Introduction
Authored by Burgstahler, Hail, and Leuz and published in the Journal of Accounting Review, the article, “The Importance of Reporting Incentives: Earnings Management in European Private and Public Firms” investigates the mechanism through which issues such as pressure in capital markets and institutional factors induce organizations to adopt incentives for reporting paychecks in a manner that reflects their economic performance. The article reveals that since firms operate under the same legal forms in the EU, both publicly listed and private organizations exploit similar accounting standards. This paper summarizes the main arguments raised by Burgstahler, Hail, and Leuz.
Summary
Quoting the work of Levitt, the authors assert that the focus of international accounting practice has been on increasing the quality of reporting by standardizing accounting practices (82). For example, in the EU, Van Hulle reveals how coordination efforts have emphasized the reduction of any variations in accounting principles (29). The primary goal is to improve the quality of reporting. However, Burgstahler, Hail, and Leuz emphasize the necessity for regarding the contribution of forces of capital markets together with institutional factors as incentives for providing edifying information about organizations’ earnings.
The article’s main argument is that although accounting standards are standardized, they are applied to data that is privately provided by organizations. An assumption is made that the information provided is of high quality. However, Burgstahler, Hail, and Leuz observe, “reporting incentives and forces that shape them are likely to play an integral role in ensuring accounting quality” (984). The researchers hypothesize that capital market forces and institutional factors play an essential role in determining firms’ reported earnings. The article documents variations in the reported earnings, despite the many years of harmonizing accounting practices (Burgstahler, Hail, and Leuz 993).
Synchronization of accounting practices constitutes the fourth and the seventh directives for 5 million companies that operate as limited liability companies without any segregation in terms of their type of listing (Burgstahler, Hail, and Leuz 990). The companies must prepare financial accounts that are audited following the directives. The orders recommend the tolerable bookkeeping regulations in both public and classified institutions in matters concerning their combined and unconsolidated monetary documents. Burgstahler, Hail, and Leuz report that variations arise due to different reporting incentives (991).
Using bivariate, univariate, and multivariate tests as their data analysis strategies, the researchers document various findings. For example, they find a high frequency in earnings management within private organizations compared to publicly listed organizations. The speculation that capital markets increase incentives for managing earnings is nullified. Rather, the researchers’ most significant effect of equity markets for publicly traded organizations involves enhancing the informativeness of earnings. This goal is achieved through incentives that lead to edifying earnings or via preventing organizations that provide less informative information from trading publicly. In both private and public organizations, Burgstahler, Hail, and Leuz report that earning management is more enhanced in nations that have weaker accounting legal forms and enforcements (1013).
The researchers maintain that apart from the characterization of various general legal forms, different market forces and variables influence different publicly traded organizations and private corporations. They identify these variables as the extent of alignment of financial accounting with tax accounting and the existing differences in the EU accounting rules and enforcements, the degree of protection for minority shareholders, and capital market activities and structures (Burgstahler, Hail, and Leuz 988).
Disclosure levels for public securities constitute an important variable deployed by the authors (La Porta and Lopez-de-Silanes 3). The results of their analysis of the interaction of these variables and the capital markets support their earlier assertion that capital markets have the overall implication of improving the degree of informativeness of earnings.
The strong alignment of taxes correlates directly with the extent of deploying earnings management systems. However, the implications are highly mitigated in the case of public organizations. The EU adopts various institutions for enhancing the financing of equities within the realm of capital markets (Botosan and Plumlee 325). For example, it establishes requirements for a high level of disclosures together with institutions for facilitating minority shareholder representation and rights (Li and Yang 2).
Burgstahler, Hail, and Leuz assert that these institutions correlate with the low likelihood of earnings management, especially in the case of publicly-traded organizations. Hence, institutions and markets can reinforce one another. Burgstahler, Hail, and Leuz confirm, “strong capital markets and arm’s-length financing improve earnings informativeness” (985). This argument arises from their findings that publicly traded organizations are less likely to engage in earnings management in nations that have highly developed equity markets.
Conclusion
Burgstahler, Hail, and Leuz observe that private organizations in the EU are more likely to deploy practices of earnings management compared to public organizations. They provide evidence indicating that the sampled firms in the 13 EU nations respond differently to various institutional factors that influence their earnings informativeness, depending on the type of listing. By comparing various reporting behaviors that are adopted by private and public firms that operated in the EU, Burgstahler, Hail, and Leuz’s research amplifies the existing literature on the implication of markets for public equities on reporting informativeness. It also contributes to the debate on the impact of harmonizing accounting standards across the EU on reporting incentives.
Works Cited
Botosan, Christine, and Marlene Plumlee. “Disclosure Levels and the Cost of Equity Capital.” The Accounting Review 72.1 (1997): 323-350. Print.
Burgstahler, David, Luzi Hail, and Christian Leuz. “The Importance of Reporting Incentives: Earnings Management in European Private and Public Firms.” The Accounting Review 81.5 (2006): 983-1016. Print.
La Porta, Rafael, and Florencio Lopez-de-Silanes. “What works in securities laws?” Journal of Finance 61.1(2006): 1-32. Print.
Levitt, Arthur. “The importance of high-quality accounting standards.” Accounting Horizons 12.1 (1998): 79-82. Print.
Li, Yan, and Holy Yang. Disclosure and the Cost of Equity Capital: An Analysis at the Market Level, 2012. Web.
Van Hulle, Kristine. From accounting directives to international accounting standards, Oxford, U.K.: Oxford University Press, 2004. Print.