The purpose of this Section is to develop hypotheses about the relationship between a company’s compliance with the requirements of IFRS 8 and its different company characteristics.
Prior literature suggests that numerous factors could affect compliance with financial reporting requirements. Different compliance studies used more than 20 different factors / independent variables to explain the extent of compliance with the requirements of IFRSs. (Table 5.4) Findings of these studies (Section 5.2) and the theories introduced earlier (Section 2.3) are used to develop hypotheses (stated in alternative form) to answer the research questions. (Section 5.3)
Enforcement – The auditor
Independent audit and audit quality plays an important role to influence companies to comply with the requirements of the accounting standards. Wallace et al. (1994) argue
“that the contents of annual reports and accounts are not only audited but also influenced
by auditors” (p47) (Regulation and enforcement) Jensen and Meckling (1976) and Watts
and Zimmermann (1983) argued that large audit companies act as a mechanism to reduce agency cost by limiting managers’ opportunistic behaviour. (Agency theory) The choice of an external auditor (e.g. BIG 4) can also signal to investors that the annual reports of the company are audited with high quality. (Signalling theory) Additionally, theories in audit quality (such as large auditors 1) have better reputation and brand name; 2) are more concerned to maintain their reputation; 3) have more to lose in the event of litigation; 4) have greater expertise and knowledge; 5) provide more monitoring and knowledge etc.) suggest that audit quality and therefore the quality of accounting information is positively associated with audit firms size. Empirical studies used audit firm size (generally the dichotomous BIG N / non-BIG N variable) to capture audit quality (measured by e.g. financial restatements, abnormal accruals, disclosure quality, compliance) differences.
Consistent with the theoretical background empirical research shows that larger audit firms provide higher quality audit services. (Francis, 2004 and 2011; Carlin et al., 2007, 2009, 2011) Several studies analysed the effect of audit company choice on compliance with IFRS requirements by categorising audit firms whether an auditor was one of the big international audit companies or not. Most of the studies found positive relationship between the size of auditor and the level of compliance with IAS requirements. (Abd- Elsalam and Weetman, 2003 and 2007; Al-Jabri, 2008; Camfferman and Cooke, 2002; Glaum & Street, 2003; Hodgdon et al., 2009; Prather-Kinsey & Meek, 2004; Street and Gray, 2001 and 2002; Tsalavoutas, 2009 and 2011) Thus, being audited by big international audit firms is associated with increased level of compliance compared to being audited by smaller audit firms. Employing a big international audit company acts as one of the monitoring mechanisms and leads to a reduction of agency costs. (Tsalavoutas, 2009 and 2011)
The audit market for listed companies is dominated by the BIG 4 audit companies. (Macey and Eisenberg, 2004; Francis, 2011; Carlin et al., 2007, 2009) With the exception of 6 companies (3%), the sample companies of this study were audited by one of the BIG 4 international audit firms (PWC, Deloitte, KPMG, Ernst & Young). Therefore, this study will not compare the compliance of companies audited by one of the BIG 4 audit firms with the compliance of companies audited by other audit firms. Managers may intentionally employ big international audit companies to signal the high quality audit. However, the assumption of the homogenous audit quality across the BIG N audit companies has been questioned in more recent audit quality research (e.g. Glaum and Street, 2003; Macey and Eisenber, 2004; Tilis, 2005; Carlin et al., 2007, 2009) There is some evidence to support the hypothesis that the audit quality significantly varies among BIG N audit companies. Glaum and Street (2003) found significant differences between the average compliance levels of the companies audited by the different BIG 5 audit companies. However, they used one dichotomous variable in their regression model to differentiate between companies audited by one of the BIG 5 audit companies and companies audited by other audit companies. Carlin et al. (2007) (Carlin et al, 2009) found that the identity of the audit companies seems to explain a substantial proportion of the variation in disclosure quality and compliance levels of the goodwill impairment testing disclosures made by a sample of 50 (34) Australian (Malaysian) listed companies audited by the BIG 4 audit companies. They used descriptive statistics to investigate the
This study distinguishes between the BIG 4 audit service providers (with the code A, B, C and D to preserve aninomity) to examine the effect of auditor choice on the level of compliance with the requirements of IFRS 8.
