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qWe gratefully acknowledge the helpful comments of David Alexander, Eli Bartov, Sudipta Basu,Gary Biddle, Sir Bryan Carsberg, Dan Collins, Peter Easton, Bob Holthausen (the editor), ScottKeating, Christian Leuz, Gerhard Mueller, Christopher Nobes, the late Dieter Ordelheide, PeterPope, Abbie Smith, Peter Taylor, Ross Watts, Greg Waymire, Steve Ze!, Jerry Zimmerman, thereferee, and seminar participants at: Carnegie Mellon University, University of California atBerkeley, University of California at Los Angeles, CUNY Baruch College, EIASM Workshop inEuropean Accounting in Krakow, 1999 Financial Accounting and Auditing Conference of theInstitute of Chartered Accountants in England & Wales, UniversitaK t Frankfurt am Main, HongKong University of Science and Technology 1998 Summer Symposium, IAAER/CIERA 1998Conference, Inquire Europe Autumn 1998 Seminar, University of Iowa, Harvard Business School,KPMG-AAA International 1999 Accounting Conference, London Business School, London Schoolof Economics, Massachusetts Institute of Technology, Melbourne Business School, New YorkUniversity, Ohio State University, University of New South Wales, University of Technology inSydney, and Washington University in St Louis. The paper has received a Vernon K. ZimmermanAward and an Inquire Europe Prize. Ball and Kothari received "nancial assistance from the JohnM. Olin Foundation and the Bradley Policy Research Center, and Kothari acknowledges "nancialassistance from the New Economy Value Research Lab at the MIT Sloan School of Management.
*Corresponding author. Tel.: #(617) 253-0994; fax: #(617) 253-0603.E-mail address: [email protected] (S.P. Kothari).
Journal of Accounting and Economics 29 (2000) 1}51
The e!ect of international institutional factorson properties of accounting earningsq
Ray Ball!, S.P. Kothari",*, Ashok Robin#
!Graduate School of Business, University of Chicago, Chicago, IL 60637, USA"Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02142, USA
#College of Business, Rochester Institute of Technology, Rochester, NY 14623, USA
Received 3 August 1998; received in revised form 9 June 2000
Abstract
International di!erences in the demand for accounting income predictably a!ect theway it incorporates economic income (change in market value) over time. We character-ize the &shareholder' and &stakeholder' corporate governance models of common andcode law countries respectively as resolving information asymmetry by public disclosureand private communication. Also, code law directly links accounting income to current
0165-4101/00/$ - see front matter ( 2000 Elsevier Science B.V. All rights reserved.PII: S 0 1 6 5 - 4 1 0 1 ( 0 0 ) 0 0 0 1 2 - 4
payouts (to employees, managers, shareholders and governments). Consequently, codelaw accounting income is less timely, particularly in incorporating economic losses.Regulation, taxation and litigation cause variation among common law countries. Theresults have implications for security analysts, standard-setters, regulators, and corporategovernance. ( 2000 Elsevier Science B.V. All rights reserved.
JEL classixcation: F00; F30; G15; M41
Keywords: International accounting; Standard setting; Regulation; Conservatism
1. Introduction
We show that di!erences in the demand for accounting income in di!erentinstitutional contexts cause its properties to vary internationally. The propertiesof accounting income we study are timeliness and conservatism. Timeliness isde"ned as the extent to which current-period accounting income incorporatescurrent-period economic income, our proxy for which is change in market valueof stockholders' equity. Conservatism is de"ned in the Basu (1997) sense as theextent to which current-period accounting income asymmetrically incorporateseconomic losses, relative to economic gains.
A central result is that accounting income in common-law countries issigni"cantly more timely than in code-law countries, due entirely to quickerincorporation of economic losses (income conservatism). Conversely, informa-tion asymmetry more likely is resolved in code-law countries by institutionalfeatures other than timely and conservative public "nancial statements, notablyby closer relations with major stakeholders. In contrast with Roe (1994), weconclude that enhanced common-law disclosure standards reduce the agencycosts of monitoring managers, thus countering the advantage of closer share-holder}manager contact in code-law countries.
We believe that timeliness and conservatism together capture much of thecommonly used concept of "nancial statement &transparency.' In comparisonwith a system that allows economic losses to be re#ected in accounting incomegradually over time, timely incorporation of economic losses in accountingincome incents managers to stem the losses more quickly. Because accountingincome #ows into balance sheet accounts, conservatism as we de"ne it alsomakes leverage and dividend restrictions binding more quickly. It makesoptimistic non-accounting information released by managers less credible touninformed users. Conservative accounting thus facilitates monitoring ofmanagers and of debt and other contracts, and is an important featureof corporate governance.
The principal institutional variable we study is the extent of political in#uenceon accounting. Our simplest proxy for political in#uence is a dichotomous
2 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
classi"cation of countries into code law systems with high political in#uenceversus common law systems in which accounting practices are determinedprimarily in the private sector. We hypothesize that politicization of accountingstandard setting and enforcement weakens the demand for timely and conserva-tive accounting income, and conversely increases the demand for an incomevariable with low volatility. In our sample, Australia, Canada, UK and USA areclassi"ed as common-law countries (they comprise a group known as G4#1,exclusive of New Zealand) and France, Germany and Japan are classi"ed ascode-law.
In code-law countries, the comparatively strong political in#uence on ac-counting occurs at national and "rm levels. Governments establish and enforcenational accounting standards, typically with representation from major politi-cal groups such as labor unions, banks and business associations. At the "rmlevel, politicization typically leads to a &stakeholder' governance model, involv-ing agents for major groups contracting with the "rm. Current-period ac-counting income then tends to be viewed as the pie to be divided among groups,as dividends to shareholders, taxes to governments, and bonuses to managersand perhaps also employees. Compared to common-law countries, the demandfor accounting income under code law is in#uenced more by the payoutpreferences of agents for labor, capital and government, and less by the demandfor public disclosure. Conversely, because these groups' agents are representedin corporate governance, insider communication solves the information asym-metry between managers and stakeholders. We hypothesize that their prefer-ences penalize volatility in payouts and thus in income. Thus, code-lawaccounting standards give greater discretion to managers in deciding wheneconomic gains and losses are incorporated in accounting income. Managersreduce income volatility by varying the application of accounting standards orby in#uencing operating, "nancing and investment decisions (for example, bydeferring discretionary expenditures such as R&D in bad earnings years).
Under the &shareholder' governance model that is typical of common-lawcountries, shareholders alone elect members of the governing board, payouts areless closely linked to current-period accounting income, and public disclosure isa more likely solution for the information asymmetry problem. In comparisonwith the more political process in code-law countries, the desirable properties ofaccounting income in common law countries are determined primarily in thedisclosure market. We hypothesize those properties include timeliness in incor-porating negative economic income (i.e., asymmetric conservatism).
We caution that the code/common classes are by no means homogeneous,with "nancial reporting in no country being determined in a purely market orplanning system. Notable historical examples of overlapping include the codi"-cation imposed on a predominantly common-law reporting system by theCompanies Acts in the UK and by the Securities and Exchange Acts in the US,and the enactment of French and German legislation to permit consolidated
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 3
1Asset impairment standards such as SFAS 121 in the US are an important example ofaccounting standards linking accounting and economic incomes. Information asymmetry impliesthat implementation of impairment standards depends on the incentive of "nancial statementpreparers (managers and auditors) to disclose information about economic losses, which variesinternationally (compare US and Japan).
"nancial statements prepared under common-law accounting standards. Des-pite these limitations, our results indicate the code/common classi"cation isa valid proxy for the extent of political relative to market determination of"nancial reporting. Nevertheless, we develop "ner hypotheses based on tax andregulatory di!erences across individual countries.
We also caution that institutional determinants of "nancial reporting varyover time. As a coarse test, we divide the sample into two sub-periods, andobserve an increase in asymmetric conservatism of accounting income in mostcountries. One interpretation is that timely incorporation of economic losses inaccounting income is an e$cient corporate governance mechanism, providingbetter incentives to attend to losses and hence maximize value, which increasedinternational product market competition has created incentives for even code-law corporations to adopt.
The sample studied is more than 40,000 "rm-year accounting incomes re-ported during 1985}95, under the accounting rules of seven countries. Code-lawincome in this sample is substantially less timely and less conservative onaverage than common-law income. It does not even exhibit more timeliness thandividends. Within the common-law group, there is less asymmetric conservatismin accounting income in the United Kingdom, a country we characterize interms of lower political involvement in accounting, lower litigation costs andless issuance of public debt. In addition to a detailed analysis of seven countries,we also study properties of accounting income in a sample of eighteen othercountries. The results are consistent with our general thesis, that importantproperties of accounting income (conservatism in particular) around the worldare a function of the varying demands that accounting income satis"es underdi!erent institutional arrangements.
Our research design addresses the incorporation of economic income inaccounting income over time, under di!erent international institutions. This hasseveral advantages over simply studying international variation in accountingstandards. First, much accounting practice is not determined by accountingstandards, for reasons that include: practice is more detailed than standards;standards lag innovations in practice; and companies do not invariably imple-ment standards.1 Second, the extent to which accounting practice is determinedby formal standards varies internationally, and the incentive to follow ac-counting standards depends on penalties under di!erent enforcement institu-tions, so studying accounting standards per se is incomplete and potentially
4 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
misleading in an international context. Third, reported income is in#uenced bymanagers' operating, "nancing and investment decisions, as well as by ac-counting standards. For example, managers can reduce volatility in accountingincome by deferring discretionary expenditures (such as R&D) in bad years.Because the use of accounting income in corporate governance varies interna-tionally, we expect managers' operating, "nancing and investment decisions toa!ect accounting income di!erentially across countries, and report evidenceconsistent with that expectation. For both these reasons, we study internationalvariation in properties of the actually reported income numbers, inferred from theway they incorporate economic income over time.
Our research design's validity depends on two measures. First, we study the#ow of market-valued economic income into book-valued accounting income,using the "scal-year change in market value of equity (adjusted for dividendsand capital transactions) as a proxy for economic income. A major concern isthat the accuracy of this proxy is correlated with the institutional independentvariables in the study, and in particular that code-law countries have endogen-ously lower market liquidity and public disclosure standards. Second, theresearch design requires us to infer independent variables, such as the degree ofpolitical versus market determination of reported income, from our character-ization of salient institutional facts. While our characterization is based onsurveying a wide range of sources, it undoubtedly is subject to error. In theconcluding section, we argue that both types of measurement error create a biasagainst our hypotheses.
We contribute to a growing literature on the e!ects of international ac-counting di!erences, including Jacobsen and Aaker (1993), Alford et al. (1993),Amir et al. (1993), Bandyopadhyay et al. (1994), Harris et al. (1994), Joos andLang (1994), Barth and Clinch (1996), and Pope and Walker (1999). We alsocontribute to the literature on international corporate governance, includingBaums et al. (1994) and La Porta et al. (1997).
The following section outlines the model used to test the timeliness andconservatism of accounting income. The third section describes the data. Sectionfour surveys the salient institutional facts used to develop and then test hypo-theses on properties of income internationally. Section "ve extends these tests toa comparison of income with dividends and cash #ows. The sixth section reportsspeci"cation tests and the concluding section discusses the research design andthe implications of the results.
2. A model of incorporation of economic income in accounting income
The research design infers timeliness and conservatism from the way "rms'accounting incomes incorporate their economic incomes over time. We there-fore specify accounting income as the dependent variable. We measure "rms'
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 5
2We use clean surplus accounting as a concept to motivate the research design. We assume thedegree of violation of clean surplus accounting is not systematically related to the internationalinstitutional factors we investigate. Research on the return-earnings relation typically exacerbatesclean-surplus violation by excluding extraordinary items.
economic incomes as "scal-year changes in market values of equity, adjusted fordividends and capital contributions (Hicks, 1946).&Clean surplus' accounting (Ohlson, 1988) implies two relevant identities for
all "rms. First, accounting income equals "scal-year change in book value ofequity, adjusted for dividends and capital contributions. Second, a "rm's ac-counting and economic incomes summed over its lifetime are identical.2 Weinvestigate the temporal process of the incorporation of economic income inaccounting income, i.e., the accounting model of income determination, andhow it is a!ected by international institutional factors. Our research designallows for three fundamental features of the accounting model of incomedetermination: accounting &recognition' principles that generally reduce thetimeliness of accounting income by smoothing its incorporation of economicincome over time; the e!ectiveness of accounting accruals in ameliorating serialcorrelation in operating cash #ows; and accounting income-statement conserva-tism.
The most fundamental feature of accounting determining the incorporation ofeconomic income in accounting income over time is the accounting &recognition'principles (FASB, 1985, Paras 78}89), including the Revenue Realization andExpense Matching principles. Whereas economic income immediately incorpor-ates changes in expectations of the present values of future cash #ows, therecognition principles incorporate such changes in accounting income graduallyover time, generally at points close to when the actual cash #ow realizationsoccur. Hence, accounting income systematically lags economic income (Ball andBrown, 1968) and the lag extends over multiple periods (Beaver et al., 1980;Easton et al., 1992; Kothari and Sloan, 1992). The recognition principles there-fore cause economic income to be incorporated in accounting income ina lagged and &smoothed' fashion over time.
This feature of accounting income arises because there is demand for anincome variable with properties additional to timeliness. While timeliness per seis desirable, information asymmetry between managers and users creates a de-mand for an income variable that is observable independently of managers.Accounting income thus incorporates only the subset of available value-relevantinformation that is independently observable, whereas economic income incor-porates information that is not independent of managers, such as plans andforecasts (our proxy for economic income incorporates the sharemarket reactionto managers' forward-looking statements). In other words, accounting incomedoes not attempt to anticipate future cash #ows to the same extent as economic
6 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
income. The "rst-order e!ect of the recognition principles thus is to makeaccounting income a complex moving average of past economic incomes.
The second fundamental feature of the accounting income-determinationmodel is that accounting accruals imperfectly ameliorate serial correlation inoperating cash #ows. The accounting model provides for some anticipation offuture cash #ows through accrual accounting. For example, if managers pay anaccount for inventory early, then there is a decrease in current-period operatingcash #ow and, ceteris paribus, an o!setting increase in subsequent periods.Accrual accounting rules attempt to insulate income from the e!ect of the earlypayment, by expensing an amount in both periods that is based on inventoryusage, not payments. In general, short term variation in "rms' operational"nancing and investment decisions (such as changes in inventories, accountspayable and accounts receivable) causes negative serial correlation in operatingcash #ows, which accrual accounting attempts to remove from accountingincome (Dechow et al., 1998). Hence, operating cash #ow can be viewed asa noisier and less timely version of accounting income. However, accrualaccounting is imperfect, because it is costly, so anticipation of future cash #owsvia accruals does not completely remove the noise in the cash #ow time series.
