Uncertainty, Financial Reporting Quality and Accounting Enforcement: Evidence from The European Union

Mos, Catalin Article Uncertainty, Financial Reporting Quality and Accounting Enforcement: Evidence from The European Union Journal of Accounting and Management Information Systems (JAMIS) Provided in Cooperation with: The Bucharest University of Economic Studies Suggested Citation: Mos, Catalin (2024) : Uncertainty, Financial Reporting Quality and Accounting Enforcement: Evidence from The European Union, Journal of Accounting and Management Information Systems (JAMIS), ISSN 2559-6004, Bucharest University of Economic Studies, Bucharest, Vol. 23, Iss. 3, pp. 616-642, https://doi.org/10.24818/jamis.2024.03008 This Version is available at: https://hdl.handle.net/10419/310907 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ Accounting and Management Information Systems Vol. 23, No. 3, pp. 616-642, 2024 DOI: http://dx.doi.org/10.24818/jamis.2024.03008 Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union Catalin Mos1,a aFaculty of Economics and Business Administration, Babes-Bolyai University, Romania Abstract Research Question: What is the impact of uncertainty on the quality of financial reporting in the European Union and whether accounting enforcement is a critical factor? Motivation: The advances made by the European Union (EU) in the field of financial reporting have shown the commitment to improve its quality. However, uncertainty creates a difficult context for capital markets, investors, and management. Since financial reporting represents the primary source of information for investors, its quality under uncertainty is a key topic of research. Furthermore, considering the EU efforts to strengthen accounting enforcement, it is fundamental to investigate whether accounting enforcement acts as a moderating factor between uncertainty and financial reporting quality. Idea: Our study investigates the effects of uncertainty on the quality of financial reporting in the European Union and the role of accounting enforcement. Data: The sample consists of 35,489 firm-year observations from the 27 EU countries. The sample does not include firms from the finance industry, as they are subject to specific regulations and oversight. Furthermore, the quality of financial reporting is determined differently compared to firms in the services and manufacturing industry. Tools: We measure the quality of financial reporting using existing models in the literature. We use accruals-based models and real earnings management as an alternative measure. To estimate uncertainty, we rely on two important indexes, the Economic Sentiment Indicator and Business Confidence Indicator; additionally, we use another measure for robustness check. For accounting enforcement, we use the strength of auditing and accounting standards, and another measure grounded in the literature for robustness check. Findings: Our results suggest that uncertainty is negatively associated with the financial reporting quality in the EU. This indicates that uncertainty worsens the financial reporting 1 Corresponding author: Doctoral School of Economics and Business Administration, BabesBolyai University, Romania, Teodor Mihali Street, No. 58-60, Cluj-Napoca 400591, email addresses: catali[email protected]; [email protected] Accounting and Management Information Systems Vol. 19, No. 3 617 quality. In addition, we investigate the moderating role of accounting enforcement. We find that when accounting enforcement increases by one unit, the negative association between financial reporting quality and uncertainty decreases between 2.7% and 4.5%. Our results are consistent and robust to the use of alternative measures for financial reporting quality, uncertainty, and accounting enforcement. Contribution: This study contributes to literature in several ways. The EU presents a particular context that allows us to investigate more thoroughly the association between financial reporting quality and uncertainty using cross country sample. Furthermore, this study provides relevant insights to the policymakers specific to EU institutional settings. Research at EU level is welcome as previous analysis is limited to only seven EU countries. Therefore, more evidence is needed to form solid conclusions relevant for the EU. Additionally, we provide strong evidence about the moderating role of accounting enforcement, which was not investigated in literature in the context of uncertainty. Our results are significant for the EU, since the last years were characterized by high uncertainty, and considering the current developments, the next years will also be under the sign of uncertainty. The findings provide useful information to interested parties on the association between uncertainty and financial reporting quality and highlight the importance of accounting enforcement. Keywords: financial reporting; uncertainty; accounting enforcement JEL codes: M41, M42, M48 1. Introduction High-quality and reliable corporate reporting by listed companies is of key importance for the efficiency of capital markets (EU Commission, 2021). The same report highlights that financial reporting is the foundation of capital markets because it provides investors with the necessary information to base their decision. The latest events, Covid-19, Ukraine's aggression, the energy crisis, and the inflation crisis, cause an increase in uncertainty. During the period 2020-2022, uncertainty2 increases by 93% compared to 2008 when the financial crisis started and by 70% compared to the last 10 years. This creates a difficult context for investors. The decrease in returns and the value of the shares are only two consequences of a list of adverse effects of uncertainty. Given this, the Chair of the International Accounting Standards Board (IASB) points out that when surrounded by uncertainty and its negative effects, investors need to trust financial reporting. And, in turn, this trust relies on management preparing transparent, accurate, and useful financial reports (Barckow, 2023). 