Abstract
We examine the relation between four dimensions of national culture and earnings quality of banks using a sample of banks from 39 countries. Our main analysis, which focuses on the pre-financial crisis period 1993–2006, indicates that banks in high individualism, high masculinity, and low uncertainty avoidance societies manage earnings to just-meet-or-beat the prior year's earnings. In tests of income smoothing through loan loss provisions, we find that banks in high individualism, high power distance, and low uncertainty avoidance societies report smoother earnings. Our exploratory analysis of the effects of national culture on accounting outcomes during the financial crisis period 2007–2008 indicates that cultures that encourage higher risk-taking experienced more bank troubles in the form of larger losses or larger loan loss provisions.
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Notes
There are several other advantages of focusing on the banking industry. In particular, our study mitigates error in measuring managerial discretion by focusing on a single accrual in a single industry. Focusing on a single accrual facilitates a sharper separation into its normal (nondiscretionary) and abnormal (discretionary) components. We use a number of industry-specific variables to better isolate the normal loan loss provisions (LLP) from the abnormal LLP. Also, focusing on a single, relatively homogeneous industry provides control over other determinants of cross-sectional differences in accruals, thus increasing the reliability of the inferences from our empirical analysis.
In our tests, we control for country fixed effects, bank-specific monitoring variables, and country-specific institutional variables whose influence on earnings management has been documented in the prior literature (e.g., Fonseca & Gonzalez, 2008; Han et al., 2010; Leuz et al., 2003).
Gray (1988) identifies the mapping between the four societal values identified by Hofstede (1980) and the following four selected accounting values: professionalism vs statutory control, uniformity vs flexibility, conservatism vs optimism, and secrecy vs transparency.
Please see Han et al. (2010: 125–126) for a more complete discussion of how Gray's (1988) predictions relate to expectations on earnings management.
Regulations mirroring the Sarbanes–Oxley Act have been introduced in several other countries including Australia, Canada, Singapore, and the UK, to name a few.
A recent survey of managers by Graham, Harvey, and Rajgopal (2005) finds that meeting or beating the prior period's earnings is one of the most important benchmarks for corporate managers.
The correlations for some variables are very high. For example, the correlation between INVPRO and LGDP is 0.91. This high correlation may induce a multicollinearity problem in our analysis. However, this problem is mitigated because we also use country-level controls for the country-wide fixed effects. Our results yield similar inferences when we use controls for country fixed effects or country-level institutional variables, further strengthening the reliability of our tests.
We note that IND is highly correlated with PD (ρ=−0.648) and with UAI (ρ=−0.299). Given these high levels of correlation among the independent variables of interest, we also estimate models (1a) and (1b) separately for each individual dimension of culture. In addition, we examine the variance inflation factors (VIFs) to check for multicollinearity in the full regressions that include all four cultural dimensions. We find that the VIFs are low, indicating that multicollinearity is not a major issue in these regressions.
We also use the anti-self-dealing index from Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2008) and an indicator variable for legal origin (common vs code law) as alternative proxies for investor protection. The results are similar.
These variables have also been used in several prior studies (e.g., Kanagaretnam et al., 2004; Kanagaretnam, Krishnan, & Lobo, 2010a; Wahlen, 1994) to estimate the normal component of LLP.
The inclusion of EBTP and its interaction with various cultural factors may introduce multicollinearity among the interaction terms. We mean-center the culture variables to mitigate this concern (Aiken & West, 1991; Neter, Wasserman, & Kutner, 1989).
It is generally accepted that the recent financial crisis in the US and UK started in 2007 (Ryan, 2008). However, the financial crisis spread to other countries in 2008 (Laeven & Valencia, 2010).
A total of 39 countries are available for the just-meet-or-beat test and 35 countries for the smoothing test. Some countries (e.g., Malaysia) have data for the just-meet-or-beat test but not for the smoothing test, because of missing information on capital ratio, nonperforming loans, etc.
We delete the top and bottom 1% of each of the continuous control variables used in regression models (1) and (2) to remove extreme values. The results are robust if we winsorize (rather than delete) the extreme values. The majority of the banks in our sample (over 64% for the just-meet-or-beat test and over 76% for smoothing test) are commercial banks. The results are similar when we run our tests for the subsample of commercial banks.
The coverage in BankScope is more complete from year 2000 and later. Our results are robust to excluding years 1993–1999.
The marginal effect per standard deviation (SD) change for a cultural variable is computed as p × (1−p) × β × SD, where p is the base rate (0.11) and β is the estimated coefficient from the logistic regression (Liao, 1994).
This line of reasoning is consistent with the prior literature. For example, Ball, Robin, and Wu (2003), Watts (2003), and Ball and Shivakumar (2005) argue that timely reporting of economic losses facilitates monitoring of managerial and debt contracts, increases the economic efficiency of firms’ contracting with both managers and debt holders, and improves investment efficiency and profitability. Ahmed and Duellman (2007) examine a sample of US firms and show that firms with more conservative earnings have higher future profitability and lower likelihood (and magnitude) of future special items charges.
Specifically, a country is considered to be developing if its equity market is not included in the Morgan Stanley Capital International database. Based on this definition, the following 19 economies are considered as developed: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Singapore, Spain, Switzerland, the UK, and the US.
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Acknowledgements
We thank Robert Mathieu, Amin Mawani, Tharinda Ranasinghe, Lee Radebaugh (the editor), and the three anonymous reviewers for their valuable comments. Kanagaretnam and Lobo thank the Social Sciences and Humanities Research Council of Canada (SSHRC) for its financial support. Kanagaretnam also thanks the Certified Management Accountants (CMA) of Ontario for their financial support.
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Accepted by Lee Radebaugh, Area Editor, 28 April 2011. This paper has been with the authors for two revisions.
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Kanagaretnam, K., Lim, C. & Lobo, G. Effects of national culture on earnings quality of banks. J Int Bus Stud 42, 853–874 (2011). https://doi.org/10.1057/jibs.2011.26
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DOI: https://doi.org/10.1057/jibs.2011.26