george emmanuel latridris (2011) (1)

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Accounting disclosures, accounting quality and conditional andunconditional conservatism

George Emmanuel Iatridis

University of Thessaly, Department of Economics, Volos, Greece

Accounting and Auditing Oversight Board, Ministry of Economics, Athens, Greece

a b s t r a c ta r t i c l e i n f o

Article history:

Received 17 December 2010Received in revised form 20 February 2011

Accepted 21 February 2011

JEL classication:

M41

Keywords:

Accounting disclosures

Accounting quality

Conditional conservatism

Unconditional conservatism

Managerial opportunism

Earnings management

This study investigates the motives of UK listed companies when reporting high and low quality accounting

disclosures. It also examines the relation between the quality of published nancial statements and earnings

management practises, for example, low quality accounting disclosures might be linked to earnings man-

agement. The paper further studies the relation between nancial reporting quality and the timely disclosure

of losses and difcult-to-verify accounting items, i.e. conservatism. The focus here is on conditional and

unconditional conservatism, their association and the variables that inuence the asymmetric disclosure of

losses. The ndings indicate that rms that display high quality accounting disclosures generally exhibit

highersize, protability andliquidity measures. Firms that experience a changein management or areaudited

by a Big-4 auditor also tend to report high quality disclosures. High quality disclosers tend to display higher

capital needs and to engage less in earnings management. The study shows that they display greater

conditional conservatism and less unconditional conservatism. The ndings demonstrate that the conditional

form of conservatism is negatively related to unconditional conservatism, as the former tends to enhance

contracting efciency, while the latter might facilitate managerial opportunism. The study provides evidence

of asymmetric disclosure of losses forrms with high leverage. The same holds forhigh quality disclosers that

display bad news. In contrast, rms that are in a growth phase are found to provide less conservative and less

difcult-to-verify accounting information in order to inuence their growth prospects.

2011 Elsevier Inc. All rights reserved.

1. Introduction

According to the International Accounting Standards Board (IASB),

reported accounting information should possess the following

qualitative characteristics. It should be relevant and assist users in

evaluating past, present, and future events. It should be reliable, free

from material error and presented faithfully. Reported accounting

information should also be comparable, consistent and understand-

able in the way it is presented. Information to be included in the

nancial statements should be material in the sense that its potential

misstatement or omission might inuence signicantly the decision-

makingof users.The disclosure of accounting policies employedin the

preparation of the nancial statements should be clear and accom-

panied by explanatory information on any changes in those policies.

Recognition, measurement and disclosure ofnancial information can

affect companies' market picture and nancial situation, and would

therefore require their utmost attention and consideration.

Thenancial statements should be designed to provide valid and

relevant accounting information in order to assist users in making

efcient decisions. They should reinforce investors' understanding

of a company's nancial position, changes in nancial position and

results of operations. The reportednancial information should reect

on the quality and value relevance of earnings and should be sup-

ported by appropriate quantitative and qualitative evidence. The

nancial statements should provide disclosures about the critical

assumptions and estimates relating to accounting items and issues

that are highly uncertain as well as about estimates that would have

a material impact on the presentation of the company's nancial

position and results (see Conover, Miller, & Szakmary, 2008). Like-

wise, it is vital to identify the items in the nancial statements that

are likely to be affected by the accounting estimates. The reported

accounting information should be forward-looking and should mirror

the company's future nancial prospects and the likely future effects

of potential and known risks and uncertainties. Disclosures are vital

where uncertainties and risks exist that might materially affect the

company'snancial situation. For example, items, such as loan agree-

ments or other arrangements that might trigger payment acceleration

or require additional collateral, circumstances that might impede

the company's ability to engage in transactions that are nancially

benecial or maintain a certain credit rating, level of earnings or cred-

itability, should be explicitly disclosed and discussed in the nancial

statements.

International Review of Financial Analysis 20 (2011) 88102

94 Vassani Street, Volos, 38 333, Greece. Tel.: +30 6973 963626.

E-mail address:[email protected].

1057-5219/$ see front matter 2011 Elsevier Inc. All rights reserved.

doi:10.1016/j.irfa.2011.02.013

Contents lists available at ScienceDirect

International Review of Financial Analysis
http://dx.doi.org/10.1016/j.irfa.2011.02.013http://dx.doi.org/10.1016/j.irfa.2011.02.013http://dx.doi.org/10.1016/j.irfa.2011.02.013mailto:[email protected]://dx.doi.org/10.1016/j.irfa.2011.02.013http://www.sciencedirect.com/science/journal/10575219http://www.sciencedirect.com/science/journal/10575219http://dx.doi.org/10.1016/j.irfa.2011.02.013mailto:[email protected]://dx.doi.org/10.1016/j.irfa.2011.02.013


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Information asymmetry between managers and stakeholders would

reduce (uninformed) investors' bid prices for company shares. At

the same time, a manager's (potential) concentration in manipulating

contract-based accounting numbers would lead to higher agency costs

and lower rm value (LaFond & Watts, 2008). The considerations set

out above would call for nancial reporting of high quality and less

subjectivity. Higher accounting quality in nancial reporting would be

accompanied by higher conservatism and less information asymmetry

(Ball & Shivakumar, 2005). Given managers' incentives to report goodnews, conservatism, which is the asymmetric disclosure of accounting

information, i.e. reporting losses in a more timely fashion than prots,

would make loss disclosures more credible than prot disclosures.

Also, debt covenants embedded into debt contracts would encourage

conservatism as they monitor reported numbers' validity and integrity

(Watts & Zimmerman, 1986). Therefore, conservative accounting

would facilitate monitoring of managerial behaviour as well as efcient

corporate governance mechanisms, since monitoring by board mem-

bers, nancial analysts, investors and other stakeholders would make

managers more careful when producing veriable accounting informa-

tion (Beekes, Pope, & Young, 2004; Garcia Lara, Garcia Osma, & Penalva,

2007).

Firms with high accounting quality in their reported disclosures

would be expected to provide stakeholders with veriable information

about losses, nancial failures and other unfavourable nancial events

that are depicted on nancial accounts and affect a company's per-

formance. It follows that less veriable information would be easier to

be manipulated and would also be less useful to users, reducing thereby

the overall wealth of both managers and shareholders. Thus, high

quality disclosers would apply conditional conservatism, which relates

to disclosures of difcult-to-verify accounting information, and restrict

unconditional conservatism, which is news-independent and relates

to opportunistic managerial endeavours (Basu, 2005). In contrast, rms

that provide low quality accounting disclosures would be more likely to

apply unconditional conservatism practises in order to promote their

managerial objectives, especially when subjectivity drives their deci-

sions. For example, in the case of losses and large stock price declines,

managers may be inclined to write asset values down in order to use

the resulting reserve to inuence future earnings streams (Jiraporn,Miller, Yoon, & Kim, 2008). Alternatively, in the case of information

asymmetry, rms may use discretionary accruals in order to reduce

earnings volatilityand tax obligations or increase management bonuses.

Unconditional conservatism might also be preferred in order to reduce

litigationrisks and obtain better terms ofnancingespecially whenrms

experiencenancial distress (Coppens & Peek, 2005).

The manager's reputation, remuneration and future in the com-

pany, and the company's share price are to a large degree affected by

the company's published nancial statements and accounting-based

contracts (LaFond & Watts, 2008). Hence, rms would have different

motives for conditional and unconditional conservatism. So, depend-

ing on managerial motives, the restriction of earnings management or

unconditional conservatism practises would vary and would have

differential effects on nancial reporting quality. However, (condi-tional) conservatism may not be driven only by the rm's efforts

to reinforce the quality of their reported numbers, but also by other

factors that are related to the decision to report accounting in-

formation of high quality, such as size, stock market visibility and

analyst following, leverage, litigation and agency costs and growth

(Cano-Rodrguez, 2010).

In the Review of Narrative Reporting by UK Listed Companies,

The Accounting Standards Board (2009) reports that 76% of their

sample companies provided discussion of their nancial performance

and position. 94% of their sample provided some nancial key per-

formance indicators (KPIs), while 32% of the sample did not disclose

any non-nancial KPIs. 92% of their sample outlined some objectives

or strategies, or both. 66% of the sample reported their risk exposures.

However, only 6% of the sample provided risk-related information

with signicant decision-usefulness. Only 38% of the companies

provided a critical discussion ofnancial trends and factors. The ASB

reports that it is not clear whether 52% of the sample presented

information on contractual arrangements correctly and in consistency

with the regulation.

In the 2007 Narrative Reporting Survey,PricewaterhouseCoopers,

(2007) have shown that 75% of the FTSE 350 constituents provided

explicit disclosures about their KPIs. 75% of companies provided clear

descriptions of their principal risks and uncertainties. 35% ofcompanies presented quantitative along with qualitative nancial

information. 42% of companies linked their KPIs with their strategy.

