Mandatory Financial Reporting Environment and Voluntary Disclosure

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday January 11, 2013 at 9:12 am
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Editor’s Note: The following post comes to us from Karthik Balakrishnan and Holly Yang, both of the Department of Accounting at the University of Pennsylvania Wharton School, and Xi Li of the Fox School of Business at Temple University.

In the paper, Mandatory Financial Reporting Environment and Voluntary Disclosure: Evidence from Mandatory IFRS Adoption, which was recently made publicly available on SSRN, we investigate the interaction between mandatory financial reporting environment and voluntary disclosure by employing the mandatory adoption of International Financial Reporting Standards (IFRS) in 2005 as an exogenous increase to mandatory reporting to examine changes in firms’ voluntary disclosure practices. To measure voluntary disclosure, we focus on a discretionary action, namely the extent to which managers provide earnings forecasts, the most prominent performance measure that a firm supplies to investors. Ex-ante, it is unclear how the increase in reporting quality following the mandatory adoption of IFRS could influence management forecasts. On the one hand, mandatory financial reporting and voluntary disclosure can be complements, wherein the former produces verifiable information that improves the credibility of the latter and therefore encourages managers to issue more forecasts, i.e. the confirmatory role of mandatory reporting.

Prior studies document improved reporting quality following IFRS adoption, evidenced by earnings with lower manipulation and higher value relevance, timeliness, and information content. Therefore, given the evidence that IFRS improves the verifiability of earnings, the complementary view suggests that the mandatory adoption of IFRS should increase management forecasts. On the other hand, mandatory financial reporting and voluntary disclosure could also be substitutes, as private information that was previously conveyed through voluntary disclosure is now directly reflected in mandatory financial reports. Since IFRS produces more timely and value-relevant earnings numbers, the substitution effect predicts that the increased quality of financial reporting may reduce the demand for supplementary information from investors to predict future earnings. Therefore, IFRS adoption may also lead to fewer management forecasts.

We employ a difference-in-difference research design to examine the impact of mandatory adoption of IFRS on management earnings forecasts. Our treatment sample includes firms from 27 countries that mandated IFRS adoption in 2005 and our control sample includes firms from seven countries that did not mandate the adoption during our sample period. We compare the change in management forecasts issued by firms in the treatment and control samples after the adoption. We document an increase in the likelihood and frequency of management forecast issuance following the adoption in 2005 in our treatment sample relative to firms in the control group, suggesting a complementary effect between IFRS adoption and voluntary disclosure and the confirmatory role of mandatory reporting. This increase is statistically significant and is robust to various sample compositions addressing the concerns about data coverage, a country-level model specification addressing the concern about unevenly distributed samples across different economies, as well as an alternative control group including US firms.

There is considerable heterogeneity in the effects of IFRS due to the diversity in countries’ institutional infrastructures. We exploit this cross-sectional heterogeneity to provide further evidence on the confirmatory role of reporting standards. Specifically, we focus on the differences in prior domestic GAAP and legal enforcement within the treatment group. If the positive impact of IFRS adoption on the mandatory reporting environment is larger in countries with bigger changes in accounting standards or stronger legal enforcement, then the confirmatory role of reporting standards predicts that the increase of voluntary disclosure will be greater in these countries. Consistent with this argument, we find that the increase in management forecasts following IFRS adoption is larger in countries where the difference between a country’s prior domestic GAAP and IFRS is bigger or legal enforcement, measured by the rule of law index and the European Union membership, is stronger.

We next examine how the relation between mandatory reporting and voluntary disclosure shapes a firm’s liquidity. We find that management forecasts are positively associated with liquidity, but only during the post-adoption period, supporting the complementary view that higher quality mandatory reporting enhances the credibility of voluntary disclosure and brings capital market benefits. More importantly, we also find that the increase in liquidity is stronger amongst firms that increased the level of management forecasts post-adoption of IFRS. This finding complements prior literature examining the economic consequences of IFRS by identifying an indirect mechanism through which mandatory IFRS adoption also affects capital markets. Lastly, we investigate whether the fair-value orientation of IFRS could adversely affect managers’ incentives to issue management forecasts, by analyzing the differential effect of IFRS adoption on management forecasts for firms in financial and non-financial industries. The evidence does not suggest that management forecasting behavior differs across firms in financial and non-financial industries.

Our study makes three contributions. First, it adds to the literature that examines the interplay between mandatory financial reporting and voluntary disclosure. The mandatory adoption of IFRS is a compelling setting to examine this research question because it is an exogenously imposed event and is unlikely to be affected by firms’ disclosure choice. The large scale of adoption, i.e., many companies and countries adopting IFRS at the same time, and the dramatic change in mandatory financial reporting enhances the statistical power of the setting. Further, we are able to exploit the variation in differences between prior domestic GAAP and IFRS across countries to investigate the association between voluntary disclosure and changes in mandatory financial reporting. Such a setting cannot be replicated by studies examining the change of voluntary disclosure following changes in accounting standards within a single country, such as the passage of Sarbanes-Oxley Act (SOX) in the US in 2002. Without the cross-sectional variation in the degrees of changes in financial reporting, it is difficult to disentangle the effect of financial reporting reform from other contemporaneous events that may have a direct or indirect impact on voluntary disclosure. In sum, the mandatory adoption of IFRS in a group of heterogeneous countries serves as a pseudo- natural experiment and allows us to attempt at providing plausibly causal evidence between these two constructs.

Second, this paper adds to the literature that examines the effects of IFRS. Thus far, this stream of literature has focused only on properties of mandated disclosure and has ignored the possible impact of the regulatory reform on voluntary disclosure. To the best of our knowledge, this is the first study to examine the impact of IFRS on voluntary disclosure. Further, prior studies generally document a positive effect of IFRS adoption on analysts’ information environment and capital markets. However, our finding that voluntary disclosure increases after IFRS adoption suggests that the capital market effects of IFRS are partially attributable to improved voluntary disclosure, as it also has positive impacts on the information environment and liquidity. Specifically, our finding that the liquidity benefits of IFRS are greater for firms that increase their voluntarily disclosure levels suggests the existence of an indirect mechanism by which IFRS has impacted capital markets.

Third, this paper also contributes to the literature on management forecasts. So far, extant research on management forecasts is mainly based on US data and there is very limited evidence outside the US. Examples of studies that examine management forecasts outside the US include Baginski, Hassell, and Kimbrough [2002] examining forecasts in Canada, Kato, Skinner, and Kunimura [2009] examining forecasts in Japan, Radhakrishnan, Tsang, and Yang [2012] examining forecasts around the world, and Huang, Li, Tse, and Tucker [2012] examining forecasts in China. Our study extends this literature by presenting large-sample evidence on management forecasting behavior in a large number of economies in Europe and Asia Pacific.

The full paper is available for download here.


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