Special section editorial: Enforcement of financial reporting

This editorial introduces and assesses the collective contribution of three papers that collectively provide a special section of ABR on the topic of corporate financial reporting enforcement.¹ Empirically, the papers provide insights ranging from an analysis of the cross national impact of enforcement actions on the quality of corporate financial reporting in the banking sectors of 37 countries to detailed case studies of enforcement processes, outcomes and consequences in two contrasting institutional settings – namely, Romania and Italy – and covering, respectively, the development of a national Financial Reporting Enforcement System (FRES) and the institutional actions, interactions and silences concerning a controversial share revaluation in 2013 by the Bank of Italy. This editorial summarises the contributions made by the three papers and highlights the continuing scope for empirical and theoretical research on the operation and functionality of corporate financial reporting enforcement systems.

As an essential feature of the global financial architecture, enforcement has started to attract the interest of scholars from diverse methodological perspectives. Indicatively, the bulk of the economics-informed research paradigm has demonstrated that effective enforcement leads to improved financial reporting, positive market reactions and corporate outcomes (Daske et al. 2008, Christensen et al. 2013, De George et al. 2016). While the effectiveness of enforcement differs widely around the world (Brown et al. 2014), there has been a firm belief in policy making that strong enforcement is necessary since it provides concrete corporate benefits through enhanced financial reporting quality (see Christensen et al. 2013, Brown et al. 2014). Recent literature, however, suggests that enforcement inevitably brings with it significant costs (Florou et al. 2020). The conventional wisdom that more regulation and enforcement lead always to better outcomes has also been challenged (Christensen et al. 2020), although the way the enforcement literature has been dominated by empirical investigation of the US context (Christensen et al. 2013, Hollie et al. 2013) does make it difficult to produce generalisable conclusions applicable worldwide. This is a point reiterated by scholars working within a sociopolitical and institutional perspective as they drew attention to the complex structure of the global regulatory architecture, particularly the conflict between the global nature of financial reporting rules and the institutional differences in the social, political and economic contexts upon which such enforcement efforts were applied (Davies and Green 2008, Humphrey et al. 2009, Arnold 2012, Caramanis et al. 2015).

Recognising such a state of affairs, and development potential in stimulating enforcement related research, the special section call for papers emphasised the importance of studying the establishment and practical operation of corporate financial reporting enforcement agencies, including their interactions with other informal institutions and the nature of governance systems within corporations. Of particular concern here was to learn more about the institutional diversity in corporate financial reporting enforcement processes at the local and regional level, including how the operation of enforcement mechanisms modelled on particular international conceptualisations functioned in countries or contexts with very different institutional conditions. In this regard, we were particularly interested in receiving submissions that covered non-US and institutional/sectoral contexts that had yet to be covered in great depth in the existing enforcement literature. We also put emphasis on the scope for further work on the selection and associated theoretical modelling or justification of variables associated with the operation and functionality of enforcement processes. Finally, we welcomed empirical analysis of the impact of enforcement systems, including identified firm specific outcomes and consequences of enforcement actions or broader reactions and responses of other key institutional actors, both nationally and internationally.

The three accepted papers are very much reflective of the methodological openness of the call. They comprise an appealing mix of a broad-based, cross-country analysis of the banking industry (which has not attracted a great deal of empirical attention in accounting archival research) and two detailed case studies of financial reporting enforcement processes. The first of these assesses the historical development and overall national impact of various elements of a financial reporting enforcement system in Romania, established with the assistance of a range of international accounting, auditing and other regulatory institutions. The second focuses on a controversial share revaluation initiative undertaken by the Bank of Italy and the insights provided regarding the relative force and efficacy of financial reporting enforcement processes.