2 We calculated the percents based on the global uncertainty index obtained from Economic Policy Uncertainty website (link: https://www.policyuncertainty.com/global_ monthly.html) Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 618 Vol. 19, No. 3 The first objective of this research is to investigate the association between uncertainty and financial reporting quality (FRQ) for EU member states. We focus on the EU because there is limited evidence at the cross-country level and the EU offers a suitable sample for analysis. The EU made several convergence efforts with respect to the financial reporting of the listed entities. Therefore, as noted by Schipper (2005), the EU provides a more powerful setting to test the determinants of financial reporting quality. A single set of accounting standards, similar accounting practices, and the same reporting requirements allow us to test the association between FRQ and uncertainty without carrying about the estimation errors that arise from different accounting treatments and reporting practices. Furthermore, EU countries aim to harmonize economic development, institutional settings, and regulations. Until now, notable steps have been taken in this direction. This feature of our sample allows us to control potential unobservable effects that in previous cross-country research were not fully accounted for. On the other hand, literature on the impact of uncertainty on FRQ is still emerging with no research done particularly for EU. Therefore, this study will provide applicable and specific findings for the EU. One of the pillars that guarantees the FRQ in the EU is accounting enforcement. The EU designed an institutional architecture to handle this activity. The European Securities and Markets Authority (ESMA) supervises the enforcement of IFRS, while the Committee of European Auditing Oversight Bodies (CEAOB) supervises the audit of listed entities. The goal of these institutions is to protect investors by ensuring FRQ. The second objective of this study is to test whether accounting enforcement in the EU plays a role during periods of uncertainty. There is a notable gap in the literature on accounting enforcement in the context of uncertainty. Our study fills this gap by analyzing the interaction between accounting enforcement and uncertainty and how this affects the FRQ. We use four models to capture the FRQ and two measures for uncertainty. Based on 35,489 observations, we find that uncertainty is negatively associated with FRQ in the EU. The results are consistent for all FRQ models and for both measures of uncertainty. Furthermore, we find that accounting enforcement reduces the negative association between uncertainty and FRQ. Our results are robust to an alternative measure for FRQ, we use real earnings management as an alternative measure for FRQ. We also use an alternative measure for accounting enforcement and uncertainty. In all cases, the results are similar and form a solid basis for our conclusions. Additionally, we used country and industry fixed effects in our analysis, which allows us to control country and industry characteristics and better quantify the effects of uncertainty. Our results suggest that uncertainty is a strong incentive for earnings management. Avoiding small losses (Shin, 2019), producing earnings surprises and good news (Peng et al., 2020), and creating a sense of stability are the key objectives of management in times of high uncertainty. Accounting and Management Information Systems Vol. 19, No. 3 619 The findings are of interest to investors and policy makers. Acknowledging that uncertainty is a key determinant of FRQ will help EU policymakers shape future rules and mechanisms to protect investors from untrustworthy financial reports. Furthermore, the standard setter, together with EU regulators, can require specific disclosures to the financial statements to allow investors to understand the firm’s performance under uncertainty. The FRQ is also achieved through the participation of investors. The negative association between uncertainty and FRQ should engage investors to create relevant techniques to detect earnings management. This is particularly applicable to institutional investors who have the resources to do so. Moreover, we show that accounting enforcement is essential to secure the FRQ. Therefore, our study provides an available instrument that authorities can use to mitigate the effects of uncertainty on FRQ. There are differences in the implementation of accounting enforcement guidelines across member states (ESMA, 2017). Consequently, the first step that the EU