Foreign Institutional Ownership and the Global Convergence of Financial Reporting Practices by SSRN

Vivian W. Fang

University of Minnesota – Twin Cities – Department of Accounting

Mark G. Maffett

University of Chicago – Booth School of Business

Bohui Zhang

University of New South Wales (UNSW) – School of Banking and Finance; Financial Research Network (FIRN)

February 10, 2015

Journal of Accounting Research, Forthcoming

Abstract:

This paper investigates whether foreign institutional investors affect the global convergence of financial reporting practices. Using several measures of reporting convergence, we show that U.S. institutional ownership is positively associated with subsequent changes in emerging market firms’ accounting comparability to their U.S. industry peers. We identify this association using an instrumental variable approach that exploits exogenous variation in U.S. institutional investment generated by the JGTRRA Act of 2003. Further, we provide evidence of a specific mechanism — the switch to a Big Four audit firm — through which U.S. institutional investors affect reporting convergence. Finally, we show that, for emerging market firms, an increase in comparability to U.S. firms is associated with an improvement in the properties of foreign analysts’ forecasts.

Foreign Institutional Ownership And The Global Convergence Of Financial Reporting Practices – Introduction

We examine the role of foreign institutional investors in the global convergence of financial reporting practices.1 Regulators frequently espouse comparability as a desirable characteristic of financial reporting to facilitate efficient investment decision-making and allocation of capital (Financial Accounting Standards Board [1980], U.S. Securities and Exchange Commission [2000]). Over the past 15 years, significant regulatory effort has gone into promoting comparability, the most prominent example of which is the International Accounting Standards Board’s (IASB) push for global adoption of International Financial Reporting Standards (IFRS). However, recent research (e.g., Daske et al. [2008], Christensen et al. [2013]) shows that mandating the use of a common set of accounting standards alone is unlikely to achieve financial reporting convergence.

The documented ineffectiveness of regulatory mandates suggests that alternative mechanisms capable of altering firms’ equilibrium reporting practices likely contribute to the significant global reporting convergence observed over the past three decades (e.g., Land and Lang [2002]). One potential mechanism is investor demand for more comparable reporting. Prior research argues that foreign institutional investors prefer comparable financial reporting because it reduces information processing costs and improves investment efficiency (e.g., Bradshaw et al. [2004], Covrig et al. [2007], DeFond et al. [2011]). These studies suggest that institutional investors primarily take a passive approach, seeking out firms that already have high levels of accounting comparability, rather than actively promoting reporting convergence. It remains unclear whether, and to what extent, foreign institutional investors directly affect the convergence of reporting practices.

We focus on U.S. institutional investors because they make up a substantial portion of all worldwide investment and represent the largest group of foreign investors. As of December 2005, U.S. institutions held over $2 trillion in non-U.S. equities, more than twice as much as U.K. institutions, the second largest group of foreign investors (Ferreira and Matos [2008]). Also, because U.S. institutions originate from a strong legal regime, they serve as a powerful market force in improving the governance of their non-U.S. investees (Aggarwal et al. [2011]).

As one measure of comparability, we use the output-based approach suggested by De Franco et al. [2011] (hereafter, DKV). In the absence of effective incentive alignment and/or enforcement mechanisms, comparable inputs (such as shared accounting standards) might not lead to comparable outputs. By focusing directly on outputs from the accounting system (i.e., earnings), the DKV measure allows us to assess whether foreign institutional investors change reporting practices in substance rather than simply in form. We adapt the DKV measure to capture a non-U.S. firm’s comparability to its U.S. industry peers.

Financial Reporting

Financial Reporting

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