The 2007 Black Sun research reports a signicant improvement in the

disclosure of business objectives and strategy by FTSE 100 constitu-

ents to 98%from 40%in the previous year. Similarly, 88%of companies

presented information on market trends, while 43% of the companies

supported their qualitative nancial information with quantitative

gures. TheBlack Sun research has also found that 73%of institutional

investors appreciate the provision of additional disclosures in

companies' annual reports, while 87% of them believe that high

quality accounting disclosures are likely to positively affect a

company'snancial performance and outlook (Black Sun, 2007).

The investigation of the sample annual reports shows that UK

rms may in certain cases fail to clearly present and link their

objectives to their strategies andvice versa.Empty statements, such as

our effort is to grow, should be avoided. The business and nancial

structure should be presented along with methodologies, models and

procedures that are in place. The focus of disclosures tends to be on

protability rather than on cash ow. Firms report too many KPIs

creating confusion and misleading users of accounting information.

Firms present KPIs in isolation from the rest of the report without

providing cross-references or critical links to strategy and targets.

Firms ood the annual report with economic and non-economic

information to describe nancial events and transactions or the

economic environment that may be immaterial and irrelevant to

users' decision-making. Information on how managers' actions and

decisions are monitored is found to be infrequently included in the

annual report.

Given the current world economic situation, rms would beexpected to discuss their exposure, economic reaction and defence

mechanisms to liquidity risk. Few rms, however, appear to display

satisfactory managerial information on the world economic downturn.

All sample companies provide disclosures about their risk exposures.

However, they present too many risks and limited quantiable in-

formation with regard to the nature and impact of risks on company

nancial position. Critical disclosures, such as estimates and assump-

tions, management judgement, sources of risks and uncertainty, appear

to be narrative and are not accompanied by numbers or other numerical

descriptions. In their effort to attract investors' condence to their

nancial statements and enhance the value relevance of their reported

accounting numbers, rms should provide quantications of their

narrative disclosures.On the other hand,rms provide amplenumerical

data in the notes to the accounts, without presenting appropriateevidence or explanations.

Given that the quality of nancial reporting and the content of

accounting disclosures vary fromrmto rm, the study focuses on UK

listed companies and examines the motives for the provision of high

quality accounting disclosures. Higher accounting quality would be

expected to lead to higher levels of investor condence and to easier

access to stock and debt capital. Hence, studying the motives for

providing higher or lower quality disclosures would shed some light

on managerial behaviour and would provide explanations for their

intentions. For example, the need to obtain equity or debt nancing

might encourage the preparation of a higher quality annual report.

The study also investigates the relation between accounting quality

and earnings management. It would be expected that rms that

provide accounting information that reects the decisions and actions

89G.E. Iatridis / International Review of Financial Analysis 20 (2011) 88102


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of managers in a reliable manner would be less involved in earnings

management practises.

High quality accounting disclosures and annual reports would

provide a means of verifying the reported balance sheet and prot

and loss gures. Here, the study explores the relation between con-

ditional and unconditional conservatism and examines whether high

quality disclosers display higher or lower conditional and uncondi-

tional conservatism. In countries with strong investor protection

mechanisms, such as the UK, conditional conservatism would bemore evident (see Francis & Wang, 2008). The study further tests

the relation between earnings conservatism and reporting quality, by

investigating whether in the light of high quality accounting dis-

closures, less prots and/or more losses are reported. The study also

explores how major accounting variables, such as growth options and

leverage, may inuence conservatism.

The ndings of the study indicate that rms that display high

quality accounting disclosures generally exhibit larger size and

market visibility and higher protability and liquidity. Also, their

higher capital needs and nancial obligations motivate them to

prepare nancial statements of higher quality. In general, rms that

experience a change in management and/or are audited by a Big-4

auditor tend to report accounting information of high quality. High

quality accounting disclosers also appear to recognise large losses

more timely and to engage less in earnings management. The study

has found that conditional conservatism is positively related to

accounting quality. It is found that high quality disclosers display

greater conditional conservatism and less unconditional conserva-

tism, which would further reinforce the superiority and value of the

reported accounting information of these rms as opposed to low

quality disclosers. The ndings report that the conditional form of

conservatism is negatively related to unconditional conservatism, as

the former tends to enhance contracting efciency, while the latter

might facilitate managerial opportunism. The study provides evidence

of asymmetric disclosure of losses for rms with high leverage. The

same holds for high quality disclosers that display bad news. The

ndings also show that rms that are in a growth phase tend to

provide less conservative and less difcult-to-verify accounting

information in order to inuence their growth prospects.Theremaining sections of thestudy areas follows. Section 2 presents

the background of the study.Section 3shows the research hypotheses.

Section 4describes the data and the company categorisation criteria.

Section 5discusses the empirical ndings, andSection 6presents the

conclusions and implications of the study.

2. Background considerations

2.1. Managerial opportunism

The rm's contractual arrangements, such as manager's compen-

sation and compliance with debt covenants, the reputation of the

manager and his/her quest for better compensation schemes and/or

position, and the rm's stock return performance affect managerialbehaviour (Lambert, 2001). Hence, they subsequently inuence the

information content of nancial statements (Fields, Lys, & Vincent,

2001). Managers may present favourable nancial numbers during

their term at the management of the rm or increase prots and

reduce losses (Watts, 2003). Unfavourable nancial results, large

losses and stock price drops may lead to managerial decisions that

seek to inuence earnings of future accounting periods. Managers

may also seek to transfer earnings from good to bad accounting years.

Managers may be inclined to inate their earnings in order to be

able to sell their holdings and stock options at higher rates, implying

that managerial ownership may have a signicant effect on earnings

management considerations (Beneish, 1999; Chen, 2005). Alterna-

tively, managerial reputation may make the manager of a rm to

commit to the nancial objectives and interests of the rm's stake-

holders and eventually reduce information asymmetry. This would

imply that managers' reputation and compensation would be adversely

affectedif themanager acted against thebest interestsof therm (Smith

& Watts, 1982).

Managers are likely to structure their decision-making and nancial

reporting so as to meet investors' expectations and nancial analysts'

forecasts (Healy, Hutton, & Palepu, 1999; Lang & Lundholm, 1996;

Levitt, 1998). Firms may manipulate their prots by altering their

accounting methods, in

uencing the estimates and assumptions ofkey accountinggures, exercising judgement and subjectivity, or even

misappropriating assets and manipulating formal business documents

and reports (Comer, 1998;Worthy, 1984). Items,such as cash, inventory

and related party transactions, often require judgement, and therefore,

may be associated with opportunistic managerial behaviour (SAS No. 47Audit Risk and Materiality in Conducting an Audit; Vanasco, 1998).

Likewise, the mispresentation and manipulation ofnancial statements

may also involve overstating revenues and assets by intentionally

misrecording revenues, inuencing provisions for bad debts, the value

of property, plant and equipment, misstating accounts receivable by

recording unearned sales, etc (Beasley, Carcello, & Hermanson, 1999;

Fanning & Cogger, 1998; Summers & Sweeney, 1998). Additional

examples involve mismatching sales with cost of sales in order to ma-

nipulate the gross prot margin, or reporting inventory at values other

than those required by law (Spathis, Doumpos, & Zopounidis, 2002).

In the attempt to avoid debt covenant violation, nancial distress

and/or bankruptcy, rms with high leverage may behave opportu-

nistically and not reliably present the reported nancial numbers

(Persons, 1995). In contrast,Frankel and Roychowdhury (2006)have

found that rms with high leverage would tend to present more

informed nancial statements in order to impress lenders. These

ndings imply that managerial behaviour and/or potential opportun-

ism would vary and they would depend upon rms' economic and

nancial situation and position. According toWatts (1993), litigation

may also be a driving force for disclosing more informative nancial

numbers. Also, less protable rms may be reluctant to provide

revealinginformation in their annual reports in orderto avoidscrutiny

and political attention (Spathis et al., 2002). Generally, companies that

experience low asset-related and sale-related returns would generallybe inclined to manipulate their accounting numbers in order to exhibit

betternancial measures (Beasley et al., 1999; Summers & Sweeney,

1998).

Opportunistic phenomena and behaviours can be associated with

managers' personality and inuence, such as for example their rela-

tionship with company auditors, the company's business environ-

ment and economic conditions, the nature of the company's operating

and nancing activities and transactions (SAS No. 82 Consideration

of Fraud in a Financial Statement Audit; Gibbins, Richardson, &

Waterhouse, 1990; Spathis et al., 2002). Bell and Carcello (2000)

argue that the risk factors that seek to capture the likelihood of op-

portunisticnancial reporting include weak internal control systems,

inadequate nancial performance, excessive focus on short-term -

nancial objectives and investors' perceptions ignoring the long-termperspective of the rm, ownership structure, etc.

