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Discussion of The effect on nancial reporting

quality of an exemption from the SEC reporting
requirements for foreign private issuers
Yuan Ding
China Europe International Business School (CEIBS), 699 Hongfeng Road, 201206 Shanghai, PR China
Received 2 August 2010
1. Introduction
According to U.S. regulation, foreign companies listed in United States are subject to
registration under Section 12(g) of the 1934 Securities Exchange Act and are required to
fulfill certain filings with SEC (including the annual document 20-F). However, foreign
firms can request an exemption from filing 20-F with SEC if they prove that they have
only a marginal presence in the U.S. market
. They may maintain this exemption afterward
regardless the change of their size and presence in U.S. market, if they keep submitting the
required non-U.S. disclosure documents.
In this article, Gotti and Mastrolia explore this unique institutional setting and compare
the financial reporting quality between foreign issuers registered with the SEC (hereafter
named disclosing firms) and foreign issuers exempt from filing (hereafter named exempt
firms). Using three different proxies of quality (conservatism, abnormal accruals and
predictability of earnings), the article finds that exempt firms have consistently lower
financial reporting quality in comparison with disclosing firms. Authors believe that
this study is particularly timely as the SEC is considering expanding availability of the
exemption, and our results indicate that a Rule 12g3-2(b) exemption is associated with
lower financial reporting quality (p. 4).
E-mail address: dyuan@ceibs.edu.
If they have total assets of less than $10 million, more than 500 owners worldwide and less than 300 owners in
the United States.
0020-7063/$ - see front matter 2011 University of Illinois. All rights reserved.
Available online at www.sciencedirect.com
The International Journal of Accounting
47 (2012) 7275
The triangulation among firm disclosure, financial reporting quality and external
monitoring is a fundamental issue in accounting research. The current study contributes
significantly to the literature on this issue, despite the reservations and comments I have
formulate. My discussion will start with the theory contribution and hypothesis development
in the paper (Section 2) followed by an analysis on the sample selection and measurement
issues (Section 3). It then covers some minor issues (Section 4) before the conclusion
(Section 5).
2. Theory contribution and hypothesis development
In the current version, the authors still need to clarify several important issues.
The article cites abundantly works from cross-listing literature and argues that it contributes
to this literature. However, I do not think this study belongs to the research strand on cross-
listing. First, in most studies the authors cite, comparisons are made between cross-listed
firms and their counterparts only listed in home market, or between cross-listed firms and
their counterparts listed in the target (often more developed) market. This study is about
none of these markets; because the whole sample is foreign companies listed in the U.S., it
has no possible variations in order to formulate hypotheses based on previous cross-listing
literature. Additionally, I am not sure that the foreign firms included in this study are cross-
listed or not. Some of them are simultaneously listed in their home market and in the U.S.
market and are thus cross-listed. Many others (from ANT, BMU or CYM, for example) are
companies listed in U.S. market only (some of them are even U.S. companies registered
offshore for fiscal reasons, like WorldComin Bermuda). Therefore, the article has the problem
of having irrelevance in the literature review and thus having a lack of theoretical supports for
the hypothesis development.
Using the current research design, the authors are interested in the triangulation of
relationship among firm disclosure, financial reporting quality and external monitoring.
In order to develop their hypothesis properly, they should find and add the following
1) Why do some firms opt to a lower level of disclosure?
2) Is a poorer disclosure level associated with lower financial reporting quality?
3) Do firms choosing a lower level of disclosure have also lower financial reporting
4) Does a looser external requirement for disclosure result into a lower financial reporting
quality of the firm?
