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How to Measure Country level Financial Reporting Quality?

Qingliang Tang a,*, Huifa Chen  b, Zhijun Lin c

a School of Business, University of Western Sydney, Australia

 bSchool of Economics & Management, Shanghai Maritime University, People’s Republic of China 

c Department of Accountancy & Law, Hong Kong Baptist University, Hong Kong

We thank the participants at the 6th International Conference on Asian Financial Markets, Fukuoka, Japan, the 7th International Business Research Conference, Sydney, and workshop participants at the University of WesternSydney and the University of South Australia, Neal Arthur and Sidney Gray for their insightful comments andsuggestions on earlier versions of this paper. Dr. Qingliang Tang acknowledges financial support from theAccounting & Finance Association of Australia and New Zealand for the project. Dr. Huifa Chen acknowledgesfinancial support from the grants of National Natural Science Foundation of China (NSFC, No. 70872067),Science & Technology Innovation Program of Shanghai Municipal Education Commission, People’s Republicof China (No. 12YS068), Science & Technology Program of Shanghai Maritime University, People’s Republic

of China (No. 20110062) and China Scholarship Council. Any remaining error is the responsibility of theauthors.

*  Corresponding author: Dr. Qingliang Tang, School of Business, University of Western Sydney, Locked Bag1797, Penrith South DC, NSW 2751, Australia, Tel: +61 2 9685 9465, Fax: +61 2 9685 9339, E-mail:q.tang@uws.edu.au. 

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ABSTRACT

This study constructs six accounting and auditing indicators to develop a comprehensive

index to measure financial reporting quality of 38 main capital markets in the world from

2000 to 2007. In order to test the validity of the methodology, we use the index to tests

national institutional impact on financial reporting quality and find results that are consistent

with our prediction and previous studies. The evidence suggests the innovative quality

measure is appropriate and provide a useful tool for researchers who concern financial

reporting quality at country level.

 Keywords: Country level financial reporting quality, financial reporting quality indicators andindex

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1. Introduction

In pace with the rapid growth in international business and the globalization of capital

markets, financial reporting plays an important role in promoting international trades, capital

flows, economic growth and cross-country merger and acquisition. Prior studies document

that high quality financial reporting is beneficial to reduce information asymmetry and cost of

capital (e.g., Diamond and Verrecchia, 1991; Leuz and Verrecchia, 2000; Bhattacharya and

Daouk, 2002; Bhattacharya et al., 2003; Frankel and Li, 2004; Francis et al., 2004, 2005;

Daske et al., 2008), improve the efficiency of capital resource allocation (Sun, 2006;

Bushman et al., 2011) and corporate governance (Bushman and Smith, 2001).

 Numerous efforts have been made by national and international organisations (including

stock market regulatory institutions and standards setters such as SEC, IASB, FASB,

IOSOCO) to improve financial reporting quality. However, there is a lack of an adequate

measure of the quality of financial reporting particularly at country level. While there is

 plenty of firm level research, the methods adopted are not appropriate for cross country

analysis. Firm level differences in financial reporting quality are associated with management

motivation, while national differences reflect characteristics of the legal systems, capital

market development, investor protection (Leuz et al., 2003), corporate governance practices

(La Porta et al., 2000b), culture (Gray, 1988; Gray and Vint, 1995; Guan et al., 2005;

Doupnik, 2008; Guan and Pourjalali, 2010), and accounting standards, etc. This motivates us

to develop a method to measure the quality of national financial reports using accounting and

auditing data.

Financial reporting quality refers to the extent to which the financial statements provide

true and fair information about the underlying financial position and economic performance

(FASB, IASB, ASB [UK], and AASB [Australia]). Financial reporting quality could differ

due to complex interactions among many factors, so that it is inherently difficult to measure,

especially across borders. This study attempts to analyze the outcomes of accounting and

auditing systems and identify proxy indicators for financial reporting quality. A candidate

indicator that is under consideration meets all of the following criteria: 1) The indicator can

 be reasonably, reliably measured; 2) Data for measuring the indicator is available; and 3)

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Interpretation is straightforward, i.e., there is a direct link between the value of the indicator

variable and the reporting quality. More specifically, this study uses measures that are

intended to capture six dimensions of accounting and auditing quality: the loss avoidance

ratio, the profit decline avoidance ratio, the accruals ratio (i.e., scaled accruals), the qualified

audit opinion ratio, the non-Big 4 auditors ratio and the audit fee ratio (i.e., scaled audit fee).

We focus on them because prior studies have suggested that these indicators may capture the

strength of the link between financial reporting and underlying economic performance. This

study then develops a financial reporting quality index based on the six indicators for 38 main

capital markets in the world from 2000 to 2007 (per market per year). An overall financial

reporting quality index (FRQI, based on eight years average of the yearly indexes) is

constructed to determine the overall rank of financial reporting quality of each market. Note

this index is determined by the national institutional system and is first used in literature as a

 proxy for national financial reporting quality.

In order to test whether the method is appropriate, we apply this index in an empirical

study of the impact of national institutional factors on reporting quality. If our methodology is

valid, we should find results that are consistent with our prediction and prior research. Using

data from 166,903 annual financial statements from 2000 to 2007 of publicly listed firms in

38 main capital markets around the world, we find that: 1) developed markets (such as United

States, United Kingdom, Australia, Japan and Germany) have higher financial reporting

quality than emerging markets; 2) Capital markets with stronger investor protection have

higher financial reporting quality; 3) The strength of legal enforcement also plays an

important role; and 4) Finally, despite that enormous international efforts have been made

towards the convergence, our results show that considerable diversity in accounting and

auditing still existed around the world; hence the effectiveness of global harmonisation

remains a crucial issue to be further explored.

These results are highly consistent with that documented by previous studies and thus

suggest that the methodology of this study is a valid measure of national financial reporting

quality. Prior studies typically use accounting variables only (e.g., Leuz et al., 2003;

Bhattacharya et al., 2003; Francis and Wang, 2008), which reflects a partial and incomplete

 picture of reporting practices and quality. To improve the methodology we add auditing

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factors to evaluate the reporting quality. Auditing is an independent verification that enhances

financial statement reliability and usefulness (Francis et al., 1999). Since auditing is an

integral part of the system, the inclusion of auditing variables would better reflect overall

financial reporting quality.

The rest of the paper is organised as follows. The next section discusses the

methodological issues in the measurement of country level financial reporting quality with

the development of proxy measures. Section 3 provides the data and presents financial

reporting quality of 38 national capital markets using our reporting quality index. Section 4 is

an application of our financial reporting quality index in a cross board study. The purpose of

the study is to test the validity of our methodology. We summarize our findings and discuss

the implications and limitations in the final section.

2. Country level financial reporting quality measure

2.1. Selection of financial reporting quality indicators

Financial statements are the result of management’s representations and the auditor’s

assurance to outsiders about the validity of those representations (Krishnan, 2005). Therefore,

we consider both accounting and auditing aspects to determine the indicators of national

financial reporting quality.

2.1.1. Loss avoidance ratio

The first indicator is a measure of earnings management. The shareholders of public

firms with a dispersed ownership are likely to use a simple and explicit earnings-based

 benchmark to assess firm’s financial position and economic performance. This gives

managers incentives to manipulate earnings in order to present a more favourable picture to

maximise their compensation and maintain their employment with the firm (Healy and

Wahlen, 1999). These incentives for self-wealth maximisation of managers would result in a

higher than expected number of firms with small profits. Prior studies support this conjecture.

For example, Burgstahler and Dichev (1997) present persuasive evidence that firms in the

United States actively engage in earnings management to avoid reporting losses. Prospect

theory provides an alternative explanation for the loss avoidance and profit decline avoidance

managerial behaviour. Prospect theory suggests that individuals’ value functions are concave

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in gains and convex in losses (Kahneman and Tversky, 1979). Therefore, if zero is a natural

reference point for change in profit, then managers will manipulate earnings so the change is

 positive. Such earnings management behaviour obscures the relationship between accounting

earnings and underlying economic performance, thus reduces financial reporting quality.

