Understanding the impact of sovereign accounting errors on financial markets

What are sovereign financial reporting errors?

The financial market closely scrutinises corporate accounting quality, but what about the fiscal reporting quality of sovereign entities (ie countries)? A recent academic paper titled “Market consequences of sovereign accounting errors”, co-authored by Jenny Chu and Marion Boisseau-Sierra of University of Cambridge together with Shiva Rajgopal of Columbia University, delves into the implications of sovereign fiscal reporting errors on the broader financial market, shedding light on an overlooked aspect in the accounting and finance literature.

This research explores the repercussions of accounting errors in the context of European countries whose fiscal data reporting undergo regular scrutiny by Eurostat, a division of the European Commission. Eurostat periodically assesses the fiscal data releases of EU member states, highlighting reservations that outline discrepancies in financial reporting. The study spanning from 2004 to 2018 found a significant trend: when Eurostat announces reservations, particularly when mentioning deficit or debt errors in recent fiscal data, sovereign bond yields witness abnormal increases. Moreover, consistent with a home bias, these reservations prompt domestic but not foreign investors to increase their holdings of sovereign debt.

Why should we care?

The sheer size of sovereign debt across the globe – amounting to 98.6% of global GDP in 2020 – highlights the critical importance of assessing the quality of this financial asset. Investors, including domestic and foreign commercial banks, central banks, and institutional investors, heavily rely on the credibility and performance of this asset class. Therefore, the accuracy of sovereign financial reporting plays a crucial role in determining global economic stability.

Our findings and implications

The study’s findings challenge the traditional belief that sovereign accounting quality might not hold as much weight as corporate or local government accounting quality as countries rarely default. It demonstrates that errors in sovereign accounting significantly impact the market, influencing sovereign bond yields. The impact is particularly strong when reservations specifically quantify errors in recent fiscal data, shedding new light on the country’s fiscal health.

This study exploits a unique setting using reservations issued by Eurostat, akin to the enforcement actions released by the US Securities and Exchange Commission in the corporate accounting realm. The results emphasise the importance of these reservations as novel information for investors, prompting market reactions when reservations contain more relevant, precise, and timely data.

The research also unveils an interesting investor behaviour termed ‘home bias’ in the sovereign debt market. Following negative news revealed by Eurostat reservations, domestic, but not foreign, investors tend to increase their investment in local sovereign bonds, signifying lower information asymmetry for domestic investors. In summary, this research reveals that sovereign fiscal accounting errors do matter in the financial world and that investors care about sovereign accounting quality. Furthermore, it paves the way for further research in the areas of sovereign governance, disclosure environments, and sovereign accounting quality on a global scale.