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Microsoft Word - 20-11-2009 Legal regime and corporate ... Document Transcript

  • 1. Legal Regime and Corporate Financial Reporting Quality Andrei Filip Assistant Professor ESSEC Business School filip@essec.fr Réal Labelle Chair in Governance and Forensic Accounting HEC Montréal real.labelle@hec.ca Stéphane Rousseau Chair in Business Law and International Trade Faculty of Law, Université de Montréal stephane.rousseau@umontreal.ca November 2009 Acknowledgements: The authors are grateful for comments received by Christine Pochet, Cédric Lesage, Voltec???, Heidi Wechtler and other participants in the Paris1-IAE research workshop. The usual caveat applies. 0
  • 2. Legal Regime and Corporate Financial Reporting Quality Abstract This article uses the unique Canadian bi-juralism environment where Common Law coexists with Civil Law, as a laboratory to contribute to the international debate on the influence, or even superiority, of one legal system over the other regarding firms’ financial reporting quality. Our results show that, the relationship between the legal regime and the corporate financial reporting quality is not as simple as we expected. Ceteris paribus, in the Civil Law environment the quality of corporate financial reporting seems to be higher. 1
  • 3. 1. Introduction Investors' confidence in corporate governance and financial reporting has been shaken severely and on several occasions since the beginning of the century. These upheavals induced and are still nourishing an international wave of regulatory shocks rarely seen before with the Sarbanes-Oxley Act as its epicenter. These reforms reveal a strong concern by legal, regulatory and standard setting bodies around the world for public companies’ financial information quality. This concern for corporate financial reporting quality (FRQ) is echoed at the academic level by La Porta et al. (2006) which report significant benefits of full disclosure for investor protection and stock market development with regard to firms issuing securities to the public. Djankov et al. (2008) also conclude that laws mandating extensive disclosure and facilitating private enforcement through liability rules, that facilitates the compensation of the investors, benefit stock markets. Furthermore, in line with the results of La Porta et al. (1997 & 1998), Djankov et al. (2008, p. 462) conclude that, for all the measures of shareholder protection they have considered, there is a pronounced difference in favor of Common Law countries over French Civil Law countries. For example, Common Law countries subject related party transactions to greater disclosure requirements than do French Civil Law countries. In this article, we use the unique Canadian bijuralism environment, where Common Law coexists with French Civil Law, as a field study to contribute to the international debate on the influence, or even superiority, of one legal system over the other regarding firms’ financial information. This setting allows us to compare both systems including their enforcement conditions with regard to FRQ. We also aim at reconciling this line of 2
  • 4. research with Ball et al. (2008) results which are more consistent with the ‘‘costly contracting’’ than with the ‘‘value relevance’’ school of accounting thought1. Our research question is: Caeteris paribus, is the nature of the legal system including its enforcement conditions likely to affect the quality of corporate financial reporting? Canada offers a legal framework and an exceptional empirical field with the coexistence of two systems: the Civil Law in the province of Quebec and the Common Law in the rest of Canada. Further, Quebec provides us with an interesting context in which comparative studies can be performed as two corporate statutes co-exist in the province: the Companies Act (QCA), adopted by the provincial legislator, and the Canada Business Corporations Act (CBCA), decreed by the federal legislator. Both statutes are available to Quebec firms that want to incorporate their business, but they differ with respect to the level of protection afforded to minority shareholders, QCA being perceived as less protective than CBCA (Québec, 2007). It is therefore a good setting for examining their presumed differential influence on the quality of financial information published by corporations and on the responsibility of the external auditors as an enforcement mechanism. This is equally a context where several alternative explanations regarding the quality of financial information are practically eliminated such as the quality of the accounting and auditing standard setting processes, the level of economical growth and of financial development, the political framework, etc. All these are factors that the vast majority of previous studies that used different countries or an international sample of firms attempted to control for or have been simply forced to ignore and admit as limits of their research. 1 The two schools of thought are debated in Holthausen and Watts (2001) and Barth et al. (2001). 3