The "rst two features of the accounting model of income determinationtogether imply:
>it"f
j(*<
it, *<
it~1, *<
it~2, *<
it~3,2, <
it) (1)
where > and *<, respectively, denote accounting and economic income, and< denotes noise due to imperfect accounting accruals. Economic income, *<, is"scal-year change in the market capitalization of equity plus dividends andminus capital contributions during the year (Hicks, 1946). We hypothesize thatthe accounting model is applied di!erently across countries, and assume themodel's parameters hold for all "rms i that report under the accounting systemsof country j. Assuming that *< is independent over time, this simpli"es to
>it"g
j(*<
it, g
it) (2)
The disturbance git
incorporates lagged changes in market values (*<it~1
,*<
it~2, *<
it~3, 2) as well as noise due to the residual serial correlation in cash
#ows not removed by accounting accruals (<it). Both components of the
disturbance term a!ect the R2 of regression (2), which is used as a proxy for thetimeliness property of accounting income. After scaling by opening marketvalue, <
it~1, the dependent and independent variables are annual rate of return
(Rit,*<
it/<
it~1) and earnings yield (NI
it,>
it/<
it~1), and a linear speci"ca-
tion gives
NIit"a
0j#a
1jR
it#m
it(3)
The third fundamental feature of the accounting income model we study isconservatism. A longstanding example of income conservatism is the &lower of
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 7
3This 1995 accounting standard formalized what already had become common practice. Elliottand Hanna (1996) report an increase in negative &one time' charges against income for US "rmsaround 1970, rising to 20% of "rms annually by the early 1990s. Collins et al. (1997) report a similarincrease, and that by the early 1980s 25}30% of US "rms reported negative incomes before one-timecharges. These data are consistent with our view that formalized common-law accounting standardsprimarily arise endogenously from common practice in the market for accounting.
4Asset revaluations occur for acquisitions accounted under the purchase method, but do not #owthrough income.
cost or market' inventory rule, which incorporates inventory losses more quick-ly in income than gains. A topical example is new information about future cash#ows from long-term assets. The recognition principles normally incorporatethis information in accounting income at or near the point when the actual cash#ow realizations occur. However, a variety of accounting rules and practicescause immediate write-o!s against income when expected future cash #owsdecrease, without waiting for the cash #ow decreases to be realized. In the US,SFAS 121 recently formalized longstanding write-o! practices for long-livedassets in the form of asset impairment rules.3 Upward revaluation is compara-tively rare in the US: it has not been practiced since the Securities and ExchangeCommission (SEC) was established in 1934, though it is practiced in somecountries. Consequently, unrealized increases in asset values generally do not#ow into income until approximately when the underlying cash #ow increasesoccur, but unrealized decreases are more likely to be incorporated quickly.4
Following Basu (1997), we incorporate conservative asymmetry in accountingincome timeliness by modifying (3) for asymmetric incorporation of negativeeconomic income:
NIit"b
0j#b
1jRD
it#b
2jR
it#b
3jR
itRD
it#e
it(4)
The dummy variable RDtassumes its value based on the sign of stock return,
not earnings: one if return Rtis negative, and zero otherwise. b
2jand (b
2j#b
3j)
capture the incorporation in current-year accounting income of positive andnegative economic income respectively, in country j.
This speci"cation has several attractive features. One advantage of specifyingaccounting income as the dependent variable is avoiding the need for a noisyearnings expectations model. Here, the independent variable (annual stockreturn) is relatively free of short-term microstructure, liquidity or mispricinge!ects. An additional advantage of the speci"cation is that it incorporates thefundamental tenets of accounting income recognition. In particular, it incorpor-ates lags that arise from the demand for an independent income measure, andpiecewise linearity allows us to study international di!erences in asymmetrictimeliness, or conservatism.
Initially, we estimate separate individual-country relations for each country j,pooling all "rms i reporting under the country's accounting standards and allyears t. International di!erences in income timeliness, for positive and negative
8 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
5German companies do not deduct minority interest from consolidated net income, but GlobalVantage alters their numbers to comply with US practice. We therefore de"ne German Y as IC data32# data 27, which reconciles to the numbers actually reported. The adjustment has only a triviale!ect on the results.
6 In correspondence, Christian Leuz and the late Dieter Ordelheide note that some French andGerman "rms recently have issued consolidated "nancial statements prepared under InternationalAccounting Standards. This practice largely post-dates our sample. If Global Vantage classi"esthese observations as &German,' the errors create a potential bias against our hypotheses.
7The rationale is to eliminate observations potentially with errors or with extreme values due toscaling. The disadvantage is that potentially informative observations are deleted and there is thedanger of an incorrect inference.
economic income combined, are re#ected in the R2's of individual-countryregressions (4).
3. Data
Accounting income, cash #ow, and dividends over 1985}95 are from theGlobal Vantage Industrial/Commercial (IC) "le. Accounting income NI
tis net
income before extraordinary items (IC data 32).5 Dividends (DIV) is dividendspaid (IC data 36). Operating cash#ow (OCF) is net income before extraordinaryitems (IC data 32) plus depreciation (IC data 11), minus the change in non-cashcurrent assets (IC data 75 minus data 60), plus the change in current liabilitiesother than the current portion of long-term debt (IC data 104 minus data 94). Allvariables are scaled by market value of equity, calculated from the GlobalVantage Issue "le as price times number of outstanding shares, adjusted forstock splits and dividends using the Global Vantage adjustment factor. Changein accounting income *NI
tis NI
t!NI
t~1. Stock return R is the holding-
period return, including dividends, over the "rm's "scal accounting year. Each"rm/year observation is assigned to a country based on Periodic DescriptorArray 13 on the IC "le, indicating the accounting standards used in preparing its"nancial statements that year (normally the country of the "rm's home ex-change).6
We exclude the two extreme percentiles of each variable (NI, *NI, DIV, OCFand R).7 Next, we exclude each "rm/year with a missing value for any variable,giving the same observation set for the various variables and models estimated.Finally, we exclude countries with less than 1000 "rm/year observations overthe thirteen years. This leaves us with a "nal sample of 40,359 "rm/yearobservations in eleven years from seven countries: Australia, Canada, UK andUSA (common law countries) and France, Germany and Japan (code lawcountries). We also summarize results for a secondary sample of 18 countrieswith at least 100 "rm-year observations.
Table 1 contains sample descriptive statistics. Individual-country samples arepooled "rm-years, ranging in size from 1054 (France) to 21,225 (US). In Panel A,
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 9
Tab
le1
Sam
ple
char
acte
rist
ics!
Pan
elA
:de
scri
ptiv
est
atis
tics
NR
NI
DIV
OC
F
kM
edp
kM
edp
kM
edp
kM
edp
Aus
tral
ia1,
321
17.3
9.9
52.6
2.6
6.7
19.0
3.5
3.6
3.3
11.6
10.9
33.3
Can
ada
2,90
112
.16.
046
.83.
25.
315
.42.
01.
42.
415
.112
.228
.9U
S21
,225
12.7
8.1
42.8
3.1
6.2
14.4
1.9
1.0
2.4
11.7
10.3
21.4
UK
5,75
813
.59.
838
.06.
67.
28.
83.
43.
32.
012
.710
.418
.8Fra
nce
1,05
414
.96.
643
.06.
16.
610
.82.
32.
11.
922
.115
.736
.2G
erm
any
1,24
58.
94.
231
.53.
74.
29.
02.
02.
01.
718
.414
.326
.8Ja
pan
6,85
53.
7!
2.8
33.4
1.7
1.8
2.1
0.7
0.7
0.4
4.7
4.2
7.8
Pan
elB
:O
bser
vati
ons
byx
scal
year
end
(mon
th)
12
34
56
78
910
1112
Tota
l
Aus
tral
ia5
032
430
964
322
450
620
11,
321
Can
ada
113
2613
151
2110
547
144
155
7231
2,00
52,
901
US
964
405
872
401
446
2,09
456
250
61,
666
700
425
12,1
8421
,225
UK
297
119
1,22
233
311
934
412
114
359
016
466
2,24
05,
758
Fra
nce
02
230
03
012
245
098
51,
054
Ger
man
y0
194
00
759
018
37
394
51,
245
Japa
n94
363
5,34
139
6829
914
150
6714
453
76,
855
Tota
l1,
473
934
7,62
582
868
43,
614
780
821
2,81
31,
015
675
19,0
9740
,359
10 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Pan
elC
:O
bser
vati
ons
byye
ar
8586
8788
8990
9192
9394
95Tota
l
Aus
tral
ia11
2988
9111
616
516
016
418
117
813
81,
321
Can
ada
189
221
277
276
306
325
306
311
317
325
482,
901
US
1,58
61,
661
2,23
42,
240
2,15
92,
098
2,00
62,
111
2,15
32,
189
788
21,2
25U
K98
314
438
508
621
703
722
751
756
733
114
5,75
8Fra
nce
966
7472
9814
715
515
113
114
65
1,05
4G
erm
any
2074
8376
9014
518
018
917
019
226
1,24
5Ja
pan
332
866
873
984
188
185
085
787
481
40
6,85
5Tota
l1,
916
2,69
33,
862
4,00
24,
231
4,46
44,
379
4,53
44,
582
4,57
71,
119
40,3
59
!Sam
ple
consist
sof40
,359"rm
-yea
robse
rvat
ions
sele
cted
from
the
Glo
bal
Van
tage
Indust
rial
/Com
mer
cial
and
Issu
e"le
sove
r19
85}95
,using
the
follo
win
gpro
cedu
re.F
irst
,fo
rea
chva
riab
le(see
bel
ow)w
eel
imin
ate
the
two
extr
eme
per
cent
iles
of"rm
-yea
robse
rvat
ions
.Sec
ond,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sw
ith
missing
valu
esfo
rone
orm
ore
variab
les,
tofa
cilit
ate
com
para
bilit
yw
ith
resu
lts
inpre
viou
sta
bles
.Thi
rd,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sfrom
count
ries
with
less
than
1,00
0ob
serv
atio
ns,l
eavi
ngse
ven
count
ries
repre
sent
ed.A
ustr
alia
,Can
ada,
Uni
ted
Stat
es,a
ndth
eU
nited
Kin
gdom
are
the
com
mon
-law
count
ries
,th
ere
star
eco
de-
law
count
ries
.R"
buy-
and-h
old
secu
rity
retu
rnin
clusive
ofdiv
iden
dsove
rth
e"sc
alye
ar;
NI"
annu
alea
rnin
gspe
rsh
are
befo
reex
trao
rdin
ary
item
sde#
ated
bybe
ginnin
gofper
iod
price
;D
IV"
annua
ldiv
iden
ds
per
shar
ede#
ated
bybeg
innin
gof
period
price
;O
CF"
annu
aloper
atin
gca
sh#ow
per
shar
ede#
ated
bybe
ginnin
gofper
iod
price
;N"
the
num
ber
of"rm
/yea
robs
erva
tions
.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 11
mean "scal-year returns range from 3.7% (Japan) to 17.3% (Australia). MeanNI ranges from 1.7% (Japan) to 6.6% (UK). All countries' mean andmedian OCF (from which capital investments are not deducted) exceed NI(from which depreciation, a weighted average of past capital investments, isdeducted).
Consistent with asymmetric conservatism, accounting income is negativelyskewed (all medians exceed means), which contrasts with the positive skew ofstock returns (all means exceed medians). That is, conservative accounting tendsto incorporate economic losses as larger but transitory, capitalized amounts,and to incorporate economic gains as smaller but persistent #ows over time,thus generating the negative skew of accounting income. The di!erential skewof earnings relative to returns calls into question the traditional linearearnings-returns speci"cation, and supports the Basu (1997) piecewise linearversion.
Also consistent with our model, in all seven countries the rank orderof volatilities across variables is (highest "rst): R, OCF, NI and DIV. Ourinterpretation is: (i) accounting income is a lagged function of present andpast years' returns (a type of moving average), and hence has lowervolatility than individual-year stock returns; (ii) cash #ow from operations isnoisier than income, and hence is more volatile; and (iii) dividends is afurther lagged function of accounting income, and hence is the least volatilevariable. We comment on the relative magnitudes of the R and NI volatilitiesbelow.
Panel B reports the distribution of ending months for companies' "scal years.December is the norm in Canada, France, Germany and US. March is the normin Japan and June is the norm in Australia. Code law countries exhibit moreconformity with their norm, presumably due to the greater in#uence of regula-tion and tax accounting in those countries, discussed below. UK, which wecategorize below as the least regulated country in the sample, exhibits thegreatest dispersion in "scal year-ends. Panel C reports the sample distributionby calendar year.
4. Hypotheses and tests: international timeliness and conservatism of accountingincome
We develop hypotheses concerning the in#uence of institutional variables onthe two properties of accounting income captured by our model: timelinessand conservatism (or asymmetric timeliness). There have been numerousattempts to classify nations' accounting systems, based on a variety of institu-tional variables, but little empirical research has been directed at determining
12 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
8American Accounting Association (1977) classi"es accounting systems using eight variables:political system (traditional oligarchy, totalitarian oligarchy, modernizing oligarchy, tutelarydemocracy, political democracy), economic system, stage of political development, "nancial report-ing objectives, source of accounting standards, education and licensing of accountants, mechanismto enforce standards, and accounting client (public or private). Nobes (1992) and Nobes and Parker(1995, Chapter 4) survey classi"cation schemes. How these variables a!ect important properties ofaccounting information internationally is largely untested. International accounting texts typicallylist variables to justify classi"cations, without correlating them with the national accountingstandards listed in subsequent chapters, let alone with properties of the "nancial statements actuallyprepared under those standards.
9David and Brierley (1985) provide a survey.
which variables explain di!erences in important properties of accountingincome.8
4.1. Demand for timely accounting income in code and common law governance
Perhaps the most fundamental institutional variable causing accountingincome to di!er internationally is the extent of political in#uence on bothstandard setting and enforcement. An admittedly imperfect proxy for politicalin#uence } but a proxy our results legitimate } is whether standard setting andenforcement occur under codi"ed law (a governmental process) or common law(a market process).9 We hypothesize that the demand for timely incorporationof economic income in accounting income is lower under the code-law &stake-holder' model of corporate governance than under the common-law &share-holder'model. Below we describe the origins of and salient features of code- andcommon-law institutional environments. The discussion highlights the di!er-ences between the two systems and their di!erential implications for propertiesof accounting income. However, there is overlap between the code- and com-mon-law institutions and accounting standard setting, which likely weakensempirical support for the hypotheses we develop.
