor protection laws of civil law countries.