  • 5. In the next section, we develop this study’s theoretical framework and review prior research on the institutional determinants of corporate financial reporting. This stream of empirical research mainly uses international data. In the third section, we explain why we believe the Canadian institutional setting constitutes a good laboratory to compare the presumed influence of the legal origin on FRQ. In the fourth one, we develop our research design and FRQ models. In the fifth section, we present and analyse our results before concluding in the last section. 2. Hypothesis development and prior research We draw from the law and finance2 strand of research and to a lesser degree from the value relevance and costly contracting literatures to analyze the incidence of the legal regime on the quality of corporate financial reporting. The ultimate objective of this line of research is a better understanding of the role of law and financial reporting in the development of financial markets (La Porta et al. 1998) and, thereby, in the economical growth of nations (Rajan and Zingales, 1996). In Figure 1, we summarize the theoretical development and attempt to reconcile the competing hypotheses of value relevance and costly contracting. La Porta et al. (1998) and Djankov et al. (2008) show that investor protection is generally stronger in Common Law than in French Civil Law countries. These authors also conclude that the legal tradition affects capital markets, a better investor protection inducing more developed financial markets. More developed financial markets offer larger opportunities for external financing, and lead to less ownership concentration (La Porta et al. 1999). 2 . Shleifer and Vishny 1997; LaPorta, Lopez-De-Silanes, Shleifer and Vishny 1997, 1998, 1999, 2000, 2002 and 2006; Djankov, La Porta, Lopez-De-Silanes, Shleifer and Vishny 2008; Francis, Khurana and Pereira 2003; Hope 2003a. 4
  • 6. - insert figure 1 about here - On the one hand, the presence of more widely held corporations exacerbates agency problems related to asymmetry of information. Quality financial accounting information, i.e. conservative, relevant and reliable or relatively free of earnings management, may help reduce these agency costs caused by information asymmetry between the firms and external investors (Ball, Kothari and Robin, 2000). Therefore, in a Common Law environment, presumed to offer a stronger protection to investors, one expects firms to publish value relevant audited financial information in order to respond to the stock market demand for such information. On the other hand, because it provides weaker investor protection, French Civil Law induces more proximity financing such as in the case of ownership concentration and indebtedness. In that Civil Law environment, the information asymmetry situation may be solved by private communications and institutional means other than financial statements (Ball et al. 2000), notably by closer and more consistent relationships with the stakeholders. Ball et al. (2008) results are more consistent with the ‘‘costly contracting’’ than with the ‘‘value relevance’’ school of accounting thought. Nevertheless, according to the criticisms addressed to this theoretical approach by Deffains and Guigou (2002) and Roe (2006), a more in depth analysis of the common and Civil Law environments is warranted. La Porta et al. (1997 & 1998) are limiting their analysis to regulations related to securities in order to conclude to the superiority of one system over the other regarding investor protection. As recognised by La Porta et al. (2006), other variables have to be considered, such as the enforcement of these rules (Deffains and Guigou, 2002: 23). Notably, is there any difference in the manner in which 5
  • 7. these systems treat the litigations between investors and auditors, as the ultimate protectors of financial reporting quality? Prior empirical studies generally report that the legal system is not without influence and that the thesis of the neutrality of the law system, such as suggested by the theorem of Coase, is not verified (Ayyagari et al. 2006 a and b). Nevertheless, this literature has several shadowed areas. Notably, the empirical models (Francis et al. 2001, 2003, 2005; Barniv et al. 2005; Bushman et al., 2004; Bushman and Piotroski 2006; Bushman and Smith, 2003 and Hope, 2003a and b) are using international data, which weakens their capacity to test for alternative explanations. A closer examination of the differences between these systems is necessary. Such a comparison necessitates an in depth knowledge of not only all the laws and regulations, but also of the conditions of enforcement relating to the protection of minority shareholders and creditors rights, to the responsibility of the administrators, managers and auditors, to the accounting and governance standards, etc. This required background information is developed in the next section. 3. Institutional setting or why use Canadian data? Unlike the other Canadian provinces, Quebec is a mixed jurisdiction in which the Civil law and the Chommon law systems co-exist. Common law governs public law, such as administrative law and criminal law (Hogg, 1997), while Civil law governs private law, such as the law of contracts and company law. Thus, in Quebec, “the backdrop of company law is civil law” (Crête and Rousseau, 2008; Bozec et al, 2008). 6