Ha1: The degree of compliance with the disclosure requirements of IFRS 8 is
associated with the identity of the auditor.
Market competition
Prior research (Hayes and Lundholm, 1996; Harris, 1998; Botosan and Stanford, 2005; Birt et al., 2006; Pisano and Landriana, 2012) suggests that a higher level of competition may decrease the competitive harm associated with segment disclosure. Thus, companies operating in more competitive industries might have greater incentive to disclose more segmental information, because it is less likely that the disclosure will harm their competitive position in the market. (Proprietary theory) “In fact, the release of additional
information could benefit the firm by reducing information asymmetries between
management and shareholders.” (Birt, et al., 2006, p236) (see more in Section 2.4.4)
In this study two variables (the HHI and capital intensity) are used to proxy for market competition. The four-firm (eight-firm) concentration ratio and / or Herfindahl- Hirschamn Index (HHI) (Equation 5.1) is widely used to proxy the level of industry competition. (Ettredge et al., 2002; Harris, 1998; Berger and Hann, 2002, 2003 and 2007; Ettredge et al., 2006; Birt et al., 2006; Wang et al., 2011; Wang and Ettredge, 2014; Bens et al., 2011) In this study the HHI index is used to proxy for market competition because it takes into account both the relative size and the distribution of the companies in a market. The higher the index, the higher (lower) the concentration (competition) in the market. (Equation 5.1)
(Equation 5.1)
Where
si = sales of company i
S = the sum of sales for all companies in the industry
= market share of company i
2 1
n i i S s HHIS
s
in = the number of companies in the industry
Capital intensity is an indicator of the barriers to entry in a market. Therefore, it can be used as a negative proxy for market competition. (Givoly et al., 1999; Leuz and Verrecchia, 2000; Wang et al., 2011) The higher the capital intensity the more difficult to enter to the market. Thus, the higher the capital intensity, the lower the market competition. Capital intensity is measured as net PPE divided by total assets.
This study measures the competition of each industry sector by using the HHI and the capital intensity of the companies.
Ha2: The market competitionis positively associated with the level of compliance
with the disclosure requirements of IFRS 8.
Early adoption
The study focused on the first adoption of the new segmental reporting requirements. There are companies within the sample that adopted the new standard earlier than its effective date. Early adoption enables other companies to learn from the disclosure practice of the early adopters (Tsalavoutas, 2009 and 2011) and prepare themselves for the new requirements. On the other hand, companies might choose to adopt the new standard earlier, because they were already prepared for the requirements of the new regulation (e.g. because of their US listing, because the managements approach did not result in change in reporting segments etc.). Additionally, early adopter companies might choose to adopt an IFRS earlier than its effective date to (1) signal to the market and to the different stakeholders and (2) differentiate themselves from their competitors. (Signalling theory, Agency theory) It is therefore of interest to examine whether the date of adoption (early adoption or not) of the new regulation has any effect on the level of compliance of the sample companies.
Ha3: Early adoption is associated with the extent of compliance with the disclosure
requirements of IFRS 8.
Size
Additionally, larger companies are more likely followed by financial analyst and investors and disclose more information to (1) reduce risk associated with information asymmetry, (2) increase investors’ and debt providers’ confidence, (3) reduce their cost of capital and (4) facilitate investors’ better resource allocation. (Botosan, 1997; Lang and Lundholm, 1996; Elliott and Jacokbson, 1994) (Capital need theory) However, political, agency, proprietary cost and competition (e.g. entry barriers) on the market also can motivate companies to disclose more (less) information (e.g. Jensen and Meckling, 1976; Watts and Zimmerman, 1978 and 1990; Dye, 1986; Hayes and Lundholm, 1996; Nagarajan and Sridhar, 1996) when complying with the requirements of accounting regulations. Watts and Zimmerman (1986) argued that larger companies are more politically visible and are more likely to be subject to wealth transfer as a result of government intervention. Therefore, a company may disclose more, better quality information in order to reduce its political cost (Political cost theory) and enhance the company’s public image (Signalling theory). The authors also argued that politicians and government bureaucrats who are responsible for regulating financial reporting are influenced by the likelihood of any future crisis blamed on them. (Regulation and enforcement) It can be argued that detailed segmental information is more likely commercially harmful for smaller companies than for bigger ones. (Katselas et al., 2011; Bens et al., 2009) (Proprietary theory) The larger the company it is more likely that it operates in more business and / or geographical areas. The management of these companies might consider to provide more (less), better (worse) quality information about the company’s activities in different business and / or geographical areas to help financial statement users to evaluate risks and prospects related to these areas (to hide earning management between the different segments or conceal the management’ empire building plans). (Hann and Lu, 2009; Wang and Ettredge, 2014) (Agency theory) Cooke (1998) argues that “the theoretical relationship is somewhat uncertain” (p218) between the company size and the level of disclosure.