should take is to improve the convergence of accounting enforcement between member states. A possible expansion of the current accounting enforcement guidelines must consider the impact of uncertainty. Accounting enforcement priorities in times of uncertainty must focus on accounting estimates, presentation of performance, and management assumptions. By analyzing the accrual-based models, we draw attention to the fact that estimates are subject to management discretionary behavior when uncertainty rises. However, discretionary behavior is not limited to accounting estimates but is also present in determining whether to incur an expense. The positive association between real earnings management and uncertainty supports this statement. This is of interest for investors, who should focus on business decisions taken by management and their future effects on business developments. Besides the above-mentioned contributions, our study aims to expand the sample period to 2022; therefore, we are able to reckon important events that increased the uncertainty in the EU. Additionally, the structure and characteristics of our sample allow for high variability, which is desired in the analysis of firm outcomes (FRQ) and macroeconomic aspects (uncertainty). The results of previous research that relies on samples consisting of only one country may be biased due to low variability. Taken together, the characteristics of our sample mentioned above, the period analyzed, the incorporation of accounting enforcement into the analysis, and the additional tests provide a valuable contribution to the existing literature. The motivation of this study is grounded in the fact that, as Yung and Root (2019) highlight, high uncertainty led to a different economic reality and industry regulations. Moreover, Baker et al. (2016) emphasize that uncertainty has harmed the economic performance in the United States and EU. In these circumstances, investors need reliable sources of information, and, as Andrei et al. (2023) point out, the investors turn to financial statements. However, most of the research done on the association between uncertainty and FRQ is heavily concentrated in the United States (e.g. Bermpei et al., 2021; Dhole et al., 2021; and Nagar et al., 2018) with no Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 620 Vol. 19, No. 3 evidence for the EU which made notable progress toward the harmonization of financial reporting. To protect investors from misleading information, there are several monitoring mechanisms in place; Jiang et al. (2022), Cui et al. (2021), and El Ghoul et al. (2021) indicate that strong external monitoring is beneficial for FRQ when uncertainty rise. However, the accounting enforcement which can be considered as the most important component of external monitoring was not yet examined. The remainder of this paper is organized as follows. In Section 2, we review the existing literature and build the hypothesis. In Section 3, we present the methodology. In Section 4 we present and discuss the findings, and in Section 5 we draw conclusions. 2. Literature review and hypothesis development 2.1 Uncertainty effects on FRQ The role of financial reporting is to reduce the asymmetry between management and investors and to attenuate agency conflict. Financial reports are the main source of information for investors when assessing the performance of the firm and making investment decisions. Because uncertainty can create certain constraints and concerns for investors, they pay more attention to financial reports (Andrei et al., 2023). In this context, accounting scholars were interested in the effects of uncertainty on different dimensions of the FRQ. The literature on the subject has grown in recent years; however, most of the research focusses on the United States (e.g., Bermpei et al., 2021; Dhole et al., 2021; and Nagar et al., 2018) and there is little evidence at the cross-country level (e.g., El Ghoul et al., 2021). This aspect has implications for the validity of the results. To better estimate the association between FRQ and uncertainty, high variability between firm outcomes and macroeconomic aspects is required. In the case of one country sample, the uncertainty varies only over time and not cross-sectionally. This limits the explanatory power of uncertainty and does not allow the analysis of other country factors. However, when crosscountry samples are analyzed, careful attention should be paid to differences between countries regarding accounting practices and institutional settings. From this perspective, the EU, which has the same requirements and accounting practices for listed entities, presents a pertinent sample to analyze the association between FRQ and uncertainty. There are three methods to measure uncertainty in the literature. Dai and Ngo (2020), Jain et al. (2021), and Goncalves et al. (2022) use elections. In election years, the uncertainty about future government policies increases. Shin (2019) uses market volatility to measure uncertainty, while most authors use the index developed by Baker et al. (2016). Election years can have great applicability in states like the Accounting and Management Information Systems Vol. 19, No. 3 621 United States, where notable changes are expected to occur when the new administration is invested. However, in other countries, it