The potential opportunistic behaviour that might be expressed by

managers is likely to be associated with the private information that

they possess and which they might use to the detriment of investors

and for their own benet. The possession of private information would

lead to buying or selling decisions aiming at the maximisation of

managers'interests. In a similar vein,information asymmetrymight lead

uninformed investors to incorrect and loss-making decisions. Large

quantities of private information would be associated with large bid-ask

spreads and lower stock returns for uninformed investors (Amihud &

Mendelson, 1986; Easley & O'Hara, 2004). In contrast, rms with high

nancial reporting quality and less information asymmetry appear to

display lower bid-ask spreads (Chang, D'Anna, Watson, & Wee, 2006)

and higher abnormal returns (Agarwal, Liao, Nash, & Tafer, 2008).

90 G.E. Iatridis / International Review of Financial Analysis 20 (2011) 88102


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Information asymmetry would tend to vary depending on therm'sgrowth options and investment strategy. It is uncertainwhether

the growth prospects of a rm will eventually yield the expected

returns,or how the use offairvalues would impact ontherm's value,

implying that the information asymmetry between rm and stake-

holders would likely be signicant (Smith & Watts, 1982). Higher

information asymmetry and subsequently higher variability in

expected cash ows might result in projects being rejected while

they should be accepted, or being accepted while they should berejected. Similar considerations would hold when acquiring a rm

with high growth options, in which case the value of the rm would

be affected by the value of growth options and the inherent infor-

mation asymmetry. Piotroski (2003) and Leuz (2004) have found that

rms with growth opportunities would tend to display lower quality

reporting. In contrast, when a rm disposes of a growth subsidiary or

its investment projects are close to completion, and subsequently its

growth potential becomes lower, information asymmetry would tend

to decrease (LaFond & Watts, 2008).

Therefore, a main issue that arises in nancial reporting is the

information asymmetry that may exist between informed and un-

informed users of accounting information, generally following from

managers' tendency to be reluctant to present losses, while willing to

disclose prots. A conservative presentation of nancial statements

would reduce the scope for earnings manipulation as well as infor-

mation asymmetry, and would in turn lead to higher quality in

nancial reporting (seeBall, 2001; Watts, 2006). Thus, it would be

closely associated with the objectives of efcient corporate gover-

nance as it seeks to minimise the potential for managing earnings and

misleading investors and to increase rm value (LaFond & Watts,

2008). It follows that as information becomes more specic and falls

within certain recognition and presentation criteria, earnings manip-

ulation becomes less feasible. The enhancement of the credibility of

the rm is crucial, especially when it relates to issues, such as equity

issues, mergers and acquisitions (Argenti, Howell, & Beck, 2005;

Brennan & Tamarowski, 2000; Gruner, 2002). Credible and informa-

tive nancial statements would reduce phenomena of miscommuni-

cation between interested parties and would also mitigate users'

scepticism about managers' decisions as well as any agency costs thatreduce the rm's expected cash ows. The existence of agency costs,

which would increase as outside equity increases (Jensen & Meckling,

1976), would motivate stakeholders to instal mechanisms to monitor

managers' behaviour (see Crutchley, Jensen, Jahera, & Raymond,

1999). Such monitoring mechanisms might however be costly and

slow down a rm's nancial progress. On the other hand, it may be

that through increased disclosure, rms seek to inuence or window-

dress their nancial numbers or even mislead investors' attention

(Premuroso, Skantz, Terrance, & Bhattacharya, 2008). The question,

however, is whether and to what extent the stock market sees

through such actions and penalises rms accordingly.

2.2. Financial reporting quality and the rm

The benets of transparency and effective accounting disclosure

would improve company nancial performance, risk management,

internal control systems and stock tradeability, while it would also

enhance company growth, nancial reporting quality and communi-

cation (Ambler & Neely, 2007). The use of effective nancial reporting

procedures would be dependent upon the resulting capital market

benets and agency cost savings and costs of reporting nancially

sensitive information (Bradbury, Dean, & Clarke, 2007; Hayes &

Lundholm, 1996). Informative disclosures are also provided especially

when rms have capital needs and seek to raise money in stock and

debt markets (seeMitchell, Chia, & Loh, 1995; Verrecchia & Weber,

2006). Generally,Lang and Lundholm (1993)have found that rms

would be inclined to disclose high quality accounting information

when their performance is favourable.Graham, Harvey, and Rajgopal

(2005) show that rms may produce informative accounting

disclosures to reduce information asymmetry and stock price risk.

However, they argue that rms avoid setting a high disclosure level as

it may be difcult to attain it in future periods.

The quality of a rm's nancial behaviour and nancial reporting

would also depend on the level of information asymmetry (Chang et al.,

2006). Effective nancial reporting implies the continuous provision

of voluntary, up to date and high quality disclosures (Marston, 1996).

The level of accounting disclosure, such as informative annual reports,earnings forecasts and information on risk exposure, investment

strategy, corporate governance mechanisms, dividend policy, operating

andnancing strategy,etc,would in turnreduce information asymmetry

(Marston, 1996). Periods of uncertainty, such as around the announce-

ment of earnings or the publication of annual reports, may involve

information asymmetry regarding the company's nancial results, -

nancial analysts' future earnings forecasts and other sensitive company

nancial information, whichmay adversely affect investors' perceptions

and stock liquidity (Kim & Verrecchia, 1994). Firms with effective

nancial reporting would tend to exhibit lower information asymmetry

under such periods of uncertainty and would be rewarded by the stock

market, as they inform investors about the company's nancial and

business strategies and future prospects.

In consistency with agency theory, the assessment of a rm's

nancial reporting quality would assist in the inspection of manage-

rial actions and decisions and would also examine whether managers

act in the best interest of shareholders (Deller, Stubenrath, & Weber,

1999). Effective nancial reporting can essentially inuence market

participants and reduce political and regulatory costs as well as any

potential negative managerial signals (Lev, 1992; Ryder & Regester,

1989). Firms with effective nancial reporting tend to present higher

levels of disclosure, press attention, stock trading volume, institu-

tional ownership and analyst following (Agarwal et al., 2008; Bushee

& Miller, 2007; Lang & Lundholm, 1996, October). Firms with dis-

persed ownership that seek to attract institutional investors would

also tend to provide extensive disclosures in order to disseminate

information to interested parties (Bradbury et al., 2007; Bushee &

Miller, 2007). Bradbury (1991) argues that the cost of accounting

disclosure would depend on the decisions of newcomers in themarket and those of existing market participants. He shows that the

cost of disclosing proprietary information is likely to be higher in

concentrated industries.

Effectivenancial reporting would enablerms to strengthen their

presence in the domestic capital markets and enter into foreign

capital markets and thus attract investors internationally. Firms with

effectivenancial reportingwouldtend to experience lowerinformation

asymmetry-related risks and subsequently lower cost of capital, while

their ability to issue capital would appear to be stronger (Agarwal

et al., 2008; Chang et al., 2006). Likewise, Diamond and Verrecchia

(1991) and Brennan and Tamarowski (2000) suggest that the reduction

of information costs and uncertainty can lower the cost of capital and

increase the stock return.

Effective nancial reporting would also reduce the costs of col-lecting company nancial information that nancial analysts may

face. This would imply that rms with higher nancial reporting

quality would tend to have better analyst coverage and higher stock

trading volume and stock returns (Agarwal et al., 2008). In a similar

vein, Farragher, Kleiman, and Bazaz (1994) argue thatrms with highnancial reporting quality exhibit lower stock information risk and

lower dispersion in analyst forecasts. It is argued that media coverage

may be more essential than analyst coverage, while sometimes rms

tend to improve the quality of accounting disclosure before setting

up their nancial reporting procedures and investor communication

structures (Bushee & Miller, 2007; Falkenstein, 1996; Grullon,

Kanatas, & Weston, 2004).

Enhancing nancial reporting quality appears to be positively

related to rm size, liquidity and exchange listing (see Kadlec &



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McConnell, 1994). This would imply that large and subsequently

visiblerms would be inclined to improve their market picture and

information disclosures (Chang et al., 2006).Chang et al. (2006)also

argue that rms with lower liquidity stocks would be motivated to

strengthen their nancial reporting quality in order to attract

investors and increase their stock marketability. Small and medium-

sizedrms that are not listed on a major stock exchange or are less

visible in the market place and struggle to obtain signicant analyst

following would bene

t by strong

nancial reporting quality andwould in turn be able to achieve better market valuations (Agarwal

et al., 2008; Brennan & Tamarowski, 2000; Hong & Huang, 2005).