Several previous empirical studies found significant positive association between company size and the extent of compliance with IASs. (Al-Jabri, 2008; Al-Ulis, 2006; Bova and Pereira, 2012; Camfferman and Cooke, 2002; Chatham, 2004; De Vicente Lama et al., 2011; Fekete et al., 2008; Hodgdon et al., 2009; Prather-Kinsey and Meek, 2004; Al-Shammari et al., 2008; Tsalavoutas, 2009; Pisano and Landriana, 2012) Thus, larger companies have higher level of IASs compliance than smaller companies. On the other hand, Abd-Elsalam and Weetman (2003), Glaum and Street (2003), Street and
Bryant (2000), Street and Gray (2001 and 2002), Taplin et al. (2002) and Tower et al. (1999) did not find significant relationship between company size and compliance level.
Company size can be represented in different ways. Prior compliance studies used total assets (Abd-Elsalam and Weetman, 2003; Camfferman and Cooke, 2002; Taplin et al., 2002; Tower et al., 1999; Street and Bryant, 2000; Street and Gray, 2001 and 2002; Prather-Kinsey and Meek, 2004; Al-Ulis, 2006; Al-Jabri, 2008; Bova and Pereira, 2012; Fekete et al., 2008; Al-Shammari et al., 2008; De Vicente Lama et al., 2011; Pisano and Landriana, 2012), total sales (Street and Gray, 2001 and 2002; Hodgdon et al., 2009; Fekete et al., 2008), market capitalisation (Chatham, 2004 and 2008; Street and Gray, 2001 and 2002; Al-Jabri, 2008), firm value (Glaum and Street, 2003; Tsalavoutas, 2009) and number of employees (Chatham, 2004 and 2008) to proxy company size. However, Cooke (1989, 1992) indicated that “there is no overwhelming theoretical reason to prefer
one size variable to another”. (Cooke, 1992, p232)
Additionally, Crawford et al. (2012a) found differences between the segmental disclosure practice of the FTSE 100 (bigger) and the FTSE 250 (smaller) companies. The FTSE 250 companies reported fewer reportable segments, they provided generally lower level entity-wide information and used fewer words in their segmental note. On the other hand FTSE 250 companies provided greater disclosure about major customers, and disclosed finer geographic information than the FTSE 100 companies. The authors argue that
“some of this difference may be due to the fact that these are smaller companies” that
“more likely to have major customers to meet the threshold requirements of IFRS 8” and
they “may not operate in very many regions”. (p26)
In this study total sales and FTSE 100 /250 listing status are used as the measure of company size. Since prior research produced mixed results no direction is predicted regarding the effect of company size on the level of IFRS 8 compliance.
Ha4: Company size is associated with the extent of compliance with the disclosure
requirement of IFRS 8.