Duru et al. (2020) study the comparative impact of enforcement regimes on the value relevance of earnings and common equity across the banking sectors of 37 major economies for the estimation window 1999-2012. Following the approach of Barth et al. (2008), they measure regulation and enforcement using the World Bank’s Bank Regulation and Supervision Surveys. In relation to the banking sector, these surveys cover questions taken from country officials at national regulatory and supervisory agencies about the administrative structure of banking supervision, different selected aspects of the banking industry and its regulatory and supervisory environment. Thus, Duru et al. (2020) measure enforcement in a fashion that is directly specific to the country’s banking sector and, as such, advance the typical approach in prior (limited) banking studies where enforcement variables are based on broader, more generic country foundations such as legal origin (e.g. Anandarajan et al. 2011). Duru et al. (2020) provide strong evidence that the informativeness of banks’ financial statements is higher in countries with more exacting modes of enforcement and that the effects of bank accounting regulations are more pronounced in countries with stronger enforcement systems, lending support to the argument that regulatory provisions and enforcement mechanisms are mutually dependent, particularly in the sense that regulations loosely enforced tend not to be associated with desired outcomes such as enhanced financial reporting quality.

Albu et al. (2021) examine the development and implementation of a financial reporting enforcement system (FRES) in Romania subsequent to the collapse, in 1989, of its socialist republic. They highlight a range of significant institutional factors, including, as an emerging economy seeking to embrace Western standards and committed to post-socialist marketisation, the critical dependence on the continuous external provision of adequate resources and the enrolment of national actors in the deployment of such resources. Albu et al. (2021) conclude that assessments of any substantive operational or functional impact of such an enforcement system will likely only become visible over the longer term and be dependent on a considerable degree of alignment in national and Western actors’ expectations. They stress the importance of initiatives being suitably targeted and adapted to the local circumstances and context, drawing on knowledge of the varying pertinence of incentive structures at the practice level. They point to some enabling impact on the part of the large international accounting firms, the European Union and the potentially promising impact of a nationally stylised public oversight board, but also reflect on the problems that can arise if state support for the enforcement system does not extend much beyond contentment with an appearance of adoption. In referencing its ‘limiting role’, they conclude that the Romanian state suspended its commitment to setting up a FRES as soon as it realised its international constituents were satisfied, and reallocated resources to other projects. As such, the scale and impact of regulatory enforcement processes are seen to be fundamentally dependent on the local political climate and the desire to enable material change. A residing problematic highlighted by Albu et al. (2021) in terms of any overall assessment of the functionality of Romania’s FRES is the country’s continuing prominent position in international surveys of countries with high levels of corruption. While finding no visible evidence of corruption in the development of FRES, Albu et al. (2021) close their paper by reiterating Jeppesen’s (2019) recent emphasis on the importance of accounting researchers devoting more attention to corruption and its particular pertinence in post-socialist countries with higher levels of institutional instability and political influence.

Quagli et al. (2021) complement and expand on a number of prominent themes and findings emerging from Albu et al. (2021). Motivated by a belief that a qualitative research approach has the potential to enhance insights of the complex and contradictory nature of enforcement processes, Quagli et al. (2021) analyse a major regulatory incident concerning an apparent failure on the part of a substantial number of private Italian banks to comply with the stipulations of IAS 39 regarding the valuation of (available for sale) shares that they all held in the Italian central bank (the Bank of Italy – BI). Having outlined the accounting details of the case, Quagli et al. (2021) analyse the nature of the interactions between key national and international institutions, including the national public enforcer (Commissione Nazionale per le Società e la Borsa - CONSOB), the external auditors of the banks, the European Securities and Markets Authority (ESMA) and the IFRS Interpretations Committee (IFRS IC), and suggest that the analysis invites serious questioning of the functionality of enforcement processes. They highlight a strategic failure on the part of a number of key enforcement bodies to take visible public positions on the utilised accounting treatments and, by implication, to delegate choice and the scope for action, to other actors. Where enforcement agencies did act in a more proactive enforcement body, such as the case of ESMA openly calling for the IFRS IC to take a firm position on the revaluation issue, restrictions in their regulatory reach served to contribute to a predominant regulatory silence (with the IFRS IC failing to provide the requested declaration).

