Accounting Research Center, Booth School of Business, University of Chicago

Discussion of Disclosure Practices, Enforcement of Accounting Standards, and Analysts'

Forecast Accuracy: An International Study
Author(s): Peter F. Pope
Source: Journal of Accounting Research, Vol. 41, No. 2, The Effects of Regulation
(Including Taxation) on Financial Reporting and Disclosure (May, 2003), pp. 273-283
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Journal of Accounting Research

Vol. 41 No. 2 May 2003
Printed in U.S.A.

Discussion of Disclosure Practices,

Enforcement of Accounting
Standards, and Analysts' Forecast
Accuracy: An International Study
PETER F. POPE*

1. Introduction

Hope's study reports new evidence on the links between the accuracy of
analysts' earnings forecasts and international accounting differences. The
focus of the analysis is on differences in annual report disclosures and in
the enforcement of accounting standards. He relates the CIFAR index of
the level of annual report disclosure and self-constructed indexes of enforcement to forecast accuracy for a sample of 1,553 firm-years from 22 countries.
The study provides new insights on the links among equity market expectations, the information environment, and the institutional context of financial reporting. In a world with significant institutional differences between
countries, understanding of these links is potentially important for regula-

tors engaged in the drive toward harmonization of accounting principles.

Investors and corporations may also benefit from improved understanding
of these links, to the extent that market expectations of earnings are important in the pricing of equities.

Early international accounting research associated differences in accounting principles and measurement with characteristics of the financial reporting environment such as managerial philosophy, the legal system, the development of equity and debt markets, tax law, and the governance model (e.g.,

*Lancaster University.
273
Copyright ?, University of Chicago on behalf of the Institute of Professional Accounting, 2003

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274 P. F. POPE

see Gray [1980]). More recently, the availability of international databases

has created significant opportunities to use capital markets methodologies
to assess the consequences of international accounting differences for the
price-earnings relationship. There is now extensive evidence of differences
across countries in valuation weights and response coefficients obtained
in regressions of stock prices (or returns) on financial statement numbers
(e.g., see Alford et al. [1993],Joos and Lang [1994], Ali and Hwang [2000],
Hung [2001]). Abroad conclusion emerging from most such research is that
differences in accounting principles, possibly associated with other institutional factors, lead to international variation in the relevance (or "quality")
of financial statement numbers for stock market investors.

A small number of recent studies directly examine attributes of financial statement quality in an international comparative setting. Ball, Kothari,

and Robin [2000], Ball, Robin, and Wu [2002], and Fan and Wong [2001]
document significant international variation in the degree of asymmetric
timeliness of earnings with respect to bad news and good news. They explain these differences with reference to institutional features of the finan-

cial reporting environment. Leuz, Nanda, and Wysocki [2001] document

significant variation in earnings management across 31 countries and show
that earnings management decreases with the degree of investor protection
provided by a country's institutional and legal framework. As discussed later,

both asymmetric timeliness of earnings and earnings management are potentially important in explaining the ability of stock market participants to
forecast earnings.
Basu, Huang, and Jan [1998] (hereafter, BHJ) study a further aspect of
comparative international accounting differences. They document significant country-level differences in earnings volatility and predictability. They
associate these differences with variation in accounting principles, including the extent of accrual accounting, the extent of the use of historical cost
versus market or fair value accounting, and the degree of accounting choice.
BHJ also consider the influence of country-level disclosure differences on
earnings variability and predictability.
Hope's study of the determinants of forecast accuracy is most closely related to BHJ's study. It is similar in that both studies employ the accuracy
of analysts' earnings forecasts as a criterion for comparing accounting systems. It differs from BHJ in that the analysis of disclosure effects is at the
firm level and because it considers the relation between forecast accuracy
and enforcement, based on both country-level and firm-level information.
To my knowledge, prior empirical research has not attempted to examine
directly the effects of enforcement differences on the usefulness of financial
statements.