is difficult to measure uncertainty using elections because it will not necessarily lead to significant changes in administration. For example, in EU countries, elections may not create the context for uncertainty. The monetary policy is centralized under the European Central Bank (ECB), while the fiscal policies should adhere to EU rules. On the other hand, market volatility only reflects shocks in the market, which does not always imply uncertainty. The index determined by Baker et al. (2016) is superior to the others, it is a comprehensive measure constructed based on the presence of relevant keywords in the main newspapers, changes in monetary and fiscal policy, and macroeconomic forecasts. However, the index is available for 29 countries, of which 11 are from the EU. In most cases, the sample period ends in the 2015-2018 interval (e.g., Bermpei et al., 2021; El Ghoul et al. 2021; Nagar et al., 2018; and Yung & Root, 2019). Consequently, previous research is limited to one single major event that led to an increase in uncertainty, namely the financial crisis of 2008. Therefore, future research is needed that incorporates the latest important events, such as the Covid19 pandemic or the Ukraine aggression. These increase uncertainty worldwide and help us to better analyze uncertainty. Regarding the reasons for the decline in FRQ, most researchers argue that this is related to management incentives. Bermpei et al. (2021) suggested that management wants to improve financial performance when uncertainty is high. This is linked with the concept introduced by Hirshleifer et al. (2009) 'lean against the wind', when everything is going down and the uncertainty rises, the management is incentivized to smooth the earnings to create a sense of stability. Shin (2019) suggests that to avoid small losses, management smooths the earnings until the firm becomes profitable. The author then highlights that investors react more strongly to small losses in times of high uncertainty than in other periods. On the contrary, Jin et al. (2019) and Du et al. (2023) point out that the decline in FRQ during high uncertainty can be attributed to investors. When uncertainty increases, investors are more concerned with macroeconomic news than with firm-level information. Therefore, it would be difficult for investors to detect the earnings management. The first stream of explanations linking the decline in FRQ with the management incentives is more appropriate, since the literature suggests that investors pay more attention to the financial reports in times of uncertainty (Andrei et al., 2023 and Walters et al., 2023). This is more suitable for the EU, where most of the investors are institutional investors and investment funds that constantly analyze the performance of their portfolio. However, given that there is no specific research for the EU, it is difficult to generalize the previous findings. The literature shows that uncertainty is disruptive for capital markets, investors, and the economy. Investor pessimism increases in periods with high uncertainty, and due Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 622 Vol. 19, No. 3 to financial constraints and fear of future losses, they are concerned about their investments. In this context, financial statements represent a cornerstone and ensuring the FRQ is vital. However, management incentives may prevail over accounting standards, and therefore earnings management is more frequent in periods of high uncertainty. We present that literature has some gaps that need to be addressed to further advance research in this field. First, there was insufficient research done at the cross-country level with all the disadvantages presented above. The period between 2020-2022 has not yet been addressed in the literature, when uncertainty increases significantly. Furthermore, the limitations that arise from previous measures from uncertainty; some of them are not generally applicable, others do not necessarily imply uncertainty, while the index developed by Baker et al. (2016) is restricted to several countries. Given these points and the particularities that characterize the EU research, which focusses on the EU is welcome. H1: In the EU, the FRQ is negatively associated with uncertainty. 2.2 Accounting Enforcement and FRQ Jiang et al. (2022), Cui et al. (2021), and El Ghoul et al. (2021) emphasize that external monitoring is essential to reduce the negative association between FRQ and uncertainty. They analyze the coverage of analysts and auditors as a form of external monitoring. Accounting enforcement is also a form of external monitoring. In the latest annual report, ESMA defines accounting enforcement as the examination of the compliance of financial reporting with the applicable framework and taking appropriate measures when infringements are discovered (ESMA, 2023). Ball (2006) discussed the expected outcome of the adoption of IFRS in the EU. The author emphasizes that in the absence of strong accounting enforcement practices, the FRQ will not improve as expected. In this case, after IFRS adoption, the EU made several efforts to improve and harmonize accounting enforcement between member states. ESMA has a dedicated department that coordinates accounting enforcement in the EU. Over the years, this activity has made notable advances. In 