Following prior research, we define small profit (small loss) firms as firms with net

income scaled by lagged total assets between 0 and 1 percent (between -1 and 0 percent), and

the loss avoidance ratio is the ratio of the total number of small profit firms divided by the

total number of small loss firms (Burgstahler and Eames, 2003; Leuz et al., 2003; Burgstahler

et al., 2006; Jacob and Jorgensen, 2007). The higher the ratio is, the greater the level of

earnings management is, and thus the lower financial reporting quality is. The formula for

loss avoidance ratio for capital market k , year t is as follows:

,

,

,

 k t 

k t 

k t 

Total number of small profit firms Loss Avoidance Ratio

Total number of small loss firms   (1)

2.1.2. Profit decline avoidance ratio

The second indicator is profit decline avoidance ratio. Barth et al. (1999a, 1999b) show

that firms with longer strings of consecutive profit increases are priced at a premium, and that,

when these firms experience declines in profit, the premiums fall sharply. Similarly,

DeAngelo et al. (1996) find that a break in a pattern of consistent earnings growth is

associated with a substantial decline in stock price. Beatty et al. (2002) demonstrate that

 public banks have more incentives to report steadily increasing earnings and tend to report

less small profit declines (relative to private banks). In summary, the price penalties for

falling short of prior profit, together with the possible effect of the stock price on managers’

compensation package, gives managers of publicly traded firms a considerable incentive to

report a pattern of increasing profit.

Consistent with prior research (Burgstahler and Dichev, 1997), this study defines small

 profit increase (decrease) firms as firms with change in net income scaled by lagged total

assets between 0 and 0.005 (between -0.005 and 0). The ratio decreases in financial reporting

quality. The formula for profit decline avoidance ratio for capital market k , year t  is as

follows:

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,

,

 k t 

k,t 

k t 

Total number of small profit increase firmsProfit Decline Avoidance Ratio =

Total number of small profit decrease firms  (2) 

2.1.3. Accruals ratio

The third indicator is the accruals ratio (also called scaled accruals), which is a measure

of accruals quality. Prior studies use accruals to measure earnings aggressiveness (e.g.,

Bhattacharya et al., 2003). Accruals magnitude reflects the degree of aggressiveness or

conservativeness of accounting policy. An aggressive accounting policy tends to delay the

recognition of losses and accelerate the recognition of gains, while a conservative accounting

 policy does the opposite. Ball et al. (2000) argue that accounting conservatism implies a more

timely incorporation of economic losses into accounting earnings than economic gains, which

arises to reduce information asymmetry between managers and investors. Since managers are

more likely to report economic gains and might have incentives to suppress information

about economic losses, bad news information is more credible and timely incorporation of

economic losses into accounting earnings provides a quick feedback about bad business

decisions that managers may sometimes be reluctant to disclose.

The level of accruals is used to measure the degree of aggressiveness of an accounting

system. If we hold cash flow from operations realization as constant, we would expect

accruals to increase as earnings aggressiveness increases. Following previous studies, we

measure the accruals quality using accruals divided by lagged total assets (i.e., accruals ratio).

The following equation is used to calculate the firm-level accruals ratio (Healy, 1985; Jones,

1991; Dechow et al., 1995; Sloan, 1996):

, , , , , ,

,

, 1

( ) ( )i t i t i t i t i t i t  

i t 

i t 

CA Cash CL STDEBT TP Dep Accruals Ratio

TA

  (3)

where ,i t CA is the change in current assets for firm i at year t, ,i t Cash is the change in cash

for firm i at year t,,i t CL is the change in current liabilities for firm i at year t,

,i t STDEBT  is the change in short-term debt included in current liabilities for firm i at year t,

,i t TP is the change in income taxes payable for firm i at year t, ,i t  Dep is the depreciation and

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amortization expenses for firm i at year t, and , 1i t TA is the total assets for firm i at year t -11.

Then, the median observation of the firm-level accruals ratio (rather than the average to avoid

or minimize the influence of extreme values) of the firms in a capital market is used to

measure the market level reporting quality (e.g., Leuz et al., 2003). A smaller accruals ratio

suggests less managerial discretion and earnings management, and therefore, higher financial

reporting quality of the capital market in question.

Prior studies also use discretionary/abnormal accruals to detect firm-level earnings

management (e.g., Dechow et al., 1995, 2003; Jones et al., 2008). Discretionary accruals are

typically measured as the difference between total accruals and estimated non-discretionary

(normal) accruals that are determined by various cross-sectional discretionary accruals

models, e.g., the Jones model, the modified Jones model, the adapted Jones model, the

modified Jones model with book-to-market ratio and cash flows from operations, etc. (Jones,

1991; Dechow et al., 1995, 2003; Larcker and Richardson, 2004; Geiger and North, 2006;

Jones et al., 2008). The discretionary accruals are not employed because we do not have a

theory to estimate normal accruals in an international setting2.

2.1.4. Qualified audit opinion ratio

 Next, we consider auditing variables. Financial statements are the representations of

management, and individual investors use them to make decisions but rely on the auditor to

verify the credibility of financial statements (Firth, 1978; Chow and Rice, 1982; Dopuch et

al., 1986; Chen et al., 2000). As an audit can effectively reduce and mitigate information

asymmetry, auditing is an integral part of the modern financial reporting system. When we

evaluate an accounting system in a capital market we should adequately consider the

auditor’s opinion and assurance on financial reports. An auditor may issue an unqualified or a

qualified opinion based on his/her examination. A qualified audit opinion is prima facie

evidence of low financial reporting quality, holding audit quality constant. Thus, the fourth

indicator is:

1  One of the reviewers of an early version of the paper pointed out the reversing nature of accruals. While we admit there isinherent limitation, our method is consistent with previous studies in a similar research setting and context (Leuz et al., 2003;

Bhattacharya et al., 2003; Francis and Wang, 2008). For example, Bhattacharya et al. (2003) use total accruals in their study

that covers 34 countries from 1984 to 1998.2  Discretionary accruals were hardly used in prior cross-country studies (e.g., Meuwissen et al., 2007; Francis and Wang,2008; Wysocki, 2009) due to heterogeneity of institutional systems in national capital markets across borders.

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,

,

 k t 

k,t 

k t 

Total number of qualified audit opinionsQualified Audit Opinion Ratio =

Total number of the auditees  (4)

2.1.5. Non-Big 4 auditor ratio

When we compare the proportion of qualified audit opinions between two capital

markets, we need to consider the identification of the auditors who issued the report. A low

quality auditor may issue an unqualified opinion without rigorous substantive testing. So we

introduce the fifth indicator, non-Big 4 auditor ratio, as a measure of external audit quality.

Auditing standards and practices, auditor training and education and the degree of auditor

independence varies across countries and so is the auditor quality. It is expected that a high

level of auditor quality is associated with a high quality of financial reporting. Therefore,

auditor quality is an important dimension of financial reporting quality.

Following prior research, we adopt auditor size as a proxy. Although large auditing firms

are not immune from audit risk and audit failure, large auditors are generally perceived as

 being more independent (DeAngelo, 1981a, 1981b), more experienced, having a higher

industry expertise (Carcello and Nagy, 2003; Krishnan, 2003) and making larger investments

in professional education and training (Dopuch and Simunic, 1980). Big 4 auditors3  are more

 prudent in order to protect their brand name since they have more to lose than non-Big 4

auditors in the event of reputation loss (Krishnan, 2005). Based on the above analysis, it is

expected that high quality auditors will affect earnings quality by constraining aggressive

reporting of accruals and persuading clients to reveal economic losses in a timely fashion. So

the fifth indicator of financial reporting quality is non-Big 4 auditor ratio, and the formula is

as follows.

,

,

 1

 

k t 

k,t 

k t 

Total number of firms that are audited by Big 4 auditors Non- Big 4 Auditor Ratio =

Total number of the auditees   (5)

2.1.6. Audit fee ratio

Though large auditors generally deliver better services, it does not mean all large

auditors (or small auditors) provide the same quality of audit services. Thus we use the audit

fee to further differentiate auditing quality within the groups of large as well as small auditors.