Hope reports evidence that the accuracy of earnings forecasts is positively

associated with the level of annual report disclosure, consistent with the
country-level analysis in BHJ. Also, the positive association between forecast accuracy and disclosure is more pronounced when analyst following is
low. With regard to enforcement, Hope shows that the forecast accuracy is

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DISCLOSURE PRACTICES 275

positively associated with enforcement, especially when the estimated degree of accounting choice available in a country is high.
Hope's study represents a very significant research effort. It has required
the collection and consolidation of data from a wide number of electronic

and hard-copy sources. The author has also invested considerable effort in
developing a quantitative index of enforcement, in validating the disclosure index, and in examining the robustness of results to alternative measurement definitions. Much of the conference discussion focused on the

measurement properties of the disclosure and enforcement indexes used

by Hope.
With regard to the CIFAR disclosure index, there are two main issues
to bear in mind. First, sample selection is constrained by CIFAR coverage,
is confined to two years, and is skewed toward the larger industrial firms
within each country and toward industrialized countries with developed
stock markets. The United States, Japan, and the United Kingdom account
for, respectively, 32%, 12%, and 9% of the sample observations. Thus, the
generalizability of results reported in the study needs to be qualified. Second, in common with most other disclosure studies, the disclosure index

captures variation in disclosure levels (or volume). It scores disclosure of

the items listed in the Appendix and arbitrarily (equally) weights scores on
individual items. The resulting index is a measure of the "size" of annual
report disclosures, one dimension determining the "richness" of the information environment within which earnings forecasts are generated. It does
not provide a direct measure of the "quality" or relevance of disclosures for
informing forecasts of earnings. Hope is well aware of this issue and is careful to avoid use of the term "disclosure quality." It would be interesting to see

future work examining disclosure quality from the perspective of analysts

attempting to forecast earnings. Such work would need to consider why the

existence of various disclosure items could be expected to enhance forecasting ability. Some of the disclosure items affecting CIFAR scores might
well be considered irrelevant in this context (e.g., frequency of dividend
payments, board members, and affiliations).
There was also interest during conference discussion in the enforcement
measure used in the study. Hope argues that enforcement of accounting
standards will reduce accounting uncertainty and accounting fraud, thus
making forecasting easier. The country-level enforcement measure employed by Hope aggregates information on five main aspects of the regulatory environment surrounding financial reporting using factor analysis:
audit spending, insider trading regulation, judicial efficiency, rule of law,
and antidirector rights. The alternative measure uses firm-specific data on
stock exchange listings and audit firm type in place of audit spending. Hope
accepts that interpretation of the enforcement measures is controversial. In
relation to the components of the country-level enforcement measure, audit

spending will be positively associated enforcement of accounting standards

to the extent that it proxies for audit quality, as distinct from the risks or
costs of audits. The other factors entering the enforcement index primarily

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276 P. F. POPE

reflect the general constraints placed on actions by managers (and other

citizens) through the legal system and the general level of tolerance toward opportunistic behavior by managers. Therefore, they are potentially
associated with the incentives of managers to manipulate financial reporting information. However, it is unclear to what degree the enforcement
measures used in the study actually capture the extent of enforcement of
accounting standards. Therefore, interpretation of the empirical results re-

lating to enforcement must be considered ambiguous as far as the links to

enforcement of accounting standards is concerned.
The published version of the paper addresses several issues from the conference discussion and, in particular, clarifies details of the methods used to

estimate the enforcement index. It also includes various checks indicating

that the main results are statistically robust-the accuracy of analysts' forecasts is associated with the firm-level variation in disclosure levels and with

the enforcement measures developed in the study. But what lessons can
we take away from these results, particularly with regard to international
accounting differences? In the remainder of this discussion I first reflect
on some issues raised by Hope's analysis for modeling forecast quality in
an international context with cross-country accounting differences. A key
question is how accounting differences affect the predictability of earnings.

Second, I provide a brief discussion on the relevance of earnings forecast

accuracy as a criterion for evaluating international accounting differences.