Indeed, Bushee and Miller (2007) report that rms with effectivenancial reporting obtain better market valuations in the year after

the improvement of their nancial reporting procedures. Also, small

and newly listed rms would seek to reinforce their nancial

reporting quality in order to signal that their future nancial per-

formance will improve and therefore impress investors (Hong &

Huang, 2005). For example, managers that fail to meet the targeted

protability levels might resort to earnings manipulation and to a

misleading presentation of companynancial performance in order to

avoid providing negative managerial signals (Summers & Sweeney,

1998). This would be more evident especially when managers have

signicant personal interests vested in the rm. Similar considera-

tions would also hold for rms that underperform or exhibit negative

market returns (Premuroso et al., 2008).

Financial reporting quality can be improved by increasing quan-

tity, quality and timeliness of information disclosed in earnings an-

nouncements, annual report, press releases and company website.

Financial reportingquality can also be reinforced by keeping the press

continuously informed about the company's nancial performance,

prospects and decisions, and by providing explanations about policies

adopted by management and information about the company's

operating, investing and nancing activities (Chang et al., 2006).

Mediratta and Jain (2007) have found that rms generally tend to

report sufcient information on their business and strategies as well

as on their current performance, while they experience difculties

when preparing information about their future nancial prospects

and off-balance sheet items.

3. Research hypotheses

3.1. High quality accounting disclosures

The study focuses on the identication of the motives for the

provision of high quality accounting disclosures. While providing

comprehensive accounting disclosures, rms provide evidence and

assurance that their actions are consistent with the law and ac-

counting regulation and in line with investors' expectations and

interests (Zimmerman, 1983). Such assurance would lead to lower

political, agency and regulatory costs. The considerations above

would hold especially for large rms, which are subject to politicalattention and scrutiny to a greater degree than smaller rms (see

Ali & Kumar, 1994; Moses, 1987; Ndubizu & Tsetsekos, 1992).

Firms that are not performing well are not likely to provide rich

accounting disclosures. In contrast, rms that perform well would

be inclined to disclose detailed and sensitive accounting informa-

tion in order to provide evidence of superior managerial ability.

Firms would tend to disclose higher quality information in periods

of large negative earnings news, or when they seek to reduce stock

return risk (Bens, 2002; Kasznik & Lev, 1995). Also, rms that seek

to raise capital in stock and debt markets would be expected to

provide market participants with informative accounting disclo-

sures in order to give evidence of higher quality nancial reporting,

lower the cost of capital and improve the terms and the prospects

of the capital issue (Bushman & Smith, 2001; Errunza & Miller,

2003; Gietzmann & Trombetta, 2003). The hypothesis that is tested

is as follows:

H1. Firms that provide high quality accounting disclosures are likely to

be signicantly different than those that do not.

To testH1, the study categorises samplerms based on the quality

of their reported accounting disclosures. The study seeks to identify

differences in thenancial measures ofrms that provide high quality

accounting information andrms that provide low quality accountingdisclosures and report the minimum required by accounting regula-

tion. This categorisation is based on theexaminationofrms' nancial

statements using specic criteria, which are set by the Investor

Relations Society (IRS) and are detailed in Section 4.2. These criteria

formed a checklist of quality standards, which aimed to overall char-

acterise each sample rm as a high or low quality discloser. It must

be noted that a rm may, for example, display a rich discussion on

company risk exposure and ample information on KPIs or corporate

responsibility, but it may provide poor quantications of the reported

non-nancial information. So, the company characterisation gives a

general picture of a rm's accounting disclosures and reported in-

formation. Here, the dummy dependent variable used in the logistic

regression takes 1 for high quality information providersand 0 for low

quality information providers.Based on the categorisation presented above, i.e. presentation of

high/low quality disclosures, the study implements a logit model

whereby the explanatory variables are strictly accounting (see

Eq. (1)), followed by a logit model, based on Bushee and Miller

(2007), whereby the explanatory variables are a mixture of general

rm-specic nancial attributes (see Eq. (2)). The study focuses on

the period 2005 to 2009. The logit models used in the study are

presented below:

AQi;t= a0 + a1ROAi;t+ a2MVBVi;t+ a3TLSFUi;t+ a4OCFi;t

+a5LNAi;t+ a6ECNi;t +a7DCNi;t+ a8i;t+ ei;t

1

where

AQi,t is a dummy variable representing the quality of reported

accounting information. AQi,t=1 for rms reporting high

quality accounting information andAQi,t=0 otherwise,

ROAi,t is net income before extraordinary items scaled by total

assets,

MVBVi,t is market value scaled by book value,

TLSFUi,t is total liabilities scaled by shareholders' funds,

OCFi,t is operating cashows scaled by total assets,

LNAi,t is the log of total assets,

ECNi,t is a dummy variable indicating company equity capital

needs. ECNi,t=1 for rms with equity capital needs and

ECNi,t=0 otherwise,

DCNi,t is a dummy variable indicating company debt capital needs.

DCNi,t

=1 for rms with debt capital needs and DCNi,t

=0

otherwise,

i,t is the change in net income before extraordinary items,

ei,t is the error term.

AQi;t= a0 + a1TVi;t+ a2PCi;t+ a3MCi;t+ a4Di;t +a5SHi;t

+a6AUi;t +a7Ii;t+ ei;t

2

where




TVi,t is the share trading volume scaled by shares outstanding,

PCi,t is the log of the number of pages in the annual report,



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MCi,t is a dummy variable that proxies for changes in the man-

agement. MCi,t=1 when changes in the management have

occurred in the year and MCi,t=0 otherwise,

Di,t is the number of days with a non-zero volume in the period

scaled by the total number of trading days (see Bushee &

Miller, 2007),

SHi,t is the log of the number of outstanding shares,

AUi,t is a dummy variable that proxies for auditing. AUi,t=1

when a

rm is audited by a Big-4 auditor and AUi,t=0otherwise,

Ii,t is a dummy variable to control for industry,


3.2. Discretionary accruals and high quality accounting disclosures

High quality accounting disclosures would provide interested

parties with signicant accounting information relating to managerial

behaviour, actions and decision-making, company strengths and weak-

nesses, and would assist users in making forwarding-looking company

assessment and investment decisions. Therefore, the provision of high

quality disclosures and the subsequent investor awareness would tend

to reduce the potential for earnings management. The hypothesis that

is tested is as follows:

H2. Firms that provide high quality accounting disclosures are likely to

exhibit lower discretionary accruals.

The study focuses on the period 2005to 2009and usesan Ordinary

Least Square (OLS) regression to determine the association between

discretionary accruals and cash ows as well as protability, leverage

and size. Theregression model that is used is as follows (see Tendeloo

& Vanstraelen, 2005):

DACi;t= a0+ a1AQi;t+ a2AQi;tx OCFi;t+ a3AQi;tx LNAi;t

+a4AQi;tx ROAi;t+ a5AQi;tx TLSFUi;t+ ei;t

3

where

DACi,t is the discretionary accruals that are estimated using the

cross-sectional Jones model (Jones, 1991). The study uses

the residuals of the following regression model as discre-

tionary accruals (see alsoDeFond and Subramanyam, 1998;

Bartov, Gul, & Tsui, 2001; Kothari, Leone, & Wasley, 2004;

Garza-Gomez, Lee, & Du, 2006).

ACi;t= a0 1=Ai;t1

+ a1REVi;t+ a2PPEi;t+ ei;t 4

where

ACi,t is accruals in yeartscaled by lagged total assets, i.e. totalassets in year t1. Accruals equal the annual change in

current assets (excluding cash) minus current liabilities

(excluding short-term debt and income tax payable) minus

depreciation,

Ai,t-1 is total assets in yeart1,

REVi,t is the annual change in revenues in yeartscaled by lagged

total assets,

PPEi,t is property, plant and equipment in yeartscaled by lagged

total assets,


All other variables are dened as in Eq.(1).

The second test examines rms' aptitude to manage accounting

numbers in order to report, for example, small prots rather than

losses (Burgstahler and Dichev, 1997; Leuz, Nanda, & Wysocki, 2003).

The study also examines the speed by which losses are recognised, in

the sense that the timely recognition of large losses should provide

evidence of lower earnings management (Lang, Raedy, & Wilson,

2005). Within the independent variables, the study uses a dummy

variable, SP, as a measure of small prots (seeLang, Lins, & Miller,

2003;Barth, Landsman, & Lang, 2008), and a dummy variable, LL, as a

measure of timely loss recognition (seeLang et al., 2003, 2005). The

logit model takes the following form:

AQi;t= a0 + a1ROAi;t+ a2MVBVi;t+ a3TLSFUi;t+ a4OCFi;t

+a5LNAi;t+ a6SPi;t+ a7LLi;t+ ei;t

5

where

SPi,t is a dummy variable indicating a measure of small prots.

