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Is financial reporting shaped by equity markets or by debt markets? An international study of timeliness and conservatism


We hypothesize debt markets—not equity markets—are the primary influence on “association” metrics studied since Ball and Brown (1968 J Account Res 6:159–178). Debt markets demand high scores on timeliness, conservatism and Lev’s (1989 J Account Res 27(supplement):153–192) R 2, because debt covenants utilize reported numbers. Equity markets do not rate financial reporting consistently with these metrics, because (among other things) they control for the total information incorporated in prices. Single-country studies shed little light on debt versus equity influences, in part because within-country firms operate under a homogeneous reporting regime. International data are consistent with our hypothesis. This is a fundamental issue in accounting.

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  1. 1.

    Gilman (1939, p. 232), Jensen and Meckling (1976, p. 338), Smith and Warner (1979), Leftwich (1983) Watts (1977, 2003a, b) and Holthausen and Watts (2001) address the relation between financial reporting and debt contracting. Basu (1997) is the first to study timely loss recognition, and Ball (2001), Ball et al. (2003) and Ball and Shivakumar (2005) address its debt-contracting role.

  2. 2.

    Association-study metrics are of interest to the accounting profession (for example, the association-study R 2 is a type of information-market share variable), though the usefulness of financial reporting likely is not a monotone increasing function of R 2 (Ball 2001).

  3. 3.

    An effective institutional structure is easily taken for granted by participants in a highly developed economy. US participants have been alerted recently to Sarbanes–Oxley Act compliance costs, yet these are but a subset of the total costs of an effective reporting system. Lesser-developed economies do not devote the same amount of resources to institutional development and operation as is familiar in countries with more developed financial systems. See Ball (2001) for an analysis of efficient financial reporting systems in developing economies.

  4. 4.

    Data are from La Porta et al. (1997, 1998). Debt excludes trade credit, which we expect induces a demand for timely loss recognition in working capital (inventory and receivables write-downs, and loss accruals).

  5. 5.

    Some conclusions can be drawn from single-country studies, for example that the asymmetry reported by Basu (1997) for US firms is consistent with debt exerting an important influence on financial reporting (Holthausen and Watts 2001), but the evidence underlying these conclusions arises from what in essence is a single observation.

  6. 6.

    The two schools of thought are debated in Holthausen and Watts (2001) and Barth et al. (2001).

  7. 7.

    AICPA (1970, para 35); FASB (1980, paras 91–97).

  8. 8.

    Statement of Financial Accounting Concepts No. 1, FASB (1978, \(\P\)30).

  9. 9.

    See Ball (2001) for an analysis of effective financial reporting systems in a developing economy and Ball (2006) for the argument that the major costs of effective reporting systems lie in enforcement rather than standard-setting.

  10. 10.

    Political solutions differ from market solutions, and vary internationally. We therefore control for various country-level system variables when testing the influence of debt and equity markets on financial reporting.

  11. 11.

    The notion of earnings timeliness was introduced by Ball and Brown (1968), who concluded (p. 176): “the annual income report does not rate highly as a timely medium.” Nevertheless, subsequent literature emphasized the informativeness of earnings and focused on event-day price responses to earnings announcements, which (while statistically significant in large samples) are a minor component of the variance of annual and longer-horizon stock returns. Lev (1989) reiterated the low timeliness of earnings, expressing in terms of the R 2 between earning and contemporaneous returns, and called (section 8) for research to improve the quality of financial information, presumably to increase the R 2. Similar views are evident in the literature as far back as Canning (1929), and were central to the debates in the so-called “golden era” of accounting research (for example, Chambers 1966).

  12. 12.

    Differential costs of processing financial-statement versus other information do not affect this argument, because the amount of information incorporated in prices reflects processing costs. Second-order effects could arise if, for some reason, there were non-optimal quantities of either financial-statement or other information in supply, for example due to agency costs or political intervention (for which we control). Shareholders have indirect interests in reporting timeliness that we discuss below.

  13. 13.