2. Forecast Quality and Accounting Differences

2.1 FUNDAMENTAL DETERMINANTS OF FORECAST QUALITY
Assume for the moment that we agree that the quality of analysts' earnings

forecasts is a relevant criterion for comparing accounting systems. Hope

studies differences in a subset of the defining characteristics of a financial

reporting environment and their links with analyst forecast accuracy. The
study is not based on a well-specified model of the determinants of forecast

accuracy in an international comparative setting-to my knowledge, the

literature to date has not provided such a model to guide empirical research.
An intuitive model of forecast quality might be sketched out as follows:
Forecast quality = f(Information, Predictability, Skill, Incentives)

Prior research in accounting and finance examines three main dimensions of forecast quality: accuracy, bias, and efficiency. The explanatory
variables in this model are potentially related to each quality dimension.
Predictability captures fundamental characteristics of uncertainty in the out-

comes being forecasted. Information captures the extent and quality of inputs to the forecasting model being used in prediction. Skill refers to the
forecaster's ability to design and implement a forecasting model. Finally,
Incentives reflects individual forecasters' choices over the level of effort

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DISCLOSURE PRACTICES 277

expended in forecasting.' It also reflects the potential influence that analysts' loss functions might have on the decision on the exact point forecast
to issue, given that ex ante earnings distributions might be asymmetric (Gu

and Wu [2000]).
The "dependent variable," forecast quality, is multi-dimensional. Prior an-

alyst forecast research has considered primarily forecast bias, accuracy and
efficiency, i.e. dependence of forecast errors on other information. Hope
elects to study accuracy, defined as the scaled absolute value of forecast
errors. The choice of the attribute of forecast quality to study raises important issues concerning the objective functions of the potential users of
research such as Hope's. Different research users might well be interested
in different attributes of forecasts and forecast errors. For example, regulators might be interested in the likelihood of investors experiencing large
negative shocks. Thus forecast quality cannot be defined or measured independently of characteristics of predictability, nor of the incentives of the

consumers of research. This would be true even in a highly stylized world,

where predictability can be characterized by normally distributed forecast
errors.2 However, as Gu and Wu [2000] illustrate, accounting principles lead
to the real world being far from this stylized world. Earnings are typically
left-skewed, as a result of conservative accounting principles, and this affects

the distributional properties of forecast errors. The challenge of defining

forecast quality then increases substantially. To undertake a comprehensive
analysis of forecast quality we will also need to articulate the importance
of higher moments (e.g. skewness) of the distribution of forecast errors to
research consumers.3

The relations between selected forecast quality metrics and the right-hand

side variables will potentially involve complex interactions among accounting principles, the legal and regulatory institutions surrounding accounting
standard setting, and stock markets and economic incentives. Empirical researchers, including Hope, must make compromises trading off empirical
model completeness and research cost and feasibility. I interpret Hope's
empirical tests as focusing on two potentially complementary determinants
of predictability-that is, enforcement and accounting choice-and two elements of the information environment-that is, annual report disclosure
level and analyst following. Hope includes as controls other potential correlates of predictability such as prior-year losses, the magnitude of prior-year

earnings change, and, less convincing in my view, governance-related variables from La Porta et al. [1997] such as the importance of the stock market

and a legal system indicator variable. He does not attempt to incorporate

1 See Kothari [2001] for a compact review of the literature on analysts' forecasts.
2 In this case one would need to evaluate forecast quality in terms of two dimensions: bias

(mean) and accuracy (variance); and evaluation of forecast quality would still be conditional
on the research user's loss function, specifying the rate of trade-off between bias and accuracy.
3 Defining predictability itself also becomes problematic (e.g. mean v. median, standard deviation v. skewness), as does controlling for analysts' incentives (e.g. are analysts' compensated
asymmetrically based on the sign and magnitude of forecast errors?).