3  We use the term Big 4 auditors throughout the paper to refer to Deloitte Touche Tohmatsu, Ernst & Young, KPMG andPricewaterhouseCoopers. But Big 4 auditors include Arthur Andersen before 2002.

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Different auditors (whether in larger or small auditor groups) charge different fees and we

conjecture the audit fee is associated with the audit quality. It is well known that the audit fee

charged is directly based on the working hours of auditors, and the hour rate is different

among partners, managers and junior audit staff, suggesting audit fee is highly related to

experience, expertise, knowledge of auditor, ceteris paribus. The difference in experience and

knowledge of auditing staff determines or at least is a decisive factor for the audit quality.

Auditor experience and expertise is the result of investment by auditing firm, and the audit

fee charged must compensate for the investment in audit quality including training, education,

working experience for audit staff, etc. From the client’s perspective, audit fee represents the

expected quality of services the client pays for. Thus holding all else constant, the more the

audit fee paid the better the audit service acquired. From the auditor’s perspective, an

increase in the auditor’s non-detection penalty would increase the audit fee because in a

competitive audit market the fee must compensate the auditor for the higher expected loss

(Newman et al., 2005). If the inherent risk is perceived high, auditing firms will assign the

engagement to more competent and experienced staff thus resulting in a higher charge of

audit fee. In other words, a higher audit fee reflects the higher level of auditor efforts to

control and minimize the risk of audit failure. Thus, audit fee is a measure of audit quality

that complements, rather than duplicates the auditor size indicator. Since the audit fees are

also determined by other factors such as the complexity of transactions, volume of audit

services, quality of internal control and so on (e.g., Simunic, 1980; Palmrose, 1986; Hay et al.,

2006), we use total assets to control for these factors. The high quality of audit service would

have a positive impact on financial reporting quality4. So our last financial reporting quality

indicator is the audit fee ratio:

i,t 

i,t 

i,t 

 Audit fee Audit Fee Ratio =

Total assets  (6)

We use the median observation of firm-level audit fee ratio (rather than the average) for a

capital market in this study. The audit fee ratio increases in the quality of financial reporting

of the capital market.

4  Note we argue that audit fee is related to audit quality under the assumption of competitive audit market as opposed tomonopoly market.

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2.2. Calculation of financial reporting quality index (hereafter FRQI)

Given the six individual indicators per capital market per year, we adopt an overall

quality index method (PricewaterhouseCoopers, 2001; Kurtzman et al., 2004; Kurtzman and

Yago, 2007, 2008) to calculate the financial reporting quality index (FRQI) for the sample

markets. The steps of this method application are as follows. First, we rank capital markets by

the six individual financial reporting quality indicators as defined above. All indicators,

except for audit fee ratio (which is positively related to reporting quality), are negatively

associated with financial reporting quality. Second, for each indicator of the first five (except

for audit fee ratio), the market with the lowest (highest for audit fee ratio) indicator value is

assigned a score of 100, and the score of other markets are calculated as a percentage of the

top score respectively5. Next, the scores for each indicator are equally weighted to calculate

the yearly financial reporting quality index (FRQI) for each capital market (i.e., FRQI = the

arithmetic average of the scores of 6 indicators)6. The index increases in reporting quality.

Finally, the eight-year average of FRQI determines a market’s overall FRQI (or OFRQI) and

rank, which reflects the number of total markets of our sample that sit above it. Table 1

summarizes the definition and measurement of financial reporting quality indicators and both

yearly and overall FRQI.

Insert Table 1 here

3. Data and descriptive statistics

3.1. Sample and data

We select listed companies on 38 main capital (i.e., stock) markets in the world for this

study. A capital market in our sample must have at least 300 total firm-year observations

from 2000 to 20077. As some countries may contain more than one stock exchange8, if this is

5  If a market’s accruals ratio is positive, then the score on the accruals ratio of the market is assigned zero. In a robustness

test, if a capital market’s accrual ratio is positive, then the negative score on the accruals ratio is used to calculate themarket-year’s FRQI, the results are virtually unchanged (not tabulated).6  In our sample, the audit fees data of seven markets (i.e., Santiago Stock Exchange, Athens Stock Exchange, Indonesia

Stock Exchange, Korea Exchange, Mexican Stock Exchange, Moscow Interbank Currency Exchange (MICEX) and TaiwanStock Exchange) are not available from the Worldscope database for 2000 to 2007. In this case, the scores for the first five

financial reporting quality indicators (i.e., score on the loss avoidance ratio, score on the profit decline avoidance ratio, scoreon the accruals ratio, score on the qualified audit opinion ratio, and score on the non-Big 4 auditor ratio) are used to calculatethe market-year’s FRQI.7  For example, the Istanbul Stock Exchange (Turkey) and the Buenos Aires Stock Exchange (Argentina) are not included as

the total firm-year observations are less than 300 from 2000 to 2007.8  In our 38 sample capital markets, 19 national markets have only one stock exchange (e.g., Austria, Belgium, France, HongKong, Singapore, Taiwan), 8 markets have two stock exchanges (e.g., Chinese Mainland, Korea, Sweden, Thailand, UK), 3

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the case, we chose the stock exchange(s) that is (are) the most important in the country.

Regarding sample firms, we only include companies that have financial statement data in the

Worldscope database needed to calculate the reporting quality indicators for at least three

consecutive years. In addition, consistent with prior studies (e.g., Hung, 2001; Francis and

Wang, 2008), financial institutions (i.e., those with four-digit Standard Industrial

Classification Codes between 6000 and 6999) are excluded from the sample due to their

distinct regulation and disclosure requirements. Our final sample consists of 166,903

firm-year observations (see far-right column of Table 2).

Insert Table 2 here

3.2. Descriptive statistics of firm-year observations and financial reporting quality of capital

market

Table 2 presents the overall FRQI (OFRQI) and ranking, yearly FRQI, market

development level and sample distribution. It shows that the total firm-year observations per

market range from 445 observations for the Portugal market (Euronext Lisbon) to 28,513

observations for the Japan market (Tokyo Stock Exchange). There are 21 (17) developed

(emerging) markets in our sample (see column 5 of Table 2). 

The third column of Table 2 shows that the US market (NYSE) gets the highest overall

FRQI 42.49 (i.e., average of eight yearly FRQI), which ranks the US first in our sample. The

UK market (London Stock Exchange, 40.19) ranks next and the Finland market (NASDAQ

OMX Helsinki, 40.15) ranks the third on the list. The overall FRQI also indicates that

Australia (Australian Securities Exchange, 38.39), Japan (Tokyo Stock Exchange, 38.22),

Germany (Frankfurt Stock Exchange, 32.77) and three Scandinavian markets ((i.e., Finland,

Denmark [NASDAQ OMX Copenhagen] and Sweden [NASDAQ OMX Stockholm]) are

among the top 10 markets in terms of financial reporting quality. The overall FRQI of

Pakistan (Karachi Stock Exchange, 20.06), Malaysia (Bursa Malaysia, 19.26), Indonesia

(Indonesia Stock Exchange, 17.52), India (Bombay Stock Exchange, 16.34) and China

(Chinese Mainland Stock Exchange, 12.18) are among the lowest financial reporting quality

markets have three (i.e., Chile, Pakistan and Russia), Australian and Spanish markets have four, Canadian market has five,

Brazilian and Japanese markets have six, German market has eight, Indian and American markets have more than ten stock

exchanges. We select only one or two stock exchanges to represent the country’s capital market. For example, we choose NYSE, because we believe NYSE is more representative for US capital market than other stock exchanges such as NASDAQ, etc.

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markets, which is consistent with prior studies that these markets9  have the greatest level of

earnings management in financial reporting (Leuz et al., 2003). The remainder columns of

Table 2 respectively report the yearly FRQI and rank (in parentheses) of our sample markets.

