Impact of integrated reporting on managers’ decision-making : does it lead to maximizing shareholders’ wealth?

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Impact of Integrated Reporting on Managers’ Decision-making:

Does it lead to maximizing shareholders’ wealth?

Name: Celine von Meijenfeldt Student number: 11298588

Thesis supervisor: G. Georgakopoulos Date: June 25, 2018

Word count: 19973, 0

MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam

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Statement of Originality

This document is written by student Celine von Meijenfeldt who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

Integrated Reporting is seen as a response to the observed shortcomings of regulated forms of financial reporting. Its emphasis is on disclosing how a firm’s strategy is reflected in its business model, which subsequently could change the view of managers and start to see the business and its long-term prospects in a different light. This is linked to the concept of ‘integrated thinking’. The process of preparing an Integrated Report should improve information for outside providers of financial capital and affect managers’ internal decisions. Consistently, it implies value-creation over time for all stakeholders. Prior literature found that Integrated Reporting reduces information asymmetry, facilitates corporate decision-making and mitigates the agency problem. Therefore, firms should experience an improvement in cash flow activities. This study examines whether managers are more aligned with the claimed concept of ‘integrated thinking’. More specifically, it studies the impact of Integrated Reporting on managers’ behaviour regarding investment, financing and operating decisions. As prior literature found that Integrated Reporting mitigates information asymmetry and therefore aligns the interest of shareholders and managers, I follow other studies by modelling the behaviour of managers wanting to maximize shareholders’ wealth by improving cash flow activities. The sample consists of 60 European matched-pair firms which compares the results of Integrated Reports to the control group. Overall, the results do not support the hypotheses and there is no evidence that Integrated Reporting improves shareholders’ wealth through improved investment and financing decisions. Contrary to expectations, this paper found that relative to other types of reports, firms adopting Integrated Reporting decrease payouts to shareholders, and use their assets less intensively. These actions are not consistent with managers overcoming the free cash flow agency conflict. Additionally, this study found that Integrated Reporting improves operating decisions; however, this was contradicted by its robustness test.

Keywords: Integrated Reporting, Integrated Thinking, Managers’ behaviour, Managers’ decision-making,

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Acknowledgement

I would like to thank my supervisor Georgios Georgakopolous, who guided and provided me with helpful and fast feedback. Furthermore, I want to thank Daan for helping me with all the issues I encountered during my thesis; even at the stroke of midnight. What do we now do with this sudden gap in our lives? On top of that, I want to thank my SCHIMMEL group, for making this period one of much laughter and joy! A special thanks to Joëlle who was always a real G in helping me out, and more important: being that one person whom I could cry with when there was a lot of ‘mist’ and illuminate was tacking over (wait for it….). And of course I want to thank Hana for going on business trips with me; some well-deserved breaks to clear the head from all that writing.

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1 Introduction

Corporate disclosure is critical for how an efficient capital market functions. Firms provide this disclosure through regulated financial reports, including financial statements, footnotes, management discussion and analysis, and other regulatory filings. In addition, some firms engage in voluntary communication, such as management forecasts, analysts’ presentations and conference calls, press releases, internet sites, and other corporate reports (Healy & Palepu, 2001). The aim of corporate reports is to lower the expectation gap between investors and managers and as a result reduce information asymmetry. It focuses on the way business is done and value is created, and the context in which business operates (García-Sánchez & Noguera-Gámez, 2017a). In recent years enhanced complexity of the business world has led to growing demands by companies regarding reporting. Investors cannot obtain information in a timely manner with only regulated information, and are inclined to acquire private information about ﬁrms behaviour. The financial crisis and its negative effects upon the global economy emerged in demand for corporate reporting transparency (Dragu & Tiron-Tudor, 2013). Thus, instead of focusing merely on mandatory disclosure of higher-quality ﬁnancial reports, voluntary disclosure of corporate governance, sustainability and other thematic reports are of upcoming importance (Lakhal, 2008).

Due to this growing gap - of not being able to capture all the material information through corporate disclosures - an increasing amount of leading companies have begun to voluntarily report on their non-financial information over the past years (Kennedy & Perego, 2016). To stimulate this development, European legislation (i.e. the EU Directive on disclosure of financial information, 2014/95/EU) enforce large public interest entities to report on non-financial information as from reporting year 2017.