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278 P. F. POPE

into his model controls for other aspects of the information environment,
such as other forms of information disclosure and differences in skill and

analysts' incentives, except to the extent that such differences are captured
by country-level or industry indicator variables. Choices to omit potentially
relevant variables, perhaps because they are difficult to measure, may be innocuous, but they could also lead to well-known inference problems. Specifically, we will not know whether a variable found to be a significant determinant of forecast quality simply acts as a proxy for another relevant variable

excluded from the analysis. My main concern with Hope's analysis is that
it gives insufficient attention to the effects of international differences in

accounting principles and how such differences are related both to forecast
accuracy and to variables included in the analysis.
2.2 EARNINGS PREDICTABILITY AND INTERNATIONAL
ACCOUNTING DIFFERENCES

Forecast accuracy depends on the inherent predictability of the construct

being forecasted. Evidence from earnings forecasting research confirms that
earnings forecast errors depend on firm-level variation in the predictability

of earnings (Das, Levine, and Sivaramakrishnan [1998]). The predictability

of earnings depends on the fundamental uncertainty of economic events
affecting cash flows and on the accounting recognition rules underpinning

accruals.4

Differences in economic uncertainty are potentially large and likely

to vary over time, between countries and within countries. For exam-

ple, as of December 1992 the historical standard deviation of local

currency-denominated stock returns for Hope's sample countries ranged
from 11.2 for Canada to 25.8 for Norway, suggesting significant differences

in the level of fundamental economic uncertainty across countries.5 Crosssectional variation in the dispersion of earnings across countries is also large
(BHJ [1998, table 4]). Volatility does not necessarily imply lack of predictabil-

ity of earnings. However, it seems reasonable to assume that the inherent

predictability of earnings does vary across countries, partly as a result of
differences in economic uncertainty. Hope includes industry indicator vari-

ables in all ordinary least squares (OLS) models and country indicator variables in one OLS specification (table 4, model 4), where they appear to
be jointly significant. This industry/country effects approach captures two

main drivers of unobservable economic uncertainty, but not firm-specific

uncertainty.

Differences in the predictability of earnings could also be attributable to

differences in recognition rules. To use an analogy, point-spread forecasts
for American football game outcomes might appear to be less accurate than
4 Cross sectional variation in earnings predictability will also depend on differences on
preparers' incentives to exercise accounting choices available within a given set of recognition
rules.

5 Estimates of stock return volatility are obtained from Quantec Quarterly, December 1992.

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DISCLOSURE PRACTICES 279

for soccer games because more points are usually scored in football than
goals are scored in soccer. We need to control for differences in the rules
if we are to make informed comparisons of the quality of punters' forecasts

relating to different sports. Similarly, if earnings numbers are measured

under different rules, we need to understand the effects of accounting rules

on earnings predictability and control for such differences when modeling

forecast accuracy. Variation in the degree of enforcement of the rules may
also be important in determining forecast accuracy, but may not be the main
factor influencing predictability.
There are two primary dimensions of accounting systems that affect the
predictability of earnings, holding economic uncertainty constant: accruals
measurement rules and the degree of disclosure. Hope controls for disclosure differences but not for differences in recognition rules. Accruals procedures can both enhance and reduce the predictability of earnings and their
components. Accruals based on the realization and matching principles reduce the variance of earnings relative to cash flows (Dechow [1994]) and
create more permanent, predictable earnings components (e.g., depreciation and amortization). If an accounting regime permits managers choice
over accounting policies, it may be in their interests to voluntarily select
accounting measurement rules that lead to the most informative measures
of current and future performance (Watts and Zimmerman [1986, 1990]),
thereby enhancing earnings predictability. In contrast, accruals procedures
may also reduce the predictability of earnings when they reflect (unanticipated) changes in market values of assets or liabilities. As discussed further later, application of the conservatism principle leads to an asymmetric
trade-off between application of the realization principle and accruals designed to capture market value changes. Additionally, accounting choice and
flexibility might reduce earnings predictability, depending on managers'
incentives to manage earnings through transitory and potentially difficultto-observe abnormal accruals. Hope adopts this perspective in relation to
the role of accounting choice in hypothesis 3.