3.3. Descriptive statistics of financial reporting quality indicators 

3.3.1. Loss avoidance ratio

Panel A of Table 3 presents eight-years’ average and rank (in parentheses) for the six

reporting quality indicators respectively. The mean of loss avoidance ratio (LAR) is 3.30,

which indicates the number of small profit firms is on average more than three times of that

of small loss firms10. This skewed distribution in favour of small profit firms suggests

earnings management is an international phenomenon and loss avoidance is one of the major

earnings management objectives. If we take the average ratio 3.30 as a benchmark, any

market whose ratio is above (below) 3.30 is a high (low) risk market with respect to earnings

management activities. High risk markets include: China (Chinese Mainland Stock Exchange,

17.16), Indonesia (Indonesia Stock Exchange, 5.48), Portugal (Euronext Lisbon, 5.24), Spain

(Madrid Stock Exchange, 5.11), Russia (MICEX 5.00), Japan (Tokyo Stock Exchange, 4.34),

India (Bombay Stock Exchange, 4.15) and Taiwan (Taiwan Stock Exchange, 4.11), while low

risk markets include Chile (Santiago Stock Exchange, 1.39), South Africa (Johannesburg

Stock Exchange, 1.40), Australia (Australian Securities Exchange, 1.46), Norway (Oslo Stock

Exchange, 1.58), Finland (NASDAQ OMX Helsinki, 1.70), Canada (Toronto Stock Exchange,

1.74), US (NYSE, 1.75) and UK (London Stock Exchange, 1.77).

Insert Table 3 here

3.3.2. Profit decline avoidance ratio

The overall eight year average of profit decline avoidance ratio (PDAR) is 1.61, which is

much lower than the loss avoidance ratio. The result suggests that firms have stronger

incentives to avoid a loss than to avoid a profit decrease. The best PDAR ratios are found in

the capital markets of Taiwan (1.06), India (1.11), Korea (Korea Exchange, 1.19), Brazil

(BM&FBOVESPA, 1.21), Sweden (NASDAQ OMX Stockholm, 1.22), Greece (Athens

9  Leuz et al. (2003), using cluster analysis, grouped these capital markets as insider economies with weak legal enforcement

cluster.

10  Our average loss avoidance ratio is slightly higher than that (3.196) reported in prior research using data of 31 countriesfor 1990 to 1999 (Leuz et al., 2003). If we use the same 31 sample countries, the average loss avoidance ratio in 2000 to2007 is 2.97 (not reported).

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Stock Exchange, 1.26), Mexico (Mexican Stock Exchange, 1.27) and Israel (Tel Aviv Stock

Exchange, 1.30). High risk markets in profit decline avoidance activities include Spain

(Madrid Stock Exchange, 2.91), Russia (2.59), New Zealand (New Zealand Stock Exchange,

2.51), Ireland (Irish Stock Exchange, 2.34), Pakistan (Karachi Stock Exchange, 2.11), Austria

(Vienna Stock Exchange, 1.99), Indonesia (1.91) and Hong Kong (Hong Kong Stock

Exchange, 1.90).

3.3.3. Accruals ratio

The overall eight-year average accruals ratio (AR) is -0.035311. Using this as a

 benchmark; we found that low earning management risk markets include Belgium (Euronext

Brussels, -0.0591), Austria (Vienna Stock Exchange, -0.0578), Germany (-0.0574), Finland

(-0.0534), Netherlands (Euronext Amsterdam, -0.0522), Denmark (NASDAQ OMX

Copenhagen, -0.0510), Norway (Oslo Stock Exchange, -0.0461), France (Euronext Paris,

-0.0454), Switzerland (SIX Swiss Exchange, -0.0454), Sweden (NASDAQ OMX Stockholm,

-0.0450) and UK (-0.0449). The high risk markets are China (-0.0124, which also shows a

highest loss avoidance ratio), India (Bombay Stock Exchange, -0.0137), Taiwan (-0.0156),

Greece (Athens Stock Exchange, -0.0179), Singapore (Singapore Exchange, -0.0181),

Indonesia (-0.0191), Hong Kong (-0.0191), Malaysia (Bursa Malaysia, -0.0194), Brazil 

(BM&FBOVESPA, -0.0222), Korea (-0.0237) and Russia (MICEX, -0.0252)12.

3.3.4. Qualified audit opinion ratio

 Next, we go through the auditing indicators. First, the overall eight-year average of

qualified audit opinion ratio (QROR) is 3.78%. We found the ratio varies considerably across

national capital market. In some markets firms received a pretty high percentage of qualified

audit opinions, e.g., Portugal (Euronext Lisbon, 20.77%), Australia (13.07%), Thailand

(Stock Exchange of Thailand, 12%), Indonesia (9.17%), Philippine (Philippine Stock

Exchange, 8.99%), Spain (Madrid Stock Exchange, 8.63%), Greece (8.54%) and Brazil

(8.20%). But, in other markets the ratio is quite low, for example, Japan (0.04%), Taiwan

11  This is lower than -0.02141 found by Bhattacharya et al. (2003) that cover 34 countries from 1984 to 1998. If we use thesame 33 countries (excluding the Istanbul Stock Exchange in Turkey), the average accruals ratio in 2000 to 2007 is -0.0362.12  Note the ratio is calculated excluding financial firms. If the financial institutions are included, this ratio is -0.0254, which

is higher than that of the sample (i.e., -0.0353) excluding financial institutions. The result seems consistent with priorresearch. For example, Beatty et al. (2002) demonstrate that public banks have more incentives to report steadily increasingearnings and tend to report less small profit declines.

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(0.26%), France (0.31%), Germany (0.63%) and Sweden (0.72%).

3.3.5. Non-Big 4 auditor ratio

The average non-Big 4 auditor ratio (NBAR) is 42.39% in our sample, suggesting a

huge difference in terms of audit market distribution. In the US market (NYSE), Big 4

auditors occupied nearly 94% of the audit market, while in Pakistan and India it is only

7.70% and 11.63%, respectively. In the world’s largest emerging market, China, the Big 4

auditors accounted for 12.20% of the audit market. These results suggest large auditors have

less influence in developing markets. However, the market difference also exists in developed

markets. For example, the Big 4 auditor ratio is about 35% in France, which is much lower

than that in the US (93.49%), Switzerland (86.15%), Spain (85.69%), Belgium (85.24%),

Ireland (83.06%) and Italy (Borsa Italiana, 80.47%).

3.3.6. Audit fee ratio

The average audit fee ratio (AFR) of eight years is about 0.12%, i.e., the audit fee

accounts for 0.12% of total assets in our sample. The top three highest audit fee ratios are

found in the UK (0.33%), Australia (0.31%) and Israel (Tel Aviv Stock Exchange, 0.22%),

while the bottom three lowest audit fee ratios are in Pakistan (0.01%), India (0.02%) and

China (0.03%).

In short, we find that the above six indicators present fairly large differences in financial

reporting quality across our sample markets. To the extent that the values of these indicators

are the outcome of the application of national accounting and auditing standards, the results

do not suggest substantial convergence of financial reporting and auditing practices around

the world.

3.4. Univariate results of capital market development level on FRQI and financial reporting

quality indicators

Panel B of Table 3 shows that the financial reporting quality index (FRQI ) is statistically,

significantly higher in the developed markets than in the emerging markets (both mean and

median are different at 1% significance level). In addition, the results reveal that the

developed markets have on average a lower loss avoidance ratio, accruals ratio, qualified

audit opinion ratio and non-Big 4 auditor ratio, higher audit fee ratio (both mean and median

are different at 1% significance level), but higher profit decline avoidance ratio (the median

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difference is significant at 5% level), indicating that listed companies in the developed

markets have demonstrated a higher overall reporting quality as well as a better individual

quality indicators (except for the profit decline avoidance ratio).

3.5. Correlations among financial reporting quality indicators

Panel C of Table 3 presents a correlation matrix among the six financial reporting quality

indicators. The results show that the absolute values of all correlation coefficients are less

than 0.50, suggesting multicollinearity is not a serious issue and the six indicators reflect

distinct dimensions of financial reporting quality and do not suffer from an overlapping

 problem. Note the Pearson (Spearman) correlation coefficient between audit fee ratio ( AFR) 

and loss avoidance ratio ( LAR) is -0.342 (-0.407) (significant at 1% level). This evidence

indicates higher audit fees relate to lower loss avoidance ratio (i.e., higher financial reporting

quality) and justifies the utility of audit service in terms of its function to ensure the reliability

of financial statements.

