The Effect of Legal Quality on Accounting Quality in the European Union Has East Met West?

Abstract

Among the global efforts to improve the operation of financial markets, one is better accounting standards (i.e., IFRS). Research has shown that besides high quality accounting standards there is also a need for functional institutions, regulations, incentives and enforcement to achieve financial reporting quality (Holthausen, 2009). A factor often included in accounting research is the legal system, but the research has yielded little information about the law’s effect. This paper connects, theoretically and empirically, the operation of law with the quality of reporting in 25 EU countries. The setting is Europe, which is a “natural experiment” for analyzing the effect of law on financial reporting. For more than 40 years, ten countries in eastern Europe that are now part of the EU were communist countries. The rest of the EU maintained legal systems based on capitalist principles of property rights. If remnants of communism remain that still affect the legal climate in the eastern EU, it is possible to test whether and how different legal conditions are reflected in managers’ reporting decisions. The “natural experiment” is strengthened by the adoption of IFRS throughout the EU. This eliminates the possibility that financial reporting quality varies according to different national accounting rules. It does not, however, eliminate the possibility of earnings management. Different legal climates can reasonably be linked to different levels of truthfulness in reporting to investors. Results show empirically that legal climates are not uniform within the EU, and that the legal quality is associated with reporting quality.