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Legal Regime and Corporate Financial Reporting Quality
Andrei Filip
Assistant Professor
ESSEC Business School
Réal Labelle
Chair in Governance and Forensic Accounting
HEC Montréal
Stéphane Rousseau
Chair in Business Law and International Trade
Faculty of Law, Université de Montréal
November 2009
Acknowledgements: The authors are grateful for comments received by Christine Pochet, Cédric Lesage, Voltec???, Heidi Wechtler and other participants in the Paris1-IAE research workshop. The usual caveat applies.
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Legal Regime and Corporate Financial Reporting Quality
Abstract
This article uses the unique Canadian bi-juralism environment where Common Law
coexists with Civil Law, as a laboratory to contribute to the international debate on the
influence, or even superiority, of one legal system over the other regarding firms’
financial reporting quality. Our results show that, the relationship between the legal
regime and the corporate financial reporting quality is not as simple as we expected.
Ceteris paribus, in the Civil Law environment the quality of corporate financial reporting
seems to be higher.
2
1. Introduction
Investors' confidence in corporate governance and financial reporting has been shaken
severely and on several occasions since the beginning of the century. These upheavals
induced and are still nourishing an international wave of regulatory shocks rarely seen
before with the Sarbanes-Oxley Act as its epicenter. These reforms reveal a strong
concern by legal, regulatory and standard setting bodies around the world for public
companies’ financial information quality.
This concern for corporate financial reporting quality (FRQ) is echoed at the academic
level by La Porta et al. (2006) which report significant benefits of full disclosure for
investor protection and stock market development with regard to firms issuing securities
to the public. Djankov et al. (2008) also conclude that laws mandating extensive
disclosure and facilitating private enforcement through liability rules, that facilitates the
compensation of the investors, benefit stock markets. Furthermore, in line with the results
of La Porta et al. (1997 & 1998), Djankov et al. (2008, p. 462) conclude that, for all the
measures of shareholder protection they have considered, there is a pronounced
difference in favor of Common Law countries over French Civil Law countries. For
example, Common Law countries subject related party transactions to greater disclosure
requirements than do French Civil Law countries.
In this article, we use the unique Canadian bijuralism environment, where Common Law
coexists with French Civil Law, as a field study to contribute to the international debate
on the influence, or even superiority, of one legal system over the other regarding firms’
financial information. This setting allows us to compare both systems including their
enforcement conditions with regard to FRQ. We also aim at reconciling this line of
3
research with Ball et al. (2008) results which are more consistent with the ‘‘costly
contracting’’ than with the ‘‘value relevance’’ school of accounting thought1. Our
research question is: Caeteris paribus, is the nature of the legal system including its
enforcement conditions likely to affect the quality of corporate financial reporting?
Canada offers a legal framework and an exceptional empirical field with the coexistence
of two systems: the Civil Law in the province of Quebec and the Common Law in the rest
of Canada. Further, Quebec provides us with an interesting context in which comparative
studies can be performed as two corporate statutes co-exist in the province: the
Companies Act (QCA), adopted by the provincial legislator, and the Canada Business
Corporations Act (CBCA), decreed by the federal legislator. Both statutes are available
to Quebec firms that want to incorporate their business, but they differ with respect to the
level of protection afforded to minority shareholders, QCA being perceived as less
protective than CBCA (Québec, 2007). It is therefore a good setting for examining their
presumed differential influence on the quality of financial information published by
corporations and on the responsibility of the external auditors as an enforcement
mechanism. This is equally a context where several alternative explanations regarding the
quality of financial information are practically eliminated such as the quality of the
accounting and auditing standard setting processes, the level of economical growth and of
financial development, the political framework, etc. All these are factors that the vast
majority of previous studies that used different countries or an international sample of
firms attempted to control for or have been simply forced to ignore and admit as limits of
their research.
1 The two schools of thought are debated in Holthausen and Watts (2001) and Barth et al. (2001).
4
In the next section, we develop this study’s theoretical framework and review prior
research on the institutional determinants of corporate financial reporting. This stream of
empirical research mainly uses international data. In the third section, we explain why we
believe the Canadian institutional setting constitutes a good laboratory to compare the
presumed influence of the legal origin on FRQ. In the fourth one, we develop our
research design and FRQ models. In the fifth section, we present and analyse our results
before concluding in the last section.
2. Hypothesis development and prior research
We draw from the law and finance2 strand of research and to a lesser degree from the
value relevance and costly contracting literatures to analyze the incidence of the legal
regime on the quality of corporate financial reporting. The ultimate objective of this line
of research is a better understanding of the role of law and financial reporting in the
development of financial markets (La Porta et al. 1998) and, thereby, in the economical
growth of nations (Rajan and Zingales, 1996).