4. Institutional system and financial reporting quality

4.1. Investor protection and financial reporting quality

In this section, we examine whether country level institutional factors affect the quality

of financial reporting. Many cross-country studies define investor protection as the extent to

which the national law protects investors, and document that investor protection affects

capital market development and corporate policy choices (see La Porta et al. 1997, 1998,

1999, 2000a, 2000b, 2002).

Prior studies argue and find evidence that strong investor protection limits managers’

ability to acquire private control benefits and thus reduces their incentives to manage earnings

and increase the demand for greater transparency (La Porta et al., 1998; Ball et al., 2000;

Leuz et al., 2003; Burgstahler et al., 2006; Morris and Gray, 2007). Appropriate investor

 protection establishment also significantly mitigates the negative effect of higher accruals on

the value-relevance of earnings (Hung, 2001) and results in earnings that are more likely to

reflect underlying firm performance and reduce analyst forecast dispersion (Chang et al.,

2000). On the other hand, capital markets with weaker investor protection institutions have a

lower demand for public information and less voluntary disclosure (Francis et al., 2005),

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lower quality accounting standards and auditing (La Porta et al., 1998; Hung, 2001). Based

on the above discussion, we develop the following hypothesis:

 Hypothesis 1.  Ceteris paribus, capital markets with higher outside investor rights have

higher financial reporting quality.

We use the revised anti-director rights index13  developed by Djankov et al. (2008) as a

 proxy for outside investor protection institutions. It is an aggregate measure of minority

shareholder rights that ranges from zero to six in scale. Higher values of the index indicate

that minority shareholders are better protected against expropriation by management or large

shareholders.

4.2. Legal enforcement and financial reporting quality

Prior research suggests that rules alone are unlikely to be effective without proper

enforcement (Bhattacharya and Daouk, 2002). There is evidence that legal enforcement plays

a relatively more prominent role in corporate governance than investor protection laws

(DeFond and Hung, 2004). A strong system of legal enforcement could substitute for weak

rules since active and well-functioning courts could step in and rescue investors abused by

management (La Porta et al., 1998). Capital markets with a strong legal enforcement

mechanism are expected to effectively implement securities and corporate laws and

accounting standards that further limit managers’ ability to manipulate earnings (Leuz et al.,

2003; Burgstahler et al., 2006; Hay et al., 1996). In a stronger enforcement environment,

there are more stringent consequences for corporate directors from financial misstatements in

terms of civil and criminal liabilities, and other punishment and sanctions imposed by

regulatory agencies (Francis and Wang, 2008). Therefore, it is expected that strong legal

enforcement mechanisms will reduce the management opportunistic behavior and moral

hazard. Thus we propose the following hypothesis:

 Hypothesis 2. There is a positive association between the strength of legal enforcement and

13  The revised anti-director rights include (1) the ability to vote by mail, (2) the ability to gain control of shares during theshareholder’s meeting, (3) the possibility of cumulative voting for directors, (4) the ease of calling an extraordinary

shareholder’s meeting, (5) the availability of mechanisms allowing minority shareholders to make legal claims againstdirectors, and (6) shareholders have preemptive rights that can be waived only by a shareholder’s vote. Compared to theoriginal anti-director rights index developed by La Porta et al. (1998), the revised anti-director rights index is based on laws

and regulations applicable to publicly traded firms in May 2003 for 72 countries (versus in 1993 for 49 countries). The key

difference between the original and revised indices of anti-director rights lies in the treatment of enabling provisions(Djankov et al., 2008). In the robustness test, we use the original anti-director rights index as an alternative measure ofoutside investor rights. The results are virtually unchanged.

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 financial reporting quality.

We use the rule of law index developed by Kaufmann et al. (2008) to proxy for legal

enforcement. It measures the extent to which agents have confidence in and abide by the rules

of society. The index covers many aspects of rule of law such as enforceability of government

and private contracts, confidence in the judicial system, the courts and police, property rights,

executive accountability, confiscation/expropriation, as well as the likelihood of crime and

violence, and so on (see Kaufmann et al., 2008, 76-77). The value of this index ranges from

minus 3 to plus 3, with large values associated with a higher level of enforcement. 

We also consider firm size, financial leverage, profitability and firm growth that are

related to the quality of financial reporting. It is expected that firm size is positively related to

the FRQI. Firm size may proxy for many influences, and particularly larger firms are more

likely to be subject to public scrutiny, analyst following, media coverage and regulator’s

examination (Ball and Foster, 1982; Lang and Lundholm, 1993; Ahmed and Courtis, 1999).

As a result, these firms would adopt more conservative accounting policies and are more

likely to be audited by Big 4 auditors. Financial leverage and profitability are used to control

for other firm-specific influencing factors (such as debt financing). It is expected that firm

growth is negatively related to the FRQI as higher growth firms may engage in more earnings

management activities. Based on the discussion and prior studies, we construct the following

regression model to perform our tests.

, 0 1 , 2 , 1 , 2 , 3 ,

4 , ,

k t k t k t k t k t k t  

k t i t k t  

FRQI InvPro LegEnf SIZE LEV ROA

Growth Year Controls

 

   

  (7)

In the equation (7), the dependent variable is country level reporting quality proxy,

financial reporting quality index (FRQI ) and the main explanatory variables are investor

 protection ( InvPro) and legal enforcement ( LegEnf ). The coefficients of InvProk,t  and LegEnf k,t  

are expected to be positive and significant, indicating that both play an important role in

determining the quality of financial reporting. We include year dummy variable to control for

its impact in the empirical analyses.

4.3. Empirical results

4.3.1. Univariate analysis

Insert Table 5 here

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Table 5 presents Pearson and Spearman correlation matrix between financial reporting

quality index (FRQI ) and the test (explanatory) and control variables. As expected, there is a

 positive relation between outside investor rights  ( InvPro) and FRQI   (but insignificant), and

 between legal enforcement ( LegEnf ) and FRQI  (significantly positive, p=0.000). This result is

consistent with the Hypothesis 1 and 2. Turning to the other variables, we find firm size  

(SIZE ) is positively and significantly related to FRQI  (p=0.000), suggesting larger firms have

a higher financial reporting quality. There is no significant relation between financial leverage

( LEV ) and   FRQI . The profitability ( ROA) and   FRQI   is negatively associated (p=0.000).

Finally, we find that, as predicted, the association between firm growth (Growth) and FRQI  is

significantly negative (p=0.000).

4.3.2. Multiple regression analysis

Table 6 presents the multiple regression results of investor protection and legal

enforcement on financial reporting quality. As expected, both investor protection ( InvPro) and

legal enforcement  ( LegEnf ) are significantly and positively associated with FRQI   (t=2.38,

 p 0; LegEnf = InvPro, F value =15.33， p

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remote in our analyses. The D-W value of Model (7) is close to 2, suggesting autocorrelation

does not appear as an issue in the research design. The above results also suggest that the

FRQI is likely to be a reasonably appropriate measure of the quality of financial reporting

system at country level. Note for the signs of the regression coefficients, the two-tailed tests

we applied are conservative statements of the results.

4.4. Robustness tests

We run a number of robustness tests to check whether our results are sensitive to the

research design and model specifications.

First, we use equal weight (i.e., 1/6) to each of the 6 indicators to calculate the FRQI in

the main tests. However, some financial reporting quality indicators may be arguably more

important than others. For example, it can be argued that the LAR, PDAR and AR could be

more vital for measuring financial reporting quality than NBAR. Thus, we assign more weight

(i.e., 20%) to LAR, PDAR and AR and 13.3% weight to QAOR, NBAR and AFR,

respectively. The results (un-tabulated) are essentially the same.

