Measuring Country Differences in Enforcement of Accounting Standards: An Audit and Enforcement Proxy

Abstract

In this paper we present an index designed to capture differences between countries in relation to the institutional setting for financial reporting, specifically the auditing of financial statements and the enforcement of compliance with each country's accounting standards. The use of a common set of standards such as International Financial Reporting Standards (IFRS) aims, in broad terms, to promote the comparability and transparency of financial statements and to improve the quality of financial reporting. However, the effectiveness of IFRS adoption may be hampered by differences, across countries, in the institutional setting in which financial reporting occurs. Studies of outcomes from adopting IFRS use a range of legal system proxies to capture these country differences, but the proxies are deficient in that they seldom focus explicitly on factors that affect how compliance with accounting standards is promoted through external audit and the activities of independent enforcement bodies. To address this deficiency, we calculate measures of the quality of the public company auditors’ working environment (AUDIT) and the degree of accounting enforcement activity (ENFORCE) by independent enforcement bodies. We do this for 51 countries for each of the years 2002, 2005 and 2008, using publicly available data provided by the International Federation of Accountants (IFAC), the World Bank and the national securities regulators. Preliminary tests suggest our indices have additional explanatory power (over more general legal proxies) for country‐level measures of economic and market activity, financial transparency and earnings management. We expect they will prove useful to researchers and other interested parties who require country‐level measures that focus on the degree of enforcement of financial reporting practices.