Common law arises from individual action in the private sector. It emphasizesfollowing legal procedure over rules (David and Brierley, 1985, p. 24; Posner,1996). Common laws } including accounting standards } evolve by becomingcommonly accepted in practice. While it might be e$cient for private-sectorbodies to codify generally accepted accounting rules and make them binding ontheir members, such standards arise in an accounting market, not in govern-ment. Common law enforcement is a private matter, involving civil litigation.Common law originated in England and it is now found in UK and manyformer British colonies. The common-law countries in our sample are Australia,Canada, UK and US.
Common law historically has evolved to meet the demands of contractingin markets. The &shareholder' model of corporate governance, in which
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 13
10Romans implanted code-law (also referred to as civil law, La Porta et al., 1997) in manycontinental European countries. The most detailed accounting code is the French Plan comptablege&ne& ral, adapted under occupation from Germany's 1937 standardization of accounting for warplanning (Standish, 1997, p. 60). Japan has a code-law system, derived from the German legal andFrench accounting systems during the Meiji Era (1868}1910). Scandinavian law is another code-lawcategory with origins in Roman law (David and Brierley, 1985 and La Porta et al., 1997).
11See Nobes and Parker (1995, Chapter 12), Roe (1994) and Miwa (1996).
shareholders alone elect the governing board, predominates in common-lawcountries. Alchian and Demsetz (1972) argue this is e$cient due to the addi-tional incentive of residual claimants to e!ectively monitor managers. Com-pared to code-law governance, board members are less likely to hold largeblocks, there is more monitoring of managers by external debt and equitymarkets (including analysts), and lenders and employees seldom have boardrepresentation. We hypothesize that, because parties contracting with the "rmoperate at greater &arm's length' from managers, information asymmetry incommon-law countries is more likely to be resolved by timely public disclosure.
Code-law originates from collective planning in the public sector. Govern-ments or quasi-governmental bodies, such as France's Conseil National de laComptabilite& or Japan's Business Accounting Deliberation Council (which ad-vises the Ministry of Finance) establish code-law accounting standards.10 Thecode prescribes regulations ranging from abstract principles (e.g. &prudence') todetailed procedures (e.g. the format of "nancial statements). Code-law enforce-ment is a governmental function, involving administrative bodies undertakingcriminal prosecution for code violation. Code-law countries in our sample areFrance, Germany and Japan.
The code- and common-law common classes overlap in practice, in that"nancial reporting in no country is determined in a purely market or planningsystem. The UK Companies Acts imposed codi"cation on a predominantlycommon-law system during the 19th century. In the US, the Securities andExchange Acts played a similar role in the 1930s, among other things creatingthe SEC as a US government agency with responsibility for regulation ofaccounting standards. We acknowledge that the code- and common-law separ-ation is not watertight and that there is some overlap in the nature of standardsetting in the two categories of countries. Nevertheless, we believe the distinctionis informative because, after reviewing the institutional details, we conclude itcaptures di!erences in the extent of political in#uence on accounting standard-setting (versus private contracting in the markets).
An important di!erence between common-law and code-law countries is themanner of resolving information asymmetry between managers and potentialusers of accounting income, including debt and equity investors, employees,suppliers and customers. Code-law corporate governance tends to be conductedby elected or appointed agents for these parties.11 These agents tend to be
14 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
12La Porta et al. (1997) predict that, in addition to di!erences in legal systems, di!erences in theextent of law enforcement a!ects the development of capital markets across countries. It is possiblethat variation in law enforcement has predictive power with respect to the demand and supply ofaccounting information that we ignore.
13Daimler-Benz reported 1993 German-rule income of DM615 million, but subsequent USGAAP disclosure revealed that a loss of DM1839 million had been hidden by various accountingadjustments (Ball, 1998).
informed by private &inside' access to information. Thus, employees and stock-holders each elect 50% of the supervisory board of German Aktiengesellschaft(stock corporations). Banks typically dominate stock voting due to their large-block holdings and due to the German practice of banks voting individuals'stocks as agents (KoK ndgen, 1994). The supervisory board appoints and monitorsthe managerial board, and approves the "nancial statements. For the system tobe tractable, the number of contracting parties must be small, so managers haveclose relations with intermediaries: notably, banks, other "nancial institutions,labor unions, governments, major customers and suppliers. There is no pre-sumption that parties operate at a distance. Consequently, the demand fortimely public disclosure in code-law countries is not as great as in common-lawcountries.12 We propose that this reduces the demand for timely incorporationof economic income in code-law accounting income.
Conversely, we propose that code-law accounting income meets other de-mands. The stakeholder model views accounting income as a common &pie'divided among stakeholders, as dividends to shareholders, taxes to govern-ments, and bonuses to managers and perhaps employees. The portfolio weightsof managers and employees typically are skewed toward their employer "rms, sotheir incentive is to reduce volatility in payouts. Regulation of bank leverageratios penalizes volatility in bank income and thus in the accounting incomeand/or dividends on their equity investments. Code-law banking systems typi-cally are hierarchical, so bank representatives are well aware of governments'incentives to reduce volatility of tax receipts. Employee representatives typicallyare re-elected annually. While incentives to reduce volatility in accountingincome exist in common-law countries (Healy, 1985), we hypothesize thatcode-law governance ampli"es them.
Volatility can be reduced, at the expense of timeliness, through accountingmethods that &smooth' accounting income over time, incorporating economicincome gradually over several periods. The Recognition Rules inherentlysmooth accounting income in all countries (though we also argue they fre-quently are overridden in the case of negative economic income). Nevertheless,code-law accounting gives managers considerably more latitude in timing in-come recognition. In good years, income can be reduced by asset write-downs(e.g. excessive allowances for bad debts), by provisions (e.g. excessive provisionsfor future losses or future expenses) and by transfers to reserves. In bad years,accounting income can be increased by reversing these adjustments.13 We
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 15
14The code-law ratio range is 0.06}0.29; common-law is 0.33}0.36 (excluding 0.23 for UK,discussed below).
predict that code-law accounting income incorporates a lower proportion ofcurrent-period economic income, &smoothing' its incorporation to a greaterextent over time.
H1: Code-law countries+ accounting incomes are more &smoothed+ and less timely
in incorporating current-period changes in market value than common-lawcountries'.
The summary statistics reported in panel A of Table 1 are broadly consistentwith this hypothesis, in that code-law countries exhibit a lower ratio of NIvolatility to R volatility.14 We formally test the hypothesis using a variety ofBasu regressions (4): individual-country regressions with observations pooledacross time; annual Fama/MacBeth cross-sectional regressions for individualcountries; a secondary sample of eighteen other countries; and (in Section 4.3)a pooled-countries regression that allows formal tests of di!erences amongcountries.
4.1.1. Evidence from country regressions with observations pooled across timeInitially, we test Hypothesis 1 by comparing the adjusted R2's of the indi-
vidual country, each estimated from pooled time series and cross-section data.While we make a distinction between common- and code-law countries, thecategories are by no means homogeneous. For example, in Section 4.4 we arguethat the UK is di!erent from the remaining three common-law countries due todi!erences in the extent of accounting regulation, litigation environment, andthe existence of public versus private debt. The empirical analysis thereforereports results separately for the common-law countries excluding the UK, forthe UK, and for the code-law countries.
The left-hand side of panel A of Table 2 reports the results and Fig. 1 graphsthem. With the possible exception of France, there is a clear di!erence betweenindividual code-law country R2s (ranging from 4.2% to 12.6%) and common-law country R2's (from 9.1% to 17.0%), consistent with the hypothesis. Whencountries are grouped, the R2 for the pooled code-law sample is 5.2%, approx-imately one-third the common-law equivalent of 14.4% (excluding UK). Theinternational di!erences in the degree of income-return association we docu-ment are similar to those in Alford et al. (1993), despite slightly di!erent timeperiods and models.
To assess whether the di!erences in R2's are statistically signi"cant, weestimate the standard deviation of estimated R2's, which Cramer (1987) shows isa function of sample size, the number of independent variables and the true R2.For four independent variables including intercepts, a true R2 of 5%, andsample size 1,000 (5,000, 20,000), the standard deviation of the estimate is 1.3%
16 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Fig. 1. International di!erences in earnings timeliness R-squares from individual country regres-sions of earnings on (a) annual return and (b) annual return times negative return dummy.
(0.6%, 0.3%). For a true R2 of 15%, it is 2.0% (0.8%, 0.5%). Assumingindependence across countries, di!erences in the order of 5% between oursample countries are signi"cant, and the pooled common-law sample R2 of14.4% signi"cantly exceeds the code-law R2 of 5.2%. Since independence likelyis violated, we report alternative tests below.
4.1.2. Annual cross-sectional regressionsAn alternative test, due to Fama and MacBeth (1973), estimates separate
annual cross-sectional Basu regressions (4), using observations for each countryas well as for each of three pooled country groups (code-law, common-law andUK). We exclude the 6 of 77 country-years with fewer than 20 "rm observations.For each country and each country-group, the right-hand side of panel A ofTable 2 reports the time-series average of the estimated annual slope coe$cientsand the average of the annual regression R2's and their t-statistics. The t-statisticis the ratio of the sample mean to the standard deviation of the time-seriesdistribution of the estimated coe$cients or R2's, divided by the square root ofthe number of annual cross-sections ("11 or 10 depending on the availabilityof 20 or more observations). From this test, the mean R2 for the common-lawgroup is 16.7% (t-statistic "12.85) compared to 7.0% (t-statistic "6.07) for thecode-law group and 16.8% (t-statistic "8.81) for the UK. The common-lawcountries' average R2 is signi"cantly greater than that for the code-law countriesat the 0.01 level.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 17
Tab
le2
Con
tem
por
aneo
us
asso
ciat
ion
bet
wee
nea
rnin
gsan
dre
turn
s.Sta
tist
ics
bas
edon
pool
edcr
oss
-sec
tion
and
tim
e-se
ries
regr
essions
and
annual
cross
-se
ctio
nal
regr
essions
using"rm
-yea
rob
serv
atio
ns
for
each
countr
y.In
terc
epts
are
not
repor
ted!
Pan
elA
:N
I"b 0
#b 1
RD#
b 2R#
b 3RHR
D#
e
Pool
edre
gres
sions
Annua
lcr
oss
-sec
tion
alre
gres
sion
s
b 2t(b 2
)b 3
t(b 3
)A
dj.R
2
(%)
NA
vg.b
2t(b 2
)A
vg.b
3t(b 3
)A
dj.R
2
(%)
t(R
2)
Aust
ralia
!0.
01!
0.53
0.37
8.63
9.1
1,32
10.
020.
990.
336.
1211
.15
3.68
Can
ada
0.00
0.12
0.40
17.2
117
.02,
901
0.01
0.51
0.39
6.82
18.1
95.
59U
SA
0.03
8.57
0.29
34.0
214
.721
,225
0.03
3.43
0.33
14.3
417
.15
13.8
2U
K0.
0410
.14
0.15
13.3
213
.85,
758
0.05
4.23
0.14
5.41
16.7
68.
81Fra
nce
0.08
7.30
0.07
2.30
12.6
1,05
40.
062.
950.
142.
7117
.59
4.52
Ger
man
y0.
054.
280.
103.
275.
41,
245
0.04
2.01
!0.
01!
0.06
7.47
4.85
Japa
n0.
015.
950.
012.
584.
26,
855
0.00
0.55
0.02
3.26
6.88
4.07
Com
mon
0.02
7.07
0.31
39.1
014
.425
,447
0.02
2.36
0.34
15.3
116
.74
12.8
5U
K0.
0410
.14
0.15
13.3
213
.85,
758
0.05
4.23
0.14
5.41
16.7
68.
81C
ode
0.04
13.2
70.
012.
195.
29,
154
0.04
4.55
0.04
1.91
7.00
6.07
18 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Tab
le2
(cont
inued
)
Pan
elB:
R"
b 0#
b 1N
I#e
R"
b 0#
b 1N
I#b 2
*N
I#e
b 1t(b 1
)A
dj.R
2(%
)b 1
t(b 1
)b 2
t(b 2
)A
dj.R
2(%
)N
Aust
ralia
0.47
6.30
2.9
0.44
5.75
0.12
2.84
3.4
1,32
1C
anad
a0.
7914
.49
6.7
0.72
13.0
60.
266.
448.
02,
901
USA
0.90
46.0
89.
10.
7636
.52
0.37
18.5
810
.521
,225
UK
1.44
26.6
711
.01.
2120
.40
0.46
9.07
12.2
5,75
8Fra
nce
1.40
12.2
212
.31.
2810
.86
0.46
4.23
13.7
1,05
4G
erm
any
0.76
7.84
4.6
0.71
6.78
0.13
1.30
4.7
1,24
5Ja
pan
3.16
16.8
24.
02.
2311
.04
2.85
11.8
35.
96,
855
Com
mon
0.85
47.5
28.
20.
7439
.71
0.30
18.9
29.
425
,447
UK
1.44
26.6
711
.01.
2120
.40
0.46
9.07
12.2
5,75
8C
ode
1.44
22.4
45.
21.
2919
.10
0.47
7.04
5.7
9,15
4
!Sam
ple
cons
ists
of40
,359"rm
-yea
robs
erva
tions
sele
cted
from
the
Glo
bal
Van
tage
indust
rial
/Com
mer
cial
and
Issu
e"le
sove
r19
85}95
,us
ing
the
follo
win
gpro
cedu
re.F
irst
,fo
rea
chva
riab
le(see
bel
ow)w
eel
imin
ate
the
two
extr
eme
per
cent
iles
of"rm
-yea
robse
rvat
ions
.Sec
ond,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sw
ith
missing
valu
esfo
rone
orm
ore
variab
les,
tofa
cilit
ate
com
para
bilit
yw
ith
resu
lts
inpre
viou
sta
bles
.Thi
rd,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sfrom
count
ries
with
less
than
1,00
0ob
serv
atio
ns,l
eavi
ngse
ven
count
ries
repre
sent
ed.A
ustr
alia
,Can
ada,
Uni
ted
Stat
es,a
ndth
eU
nited
Kin
gdom
are
the
com
mon
-law
count
ries
,th
ere
star
eco
de-
law
count
ries
.R"
buy-
and-h
old
secu
rity
retu
rnin
clusive
ofdiv
iden
dsove
rth
e"sc
alye
ar;
RD"
equa
lson
eif
retu
rnR
isneg
ativ
ean
dze
rooth
erw
ise.