2014, ESMA implemented the accounting enforcement guidelines, in 2017 it published the report on the implementation of these guidelines in each member state and starting with 2018 the annual reports for accounting enforcement contain more relevant information. On the other hand, Directive 2006/43/EC and Directive 2014/56/EU strengthen accounting enforcement by regulating audit supervision in the EU. The literature shows that accounting enforcement is positively associated with FRQ (for example: Brown et al., 2015; Ernstberger et al., 2012; Windisch, 2021; and Böcking et al., 2015). Windisch (2021) describes the mechanism through which accounting enforcement works, that is, name and shame. Accounting errors and infringements are made available to the market by relevant institutions. Following disclosure of accounting errors in the capital market, prior evidence suggests that companies face a decrease in market valuation and an increase in the cost of equity Accounting and Management Information Systems Vol. 19, No. 3 623 (for example, Christensen et al., 2020; Ernstberger et al., 2012; and Dee et al., 2011). Accounting enforcement is a powerful mechanism through which the FRQ is secured worldwide. However, the EU presents a particular context because, in the last few years, there has been an improvement in accounting enforcement, and all the member states must follow the same rules. The only difference is in the implementation of these rules, an aspect pointed out also by ESMA in the implementation report (ESMA, 2017). Therefore, this feature allows us to investigate whether accounting enforcement is essential to reduce the uncertainty effects on FRQ. H2: In countries with strong accounting enforcement, uncertainty is less negatively associated with FRQ. 3. Research methodology 3.1 Uncertainty To measure uncertainty, we use two indicators, the Business Confidence Indicator (BCI) determined and published by the OECD and the European Sentiment Indicator (ESI) calculated by Eurostat. In previous research, most scholars used the index developed by Baker et al. (2016) or a dummy variable for years with political elections. However, the index developed by Baker et al. (2016) has data only for 11 EU countries, and political elections do not necessarily increase the uncertainty in EU as already explained above. Both BCI and ESI are survey-based indexes. A high value of the ESI and BCI indicates increased confidence in the future performance of the economy, while a low value means uncertainty about the future. We can argue that BCI and ESI are relevant candidates to measure uncertainty and appropriate for this study due to: a) BCI and ESI are survey-based and reflect the opinion of economic agents about the future. Therefore, when uncertainty rises, the indexes deteriorate; b) BCI and ESI are calculated for each individual country of the EU. This ensures adequate variability within our sample, since our uncertainty measures vary between the countries included. This facet increases the explanatory power of our results; c) BCI and ESI decrease around major events or crises such as the financial crisis or the Covid-19 pandemic (please see Figure 1). In this case, BCI and ESI are adequate to capture the uncertainty. In our analysis, we use the change in BCI and ESI from year to year for each EU country. Both indexes have data available for each EU country on the OECD and Eurostat websites. Bulgaria, Croatia, Cyprus, Malta, and Romania are not part of the OECD, therefore, for BCI we use the value determined for EU 27 instead. Figure 1 shows the evolution of the median value of BCI and ESI for the 27 EU countries. Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 630 Vol. 19, No. 3 Table 5. Regression results Source: author’s processing Table description: The table shows the regression results. In each case, we employed an OLS model with countryand industry-fixed effects. BCI#ENF and ESI#ENF are the interaction effects between our uncertainty measures and accounting enforcement. In terms of interaction, each variable was centred by subtracting the median value. In each model, the standard errors are clustered at the firm level. The T values are in parentheses. The significance levels at 10%, 5%, and 1% are represented by *, **, and ***, respectively. Accounting and Management Information Systems Vol. 19, No. 3 631 Challenges arising from climate change, existing conflicts, and a fragile economic situation will make uncertainty a persistent state in the coming years. If policymakers do not take the appropriate measures, the decline in FRQ will result in a deterioration in investor confidence, reduced market participation, and withdrawal of investors and orientation towards other capital markets. Consequently, the inability to obtain financing from the capital market will increase the cost of capital for the companies, and this will affect the EU economy. Next, we investigate whether accounting enforcement can act as a moderating factor between FRQ and uncertainty. The literature suggests that accounting enforcement is positively associated with FRQ. Our results are consistent with the literature, the coefficient of ENF is 0.0068 in Model 1, 0.0071 in Model 2, 0.0066 in Model 3, 0.0065 in Model 4, 0.0072 in Model 5, 0.0073 in Model 6, 0.0071 in Model 7, and 0.0067 in Model 8. The coefficient