  • 8. In the province of Quebec, there are two corporate statutes: one is enacted by the federal parliament, the Canada Business Corporations Act (CBCA) and one by the National Assembly of Quebec, the Quebec Companies Act (QCA). While similar in many ways, these statutes diverge in one important area that pertains to shareholder protection, the CBCA offering more effective protection of shareholders’ rights, compared to QCA. This difference is important given the path dependency associated with the choice of QCA as incorporation statute. Indeed, the choice of the law of incorporation is usually made by entrepreneurs at the start-up stage. Significantly, where a business is incorporated under the QCA, it is unlikely that the corporation can easily change its law of incorporation. Indeed, the QCA does not provide an emigration mechanism allowing reincorporation under another corporate statute. Since liquidation is the only option for a firm wishing to forego its incorporation under the QCA, and reincorporate under the CBCA, changes in this respect rarely take place. In contrast, the CBCA does enact an import and export mechanism which allows firms to switch incorporation statutes. 3.1. Shareholder Protection under the Canada Business Corporations Act Strongly influenced by American law, and to some extent, British law, the Dickerson Report that produced the CBCA proposed a new corporate law framework characterized by different fundamental approaches among which, the most relevant to our study, is the fact that the law creates specific mechanisms to safeguard the rights and interests of minority shareholders against managerial and dominant shareholder opportunism. For instance, the CBCA provides mechanisms that can be used at shareholders’ general meetings. The Act mandates the disclosure of information on the subject matters to be 7
  • 9. discussed at the meetings. For larger corporations, it also enacts a regime governing the solicitation of proxies that provides additional information to the shareholders whose votes are solicited. Further, under certain conditions, shareholders have the right to submit proposals at the annual general meeting so they can be discussed and voted on by the shareholder group. The Act enables the holder of at least 5% of the voting shares of the corporation to call a special meeting of shareholders. Under the CBCA, shareholders have the power to have their say on important decisions taken at the general meetings. It is the shareholders who elect the directors of the corporations as well as its auditors. Furthermore, shareholders must authorize “fundamental changes” following a procedure that gives them clout over the decision- making process. The concept of fundamental changes refers to a variety of changes that affect the corporation’s constitution, such as amendments to its articles of incorporation, amalgamation with another corporation, or the corporation’s continuation under another corporate statute. Where the corporation undertakes a fundamental change, the CBCA grants special class voting rights to holders of a class of shares, irrespective of whether the shares of the class otherwise carry the right to vote, when the change contemplated is likely to affect the specific rights of that class. The special class voting rights enable the holders of the class to vote separately from the holders of other shares of the corporation, giving them a form of veto over the proposed change. Further, the CBCA provides a right of dissent or appraisal remedy enabling a shareholder to compel the corporation to buy her shares at fair value in the case of a fundamental change. Finally, the CBCA provides mechanisms enforced by the courts that offer protection to shareholders against management or dominant shareholder opportunism. The Act 8
  • 10. imposes duties of care and fiduciary duties on managers in regard to the corporation. These duties can be enforced through the derivative action that allows shareholders and other plaintiffs to bring an action in lieu of the corporation to rectify a wrong committed against it, such as a breach of duties. Shareholders can use the derivative action when managers refuse to take action to redress a breach of their duties that has led to a loss for the corporation. It is thus an important tool to ensure the enforcement of managers’ duties, and consequently, their accountability. The most powerful remedy offered to minority shareholders is however the oppression remedy. The remedy can be used when the business or the affairs of the corporation are being carried on or conducted, or the directors’ powers are being exercised in a manner that is oppressive or unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director, or officer. The remedy gives the plaintiff the right to apply to the court, which then has the power to make any order it sees fit to correct the situation. The oppression remedy is both very powerful and broad. 3.2. Shareholder Protection under the Quebec Companies Act There are some protective mechanisms in the QCA that operate at shareholders’ general meetings: for instance, it enables shareholders to exercise their votes meaningfully, and also mandates the disclosure of information on the subject matter to be discussed at the meetings. However, unlike the CBCA, it does not currently enact a regime governing the solicitation of proxies, nor does it grant shareholders the right to submit a proposal at the annual general meeting. 9