In Figure 1, we summarize the theoretical development and attempt to reconcile the
competing hypotheses of value relevance and costly contracting. La Porta et al. (1998)
and Djankov et al. (2008) show that investor protection is generally stronger in Common
Law than in French Civil Law countries. These authors also conclude that the legal
tradition affects capital markets, a better investor protection inducing more developed
financial markets. More developed financial markets offer larger opportunities for
external financing, and lead to less ownership concentration (La Porta et al. 1999).
2. Shleifer and Vishny 1997; LaPorta, Lopez-De-Silanes, Shleifer and Vishny 1997, 1998, 1999, 2000, 2002 and 2006; Djankov, La Porta, Lopez-De-Silanes, Shleifer and Vishny 2008; Francis, Khurana and Pereira 2003; Hope 2003a.
5
- insert figure 1 about here -
On the one hand, the presence of more widely held corporations exacerbates agency
problems related to asymmetry of information. Quality financial accounting information,
i.e. conservative, relevant and reliable or relatively free of earnings management, may
help reduce these agency costs caused by information asymmetry between the firms and
external investors (Ball, Kothari and Robin, 2000). Therefore, in a Common Law
environment, presumed to offer a stronger protection to investors, one expects firms to
publish value relevant audited financial information in order to respond to the stock
market demand for such information.
On the other hand, because it provides weaker investor protection, French Civil Law
induces more proximity financing such as in the case of ownership concentration and
indebtedness. In that Civil Law environment, the information asymmetry situation may
be solved by private communications and institutional means other than financial
statements (Ball et al. 2000), notably by closer and more consistent relationships with the
stakeholders. Ball et al. (2008) results are more consistent with the ‘‘costly contracting’’
than with the ‘‘value relevance’’ school of accounting thought.
Nevertheless, according to the criticisms addressed to this theoretical approach by
Deffains and Guigou (2002) and Roe (2006), a more in depth analysis of the common and
Civil Law environments is warranted. La Porta et al. (1997 & 1998) are limiting their
analysis to regulations related to securities in order to conclude to the superiority of one
system over the other regarding investor protection. As recognised by La Porta et al.
(2006), other variables have to be considered, such as the enforcement of these rules
(Deffains and Guigou, 2002: 23). Notably, is there any difference in the manner in which
6
these systems treat the litigations between investors and auditors, as the ultimate
protectors of financial reporting quality?
Prior empirical studies generally report that the legal system is not without influence and
that the thesis of the neutrality of the law system, such as suggested by the theorem of
Coase, is not verified (Ayyagari et al. 2006 a and b). Nevertheless, this literature has
several shadowed areas. Notably, the empirical models (Francis et al. 2001, 2003, 2005;
Barniv et al. 2005; Bushman et al., 2004; Bushman and Piotroski 2006; Bushman and
Smith, 2003 and Hope, 2003a and b) are using international data, which weakens their
capacity to test for alternative explanations. A closer examination of the differences
between these systems is necessary. Such a comparison necessitates an in depth
knowledge of not only all the laws and regulations, but also of the conditions of
enforcement relating to the protection of minority shareholders and creditors rights, to the
responsibility of the administrators, managers and auditors, to the accounting and
governance standards, etc. This required background information is developed in the next
section.
3. Institutional setting or why use Canadian data?
Unlike the other Canadian provinces, Quebec is a mixed jurisdiction in which the Civil
law and the Chommon law systems co-exist. Common law governs public law, such as
administrative law and criminal law (Hogg, 1997), while Civil law governs private law,
such as the law of contracts and company law. Thus, in Quebec, “the backdrop of
company law is civil law” (Crête and Rousseau, 2008; Bozec et al, 2008).
7
In the province of Quebec, there are two corporate statutes: one is enacted by the federal
parliament, the Canada Business Corporations Act (CBCA) and one by the National
Assembly of Quebec, the Quebec Companies Act (QCA). While similar in many ways,
these statutes diverge in one important area that pertains to shareholder protection, the
CBCA offering more effective protection of shareholders’ rights, compared to QCA. This
difference is important given the path dependency associated with the choice of QCA as
incorporation statute. Indeed, the choice of the law of incorporation is usually made by
entrepreneurs at the start-up stage. Significantly, where a business is incorporated under
the QCA, it is unlikely that the corporation can easily change its law of incorporation.
Indeed, the QCA does not provide an emigration mechanism allowing reincorporation
under another corporate statute. Since liquidation is the only option for a firm wishing to
forego its incorporation under the QCA, and reincorporate under the CBCA, changes in
this respect rarely take place. In contrast, the CBCA does enact an import and export
mechanism which allows firms to switch incorporation statutes.