SPi,t=1 if net prot scaled by total assets is between 0 and

0.01 andSPi,t=0 otherwise,

LLi,t is a dummy variable indicating a measure of timely loss

recognition.LLi,t= 1 if net prot scaled by total assets is less

than 0.20 andLLi,t=0 otherwise. All other variables are

dened as in Eq.(1).

A negative coefcient for SPi,twould show that rms reporting

high quality accounting information tend to manage their prot

gures,in order to report smallpositiverather than negative amounts,

less frequently. A positive coefcient forLLi,twould suggest thatrms

reporting high quality accounting information tend to recognise large

losses more readily.

3.3. Conservatism and high quality accounting disclosures

Conservatism is dened as the accountant's tendency to require

a higher degree of verication to recognise good news as prots than

to recognise bad news as losses (Basu, 1997, p. 7). The accounting

literature identies two types of accounting conservatism. The con-

ditional conservatism is described as the higher degree of vericationthat is required when good news is reported (Basu, 1997). Un-

conditional conservatism relates to the early recognition of losses

regardless of whether the news is good or bad (Qiang, 2007).

Managers may be opportunistically motivated to overstate assets

and earnings related gures and understate liabilities in order to

improve their bonuses and wealth or the company nancial prole

and future nancial prospects. Conservatism would tend to under-

state assets and earnings and offset managers' opportunistic behav-

iour (Watts, 2003). However, unconditional conservatism may arise

from tax, litigation and managerial self-interest (Cano-Rodrguez,

2010, p. 132), and it may subsequently lower the information value

of reported nancial information (Ball, Robin, & Sadka, 2008). For

example, unconditional conservatism may be related to the imple-

mentation of depreciation or stock valuation methods that servecertain managerial and opportunistic goals. It follows, therefore, that

unconditional conservatism may introduce noise in the nancial

reports and lead to biassed and inefcient economic decisions (Ball &

Shivakumar, 2005). Unconditional conservatism may be desirable in

order to obtain better terms ofnancing, to meet earnings targets, or

to hide adverse movements inrm nancial numbers or economically

bad decisions(Burgstahler, Hail, & Leuz, 2006; Coppens & Peek, 2005).

Cano-Rodrguez (2010)has found that unconditional conservatism is

present in the case of rms with large size, high leverage and low

growth, and particularlyrms that are close to nancial distress and

experience high litigation risk and low reputation levels.

Only conditional conservatism can improve contracting efciency

as it relates to disclosures of difcult-to-verify accounting information

(Basu, 2005). It follows, therefore, that rms with higher contracting



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costs would incorporate conditional conservatism in their nancial

reporting process as opposed to unconditional conservatism (Qiang,

2007). For example, conditional conservatism arises in the case of

goodwill impairment, when the respective assets are carried at more

than their recoverable amount (IAS 36 Impairment of Assets). Thus,

conditional conservatism reinforces the value relevance and informa-

tion usefulness of reported accounting numbers. Hence, conditional

conservatism is desired by shareholders, lenders and other stake-

holders, because it would give them a clear view of the

rm'sstrengthsand weaknesses and assist them in making correct judgment and

investment choices (seeGuay & Verrecchia, 2007). Conditional con-

servatismwould subsequentlybe evident especially whenhigh quality

accounting information is required,such as in the caseof issuing equity

and debt capital, cross-listing, or when strong investor protection

mechanisms are in place, such as in common-law countries (Ball,

Kothari, & Robin, 2000; Bushman & Piotroski, 2006; Francis & Wang,

2008).

It follows therefore that conditional and unconditional conserva-

tism cannot be regarded as substitutes (Basu, 2005). In contrast, they

may be negatively related (Qiang, 2007; Vander Bauwhede, 2007).

Unconditional conservatism anticipates future bad news and may be

applied in a manner so as to meet the rm's managerial objectives

before the event, obstructing the use of conditional conservatism after

the event, i.e. after the realisation of the anticipated bad news (Beaver

& Ryan, 2005). The study predicts that earnings ofrms that prepare

high quality annual reports would be more conservative than

earnings ofrms that present low quality annual reports.1 The period

under investigation is 2005 to 2009. The hypothesis and the OLS

model are based on Cano-Rodrguez (2010, p. 141) and are as follows:

H3. Firms that report high quality accounting disclosures are likely to

display higher conditional conservatism and lower unconditional

conservatism compared to low quality accounting disclosers.

DACi;t= a0 + a1CFDi;t+ a2OCFi;t+ a3CFDi;tx OCFi;t+ a4AQi;t

+ a5AQi;tx CFDi;t+ a6AQi;tx OCFi;t+a7AQi;tx CFDi;txOCFi;t+ei;t

6

where

DACi,t is the discretionary accruals dened as in Eq.(3),CFDi,t is a dummy variable representing the sign of operating cash

ows. CFDi,t=1 if operatingcashows scaled by total assets

is negative andCFDi,t= 0 otherwise,

OCFi,t is operating cash ows scaled by total assets,AQi,t is a dummy variable representing the quality of reported




The relation between nancial reporting quality, as expressed by

the quality of accounting disclosures, and conditional conservatism iscaptured with a7. A signicantly positivea7would signify that rms

that provide high quality accounting disclosures display signicantly

greater conditional conservatism compared to rms that provide low

quality accounting disclosures. In other words, in the presence of

conditional conservatism, a rm that reports high quality accounting

information would be expected to exhibit low discretionary accruals

even if it experienced negative or low cash ows.

To capture the relation between nancial reporting quality and un-

conditional conservatism,the studyemploysthe variableUC AQ=1 =4 + 5xNOCF AQ= 1 used inCano-Rodrguez (2010, p. 141). 4and 5 are the estimates of 4 and 5 presented in Eq. (6). NOCF

(AQ= 1) is the proportion ofrms that display high accounting quality

and negative cash ows.Cano-Rodrguez (2010)argues that following

thatunconditionalconservatism is news-independent only conditional

conservatism provides new information, which essentially is the

dif

cult-to-verify accounting information

UC (AQ=1) would seek tofocus on the accruals that are independent of good or bad news among

high and low accounting quality disclosers (see also Beaver & Ryan,

2005; Vander Bauwhede, 2007). UC (AQ=1) is inversely related to

unconditional conservatism, implying that a positive value would show

thatrmsthatprovide highqualityaccountingdisclosuresare associated

with lower unconditional conservatism.

3.3.1. The relation between conditional and unconditional conservatism

Following the discussion on conditional and unconditional con-

servatism and their inverse relation set out in the previous section,

the study tests the association of the two types of conservatism in

the light of high and low quality accounting disclosures. As described

above, conditional conservatism would be expected to be inversely

related to unconditional conservatism (see Qiang, 2007; Vander

Bauwhede, 2007). The hypothesis that is tested is as follows:

H4. For high quality accounting disclosers, conditional conservatism is

negatively related to unconditional conservatism.

The study focuses on the period 2005 to 2009 and employs the OLS

models used inCano-Rodrguez (2010, p. 153)as follows:

Rank UCi;t= 0+1AQPi;t+ 2Ai;t+ 3TLSFUi;t+ 4VBVi;t+ei;t

7

Rank CCi;t= 0+ a1Rank UCi;t+ a2AQPi;t+ 3Ai;t

+ 4TLSFUi;t+ 5VBVi;t +ei;t

8

where

Rank UCi,t accounts for unconditional conservatism and is the rank

ofUCi,tcomputed as 0 + 1x NOCF, with 0and 1being

the estimates of0and 1of Eq.(9).NOCFis the proportion

ofrms that display high accounting quality and negative

cashows.

DACi;t= a0 + a1CFDi;t+ a2OCFi;t+ a3CFDi;tx OCFi;t+ ei;t 9

All variables in Eq.(9)are dened as in Eq.(6).

Rank CCi,t accounts for conditional conservatism and is the rank of3obtained from Eq.(9),

AQPi,t is the proportion ofrms that report high quality account-

ing disclosures,

Ai,t is the average of the log of total assets,

TLSFUi,t is the average of total liabilities scaled by shareholders'

funds,

MVBVi,t is the average of the ratio of market value to book value,


3.3.2. Earnings sensitivity and conservatism

Following the discussion about conditional and unconditional con-

servatism inSections 3.3 and 3.3.1, here the study examines earnings

sensitivity and conservatism of high and low quality accounting

1 In the absence of strong investor protection mechanisms and effective market

rules, company insiders might take advantage of the information asymmetry that

would stem from poor accounting disclosures to make abnormal prots to the

detriment of investors (Ball et al., 2000). Therefore, future research should examine

the motives for (non-) application of conservative nancial reporting under different

levels of stock market efciency and regulatory effectiveness.

http://-/?-http://-/?-


8/15

disclosers. This section seeks to test the relation between earnings

conservatism and reporting quality, i.e. whether in the light of high

quality accounting disclosures, less prots and/or more losses are

reected in company nancial statements. To this end, the study uses

the following OLS model that is based onBall et al. (2000) and LaFond

and Watts (2008)and is applied for the positive and negative return

samples separately. The period under investigation is 2005 to 2009.

