The Role of Foreign Shareholders in Disciplining Financial Reporting

In a recent paper that we have published in the Journal of Business Finance and Accounting, we investigate the role of foreign shareholders in improving the quality of accounting information provided by firms domiciled in countries with low de facto institutional quality. Using a sample of firms from four South-European countries (Greece, Italy, Portugal and Spain), for which we observe detailed ownership evolutions over the period 2002-2007, we find that increases in foreign ownership lead to increases in financial reporting quality, but only if the foreign shareholders are domiciled in countries with strong investor protection mechanisms. Further, we find that the improvement in financial reporting quality is more pronounced in the case of foreign institutional investors. Finally, our results hold before and after the introduction of the International Financial Reporting Standards (IFRS) in 2005.

We think our results are of interest for accounting regulators. Regulators seem to share the view that ‘better accounting standards’ should help improve the accounting information in the countries adopting them. However, the fear, often highlighted by the academic community, is that, if the proper enforcement mechanisms are not in place, it might well be the case that adopting new international accounting standards come to not much more than window-dressing. While this is a problem often linked to developing countries with low investor protection and weak enforcement, we study whether this problem also affects certain EU countries.

We focus our research on Greece, Italy, Portugal and Spain. These countries have substantial foreign direct ownership holdings but at the same time rank relatively low in investor protection mechanisms and other institutional features relative to the US, the UK, and other developed countries. They are often viewed as a cluster of low governance-ranked countries in many respects, with lower quality financial reporting than other developed countries. Consistent with the view that these countries are perceived as having a weak institutional design and poor reporting practices, the financial press has referred to them with the pejorative acronym ‘PIGS’.

Nevertheless, foreign investments in these countries have been steadily increasing, and they are typically considered to be more stable and culturally closer to developed markets like the US, the UK and Germany, than other high-growth countries like Brazil, Russia, India, China and South Africa (the so-called ‘BRICS’ countries). Also, even if the institutional framework is weaker in Greece, Italy, Portugal and Spain compared to other developed countries, they are all EU countries and follow EU-wide regulations, making the legal and institutional framework substantially better than in developing countries. Thus, we believe that these four countries are an interesting case to study, as they have “de jure” a developed institutional framework that is backboned by the European Union, but weak implementation and lax enforcement of regulations might lead to a weaker than expected “de facto” institutional quality.

We study changes in foreign and domestic ownership in these four countries, and find that increases in foreign ownership lead to a subsequent increase in firm-level financial reporting quality but only if the foreign shareholders are domiciled in countries with strong institutional quality. One concern with our research is that our findings are attributable to foreign investors investing only in already good governed firms with high financial reporting quality. We show this is not the case, as we find that increases in ownership by firms from strong institutional quality countries lead to subsequent increases in financial reporting quality, while the opposite does not hold. The results are stronger when foreign shareholders are institutional investors.

Given that our results remain unaltered before and after the implementation of International Financial Reporting Standards, which in 2005 superseded the local accounting standards in each EU country, our results provide support for the claims of those who view changes in accounting standards as a necessary yet insufficient condition to reach higher reporting quality and argue that, in the process of improving the financial reporting system, improvements in the institutional framework (ie, enforcement mechanisms) play a pivotal role.

Christof Beuselinck is an Associate Professor of Finance, Audit and Control at the IESEG School of Management, Catholic University of Lille.

Belen Blanco is Senior Lecturer Accounting and Finance at The University of Adelaide.

Juan M. García Lara is a Professor of Accounting at the Department of Business Administration, Universidad Carlos III de Madrid.