International Differences in the Relationship between Public Financial Reports and Bond Markets: Evidence from Japanese Local Governments and U.S. States

The purpose of this study is to provide new evidence on the comparative decision-usefulness of local government public financial report (PFR) information in bond markets. Using Japanese and U.S. data, we compare the correlation between financial indicators calculated using PFRs and credit bond ratings, and find that there is a difference in the relationship between the two countries. Japanese local governments just began to prepare full-accrual based financial reports. In 2015, the Japanese central government agency released the uniform accounting standards for local governments which required PFRs be prepared on an accrual basis no later than 2017 fiscal year. On the other hand, in the U.S., states and local governments have issued consolidated government-wide financial statements prepared on a full-accrual basis since 2002, in accordance with the Governmental Accounting Standards Board (GASB) Statement No. 34 released in 1999. GASB (1999) states that PFSs help users assess a government’s medium- and long-term financial condition, and recent studies have developed a number of financial indicators to measure and evaluate the financial condition of states and local governments using PFRs (Chaney et al. 2002, Chase and Phillips 2004, Kamnikar et al. 2006, Wang et al. 2007, Rivenbark et al. 2010). One of the greatest research interests is whether accrual-based PFRs actually provide information useful for assessing the financial condition of local governments. In this study, we especially focus on the relationship between governmental financial condition and credit risk, which is typically represented by bond ratings. Previous studies have shed light on the relationship between PFRs and bond ratings (hereafter, the PFR–BR relationship), and showed that financial indicators calculated using information in PFRs of U.S local governments have a significant effect on bond ratings (Plummer et al. 2007, Johnson et al. 2012, Pridgen and Wilder 2013, Callahan and Waymire 2015). Consequently, Plummer and Patton (2015, p. 231) concluded that PFRs are relevant for assessing the credit risk and financial solvency of states and local governments. This PFR–BR relationship suggests PFRs can provide useful information for rating agencies in their determination of bond ratings, and that the information is incorporated into U.S. bond markets. However, no previous studies investigate the PFR-BR relationship for Japanese local governments. The introduction of new public accounting standards in Japan not only brought about comparability of PFRs among Japanese local governments but also effectively established international comparability. Therefore, we examine the PFR-BR relationship of Japanese local governments, and compare it with that of U.S. states using the same financial indicators calculated from PFRs. Regarding U.S. states, our results strongly support the findings of previous studies. That is, the net asset ratio (NAR; the stock-based measurement ratio defined by Wang et al. (2007)) is significantly positively correlated with the bond rating indicator (RATING; the numerical conversion of credit bond ratings given by S&P) in U.S. states. On the other hand, the NAR of Japanese local governments is clearly not correlated with RATING in 2017. These results indicate that the U.S. bond market strongly depends on NARs, while the Japanese bond market does not. We find that this difference between the two countries is caused by the lower variance of NARs in Japanese local governments compared to that in U.S. states. When the differences in financial condition (i.e., NARs) are small among local governments, they will have little effect on bond ratings because the ratings are not continuous but are discrete values. In other words, a sufficient variance of NARs among local governments is necessary for the appearance of the PFR–BR relationship. The small variance of NARs in Japan can be attributed to the strict “balanced budget requirement” of the Local Autonomy and Local Finance Acts in Japan. Another reason for this difference might be the so-called “implicit national government guarantees,” which lead investors in a local bond market to expect the national government to bail out local governments when they cannot redeem their debt. In this study, we reveal the difference in the PFR-BR relationships of Japanese local governments and U.S. states. The introduction of the uniform accrual-based public accounting standards for local governments in Japan brought about the international comparability of their PFRs, and made this study possible. The evidence we provide will contribute to clarifying the decision-usefulness of PFR information in bond markets in diverse countries.