Second, it can be argued that some large but non-Big 4 auditors perform equally good

audit work, thus the use of NBAR could be biased in favour of large auditors (i.e., Big-4) in

some countries15. To address this concern, we substitute Big-4 auditors with the Big N

auditors that are the full members of the Forum of Firms (FOF) of International Federation of

Accountants16  to calculate the non-Big N auditor ratio. Based on this new audit quality

indicator, we re-calculated the FRQI, the FRQI ranking and rerun the analyses. The results

(not tabulated) are virtually unchanged.

Third, we consider three widely used alternative measures of outside investor protection:

national legal system (i.e., common law versus code law), the original anti-director rights

index and the disclosure requirement index. Prior research shows that common law countries

15  For example, Panel A of Table 3 shows that the NBAR for the NYSE Euronext New York Stock Exchange is 6.51%,which suggests that Big 4 auditors occupied nearly 94% of audit market in the NYSE Euronext New York Stock Exchange.16  The Forum of Firms (FOF) is an association of international networks of accounting firms that perform transnational

audits, which is formally established in 2002. The full members of the FOF have committed to adhere to and promote theconsistent application of high-quality audit practices and standards worldwide, support convergence of national audit

standards with the International Standards on Auditing, and commit to meeting the FOF’s membership obligations. Up to 13April 2011, there are 22 full members of the FOF, i.e., BDO, Constantin Associates Network, Crowe Horwath International,Deloitte Touche Tohmatsu Limited, Ernst & Young Global Limited, Grant Thornton International Ltd., HLB International,

IECnet, INPACT Audit Limited, JHI, JPA International, KPMG International Cooperative, Kreston International, Mazars,

Moore Stephens International Limited, PKF International Limited, PricewaterhouseCoopers International, RSM InternationalLimited, Russell Bedford International, SMS Latinoamérica, Talal Abu Ghazaleh & Co. International and UHY InternationalLimited.

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 provide stronger investor protection than code law countries due to common law countries

having a stronger orientation to private contracting and the protection of private property

rights (La Porta et al., 1998). The original anti-director rights index is an aggregate measure

of minority shareholder rights and ranges from zero to five (La Porta et al., 1998). The

disclosure requirement index measures the extent to which there is required disclosure of

information on insiders’ compensation, ownership by large shareholders, transactions with

related parties, etc. for firms issuing securities. A larger index value indicates stronger

investor protection (La Porta et al., 2006). We repeated the analyses and found the results

(unreported) are robust to the three alternative measures of outside investor rights.

Fourth, we repeated our tests using the following three alternative measures of legal

enforcement: the rule of law index17, the quality index of the legal system and enforcement,

and the Worldwide Governance Indicators. The quality index of the legal system and

enforcement is the mean value of three indices (i.e., efficiency of judicial system index, rule

of law index, and corruption index) (Leuz et al., 2003). The Worldwide Governance

Indicators18  are measured by the mean value of six indices (i.e., voice and accountability

index, political stability and absence of violence index, government effectiveness index,

regulatory quality index, rule of law index, and control of corruption index developed by

Kaufmann et al. (2008)). The results from using alternative legal enforcement measures do

not alter our inferences (unreported).

Finally, the results are also not sensitive to alternative measures of firm size (i.e., total

assets or market capitalization) and profitability (i.e., return on equity instead of return on

assets).

5. Conclusions and implications

The knowledge of financial reporting quality at country level is important for investors

and prior research shows investment risk is inversely related to financial reporting quality.

17  The rule of law index is an assessment of the law and order tradition in the country produced by the country risk ratingagency International Country Risk (ICR). It is the average of the months of April and October of the monthly index between

1982 and 1995 and the scale is from zero to ten (La Porta et al., 1998). A larger index indicates stronger legal enforcement.18  The Worldwide Governance Indicators are based on hundreds of specific and disaggregated individual variablesmeasuring various dimensions of governance, taken from 35 data sources provided by 32 different organizations. They

assign these individual measures of governance to categories capturing these six dimensions of governance, and use an

unobserved components model to construct six aggregate governance indicators in each period. They cover 212 countriesand territories for 1996, 1998, 2000, and annually from 2002 to 2007. All six dimensions of governance range from minus 3to plus 3 (Kaufmann et al., 2008).

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Although the level of disclosure and accounting standards (e.g., IFRS, US GAAP) are often

used to proxy for financial reporting quality (e.g., Kurtzman et al., 2004; Kurtzman and Yago,

2007, 2008), there is lack of a reliable measure of national level financial reporting quality in

the accounting literature.

This paper extends the literature by constructing and employing the financial reporting

quality index (FRQI). This measure is innovative because the study is the first in literature to

use both accounting and auditing data to construct financial reporting quality indicators.

Using the index, we find our results of typical international tests are consistent with our

 predictions and previous studies, suggesting the fFRQI is appropriate for country level

studies. Further research may adopt this quality measure to perform cross-country studies

such as investigating the impact of accounting reforms (e.g., IFRS adoption) as well as

changes in capital market legislation (e.g., the Sarbanes-Oxley Act) and corporate governance

on financial reporting quality around the world. In addition, the diversity of financial

reporting quality around capital markets in the world as documented in this study should

 prompt market regulators, accounting standard setters and professional accounting bodies to

reinforce the efforts on international convergence of accounting and financial reporting

standards and practices.

One limitation of our study is that some data for the accounting and auditing indicators

are not available for some firms particularly in emerging markets. Another limitation is that

our sample includes only listed companies that may not fully represent financial reporting

 practice of other organizations in the economies. Unavailable data further restrict our ability

to take into account of other potential indicators (e.g., accuracy of analysts’ earnings forecasts,

the ratio of firms with controlling shareholders) that may impact financial reporting quality at

country level, which is certainly an issue to be explored by future studies.

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1-32.

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Leuz, C., and R. Verrecchia. (2000). The economic consequences of increased disclosure. Journal of Accounting

 Research 38 (Supplement), 91-124.

Leuz, C., D. Nanda, & P. D. Wysocki. (2003). Earnings management and investor protection: an international

comparison. Journal of Financial Economics 69, 505-527.

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sample: An international test. Working paper, University of Maastricht.

Morris, R. D., & S. J. Gray. (2007). Corporate transparency differences in the Asian region: the feasibility of

global standardization in practice? Working paper, University of New South Wales and University of

Sydney.

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97-110.

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(3), 161-190.

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The Accounting Review 71 (3), 289-315.

Sun, K., (2006). Financial reporting quality, capital allocation efficiency, and financial structure: an international

study. Working paper, University of Hawaii at Manoa.

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Western Sydney.

Wysocki, P. (2009). Assessing earnings and accruals quality: U.S. and international evidence. Working Paper,

Massachusetts Institute of Technology. 

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Table 1

Measurement of financial reporting quality indicators and index 

Variable Variable Name Measurement Source

 LAR Loss Avoidance

Ratio

Loss avoidance ratio is the ratio of total number of small profit

firms divided by total number of small loss firms. Firms with netincome scaled by lagged total assets between 0 and 0.01 (between-0.01 and 0) are defined as small profit (small loss) firms.

Burgstahler

and Dichev(1997); Leuzet al. (2003)

PDAR Profit DeclineAvoidance Ratio

Profit decline avoidance ratio is the ratio of total number of small profit increase firms divided by total number of small profit

decrease firms. Firms with change in net income scaled by laggedtotal assets between 0 and 0.005 (between -0.005 and 0) aredefined as small profit increase (decrease) firms.

Burgstahlerand Dichev

(1997)

 AR Accruals Ratio Accruals ratio is the capital market’s median ratio of the firm-level

accruals scaled by lagged total assets, where accruals are

calculated as (∆current assets - ∆cash) - (∆current liabilities -

∆short-term debt - ∆tax payable) - depreciation and amortization

expense.

Dechow et al.

(1995); Sloan(1996); Leuzet al. (2003)

QAOR Qualified AuditOpinion Ratio

Qualified audit opinion ratio is the ratio of total number ofqualified audit opinions divided by total number of the auditees.

 NBAR  Non-Big 4 AuditorRatio

 Non-Big 4 auditor ratio equals one minus Big 4 auditor ratio,where Big 4 auditor ratio is the ratio of total number of firms thatare audited by Big 4 auditors divided by total number of theauditees.