NI"
annu
alea
rnin
gper
shar
ebef
ore
extr
aord
inar
yitem
de#ec
ted
by
beg
innin
gofpe
riod
pric
e;*N
I"ch
ange
inN
Ipe
rsh
are,
adju
sted
for
stock
split
san
dst
ock
dev
iden
ds,
de#at
edby
beg
innin
gofper
iod
pric
e;N"
the
num
ber
of"rm
/yea
rob
serv
atio
ns.
Inpan
elA
,the
repo
rted
t-st
atistics
forth
eav
erag
eoft
heslope
coe$
cien
tsfrom
annual
cross
-sec
tion
alre
gres
sionsfo
rea
chco
unt
ryar
eth
era
tiosoft
he
mea
nes
tim
ated
coe$
cien
tsto
the
stan
dar
ddev
iation
ofth
edistr
ibution
of11
annual
estim
ated
slope
coe$
cien
ts,d
ivid
edby
the
squa
rero
otof11
(see
Fam
aan
dM
acBet
h,19
73).
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 19
15We describe asymmetric timeliness in incorporating economic losses as &income conservatism.'The concept is related to, but di!erent from, balance sheet conservatism (reporting low book value ofequity by under-stating assets and/or over-stating liabilities). Income conservatism implies balancesheet conservatism, but not vice versa: while code-law companies typically report conservative bookvalues, they also are more likely to boost income in bad years. This reduces the asymmetrictimeliness of accounting income and is di$cult to describe as &conservative' in its e!ect on income.Asymmetric timeliness is di!erent from, but related to, Gray's (1980) concept of conservatism.
4.1.3. Secondary sample of eighteen countriesA secondary sample of eighteen countries with between 100 and 1000 "rm-
year observations provides similar results. We use the Mueller et al. (1997, pp.11}12, Exhibits 1}4) classi"cations of countries as following a British}Americanor a Continental accounting model to proxy for our private-sector common-lawand public-sector code law categories. We thereby classify eight additionalcountries as common-law (Hong Kong, India, Ireland, Malaysia, Netherlands,New Zealand, Singapore, and South Africa), nine as code-law (Austria, Belgium,Denmark, Finland, Italy, Norway, Spain, Sweden, and Switzerland), and addThailand as a code-law country based on our own assessment. While theMueller et al. classi"cations agree with ours for each of the seven countries inour primary sample, we are less con"dent of the eighteen additional countryclassi"cations. Speci"cally, we suspect that many countries followingBritish}American accounting rules nevertheless lack common-law litigationenforcement and exhibit reduced demand for timely accounting income.Classi"cation errors are expected to reduce the signi"cance of the secondarysample results.
For each of the eight common-law and ten code-law countries, we estimatea pooled Basu regression (4). Annual cross-sectional regressions for each coun-try are not feasible due to insu$cient observations. In the interest of parsimony,we summarize the main results. Detailed results in tabulated form are availableto interested readers upon request. The average R2 for the code-law countries is6.5%, the median is 7.0%, the minimum is 1%, and the maximum is 14.6%. Incomparison, the average R2 for the common-law countries is 15.3%, the medianis 12.4%, the minimum is 9.8%, and the maximum is 22.5%. The di!erence inmean R2's of the common and code-law countries is statistically signi"cant. Theresults are consistent with those reported for the seven countries in Table 2 andprovide an independent con"rmation of H
1.
4.2. Universal demand for conservative accounting income
In this section we argue that conservatism, de"ned as asymmetric timelinessin incorporating economic gains and losses (Basu, 1997), is a general property ofaccounting income.15 This section serves as a lead-in to Section 4.3, which
20 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
16For the separate positive and negative return regressions, we examined plots of the residualsagainst returns, and found no evidence of non-linearity (which was a concern for the negative-returnsample in particular).
focuses on the e!ect of code- and common-law institutional di!erences on thedegree of accounting conservatism.
Accountants contract to supply users with asymmetrically conservative in-come (i.e., to incorporate economic losses in a more timely fashion than gains)due to three properties of the accounting information market. First, managerspossess speci"c information (Alchian, 1984) that is costly for external users toproduce themselves (is not independently veri"able). Because managers haveasymmetric incentives to disclose positive and negative speci"c information,information of negative innovations in expected future cash #ows (economiclosses) is more credible than positive innovations, and accountants are morelikely to incorporate it in income. Second, lenders are important users ofaccounting information, including income and book value (a function of in-come), and they are asymmetrically a!ected by economic gains and losses(Watts and Zimmerman, 1986). Third, we propose that timely disclosure ofeconomic losses is an important corporate governance mechanism. We assumethat reversing bad investment decisions and strategies is personally more costlyto managers than continuing good ones, and that informed monitoring byboards, analysts, investors and lenders is a mechanism to force them to under-take the cost. For these reasons, accountants supply income and book valuesthat incorporate economic losses in a more timely fashion than economic gains.
The above properties of the market for accounting information are universal(though we argue below that they vary in degree internationally). We thereforeexpect accounting income to be asymmetrically conservative in all countries.Empirically, accounting income should exhibit higher R2's for bad news (i.e.negative "scal-year return) observations than for positive. Table 3 reports thatnegative-return R2's exceed their positive-return counterparts in all common-law countries and in Germany.16 The exceptions are the code-law countriesFrance and Japan, discussed below.
Table 3 and Fig. 2 show that in all seven countries the coe$cient on negativereturns exceeds its counterpart on positive returns. Accounting income in theUS is approximately ten times as sensitive to negative as to positive returns(estimated slopes of 0.32 and 0.03). The median country in terms of relativesensitivity to negative versus positive returns is the UK, with a ratio of approx-imately "ve (0.19: 0.04). A formal test of the asymmetry is provided in Table 2,panel A. The incremental slope b
3on negative "scal-year returns (i.e. return
interacted with the return dummy variable, RHRD) is signi"cantly positive for allseven countries. A Fama}MacBeth test, with the b
3coe$cients estimated from
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 21
Table 3Contemporaneous association between earnings and returns separately in good and bad news years
Statistics from pooled cross-section and time-series regressions using "rm-year observations foreach country. Intercepts are not reported!
Good news:NI"b
0#b
1R#e(R50)
Bad news:NI"b
0#b
1R#e(R(0)
b1
Adj. R2 (%) N b1
Adj. R2 (%) N
Australia !0.01 !0.1 813 0.36 10.1 508Canada 0.00 !0.1 1,688 0.40 17.9 1,213USA 0.03 0.8 12,721 0.32 11.7 8,504UK 0.04 3.2 3,612 0.19 11.6 2,146France 0.08 9.0 611 0.16 4.7 443Germany 0.05 2.4 712 0.16 4.9 533Japan 0.01 1.1 3,141 0.02 0.8 3,714
Common 0.02 0.4 15,222 0.33 12.2 10,225UK 0.04 3.2 3,612 0.19 11.6 2,146Code 0.04 3.3 4,464 0.05 1.7 4,690
!Sample consists of 40,359 "rm-year observations selected from the Global Vantage indus-trial/Commercial and Issue "les over 1985}95, using the following procedure. First, for each variable(see below) we eliminate the two extreme percentiles of "rm-year observations. Second, we eliminateall "rm-year observations with missing values for one or more variables, to facilitate comparabilitywith results in previous tables. Third, we eliminate all "rm-year observations from countries withless than 1,000 observations, leaving seven countries represented. Australia, Canada, United States,and the United Kingdom are the common-law countries, the rest are code-law countries.
R"buy-and-hold security return inclusive of dividends over the "scal year;NI"annual earnings per share before extraordinary items de#ated by beginning of period price;N"the number of "rm/year observations.
separate annual cross-sectional country regressions, also is reported in Table 2,panel A. The average incremental slope is signi"cant for all countries exceptGermany.
Unreported results for the secondary sample of 10 code-law and 8 common-law countries also are consistent with asymmetric timeliness being a universalproperty of accounting income. The incremental slope on negative returns ispositive in 12 of the 18 countries.
4.3. Demand for greater income conservatism under common-law governance
We propose that common-law accounting income is more asymmetricallyconservative than code-law, due to greater demand for timely disclosure ofeconomic losses. Each of the three properties of the market for accountinginformation described above is qualitatively weaker in code-law governance.First, the closer code-law relation between managers and agents for contracting
22 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Fig. 2. International di!erences in asymmetry in earnings response to good and bad news; sensitiv-ity to positive and negative returns from pooled regression of earnings on (a) annual return and (b)annual return times negative return dummy.
groups (banks, labor unions) reduces information asymmetry. Second, banksand other "nancial institutions tend to supply both debt and equity capital,making their loss function more symmetric. Third, there is less reliance onexternal monitoring of managers. Consistent with lower demand for timelyincorporation of economic losses, the expected litigation cost of untimelyincorporation is lower. Conversely, in code-law countries there is a demand fora low-volatility income variable, due to the more direct relation betweencurrent-year accounting income and short-term payouts such as dividends andbonuses. Reluctance to cut dividends (Lintner, 1956) leads to a preference forgradually incorporating an economic loss in income over time, for example bywaiting for the reduced underlying cash #ow realizations to occur, as distinctfrom recognizing it as a large, capitalized, transitory amount.
H2: Common-law accounting income is more asymmetrically conservative than
code-law.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 23
17Unreported incremental negative return slopes in the additional 18-country sample are incon-sistent with our hypothesis. While the R2's are consistent with greater conservatism in common-lawcountries and the slopes are consistent with universal conservatism, the slopes do not suggest greaterconservatism in common-law countries. However, due to small sample sizes many of the positivecode-law country incremental slopes are not signi"cant.
18Nobes and Parker (1995, pp. 298}300).
The separate positive and negative return samples in Table 3 reveal that thegreater overall timeliness of common-law accounting income reported above isdue entirely to years with economic losses. For the common-law group, the12.2% negative-return year R2 signi"cantly exceeds the 0.4% in positive-returnyears. In all common-law countries, R2's in negative-return years exceed those inpositive-return years. Accounting income in Australia, Canada and the US overthe sample period essentially ignores current-year economic gains. Common-law accounting income seems directed primarily toward incorporation of eco-nomic losses. With the exception of Germany, the same cannot be said ofcode-law accounting. For the code-law sample, the negative-return year R2 of1.7% actually is lower than 3.3% for the positive-return years. These results areconsistent with the hypothesis that, relative to code-law countries, the common-law demand for accounting income originates more in arm's length corporategovernance, debt contracts, and investor litigation, and less in determiningshort-term payouts.
As another test of a di!erential degree of conservatism in code- and common-law countries, we focus on the slope coe$cients from the Basu regression (4)results in Table 2 and Fig. 2. The b
2jslopes 2 show that accounting income in
every common-law country exhibits less sensitivity to positive returns than inFrance and Germany (accounting income in Japan exhibits the least timelinessfor both return samples). In contrast, the incremental negative-return slopesb3j
for common-law countries range from 0.15 to 0.40, considerably larger thanthe code-law range of 0.01}0.10. The pooled incremental slopes are 0.31 for thecommon-law group as a whole (excluding UK) and 0.01 for the code-law group.The di!erence is statistically signi"cant at the 0.01 level.17
The incremental b3j
slope of 0.01 for Japan is the lowest in the sample (due torelative sample sizes it dominates the code-law group slope). Low incomeconservatism is consistent with the stylized institutional facts for Japan, in whichone-time accounting write-o!s are rare, economic losses reputedly are dribbledslowly into reported income over time (the banking sector being a notoriouscase), there is no provision for under-funded pension liabilities or other post-retirement liabilities, and the &lower of cost or market' rule is not even used forinventories.18
24 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
4.3.1. Pooled sampleTo formally test for international di!erences in the degree of conservatism, we
estimate (4) using data pooled across countries:
NI"b0#+
j
b0j
CDj#b
1RD#+
j
b1j
RD CDj#b
2R
#+j
b2j
R CDj#b
3R RD#+
j
b3j
R RD CDj. (5)
Six dummy variables identify the country of the accounting standards used foreach "rm/year, with CD
j"1 for "rm/years under country j and "0 otherwise.
US is the &base country,' with zero values for all country dummy variables. Thecoe$cient b
2on return measures the incorporation of current economic income
into US "rms' accounting incomes. The coe$cient b2j
on the product of returnand the country j dummy variable measures the country's incremental incorpo-ration, relative to the US. The coe$cients b
3and b
3jmeasure the asymmetric
conservatism of accounting income under US standards and the incrementalconservatism under other countries' standards. Thus, b
2#b
2j#b
3#b
3jmeasures the incorporation of negative economic income in country j. Table 4reports results of the pooled country-dummy regression Eq. (5). Accountingincome in all sample code-law countries (France, Germany and Japan) exhibitssigni"cantly less incremental sensitivity to negative economic income thanunder US standards.
4.4. Regulation, litigation and debt diwerences among common-law countries
The distinction between common-law and code-law countries provides usefulinsights, but as we observe above the categories are by no means homogeneous.We consider two important institutional di!erences within the class of com-mon-law countries: the method and extent of their regulation of accounting; andthe extent to which their securities litigation rules favor plainti!s.
4.4.1. RegulationWe propose that, among common-law countries, income conservatism in-
creases with regulation of accounting standard setting and enforcement. Build-ing on Peltzman (1976), Watts and Zimmerman (1986, pp. 229}231) argue thatthe political process and the SEC as its agent have an incentive to avoidperceived responsibility for investor losses. We argue that responsibility isattributed more to managers, and less to the political process, if losses aredisclosed in "nancial statements in a more timely fashion. Consequently, regula-tion adds criminal penalties to the common-law civil remedy of damages foruntimely disclosure of material bad news. Accounting is regulated to varyingdegrees in all common-law countries. For reasons summarized below, we
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 25
Table 4Comparative asymmetry in the contemporaneous returns-earnings relation: pooled regressions withindividual-country e!ects!
Reported statistics are for the following model using the pooled cross-section and time-series of"rm/year observations for all countries:
NI"b0#+
j
b0j
CDj#b
1RD#+
j
b1j
RD CDj#b
2R#+
j
b2j
R CDj#b
3R RD
#+j
b3j
R RD CDj#e
Results are not reported for the intercept, the negative-return intercept, and their respective countrydummies. The country category models use the common law countries of Australia, Canada and theUS as the base category; dummies are used for (1) the UK and (2) the code law countries of France,Germany and Japan.