As with Albu et al. (2021), the residing impression from Quagli et al.’s (2021) analysis is of processes of corporate financial reporting enforcement being far less deterministic, routine and clear-cut than that typically represented, or at least, presumed in the more quantitative-styled literature – and one through various modes and means has a tendency to lend itself to the construction and application of formal rather than substantive levels of compliance with financial reporting standards. Much here can be seen to depend not just on the formal functional specifications and responsibilities of enforcement agencies but also on the nature of their public and private interactions, and the capacity of the enforcement field to accommodate, if not silently permit, a systemic failure to resolve vivid disconnects between espoused intent and actioned behaviour. Consistent with their spirit of studying and seeking to demonstrate that enforcement needs to be regarded as ‘a complex and nuanced phenomenon shaped by the dynamics of its social context’, Quagli et al. (2021) close by emphasising a number of important public policy implications of their study. These include the importance of not presuming or classifying the strength of an enforcement system in absolute terms, especially when its overall functionality does appear to be so dependent on the relative strength of individual elements or components. Additionally, they stress the value of pinpointing specific areas where targeted enforcement reforms could contribute to an overall strengthening of the system, notably in terms of recognising the institutional tendencies that promote inaction and silence, and the respective potential countering actions of promoting more visible, responsive IFRS interpretation processes and reassessing the case for a pan-European enforcement agency.

A key intent with this guest editorial is to provide an introductory flavour of the papers including in the special section. However, it is also an opportunity for us to thank the senior editorial team at ABR for their invaluable support, advice and patience, which collectively enabled us, with the help of a good number of independent academic reviewers, to bring the special section to fruition. We would also like to thank the authors for their willingness to keep developing their papers in receipt of a substantial set of reviewer and editorial suggestions and advice. Finally, we would also like to express our personal thanks to former ABR editor, Vivien Urquart (formerly Beattie), for inviting and inspiring the initial call for papers. While we now bring this editorial to a close, it is also very evident that the area of financial reporting enforcement remains a live and very exciting one. At the time of writing, one does not have to look far to find a host of ongoing events, including concerns regarding politicisation pressures at the PCAOB and concerns with the efficacy and integrity of national oversight boards, with notable questions being raised in Germany in the aftermath of the Wirecard AG case and the anticipated transition in the UK of the Financial Reporting Council (FRC) into a new Audit Reporting and Governance Authority (ARGA). As a range of financial reporting standard setting and oversight boards make more explicit or shift the focus of their public interest responsibilities, whether directly or through external pressures, or as the remit of financial reporting extends to a direct consideration of climate related, sustainability and fiscal (taxation) disclosures (and the financial consequences of varying related levels of corporate commitment to and performance regarding such matters), one central conclusion is very evident. Namely, that the subject matter falling with the remit of, the influences on, and the nature, impact and consequences of financial reporting enforcement mechanisms, processes and institutions is both live and dynamic.

At the most basic of insistences - i.e. standards must not only be formally adopted but substantively complied with - enforcement can sound a relatively routine, automatic function. The practical reality is very different, as the special section’s focus on varying enforcement processes and emphases has shown and reiterated. The intriguing thing going forward is that research interest will not just lie in terms of investigating the varying nature of financial reporting enforcement processes, but has the capacity to study the shifting scope, reach and significance of what is deemed to fall under the remit of ‘financial reporting’ enforcement. There are also related matters to contemplate with respect to the operationalised construction and meaning of ‘independent’ and/or ‘public interested’ oversight and the impact of national and cross-national regulatory body interactions, whether through the direct exercising of jurisdictional authority, the specification and development of new enforcement standards of practice and the sharing of ideas and experiences through international collaborative agencies and exercises.

There are also fundamental questions to ask as to whether the desired enforcement goal is for the development of more rigorous and stronger regulatory enforcement regimes and authorities, or whether the more effective of ‘enforcement’ regimes could be ones where the systemic emphasis rests less on ever increasing levels of inspection and intrusion (to secure compliance with standards) and more on engendering an acceptance of responsibility; securing compliance through a spirit of enablement rather than a fear of punishment. Important intellectual and ethical issues remain for researchers to contemplate in terms of whether by an eager search to prove the impact of stronger and more proactive enforcement regimes, they close down the possibilities of encouraging different behavioural patterns – including different modes for ensuring corporations meet their business and societal responsibilities. Is there even a risk here of encouraging a ‘one-approach fits all’, compliance-driven mode of enforcement, which depends crucially on formal, externally specified reporting standards and ‘performance’ metrics – and, in the process, restricts the scope for, and undermines the legitimacy of, considered professional judgement? As the pressures grow to expand the scope of corporate financial reporting into more vivid forms of public interest reporting, researchers must be especially sensitive to the development processes generating the reporting standards to be ‘enforced’ – and the institutionalised presumptions determining the mechanisms through which ‘better’ corporate performance can be delivered or stimulated. For example, conceptually, it could be argued that governance systems which prioritise and encourage responsibility first and accountability second may require less intrusive enforcement systems as the underlying behavioural intentions are to get things right first time. There are live issues to explore regarding the relationship between compliance and enforcement and comparability – and whether enforcement regimes encourage mock-compliance or enforce comparability in situations where results and performance are fundamentally different and need to be understood and interpreted as such. It is also pertinent here to consider ideas and perspectives developing through conceptions of dialogical accountability, participatory governance and notions of governance as empowerment rather than monitoring and enforcement (see Thomson and Bebbington 2005, Bebbington et al. 2007, Brown and Dillard 2015, Lail et al. 2015, Dillard and Vinnari 2019).²