3.1. Shareholder Protection under the Canada Business Corporations Act
Strongly influenced by American law, and to some extent, British law, the Dickerson
Report that produced the CBCA proposed a new corporate law framework characterized
by different fundamental approaches among which, the most relevant to our study, is the
fact that the law creates specific mechanisms to safeguard the rights and interests of
minority shareholders against managerial and dominant shareholder opportunism. For
instance, the CBCA provides mechanisms that can be used at shareholders’ general
meetings. The Act mandates the disclosure of information on the subject matters to be
8
discussed at the meetings. For larger corporations, it also enacts a regime governing the
solicitation of proxies that provides additional information to the shareholders whose
votes are solicited. Further, under certain conditions, shareholders have the right to
submit proposals at the annual general meeting so they can be discussed and voted on by
the shareholder group. The Act enables the holder of at least 5% of the voting shares of
the corporation to call a special meeting of shareholders.
Under the CBCA, shareholders have the power to have their say on important decisions
taken at the general meetings. It is the shareholders who elect the directors of the
corporations as well as its auditors. Furthermore, shareholders must authorize
“fundamental changes” following a procedure that gives them clout over the decision-
making process. The concept of fundamental changes refers to a variety of changes that
affect the corporation’s constitution, such as amendments to its articles of incorporation,
amalgamation with another corporation, or the corporation’s continuation under another
corporate statute. Where the corporation undertakes a fundamental change, the CBCA
grants special class voting rights to holders of a class of shares, irrespective of whether
the shares of the class otherwise carry the right to vote, when the change contemplated is
likely to affect the specific rights of that class. The special class voting rights enable the
holders of the class to vote separately from the holders of other shares of the corporation,
giving them a form of veto over the proposed change. Further, the CBCA provides a right
of dissent or appraisal remedy enabling a shareholder to compel the corporation to buy
her shares at fair value in the case of a fundamental change.
Finally, the CBCA provides mechanisms enforced by the courts that offer protection to
shareholders against management or dominant shareholder opportunism. The Act
9
imposes duties of care and fiduciary duties on managers in regard to the corporation.
These duties can be enforced through the derivative action that allows shareholders and
other plaintiffs to bring an action in lieu of the corporation to rectify a wrong committed
against it, such as a breach of duties. Shareholders can use the derivative action when
managers refuse to take action to redress a breach of their duties that has led to a loss for
the corporation. It is thus an important tool to ensure the enforcement of managers’
duties, and consequently, their accountability. The most powerful remedy offered to
minority shareholders is however the oppression remedy. The remedy can be used when
the business or the affairs of the corporation are being carried on or conducted, or the
directors’ powers are being exercised in a manner that is oppressive or unfairly
prejudicial to or that unfairly disregards the interests of any security holder, creditor,
director, or officer. The remedy gives the plaintiff the right to apply to the court, which
then has the power to make any order it sees fit to correct the situation. The oppression
remedy is both very powerful and broad.
3.2. Shareholder Protection under the Quebec Companies Act
There are some protective mechanisms in the QCA that operate at shareholders’ general
meetings: for instance, it enables shareholders to exercise their votes meaningfully, and
also mandates the disclosure of information on the subject matter to be discussed at the
meetings. However, unlike the CBCA, it does not currently enact a regime governing the
solicitation of proxies, nor does it grant shareholders the right to submit a proposal at the
annual general meeting.
10
More importantly, the QCA does not provide a general class veto regime, as does the
CBCA, to protect minority shareholders in the case of fundamental changes. Fundamental
changes need only be authorized by at least two-thirds of the votes cast by the
shareholders who voted in respect of that resolution. Unlike the CBCA, the QCA does
not mandate shareholder approval for the sale of all or substantially all of the assets of the
corporation (Rona inc. v. Matco Ravary Inc., 2003 CANLII 52752 (Qc.S.C.)).
Furthermore, the QCA does not establish an appraisal remedy enabling minority
shareholders who oppose a fundamental change to force the corporation to buy back their
shares at fair value.
With respect to judicially enforced mechanisms providing protection to shareholders
against management or dominant shareholder opportunism, there is no derivative action
in the QCA or the Civil Code similar to the derivative action enacted by the CBCA.
Shareholders who wish to use derivative action against their directors and officers must
convince the court that the conduct of officers, directors, or dominant shareholders
amounts to a fraud. For instance, mere negligence would not be sufficient.
Finally, neither the QCA nor the Civil Code provide for an oppression remedy permitting
an aggrieved party—security holder, creditor, director, or officer—to seek redress when
the corporation has not regarded their interests fairly. Thus, in cases of abuses, minority
shareholders have traditionally had few remedies apart from the winding-up of the
corporation (Développements Urbain Candiac inc. v. Combest Corporation, [1993] R.J.Q.