Coe!. t-Stat.Panel A: country dummies model
Earnings &good news+ sensitivity
b2
(Return) 0.03 9.88b2j
(Return*Country Dummies):Australia !0.03 !3.95Canada !0.03 !3.80UK 0.02 2.40France 0.05 4.16Germany 0.03 1.57Japan !0.02 !2.64
F-stat. for country return dummies 11.35p(0.01
Incremental *bad news+ sensitivity
b3
(Return Dummy*Return) 0.29 39.21b3j
(Return Dummy*Return*Country Dummies)Australia 0.07 2.64Canada 0.11 5.28UK !0.14 !8.26France !0.22 !5.81Germany !0.19 !4.41Japan !0.29 !15.74
F-stat.: Country Negative Ret Dummies 67.44p(0.01
Regression
N 40,359Adj. R2 15.4%F 272.98
26 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Table 4 (continued)Panel B: country category dummies model
Earnings *good news+ sensitivity Coe!. t-stat.
b2
(Return) 0.02 8.36b2j
(Return*Country Category Dummy):UK 0.02 3.52Code 0.01 2.37
F-stat. for country category return dummies 7.94p(0.01
Incremental &bad news+ sensitivity
b3
(Return Dummy*Return) 0.31 46.23b3j
(Return Dummy*Return*Country Category Dummy):UK !0.16 !9.50Code !0.30 !19.00
F-stat.: Country Category Negative Return 200.92Dummy p(0.01
Regression
N 40,359Adj. R2 14.9%F 642.07
!Sample consists of 40,359 "rm-year observations selected from the Global Vantage indus-trial/Commericial and Issue "les over 1985}95, using the following procedure. First, for eachvariable (see below) we eliminate the two extreme percentiles of "rm-year observations. Second, weeliminate all "rm-year observations with missing values for one or more variables, to facilitatecomparability with results in previous tables. Third, we eliminate all "rm-year observations fromcountries with less than 1,000 observations, leaving seven countries represented. Australia, Canada,United States, and the United Kingdom are the common-law countries, the rest are code-lawcountries.
R"buy-and-hold security return inclusive of dividends over the "scal year;NI"annual earnings per share before extraordinary items de#ated by beginning of period price;RD"the proxy for bad news"1 if R(0 and "0 otherwise;CD
j"country identi"er"1 for "rm/years in country j and "0 otherwise. USA is the &base
country' with CDj"0 ∀j.
characterize UK as the least regulated accounting market among our samplecommon-law countries.
The Securities Exchange Act of 1934 created the SEC as a US Governmentagency authorized to mandate and administer accounting standards. The SECby-and-large has accepted the standards of the accounting profession, but
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 27
nevertheless has retained a close supervisory role. It has intervened in standardsetting on several occasions, as has Congress on occasions (e.g., in the debate onmark-to-market accounting, and by examining some "rms' in-process R&D write-o!s). We conclude that the US operates a closely regulated common-law system.
The e!ect is to compound the civil and criminal penalties for non-disclosureof material bad news. It has become a violation of both the common-lawobligation to disclose (the civil law penalty for which is remedial damagesawarded in private litigation) and a similar and sometimes stronger statutoryobligation (the criminal law penalty for which is a "ne, incarceration and/orprohibition from practice). We conjecture that this dual system of penaltiescreates additional incentives to recognize economic losses in regulated com-mon-law countries.
Australia and Canada are widely viewed as having evolved from the looselyregulated UK model (described below) to the US regulatory model. Bothcommenced with a largely self-regulating profession, initially adopted provincial(rather than federal) regulation, and then moved to a system in which govern-mental or semi-governmental bodies set national accounting standards. Austra-lia created a regulatory body (now constituted as the Australian SecuritiesCommission) &obviously modeled on the SEC' (Nobes and Parker, 1995, p. 106).It also removed standard setting from the private sector, assigning it in 1984 toa government-appointed authority (now the Australian Accounting StandardsBoard), whose accounting standards can be overturned only by the AustralianParliament. These changes predate our sample period, so we characterizeAustralian accounting as highly regulated (see Choi and Mueller, 1992, p. 86).
Canada has evolved to a regulated federal model in a similar fashion. Ac-counting was increasingly regulated with the establishment of the provincialsecurities commissions, and the enactment of provincial and federal securitieslaws. Various revisions of the Ontario Companies Act have been particularlyin#uential. In 1975, federal regulations required "nancial statements to complywith the accounting standards promulgated in the Canadian Institute of Char-tered Accountants' CICA Handbook, thereby giving them statutory status. TheSEC has indirectly in#uenced Canadian accounting, due to large Canadiancorporations listing in New York.
Among the common-law countries in our sample, we classify the UK ashaving the least regulated accounting market over our sample period. There isno UK regulatory body comparable to the SEC in the US. UK "nancialmarkets (the City of London) have historically been viewed as primarily &self-regulating,' and the UK parliament has seldom intervened in accounting mat-ters (Choi and Mueller, 1992, Chapter 3; Nobes and Parker, 1995, Chapter 6;Radebaugh and Gray, 1997, Chapter 5). In 1990, UK established the AccountingStandards Board (ASB), modeled on the US FASB and accountable to anewly created Financial Reporting Council. The ASB was authorized to issueFinancial Reporting Standards (FRSs) that are backed by law (Radebaugh and
28 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
19The English rule is applied in UK, Australia, and most of Western Europe (Posner, 1986, p.537), though not uniformly. It a!ects expected litigation costs via the frequency of litigation and thelegal costs of the defendant, but not the size of awards, with unclear net e!ect. Katz (1987) argues:&While it is conceivable that the English rule would lower the total number of cases brought to trial,it would likely increase the average expenditure per case. 2Even if the number of cases were to fallby as much as 30 percent, total expenditure could rise by more than 50 percent under the Englishrule.'Katz' analysis does not take account of one institutional detail, however: English courts awardonly reasonable costs of successful defendants, thus reducing the incentive to spend. See also Shavell(1982), Posner (1986, pp. 534}540), Hughes and Snyder (1995), Posner (1996) and Miceli (1997).
Gray, 1997, pp. 91}92; Choi and Mueller, 1992, pp. 116}118). Nevertheless, thelaw allows a company to deviate from FRSs if it discloses the e!ect on itsaccounts. Even these changes did not take place until near the end of our sampleperiod, 1985}95. We therefore treat UK accounting as less regulated than othersample common-law countries (Australia, Canada and US).
4.4.2. LitigationAmong common-law countries, we also propose that income conservatism
increases in the expected costs to accounting "rms and their clients fromsecurities litigation. Expected litigation costs a!ect managers' and auditors'disclosure decisions (Kothari et al., 1988). The expected costs are a function oflawsuit probability, award size and legal fees. Securities lawsuits induce a de-mand for conservatism because the payo! function is asymmetric: they almostinvariably allege investor losses arising from insu$ciently conservative dis-closures. We expect countries with higher expected litigation cost of non-disclosure are more likely to demand accounting income that incorporateseconomic losses in a timely fashion.
Our assumption is that expected litigation costs are lower in the UK than inAustralia, Canada and US. Relevant UK institutional facts include: punitivedamages are more di$cult to obtain; juries are seldom used in civil litigation;absence of class action suits; and the so-called &English rule,' under which losingplainti!s pay part of defendants' costs.19 In code-law countries, civil litigation iscomparatively rare and the size of awards is comparatively small.
4.4.3. Private debtUK corporate debt is predominantly private. We conjecture there is less
information asymmetry between managers and private lenders than in the caseof public debt, thus reducing the demand for timely incorporation of economiclosses in UK accounting income.
4.4.4. Regulation, litigation and private debt considered jointlyOverall, we classify UK as having lower regulatory and litigation costs and
predominantly private debt, so we predict less conservatism in UK accountingincome than in other common-law countries. Nevertheless, relative to code-lawcountries, UK is expected to be more income conservative.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 29
20 In response to a prior draft of this paper, Pope and Walker (1999) claim that the UK incomebefore extraordinary items appears less conservative than US because UK "rms enjoy greaterdiscretion in reporting economic losses as extraordinary items. They use data from Datastreamwhereas we use the Compustat Global Vantage database. Reconciliation of the di!erences betweenthe two studies is beyond the scope of our research.
H3: U.K. accounting income is less conservative than in other common-law coun-
tries and more conservative than in code-law countries.
The data weakly support this hypothesis. The UK negative-return R2 of11.6% in Table 3 falls between that of the common-law group (12.2%) and thecode-law group (1.7%). The incremental negative-return slope b
3of 0.15 in
panel A of Table 2 is signi"cantly smaller than those for the other common-lawcountries (b
3from 0.29 to 0.40), and it is marginally signi"cantly greater than
those for the code-law countries (b3
from 0.01 to 0.10).20
4.5. Advantage of the Basu (1997) piecewise linear model
The misspeci"cation in linear models for the common-law countries is seenfrom their generally lower R2's in panel B of Table 2, compared with the Basupiecewise linear regressions in panel A, which is graphically depicted in Fig. 3.Code-law countries exhibit considerably less asymmetry, and hence their R2'sdi!er little between the speci"cations. In contrast, the asymmetry is su$cientlystrong in Australia, Canada and US to cause R2's from the Basu model to beapproximately 1.6 to 3.2 times their linear model equivalents. Thus, linearearnings-returns models are potentially misleading in a common-law contextand in international comparisons, due to substantial international di!erences intiming of economic loss incorporation.
5. Hypotheses and tests: accounting income versus dividends and cash 6ows
In this section, we compare accounting income with dividends and cash #owsinternationally. We argue that code-law institutional links between current-yearincome and dividends imply they incorporate similar information. Consistentwith this hypothesis, we report that accounting income is timelier than divi-dends in common-law countries but not in code-law countries. Income is lesstimely than dividends in Germany and Japan. In contrast, accounting income istimelier than cash #ows from operations in all countries.
5.1. Laws and practices linking current-period income and dividends
Accounting income is in#uenced, in varying degrees across countries, by "rms'current dividend decisions. One in#uence results from laws on the taxation
30 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Fig. 3. International di!erences in the contemporaneous relation between earnings and returns;R-squares from (1) the pooled reverse regressions of earnings against (a) annual return and (b)Annual return times negative return dummy and (2) annual return against NI and *NI.
21Except as indicated, taxation facts are from annual editions of Coopers & Lybrand Interna-tional Tax Summaries.
of corporate income and of dividend distributions.21 We address these linkagesin code and common-law countries separately.
5.1.1. Code-law links between dividends and accounting incomeIn the code-law &stakeholder' corporate governance model, governments
frequently are viewed as stakeholders, and tax payments are viewed as govern-ment's share of the same income &pie' from which dividends and bonuses arepaid. Politics requires reported and taxable incomes to converge, particularlysince the government is responsible for both tax and accounting codes. Tax rulesin the three sample code-law countries allow a deduction against taxable incomeonly if also taken against reported accounting income (Choi and Mueller, 1992,p. 104). In code-law countries generally, it thus is considered imprudent toreport income in excess of that required to justify dividends and bonuses, tominimize corporate tax. The consequence is that accounting income is in-#uenced by short-term dividend policy.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 31
Table 5Contemporaneous association between dividends and returns!
Statistics are from regressions using the pooled cross-section and time-series of "rm/year observa-tions for each country. Intercepts are not reported.
Panel A: DI<"b0#b
1RD#b
2R#b
3RHRD#e
b2
t(b2) b
3t(b
3) Adj.R2(%) N Ratio
Australia 0.00 !1.85 0.06 8.67 11.1 1,321 0.82Canada !0.01 !9.06 0.04 11.26 7.3 2,901 2.34USA !0.02 !26.54 0.05 34.24 9.2 21,225 1.60UK 0.01 8.69 0.02 9.25 9.7 5,758 1.42France 0.01 4.22 0.02 3.90 8.8 1,054 1.43Germany 0.02 6.66 0.01 0.99 9.6 1,245 0.56Japan 0.00 2.28 0.01 9.72 5.5 6,855 0.78
Common !0.01 !25.23 0.05 35.67 8.4 25,447 1.70UK 0.01 8.69 0.02 9.25 9.7 5,758 1.42Code 0.01 10.08 0.01 3.78 5.5 9,154 0.96
The in#uence is particularly strong in Germany, where (Nobes and Parker1995, pp. 269}272) the Handelsgesetzbuch (&commercial code') includes the Mas-sgeblichkeitsprinzip (&authoritative principle') that tax accounting be based on the"rm's Handelsbilanz (&commercial balance sheet'). Choi and Mueller (1992, p. 96)conclude of Germany: &The dominance of tax accounting rules means that there isliterally no di!erence between "nancial statements prepared for tax purposes and"nancial statements published in "nancial reports. 2Financial reports re#ect taxlaws } not primarily the information needs of investors and other "nancial marketparticipants.' The relation between income and dividends is tightened in Germanyby two additional institutional factors. First, Federal law forbids managementfrom paying dividends less than 50% of income without stockholders votingapproval. Second, undistributed pro"ts are taxed at a higher rate than distributedpro"ts (currently 45% versus 30%, excluding the &solidarity surcharge').
These code-law institutional factors impose an additional role on the (alreadyreduced) public-disclosure role of accounting income: corporate policy on cur-rent payouts to &stakeholders,' including governments (via taxation), share-holders (via dividends), and managers and employees (via bonuses). If thesedistributions per se are uninformative, then the testable implication is thatcode-law accounting income is noisier and less oriented to incorporating currenteconomic income, relative to dividends, than common-law income.
H4: Code-law accounting income is less timely relative to dividends than common-
law.
Table 5 reports the contemporaneous association between returns and divi-dends, for the same sample of "rm-years as for accounting income in Table 2.
32 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Tab
le5
(cont
inued
)
Pan
elB
:D
I<"
b 0#
b 1R#
e(R5
0)D
I<"
b 0#
b 1R#
e(R(
0)
b 1A
dj.R
2(%
)N
Rat
ioV
uong
b 1A
dj.R
2(%
)N
Rat
ioV
uong
Aust
ralia
0.00
0.2
813
!0.
360.
650.
0618
.350
80.
552.
41C
anad
a!
0.01
3.8
1,68
8!
0.02
5.22
0.03
7.9
1,21
32.
26!
3.69
USA
!0.
024.
412
,721
0.18
9.67
0.04
10.4
8,50
41.
12!
1.48
UK
0.01
1.9
3,61
21.
73!
1.74
0.03
9.3
2,14
61.
24!
1.48
Fra
nce
0.01
2.2
611
4.12
!2.
460.
039.
544
30.
491.
88G
erm
any
0.02
4.8
712
0.50
1.43
0.02
3.8
533
1.31
!0.
6Ja
pan
0.00
0.1
3,14
111
.00
!2.
740.
014.