    The point is hinted at in Dhaliwal et al. (1999, fn. 5), a reference that Holthausen and Watts (2001, p. 15) describe as “probably unique.”

  14. 14.

    This should be obvious from a cursory review of the results in studies such as Bernard and Thomas (1989, Figs. 1–4), even though the portfolios in these studies are formed on the basis of common earnings behavior and hence are poorly diversified.

  15. 15.

    Presumably, this is because: (1) managers who have made negative-NPV decisions in the past are more likely to keep making bad decisions in the future, due for example to poor strategies and/or low ability or effort; and (2) managers in firms who hold “out of the money” options due to past losses have incentives to gamble on new investments and acquisitions even if they have a negative expected NPV.

  16. 16.

    See Ball (2001), Ball et al. (2003) and Ball and Shivakumar (2005).

  17. 17.

    Losses followed by gains can be handled by lenders electing not to exercise their decision rights. Some demand for timely gain recognition is generated by debt repricing (Asquith et al. 2005) and by debt selling substantially below face value. The argument is not that there is no debt demand for timely gain recognition; it is that there is less demand for it than for losses.

  18. 18.

    No allowance is made for cross-listing, which constitutes a bias against our hypotheses.

  19. 19.

    Data limitations do not permit an analysis of changes over time. Basu (1997) shows that gain recognition timeliness has increased in the US Ball et al. (2000a) report similar evidence internationally.

  20. 20.

    Givoly and Hahn (2000), Beaver and Ryan (2005), Givoly et al. (2007) and Roychowdhury and Watts (2007).

  21. 21.

    See also Collins and Kothari (1989) and Easton and Zmijewski (1989).

  22. 22.

    Consistent with the interpretation in Ball and Kothari (2007, unpublished manuscript), we model this as a property of equilibrium income recognition practices in each country. Roychowdhury and Watts (2007) model it as an errors-in-variables issue.

  23. 23.

    More precisely, the ratio of the variances of booked and unbooked economic gains need not equal the corresponding ratio for booked and unbooked economic losses. Here, “unbooked” refers to gains and losses that are not recorded in contemporary accounting income, such as revisions in the value of economic rents.

  24. 24.

    Our results are robust with respect to alternative specifications of BM. We also find similar results when we exclude two countries (Brazil and Indonesia) with unusually low values for BM.

  25. 25.

    The market/book ratio has extreme values for Brazil and Indonesia, perhaps due to inflation, but is used only in some specifications, and then as a robustness control (without materially influencing the results).

  26. 26.

    In contrast to Bushman and Piotroski (2006), who use debt/equity ratios, our regression includes both debt and equity as independent variables because our goal is to assess their individual roles. For example, a positive coefficient on debt/equity can indicate a positive association with debt, a negative association with equity, or both.

  27. 27.

    See also Alexander and Schwencke (2003).

  28. 28.

    This result implies that, for the purpose of predicting countries’ earnings qualities measured in terms of loss recognition timeliness, a simple classification of countries by legal system origins (e.g., Ball et al. 2000a) performs better than more specific measures of legal environment (e.g., Leuz et al. 2003). The result is insensitive to including various combinations of the legal environment variables in the regression.

  29. 29.

    The negative slope for equity cannot be explained by incremental loss recognition sensitivity encountering increasing marginal costs, because it does not occur by equity market size increasing timely gain recognition: it occurs by equity market size decreasing timely loss recognition. We are aware of no version of the “value relevance” hypothesis that is consistent with this result.

  30. 30.

    Symmetry is consistent with but not required by the Vuolteenaho (2000, 2002) model. The ratio of the variances of booked and unbooked economic gains need not be the same as the ratio for booked and unbooked losses.

  31. 31.

    It is consistent with the hypothesis that the primary role of accounting earnings in equity markets is not to inform them in a timely manner, but to subsequently confirm or contradict managers’ non-financial forecasts and disclosures, and hence exert a discipline on them. See Ball (2001, pp. 133–138).