  • 11. More importantly, the QCA does not provide a general class veto regime, as does the CBCA, to protect minority shareholders in the case of fundamental changes. Fundamental changes need only be authorized by at least two-thirds of the votes cast by the shareholders who voted in respect of that resolution. Unlike the CBCA, the QCA does not mandate shareholder approval for the sale of all or substantially all of the assets of the corporation (Rona inc. v. Matco Ravary Inc., 2003 CANLII 52752 (Qc.S.C.)). Furthermore, the QCA does not establish an appraisal remedy enabling minority shareholders who oppose a fundamental change to force the corporation to buy back their shares at fair value. With respect to judicially enforced mechanisms providing protection to shareholders against management or dominant shareholder opportunism, there is no derivative action in the QCA or the Civil Code similar to the derivative action enacted by the CBCA. Shareholders who wish to use derivative action against their directors and officers must convince the court that the conduct of officers, directors, or dominant shareholders amounts to a fraud. For instance, mere negligence would not be sufficient. Finally, neither the QCA nor the Civil Code provide for an oppression remedy permitting an aggrieved party—security holder, creditor, director, or officer—to seek redress when the corporation has not regarded their interests fairly. Thus, in cases of abuses, minority shareholders have traditionally had few remedies apart from the winding-up of the corporation (Développements Urbain Candiac inc. v. Combest Corporation, [1993] R.J.Q. 1321 (Qc.C.A.)]. Widely recognized in the literature (Crête and Rousseau 2008, Martel and Martel, 2004), the fact that QCA is less protective of minority shareholders was underlined by the Quebec Minister of Finance in a working paper purporting to launch a 10
  • 12. reform of QCA: “When compared with company law in other jurisdictions in Canada, Québec law governing legal persons currently has few legal recourses specifically adapted to investors. Although some recourses are provided under the Civil Code of Québec, Québec investors have less legal protection in comparison for example with the federal regime” (Québec, 2007)3 The differences between investor protection under QCA and CBCA is summarized in the table 1: - insert table 1 about here - The difference in the level of investor protection rights afforded by the QCA and the CBCA is particularly interesting for the quality of financial information. Ex ante, investor protection rights can influence the quality of financial information by rendering managers more accountable and more responsive to investors’ information needs. Ex post, investor protection rights affect the level of litigation risk which, in turn, conditions the quality of financial information (Chung and Wynn, 2008). This difference is made even more interesting by the fact that the common law and civil law liability regimes have proved equally ineffective in providing an effective remedy against corporations and their managers in the case of false or misleading disclosure (Donald, 2000; Rousseau et Crête, 1999. Further, the common law provinces and the province of Quebec have recently enacted similar statutory liability regimes enabling investors to sue corporations and their managers in this case. 3 Québec, Reform of the Company Act, Working Paper, 2007 [on line: http://www.finances.gouv.qc.ca/en/page.asp?sectn=2&contn=257]. 11
  • 13. 4. Research design This section presents the research design and develops the models used to examine if the quality of firms' financial reporting is different between the Common and Civil Law systems. As the quality of accounting information cannot be observed per se, we build on the existing literature, which expresses the quality of financial reporting in terms of attributes (Schipper and Vincent, 2003). Value relevance, conservatism and reliability as measured by a relative absence of earnings management have been interchangeably used by prior literature as attributes of accounting quality (Barth et al. 2008, Van der Meulen et al. 2007, and many others). Using the unique Canadian bijuralism setting, we test these attributes for Quebec based corporations (QC - Civil Law environment) versus corporations based in the rest of Canada (ROC - Common Law environment). We next restrict our Quebec sample to the firms incorporated under Quebec Law (LQC). By focusing on this specific Canadian capital market environment, other institutional factors are kept as homogeneous as possible. To assess FRQ, we proceed to a three step comparison of each attribute mentioned above between the LQC, QC and ROC subsamples of firms. First, we compare the value relevance of earnings, the incremental timely loss recognition, and the accruals quality of the three subsamples. If the costly contracting hypothesis prevails, we anticipate that Quebec companies exhibit higher value relevance of earnings, higher incremental timely loss recognition, and higher accruals quality than ROC companies. If the value relevance hypothesis prevails, we expect the opposite results. We test that our results are not driven by firms’ specific characteristics by including control variables which are presumed in the voluntary disclosure literature to affect 12