53,
714
0.19
6.06
Com
mon
!0.
013.
415
,222
0.13
8.71
0.04
10.3
10,2
251.
19!
2.45
UK
0.01
1.9
3,61
21.
73!
1.74
0.03
9.3
2,14
61.
24!
1.48
Cod
e0.
011.
54,
464
2.17
!2.
870.
012.
74,
690
0.62
1.89
!Sam
ple
cons
ists
of40
,359"rm
-yea
robs
erva
tions
sele
cted
from
the
Glo
bal
Van
tage
indust
rial
/Com
mer
cial
and
Issu
e"le
sove
r19
85}95
,us
ing
the
follo
win
gpro
cedu
re.F
irst
,fo
rea
chva
riab
le(see
bel
ow)w
eel
imin
ate
the
two
extr
eme
per
cent
iles
of"rm
-yea
robse
rvat
ions
.Sec
ond,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sw
ith
missing
valu
esfo
rone
orm
ore
variab
les,
tofa
cilit
ate
com
para
bilit
yw
ith
resu
lts
inpre
viou
sta
bles
.Thi
rd,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sfrom
count
ries
with
less
than
1,00
0ob
serv
atio
ns,l
eavi
ngse
ven
count
ries
repre
sent
ed.A
ustr
alia
,Can
ada,
Uni
ted
Stat
es,a
ndth
eU
nited
Kin
gdom
are
the
com
mon
-law
coun
trie
s,th
ere
star
eco
de-
law
coun
trie
s.H
ow
ever
,the
com
mon
law
coun
try
cate
gory
inth
eth
ird
row
from
the
bott
om
excl
udes
the
UK
.R"
buy-
and-h
old
secu
rity
retu
rnin
clusive
ofdiv
iden
dsove
rth
e"sc
alye
ar;
RD"
1if
R"
0an
dR
D"
0if
R'
0;D
IV"
annua
ldiv
iden
ds
per
shar
ede#
ated
bybeg
innin
gof
period
price
;N"
the
num
ber
of"rm
/yea
robs
erva
tions
.R
atio"
inpan
elA
,the
ratio
ofth
eR
2'soft
heeq
uiva
lent
earn
ings
(Tab
le2)
and
div
iden
ds(this
tabl
e)re
gres
sions
,in
pan
elB
,the
ratio
oft
heR
2'soft
he
equi
vale
ntea
rnin
gs(T
able
3)an
ddiv
iden
ds
(thi
sta
ble
)re
gres
sions.
Vuo
ng
stat
isticis
alik
elih
ood
ratio
stat
istic
that
com
par
esth
e"tof
there
turn
/div
iden
dm
ode
lin
this
table
inpan
elB
agai
nstth
ere
turn
/ear
nin
gsm
ode
lin
Tab
le3,
bot
hes
tim
ated
sepa
rate
lyusing
the
good
new
san
dba
dnew
sre
turn
obse
rvat
ions
.T
heV
uong
stat
istic
isdistr
ibut
edunit-N
orm
al,i.e
.,a
Z-st
atistic.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 33
Fig. 4. Earnings versus dividends; R-squares from the individual country reverse regressions of(1) NI and (2) DIV against (a) annual return and (b) annual return times negative return dummy.
Fig. 4 depicts comparative R2's for income and dividends. Results generallysupport the hypothesis that common-law accounting income is more timelyrelative to dividends than code-law. In the last column of panel A, the ratio ofthe returns/income R2 to the returns/dividends R2 exceeds unity for three of thefour common-law countries. For the pooled common-law countries, the ratio is170%. In contrast, dividends are more timely than income in two of the threecode-law countries (Germany and Japan). In Germany, where there are parti-cularly binding institutional links between them, accounting income capturesonly 56% as much current value relevant information as dividends. The equiva-lent ratio for Japan is 78%. For the pooled code-law group, the ratio is 96%,meaning current-year income and dividends capture approximately the same
34 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
22The Australian imputation system is described in Hamson and Ziegler (1990). The Canadiansystem is dividend credits, not full imputation; and the marginal Canadian investor could pay UStax and thus not receive credits.
23We expect this to be reinforced in US by stock repurchases to distribute cash to investors.Repurchases contain information about future income (Dann et al., 1991), likely reducing informa-tion in dividends.
amount of current-year economic income. These results are consistent with thetimeliness of code-law accounting income being constrained by its direct role indetermining current-year dividend payouts.
Panel B of Table 5 reports separate dividend/return relations in positive andnegative return years, comparable to Table 3 for accounting income. Since theseare univariate regressions, we can report Vuong's (1989) likelihood ratio statisticfor selection among non-nested models in which the dependent variable is thesame, but the independent variables di!er. We calculate the Vuong statistic witha common dependent variable (returns) but competing independent variables(accounting income and dividends). The results from the Vuong test in panelB of Table 5 are weakly consistent with Hypothesis 4. For example, for the badnews or negative returns sample, the Vuong test statistic (distributed as unit-Normal, i.e., a Z-statistic) shows that common-law accounting income explainsreturns signi"cantly more than dividends, but that the opposite is true forcode-law countries. We also estimate, but do not report, a linear relation modelwith dividends levels and changes, comparable to panel B of Table 2. Theseresults also support Hypothesis 4.
5.1.2. Common-law tax imputation link between dividends and accounting incomeAmong common-law countries, there is considerable variation in the taxation
of dividend distributions. We focus on &imputation,' which penalizes corpora-tions for reporting taxable income in excess of distributed dividends. There is anincentive to structure transactions and use accounting standards that maketaxable income conform to dividend policy, which a!ects accounting incomebecause it is correlated with taxable income. Australia, Canada and the UKoperate imputation systems (Coopers & Lybrand, 1982}95), but not the US.22Provided dividends per se are uninformative, the testable implication is thataccounting income in the US exhibits greater timeliness relative to dividendsthan it does in Australia and Canada.23
H5: The diwerential timeliness of accounting income relative to dividends is greater
in the US than in common-law countries with dividend imputation (Australia,Canada, UK).
There are mixed results for this hypothesis as seen from the &ratio' reported inthe last column of panel A of Table 5. The results for Australia and UK reported
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 35
Table 6Contemporaneous association between cash#ows and returns!
Statistics are from regressions using the pooled cross-section and time-series of "rm/year observa-tions for each country. Intercepts are not reported.
Panel A: OCF"b0#b
1RD#b
2R#b
3RHRD#e
b2
t(b2) b
3t(b
3) Adj. R2(%) N Ratio
Australia 0.07 2.74 0.16 2.11 2.4 1,321 3.80Canada 0.02 1.07 0.25 5.28 3.6 2,901 4.75USA 0.04 7.81 0.10 7.39 3.1 21,225 4.78UK 0.11 11.40 !0.02 !0.87 3.7 5,758 3.69France 0.19 4.78 !0.16 !1.39 3.3 1,054 3.79Germany 0.16 4.28 !0.04 !0.37 2.6 1,245 2.10Japan 0.01 1.17 0.08 7.18 1.7 6,855 2.49
Common 0.04 8.04 0.12 9.19 3.0 25,447 4.79UK 0.11 11.40 !0.02 !0.87 3.7 5,758 3.69Code 0.08 8.92 0.00 !0.04 2.2 9,154 2.34
are consistent with the hypothesis (the ratios are less than that for USA), butthose for Canada are not. One conjecture is that the marginal investor inCanada is a US resident and does not receive imputation credits, so that Canadae!ectively is in the same tax category as the US.
5.2. Accounting income and cash yows from operations
We propose that cash #ows are noisier than accounting income in re#ectingcontemporaneous value-relevant information (Dechow, 1994) in all countries.Provided there is no new information in managers' current "nancing andinvestment decisions, accruals are expected to make accounting income incor-porate economic income in a more timely basis than cash #ows. This logic holdsunder the accrual-accounting systems of all countries.
Table 6 and Fig. 5 report results for the contemporaneous association be-tween returns and operating cash #ow, for the same sample of "rm/years as forincome and dividends in Tables 2, 3 and 5. In all countries, the income R2's arehigher than those of operating cash #ow, the ratio ranging from 2.10 (Germany)to 4.78 (US). This result would be obtained in less than 1% of cases by chance,assuming independence across the seven countries. The Vuong statistic and theratio of explanatory powers of the income/return and cash #ow/return relationsreported in panel B indicate that the greater timeliness of accounting incomethan operating cash #ow is due largely to bad news years. These "ndingsgeneralize well-known US results on timeliness of accounting income comparedto cash #ow (Ball and Brown, 1968; Dechow, 1994; Basu, 1997), and contrastsharply with results reported above for dividends.
36 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Tab
le6
(cont
inued
)
Pan
elB
:O
CF"
b 0#
b 1R#
e(R5
0)O
CF"
b 0#
b 1R#
e(R(
0)
b 1A
dj.R
2(%
)N
Rat
ioV
uong
b 1A
dj.R
2(%
)N
Rat
ioV
uong
Aus
tral
ia0.
070.
981
30.
250.
920.
231.
450
812
.88
!3.
38C
anad
a0.
020.
01,
688
384.
000.
420.
272.
81,
213
2.82
!6.
23U
SA
0.04
0.5
12,7
219.
34!
1.51
0.14
1.4
8,50
47.
31!
12.8
8U
K0.
113.
43,
612
0.55
0.18
0.09
0.7
2,14
613
.85
!6.
93Fra
nce
0.19
2.9
611
0.76
!2.
120.
03!
0.2
443
!47
.40
!1.
67G
erm
any
0.16
2.2
712
2.22
!0.
160.
130.
353
313
.96
!2.
18Ja
pan
0.01
0.0
3,14
110
.00
!2.
790.
092.
23,
714
2.07
2.61
Com
mon
0.04
0.4
15,2
228.
12!
0.13
0.16
1.6
10,2
256.
45!
14.6
2U
K0.
113.
43,
612
0.55
0.18
0.09
0.7
2,14
613
.85
!6.
93C
ode
0.08
1.3
4,46
41.
20!
3.10
0.08
0.5
4,69
05.
49!
2.18
!Sam
ple
cons
ists
of40
,359"rm
-yea
robs
erva
tions
sele
cted
from
the
Glo
bal
Van
tage
indust
rial
/Com
mer
cial
and
Issu
e"le
sove
r19
85}95
,us
ing
the
follo
win
gpro
cedu
re.F
irst
,fo
rea
chva
riab
le(see
bel
ow)w
eel
imin
ate
the
two
extr
eme
per
cent
iles
of"rm
-yea
robse
rvat
ions
.Sec
ond,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sw
ith
missing
valu
esfo
rone
orm
ore
variab
les,
tofa
cilit
ate
com
para
bilit
yw
ith
resu
lts
inpre
viou
sta
bles
.Thi
rd,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sfrom
count
ries
with
less
than
1,00
0ob
serv
atio
ns,l
eavi
ngse
ven
count
ries
repre
sent
ed.A
ustr
alia
,Can
ada,
Uni
ted
Stat
es,a
ndth
eU
nited
Kin
gdom
are
the
com
mon
-law
coun
trie
s,th
ere
star
eco
de-
law
coun
trie
s.H
ow
ever
,the
com
mon
law
coun
try
cate
gory
inth
eth
ird
row
from
the
bott
om
excl
udes
the
UK
.R"
buy-
and-h
old
secu
rity
retu
rnin
clusive
ofdiv
iden
dsove
rth
e"sc
alye
ar;
RD"
1if
R4
0an
dR
D"
0if
R'
0;O
CF"
annual
ope
rating
cash#ow
per
shar
e,w
her
eoper
atin
gca
sh#ow
isde"
ned
asea
rnin
gsplu
sdec
reas
ein
non-
cash
curr
entas
sets
plu
sin
crea
sein
non-d
ebtcu
rren
tlia
bilit
ies
plus
depr
ecia
tion
;N"
the
num
ber
of"rm
/yea
robs
erva
tions
.R
atio"
inpa
nel
A,t
hera
tio
oft
heR
2'soft
he
equi
vale
ntea
rnin
gs(T
able
2)an
dop
erat
ing
cash#ow
(thi
sta
ble
)reg
ress
ions,
inpan
elB
,the
ratio
oft
he
R2's
ofth
eeq
uiva
lent
earn
ings
(Tab
le3)
and
ope
rating
cash#ow
(thi
sta
ble)
regr
essions.
Vuo
ng
stat
istic
isa
like
lihood
ratio
stat
istic
com
paring
the"tof
the
retu
rn/o
per
atin
gca
sh#ow
model
inth
ista
ble
with
the
retu
rn/e
arni
ngs
mode
lin
Tab
le3,
both
estim
ated
sepa
rate
lyfrom
the
good
new
san
dbad
new
sobs
erva
tion
sin
pane
lB
.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 37
Fig. 5. Earnings versus cash#ows R-squares from the individual country reverse regressions of (1)NI and (2) OCF against (a) annual return and (b) annual return times negative return dummy.
The incremental timeliness of accounting income (relative to cash #ows)measures the extent to which accruals under a particular country's accountingrules are oriented toward timely incorporation of economic income. We hy-pothesize that common-law accruals re#ect a greater demand for timely ac-counting income, and hence predict that common-law accounting income hasmore incremental timeliness (relative to cash #ows) than code-law accountingincome.
H6: Common-law accounting income is more timely relative to operating cashyows.
Results generally support Hypothesis 6. In panel A of Table 6, three of thetop four ratios of return/income R2 to return/cash #ow R2 are common-lawcountries. Accounting income in Germany and Japan incorporates the leastamount of current-period economic income, relative to cash #ows. Thus, thegreater timeliness of common-law income is not due entirely to underlyingtransactions.
38 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
6. Speci5cation tests: income and returns
The relation between accounting income and stock returns is robust withrespect to a variety of speci"cation tests, reported in Tables 7 and 8.
6.1. Variation in expected returns
When economic income is the independent variable, a possible misspeci"ca-tion arises from variation in expected returns (across time, countries and "rms).Assume the true model for accounting income incorporates only the componentof *<
tdue to information about future cash #ows a, and not due to variation in
expected returns r. Assume these components are independent, both of eachother and over time. Our model (2) then can be simpli"ed as
NIt"h(a
t, f
t) (6)
where the disturbance term ft
now incorporates expected return e!ects, inaddition to lagged information about cash #ows and accounting noise. Using*<
tas a proxy for a
tthen would introduce measurement error in the indepen-
dent variable, due to variation in expected returns.Table 7 reports pooled regressions with two alternative controls for market-
wide expected return e!ects. In column (2) the independent variable, annualreturn, is de"ned relative to the mean return for the "rm's country/year. Incolumn (3) the dependent variable, accounting income, is scaled by the coun-try/year long-term interest rate. In both cases, results are similar to those incolumn (1), which repeats the results from Table 4 for comparison. We concludemarket-wide e!ects do not substantially in#uence our results.