There is, at present, in the UK a quite interesting contrast between two proposals for public interest entities (PIEs) to demonstrate through their annual corporate reports the discharging of their public interest responsibilities. One report, the Brydon Report (2019), calls for such reporting without specifying in detail what such entities should disclose (allowing them to make the choice and to be judged accordingly in light of the respective quality of their disclosures compared to those of other, competitor, PIEs). The other report, a discussion paper on the future of corporate reporting (FRC 2020), similarly stresses the critical importance of public interest reporting and respecting the rights of a broad range of corporate stakeholders. However, it chose to stipulate more precisely the various disclosure requirements and frameworks to be followed by PIE’s in meeting their public interest reporting responsibilities. Given the acknowledged concerns over the ‘alphabet soup’ nature of a proliferation of ‘ESG’ indicators and the intense politicking and collaborations taking place as varying standard setting bodies and advocates lobby and push for their standards to be accepted for global adoption, it is just one reminder that the Standards–Surveillance–Compliance (SSC) ‘enforcement’ framework of globally-integrated financial markets which aims to secure the stable operation of global markets through the widespread employment of comprehensive and universal standards, as well as codes of good practice, policed by a variety of regulatory agencies at a local, regional or global level, is not uniform or absolute and not without or beyond challenge (see Wade 2007a, 2007b, Humphrey et al. 2009, Βüthe and Mattli, 2011, Caramanis et al. 2015).

The importance of such critical reflection was nicely captured by Black (2012) when reviewing the regulatory lessons to be learned from the global financial crisis: ‘If the financial crisis has a broader lesson for regulators elsewhere it is this: it is not enough to ask regulators or others to engage in self-critical learning, to assess whether they are performing their tasks well. It has to be asked whether they are performing the right tasks at all. Whilst observation and learning are important, those observing and learning may only see what they expect to see, and when they do see it will be through the refractive filters of their own cognitive frames. Designers and regulators do need to build in structures for cognitive challenge and experimentation’ (pp. 1062–63, emphasis added). Black’s words have a continuing resonance today, both for policy makers and academics, as regulatory debates and discussions continue with respect to the best way forward regarding financial reporting enforcement and to be very sensitive to the fact that regulatory reforms tend to over-promise and under-deliver’ (Black 2012, p. 1063). Gunningham (2017) reinforces such messages in concluding that regulatory excellence requires the conscious application of different intervention strategies according to their suitability to particularly regulatory contexts and circumstances; ‘there is no singular formula for achieving regulatory excellence’ and a constant need, among other things, for self-evaluation, learning and adaptation (p. 203). Or as Coglianese (2017) stresses, regulatory excellence requires listening attentively to changing public concerns and not just seeking the measurement of excellence but, more importantly, measures for excellence (pp. 16-17).