  • 14. corporate FRQ. The control variables are: industry fixed effects, time fixed effects, audit quality (Big 4 vs. Non Big 4), and Size (log of assets). Most of these controls work against our hypothesis, in the sense that they are probably correlated with the civil and Common Law environments (our underlying variable of interest). In fact, our results indicate that most of these control variables exhibit only weak effects. 4.1. Value relevance Different empirical models have been used in the past to assess the value relevance of accounting data. All models consist in regressing accounting data on corresponding measures of market performance. Data may be expressed in absolute (price models) or relative (return models) values. Because price models seem to be affected by the spurious effect of scale, while return models seem to suffer less from econometrical problems4, we use the following return model: Ejt ∆Ejt R jt α0 α1 α2 α3 (1) MVjt‐1 MVjt‐1 where: MVjt ‐MVjt‐1 Djt R jt is the market return of company j in year t; MVjt‐1 MVjt is the year-end t market value for company j; Djt is the dividend paid by company j in year t; Ejt and ∆Ejt are respectively the earnings and the change in earnings of firm j in year t. 4 For a discussion on the ability of return models to capture the value relevance of accounting data, see Dumontier and Raffournier (2003). 13
  • 15. Although association studies do not imply any underlying valuation model, equation (2) is often presented as deriving from the Feltham-Ohlson model (Ohlson, 1995; Feltham and Ohlson, 1995). Within this framework, the value relevance of earnings is measured by the explanatory power (adjusted R2) of the regression model (1). 4.2. Conservatism Consistent with prior research, we test this attribute by using the Basu (1997) model. The asymmetric treatment of losses and gains is captured by the pricewise linear regression of accounting earnings on stock returns: Ejt β0 β1 DR jt β2 R jt β3 DR jt R jt β4 (2) MVjt‐1 where: Ejt are the earnings of firm j in year t; MVjt is the year-end t market value for company j; MVjt ‐MVjt‐1 Djt R jt is the market return of company j in year t; MVjt‐1 Djt is the dividend paid by company j in year t; DR jt is a dummy variable equaling 1 if R jt is negative (indicating economic losses), and 0 otherwise (indicating economic gains). In this model, the focus is on the β3 coefficient of the product of stock return by the return dummy which measures the incremental timeliness of loss recognition. A positive significant coefficient implies asymmetric timely loss recognition. A higher coefficient denotes more incremental timely loss recognition. Coefficient β2 on stock return 14
  • 16. measures the timeliness of gain recognition, while the sum of β2 β3 is measuring the timely loss recognition. 4.3. Earnings management Different empirical models have been used in previous studies to detect earnings management. Some recent studies apply the Dechow and Dichev (2002) model to assess accruals as a measure of earnings quality arguing that accruals are temporary adjustments to better measure firm performance. The focus of this model is on the firm’s working capital accruals, as related cash flow realizations generally occur within one year. Therefore, the changes in working capital are regressed on past, present and future cash flows: ∆WCjt OCFjt‐1 OCFjt OCFjt 1 γ 0 γ1 γ2 γ3 γ4 (3) TAjt TAjt‐1 TAjt TAjt 1 where: ∆WCjt are changes in working capital of firm j in year t; WCjt is the working capital defined as non cash current assets minus current liabilities (adjusted by the current portion of debt); TAjt is the total of assets of firm j in year t; OCFjt is the operating cash flow of firm j in year t. As pointed out in Dechow and Dichev (2002), a higher explanatory power of the model indicates higher earnings or accrual quality. Therefore, the model is estimated for the QC and ROC samples and the comparison is based on the explanatory power (adjusted R2) of the regression model (3). 15
  • 17. 5. Data collection and sampling The data is collected for listed Canadian firms from the Compustat database (3’878 firms). Based on the headquarters’ address, we split the sample into Quebec firms (QC) and rest of Canada (ROC). All firms with non-available address (1’305 firms) or with an address outside Canada (181 firms) are eliminated from the sample. In addition, for each QC firm we search on its internet webpage to check if the company is incorporated under Quebec law (LQC). Because financial institutions follow specific reporting regulations, they are deleted from the sample (582 firms). Therefore, our sample is composed of 1’810 firms. We collect market and accounting data for the period 1998 to 2007 (10 years). Year- observations with negative total equity for any of the years are eliminated in order to avoid bias in our results, leading to a sample of 9’543 year-observations. For each regression, outliers are eliminated based on the standardized residuals. Another reason for this exclusion is the transitory nature of extreme variables. As such variations are not expected to persist, their association should be lower than for more moderate values. A number of year-observations are also dropped from the sample because of missing or incomplete capital market or financial statement data in the Compustat database. In order to obtain comparability across our different metrics, we limit our analysis only to the year-observations with available control variables. - insert table 2 about here - 16