Evidence that variation in accruals procedures affects earnings predictability is reported by BHJ [1998] and suggests that accounting measure-

ment differences could be important in understanding the roles of disclosure and enforcement in the accounting environment. For example, Alford
et al. [1993] report international differences in earnings timeliness. When
earnings are relatively untimely, the market will likely demand greater disclosure of information about current economic performance that will even-

tually show up in earnings. Hope does not attempt to control for variation
in accounting recognition rules in testing hypothesis 1-the cost of developing firm-level measures of recognition rules would surely be prohibitive.6
Thus, the finding that forecast accuracy is positively related to disclosure may
6 The average effects of cross-country variation in accounting measurement rules will be
captured by the country indicator variables in model 4 of table 4. But the other models in
tables 4 and 5 do not contain country-level controls.

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280 P. F. POPE

reflect pure information effects, or it may proxy for underlying differences

in the timeliness of earnings.
Similarly, enforcement might interact with accounting system characteristics. Again, lack of control for accounting differences prevents us from fully

understanding the origin of the positive relation between accuracy and enforcement in tests of hypothesis 2. However, the test of hypothesis 4 does
provide an indication that interaction between enforcement and accounting characteristics is important. The test of hypothesis 4 (table 5, model
2) reveals that forecast accuracy is negatively related to BHJ's [1998] index
of accounting choice. It is interesting that this result conflicts with BHJ's
own findings, but they do not control for enforcement. Hope also finds
that the association between enforcement and accuracy is largely due to
the interaction between enforcement and choice. Bearing in mind that the
properties and interpretation of the accounting choice index are unclear
(O'Brien [1998]), and that accounting choice is only one potentially relevant accounting dimension, it would be interesting to see future research
consider possible links between a broader set of accounting properties and
both disclosure and enforcement.

What accounting properties might be of relevance in developing a better understanding of earnings forecast accuracy? Apart from accounting
choice, BHJ [1998] suggest links between forecast accuracy and accounting
systems' use of market value accounting and of accruals. They construct
self-scored rankings of accounting systems based on these three accounting
dimensions. However, the subjectivity and ad hoc nature of the weighting of

individual accounting items in this approach is easy to criticize and leads to

difficulties in interpretation of results (see O'Brien [1998]). O'Brien [1998]
also suggests that further work might consider choices made by managers in
implementing given accounting methods (e.g., selection of asset lives). An
alternative, and possibly more profitable, line of enquiry could be to attempt
to control directly for known attributes associated with earnings predictability when testing for the marginal effects of variables such as disclosure and
enforcement. Obvious possibilities include the lack of timeliness of earnings
and asymmetric timeliness of earnings (or income statement conservatism).
Lack of timeliness is one property of the earnings-price relationship that
results from differences in accounting rules. Kothari and Sloan [1992],
Collins et al. [1994], and others show that earnings are not timely--prices
lead earnings in the United States by up to three years. Comparable international evidence is not extensive but suggests some differences in the
ability of the market to anticipate earnings (Alford et al. [1993]). The evidence that market prices lead earnings recognition is relevant to studies
such as Hope's, and he recognizes this in his discussion of the control variables. When prices lead earnings the market receives information before
it is recognized in earnings. Disclosure of forecasting-relevant information
by firms will be an important determinant of the degree to which earnings
are anticipated. Hope's evidence that the annual report disclosure level is
positively associated with forecast accuracy is consistent with high levels of

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DISCLOSURE PRACTICES 281

disclosure being demanded when earnings are less timely. It is not simply
the level of disclosure, but the timing and content of disclosures relative
to the timing of income recognition that will determine the link between
forecast accuracy and disclosure. Thus, caution needs to be exercised in interpreting Hope's results. It might be income-recognition rules that causally
determine disclosure levels and, hence, are the more fundamental determinant of predictability and forecast accuracy.