is statistically significant at the 5% level in all cases. The results show that if accounting enforcement increases by one unit, the FRQ will increase on average across all models with 0.0069. To analyze whether accounting enforcement holds significance in context of uncertainty, we introduce two interaction terms between accounting enforcement and the two measures for uncertainty. The positive coefficient of both interaction terms indicates that accounting enforcement has the ability to reduce the negative association between FRQ and uncertainty. The interaction term between BCI and ENF is statistically significant at the 10% level, while the interaction term between ENF and ESI is statistically significant at the 5% level in Model 5 and Model 7 and at 10% in Model 6 and Model 8. The results indicate that when accounting enforcement increases by one unit, the negative association between uncertainty and FRQ will decrease on average by 2.7% in the first four models and by 4.57% in the last four models. Regarding the interaction term between ENF and BCI/ESI, the results can be linked to the existing literature. There is a body of research suggesting that accounting enforcement infringements produce strong negative market reactions when they are made available to the public (Christensen et al., 2020; Dechow et al., 1996; Ernstberger et al., 2012; Dee et al., 2011). In the EU, accounting enforcement bodies select a sample of several companies or auditors to be scrutinized in a financial year. Errors are made available to the public through different channels: changes in the financial statements, public corrective notes, or an official announcement from the accounting enforcement body. We know that uncertainty is generalized to the entire market and produces negative effects for investors and companies. However, when an accounting enforcement action is taken against a company or its auditor, this creates a particular context that captures the attention of the entire market. Therefore, the negative effects produced by uncertainty combined with accounting enforcement actions worsen the company’s position in the capital market. Consequently, in EU countries where accounting enforcement is strong, management is not likely to engage in earnings management frequently. Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 632 Vol. 19, No. 3 The results are of interest to EU policymakers; accounting enforcement is a useful instrument that can counter the negative association between FRQ and uncertainty. In the latest peer review report on the implementation of enforcement guidelines, ESMA lists several points of deficiency for specific EU member states such as inadequate staffing, insufficient qualification of human resources, improper selection methods, and inconsistencies regarding the timing and extent of procedures (ESMA, 2017). Therefore, strengthening the implementation of the enforcement guidelines and the convergence between the member states is a starting point. Furthermore, possible changes in guidelines should incorporate the effects of uncertainty, for example, to increase the sample of companies to be examined when uncertainty rises or to focus on specific industries, for example, Bermpei et al. (2021) demonstrate that the FRQ of companies from healthcare, transport, defense, tabaco, and pharma is more susceptible to uncertainty. Additionally, the member states should allocate sufficient resources to accounting enforcement to facilitate proper staffing, talent attractiveness, and enough training. We rely on accruals-based models in testing our hypotheses and we show that management discretionary behavior intensifies in times of uncertainty. Therefore, the enforcer bodies should prioritize the accounting estimates and the management assumptions. Inspectors should check how accounting estimates are determined, their presentation in financial statements, and related disclosures. Cooperation between member states is also a key point in ensuring strong accounting enforcement. The control variables are consistent with the literature. There is a negative association between firm size and FRQ, resulting in smaller companies managing earnings more frequently than larger companies. Firms that are audited by a Big4 auditor, reports under IFRS, have good financial performance, and are not leveraged are positively associated with FRQ. The adjusted R squared is approximately 10%, which is comparable to the adjusted R squared obtained by Bermpei et al. (2021), Goncalves et al. (2022), Yung and Root (2019), Jain et al. (2021), and El Ghoul et al. (2021). 