NIi;t= a0 + a1Ri;t+ a2AQi;t +a3AQi;tx Ri;t+ ei;t 10

where

NIi,t is net income before extraordinary items scaled by begin-

ning ofscal year market value of equity,Ri,t is the annual stock return,



quality accounting information and AQi,t=0 otherwise,ei,t is the error term.

The study anticipates that a3 will be signicantly negative forrms

that bear good news, and positive for rms that exhibit bad news.

Subsequently, the study uses the OLS model below that combines thepositive and negative return samples (seeLaFond & Watts, 2008).

NIi;t= a0 + a1NDRi;t+ a2Ri;t+ a3Ri;tx NDRi;t+ a4AQi;t

+a5NDRi;tx AQi;t+a6AQi;tx Ri;t+a7Ri;tx NDRi;tx AQi;t+ei;t

11

where

NDRi,t is a dummy variable that proxies for badnews. NDRi,t=1for

negative returns and NDRi,t=0 otherwise. All other vari-

ables are dened as in Eq.(10).

The study predicts that a7will be signicantly positive, implying

that higher quality in accounting disclosures would lead to higherasymmetry in the recognition of prots and losses in annual reports,

i.e. greater conservatism.

The study also uses the following OLS model to control for growth

and leverage that inuence conservatism based on Fama and MacBeth

(1973) and LaFond and Watts (2008).

NIi;t= a0 + a1NDRi;t+ a2Ri;t+ a3Ri;tx NDRi;t+ a4MVBVi;t

+a5MVBVi;tx NDRi;t+a6MVBVi;tx Ri;t+a7MVBVi;tx Ri;tx NDRi;t

+a8TLSFUi;t+ a9TLSFUi;tx NDRi;t+ a10TLSFUi;tx Ri;t

+a11TLSFUi;tx Ri;tx NDRi;t+ a12AQi;t+ a13AQi;tx NDRi;t

+a14AQi;tx Ri;t+ a15AQi;tx Ri;tx NDRi;t+ ei;t

12

All variables are dened as in Eqs.(1), (10) and (11).

Roychowdhury and Watts (2007) and LaFond and Watts (2008)

argue that rms with high growth options (MVBV) would tend to

display higher information asymmetry between management and

investors and therefore exhibit lower conservatism (Smith and Watts,

1982). They also indicate that leverage (TLSFU) and accounting quality

(AQ) would display a positive association with conservatism. Watts

(1993 and 2006)shows that debt contracting inuences conservatism

signicantly, sincedebt capital providers wouldrequire conservatism as

a means of enhancing accounting quality and the reliability of reported

numbers, and assessingrms'futurenancial potential. Hence, earnings

conservatismwouldbe expected to improvethe terms of borrowing and

reduce agency costs.

4. Data and company categorisation

4.1. Datasets and empirical methods

The empirical analysis concentrates on the period after the adoption

of the International Financial Reporting Standards (IFRS), i.e. 2005 to

2009. The sample consists of 500 UK rms. All sample rms are IFRS

users. The study has found that 120 samplerms provided high quality

accounting disclosures in 2005, 145

rms in 2006, 165

rms in 2007,180 rms in 2008 and 193 rms in 2009. Accounting andnancial data

were collected from DataStream. Information about the accounting

policies of the sample rms was obtained from their published annual

reports. Annual report collectability has rounded the sample size down

to 500 rms. All sample rms are listed on the London Stock Exchange.

The analysis has excluded banks, insurance, pension and brokerage

rms, as their accounting measures are not always comparable with

those of industrial rms. The research hypotheses are tested using the

binary logistic regression analysis and the OLS regression analysis.

The logisticregression is useful in analysingcategorical data,where

the dependent variable is dichotomous and takes only two values,

i.e. 0 and 1. The parameters of the logistic regression are estimated

based on the maximum likelihood method, while the hypothesis

testing is based on the Wald statistic. The diagnostic tests entailed an

assessment of: (i) the relativesignicanceof theestimated coefcients

(p-valueb0.01; two-tailed); (ii) the magnitudes of the logit models'

studentised residuals (b3.0);and (iii) the naive proportional chance

model (seeJoy & Tollefson, 1975). All the logistic regression results

reported in this study have consistently passed those tests.

The study has accounted for heteroscedasticity, autocorrelation,

departure from normality and multicollinearity, where appropriate.

The tests that have been performed to check the OLS assumptions are

the White test and the Autoregressive Conditional Heteroscedasticity

(ARCH) test for heteroscedasticity; the DurbinWatson test and the

BreuschGodfrey test for autocorrelation; the JarqueBera test for the

departure from normality of residuals; and the correlation coefcients

among the test variables for multicollinearity.

The study is limited in the sense that it focuses on a common-law

country with strong investor protection mechanisms and investor-oriented nancial reporting (Tendeloo & Vanstraelen, 2005), which

would be likely to facilitate conservatism to a greater extent than

other settings, such as code-law countries. Hence, future research

should examine the use of conditional and unconditional conserva-

tism in code-law countries, which, unlike common-law countries,

would tend to call for less public disclosure, encouraging therefore

phenomena of opportunism (Leuz et al., 2003). Also, while the study

has focused on the period after the adoption of IFRSs, i.e. 2005, the

examination of a larger period encompassing the transition from UK

GAAP to IFRSs would be in position to describe the evolution of con-

servatism under different accounting rules or institutional character-

istics. Future research should investigate which items of accounting

information are veriable, to what extent they are veriable and

how easily and objectively. For example, Watts (2006) has foundthat only a limited set of future cash ow items, such as accounts

receivable, may be adequately and satisfactorily veriable and useful

to investors.

4.2. Annual report classication

Due to the various elements that accounting disclosures encom-

pass, it is difcult to build a single measure to evaluate the quality of

reported accounting information. LikeGeerings, Bollen, and Hassink

(2003), who examined corporate websites to evaluate companies'

investor relations schemes, this study examines companies' annual

reports by using a checklist to rate the quality of reported accounting

information. IRS issues best report guidelines to assist rms in the

preparation of higher quality annual reports. The guidelines issued by



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IRS have formed the basis for formulating the checklist used in the

study. The examination of companies' annual reports based on the

IRS checklist sought to distinguish the sample companies into high

and low quality information providers. As used in the study, the IRS

checklist contains the following items (see http://www.ir-soc.org.uk).

a) Communication of strategy and KPIs: understandable presenta-

tion of the company's business; efcient implementation of key

performance indicators, including nancial and non-nancial mea-

sures; disclosure and analysis of qualitative and quantitative

evidences; discussion of positive and negative developments; ex-

planation ofnancial and business trends and prospects; provision

of information on operational performance at group and segment

level.

b) Communication of governance and risk: compliance with the

combined code of corporate governance; discussion of the reasons

of non-compliance or deviation from the provisions of the com-

bined code; disclosure of the company directors' remuneration

policy; presentation of the company's communication with share-

holders; discussion of risks and how they are managed; explana-

tion of how risks are identied and monitored.

c) Communication of corporate responsibility: how corporate respon-

sibility objectives are met; provision of information on corporate

responsibility monitoring and evaluation process; and honestdescription of weaknesses, uncertainties or failures.

d) Presentation and effectiveness of annual report: layout and struc-

ture (e.g. target audience, key messages, etc); simplicity, clarity

and consistency; understandability of quantitative data; key area

coverage (e.g. nancial results, segmental analysis, directors'

remuneration, and corporate responsibility); usability and func-

tionality in meeting user needs; and feedback from users as to

how to improve the content and style of reported accounting

information.

e) Analysis of nancial position (seeAmbler & Neely, 2007): pre-

sentation of accounting policies; disclosure of short and long-term

capital structure; analysis of cash ows; liquidity (e.g. working

capital and borrowing requirements); and protability (e.g. sales

volume and prot ratios).

