Foreign Direct Investments Affecting Accounting Quality in Transitional Economies of Europe

The purpose of this paper is to examine the effect of Foreign Direct Investments (FDIs) on financial reporting quality in transitional economies. After moving from a planned economy towards a market based economy, firms need to attract more non-governmental financing. When the quality of institutions is low, foreign investments mostly come in the form of FDI. Therefore, in a changed environment firms need to produce high quality financial reporting to be able to acquire capital. Accounting quality is measured as earnings conservatism, i.e. asymmetric recognition of gains and losses. Data from 12 transitional economies in Central and Eastern Europe is analyzed. The results of this paper indicate that investment freedom, especially free flow of foreign capital, and freedom from corruption increase earnings quality measured by earnings conservatism. Moreover, the results show that high level of FDIs is associated with high earnings conservatism indicating that FDIs increase the incentives for high quality financial reporting. The results also show that FDIs improve earnings quality only when the free flow of foreign capital is limited. When FDIs are defined as change in FDI, the results are reversed. This is because the growth is highest in countries with low level of FDIs.