Financial Reporting Quality

The quality of financial reporting is crucial for the efficient functioning of capital markets and for management decisions to direct scarce resources to their best use. The objective of current developments of accounting standards and quality assurance institutions is to improve the quality of financial reporting. This project explores aspects of quality and at analyzes the economic effects of these developments in reporting standards. It studies financial reporting quality from both a financial and a management accounting perspective, that is, a stewardship perspective. It tackles the basic characteristics and their economic effects, and it also considers transactions- to events-based accounting and the form of standards (rules- or principles-based). While much has been written on these issues, they are still not well understood, particularly given the increasing dynamics of markets, the rise of intangibles as a major value driver, and the increasing use of financial instruments. Issues are measurement concepts, such as fair values, and attributes of core financial numbers used in financial reporting, the trade-off between relevance and reliability, and the use of conservative reporting and timeliness of information. The way financial reporting is designed has important implications for management incentives, and these incentives may bias the desired reporting quality in equilibrium. The research methods employed are analytical modelling and empirical methods, particularly using archival data. Auditor regulation and audit quality The quality of financial reporting depends crucially on the quality of audits. The auditors task is to provide reasonable assurance that the financial statements presented to the capital market conform to rules and/or standards as required by national and/or international GAAP. To guarantee high quality audits, there is extensive regulation of the audit profession worldwide such as, e.g., the Sarbanes-Oxley Act (SOX) 2002 in the USA and the Auditor Directive 2006 in the EU. Auditing is no longer mainly selfregulated by the auditing profession but is now overseen by independent supervisory bodies (due to the status of its members, financing etc.) from the audit profession. Furthermore, the regulation restricts services that audit firms may provide to their clients in addition to assurance, and the issue of auditor liability and market structure has come under scrutiny. It is an open question whether the recent regulatory activities of standard setters in the auditing area are really beneficial for fostering audit quality (and financial reporting quality). The SOX has even been termed quack corporate governance because at least some of its rules have apparently turned out to be ill-conceived in the light of results from audit research. This project aims to comprehensively assess the effectiveness of recent trends in audit regulation with respect to audit quality and to develop proposals based on conceptual insights that lead to more appropriate regulatory actions. Accounting and corporate governance In selecting governance mechanisms, decision makers in firms try to deal with conflicts of interests, incentive issues, dispersed and distorted information, and allocation of decision rights. A critical element in the choice of the design of an organization is the information which decision makers have or obtain from an accounting system, including observability, verifiability, and timeliness of this information. It is important to consider, however, that in addition to generating and influencing management incentives, the organizational form and accounting reports also have strategic consequences in product markets. The relation between the internal governance and the external environment has not been as thoroughly researched as it could be. Therefore, this project focuses on the link between the (choice of the) organizational mode/governance structure and the performance measures in firms in imperfectly competitive product markets. In order to analyze and evaluate how performance measurement and governance mechanism are connected with a firms competitive advantage, elements from agency theory, transaction cost theory, and property rights theory are combined with the rich arsenal of market models.

Taxation and incentives Tax research plays a major role in linking the research agendas of economics and business administration, particularly in accounting, finance, public economics, and law. Taxation and tax aspects are getting more international and intertwined with corporate governance. This project particularly picks up the interrelation of taxation and incentives with respect to economic decisions in firms. Taxes are being widely neglected in models, such as agency theory, transaction cost theory, and property rights theory. Hitherto, the impact of taxation on managerial decisions in the realistic setting of informational asymmetry has been rarely investigated. Whereas the effects of incentive schemes are well-known in the absence of taxation, the impact of corporate and individual income taxation on the effectiveness of these incentive schemes has been investigated only for linear contracts. The design of optimal performance measurement systems and optimal incentive schemes in the presence of taxation is still unknown. Recent research in accounting as well as in public finance indicates that a firms organizational structure is essential for the way taxation affects investment and financing decisions, especially for multinational corporations facing substantial tax rate differentials between different subsidiaries. There is little knowledge about the optimal organizational structure under different international tax allocation rules. Managerial performance measurement A central issue in managerial accounting is the design of incentive systems for employees. Frequently expressed concerns are that employees may undertake (investment) decisions which are not in line with the firms overall objectives. In practice, almost every well-known consulting company has developed its own metric and incentive system which is typically based on a trademarked variant of the residual income concept (for instance, Stern Stewarts Economic Value Added, McKinseys Economic Profit or the Boston Consulting Groups Cash Value Added). Many of these metrics require adjustments of financial reporting numbers, which implies that financial reporting systems often include measurement rules that are not optimal from an incentives and managerial decision-making perspective. Most incentive schemes applied in practice include kinks, caps and floors in the pay-performance relation. In theory, different approaches have been utilized to analyze the design of incentive systems properly, including agency theory, goalcongruence, and preference-similar approaches. While there has been a lot of progress, there are still many questions that remain unresolved. For example, most of the approaches require that goals coincide, but this needs quite ideal settings. They also assume technological independence, and typically simple organizational contexts. It is not clear what happens with an imperfect matching of preferences and technological dependencies, and how this interacts with the organizational structure. Accounting and Intangibles Accounting standards define the amount and quality of information in financial reports. Corporate governance rules ask users outside a firm, particularly investors for additional information. Despite detailed requirements, there is a demand for additional information on intangibles. Firms do provide such information on a voluntary basis. It is an open question if it is beneficial for firms to provide information, e.g., on research and development (R&D) or know how, and what reporting incentives they really have. Reports on intangibles may provide relevant information for investors, but the information is less reliable than mandatory accounting information. Auditing may help to increase reliability, but specific characteristics of reports on intangibles make that task difficult. Another question is what impact information on intangibles has on management decisions within the firm. Can known results in management accounting and control procedures be applied in the context of controlling intangibles? The reliability of such information also has an impact on the choice of performance measures and the design of incentive contracts. Therefore, the increasing importance of intangibles within firms provides a challenge for accounting research and requires a close interrelationship between different areas of accounting research. While much of the literature uses qualitative research, and more recently, also empirical methods to address problems of intangibles in accounting, this project uses analytical economic modelling to study these issues and to advance our knowledge in this area.