The company’s capital structure - Gearing
can be expected to have higher agency cost. Thus, the more highly geared the company is, the greater the necessity to ensure an efficient monitoring (e.g. through the company’s annual reports) of the agency relationship between the managers and creditors and / or managers and shareholders. (Jensen and Meckling, 1976; Dumontier and Raffournier, 1998) Therefore, it is likely that highly geared companies provide more disclosure and comply with the requirements of IASs / IFRSs to mitigate agency cost and signal to the market (both to investors and debt providers) that they are capable to meet their obligations. The opposite can also be argued. Companies with low gearing depend on equity financing which might result in an increased interest in information from the current and potential shareholders. (e.g. Zarzeski, 1996) Additionally, companies with higher level of gearing might provide less information in their annual reports in order to conceal the level of financial risk associated with the higher proportion of debt financing in the companies’ capital structure. (e.g. Hossain, 1999) (Agency theory and Signalling theory)
Some empirical studies found that the level of compliance is associated with gearing (positive association: Camfferman and Cooke, 2002; Al-Shammari et al., 2008; De Vicente Lama et al., 2011; Bova and Pereira, 2012; negative association: El-Gazzar et al., 1999; Abd-Elsalam and Weetman, 2003 and 2007; Pisano and Landriana, 2012). However, other studies could not find any significant connection between the level of compliance and the company’s capital structure (Tower et al., 1999; Taplin et al., 2002; Al-Jabri, 2008; Fekete et al., 2008; Hodgdon et al., 2009; Tsalavoutas, 2011). Thus, the relationship between the company’s capital structure and its level of disclosure / compliance is unclear. However, both theoretical and empirical research indicate that there might be an association between them.
Ha5: Gearing is associated with the extent of compliance with the disclosure
requirements of IFRS 8.
Liquidity
A company’s ability to meet its short-term financial obligations is one of the important factors in evaluating of a company by users of financial statements. It can be argued that the better the liquidity position of the company, the greater the incentive to signal this condition to the market. Thus, companies with higher liquidity ratio will present more disclosure and have greater compliance. (Signalling theory) On the other hand, it may
also be argued that a company with a low liquidity ratio might be keen on disclosing additional information and complying with IASs / IFRSs in order (1) to reduce agency cost and (2) to inform its financial statement users (especially its shareholders and lenders) that necessary actions have been taken and the company is a going concern. (Camfferman and Cooke, 2002; Wallace and Naser, 1995; Al-Shammari et al., 2008) (Agency theory) Thus, the direction of the relationship (if there is any) can be either positive or negative.
Previous empirical studies also show inconsistent results regarding the relationship between the level of compliance with IASs / IFRSs and the company’s liquidity position. (Camfferman and Cooke, 2002; Abd-Elsalam and Weetman, 2007; Al-Shammari et al., 2008; Tsalavoutas, 2011)
Ha6:The extent of compliance with the disclosure requirements of IFRS 8 is
associated with the company’s liquidity.
Profitability
Watts and Zimmermann (1986) argued that companies with larger profits could be more interested in disclosing more detailed information in their annual reports in order to reduce political cost and justify their performance. (Political cost theory) It is also likely that these companies wish to signal to the different market participants 1) their success and strength (Signalling theory) and 2) that they act as a good agent (Agency theory).