1321 (Qc.C.A.)]. Widely recognized in the literature (Crête and Rousseau 2008, Martel
and Martel, 2004), the fact that QCA is less protective of minority shareholders was
underlined by the Quebec Minister of Finance in a working paper purporting to launch a
11
reform of QCA: “When compared with company law in other jurisdictions in Canada,
Québec law governing legal persons currently has few legal recourses specifically
adapted to investors. Although some recourses are provided under the Civil Code of
Québec, Québec investors have less legal protection in comparison for example with the
federal regime” (Québec, 2007)3
The differences between investor protection under QCA and CBCA is summarized in the
table 1:
- insert table 1 about here -
The difference in the level of investor protection rights afforded by the QCA and the
CBCA is particularly interesting for the quality of financial information. Ex ante, investor
protection rights can influence the quality of financial information by rendering managers
more accountable and more responsive to investors’ information needs. Ex post, investor
protection rights affect the level of litigation risk which, in turn, conditions the quality of
financial information (Chung and Wynn, 2008). This difference is made even more
interesting by the fact that the common law and civil law liability regimes have proved
equally ineffective in providing an effective remedy against corporations and their
managers in the case of false or misleading disclosure (Donald, 2000; Rousseau et Crête,
1999. Further, the common law provinces and the province of Quebec have recently
enacted similar statutory liability regimes enabling investors to sue corporations and their
managers in this case.
3 Québec, Reform of the Company Act, Working Paper, 2007 [on line: http://www.finances.gouv.qc.ca/en/page.asp?sectn=2&contn=257].
12
4. Research design
This section presents the research design and develops the models used to examine if the
quality of firms' financial reporting is different between the Common and Civil Law
systems. As the quality of accounting information cannot be observed per se, we build on
the existing literature, which expresses the quality of financial reporting in terms of
attributes (Schipper and Vincent, 2003). Value relevance, conservatism and reliability as
measured by a relative absence of earnings management have been interchangeably used
by prior literature as attributes of accounting quality (Barth et al. 2008, Van der Meulen
et al. 2007, and many others). Using the unique Canadian bijuralism setting, we test these
attributes for Quebec based corporations (QC - Civil Law environment) versus
corporations based in the rest of Canada (ROC - Common Law environment). We next
restrict our Quebec sample to the firms incorporated under Quebec Law (LQC). By
focusing on this specific Canadian capital market environment, other institutional factors
are kept as homogeneous as possible.
To assess FRQ, we proceed to a three step comparison of each attribute mentioned above
between the LQC, QC and ROC subsamples of firms. First, we compare the value
relevance of earnings, the incremental timely loss recognition, and the accruals quality of
the three subsamples. If the costly contracting hypothesis prevails, we anticipate that
Quebec companies exhibit higher value relevance of earnings, higher incremental timely
loss recognition, and higher accruals quality than ROC companies. If the value relevance
hypothesis prevails, we expect the opposite results.
We test that our results are not driven by firms’ specific characteristics by including
control variables which are presumed in the voluntary disclosure literature to affect
13
corporate FRQ. The control variables are: industry fixed effects, time fixed effects, audit
quality (Big 4 vs. Non Big 4), and Size (log of assets). Most of these controls work
against our hypothesis, in the sense that they are probably correlated with the civil and
Common Law environments (our underlying variable of interest). In fact, our results
indicate that most of these control variables exhibit only weak effects.
4.1. Value relevance
Different empirical models have been used in the past to assess the value
relevance of accounting data. All models consist in regressing accounting data on
corresponding measures of market performance. Data may be expressed in absolute
(price models) or relative (return models) values. Because price models seem to be
affected by the spurious effect of scale, while return models seem to suffer less from
econometrical problems4, we use the following return model:
Rjt α0 α1Ejt
MVjt‐1α2
∆Ejt
MVjt‐1α3 (1)
where:
RjtMVjt‐MVjt‐1 Djt
MVjt‐1 is the market return of company j in year t;
MVjt is the year-end t market value for company j;
Djt is the dividend paid by company j in year t;
Ejt and ∆Ejt are respectively the earnings and the change in earnings of
firm j in year t.
4 For a discussion on the ability of return models to capture the value relevance of accounting data, see Dumontier and Raffournier (2003).
14
Although association studies do not imply any underlying valuation model, equation (2)
is often presented as deriving from the Feltham-Ohlson model (Ohlson, 1995; Feltham
and Ohlson, 1995). Within this framework, the value relevance of earnings is measured
by the explanatory power (adjusted R2) of the regression model (1).