5. Empirical ndings

5.1. Descriptive statistics

Table 1 presents the descriptive statistics for the sample rms

examined in the study. Panel A displays the means and standard

deviations forhigh quality accounting disclosers,whilePanelB forlow

quality accounting disclosers. The descriptive statistics show that

rms that disclose accounting information of lower quality exhibit

higher growth (MVBV). High quality accounting disclosers display

higher size (LNA) and share turnover (TV), indicating that they are

visible in the market, while they also exhibit higher level of debt

(TLSFU). Firms that prepare high quality nancial statements aremore protable (NI) and show higher changes in net income() and

stock returns (R). It is noteworthy that the standard deviationof stock

returns that is observed for low quality accounting disclosers is 1.024,

as opposed to 0.571 for high quality accounting disclosers, reecting

a higher probability of reporting negative returns. High quality

accounting disclosers also display a higher mean value for operating

cash ows (OCF). Table 1 indicates that the discretionary accruals

(DAC) of high quality accounting disclosers carry a negative mean

(0.148) as opposed to the positive mean value (0.091) that is

obtained for low quality accounting disclosers. This nding signies

that the disclosure of high quality accounting information would

discourage the implementation of earnings management practises

and would encourage conservatism. In contrast, the presentation of

low quality accounting disclosures in nancial statements is likely to

reect and/or reinforce the potential for earnings management. In

addition, high quality accounting disclosers exhibit a less positive

mean value for small positive earnings (SP) and a more positive mean

value for large losses (LL) than low quality accounting disclosers,

implying that the former would report small positive earnings less

frequently and would recognise large losses more timely. The de-

scriptive statistics also show that high quality accounting disclosersdisplay higher page count (PC) in their annual reports, and are more

likely to be audited by a Big-4 auditor (AU) and to exhibit a change in

their management (MC).

5.2. High quality accounting disclosures

Panel A ofTable 2shows that H1 holds, implying that rms that

display high quality reported information are signicantly different

compared to those that do not. High quality information providers are

visible in the stock market, as they exhibit higher size (LNA) and

therefore their nancial decisions and actions are monitored by

nancial analysts, investors and stock market authorities. Their higher

return on assets (ROA) and cash ow ratio (OCF) would encourageand motivate high quality information providers to prepare and

publish high quality accounting disclosures to ensure that stock

market participants become aware of their favourable nancial mea-

sures. Higher protability and liquidity and high quality disclosures

would be expected to be linked as the latter might be considered to

be a reasonable path for rms with higher protability. The opposite,

i.e. rms with lower protability or liquidity providing high quality

disclosures, would tend to have higher informational and research

value.

The study has also found that debt and equity capital dependence

would make rms disclose accounting information of higher quality.

Panel A shows that high quality disclosers tend to exhibit higher

equity (ECN) and debt (DCN) capital needs and leverage (TLSFU).

This would signify that high quality accounting disclosures would

Table 1

Descriptive statistics.

Panel A high quality disclosers Panel B low quality disclosers

Variables Mean Std deviation Mean Std deviation

MVBV 2.326 2.414 2.802 3.061

TLSFU 2.391 3.033 1.509 1.360

LNA 3.288 1.703 2.785 1.640

0.786 0.392 0.805 0.562

R 0.312 0.571 0.119 1.024

TV 3.376 1.031 2.961 1.044

PC 0.285 0.452 0.030 0.171

MC 0.179 0.084 0.125 0.101

AU 0.220 0.116 0.175 0.138

DAC 0.148 0.197 0.091 0.234

SP 0.117 0.183 0.280 0.249

LL 0.025 0.157 0.006 0.079

OCF 0.033 0.091 0.024 0.071

NI 2.306 2.959 1.899 2.161

The sample period is 2005 to 2009. The study reports that 120 sample rms provided

high quality accounting disclosures in 2005, 145 rms in 2006, 165 rms in 2007, 180

rms in 2008 and 193 rms in 2009. MVBV is market value scaled by book value. TLSFU

is total liabilities scaled by shareholders' funds. LNA is the log of total assets. is the

change in net income before extraordinary items. R is the annual stock return. TV is the

share trading volume scaled by shares outstanding. PC is the log of the number of pages

in the annual report. MC is a dummy variable that takes 1 when changes in the

management have occurred in the year and 0 otherwise. AU is a dummy variable thattakes 1 when a rm is audited by a Big-4 auditor and 0 otherwise. DAC is the

discretionary accruals that are estimated using the cross-sectional Jones model. SP is a

dummyvariablethattakes1 if netprot scaledby total assetsis between 0 and0.01and

0 otherwise. LL is a dummy variable that takes 1 if netprot scaled by total assets is less

than 0.20 and0 otherwise. OCF is operating cashows scaled by total assets. NI is net

income before extraordinary items scaled by the beginning ofscal year market value

of equity.

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reinforce the validity and reliability of the reported accountinginformation and would also provide capital providers with safety

and lower uncertainty. The considerations set out above would

therefore enable rms to obtain equity and debt nancing on better

terms and positively inuence the capital issue. In contrast, rms that

experience higher growth (MVBV) appear to report lower quality

accounting disclosures perhaps to conceal unfavourable performance

measures, avoid disappointing capital providers, and facilitate their

growth process.

Panel B of Table 2 shows that rms that disclose high quality

accounting information tend to display higher share trading volume

(TV). This shows that the provision of informative and high value

accounting disclosures attracts investors' attention as reected by the

higher trading volume. It may also be that rms disclose high quality

accounting information because investors and other stock marketparticipants watch their decisions and actions.2 This is also evidenced

by the higher number of days with a non-zero volume in the period

(D), which expresses investors' interest in and appreciation of high

quality disclosers' shares (seeBushee & Miller, 2007). The higher log

of number of outstanding shares (SH) shows that the large part of

rm ownership that belongs to outsiders, and potentially the large

investor information needs, would makermsto reporthigher quality

accounting disclosures. High quality disclosers experience a change in

management (MC), indicating that the new management seeks

to report information of value to investors to obtain their condence,

ease of access to capital markets, and show their superiority as op-

posed to their predecessors. Firms that are audited by a Big-4 auditor

would have higher quality guidance on preparing their accounts,

while they should also be inclined to provide informative accounting

disclosures in order to obtain a favourable (Big-4) audit report.

Accounts that are audited rigorously would be expected to be less

misleading and less prone to error, and would therefore reect higher

credibility and reliability (Bushman & Smith, 2001). Indeed, Panel Bshows that high quality disclosers tend to be audited by a Big-4

auditor (AU).

5.3. Discretionary accruals and high quality accounting disclosures

Table 3provides evidence that H2holds, implying that rms that

provide high quality accounting disclosures are likely to exhibit lower

discretionary accruals. Panel A shows that AQ carries a signicantly

negative coefcient, suggesting that rms that report high quality

accounting information exhibit lower discretionary accruals and

therefore are likely to be less prone to earnings management. Panel

A also shows that AQOCF and AQROA are signicantly positive,

implying thatrms with high quality accounting disclosures and, say,

low operating cash ows (OCF) and return on assets (ROA) would

display low discretionary accruals. Likewise, rms with high quality

nancial reporting carry a signicantly negative coefcient for

AQTLSFU and AQLNA, indicating that rms with high total liabilities

to shareholders' funds (TLSFU) and size (LNA) would engage less in

earnings management.

Panel B examines whether rms manage their accounting num-

bers to report small prots rather than losses, and also assesses the

timely recognition of large losses in the income statement as a

measure of earnings management. The ndings show that rms that

provide high quality accounting disclosures display higher return on

assets (ROA) and cash ow ratio (OCF) as reported inTable 2. Firms

that disclose high quality accounting information carry a signicantly

Table 2

High quality accounting disclosures.

Panel A logistic regression Panel B logistic regression

Accounting variables Firm-specic nancial variables

Variables Coef cients Variables Coef cients

ROA 1.135***

(0.356)

TV 0.0001***

(0.0001)

MVBV 0.322*

(0.180)

SH 0.402***

(0.107)LNA 0.257***

(0.070)

MC 2.191*

(1.252)

OCF 0.169***

(0.055)

D 0.338**

(0.166)

TLSFU 0.040**

(0.019)

AU 0.643***

(0.242)

ECN 0.911***

(0.365)

Constant 0.795

(0.584)

DCN 1.053***

(0.169)

Constant 1.525

(0.277)

Model2 33.471*** Mode l2 28.398*

% Correctly classied 65.9 % Correctly classied 57.1

Sample size = 2500 Sample s ize =2500

***, ** and * indicate statistical signicance at the 1%, 5% and 10% level (two-tailed)respectively. All the explanatory variables were entered/removed from the logistic

regressions using a step-wise procedure with a p-value of 0.05 to enter and a p-value of

0.10 to remove. The Wald statistic was used to test the null hypothesis that each

coefcient is zero. The sample period is 2005 to 2009. ROA is net income before

extraordinary items scaled by total assets. MVBV is market value scaled by book value.

LNA is the log of total assets. OCF is operating cash ows scaled by total assets. TLSFU is

total liabilities scaled by shareholders' funds. ECN is a dummy variable that takes 1

when a rm has equity capital needs and 0 otherwise. DCN is a dummy variable that

takes 1 when a rm has debt capital needs and 0 otherwise. TV is the share trading

volumescaled by sharesoutstanding. SH is thelog of thenumber of outstanding shares.