  • 18. Our final sample consists therefore of 6’336 year-observations for model 1 and 2 and 4’698 year-observations for model 3. The difference between the two samples is explained by data availability (because model 3 refers to past, present and future cash flows, only 9 years can be taken into account). Table 1 presents some descriptive statistics. 6. Results Differences between LQC, QC and ROC firms with regard to the three attributes of FRQ are reflected in the models’ R2. However, cross-samples comparisons would be incomplete without employing a more formal test. For instance, Ball et al. (2000), Sami and Zhou (2004) or Lang et al. (2006) are using the Cramer’s standard deviation in order to assess the significance of differences between R2 across different regressions. According to Cramer (1987), the standard deviation of the estimated R2 is a function of the sample size, the number of independent variables (including intercept), and the “true” R2. Following Arce and More (2002), we use a more appealing test that compares R2 from two different samples based on the following Z-statistic: R2 2 LQC/QC ‐R ROC Z σ2 2 LQC/QC σROC Where R2 , R2 , and R2 are the R2 from LQC, QC, respectively, and ROC firms, LQC QC ROC while σ(.) is the variance. Under the null hypothesis of no difference between both R2, this Z-statistic is approximately standard normal in large samples. Therefore, the number reported in the tables indicates the probability to accept the null hypothesis of no difference in adjusted R2. 17
  • 19. We run separate regressions for the LQC, QC and ROC samples (for reasons of comparison the results for the pooled sample are reported as well). Finally control variables are introduced into the equations in order to check whether the results are driven by firms’ specific factors, rather than by the legal environment in which they operate. Table 3 reports the results of the regressions for the value relevance tests (model 1). In line with previous association studies performed on mature capital markets where alternative sources of information are abundant, accounting information displays low value relevance. Market returns seem to be associated to earnings in all the cases, while earnings changes only for the QC and the ROC samples. - insert table 3 about here - LQC earnings and earnings changes seem to be more value relevant to investors as the adjusted R2 reaches 16.6%, which is almost triple if compared to the adjusted R2 of 6.6% for the ROC sample. According to the Cramer test, this difference is significant at 0.2%, while the difference between QC and ROC is not significant. The above results hold even after adding the control variables to the regression. Industry fixed effects and time fixed effects are the only control factors statistically significant, while the Cramer test indicates statistically significant differences between LQC and ROC firms. These results are consistent with the hypothesis that the corporate financial reporting of Civil Law firms incorporated under Quebec Law is of better quality compared to Common Law firms. According to Basu (1997), accounting earnings reflect bad news more quickly than good news, while market returns capture both good news and bad news simultaneously. This conjecture is captured in model 2, and the results for the asymmetric timeliness of 18
  • 20. earnings are presented in table 4. Consistent with prior studies, the overall power of the Basu model remains relatively low, but higher for LQC and QC samples (adjusted R2 of 20.4% and 18.0%) if compared to the ROC (adjusted R2 of 13.1). The Cramer test reveals that both differences are significant. Results are similar even after controlling for other firm-specific factors, industry fixed effects, time fixed effects, and size being the only control variables that are significant. - insert table 4 about here - Turning now to the response coefficients, the only coefficient significant at 1% in all the cases is β3 (on the product of the stock return with the return dummy) which measures the incremental timeliness of loss recognition. Its absolute value seems to be higher for the QC sample (0.449), and it is taking similar values for the LQC and ROC samples (0.330 and 0.353, respectively). However, given that the coefficient β1 on the return dummy is not significant for the LQC and QC sample, it is difficult to draw conclusions with regard to the level of conservatism. Finally, the results with regard to accrual quality as measured by model 3 are reported in table 5. The highest explanatory power of the model is achieved for the LQC and QC sample (adjusted R2 of 31.1% and 26.5%), while for the ROC sample the adjusted R2 is only 10.7%. The Cramer test reveals that these differences are statistically significant, which confirms the hypothesis that Civil law firms do not manage earnings as much as Common law firms. Similar results are obtained even after controlling for firms specific factors. - insert table 5 about here - 19