4.2. Conservatism
Consistent with prior research, we test this attribute by using the Basu (1997) model. The
asymmetric treatment of losses and gains is captured by the pricewise linear regression of
accounting earnings on stock returns:
Ejt
MVjt‐1β0 β1DRjt β2Rjt β3DRjtRjt β4 (2)
where:
Ejt are the earnings of firm j in year t;
MVjt is the year-end t market value for company j;
RjtMVjt‐MVjt‐1 Djt
MVjt‐1 is the market return of company j in year t;
Djt is the dividend paid by company j in year t;
DRjt is a dummy variable equaling 1 if Rjt is negative (indicating
economic losses), and 0 otherwise (indicating economic
gains).
In this model, the focus is on the β3 coefficient of the product of stock return by the
return dummy which measures the incremental timeliness of loss recognition. A positive
significant coefficient implies asymmetric timely loss recognition. A higher coefficient
denotes more incremental timely loss recognition. Coefficient β2 on stock return
15
measures the timeliness of gain recognition, while the sum of β2 β3 is measuring the
timely loss recognition.
4.3. Earnings management
Different empirical models have been used in previous studies to detect earnings
management. Some recent studies apply the Dechow and Dichev (2002) model to assess
accruals as a measure of earnings quality arguing that accruals are temporary adjustments
to better measure firm performance. The focus of this model is on the firm’s working
capital accruals, as related cash flow realizations generally occur within one year.
Therefore, the changes in working capital are regressed on past, present and future cash
flows:
∆WCjt
TAjtγ0 γ1
OCFjt‐1
TAjt‐1γ2
OCFjt
TAjtγ3
OCFjt 1
TAjt 1γ4 (3)
where:
∆WCjt are changes in working capital of firm j in year t;
WCjt is the working capital defined as non cash current assets
minus current liabilities (adjusted by the current portion of
debt);
TAjt is the total of assets of firm j in year t;
OCFjt is the operating cash flow of firm j in year t.
As pointed out in Dechow and Dichev (2002), a higher explanatory power of the model
indicates higher earnings or accrual quality. Therefore, the model is estimated for the QC
and ROC samples and the comparison is based on the explanatory power (adjusted R2) of
the regression model (3).
16
5. Data collection and sampling
The data is collected for listed Canadian firms from the Compustat database (3’878
firms). Based on the headquarters’ address, we split the sample into Quebec firms (QC)
and rest of Canada (ROC). All firms with non-available address (1’305 firms) or with an
address outside Canada (181 firms) are eliminated from the sample. In addition, for each
QC firm we search on its internet webpage to check if the company is incorporated under
Quebec law (LQC). Because financial institutions follow specific reporting regulations,
they are deleted from the sample (582 firms). Therefore, our sample is composed of
1’810 firms.
We collect market and accounting data for the period 1998 to 2007 (10 years). Year-
observations with negative total equity for any of the years are eliminated in order to
avoid bias in our results, leading to a sample of 9’543 year-observations. For each
regression, outliers are eliminated based on the standardized residuals. Another reason for
this exclusion is the transitory nature of extreme variables. As such variations are not
expected to persist, their association should be lower than for more moderate values. A
number of year-observations are also dropped from the sample because of missing or
incomplete capital market or financial statement data in the Compustat database. In order
to obtain comparability across our different metrics, we limit our analysis only to the
year-observations with available control variables.
- insert table 2 about here -
17
Our final sample consists therefore of 6’336 year-observations for model 1 and 2 and
4’698 year-observations for model 3. The difference between the two samples is
explained by data availability (because model 3 refers to past, present and future cash
flows, only 9 years can be taken into account). Table 1 presents some descriptive
statistics.
6. Results
Differences between LQC, QC and ROC firms with regard to the three attributes of FRQ
are reflected in the models’ R2. However, cross-samples comparisons would be
incomplete without employing a more formal test. For instance, Ball et al. (2000), Sami
and Zhou (2004) or Lang et al. (2006) are using the Cramer’s standard deviation in order
to assess the significance of differences between R2 across different regressions.
According to Cramer (1987), the standard deviation of the estimated R2 is a function of
the sample size, the number of independent variables (including intercept), and the “true”
R2. Following Arce and More (2002), we use a more appealing test that compares R2
from two different samples based on the following Z-statistic:
ZRLQC/QC
2 ‐RROC2
σLQC/QC2 σROC
2
Where RLQC2 , RQC
2 , and RROC2 are the R2 from LQC, QC, respectively, and ROC firms,
while σ(.) is the variance. Under the null hypothesis of no difference between both R2, this
Z-statistic is approximately standard normal in large samples. Therefore, the number
reported in the tables indicates the probability to accept the null hypothesis of no
difference in adjusted R2.
18
We run separate regressions for the LQC, QC and ROC samples (for reasons of
comparison the results for the pooled sample are reported as well). Finally control
variables are introduced into the equations in order to check whether the results are
driven by firms’ specific factors, rather than by the legal environment in which they
operate.