European leading companies mainly communicate on these activities through Integrated Reporting: providing a coherent summary of financial and non-financial information in one report. This statement provides, in a composite, organised and cohesive form, information on the company’s strategy, corporate governance, performance and prospects in such a way as to reﬂect the commercial, social and environmental context in which it operates. Thus, a clear and concise statement is provided of how the organisation operates and how it creates and maintains value in a broad sense (International Integrated Reporting Committee [IIRC], 2011).

The IIRC released their International <IR> Framework in December 2013, following multi-stakeholder input. Given the framework’s emphasis on disclosing how a ﬁrm’s strategy is reﬂected in its business model, managers could change their views and start to see the business and its

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long-term prospects in a different light. This is linked to the concept of ‘integrated thinking’ (IIRC, 2013). The process of preparing an Integrated Report will affect managers’ internal decisions by directing them to focus more on the ﬁrm’s long-term sustainability than on its short-term ﬁnancial performance, which will result in comprehensive disclosures (De Villiers, Venter & Hsiao, 2017). Among the drawbacks and barriers that emerged in early stages of Integrated Reporting dispersion, fragmentation in regulatory standards and across institutional settings tends to be coupled with diversity, lack of comparability and ‘decoupling’ in Integrated Reporting implementation across companies (Frias-Aceituno et al., 2014; Rowbottom & Locke, 2016). Considering the above, Perego et al. (2016) find in their literature review on Integrated Reporting and ‘integrated thinking’ that a significant part of academic literature is excessively focused on costs rather than benefits. In addition, they highlight that only a few papers attempt to assess the cost and benefit consequences of Integrated Reporting at all. Stubbs and Higgings (2014) stress that a restoration of this balance is necessary to highlight potential advantages versus drawbacks of Integrated Reporting and promote field engagement. This is supported by Kennedy and Perego (2016) and Maniora (2017) who emphasize the importance of academics on further development of theoretical and practical issues concerning Integrated Reporting. As Integrated Reporting is a relatively new reporting and management approach, Kennedy and Perego claim that there is still not enough knowledge on the ethical impact of Integrated Reporting on a company’s internal and external environment and its effect on current reporting regimes around the world in the medium and long term. In real terms, it needs to be established which concrete changes can be brought about within firms.

The goal of this thesis is to examine the impact of Integrated Reporting on managers’ behaviour regarding investment, financing and operating decisions. More specifically, it studies whether managers are aligned with ‘integrated thinking’ and maximize shareholders’ wealth by improvements in cash flow activities. It will attempt to answer the following research question:

“Does Integrated Reporting affects managers’ decision-making by improvements in investment, financing and operating decisions?”

The outcome of this study should be able to clarify the issue described by Perego, Kennedy and Whiteman (2016) on whether organisational changes induced by ‘integrated thinking’ translate concretely into an improved performance. Furthermore, this study should give managers an insight into potential value creation for company’s shareholders. García-Sánchez and Noguera-Gáme (2017a) found that Integrated Reporting reduces information asymmetry, but not yet whether it

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improves investment, financing and operating activities. Mervelskemper and Streit (2015) examined the effect of Integrated Reporting on ESG performance of companies joining the IIRC Pilot Program. They captured up to and including the year after the introduction of the <IR> Framework in 2013. This research extends this by capturing up to at least three consecutive years following the adoption and also includes companies which did not participate in the Pilot Program and adopted the framework in later years. Furthermore, a large part of the literature (e.g. Atkins & Maroun, 2015; Abeysekera, 2013) focuses on companies in South Africa, due to the fact that Integrated Reporting is mandatory since fiscal year 2013. Therefore, data on the effect of Integrated Reporting can be gathered more sufficiently on a bigger and lengthier scale. Due to the new EU Directive, the ‘Autoriteit Financiële Markten’ (AFM, 2016) expects an increase in the use of Integrated Reporting in European countries. Consequently, the AFM emphasises the importance of more research for European countries. Hence, I focus on European countries and perform a number of statistical analyses on a unique hand-collected dataset. Specifically, I concentrate on a sample of 60 European companies (613 observations) from the fiscal year 2006 through 2017. This includes companies complying with the <IR> Framework (2013 through 2017), matched with non-complying <IR> Framework companies (2006 through 2012). In this study I partly follow Fasan and Mio (2017) by rather focusing on firms adopting the <IR> Framework than firms producing an Integrated Report. This is mainly due to the fact that there is no clear distinction yet between ‘sustainability’ and ‘integrated’ reports. Companies labelling those reports do not reflect their content (Fasan & Mio, 2017). Consequently, when recognising companies adopt Integrated Reporting, I am referring to compliance with the <IR> Framework, content elements and/or fundamental concepts.