  • 21. As pointed out by Dechow and Dichev (2002), a positive sign is expected on both past and future cash flows and a negative sign on current cash flows. All coefficients are significant and have the expected sign. 7. Conclusion This research uses the unique Canadian bi-juralism environment, where Common Law coexists with French Civil Law, as a field study to contribute to the international debate on the influence, or even superiority, of one legal system over the other regarding corporate financial reporting quality. Our results show that, ceteris paribus, the nature of the legal system is not neutral and it is the Civil Law environment that seems to encourage firms to publish accounting data of better quality. These surprising results are in opposition to the most intimate beliefs of researchers and seem to indicate, at least, that the relationship between the legal regime and the corporate financial reporting quality is not as simple as we expected. Most of the previous studies analysing this research question are using heterogeneous samples, which include countries extremely different not only in terms of legal systems, but also in terms of political institutions, economic development, corporate governance mechanisms, shareholders and creditors rights, enforcement mechanisms etc. As a consequence, it is difficult to attribute the reported differences only to one variable. Corporate financial reporting quality seem to be affected by a multitude of legal incentives, market forces and firm characteristics and future research is needed to have a clear picture of the interactions between all these variables. 20
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  • 25. 24
  • 26. Table 1. Investor Protection under CBCA and QCA: Salient Differences Protective mechanism CBCA QCA Shareholder approval of Class veto Approval by 2/3 of fundamental changes shareholders Shareholder approval of the Class veto N/A sale of all or substantially all of the assets Calling shareholders’ 5% of the voting shares 10% of the voting shares meeting Right to make shareholder Provided N/A proposal Appraisal remedy Provided N/A Derivative action Provided Constrained by majority rule Oppression remedy Provided N/A 25
  • 27. Table 2. Descriptive statistics N Mean Standard Min Max deviation R jt 6 336 0.108 0.571 -1.338 2.156 Ejt 6 336 -0.003 0.133 -0.467 0.401 MVjt‐1 ∆Ejt 6 336 0.004 0.120 -0.523 0.569 MVjt‐1 ∆WCjt 4 698 0.003 0.053 -0.170 0.169 TAjt OCFjt‐1 4 698 0.046 0.117 -0.349 0.380 TAjt‐1 OCFjt 4 698 0.053 0.112 -0.309 0.350 TAjt OCFjt 1 4 698 0.053 0.118 -0.338 0.379 TAjt 1 MVjt ‐MVjt‐1 Djt Where R jt MVjt‐1 – the market return of firm j in year t; MVjt – the market value of firm j in year t; Djt – the dividend paid by firm j in year t; Ejt – the year-end t earnings for firm j; ∆WCjt – the change in working capital (non-cash current assets minus current liabilities adjusted for the current portion of long term debt) of firm j in year t; TAjt – the total of assets of firm j in year t; OCFjt – the operating cash flow of firm j in year t. 26
  • 28. Table 3. The value relevance of earnings Ejt ∆Ejt Model 1: R jt 0 1 2 3 MVjt‐1 MVjt‐1 Variables LQC QC ROC POOL LQC QC ROC POOL Intercept 0.011 0.065*** 0.119*** 0.110*** 0.036 -0.039 0.120*** 0.217*** (α0) (0.506) (4.152) (15.401) (15.891) (0.328) (-0.544) (4.163) (7.949) Earnings 0.383*** 0.256*** 0.220*** 0.223*** 0.297*** 0.223*** 0.236*** 0.240*** (α1) (6.664) (7.816) (15.100) (16.763) (4.341) (5.891) (14.951) (16.471) Change in earnings 0.059 0.072** 0.071*** 0.072*** 0.085 0.089*** 0.053*** 0.057*** (α2) (1.032) (2.191) (4.877) (5.381) (1.449) (2.669) (3.645) (4.310) Industry YES*** YES** YES*** YES*** fixed effects Time YES** YES*** YES*** YES*** fixed effects AUDIT -0.003 0.003 0.024 0.018 (-0.051) (0.086) (1.642) (1.393) SIZE 0.008 -0.002 -0.012 -0.008 (0.119) (-0.049) (-0.714) (-0.544) N 322 1 024 5 312 6 336 322 1 024 5 312 6 336 F 32.919*** 47.848*** 188.444*** 231.339*** 5.449*** 7.395*** 40.182*** 44.918*** Adj. R2 16.6% 8.4% 6.6% 6.8% 20.8% 11.1% 12.9% 12.2% Cramer test – ROC (0.002) (0.134) (0.001) (0.577) MVjt ‐MVjt‐1 Djt Where R jt – the market return of firm j in year t; MVjt – the market value of firm j in year t; Djt – the dividend paid by firm j in year t; Ejt – the year- MVjt‐1 end t earnings for firm j; Industry fixed effects – control variables that take the value one if the firm belongs to a specific industry, and zero otherwise (as identified by the first digit industry code); Time fixed effects – control variables that take the value one if the observation belongs to a specific year, and zero otherwise; AUDIT – control variable that takes the value one if the audit is conducted by one of the Big 4 auditor, and zero otherwise; SIZE – control variable computed as log of total assets of firm j in year t; ROC – sample of firms with the headquarter located outside the Quebec province; QC – sample of firms with the headquarter located in the Quebec province; LQC – sample of firms incorporated under the Quebec Companies Act. ***, **, * significant at 1%, 5% and 10% respectively; t-statistics into brackets; Cramer test – the number indicates the probability to accept the null hypothesis of no difference in adjusted R2 compared to the ROC sample. 27