MC is a dummy variable that takes 1 when changes in the management have occurred

in the year and 0 otherwise. D is the number of days with a non-zero volume in the

period scaled by the total number of trading days. AU is a dummy variable that takes 1

when a rm is audited by a Big-4 auditor and 0 otherwise.

2 Future research should use information on analyst following to assert this

argument and examine whether investors' perceptions and expectations can be a

driving force for providing accounting disclosures of higher quality.

Table 3Discretionary accruals and high quality accounting disclosures.

Panel A OLS regr ession Panel B logistic r egression

Discretionary accruals on rm

nancial measures

Small prots and large losses


AQ 0.010***

(0.003)

SP 0.430**

(0.203)

AQ ROA 0.172***

(0.054)

ROA 0.202***

(0.051)

AQTLSFU 0.211***

(0.064)

LL 0.615***

(0.230)

AQ OCF 0.036*

(0.019)

OCF 0.014**

(0.006)

AQLNA 0.001***

(0.0001)

Constant 0.576

(0.228)Constant 0.044

(0.062)

Model2 33.461***

R2 adj. 0.026 % Correctly classied 58.7

Sample size = 2500 Sample size =2500

***, ** and * indicate statistical signicance at the 1%, 5% and 10% level (two-tailed)

respectively. All the explanatory variables were entered into/removed from the logistic

regression in Panel B using a step-wise procedure with a p-value of 0.05 to enter and a

p-value of 0.10 to remove. The Wald statistic was used to test the null hypothesis that

each coefcient is zero. The sample period is 2005 to 2009. AQ is a dummy variablethat

takes 1 for rms reporting high quality accounting information and 0 otherwise. ROA is

net income before extraordinary items scaled by total assets. TLSFU is total liabilities

scaled by shareholders' funds. OCF is operating cash ows scaled by total assets. LNA is

the log of total assets. SP is a dummy variable that takes 1 if net prot scaled by total

assets is between 0 and 0.01 and 0 otherwise. LL is a dummy variable that takes 1 if net

prot scaled by total assets is less than

0.20 and 0 otherwise.

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negative coefcient for SP, suggesting that they report small positive

earnings less frequently. They also carry a signicantly positive co-

efcient for LL, implying that they tend to recognise large losses more

timely. Therefore, it follows that rms that provide accounting

disclosures of lesser quality would tend to smooth their earnings by

delaying the recognition of large losses.

5.4. Conservatism and high quality accounting disclosures

Table 4reports the ndings obtained from Eq.(6) regarding the

relation between conditional and unconditional conservatism and

accounting quality. Consistent with H3, a7that captures the associa-

tion betweennancial reporting quality and conditional conservatism

is signicantly positive, showing that rms that report high quality

accounting disclosures display higher conditional conservatism. Thisnding suggests that high qualitynancial reporting would reinforce

the contracting efciency and validity of reported nancial numbers,

thereby increasing conditional conservatism. Here, the study employs

an alternative measure of conditional conservatism, i.e. a6+ a7, which

is the non-incremental reaction of accruals to negative cash ows

based on Cano-Rodrguez (2010, p. 146). a6+ a7amounts to a positive

gure that is insignicantly different to a7. The coefcient obtained for

UC (AQ=1), which captures the relation between accounting quality

and unconditional conservatism, is signicantly positive. The positive

coefcient would indicate that the portion of accruals that are

independent of good or bad news is larger for high accounting quality

disclosers. Hence, following that UC (AQ= 1) is inversely related to

unconditional conservatism, and in consistency with H3, rms that

report high quality accounting disclosures are likely to display lower

unconditional conservatism.

5.4.1. The relation between conditional and unconditional conservatism

Panel A of Table 5 presents the results obtained from Eq. (7)

regarding the unconditional form of conservatism. Consistent with H3,

the coefcient obtained for QP is signicantly positive, indicating

that rms with high quality accounting disclosures exhibit higher

Rank UC and subsequently lower unconditional conservatism, since

Rank UC is inversely related to unconditional conservatism.

Panel B of Table 5 presents the results obtained from Eq. (8)

regarding the conditional form of conservatism. Consistent with H4,

the coefcient obtained for Rank UC is signicantly positive, reecting

a negative association between conditional and unconditional con-

servatism, since the relation between Rank UC and unconditional

conservatism is negative. Consistent with H3, the coefcient obtained

for QP is signicantly positive, implying that rms with high quality

accounting disclosures exhibit higher conditional conservatism.

5.4.2. Earnings sensitivity and conservatism

Panel A ofTable 6presents the ndings obtained from Eq.(10)for

the positive return sample and shows that consistent with H3, rms

that provide high quality accounting disclosures tend to exhibit

higher conservatism. In detail, the higher the quality in nancial

reporting, the less prots are reected in the nancial statements

ofrms that bear good news, as shown by the negative coefcient

obtained for AQR. Likewise, Panel B presents the results for the

negative return sample and indicates that the higher the quality in

nancial reporting, the more losses are reected in the nancial

statements ofrms that exhibit bad news, as shown by the positive

coefcient obtained for AQR.

Panel C ofTable 6presents the ndings obtained from Eq.(11)forpositive and negative return samples combined.3 As shown above, the

coefcient obtained for AQR is signicantly negative, suggesting that

the reported earnings of high quality accounting disclosers incorpo-

rate less good news. Panel C also shows that the coefcient obtained

for RNDRAQ is signicantly positive, indicating that higher quality

in accounting disclosures would lead to greater conservatism in

Table 4

Conservatism and high quality accounting disclosures.

OLS regression

Variables Coef cients

CFD 0.013

(0.035)

OCF 0.334**

(0.166)

CFD OCF 1.069***

(0.348)

AQ (4) 0.293***

(0.103)

AQCFD (5) 0.032

(0.049)

AQOCF (6) 0.182

(0.141)

AQCFDOCF (7) 1.176**(0.535)

Constant 0.153

(0.019)

a6+ a7UC (AQ=1)

0.994*

0.282*

R2 adj.

Sample size

0.21

=2,500

***, ** and * indicate statistical signicance at the 1%, 5% and 10% level (two-tailed)

respectively. The sampleperiod is 2005 to 2009. CFD is a dummy variable that takes 1 if

operating cash ows scaled by total assets is negative and 0 otherwise. OCF is operating

cash ows scaled by total assets. AQ is a dummy variable that takes 1 for rms reporting

high quality accounting informationand 0 otherwise. a7captures conditionalconservatism.

6+7is an alternative measure of conditional conservatism. UC (AQ= 1) examines the

relation between accounting quality and unconditional conservatism. This measure is

inversely related to unconditional conservatism and is derived from 4 + 5 x NOCF

(AQ=1). 4 and 5 are the estimates of4 and5 presented in Eq.(6). NOCF (AQ=1) is

the proportion ofrms that display high accounting quality and negative cash ows.

Table 5

Relation between conditional and unconditional conservatism.

Panel A OLS regression Panel B OLS regression

Unc onditional c onservatism Conditional conservat ism


Rank UC 0.553*

(0.323)

AQP 0.975***

(0.091)

AQP 0.067***

(0.020)A 0.100

(0.105)

A 0.005

(0.009)

TLSFU 0.120**

(0.059)

TLSFU 0.004**

(0.002)

MVBV 0.284

(0.223)

MVBV 0.076

(0.061)

Constant 0.203

(0.259)

Constant 0.126

(0.087)

R2 adj. 0.35 R 2 adj. 0.28

***, ** and * indicate statistical signicance at the 1%, 5% and 10% levels (two-tailed)

respectively. The sample period is 2005 to 2009. AQP is the proportion ofrms that

report high quality accounting disclosures. A is the average of the log of total assets.

TLSFU is the average of total liabilities scaled by shareholders' funds. MVBV is the

average of the ratio of market value to book value. Rank UC accounts for unconditional

conservatismand is therankof UC computed as 0 + 1x NOCF, with 0and 1being

the estimates of0and 1of Eq.(9). NOCF is the proportion ofrms that display high

accounting quality and negative cash ows. UC is inversely related to unconditionalconservatism.

3 The study has modied Eq.(11)to incorporate the AQ lag in the model in order to

examine the association between increases in accounting quality in the previous year

and earnings conservatism in the current year. AQt 1 is a dummy variable

representing the quality of reported accounting information, as dened in Eq.(1), in

year t1. Consistent with the results reported in Table 6, the ndings (not reported

here) indicate that the coefcient obtained for R i,t x NDRi,t x AQi,t1 is signicantly

positive, implying that increases in accounting quality in the previous year would be

linked to higher levels of earnings conservatism in the current year.

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reported earnings. Thus, as quality in nancial reporting increases,

more losses are reected in company nancial statements, implying

that changes in quality would inuence the amoun

george emmanuel latridris (2011) (1)

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