Fixing these missing points is also crucial for justifying the implications of the current
study for practitioners and policy-makers. On page 28, the authors argue, [T]hese results
should be of interest to investors and regulators as they may indicate that a Rule 12g3-2(b)
exemption may not be in the best interest of U.S. shareholders. This study is very timely as
the SEC is currently considering expanding the availability of the exemption to more
foreign private issuers, which this study indicates, may result in lower financial reporting
quality. I am not convinced by these arguments for several reasons. First, the nature of
the above-mentioned exemption is completely different from the one studied, because
73 Discussion
the former is an action the regular takes while the latter is an option the firm picks. In the
current study, one question remains unanswered: do the exempt firms have low financial
reporting quality because only firms with low financial reporting quality ask for the
exemption, or because they enjoy less restrictive disclosure requirements after obtaining
the exemption? If the former, then the generalization of disclosure exemption to all non-
U.S. issuers will not change their financial reporting quality. Moreover, I am not convinced
by the argument that the exemption may not be in the best interest of U.S. shareholders,
because from the current study, we cannot tell if the exemption has negative consequences
on these firms, like a higher risk of bankruptcy or of delisting, lower market or accounting
performance, etc. The descriptive statistics are showing more or less the opposite. We do
not know if U.S. investors either see through this accounting opacity or even punish
these exempt firms with lower stock prices (the authors mention that they study this
issue in another working paper).
3. Sample selection and measurement issues
Regarding the sample selection, I also note a couple of debatable issues.
By reading the text, we may feel that the exemption is not a free choice for every foreign
issuer. On page 7, authors write, The exemption under the rule is not available to
companies that are subject to the periodic reporting requirements or have been subject to
those requirements in the past 18 months, to companies that have acquired another
company (U.S. or non-U.S.) that was subject to the periodic reporting requirements, to
companies with securities listed on a U.S. stock exchange or quoted in NASDAQ, or to
Canadian companies. Additionally, companies may not meet the three criteria when
they are listed in the U.S. market. For all these firms, the exemption is never an option
and so should be excluded from the studied sample (at least as a robustness test).
Furthermore, on page 56, we read that exempt firms shares are exchanged over-the-
counter through the Pink Sheets. If exempt firms and disclosing firms are listed in
different markets in the U.S., the difference in financial reporting quality we observe
might just be a variation among firms listed in different markets.
As I mentioned previously, the firm chooses the exemption. We do not know if these
exempt firms choose to be in low financial reporting quality or if they have low financial
reporting quality because of the exemption (and so the low regulation pressure on their
disclosure). Because some companies are both exempt and file with SEC (see p. 36)
over the sample period, it might be a stronger test to study these firms switching from
exempt to disclosing (from disclosing to exempt) and to see if their financial reporting
quality improves (deteriorates).
From the Table 1 on page 36, we see the country distribution between exempt firms and
disclosing firms varies significantly. Some countries like Bermuda, Canada, or Japan,
might drive the results. The authors should test that as robustness check.
I also have some concerns with the three proxies of financial reporting quality. Because
exempt firms do not prepare 20F and so do not provide financial numbers based on U.S.
GAAP while disclosing firms do. These major differences among accounting standards
might impact not only accounting numbers like net income used for measuring
74 Discussion
conservatism, but also might change the flexibility regarding different manipulations of
accrual items.
Moreover, it is problematic to compare the predictability of earnings among different
industry and various countries, because the measure is strongly influenced by the industry,
the dynamism of the business environment, etc.
4. Minor issues
It would be helpful if authors provided a comparative table on the required documents
for exempt firms and for disclosing firms. The current explanation in the text is difficult to
On page 27, authors write, in this paper, we use a unique sample of foreign private
issuers that are exempt from filing with the SEC, in order to test whether reporting to
the SEC is associated with improved financial reporting quality. The improved financial
reporting quality is an over-stated claim because this paper is only discusses the level test
but not the change test.
On page 36, authors write, we exclude companies that over the sample period have
been both exempt and filing with the SEC. This statement contradicts the statement on
the following page: All companies includes not only companies that are exempt or filing
with the SEC for at least one year between 2000 and 2006, but also companies that
switched at least once from exempt to SEC filing (or vice versa) over the sample period.
5. Conclusion
The above-mentioned shortcomings cannot take away the article's quality. It is well
written and easy to follow. More importantly, it discusses a germane issue in U.S., that is:
1. How could U.S. capital market improve its attractiveness vis--vis des foreign issuers?
2. Does the ease of disclosure requirement of these foreign issuers reduce the quality of
financial reporting?
The paper certainly contributes constructively to this debate.
75 Discussion