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Brookings-Wharton Papers on Financial Services 2001 (2001) 170-178



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Comment and Discussion

[ Infrastructure Requirements for an Economically Efficient
System of Public Financial Reporting and Disclosure]

Comment by Christian Leuz: In his paper, Ray Ball outlines infrastructure requirements for an efficient accounting and disclosure regime. He emphasizes that the accounting and disclosure system is embedded in the country's institutional infrastructure. That is, the existing infrastructure determines the demand for accounting and disclosure, which in turn determines the properties of the optimal accounting and disclosure system. In this sense, accounting and disclosure are endogenous and complementary elements of the country's economic, legal, and political infrastructure.

The complementarities among the different components of a country's infrastructure imply that isolated changes in the accounting and disclosure system (for example, adopting international accounting standards) are unlikely to be effective. Concurrent modifications of the complementary elements are necessary to change the accounting and disclosure practices of firms. Therefore, the suggested infrastructure requirements for an efficient accounting and disclosure system are necessarily extensive. They comprise essentially the entire economic, legal, and political framework and pertain, in particular, to corporate governance, ownership and financing structures, legal enforcement, litigation rights, and shareholder and bondholder rights. The paper discusses several empirical studies presenting evidence from European and Asian countries that supports these arguments.

With respect to accounting and disclosure, Ball highlights two characteristics of an efficient financial reporting system: verifiability and asymmetry. Verifiability implies that financial reporting is based on transactions and events that are ex post observable by independent third parties (for example, auditors and courts) and not based on managers' expectations or [End Page 170] beliefs. Ball argues that disclosure of ex post financial information holds managers accountable and generates ex ante positive externalities for their decisions and voluntary disclosures.

Asymmetry implies that economic losses (but not gains) are reported in a timely fashion. Ball argues that asymmetry improves corporate governance and debt contracting. The timely recognition of economic losses requires adverse information about future cash flows, which typically resides with managers and is based on expectations. Thus asymmetry in financial reporting relies on nonverifiable information, which is a significant modification of the verifiability requirement. Ball points out that exposure to litigation (for not disclosing material information) is a way to enforce the timely recognition of economic losses and to make disclosures of nonverifiable information credible. He therefore argues that litigation is an essential requirement for an efficient disclosure system.

In summary, the paper is most insightful. It has several important messages for standard setters, regulators, and politicians contemplating changing their country's accounting and disclosure system. In highlighting the links between various elements of the infrastructure, Ball warns us about the difficulty and complexity of changing firms' accounting and disclosure practices. He also points out that the policy debate may have focused too narrowly on accounting standards, thereby overlooking the importance of supporting institutions in other parts of a country's infrastructure.

The remainder of this discussion reinforces some of the arguments that I find particularly important. It highlights the underlying premises of these arguments and draws attention to some unresolved questions and areas for future research.

Verifiability and the Trade-off between Relevance and Reliability

The first criterion heavily emphasizes the need for audited financial information to be independent of managers' expectations and hence manipulation. Although I agree with Ball's assessment in general, there are only very few instances where we can record a transaction without any implicit assumptions about the future. When recognizing sales on account as revenue, we assume that customers eventually will pay the firm. And when recording the purchase of an asset at its acquisition costs, we implicitly presume that the investment will generate future cash flows sufficient to justify those costs--otherwise we would have to recognize a loss at the [End Page 171] acquisition. Thus even in areas, like revenue recognition, where the transactions themselves seem easily verifiable, accounting measurement relies on expectations about the future and hence requires information that these assumptions are warranted. As this information generally resides with managers, accounting measurement is always based to some...

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