Profitability is a popular variable in compliance studies. Several prior studies examined the association between profitability and level of compliance with IAS requirements. However, with the exception of a few studies the researchers found that profitability did not have significant effect on the companies’ level of compliance. (Table 5.4) Taplin et al. (2002) found that the more profitable companies tend to have higher level compliance. On the other hand, Camfferman and Cooke (2002), Hodgdon et al. (2009) found negative association between profitability and IAS compliance. Interestingly, De Vicente Lama et al. (2011) found both significant positive (for 2005) and significant negative (for 2008) association within one study. The authors explained the different sign by the change in the economic situation in which the companies operated. In summary, the empirical results suggest that the level of compliance with IAS could be either higher or lower,
Table 5.4 Independent variables used in prior research investigating determinants of compliance with IAS/IFRS mandatory disclosures
Variable Significant Not significant
+ -
Size Al-Jabri, 2008;
Al-Ulis, 2006; Bova & Pereira, 2012; Camfferman & Cooke, 2002; Chatham, 2004;
De Vicente Lama et al., 2011; Fekete et al., 2008; Hodgdon et al., 2009; Prather-Kinsey & Meek, 2004; Al-Shammari et al., 2008 Tsalavoutas, 2011; Pisano and Landiana, 2012
Abd-Elsalam & Weetman, 2003; Glaum & Street, 2003; Street & Bryant, 2000; Street & Gray, 2001, 2002; Taplin et al., 2002; Tower et al., 1999;
Gearing / Leverage Bova & Pereira, 2012; Camfferman & Cooke, 2002; Al-Shammari et al., 2008 De Vicente Lama et al., 2011;
Abd-Elsalam & Weetman, 2003;
Abd-Elsalam & Weetman, 2007;
El-Gazzar et al., 1999; Pisano and Landriana, 2012
Al-Jabri, 2008; Fekete, et al., 2008; Hodgdon et al., 2009; Taplin et al., 2002; Tower et al., 1999; Tsalavoutas, 2011; De Vicente Lama et al., 2011; Profitability De Vicente Lama et al., 2011;
Taplin et al., 2002;
Camfferman & Cooke, 2002; De Vicente Lama et al., 2011; Hodgdon et al., 2009; Pisano and Landriana, 2012
Abd-Elsalam & Weetman, 2003; Abd-Elsalam & Weetman, 2007; Al-Jabri, 2008;
Al-Ulis, 2006; Bova & Pereira, 2012; Fekete, et al., 2008; Glaum & Street, 2003; Street & Bryant, 2000; Street & Gray, 2001, 2002; Tower et al., 1999; Tsalavoutas, 2011; Industry Abd-Elsalam & Weetman, 2003, 2007; Al-Jabri, 2008;
Camfferman & Cooke, 2002; Fekete, et al., 2008; Prather-Kinsey & Meek, 2004; Street & Gray, 2001, 2002; Taplin et al., 2002; Al-Shammari et al., 2008
Tsalavoutas, 2011;
Al-Ulis, 2006;
De Vicente Lama et al., 2011; Glaum & Street, 2003; Street & Bryant, 2000; Tower et al., 1999; Al-Shammari et al., 2008 Auditor type (big
international)
Abd-Elsalam & Weetman, 2003 and 2007;
Al-Jabri, 2008;
Camfferman & Cooke, 2002; Glaum & Street, 2003; Hodgdon et al., 2009; Prather-Kinsey & Meek, 2004; Street & Gray, 2001, 2002; Tsalavoutas, 2011;
Al-Ulis, 2006;
De Vicente Lama et al., 2011; Fekete, et al., 2008;
Table 5.4 (continued) Independent variables used in prior research investigating determinants of compliance with IAS/IFRS mandatory disclosures
Variable Significant Not significant
+ -
Liquidity Camfferman & Cooke, 2002; Abd-Elsalam & Weetman, 2007; Tsalavoutas, 2011; Al-Shammari et al., 2008 International visibility (internationality) El-Gazzar et al., 1999; Al-Shammari et al., 2008 Fekete, et al., 2008; Glaum & Street, 2003; Street & Gray, 2001, 2002; Compliance note (the
company refers to IAS)
Street & Gray, 2001, 2002; Street & Bryant, 2000;
Audit opinion (refers to compliance with IASs)
Abd-Elsalam & Weetman, 2003;
Chatham, 2004 & 2008 Street & Bryant, 2000;
Street & Gray, 2001, 2002;
Audit standards (auditor follows ISAs)
Street & Bryant, 2000; Abd-Elsalam & Weetman, 2003; Hodgdon et al., 2009; Street & Gray, 2001, 2002; Country of domicile Chatham, 2004 & 2008; Prather-Kinsey & Meek, 2004;
Street & Gray, 2001, 2002; Taplin et al., 2002; Tower et al., 1999; Al-Shammari et al., 2008
De Vicente Lama et al., 2011; Glaum & Street, 2003;
Listing status El-Gazzar et al., 1999; Glaum & Street, 2003; Prather-Kinsey & Meek, 2004; Street & Bryant, 2000; Street & Gray, 2001, 2002;
Fekete, et al., 2008; Hodgdon et al., 2009;
Level of foreign direct investment
Al-Ulis, 2006; Bova & Pereira, 2012;
Al-Jabri, 2008;
Capital intensity Al-Jabri, 2008;
Growth Glaum & Street, 2003;
Growth optins Bova & Pereira, 2012;
Glaum & Street, 2003;
Ownership structure Al-Ulis, 2006; Al-Jabri, 2008;
Glaum & Street, 2003; Al-Shammari et al., 2008;
Age of maturity Al-Shammari et al., 2008; Glaum & Street, 2003;
Activity on capital market Al-Ulis, 2006;
Length of time to report Tower et al., 1999; Taplin et al., 2002;