  • 29. Table 4. The timeliness of earnings (Basu model) Ejt Model 2: β0 β1 BNjt β2 R jt β3 BNjt R jt β4 MVjt‐1 Variables LQC QC ROC POOL LQC QC ROC POOL Intercept 0.058*** 0.064*** 0.038*** 0.043*** 0.021 -0.067*** -0.096*** -0.081*** (β0) (6.096) (8.580) (10.856) (13.471) (0.826) (-3.795) (-13.934) (-12.552) Bad news -0.011 -0.065 -0.086*** -0.084*** -0.015 -0.016 -0.066*** -0.058*** (β1) (-0.131) (-1.461) (-4.172) (-4.449) (-0.201) (-0.385) (-3.397) (-3.335) Market return 0.144 -0.096** -0.076*** -0.084*** 0.127 -0.020 0.004 0.002 (β2) (1.5670 (-2.016) (-3.546) (-4.279) (1.470) (-0.456) (0.190) (0.126) Bad news * Return 0.330*** 0.449*** 0.353*** 0.371*** 0.218*** 0.320*** 0.250*** 0.262*** (β3) (3.954) (10.049) (17.355) (20.060) (2.701) (7.432) (12.811) (14.746) Industry YES*** YES*** YES*** YES*** fixed effects Time YES** YES** YES*** YES*** fixed effects AUDIT -0.028 -0.028 0.004 -0.269 (-0.591) (-1.020) (0.276) (0.788) SIZE 0.172*** 0.275*** 0.330*** 0.322*** (2.900) (8.880) (23.188) (25.200) N 322 1 024 5 312 6 336 322 1 024 5 312 6 336 F 28.390*** 75.888*** 269.017*** 342.298*** 9.111*** 23.899*** 89.584*** 111.857*** Adj. R2 20.4% 18.0% 13.1% 13.9% 33.6% 32.0% 25.9% 26.9% Cramer test – ROC (0.020) (0.011) (0.000) (0.001) Where Ejt – the year-end t earnings for firm j; MVjt – the market value of firm j in year t; BNjt – a dummy variable equal to one if R jt is negative (indicating MVjt ‐MVjt‐1 Djt economic loss), and zero otherwise; R jt – the market return of firm j in year t; Djt – the dividend paid by firm j in year t; Industry fixed effects – MVjt‐1 control variables that take the value one if the firm belongs to a specific industry, and zero otherwise (as identified by the first digit industry code); Time fixed effects – control variables that take the value one if the observation belongs to a specific year, and zero otherwise; AUDIT – control variable that takes the value one if the audit is conducted by one of the Big 4 auditor, and zero otherwise; SIZE – control variable computed as log of total assets of firm j in year t; ROC – sample of firms with the headquarter located outside the Quebec province; QC – sample of firms with the headquarter located in the Quebec province; LQC – sample of firms incorporated under the Quebec Companies Act. ***, **, * significant at 1%, 5% and 10% respectively; t-statistics into brackets; Cramer test – the number indicates the probability to accept the null hypothesis of no difference in adjusted R2 compared to the ROC sample. 28
  • 30. Table 5. Accruals quality (Dechow and Dichev model) ∆WCjt OCFjt‐1 OCFjt OCFjt 1 Model 3: γ0 γ1 γ2 γ3 γ4 TAjt TAjt‐1 TAjt TAjt 1 Variables LQC QC ROC POOL LQC QC ROC POOL Intercept 0.009** 0.009*** 0.004*** 0.005*** 0.023 -0.001 0.007** 0.008*** (γ0) (2.082) (4.116) (4.498) (5.618) (1.415) (-0.143) (2.358) (2.791) Cash flow–previous 0.404*** 0.355*** 0.242*** 0.261*** 0.382*** 0.343*** 0.246*** 0.263*** (γ1) (5.285) (7.919) (11.388) (13.510) (4.802) (7.667) (11.398) (13.458) Cash flow–current -0.796*** -0.758*** -0.506*** -0.545*** -0.827*** -0.763*** -0.520*** -0.557*** (γ2) (-9.704) (-15.784) (-21.518) (-25.526) (-9.628) (-15.800) (-21.953) (-26.000) Cash flow–next 0.368*** 0.338*** 0.265*** 0.277*** 0.361*** 0.346*** 0.270*** 0.282*** (γ3) (4.654) (7.519) (12.504) (14.344) (4.364) (7.547) (12.691) (14.547) Industry YES** YES*** YES*** YES*** fixed effects Time YES* YES** YES*** YES*** fixed effects AUDIT 0.016 -0.016 -0.007 -0.008 (0.263) (-0.452) (-0.432) (-0.493) SIZE 0.031 0.026 0.001 0.000 (0.409) (0.643) (0.038) (0.021) N 213 694 4 004 4 698 213 694 4 004 4 698 F 32.962*** 84.255*** 160.222*** 224.233*** 6.587*** 14.819*** 29.100*** 39.901*** Adj. R2 31.1% 26.5% 10.7% 12.5% 33.4% 28.5% 12.3% 14.2% Cramer test – ROC (0.000) (0.000) (0.000) (0.000) Where ∆WCjt – the change in working capital (non-cash current assets minus current liabilities adjusted for the current portion of long term debt) of firm j in year t; TAjt – the total of assets of firm j in year t; OCFjt – the operating cash flow of firm j in year t; Industry fixed effects – control variables that take the value one if the firm belongs to a specific industry, and zero otherwise (as identified by the first digit industry code); Time fixed effects – control variables that take the value one if the observation belongs to a specific year, and zero otherwise; AUDIT – control variable that takes the value one if the audit is conducted by one of the Big 4 auditor, and zero otherwise; SIZE – control variable computed as log of total assets of firm j in year t; ROC – sample of firms with the headquarter located outside the Quebec province; QC – sample of firms with the headquarter located in the Quebec province; LQC – sample of firms incorporated under the Quebec Companies Act. ***, **, * significant at 1%, 5% and 10% respectively; t-statistics into brackets; Cramer test – the number indicates the probability to accept the null hypothesis of no difference in adjusted R2 compared to the ROC sample. 29