 AFR Audit Fee Ratio Audit fee ratio is the capital market’s median ratio of the firm-level

audit fee scaled by total assets (audit fee and total assets are bothin millions of US dollars).

Tang (2007)

FRQI Financial Reporting

Quality Index

The financial reporting quality index is jointly determined by the

above six accounting and auditing indicators. For each indicator ofthe first five, the capital market with the lowest indicator value isassigned a score of 100, and other capital markets are calculated asa percentage of the top score. The higher is the score the higher isthe financial reporting quality of a particular capital market. If acapital market’s accruals ratio is positive, then the score on theaccruals ratio of this capital market is assigned zero. For the audit

fee ratio, which is opposite to the first five indicators as the capitalmarket with the highest indicator value is assigned a score of 100,

and other capital markets are calculated as a percentage of the topscore. Each indicator scores are equally weighted to calculate theFRQI for a capital market. If the audit fee ratio is not available in acapital market, then the scores for the first five financial reporting

quality indicators (i.e., score on the loss avoidance ratio, score onthe profit decline avoidance ratio, score on the accruals ratio, score

on the qualified audit opinion ratio, and score on the non-Big 4auditor ratio) are used to calculate the capital market’s FRQI.

OFRQI Overall FinancialReporting QualityIndex

Overall financial reporting quality index equals eight years averageof yearly financial reporting quality index.

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The Stock Exchange of Thailand (SET) is the national stock exchange of Thailand, which is located in Bangkok, Thailand.

The Tokyo Stock Exchange (TSE) is located in Tokyo, Japan and is the third largest stock exchange in the world by aggregate market capitalization of its

The Toronto Stock Exchange (TSX, formerly TSE) is the largest stock exchange in Canada, the third largest in North America and the seventh larges

Canada’s largest city, Toronto, it is owned by and operated as a subsidiary of the TMX Group for the trading of senior equities. A broad range of busine

other countries are represented on the exchange.

The Vienna Stock Exchange (VSE) is the only stock exchange in Vienna, Austria, and one of the most established exchanges in Eastern and Southeastern

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Table 3

Descriptive statistics

Panel A: Descriptive statistics of financial reporting quality indicators

Capital Market (Stock

Exchange)LAR PDAR AR QAOR NBAR AFR

Greece (Athens) 2.89 (22) 1.26 (6) -0.0179 (35) 0.0854 (32) 0.7964 (35) n.a.Australia (Australian) 1.46 (3) 1.54 (20) -0.0371 (20) 0.1307 (37) 0.4898 (29) 0.0031 (2)

Brazil

(BM&FBOVESPA)

2.42 (15) 1.21 (4) -0.0222 (30) 0.0820 (31) 0.4171 (21) 0.0006 (20)

India (Bombay) 4.15 (32) 1.11 (2) -0.0137 (37) 0.0489 (29) 0.8837 (37) 0.0002 (30)

Italy (Borsa Italiana) 2.54 (16) 1.57 (22) -0.0392 (17) 0.0105 (12) 0.1953 (6) 0.0005 (23)

Malaysia (Bursa

Malaysia)

2.94 (23) 1.31 (9) -0.0194 (31) 0.0268 (24) 0.4001 (20) 0.0004 (25)

China (Chinese

Mainland)

17.16 (38) 1.70 (28) -0.0124 (38) 0.0095 (9) 0.8780 (36) 0.0003 (29)

 Netherlands (Euronext

Amsterdam)

3.58 (28) 1.79 (29) -0.0522 (5) 0.0084 (7) 0.1476 (4) 0.0014 (13)

Belgium (EuronextBrussels)

2.61 (17) 1.65 (26) -0.0591 (1) 0.0321 (26) 0.4430 (23) 0.0009 (19)

Portugal (Euronext

Lisbon)

5.24 (36) 1.86 (30) -0.0436 (12) 0.2077 (38) 0.4843 (27) 0.0004 (26)

France (EuronextParis)

3.39 (27) 1.62 (25) -0.0454 (8) 0.0031 (3) 0.6469 (34) 0.0018 (6)

Germany (Frankfurt) 2.68 (18) 1.56 (21) -0.0574 (3) 0.0063 (4) 0.5470 (30) 0.0015 (10)

Hong Kong (Hong

Kong)

3.58 (29) 1.90 (31) -0.0191 (32) 0.0481 (28) 0.3811 (17) 0.0015 (9)

Indonesia (Indonesia) 5.48 (37) 1.91 (32) -0.0191 (33) 0.0917 (35) 0.6341 (33) n.a.

Ireland (Irish) 2.40 (14) 2.34 (35) -0.0345 (22) 0.0337 (27) 0.1694 (5) 0.0017 (7)South Africa

(Johannesburg)

1.40 (2) 1.59 (24) -0.0333 (23) 0.0215 (21) 0.4796 (26) 0.0015 (11)

Pakistan (Karachi) 2.30 (12) 2.11 (34) -0.0277 (26) 0.0501 (30) 0.9230 (38) 0.0001 (31)

Korea (Korea) 3.39 (26) 1.19 (3) -0.0237 (29) 0.0103 (11) 0.6273 (32) n.a.

UK (London) 1.77 (8) 1.32 (11) -0.0449 (11) 0.0139 (16) 0.4300 (22) 0.0033 (1)Spain (Madrid) 5.11 (35) 2.91 (38) -0.0413 (15) 0.0863 (33) 0.1431 (3) 0.0005 (24)

Mexico (Mexican) 2.25 (10) 1.27 (7) -0.0360 (21) 0.0206 (20) 0.2755 (9) n.a.

Russia (MICEX) 5.00 (34) 2.59 (37) -0.0252 (28) 0.0227 (22) 0.3201 (13) n.a.Denmark (NASDAQ

OMX Copenhagen)

2.70 (19) 1.58 (23) -0.0510 (6) 0.0117 (14) 0.3659 (16) 0.0021 (4)

Finland (NASDAQOMX Helsinki)

1.70 (5) 1.43 (16) -0.0534 (4) 0.0083 (6) 0.2297 (7) 0.0013 (14)

Sweden (NASDAQ

OMX Stockholm)

2.26 (11) 1.22 (5) -0.0450 (10) 0.0072 (5) 0.3855 (18) 0.0019 (5)

 New Zealand (New

Zealand)

2.38 (13) 2.51 (36) -0.0384 (18) 0.0250 (23) 0.3115 (12) 0.0012 (16)

US (NYSE Euronext New York)

1.75 (7) 1.38 (15) -0.0399 (16) 0.0125 (15) 0.0651 (1) 0.0010 (18)

 Norway (Oslo) 1.58 (4) 1.47 (18) -0.0461 (7) 0.0099 (10) 0.2785 (10) 0.0012 (15)Philippine

(Philippine)

2.03 (9) 1.44 (17) -0.0283 (26) 0.0899 (34) 0.2747 (8) 0.0003 (28)

Chile (Santiago) 1.39 (1) 1.66 (27) -0.0275 (27) 0.0084 (8) 0.3396 (15) n.a.

Singapore (Singapore) 3.32 (25) 1.51 (19) -0.0181 (34) 0.0185 (19) 0.2881 (11) 0.0011 (17)

Switzerland (SIX

Swiss)

3.79 (30) 1.34 (12) -0.0454 (9) 0.0145 (17) 0.1385 (2) 0.0014 (12)

Taiwan (Taiwan) 4.11 (31) 1.06 (1) -0.0156 (36) 0.0026 (2) 0.5971 (31) n.a.

