Foreign Institutional Ownership and the Global Convergence of Financial Reporting Practices

• Author: BOHUI ZHANG,MARK MAFFETT,VIVIAN W. FANG
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/1475-679X.12076
• Published date: 01 June 2015

DOI: 10.1111/1475-679X.12076

Journal of Accounting Research

Vol. 53 No. 3 June 2015

Printed in U.S.A.

Foreign Institutional Ownership

and the Global Convergence

of Financial Reporting Practices

VIVIAN W. FANG,

∗MARK MAFFETT,

†AND BOHUI ZHANG

‡

Received 29 January 2014; accepted 11 February 2015

ABSTRACT

This paper investigates whether foreign institutional investors affect the

global convergence of financial reporting practices. Using several measures

of reporting convergence, we show that U.S. institutional ownership is posi-

tively associated with subsequent changes in emerging market firms’ account-

ing comparability to their U.S. industry peers. We identify this association

using an instrumental variable approach that exploits exogenous variation

in U.S. institutional investment generated by the JGTRRA Act of 2003. Fur-

ther, we provide evidence of a specific mechanism—the switch to a Big Four

audit firm—through which U.S. institutional investors affect reporting con-

vergence. Finally, we show that, for emerging market firms, an increase in

∗University of Minnesota; †University of Chicago Booth School of Business; ‡UNSW

Australia.

Accepted by Douglas Skinner. We are grateful for helpful comments from two anony-

mous referees, Hans Christensen, Elizabeth Gordon, Wayne Guay, S.P. Kothari, Christian

Leuz, Edward Owens, Rodrigo Verdi, Joanna Wu, Holly Yang,Jerr y Zimmerman, and seminar

participants at the University of Houston, University of Minnesota, University of Rochester,

2012 Singapore Management University Accounting Symposium, 2012 HKUST Accounting

Research Symposium, and 2014 MIT Asia Conference. We thank Hongping Tan for shar-

ing data on analyst location and Mark Lang and Lorien Stice-Lawrence for sharing data

on English-language financial statements. Financial support from the University of Chicago

Booth School of Business and the Centel Foundation/Robert P. Reuss Faculty Research

Fund is gratefully acknowledged. An Online Appendix to this paper can be downloaded at:

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

593

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

594 V.W.FANG,M.MAFFETT,AND B.ZHANG

comparability to U.S. firms is associated with an improvement in the proper-

ties of foreign analysts’ forecasts.

JEL codes: G32; G34; G38; M41; M42; M48

Keywords: institutional investors; mutual funds; corporate governance;

U.S. GAAP; financial statement comparability; auditor selection; analyst

forecasts

1. Introduction

We examine the role of foreign institutional investors in the global con-

vergence of financial reporting practices.1Regulators frequently espouse

comparability as a desirable characteristic of financial reporting to facilitate

efficient investment decision-making and allocation of capital (Financial

Accounting Standards Board [1980], U.S. Securities and Exchange Com-

mission [2000]). Over the past 15 years, significant regulatory effort has

gone into promoting comparability, the most prominent example of which

is the International Accounting Standards Board’s (IASB) push for global

adoption of International Financial Reporting Standards (IFRS). However,

recent research (e.g., Daske et al. [2008], Christensen, Hail, and Leuz

[2013]) shows that mandating the use of a common set of accounting stan-

dards alone is unlikely to achieve financial reporting convergence.

The documented ineffectiveness of regulatory mandates suggests that

alternative mechanisms capable of altering firms’ equilibrium reporting

practices likely contribute to the significant global reporting convergence

observed over the past three decades (e.g., Land and Lang [2002]). One

potential mechanism is investor demand for more comparable reporting.

Prior research argues that foreign institutional investors prefer compara-

ble financial reporting because it reduces information processing costs and

improves investment efficiency (e.g., Bradshaw, Bushee, and Miller [2004],

Covrig, Defond, and Hung [2007], DeFond et al. [2011]). These studies

suggest that institutional investors primarily take a passive approach, seek-

ing out firms that already have high levels of accounting comparability,

rather than actively promoting reporting convergence. It remains unclear

whether, and to what extent, foreign institutional investors directly affect

the convergence of reporting practices.

We focus on U.S. institutional investors because they make up a substan-

tial portion of all worldwide investment and represent the largest group

of foreign investors. As of December 2005, U.S. institutions held over $2

trillion in non-U.S. equities, more than twice as much as U.K. institutions,

the second largest group of foreign investors (Ferreira and Matos [2008]).

1We define “global convergence of financial reporting practices” as an increase in the ex-

tent to which firms from different countries account for similar economic events similarly

and dissimilar events differently. For parsimony, we use “convergence of financial reporting

practices” and “increased comparability” interchangeably.

INSTITUTIONAL OWNERSHIP AND THE GLOBAL CONVERGENCE 595

Also, because U.S. institutions originate from a strong legal regime, they

serve as a powerful market force in improving the governance of their non-

U.S. investees (Aggarwal et al. [2011]).

As one measure of comparability, we use the output-based approach sug-

gested by De Franco, Kothari, and Verdi [2011] (hereafter, DKV). In the

absence of effective incentive alignment and/or enforcement mechanisms,

comparable inputs (such as shared accounting standards) might not lead to

comparable outputs. By focusing directly on outputs from the accounting

system (i.e., earnings), the DKV measure allows us to assess whether foreign

institutional investors change reporting practices in substance rather than

simply in form. We adapt the DKV measure to capture a non-U.S. firm’s

comparability to its U.S. industry peers.

Using a sample of firms from 18 emerging markets and 20 developed

markets from 1998 to 2009, we find that both higher levels and larger

changes in ownership by U.S. mutual funds are positively associated with

subsequent increases in firms’ comparability to U.S. firms, but primarily

only for firms domiciled in emerging markets—a finding we attribute to the

importance of external, market-based monitoring in the face of weak regu-

latory infrastructures. A one standard deviation increase in U.S. ownership

is associated with a 14% increase in the average one-year change in compa-

rability, which corresponds to 1.5% of the difference between the average

comparability to U.S. firms of emerging market firms and their U.S. indus-

try peers. This result is robust to estimating the DKV measure using several

alternative approaches (including quarterly estimation, accounting for the

asymmetric timeliness of earnings, and using cash flows rather than stock

returns as a proxy for economic events), as well as to alternative measures

of comparability to U.S. firms (including a firm’s likelihood of choosing an

accounting treatment that conforms to U.S. reporting standards, the volun-

tary adoption of an internationally recognized set of accounting standards,

a firm’s likelihood of producing English-language financial statements, and

a firm’s accrual quality and earnings smoothness).

To identify the causal effect of U.S. institutional investors on comparabil-

ity to U.S. firms, we employ an instrumental variable approach that exploits

an exogenous shock to the level of U.S. investment—the passage of the Jobs

and Growth Tax Relief Reconciliation Act (hereafter, JGTRRA) in 2003.

Desai and Dharmapala [2011] document that, following JGTRRA, U.S. in-

stitutional investors reallocated their portfolios toward the equities of firms

eligible for the Act’s dividend tax cut and, as a result, U.S. ownership in

these firms increased significantly compared to that in ineligible firms. We

find that JGTRRA-eligible firms experienced a significant improvement in

their comparability to U.S. firms subsequent to the passage of the Act. Ad-

ditional analyses, including two placebo tests, a firm-fixed effects specifica-

tion, the inclusion of several proxies for the similarity of firms’ underlying

economics, and controlling for changes in earnings quality, further bol-

ster a causal interpretation of our results. Collectively, these tests provide