Table 3 reports the results of the regressions for the value relevance tests (model 1). In
line with previous association studies performed on mature capital markets where
alternative sources of information are abundant, accounting information displays low
value relevance. Market returns seem to be associated to earnings in all the cases, while
earnings changes only for the QC and the ROC samples.
- insert table 3 about here -
LQC earnings and earnings changes seem to be more value relevant to investors as the
adjusted R2 reaches 16.6%, which is almost triple if compared to the adjusted R2 of 6.6%
for the ROC sample. According to the Cramer test, this difference is significant at 0.2%,
while the difference between QC and ROC is not significant. The above results hold even
after adding the control variables to the regression. Industry fixed effects and time fixed
effects are the only control factors statistically significant, while the Cramer test indicates
statistically significant differences between LQC and ROC firms. These results are
consistent with the hypothesis that the corporate financial reporting of Civil Law firms
incorporated under Quebec Law is of better quality compared to Common Law firms.
According to Basu (1997), accounting earnings reflect bad news more quickly than good
news, while market returns capture both good news and bad news simultaneously. This
conjecture is captured in model 2, and the results for the asymmetric timeliness of
19
earnings are presented in table 4. Consistent with prior studies, the overall power of the
Basu model remains relatively low, but higher for LQC and QC samples (adjusted R2 of
20.4% and 18.0%) if compared to the ROC (adjusted R2 of 13.1). The Cramer test reveals
that both differences are significant. Results are similar even after controlling for other
firm-specific factors, industry fixed effects, time fixed effects, and size being the only
control variables that are significant.
- insert table 4 about here -
Turning now to the response coefficients, the only coefficient significant at 1% in all the
cases is β3 (on the product of the stock return with the return dummy) which measures the
incremental timeliness of loss recognition. Its absolute value seems to be higher for the
QC sample (0.449), and it is taking similar values for the LQC and ROC samples (0.330
and 0.353, respectively). However, given that the coefficient β1 on the return dummy is
not significant for the LQC and QC sample, it is difficult to draw conclusions with regard
to the level of conservatism.
Finally, the results with regard to accrual quality as measured by model 3 are reported in
table 5. The highest explanatory power of the model is achieved for the LQC and QC
sample (adjusted R2 of 31.1% and 26.5%), while for the ROC sample the adjusted R2 is
only 10.7%. The Cramer test reveals that these differences are statistically significant,
which confirms the hypothesis that Civil law firms do not manage earnings as much as
Common law firms. Similar results are obtained even after controlling for firms specific
factors.
- insert table 5 about here -
20
As pointed out by Dechow and Dichev (2002), a positive sign is expected on both past
and future cash flows and a negative sign on current cash flows. All coefficients are
significant and have the expected sign.
7. Conclusion
This research uses the unique Canadian bi-juralism environment, where Common Law
coexists with French Civil Law, as a field study to contribute to the international debate
on the influence, or even superiority, of one legal system over the other regarding
corporate financial reporting quality. Our results show that, ceteris paribus, the nature of
the legal system is not neutral and it is the Civil Law environment that seems to
encourage firms to publish accounting data of better quality. These surprising results are
in opposition to the most intimate beliefs of researchers and seem to indicate, at least, that
the relationship between the legal regime and the corporate financial reporting quality is
not as simple as we expected.
Most of the previous studies analysing this research question are using heterogeneous
samples, which include countries extremely different not only in terms of legal systems,
but also in terms of political institutions, economic development, corporate governance
mechanisms, shareholders and creditors rights, enforcement mechanisms etc. As a
consequence, it is difficult to attribute the reported differences only to one variable.
Corporate financial reporting quality seem to be affected by a multitude of legal
incentives, market forces and firm characteristics and future research is needed to have a
clear picture of the interactions between all these variables.
21
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Table 1. Investor Protection under CBCA and QCA: Salient Differences
Protective mechanism CBCA QCA Shareholder approval of fundamental changes
Class veto Approval by 2/3 of shareholders
Shareholder approval of the sale of all or substantially all of the assets
Class veto N/A
Calling shareholders’ meeting
5% of the voting shares 10% of the voting shares
Right to make shareholder proposal
Provided N/A
Appraisal remedy Provided N/A Derivative action Provided Constrained by majority
rule Oppression remedy Provided N/A
26
Table 2. Descriptive statistics
N Mean Standard deviation
Min Max
Rjt 6 336 0.108 0.571 -1.338 2.156
Ejt
MVjt‐1 6 336 -0.003 0.133 -0.467 0.401
∆Ejt
MVjt‐1 6 336 0.004 0.120 -0.523 0.569
∆WCjt
TAjt 4 698 0.003 0.053 -0.170 0.169
OCFjt‐1
TAjt‐1 4 698 0.046 0.117 -0.349 0.380
OCFjt
TAjt 4 698 0.053 0.112 -0.309 0.350
OCFjt 1
TAjt 1 4 698 0.053 0.118 -0.338 0.379
Where RjtMVjt‐MVjt‐1 Djt
MVjt‐1 – the market return of firm j in year t; MVjt – the market value of firm j in year t;
Djt – the dividend paid by firm j in year t; Ejt – the year-end t earnings for firm j; ∆WCjt – the change in working capital (non-cash current assets minus current liabilities adjusted for the current portion of long term debt) of firm j in year t; TAjt – the total of assets of firm j in year t; OCFjt – the operating cash flow of firm j in year t.