  32. 32.

    We view these as economically different concepts, as distinct from measures, of conservatism (cf. Roychowdhury and Watts 2007), because they have substantively different economic and political roles. We view unconditional conservatism as arising from tax, political costs and managerial self interest, and conditional conservatism as arising from efficient debt and governance contracting. Basu (1997, p. 8) draws a distinction between the concepts, though he does not use this terminology and clouds the distinction in his citation (p. 7) of FASB (1980, para 95). Ball et al. (2000a, n. 15) make the distinction, but describe it inaccurately as “income statement” versus “balance sheet” conservatism. Beaver and Ryan (2005) also use the terms “conditional” and “unconditional.” Confusion of the unconditional and conditional versions of conservatism is evident as early as Gilman (1939, p. 130) and APB Statement No. 4. The concepts clearly are related (Ball et al. 2000a, fn. 15; Roychowdhury and Watts 2007).

  33. 33.

    Under clean surplus accounting, reporting low book values implies reporting low average net incomes, though not necessarily in any given year and hence not necessarily related to contemporary economic losses. Unconditional conservatism also creates “hidden reserves” (“cookie jar reserves”) that allow firms to increase earnings in loss periods. See Schneider (1995, pp. 136–137); Ball et al. (2000a, fn. 15); and Ball (2004, pp. 126–131).

  34. 34.

    Haller (1998, pp. 78–79) states: “the principle of creditor protection has been the central concern of accounting in Germany and has had a major impact on accounting... Another effect of this focus on protecting creditors is the overall principle of conservatism.” Nobes (1998, pp. 31–32) states: “the importance of banks in Germany may be a reason for greater conservatism in reporting. It is widely held that bankers are more interested in ‘rock-bottom’ figures in order to satisfy themselves that loans are safe.” The European Federation of Accountants (1997, \(\P\)10.1) states that prudence as practiced in Austria, Czechoslovakia, Germany, Luxembourg and Switzerland was incorporated in the European Union’s Fourth Directive “with a view to protecting the interests of creditors... but also to protect management.”

  35. 35.

    Malaysia and Singapore exhibit seemingly high values for the equity variable (Table 1). We believe these data to be correct, and note that Malaysia and Singapore have substantial listed agriculture and technology sectors, respectively. Nevertheless, to alleviate concerns that these observations drive our results, we re-estimate the regressions excluding the countries from the sample. The results are qualitatively unchanged.

  36. 36.

    A potential contributor to the Basu asymmetry is that tax systems provide managers with an incentive to realize losses more quickly than gains. This incentive is universal, and in particular seems unlikely to be related to the sizes of countries’ debt and equity markets.


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We gratefully acknowledge the comments of Sudipta Basu, Robert Bushman, Peter Easton, Christian Leuz, Scott Richardson, Lakshmanan Shivakumar, Douglas Skinner, Ross Watts, Jerry Zimmerman, the discussant (Steve Monahan) and two anonymous referees, as well as from participants at the JAR/LBS London Conference, the 16th Annual Conference on Financial Economics and Accounting, the Global Issues in Accounting Conference at University of North Carolina, the Review of Accounting Studies Conference, the Burton Workshop at Columbia University, and research workshops at University of Amsterdam, University of Chicago, University of Edinburgh, George Washington University, London Business School and University of Minnesota. We are grateful for financial support from the University of Chicago, Graduate School of Business. Versions of the paper were circulated under the title: “Is Accounting Conservatism Due to Debt or Equity Markets? An International Test of ‘Contracting’ and ‘Value Relevance’ Theories of Accounting.”

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Ball, R., Robin, A. & Sadka, G. Is financial reporting shaped by equity markets or by debt markets? An international study of timeliness and conservatism. Rev Acc Stud 13, 168–205 (2008).

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  • Reporting quality
  • Association studies
  • Debt
  • Conservatism
  • Timeliness
  • International

JEL Classifications

  • F30
  • G15
  • G18
  • G32
  • K33
  • M41