4.2 Another measure for FRQ Real earnings management (RMS) is used to improve company performance by reducing discretionary expenses. This method estimates the expected discretionary expenses and then compares them with the actual discretionary expenses. The large difference between the two means that managers cut discretionary expenses to improve performance and, therefore, the FRQ decrease. The RMS is obtained following the approach of Cohen et al. (2008) and is equal to the residuals from the below model. DEit TAitit =α0+α1 1 TAit-1 +α2�REVit TAit �+εit Accounting and Management Information Systems Vol. 19, No. 3 633 The DE is discretionary expenses, which is the sum of selling and general administrative expenses and research and development expenses. The remaining variables are explained in Section 3. To facilitate interpretation, we multiply the residuals by -1. For the sake of brevity, in Table 6 we present only the results for the variables of interest. Table 6. Regression results for uncertainty and RMS (9) (10) RMS RMS BCI -0.0575*** (-10.41) ESI -0.0491*** (-14.59) ENF -0.0263*** -0.0298*** (-3.44) (-3.89) BCI#ENF 0.0011** (2.62) ESI#ENF 0.0010* (2.41) Control variables Yes Yes R-squared 0.4515 0.4522 N 35489 35489 Country and industry fixed effects Yes Yes Table description: The table shows the regression results for real earnings management (RMS). In each case, we employed an OLS model with countryand industry-fixed effects. BCI#ENF and ESI#ENF are the interaction effects between our uncertainty measures and accounting enforcement. In terms of interaction, each variable was centered by subtracting the median value. In each model, the standard errors are clustered at the firm level. The T values are in parentheses. The significance levels at 10%, 5%, and 1% are represented by *, **, and ***, respectively. The coefficients of BCI and ESI are negative, which also means that in this case the uncertainty is negatively associated with FRQ. The negative coefficient of BCI is 0.0575 while the coefficient of ESI is 0.0491 which means that for an increase with one unit of uncertainty, the FRQ will decrease by 5.75% in Model 9 and by 4.91% in Model 10. Both coefficients are statistically significant at the 1% level. Regarding accounting enforcement, the results are consistent with those obtained in the first 8 models. For an increase with one unit in accounting enforcement, the negative association between FRQ and uncertainty decreases by 1.98% in Model 9 and by 2.12% in Model 10. When comparing earnings management with real earnings management, the latest is harder to discover by auditors and enforcement bodies because it lies in operational decisions rather than accounting treatments. This implies that it is more likely that management will engage in real earnings management more frequently than in earnings management. This draws attention to the investors to monitor the business decisions taken by management and to analyze their impact. Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 634 Vol. 19, No. 3 4.3 Another measure for uncertainty Uncertainty is an event-based phenomenon. Certain events raise or prolong uncertainty. As another measure of uncertainty, we identify 6 years with notable events in the EU. Table 7 shows the year and the associated event. Table 7. Years of uncertainty in the EU Year Event 2008 Financial crisis 2011 EU sovereign debt crisis 2016 Brexit 2020 Covid-19 2021 Inflation and Energy Costs 2022 Ukraine aggression Source: author’s processing We argue that in these years the uncertainty increases across the EU. We create a dummy variable that takes 1 for those years and 0 for the remaining years. The regression results are in Table 8. For the sake of brevity, we present only the results for the variables of interest. Table 8. Regression results for EVENT (11) (12) (13) (14) FRQ1 FRQ2 FRQ3 FRQ4 EVENT 0.1790** 0.1320* 0.1970*** 0.2040*** (3.22) (2.40) (3.53) (3.68) ENF -0.0050* -0.0053* -0.0049* -0.0046* (-2.00) (-2.17) (-1.97) (-1.88) EVENT#ENF -0.0071** -0.0063** -0.0069** -0.0060** Control variables Yes Yes Yes Yes R-squared 0.1304 0.1337 0.1293 0.1326 N 35,489 35,489 35,489 35,489 Country and industry fixed effects Yes Yes Yes Yes Table description: The table shows the regression results for EVENT as another measure of uncertainty. In each case, we employed an OLS model with countryand industry-fixed effects. EVENT#ENF is the interaction effects between our uncertainty measure and accounting enforcement. In terms of interaction, the ENF was centred by subtracting the median value. In each model, the standard errors are clustered at the firm level. The T values are in parentheses. The significance levels at 10%, 5%, and 1% are represented by *, **, and ***, respectively. The results suggest that in those 6 years with events generating uncertainty, at EU level, the FRQ declines. In contrast to BCI and ESI, we expect a positive sign for the EVENT coefficient. The coefficient is statistically significant at 1% in Model 13 and Accounting and Management Information Systems Vol. 19, No. 3 635 Model 14, 5% in Model 11, and 1% in Model 12. The results for accounting enforcement are similar to those obtained previously. This robustness test demonstrates that our results hold their significance. 4.4 Another measure for accounting enforcement Isidro et al. (2020) provide a comprehensive measure consisting of four factors that explain more than 70% of the variation in FRQ. Factor 3 deals with accounting enforcement. We use the value of that factor as another measure of accounting enforcement. We rely on this because the study of the recent Isidro et al. (2020) advances a measure for accounting enforcement and has data available for 14 EU countries. The principal effect was eliminated due to collinearity with country fixed effects. In Table 9 are the results of regression; for the sake of brevity, we present only the results for the variables of interest. The results of the interaction terms are similar to the previous ones and show that accounting enforcement has the capacity to reduce the negative association between FRQ and uncertainty. In Models 15-18, the reduction is estimated at an average value of 15%, while in Models 19-22 it is estimated at 10%. The coefficient is positive and statistically significant at the 5% level. Therefore, we conclude that our results are robust to another measure of accounting enforcement. Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 636 Vol. 19, No. 3 Table 9. Regression results for another measure of accounting enforcement Table description: The table shows the regression results for ISIDRO as another measure of accounting enforcement. In each case, we employed an OLS model with countryand industry-fixed effects. BCI#ISIDRO and ESI#ISIDRO are the interaction effects between our uncertainty measures and accounting enforcement. In terms of interaction, each variable was centred by subtracting the median value. In each model, the standard errors are clustered at the firm level. The T values are in parentheses. The significance levels at 10%, 5%, and 1% are represented by *, **, and ***, respectively. Accounting and Management Information Systems Vol. 19, No. 3 637 5. Conclusions The purpose of this study is to analyze the effects of uncertainty on FRQ in the context of the EU. Based on 35.489 firm-year observations, our results suggest that uncertainty is negatively associated with FRQ. Through the present study, we draw attention to the EU institutions that the efforts made to improve the FRQ need to be reassessed, as it is expected that the next years will be characterized by high uncertainty. Furthermore, it is necessary to ensure that investors can always rely on the quality of financial information, even in periods of profound crisis and uncertainty. The functioning of modern capital markets is highly dependent on the information provided by firms; therefore, EU institutions need to find efficient measures to combat the effects of uncertainty. We analyze uncertainty in the context of EU countries since this allows us to observe directly the effects of uncertainty and accounting enforcement. Our results are robust and consistent. We use real earnings management as another measure for FRQ. We then argue that managers are likely to engage more frequently in real earnings management than in earnings management. The results of this robustness test validate the findings of this study. Furthermore, we use another measure of uncertainty and accounting enforcement. The results show that if we use other measures for our variable of interest, the findings are the same. Furthermore, we use in our analysis country and industry fixed effects and combining this with the same set of rules applied to all EU listed companies, our sample can benefit from partially eliminating the effects of potential unobservable effects. One of the available instruments that EU institutions can use to combat the effects of uncertainty is represented by accounting enforcement. We provide evidence that when accounting enforcement is strong, the negative association between uncertainty and FRQ is less pronounced. Our results can guide policy makers and motivate them to improve accounting enforcement. Our conclusions are similar to those already presented in the literature that uncertainty is negatively associated with FRQ (see, e.g., Bermpei et al., 2021; Shin, 2019; Jin et al., 2019; Du et al., 2023; and Yung & Root, 2019) and highlight that management incentives prevail in times of high uncertainty. Regarding accounting enforcement, our conclusions are in line with Jiang et al. (2022), Cui et al. (2021), and El Ghoul et al. (2021), which highlights the importance of external monitoring when uncertainty rises. In Section 4 we also discuss the implications of this study for investors and EU institutions and propose several actions to improve accounting enforcement. Implementing the enforcement guidelines and bringing the convergence among the member states of the EU are the first measures to be taken. Then, the accounting Uncertainty, financial reporting quality and accounting enforcement: Evidence from the European Union 638 Vol. 19, No. 3 enforcement methodology should account for uncertainty. All these proposed actions will strengthen accounting enforcement in the EU. The present study has some limitations. The first is that the strength of auditing and reporting standards is available until 2019. We mitigate the possible concerns regarding this by using another measure for accounting enforcement. Furthermore, certain changes could have occurred in recent years regarding accounting enforcement, changes that are not fully reflected in our accounting enforcement measure. Therefore, future research is needed in the coming years which can provide additional evidence on this subject. We include control variables already established in the literature in our regression analysis, and the explanatory power of our model is similar to those already existing in the literature on this subject. However, the results may be sensible to the inclusion of other control variables. We believe that this limitation was addressed in the present study by including industry and country fixed effects. Another limitation is that FRQ models may have some measurement errors, which are acknowledged in the literature. 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