Our study provides both new insights and methodologies. First, we develop a series of empirical measures to capture the quality of firms’ accounting numbers. These measures can be used by both academics and practitioners. Second, we show that a country’s investor protection laws and enforcement institutions are important determinants of financial reporting quality. This insight is in contrast to prior finance and economics research that treats firms’ financial numbers as pre-determined. We argue and show that the financial numbers are outcomes of managerial choices and must be considered as such.

We argue that strong legal institutions, such as good investor protection, limit the ability of managers to expropriate from outside investors and hence reduce managers’ incentives to conceal their activities in opaque financial statements. Our evidence supports this argument and has important implications for the debate on improving financial reporting and transparency. For instance, an implication is that to improve overall financial reporting quality one must change the fundamental institutions that affect managers’ incentives and, in particular, their expropriation of outside investors. Simply changing accounting rules and regulations is unlikely to be sufficient.

The idea behind this research project was initiated when we were all at the University of Rochester. (Peter Wysocki and Dhananjay Nanda were doctoral students at the time and Christian Leuz was a visiting doctoral student from the University of Frankfurt). We were interested in understanding the differences in the corporate financial reports across countries, but there was little theory to guide our analysis and only anecdotal and descriptive evidence existed at the time. Our joint work on this paper continued after each of us accepted faculty appointments at MIT, Duke, and Wharton. We are currently working on follow-up research in this area.