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Table 3. The value relevance of earnings Model 1: Rjt 0 1
Ejt
MVjt‐12
∆Ejt
MVjt‐13
Variables LQC QC ROC POOL LQC QC ROC POOL
Intercept (α0)
0.011 (0.506)
0.065*** (4.152)
0.119*** (15.401)
0.110*** (15.891)
0.036 (0.328)
-0.039 (-0.544)
0.120*** (4.163)
0.217*** (7.949)
Earnings (α1)
0.383*** (6.664)
0.256*** (7.816)
0.220*** (15.100)
0.223*** (16.763)
0.297*** (4.341)
0.223*** (5.891)
0.236*** (14.951)
0.240*** (16.471)
Change in earnings (α2)
0.059 (1.032)
0.072** (2.191)
0.071*** (4.877)
0.072*** (5.381)
0.085 (1.449)
0.089*** (2.669)
0.053*** (3.645)
0.057*** (4.310)
Industry fixed effects
YES*** YES** YES*** YES***
Time fixed effects
YES** YES*** YES*** YES***
AUDIT -0.003 (-0.051)
0.003 (0.086)
0.024 (1.642)
0.018 (1.393)
SIZE 0.008 (0.119)
-0.002 (-0.049)
-0.012 (-0.714)
-0.008 (-0.544)
N 322 1 024 5 312 6 336 322 1 024 5 312 6 336 F 32.919*** 47.848*** 188.444*** 231.339*** 5.449*** 7.395*** 40.182*** 44.918*** Adj. R2 16.6% 8.4% 6.6% 6.8% 20.8% 11.1% 12.9% 12.2% Cramer test – ROC (0.002) (0.134) (0.001) (0.577)
Where RjtMVjt‐MVjt‐1 Djt
MVjt‐1 – the market return of firm j in year t; MVjt – the market value of firm j in year t; Djt – the dividend paid by firm j in year t; Ejt – the year-
end t earnings for firm j; Industry fixed effects – control variables that take the value one if the firm belongs to a specific industry, and zero otherwise (as identified by the first digit industry code); Time fixed effects – control variables that take the value one if the observation belongs to a specific year, and zero otherwise; AUDIT – control variable that takes the value one if the audit is conducted by one of the Big 4 auditor, and zero otherwise; SIZE – control variable computed as log of total assets of firm j in year t; ROC – sample of firms with the headquarter located outside the Quebec province; QC – sample of firms with the headquarter located in the Quebec province; LQC – sample of firms incorporated under the Quebec Companies Act. ***, **, * significant at 1%, 5% and 10% respectively; t-statistics into brackets; Cramer test – the number indicates the probability to accept the null hypothesis of no difference in adjusted R2 compared to the ROC sample.
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Table 4. The timeliness of earnings (Basu model) Model 2: Ejt
MVjt‐1β0 β1BNjt β2Rjt β3BNjtRjt β4
Variables LQC QC ROC POOL LQC QC ROC POOL
Intercept (β0)
0.058*** (6.096)
0.064*** (8.580)
0.038*** (10.856)
0.043*** (13.471)
0.021 (0.826)
-0.067*** (-3.795)
-0.096*** (-13.934)
-0.081*** (-12.552)
Bad news (β1)
-0.011 (-0.131)
-0.065 (-1.461)
-0.086*** (-4.172)
-0.084*** (-4.449)
-0.015 (-0.201)
-0.016 (-0.385)
-0.066*** (-3.397)
-0.058*** (-3.335)
Market return (β2)
0.144 (1.5670
-0.096** (-2.016)
-0.076*** (-3.546)
-0.084*** (-4.279)
0.127 (1.470)
-0.020 (-0.456)
0.004 (0.190)
0.002 (0.126)
Bad news * Return (β3)
0.330*** (3.954)
0.449*** (10.049)
0.353*** (17.355)
0.371*** (20.060)
0.218*** (2.701)
0.320*** (7.432)
0.250*** (12.811)
0.262*** (14.746)
Industry fixed effects
YES*** YES*** YES*** YES***
Time fixed effects
YES** YES** YES*** YES***
AUDIT -0.028 (-0.591)
-0.028 (-1.020)
0.004 (0.276)
-0.269 (0.788)
SIZE 0.172*** (2.900)
0.275*** (8.880)
0.330*** (23.188)
0.322*** (25.200)
N 322 1 024 5 312 6 336 322 1 024 5 312 6 336 F 28.390*** 75.888*** 269.017*** 342.298*** 9.111*** 23.899*** 89.584*** 111.857*** Adj. R2 20.4% 18.0% 13.1% 13.9% 33.6% 32.0% 25.9% 26.9% Cramer test – ROC (0.020) (0.011) (0.000) (0.001) Where Ejt – the year-end t earnings for firm j; MVjt – the market value of firm j in year t; BNjt – a dummy variable equal to one if Rjt is negative (indicating