6.2. Consolidated versus parent income and control for special items
In countries where parent companies are not required to &equity account' theirshare of a$liated-company income, their accounting income omits a componentthat accrues to their stockholders. This could be viewed as introducing measure-ment error that likely is positively correlated with parent-company income,thereby biasing the regression slopes downward. A counter-argument is that weare interested in properties of accounting income as reported under di!erentcountries' accounting rules, including any omission of a$liate income. Never-theless, we replicate column (1) results for the 33,441 total "rm/years for whichPeriodic Descriptor Array No. 13 on Global Vantage speci"cally labels incomeas &fully consolidated,' thus including parent companies' proportional shares ofa$liates' incomes. The sample size reduction is due almost entirely to Japan,
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 39
Tab
le7
Com
par
ativ
eas
ymm
etry
inth
eco
nte
mpor
aneo
usre
turn
s-ea
rnin
gsre
lation
:al
tern
ativ
esp
eci"
cations
!
Rep
orte
dst
atistics
are
for
the
follo
win
gm
odel
using
the
poo
led
cros
s-se
ctio
nan
dtim
e-se
ries
of"rm
/yea
rob
serv
atio
ns
for
allco
untr
ies:
NI"
b 0#
+ j
b 0jC
Dj#
b 1R
D#
+ j
b 1jR
DC
Dj#
b 2R#
+ j
b 2jR
CD
j#b 3
RR
D#
+ j
b 3jR
RD
CD
j
Res
ults
are
not
repo
rted
for
the
inte
rcep
t,th
ene
gative
retu
rnin
terc
ept,
and
thei
rre
spec
tive
count
rydum
mie
s.The
countr
yca
tego
rym
odel
sus
eth
eco
mm
on
law
count
ries
ofA
ustr
alia
,Can
ada
and
the
US
asth
ebas
eca
tego
ry;d
um
mie
sar
euse
dfo
r(1
)th
eU
Kan
d(2
)the
code
law
count
ries
ofF
rance
,G
erm
any
and
Japan
.
Mode
l(1
)(2
)(3
)(4
)(5
)>
NI
NI
NI/
RF
NI2
yrN
IC
ontr
ol
Rjt
SIC
Coe!.
t-Sta
t.C
oe!
.t-Sta
t.C
oe!
.t-Sta
t.C
oe!
.t-Sta
t.C
oe!
.t-Sta
t.
Pan
elA
:co
untr
ydu
mm
ies
mod
el
Ear
ning
s&g
ood
new
s+se
nsit
ivit
y
b 2(R
etur
n)0.
039.
880.
013.
960.
369.
88!
0.05
!84
.24
0.04
10.2
5b 2j
(Ret
urn *
Cnt
ryD
ums):
Aust
ralia
!0.
03!
3.95
!0.
04!
3.17
!0.
48!
4.24
!0.
02!
3.02
!0.
04!
4.15
Can
ada
!0.
03!
3.80
!0.
01!
1.63
!0.
32!
3.54
0.06
10.0
3!
0.02
!3.
28U
K0.
022.
400.
033.
740.
141.
570.
092.
920.
011.
57Fra
nce
0.05
4.16
0.06
3.48
0.65
3.86
0.55
21.2
80.
053.
69G
erm
any
0.03
1.57
0.04
1.81
0.55
2.54
0.21
19.3
20.
021.
42Ja
pan
!0.
02!
2.64
0.00
!0.
51!
0.17
!1.
690.
076.
82!
0.02
!3.
12
F-s
tat
for
Cou
ntry
11.3
57.
7310
.28
164.
139.
75R
etur
nD
umm
ies
p(0.
01p(
0.01
p(0.
01p(
0.01
p(0.
01
40 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Incr
emen
tal&b
adne
ws+
sens
itiv
ity
b 3(R
dum
*Ret
urn)
0.29
39.2
10.
2947
.25
3.66
38.1
10.
4326
.13
0.29
31.0
4b 3j
(Rdu
m*R
et*C
ntry
Dum
s):
Aust
ralia
0.07
2.64
0.01
0.37
0.19
0.50
0.12
1.85
0.08
2.89
Can
ada
0.11
5.28
0.05
2.92
0.45
1.70
0.12
2.43
0.11
5.25
UK
!0.
14!
8.26
!0.
17!
11.1
1!
2.05
!9.
10!
0.24
!2.
47!
0.14
!7.
96Fra
nce
!0.
22!
5.81
!0.
14!
4.40
!2.
87!
5.99
!0.
68!
7.40
!0.
21!
5.54
Ger
man
y!
0.19
!4.
41!
0.24
!5.
74!
2.49
!4.
55!
0.31
!7.
48!
0.20
!4.
73Ja
pan
!0.
29!
15.7
4!
0.29
!16
.80
!3.
43!
14.9
0!
0.42
!10
.70
!0.
28!
15.1
6
F-s
tat:
Cou
ntry
67.4
472
.74
54.5
537
.81
63.4
3N
egat
ive
Ret
Dum
sp(
0.01
p(0.
01p(
0.01
p(0.
01p(
0.01
Reg
ress
ion
N40
,359
40,3
5939
,240
33,0
8240
,359
Adj
.R2
15.4
%16
.8%
13.8
%22
.5%
16.2
%F
272.
9830
3.32
234.
1941
0.56
117.
16
Pan
elB
:co
untr
yca
tego
rydu
mm
ies
mod
el
Ear
ning
s&g
ood
new
s+se
nsit
ivit
y
b 2(R
etur
n)0.
028.
360.
012.
820.
268.
22!
0.05
!83
.70
0.03
8.99
b 2j(R
etur
n *C
ntry
Dum
s):
UK
0.02
3.52
0.04
4.35
0.23
2.75
0.20
19.1
20.
022.
58C
ode
0.01
2.37
0.02
2.87
0.24
2.99
0.15
15.2
60.
011.
53
F-s
tat
for
Cnt
ryC
at7.
9412
.24
7.20
297.
973.
98R
etur
nD
ums
p(0.
01p(
0.01
p(0.
01p(
0.01
p(0.
01
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 41
Tab
le7
(cont
inued
)
Incr
emen
tal&b
adne
ws+
sens
itiv
ity
Mode
l(1
)(2
)(3
)(4
)(5
)>
NI
NI
NI/
RF
NI2
yrN
IC
ontr
ol
Rjt
SIC
Coe!.
t-Sta
t.C
oe!
.t-Sta
t.C
oe!
.t-Sta
t.C
oe!
.t-Sta
t.C
oe!
.t-Sta
t.
b 3(R
Dum
*Ret
urn)
0.31
46.2
30.
3053
.64
3.76
43.2
80.
4630
.27
0.31
36.6
8b 3j
(RD
um*R
et*
Cnt
ryC
atD
ums):
UK
!0.
16!
9.50
!0.
17!
11.7
2!
2.14
!9.
69!
0.34
!8.
14!
0.16
!9.
25C
ode
!0.
30!
19.0
0!
0.28
!18
.82
!3.
47!
17.4
1!
0.48
!13
.65
!0.
29!
18.3
1
F-s
tat:
Cnt
ryC
at20
0.92
218.
6617
4.82
111.
5618
7.17
Neg
ativ
eR
etD
ums
p(0.
01p(
0.01
p(0.
01p(
0.01
p(0.
01
Reg
ress
ion
N40
,359
40,3
5939
,240
33,0
8240
,359
Adj
.R2
14.9
%16
.2%
13.5
%21
.3%
15.7
%F
642.
0771
1.90
557.
8493
8.83
148.
07
!Sam
ple
cons
ists
of40
,359"rm
-yea
robs
erva
tions
sele
cted
from
the
Glo
bal
Van
tage
indust
rial
/Com
mer
cial
and
Issu
e"le
sove
r19
85}95
,us
ing
the
follo
win
gpro
cedu
re.F
irst
,fo
rea
chva
riab
le(see
bel
ow)w
eel
imin
ate
the
two
extr
eme
per
cent
iles
of"rm
-yea
robse
rvat
ions
.Sec
ond,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sw
ith
missing
valu
esfo
rone
orm
ore
variab
les,
tofa
cilit
ate
com
para
bilit
yw
ith
resu
lts
inpre
viou
sta
bles
.Thi
rd,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sfrom
count
ries
with
less
than
1,00
0ob
serv
atio
ns,l
eavi
ngse
ven
count
ries
repre
sent
ed.A
ustr
alia
,Can
ada,
Uni
ted
Stat
es,a
ndth
eU
nited
Kin
gdom
are
the
com
mon-
law
countr
ies,
there
star
eco
de-law
coun
trie
s.The
sam
ple
size
sfo
rm
odel
(3)t
hat
uses
NI/
RF
asth
edep
enden
tva
riab
lean
dm
odel
(4)th
atuse
sonly
the
two-
year
NI
valu
esar
e39
,240
and
33,0
82re
spec
tive
ly.
R"
buy-
and-h
old
secu
rity
retu
rnin
clusive
ofdiv
iden
ds
ove
rth
e"sc
alye
ar;
NI"
annua
lea
rnin
gsper
shar
ebe
fore
extr
aord
inar
yitem
sde#
ated
by
beg
innin
gof
period
price
;N
I/R
F"
earn
ings
de#
ated
by
the
long-
term
inte
rest
rate
;N
I2yr
"th
esu
mof
net
inco
me
over
the
two
year
stan
dt#
1;R
D"
the
pro
xyfo
rbad
new
s"1
ifR(
0an
d"
0ot
her
wise;
CD
j"co
unt
ryid
enti"er"
1fo
r"rm
/yea
rsin
coun
try
jan
d"
0oth
erw
ise.
USA
isth
e&b
ase
count
ry'w
ith
CD
j"0
∀j.
Inm
ode
l(2)
the
regr
ession
isco
ntr
olle
dfo
rm
ean
annu
alco
untr
yre
turn
by
scal
ing
NIan
dby
rede"
ning
RD
;in
mod
el(5
)the
regr
ession
isco
ntro
lled
for
the
10m
ostpre
vale
nt
2-di
git
SIC
code
by
crea
ting
the
appro
priat
edum
my
variab
les
bas
edon
thes
eSI
Cco
des
.In
tere
stra
tes:
RF
ism
easu
red
asth
elo
nge
stte
rmbond
yiel
dav
aila
ble
inth
eIM
F's
Inte
rnat
iona
lF
inan
cial
Stat
istics
for
the
cale
ndar
year
most
coin
ciden
tw
ith
the"rm's"sc
alye
ar[!
11,0
].R
ates
for
the
indiv
idual
countr
ies
are
for:
trea
sury
bonds
2ye
ars
(Aus
tral
ia);
govt
.bon
dyi
eld'
10yr
(Can
ada)
;gov
t.bond
yiel
d(G
erm
any)
;gov
t.bond
yiel
d,m
oyen
s(F
ranc
e);l
ong
term
govt
.bond
yiel
d(U
K);
govt
.bon
dyi
eld
(Jap
an);
govt
.bond
yiel
d10
yr(U
SA).
42 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
24Excluding these observations is not clearly necessary because Japanese rules require equityaccounting in the parent's books (Nobes and Parker, 1995, Chapter 13). Few observations areexcluded for Germany where public companies have issued consolidated income since the EuropeanUnion's Seventh Directive.
25The exception is the positive-return slopes for the US and Australia. The sample size decreases,due mainly to losing one year. Results are for overlapping samples.
which loses most of its observations.24 Results (unreported) are almost identicalexcept for Japan (due to the small sample size).
The reported results in the paper are based on using accounting incomebefore extraordinary items. Special items, which are included in calculatingaccounting income, have characteristics similar to extraordinary items, in thatthey tend to be negative and transitory (e.g., Collins et al., 1997). We repeat theanalysis using accounting income net of special items and obtain qualitativelysimilar results.
6.3. Extending the lag in accounting income
Column (4) of Table 7 reports results with the dependent variableNI2
yr"NI
t#NI
t`1, allowing an additional year to incorporate economic
income in accounting income. As expected, the coe$cients generally increase:the median two-year coe$cient is 1.6 times its one-year equivalent.25 Ac-counting income thus incorporates economic income over time (it is &smoothed,'and has &momentum' or &persistence').
6.4. Control for industry composition
Another concern is correlated omitted variables. For example, if the propor-tion of growth options relative to assets in place varies across countries, thencommon application of the revenue realization rule will cause accounting incometo vary internationally in timeliness, due to &real' rather than &accounting' e!ects.This concern is reduced by our result that international di!erences in timelinessare due in part to accounting accruals and not entirely to di!erences intimeliness of cash #ows. A related concern is that our sample contains only listedcorporations. Public corporations are less prevalent under code-law systemsprobably because the latter do not facilitate public disclosure and public capitalmarkets (see La Porta et al., 1997) to the same extent as common-law systems.For example, UK has approximately four times as many listed corporations asGermany. To alleviate concern that our results are due to di!erent samplecomposition across countries, column (5) reports results after controlling forindustry e!ects, in the form of interactive dummy variables for the ten most
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 43
Tab
le8
Cont
empor
aneo
us
asso
ciat
ion
bet
wee
nea
rnin
gs,div
iden
ds,
cash#ow
san
dre
turn
ssu
b-p
erio
dan
alys
is!
Ana
lysi
s:Sta
tist
ics
are
from
regr
essions
using
the
pool
edcr
oss
-sec
tion
and
tim
e-se
ries
of"rm
/yea
robse
rvat
ions
for
each
countr
y.In
terc
epts
are
not
repor
ted.
1985}90
1991}95
b 2t(b 2
)b 3
t(b 3
)A
dj.R
2(%
)N
b 2t(b 2
)b 3
t(b 3
)A
dj.R
2(%
)N
Pan
elA
:N
I"b 0
#b 1
RD#
b 2R#
b 3R
*RD#
e
Aust
ralia
0.02
1.04
0.26
5.31
13.0
500
!0.
02!
0.99
0.48
7.55
9.4
1,82
1C
anad
a0.
00!
0.23
0.38
12.9
419
.81,
594
0.01
1.30
0.44
11.6
315
.81,
307
USA
0.03
6.14
0.28
26.7
917
.311
,978
0.03
6.54
0.33
22.1
412
.99,
247
UK
0.04
7.49
0.09
6.92
13.7
2,68
20.
069.
020.