Israel (Tel Aviv) 2.88 (21) 1.30 (8) -0.0425 (13) 0.0115 (13) 0.3252 (14) 0.0022 (3)

Thailand (Thailand) 2.81 (20) 1.34 (13) -0.0416 (14) 0.1200 (36) 0.4898 (28) 0.0005 (22)

Japan (Tokyo) 4.34 (33) 1.36 (14) -0.0296 (24) 0.0004 (1) 0.4708 (25) 0.0004 (27)

Canada (Toronto) 1.74 (6) 1.32 (10) -0.0380 (19) 0.0315 (25) 0.4458 (24) 0.0016 (8)Austria (Vienna) 3.08 (24) 1.99 (33) -0.0578 (2) 0.0153 (18) 0.3911 (19) 0.0006 (21)

Minimum 1.39 1.06 -0.0591 0.0004 0.0651 0.0001Maximum 17.16 2.91 -0.0124 0.2077 0.9230 0.0033Mean 3.30 1.61 -0.0353 0.0378 0.4239 0.0012

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Median 2.75 1.53 -0.0375 0.0195 0.3956 0.0012Std. Dev. 2.56 0.42 0.0133 0.0446 0.2116 0.0008

Panel B: Univariate results of capital market development level on FRQI and financial reporting quality

indicators

 N Mean (Median)Indicators

Developed Emerging Developed (a) Emerging (b)

Mean (Median)Difference

(a)-(b) 

t (Wilcoxon rank

sum) testFRQI 168 136 33.54

(32.64)23.29

(23.09)10.25(9.55)

10.92***

 (9.90

***)

 LAR 168 136 2.75(2.25)

3.99(2.82)

-1.24(-0.57)

-3.56***

(-2.67***

)

PDAR 168 136 1.68

(1.43)

1.52

(1.25)

0.16

(0.18)

1.34

(2.34**

)

 AR 168 136 -0.0425

(-0.0407)

-0.0265

(-0.0281)

-0.0160

(-0.0126)

-7.44***

 

(-6.78***

)

QAOR 168 136 0.0251

(0.0126)

0.0535

(0.0265)

-0.0284

(-0.0139)

-4.54***

 

(-4.90***

)

 NBAR 168 136 0.3316

(0.3473)

0.5380

(0.4910)

-0.2064

(-0.1437)

-9.19***

 

(-7.58***

)

 AFR 141 57 0.0015(0.0014) 0.0006(0.0004) 0.0009(0.0010) 7.41

***

 (7.54***

)

Panel C: Correlations coefficients among financial reporting quality indicators (N=304a)

 LAR  PDAR   AR  QAOR   NBAR   AFR 

1.000 0.149**

  0.082 0.017 0.146*  -0.342

**  LAR

(0.009) (0.153) (0.768) (0.011) (0.000)

0.167**

  1.000 0.033 0.008 -0.171**

  -0.084PDAR

(0.004) (0.569) (0.891) (0.003) (0.242)

0.045 0.051 1.000 0.112 0.215**

  -0.236**

  AR

(0.434) (0.377) (0.052) (0.000) (0.001)

-0.138*  0.011 0.192

**  1.000 0.119

*  0.040QAOR

(0.016) (0.844) (0.001) (0.038) (0.573)

0.025 -0.147**

  0.151**

  0.094 1.000 -0.159*  NBAR

(0.661) (0.010) (0.008) (0.104) (0.025)

-0.407**

  -0.113 -0.237**

  -0.178*  -0.095 1.000 AFR

(0.000) (0.113) (0.001) (0.012) (0.183)

 Notes:Panel A:The eight years average and rank (in parentheses) of six capital market level financial reporting quality indicators for year2000 to 2007 by stock exchange are tabulated in Panel A.

n.a. denotes data is not available.

Panel B:*, **, *** Significant at 0.10, 0.05 and 0.01 level respectively (two-tailed). t-test (Wilcoxon rank sum test) is used to test mean(median) difference between developed markets and emerging markets. N is stock exchange-year observations.

Panel C:*,  **  Correlation is significant at 0.05 and 0.01 level respectively (two-tailed). p-values are in parentheses. Pearson

(Spearman) correlation coefficients are in the upper (lower) triangle.a The number of observations of audit fee ratio are 198 due to audit fee data are not available in some stock exchanges.

All variables are as defined before. 

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Table 4

Description of variables 

Variable Variable Name Measurement Source

 InvPro  Outside InvestorRights

Outside investor rights is proxied by the revisedanti-director rights index19, which is an aggregate measureof minority shareholder rights and ranges from zero to six.

Djankov etal. (2008)

 LegEnf   Legal

Enforcement

Legal enforcement is proxied by the rule of law index,

which is a component measure of many rights (e.g., theextent to which agents have confidence in and abide bythe rules of society, and in particular the quality ofcontract enforcement, property rights, the police, and thecourts, as well as the likelihood of crime and violence)and ranges from minus 3 to plus 3.

Kaufmann et

al. (2008)

SIZE   Firm Size Firm size is the capital market’s median of the firm-levelnatural logarithm of sales in millions of US dollars.

Worldscope

 LEV   FinancialLeverage

Financial leverage is the capital market’s median ratio ofthe firm-level financial leverage, which equals totalliabilities to total assets.

Worldscope

 ROA  Profitability Profitability is the capital market’s median ratio of thefirm-level return on assets, which equals net profit tolagged total assets.

Worldscope

Growth Firm Growth Firm growth is the capital market’s median ratio of thefirm-level growth, which equals (current sales - laggedsales) / lagged sales.

Worldscope

19  The revised anti-director rights index is not available for all eight years under study and we acknowledge the datalimitations (the same as some alternative measures of investor protection and legal enforcement in robustness tests). We note

that this is a common limitation in cross-country studies (e.g., Hung, 2001; Leuz et al., 2003; DeFond et al., 2007), and that

changes in country-level institutions are a slow process (North, 1990). To the extent that the revised anti-director rights indexchanges over the investigation period, which may introduce noise into our measure of outside investor rights. However, wehave no reasons to believe this noise to bias towards supporting our hypotheses.

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Table 5

Correlations coefficients among variables (N=304) 

FRQI InvPro LegEnf   SIZE LEV ROA Growth

1.000 0.011 0.545**

  0.218**

  0.078 -0.268**

  -0.349**

 FRQI  

(0.855) (0.000) (0.000) (0.175) (0.000) (0.000)

-0.126*  1.000 -0.026 -0.280

**  -0.253

**  0.111 -0.030 InvPro 

(0.028) (0.652) (0.000) (0.000) (0.054) (0.603)

0.577**

  -0.143*  1.000 0.087 0.049 -0.358

**  -0.371

**  LegEnf

(0.000) (0.012) (0.132) (0.398) (0.000) (0.000)

0.227**  -0.338**  0.148**  1.000 0.350**  0.347**  0.138* SIZE  

(0.000) (0.000) (0.010) (0.000) (0.000) (0.016)

0.106 -0.282**  0.028 0.388**  1.000 0.224**  -0.065 LEV  

(0.066) (0.000) (0.621) (0.000) (0.000) (0.261)

-0.248

**

  0.127

*

  -0.244

**

  0.250

**

  0.040 1.000 0.520

**

  ROA

(0.000) (0.026) (0.000) (0.000) (0.483) (0.000)

-0.333**  0.018 -0.294**  0.089 -0.040 0.585**  1.000Growth

(0.000) (0.760) (0.000) (0.121) (0.490) (0.000)

 Notes:*,  **  Correlation is significant at 0.05 and 0.01 level respectively (two-tailed). p-values are in parentheses. Pearson

(Spearman) correlation coefficients are in the upper (lower) triangle. N is market-year observations.All variables are as defined before. 

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Table 6

Regression results of investor protection and legal enforcement on financial reporting

quality

Variables Predicted sign

Coefficients

estimates Standard Error t-statistics VIF value Intercept ? 15.27

***  4.48 3.41 0

 InvPro + 1.13**

  0.48 2.38 1.25

 LegEnf + 4.07***

  0.54 7.53 1.38

SIZE + 2.86***

  0.52 5.49 1.50

 LEV - 1.16 5.63 0.21 1.35

 ROA ? -0.53**

  0.22 -2.44 1.99

Growth - -0.30***  0.09 -3.19 2.03

Year Controls ? included

Adjusted R 2  0.4014

F value 16.63***

 

D-W value 1.162

 N 304

 Notes:*, **, *** Significant at 0.10, 0.05 and 0.01 level respectively (two-tailed). N is market-year observations.All variables are as defined before.