In moving from such broader based reflections, to more specific considerations as to where methodological advancement in more quantitative studies of financial reporting enforcement would appear to be most needed, there is scope and support for more theoretical modelling of enforcement processes and outcomes (developing relatively rare examples such as Konigsgruber 2012, Laux and Stocken 2018, Ewert and Wagenhofer 2019). Such developments have the potential to encourage greater diversity in empirical studies on financial reporting enforcement and serve to enhance the construct validity of proxy measures of the overall strength and quality of enforcement. Due recognition, however, has to be paid here to the ensuing scale of conceptual and practical challenges – especially given the level of confidentiality, if not secrecy, that can be attached to the inner workings of enforcement agencies and the difficulty of directly pinpointing and assessing the relationship between enforcement outputs, managerial incentives and financial reporting quality. With Isidro et al. (2020) recently suggesting that many empirical results lose strength when multiple country factors are simultaneously considered, it is evident that the scope for better delineation and specification of influential variables on enforcement processes and outputs is a pressing issue. For instance, this includes knowing more about the operation and efficiency of various enforcement mechanisms (e.g. ‘name and shame’ comment letters). Likewise, with respect to the interrelation between financial reporting enforcement and other formal institutions (e.g. regulation, litigation), informal institutions (e.g. social norms, culture, trust), governance structures (e.g. institutional/family/insider ownership, board quality, internal audit, financial analysts, media) and a range of contextual factors (e.g. levels or degrees of corruption, democracy, economic growth, geopolitical status etc.). There is also scope to examine further the nature of shareholder, and other stakeholder, reactions to enforcement outcomes (e.g. debt covenants, investor lawsuits, customer/supplier effects) and the impact of enforcement on corporate outputs. This could be firm-specific (e.g. cost of capital, liquidity, risk, M&As, IPOs, season equity offerings), accounting/auditing- specific (e.g. financial reporting choices, audit fees/audit lag, going concern, auditor choice) and/or country-specific effect (e.g. credit ratings, foreign direct investment, borrowing ability). It is particularly interesting to note here how concerns with such contextual factors are also being highlighted by qualitative researchers seeking to develop understanding of the practical functioning of regulatory oversight processes and the forces enabling and/or resisting change.³

There is a need to gain more knowledge of the impact of any structural mismatching between the global nature of the international financial architecture and the fragmented, varied, character and quality of public oversight operating at the national level,⁴ including the effect of specific resourcing constraints and/or the value gained by expanding or contracting the financial resource budgets for regulatory oversight bodies (and the impact of any major differences in the funding sources for such budgets). Regulatory enforcement and oversight agencies, even in the most advanced economies, have to achieve their goals within a particular budget and specified time constraints (Kedia and Rajgopal 2011, Correia 2014, Leventis 2018) - and selective or targeted enforcement policies can impose significant direct and indirect costs on companies and their auditors, with consequent impact on corporate decision making and outcomes (see Wu and Salomon 2017). When bodies such as the IASB are paying average annual salaries of over £450,000 to its board members,⁵ it is an interesting question to pose as to what salaries really are justifiable for regulatory bodies working in the public interest.

In the current crisis times relating to covid-19 and the financial pressures on corporations and governments alike, it is vital not to forget that the pursuit of stronger regulatory and enforcement bodies and processes is far from a free good. The pursuit of ‘building back better’ and ‘new horizons’ should not exclude consideration of both the on-going and longer-term effectiveness and social suitability of the operation and spirit of enforcement regimes, in the financial reporting field and beyond. From a research perspective, it is very evident both from the papers presented in this special section and the literature reviewed and drawn upon in this editorial, that questions regarding the practical workings, impacts and overall economic value and social purposefulness of financial reporting enforcement regimes and their accompanying major regulatory bodies, approaches and techniques are of prime interest to researchers of both quantitative and qualitative methodological leanings. We hope this editorial and special section can encourage the bridging of, and learning across, such a methodological divide in the pursuit not just of better financial reporting enforcement but more meaningful and valuable financial reporting.

Notes

1 Among these three papers, two are published in this special section, i.e. Albu et al. (2021) and Quagli et al. (2021), and the third one was published in an earlier separate issue, i.e. Duru et al. (2020), but edited as part of this special section.

2 For a useful summary and review of such arguments, see Michelon et al. (2020), especially p. 39 and p. 135.

3 For example, see: Hazgui and Malsch (2020) for a discussion of the potential significance of geopolitical competition/hostility in shaping regulatory evolution; Canning and O'Dwyer (2016) for analysis of the institutional maintenance work undertaken by professional accounting bodies in resisting regulatory change; and Löhlein and Müßig (2020) for consideration of the institutional dynamics associated with the pursuit of independent auditor oversight.

4 The scope for empirical research here is clearly demonstrated by the range of public oversight arrangements for the audit profession described formally in a recent survey by Accounting in Europe (2020).

5 See https://cdn.ifrs.org/-/media/feature/about-us/funding/2019/ifrs-ar2019.pdf, p. 44.