1911
.64
17.4
3,07
6Fra
nce
0.09
5.96
0.04
1.09
19.1
466
0.06
3.15
0.22
4.24
10.5
588
Ger
man
y0.
053.
860.
040.
976.
148
80.
041.
950.
194.
085.
375
7Ja
pan
0.01
5.21
0.02
4.96
7.0
3,46
00.
000.
160.
011.
561.
03,
395
Com
mon
0.02
5.64
0.29
30.1
217
.314
,071
0.02
5.32
0.36
26.2
212
.711
,374
UK
0.04
7.49
0.09
6.92
13.7
2,68
20.
069.
020.
1911
.64
17.4
3,07
6C
ode
0.03
10.9
70.
000.
425.
34,
413
0.05
8.05
0.01
1.38
4.4
4,73
9
Pan
elB
:D
I<"
b 0#
b 1R
D#
b 2R#
b 3R
*RD#
e
Aust
ralia
0.00
!0.
360.
065.
0914
.450
0!
0.01
!1.
890.
077.
3010
.382
1C
anad
a!
0.01
!5.
370.
048.
127.
41,
594
!0.
01!
6.60
0.05
7.69
7.0
1,30
7U
SA
!0.
02!
18.0
20.
0525
.51
9.8
11,9
78!
0.01
!19
.45
0.05
23.0
98.
99,
247
UK
0.00
2.40
0.03
7.80
8.1
2,68
20.
018.
640.
025.
9911
.33,
076
Fra
nce
0.01
4.03
0.02
2.02
13.7
466
0.01
1.42
0.04
4.24
6.7
588
Ger
man
y0.
025.
400.
011.
0010
.748
80.
013.
690.
011.
348.
275
7Ja
pan
0.00
6.61
0.00
5.16
9.2
3,46
00.
00!
0.61
0.01
7.81
7.2
3,39
5C
omm
on
!0.
01!
17.2
50.
0526
.29
9.2
14,0
71!
0.01
!18
.40
0.05
24.3
38.
011
,374
UK
0.00
2.40
0.03
7.80
8.1
2,68
20.
018.
640.
025.
9911
.33,
076
Cod
e0.
019.
310.
00!
0.51
4.2
4,41
30.
019.
990.
001.
889.
74,
739
44 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
Pan
elC
OC
F"
b 0#
b 1R
D#
b 2R#
b 3R
*RD#
e
Aust
ralia
0.01
0.21
0.14
1.31
1.0
500
0.09
3.02
0.23
2.07
3.3
821
Can
ada
!0.
02!
0.73
0.29
4.62
3.4
1,59
40.
042.
070.
223.
033.
91,
307
USA
0.03
3.82
0.09
5.13
2.5
11,9
780.
057.
150.
135.
993.
89,
247
UK
0.11
7.24
!0.
02!
0.55
3.1
2,68
20.
129.
05!
0.03
!0.
784.
53,
076
Fra
nce
0.20
3.42
!0.
15!
0.96
2.6
466
0.23
3.95
!0.
17!
1.00
4.3
588
Ger
man
y0.
122.
400.
120.
872.
448
80.
254.
08!
0.19
!1.
403.
075
7Ja
pan
0.03
4.99
0.03
1.54
1.9
3,46
0!
0.01
!0.
750.
126.
723.
83,
395
Com
mon
0.02
2.87
0.12
6.88
2.5
14,0
710.
058.
130.
156.
983.
711
,374
UK
0.11
7.24
!0.
02!
0.55
3.1
2,68
20.
129.
05!
0.03
!0.
784.
53,
076
Cod
e0.
087.
30!
0.07
!2.
341.
64,
413
0.21
11.4
9!
0.08
!2.
396.
34,
739
!Sam
ple
cons
ists
of40
,359"rm
-yea
robs
erva
tions
sele
cted
from
the
Glo
bal
Van
tage
indust
rial
/Com
mer
cial
and
Issu
e"le
sove
r19
85}95
,us
ing
the
follo
win
gpro
cedu
re.F
irst
,fo
rea
chva
riab
le(see
bel
ow)w
eel
imin
ate
the
two
extr
eme
per
cent
iles
of"rm
-yea
robse
rvat
ions
.Sec
ond,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sw
ith
missing
valu
esfo
rone
orm
ore
variab
les,
tofa
cilit
ate
com
para
bilit
yw
ith
resu
lts
inpre
viou
sta
bles
.Thi
rd,w
eel
imin
ate
all
"rm
-yea
robs
erva
tion
sfrom
count
ries
with
less
than
1,00
0ob
serv
atio
ns,l
eavi
ngse
ven
count
ries
repre
sent
ed.A
ustr
alia
,Can
ada,
Uni
ted
Stat
es,a
ndth
eU
nited
Kin
gdom
are
the
com
mon
-law
coun
trie
s,th
ere
star
eco
de-
law
coun
trie
s.H
ow
ever
,the
com
mon
law
coun
try
cate
gory
inth
eth
ird
row
from
the
bott
omin
each
panel
excl
udes
the
UK
.R"
buy-
and-h
old
secu
rity
retu
rnin
clusive
ofdiv
iden
dsove
rth
e"sc
alye
ar;
RD"
1if
R4
0an
dR
D"
0if
R'
0;N
I"an
nual
earn
ings
per
shar
ebe
fore
extr
aord
inar
yitem
sde#
ated
bybe
ginnin
gofper
iod
price
;D
IV"
annua
ldiv
iden
ds
per
shar
ede#
ated
bybeg
innin
gof
period
price
;O
CF"
annu
alop
erat
ing
cash#ow
per
shar
ede#
ated
by
beg
innin
gofpe
riod
price
,whe
reoper
atin
gca
sh#ow
isde"
ned
asea
rnin
gsplu
sdec
reas
ein
non-c
ash
curr
ent
asse
tspl
us
incr
ease
inno
n-deb
tcu
rren
tlia
bilit
ies
plus
dep
reci
atio
n;N"
the
num
ber
of"rm
/yea
robs
erva
tions
.
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 45
prevalent 2-digit SIC codes. Little change is apparent. The regression adjustedR2 rises slightly and the F-statistic falls. The F-statistics for the countries'dummy slopes fall slightly. All remain signi"cant at the 0.01 level. There is littlechange in the coe$cients for both individual countries and country groups.
6.5. Subperiod results
Splitting the sample into two subperiods, 1985}90 and 1991}95, reveals threeinteresting results, reported in Table 8. First, the incremental coe$cients onnegative economic income increase in the second subperiod for six of the sevenindividual-country regressions (4), the exception being Japan. Several countriesexhibit statistically signi"cant increases, including Australia (0.48 versus 0.26),UK (0.19 versus 0.09), France (0.22 versus 0.04) and Germany (0.19 versus 0.05).The coe$cient on negative economic income for US increases, but not signi"-cantly (0.33 versus 0.28). These results suggest Basu (1997) might have erred inattributing increased asymmetry over time in US accounting income to changesin US litigation rules, since similar increases have occurred in France andGermany. An intriguing possibility is that timely incorporation of economiclosses has become a more important corporate governance mechanism overtime worldwide (if not in Japan), and that pressure to adopt it has come fromincreased international product market competition (if not from changes in thepolicies of standard-setters around the world). Under this explanation, timelyincorporation of economic losses in accounting income is an e$cient gover-nance mechanism that reduces managers' incentives to continue with loss-making investments and strategies, thereby reducing agency-related negativeNPVs. We believe this phenomenon is worthy of further study.
Second, despite increased sensitivity to economic losses, the R2's in six ofseven country regressions (4) decreased between subperiods, generalizing the USresult (Ramesh and Thiagarajan, 1995; Lev, 1997). Third, the results for cash#ow from operations, reported in panel C, contrast unexpectedly with those foraccounting income. Between subperiods, the point estimates of the slopes onpositive returns increased for six of seven countries, the incremental slopes onnegative returns show no systematic change, and the R2's in all of the indi-vidual-country cash #ow regressions increase. We have no explanation for theseapparently systematic cash #ow changes.
7. Conclusions, implications, and limitations
The worldwide trend toward &internationalization' of markets, especiallycapital markets, in which accounting information is used has rekindled aca-demic and professional interest in di!erent national accounting models. Theproperties of accounting information prepared under common-law accounting
46 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
standards are of particular contemporary interest because the InternationalAccounting Standards Committee (IASC) recently completed a set of &interna-tional' accounting standards widely viewed as re#ecting a largely common-lawapproach of &transparent,' timely disclosure.
We show that common-law accounting income does indeed exhibit signi"-cantly greater timeliness than code-law accounting income, but that this is dueentirely to greater sensitivity to economic losses (income conservatism). Thisresult has important implications for corporate governance. We conjecture thatearly incorporation of economic losses, as distinct from gradual incorporationover time, increases managers' incentives to attend to the sources of losses morequickly. It brings more and quicker pressure from security analysts, makesleverage and dividend restrictions binding more quickly, and a!ects currentmanagers' and employees' bonuses. It also makes excessively optimistic state-ments by managers less credible. Conservative accounting thus facilitatesmonitoring of managers and is an important feature of common-law corporategovernance. In contrast with Roe (1994), we conclude that enhanced common-law disclosure standards reduce the agency costs of monitoring managers, thuscountering the advantages of closer shareholder-manager contact in code-lawcountries.
Our results suggest an explanation for the emergence of a largely common-law model in international transacting, and in particular for the IASC adoptionof a more &transparent' common-law approach to disclosure. The cost ofcross-border transacting by parties who are geographically, culturally andlinguistically separated from the "rm's management presumably is greater ina system that assumes they are informed insiders than in one with more timelypublic disclosure. Timely disclosure of economic losses is particularly importantto cross-border lenders. Whether this model will prevail in international trans-acting depends on whether high disclosure-quality "rms (i.e., "rms knowna priori as likely to recognize economic losses in a timely fashion) can signaltheir quality e!ectively to users, or equivalently on whether low-quality "rmscan be excluded from false signaling. In the absence of common-law penalties tofalse signaling, it is di$cult to see how high-quality "rms in code-law countrieswill be able to reduce contracting costs through improved "nancial reporting,other than by listing in a common-law jurisdiction and exposing themselves tocommon-law penalties for low-quality disclosure.
Greater common-law income conservatism should be no surprise, consideringthe use of accounting income in common-law arm's-length debt and equitymarkets, and especially considering common-law litigation. Nevertheless, Ger-man accounting in particular is widely presumed to be more conservative,because German managers have unusual discretion to reduce reported incomeduring good years. However, they also have unusual discretion to delay recogni-tion of economic losses, and thus to increase reported income in bad years. Thiswas a common UK practice at the beginning of the twentieth century (Yamey,
R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51 47
26 Rex v. Lord Kylsant 1932 1 KB 442. This case-law was codi"ed in the 1948 UK Companies Act,which required companies to distinguish reserves from provisions, &making the creation of secretreserves more di$cult.' (Nobes and Parker, 1995, p. 103). The case can lay claim to be the legalgenesis of the Rule 10b-5 in the US. US German practice is exempli"ed by the notorious Daimler-Benz case (Ball, 1998).
1962), but e!ectively was extinguished in common-law countries by the RoyalMail case.26 Similar observations can be made about accounting in Japan.
Our research design is subject to several limitations. The most obviousconcern is the validity of stock returns as a proxy for economic income,particularly in code-law countries, which have endogenously lower liquidity andpublic disclosure standards. &Noise' in annual stock returns as a measure ofmarket-valued income could be a correlated omitted variable. We counter withthree observations. First, poor public disclosure does not necessarily impede the#ow of information into stock prices, since the information #ow can occurinstead via the trading of informed insiders. In the absence of e!ectively enforcedinsider-trading laws, which in many ways are fundamentally incompatible withcode-law governance, corporate insiders' incentives are to trade on informationand thereby incorporate it into prices. This, Ramseyer (1993) conjectures,explains the practice of Japanese banks trading in their clients' stock. To somedegree, equating poor public disclosure with uninformed stock prices involvesprojecting common-law precepts onto code-law institutions, which are morelikely to solve information asymmetry by private rather than public commun-ication. Second, our results seem inconsistent with the hypothesis that stockreturns re#ect poor information #ows in code law countries, which would implyless anticipation of accounting income, a stronger income &surprise' e!ect, anda stronger return-income association. We observe the opposite. Third, we studystock returns over intervals of one and two years, not over short &event win-dows,' which is long enough for international di!erences in liquidity, marketmicrostructure and disclosure timing e!ects to have minimal impact.
Correlated omitted variables are another obvious concern. For example, if theproportion of growth options relative to assets in place varies across countries,then common application of the revenue realization rule will cause income tovary internationally in timeliness, due to &real' rather than &accounting' e!ects.Similarly, our results hold only for listed corporations. The number of listedcode-law corporations is endogenously small compared with common-lawcountries, in part because code-law systems are not designed for the demands ofpublic disclosure, so private corporations are comparatively more e$cient andconsequently more prevalent. Thus, our sample is less representative of code-lawaccounting in general. This concern is addressed to a degree in the Table7 control for SIC codes. Another concern is whether the sample period isrepresentative. Japan, for example, went through boom and bust during
48 R. Ball et al. / Journal of Accounting and Economics 29 (2000) 1}51
1985}95. Speci"cation tests in Table 7 address this concern, where the resultschange little when annual "rm return is de"ned relative to the mean return forthat country/year, and when income is scaled by the country/year interest rate.
Another concern is our characterization of the relevant institutional featuresof the seven countries in our primary sample. In particular, the code/commonlaw categorization is a proxy for an underlying economic construct, the extent towhich accounting is determined by market supply and demand relative topolitical forces. The categories overlap, as is obvious from the roles of theCompanies Acts in the UK and the SEC in the US. To some degree, this concernis alleviated by the consistent evidence we report from our primary sample. Inaddition, we report consistent evidence from a secondary sample of eighteencountries, suggesting that our results are generalizable.
A "nal concern is that institutional determinants of "nancial reporting varyover time. For example, shareholder lawsuits are reported as rising in Japan(Wall Street Journal, January 7, 2000, p. A13), which could signal a change ingovernance or incentives of "nancial statement preparers. While we have mech-anically divided the 1985}95 period into approximately equal sub-periods andhave thereby observed a systematic increase in conservatism, a "ner partitioningbased on changes in institutional determinants of accounting might obtainclearer results.
The research design also has its strengths. It studies the incorporation ofeconomic income into accounting income over time, under di!erent interna-tional institutions, using a model of accounting income determination that isbased on fundamental properties of accounting. We believe the results to be ofinterest to accountants, analysts, standard-setters, regulators and students ofcorporate governance.
References
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