Earnings management and investor protection: an international comparison

In the last decade, economists have produced a considerable body of research suggesting that the historical origin of a country's laws is highly correlated with a broad range of its legal rules and regulations, as well as with economic outcomes. We summarize this evidence and attempt a unified interpretation. We also address several objections to the empirical claim that legal origins matter. Finally, we assess the implications of this research for economic reform.

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The Economic Consequences of Legal Origins

This paper examines the pervasiveness of earnings management across 31 countries between 1990 and 1999. It documents systematic differences in earnings management across different clusters of countries. We propose an explanation for these differences based on the notion that insiders, in an attempt to protect their private control benefits, use earnings management to conceal firm performance from outsiders. Thus, earnings management is expected to decrease in investor protection because strong protection limits insiders' ability to acquire private control benefits, which reduces their incentives to mask firm performance. Our evidence is consistent with this prediction. The findings suggest a link between corporate governance and the quality of reported earnings, and complement prior finance research that treats the quality of corporate reporting as exogenous.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1106294_code18004.pdf?abstractid=281832&rulid=177279&mirid=3

Earnings Management and Investor Protection: An International Comparison

This paper examines the economic consequences of mandatory International Financial Reporting Standards (IFRS) reporting around the world. We analyze the effects on market liquidity, cost of capital, and Tobin's q in 26 countries using a large sample of firms that are mandated to adopt IFRS. We find that, on average, market liquidity increases around the time of the introduction of IFRS. We also document a decrease in firms' cost of capital and an increase in equity valuations, but only if we account for the possibility that the effects occur prior to the official adoption date. Partitioning our sample, we find that the capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms' reporting incentives and countries' enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, we find that the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. While the former result is likely due to self-selection, the latter result cautions us to attribute the capital-market effects for mandatory adopters solely or even primarily to the IFRS mandate. Many adopting countries make concurrent efforts to improve enforcement and governance regimes, which likely play into our findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when we analyze them on a monthly basis, which is more likely to isolate IFRS reporting effects.

/pdf/mandatory-ifrs-reporting-around-the-world-early-evidence-on-3f75vtb2ll.pdf

Mandatory IFRS Reporting around the World: Early Evidence on the Economic Consequences

Outside the United States and the United Kingdom, large corporations usually have controlling owners, who are usually very wealthy families. Pyramidal control structures, cross shareholding, and super-voting rights let such families control corporations without making a commensurate capital investment. In many countries, a few such families end up controlling considerable proportions of their countries’ economies. Three points emerge. First, at the firm level, these ownership structures, because they vest dominant control rights with families who often have little real capital invested, permit a range of agency problems and hence resource misallocation. If a few families control large swaths of an economy, such corporate governance problems can attain macroeconomic importance—affecting rates of innovation, economywide resource allocation, and economic growth. If political influence depends on what one controls, rather than what one owns, the controlling owners of pyramids have greatly amplified political influence relative to their actual wealth. This influence can distort public policy regarding property rights protection, capital markets, and other institutions. We denote this phenomenon economic entrenchment, and posit a relationship between the distribution of corporate control and institutional development that generates and preserves economic entrenchment as one possible equilibrium. The literature suggests key determinants of economic entrenchment, but has many gaps where further work exploring the political economy importance of the distribution of corporate control is needed.

/pdf/corporate-governance-economic-entrenchment-and-growth-4e2ab431gn.pdf

Corporate Governance, Economic Entrenchment, and Growth

This essay first describes the differences in the ownership structure of companies in the three main economies of continental Europe - Germany, France, and Italy - with comparisons to the United States and the United Kingdom. Next, it summarizes the corporate governance issues that arise in firms with a dominant shareholder. Then, it provides a brief account of the major European corporate scandal, Parmalat, as an extreme example of investor expropriation in a family-controlled corporation. After outlining in general the legal tools that can be used to tackle abuses by controlling shareholders (internal governance mechanisms, shareholder empowerment, disclosure, public enforcement), it describes the corporate governance reforms enacted by France, Germany, and Italy between 1991 and 2005 and assesses the way in which investor protection in the three countries has changed.

Corporate Governance Reforms in Continental Europe

to alleviate the conflict of interest between dispersed small shareowners and powerful controlling managers. Classic works like Berle and Means (1932) andJensen and Meckling (1976) discussed this separation of ownership and control and its consequences. Although some companies in the United States are controlled by large blockholders-for instance, Microsoft, Ford, and Wal-Martsuch firms are relatively few and have thus drawn less attention in the corporate governance debate (Anderson and Reeb, 2003). In contrast, the fundamental problem of corporate governance in continental Europe and in most of the world is different. There, few listed companies are widely held. Instead, the typical firm in stock exchanges around the world has a dominant shareholder, usually an individual or a family, who controls the majority of votes. Often, the controlling shareholder exercises control without owning a large fraction of the cash flow rights by using pyramidal ownership, shareholder agreements, and dual classes of shares (La Porta, Lopez-de-Silanes, and Shleifer, 1999).

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1. What is Corporate Law? 2. Agency Problems and Legal Strategies 3. The Basic Governance Structure 4. Creditor Protection 5. Related Party Transactions 6. Significant Corporate Actions 7. Control Transactions 8. Issuers and Investor Protection 9. Enforcement 10. Convergence in Corporate Law 11. Beyond the Anatomy

http://www.gbv.de/dms/spk/sbb/recht/toc/356510131.pdf

The Anatomy of Corporate Law: A Comparative and Functional Approach

The paper provides an overview of the Italian corporate governance system, focusing mainly on the ownership of Italian firms and on the legal and institutional framework. Like those of most other continental European countries, the Italian corporate governance system features a high concentration of direct ownership, for both unlisted and listed companies; at first glance this suggests a very limited degree of separation between ownership and control. The analysis of direct ownership and of the identity of owners reveals that a major role is played by families, coalitions, the State, and above all by other companies: the largest stake in listed and unlisted companies is held by other non-financial or holding companies. In fact, more than 50 percent of all Italian industrial companies belong to pyramidal groups. Taking the pyramidal structure into account, one can identify ultimate owners and evaluate the actual degree of separation between ownership and control. Measuring separation as the amount of capital controlled per unit of capital owned, we find that in 1996 the average figure was 2.4 for listed companies; it was higher for private non-banking groups (4.5) and lower for State-controlled groups (1.6); for the ten largest private groups, the ratio was approximately 5. In Italy, then, pyramidal groups headed by families, coalitions, or the State have supplanted other forms of separation, whereas financial institutions have played a very limited role in fostering separation. This structure, reinforced by cross-ownership, circular ownership, and interlocking directorates, has allowed stable control over both small and large companies, with few control changes, especially hostile takeovers. The paper first provides a brief description of the legal and institutional framework and in particular of the provisions affecting corporate governance mechanisms (shareholders' rights, directors' liability etc.), and of disclosure rules. Next comes a quantitative description for listed and unlisted companies: ownership structure, taking account of groups; the control structure; the diffusion of pyramidal groups; and an evaluation of the separation between ownership and control. This is followed by a discussion of changes and trends: the simplification of the pyramidal structure due to privatization and to the financial difficulties of private groups; the increasing role of financial institutions; the debate that has led to reform of some corporate governance mechanisms and to a new law for listed companies, in force since July 1998.

Luca Enriques

Papers

Corporate Governance Reforms in Continental Europe

Corporate Governance Reforms in Continental Europe

The Anatomy of Corporate Law: A Comparative and Functional Approach

Pyramidal Groups and Separation Between Ownership and Control in Italy

The Anatomy of Corporate Law