Research also shows that earnings timeliness is asymmetric--earnings

have higher timeliness with respect to bad news than with respect to good
news (Basu [1997]). The main consequence is that negative earnings shocks
are higher and more transitory relative to positive earnings shocks. International evidence reveals that the degree of asymmetric timeliness varies
across countries (Ball, Kothari, and Robin [2000]). This evidence is potentially important in modeling the accuracy of analysts' forecasts for at least
three reasons. First, the sign and/or magnitude of analysts' forecast errors
will likely depend on whether bad or good news has arrived between forecast formation and earnings report (Helbock and Walker [2002]). Hope's
study is based on just two years data, and therefore it is possible that clustering of good or bad news in some countries could influence the results.
Second, if negative earnings shocks are costly, firms with bad news might
attempt to manage (or "walk down") analysts' expectations through disclosures made at analysts' meetings and through stock exchange and newswire
announcements (Richardson et al. [2002]). This suggests the potential importance of disclosure mechanisms other than the annual report in conditioning earnings expectations, especially in countries where analysts' forecasts are important to managers (e.g. because of capital market pressures).
Third, Ball, Kothari, and Robin [2000] link international differences in
asymmetric timeliness to institutional differences. Specifically, they find that

income recognition is more conservative in common law countries than in

code law countries. Because Hope's enforcement measure depends in part
on the legal system, it seems likely that it is correlated with an important
dimension of accounting measurement. Whether enforcement per se is fundamental to forecast accuracy or whether it is important because it correlates
with differences in recognition rules must be, at present, an open question.

3. What Can We Learn from Studying Earnings Forecast Accuracy?

It is now widely understood that accounting has emerged endogenously
in different national environments, surrounded by different institutional
structures and designed to serve different purposes and different users.7
Specifically, the balance between debt and equity financing and the relative importance of large institutional investors in corporate financing will
produce demands for accounting information with different properties and

may explain differences in accounting principles, disclosure patterns, and

7 See O'Brien [1998, p. 1253] for a more extensive discussion of these issues.

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282 P. F. POPE

enforcement mechanisms. Where accounting is oriented toward creditors

(or some other nonequity user group), one can question the relevance of
the quality of analyst forecasts as an object of study.
It has long been recognized that it is impossible to arrive at useful rankings

of accounting systems by evaluating the decision usefulness of accounting

alternatives for one user group alone (e.g., Gonedes and Dopuch [1974]).
For example, lower forecast accuracy might be the price paid for providing

more relevant accounting numbers to creditors through application of conservative accounting principles. Similarly, lower disclosure might emerge
in equilibrium in an economy dominated by insider equity financing and
private lending agreements because proprietary information costs will be
avoided, even though analysts' forecasts will be less accurate. Thus, it is important to be aware of the limits on what we can learn from studying a single
user group. We can learn about the determinants of the "performance" of
analysts across different environments. But we cannot judge whether one
system of financial reporting is preferable to another, except perhaps from
the perspective of the user group being studied. Future research might
attempt to examine for evidence of trade-offs between accounting system
properties across countries where the importance of analysts as information
intermediaries is lower.

4. Conclusions

The development of empirical accounting research resembles the development of scientific thought in other disciplines. Theory development tends to be at least partially inductive, relying on feedback from
empirical research. This often causes empirical research to appear incomplete in retrospect. Research such as Hope's is forced to make compromises
in the interests of analytical tractability and model parsimony. The need to

limit the scope of the analysis leaves some potentially interesting questions
unanswered and results in the need to qualify some of the inferences drawn
from the results, a point acknowledged by Hope in his conclusions. I suspect
that with hindsight our understanding of the determinants of properties of

stock market analysts' expectations will improve as the findings of studies

such as Hope's are combined to produce richer conceptual and empirical
models. Whether future generations of researchers will recognize enforcement and disclosure as fundamental determinants of the usefulness of an

accounting regime, or as complements to recognition rules operating in

different accounting regimes, is unclear at this stage.
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