economic loss), and zero otherwise; RjtMVjt‐MVjt‐1 Djt
MVjt‐1 – the market return of firm j in year t; Djt – the dividend paid by firm j in year t; Industry fixed effects –
control variables that take the value one if the firm belongs to a specific industry, and zero otherwise (as identified by the first digit industry code); Time fixed effects – control variables that take the value one if the observation belongs to a specific year, and zero otherwise; AUDIT – control variable that takes the value one if the audit is conducted by one of the Big 4 auditor, and zero otherwise; SIZE – control variable computed as log of total assets of firm j in year t; ROC – sample of firms with the headquarter located outside the Quebec province; QC – sample of firms with the headquarter located in the Quebec province; LQC – sample of firms incorporated under the Quebec Companies Act. ***, **, * significant at 1%, 5% and 10% respectively; t-statistics into brackets; Cramer test – the number indicates the probability to accept the null hypothesis of no difference in adjusted R2 compared to the ROC sample.
29
Table 5. Accruals quality (Dechow and Dichev model)
Model 3: ∆WCjt
TAjtγ0 γ1
OCFjt‐1
TAjt‐1γ2
OCFjt
TAjtγ3
OCFjt 1
TAjt 1γ4
Variables LQC QC ROC POOL LQC QC ROC POOL
Intercept (γ0)
0.009** (2.082)
0.009*** (4.116)
0.004*** (4.498)
0.005*** (5.618)
0.023 (1.415)
-0.001 (-0.143)
0.007** (2.358)
0.008*** (2.791)
Cash flow–previous (γ1)
0.404*** (5.285)
0.355*** (7.919)
0.242*** (11.388)
0.261*** (13.510)
0.382*** (4.802)
0.343*** (7.667)
0.246*** (11.398)
0.263*** (13.458)
Cash flow–current (γ2)
-0.796*** (-9.704)
-0.758*** (-15.784)
-0.506*** (-21.518)
-0.545*** (-25.526)
-0.827*** (-9.628)
-0.763*** (-15.800)
-0.520*** (-21.953)
-0.557*** (-26.000)
Cash flow–next (γ3)
0.368*** (4.654)
0.338*** (7.519)
0.265*** (12.504)
0.277*** (14.344)
0.361*** (4.364)
0.346*** (7.547)
0.270*** (12.691)
0.282*** (14.547)
Industry fixed effects
YES** YES*** YES*** YES***
Time fixed effects
YES* YES** YES*** YES***
AUDIT 0.016 (0.263)
-0.016 (-0.452)
-0.007 (-0.432)
-0.008 (-0.493)
SIZE 0.031 (0.409)
0.026 (0.643)
0.001 (0.038)
0.000 (0.021)
N 213 694 4 004 4 698 213 694 4 004 4 698 F 32.962*** 84.255*** 160.222*** 224.233*** 6.587*** 14.819*** 29.100*** 39.901*** Adj. R2 31.1% 26.5% 10.7% 12.5% 33.4% 28.5% 12.3% 14.2% Cramer test – ROC (0.000) (0.000) (0.000) (0.000) Where ∆WCjt – the change in working capital (non-cash current assets minus current liabilities adjusted for the current portion of long term debt) of firm j in year t; TAjt – the total of assets of firm j in year t; OCFjt – the operating cash flow of firm j in year t; Industry fixed effects – control variables that take the value one if the firm belongs to a specific industry, and zero otherwise (as identified by the first digit industry code); Time fixed effects – control variables that take the value one if the observation belongs to a specific year, and zero otherwise; AUDIT – control variable that takes the value one if the audit is conducted by one of the Big 4 auditor, and zero otherwise; SIZE – control variable computed as log of total assets of firm j in year t; ROC – sample of firms with the headquarter located outside the Quebec province; QC – sample of firms with the headquarter located in the Quebec province; LQC – sample of firms incorporated under the Quebec Companies Act. ***, **, * significant at 1%, 5% and 10% respectively; t-statistics into brackets; Cramer test – the number indicates the probability to accept the null hypothesis of no difference in adjusted R2 compared to the ROC sample.