In accordance with Wallace’s (1997) research, I model the behaviour of managers wanting to maximize shareholders’ wealth by improving cash flow activities, as a result of mitigation of information asymmetry. This is consistent with the dual objective of Integrated Reporting, namely value creation for shareholders and other stakeholders. I expect that the control group (consisting of companies issuing traditional reports) improve their cash flow activities less than the treatment group (consisting of companies issuing Integrated Reports). Accordingly, following Wallace’s research, I assume managers will be less likely to fail paying out free cash flow. Three measures are used to examine the influence of Integrated Reporting on managerial behaviour: investment decisions, financing decisions, and operating decisions.

This paper contributes to existing literature in multiple ways. First, this research is based on a unique hand-collected dataset of European countries, which are manually gathered by checking each company’s annual report for its compliance statement with the <IR> Framework

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for three consecutive years. Second, it continues to build on the findings of García-Sánchez and Noguera-Gámez (2017a) who found that Integrated Reporting reduces information asymmetry and aligns managers’ and shareholders’ interest. This research examines whether the impact of Integrated Reporting has the expected effect on managers’ behaviour, i.e. being aligned with the concept ‘integrated thinking’ and improve value for shareholders. More specifically, it contributes to the literature by evaluating whether shareholders might reliably be able to identify Integrated Reporting as high-quality businesses due to its positive effect on shareholders’ wealth.

The results of this study show that firms adopting Integrated Reports, relative to the control firms, decrease their payouts to shareholders, and use their assets less intensively. This outcome is contradictory to the expectations based on the theories described in this study. Additionally, corresponding with the theories applied and assumptions made, Integrated Reporting has a significant positive effect on ESG Score, relative to the control firms. However, the robustness test of the corresponding hypothesis contradicts this supported model. Hence, as these previous results are not consistent with managers overcoming the free cash flow agency conflict, the overall conclusion is that there is no support for the positive impact of Integrated Reporting on shareholders’ wealth by improving investment, financing and operating decisions. Thus, from this study one cannot conclude that Integrated Reporting will cause managers to make decisions that maximize shareholders’ wealth.

A first limitation of this study is that the treatment firms are hand-collected, which are not randomly selected. Second, no account has been taken of the incentives which could influence managers’ decision-making. Last, this research examines the impact of Integrated Reporting on the effect of managers’ cash flow activities, based on the theory that they want to maximize shareholders’ wealth. Another theory could lead to different assumptions and proxies. Therefore, a recommendation for future research would be to revise this research based on another theory leading to different expectations and proxies for managers’ behaviour.

This thesis is structured as follows. In the following chapter literature on Integrated Reporting and managers’ behaviour is discussed and three hypotheses are formulated. The second part contains the methodology for this study. Thereafter the results of the research are presented and the thesis ends with discussions and a conclusion.

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2 Literature Review and Hypotheses Development

This chapter discusses relevant theories and literature which develop the hypotheses for this research. First, the agency theory is discussed, through which managers’ behaviour is reviewed, and the link between information asymmetry, agency costs and free cash flow is defined. Subsequently, the stakeholder theory is reviewed. Third, the concept Integrated Reporting is explained. Thereafter, the relation between Integrated Reporting and managers’ behaviour is established and - in accordance with the above - the hypotheses assembled will be used during this study. Last, an overview is provided of the academic key papers on which this study is built.

2.1 The Agency Theory and Information Asymmetry

Information disclosure is one of the most important decisions to be made in business, because of its potential consequences, both positive and negative (Frias‐Aceituno, et al., 2014). From the standpoint of agency theory, one of the advantages is that the information provided can be used for decision-making by shareholders and managers. Moreover, it provides a mechanism for shareholders to supervise managerial actions, evaluating whether managers have overseen the firm’s resources in the interest of shareholders, and monitoring compliance with contractual agreements (Jensen & Meckling, 1976). The disclosure mechanism should align the interest of managers and shareholders or limit managerial discretion to reduce agency costs.

The principal-agent relationship is formulated by Jensen and Meckling (1976) as: “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent” (p. 308). In this context, the shareholder (principal) engages the manager (agent) to perform some service on their behalf which involves delegating a degree of decision-making authority to the manager. Managers of firms who act as agents to the firm's shareholders have a duty to make all efforts to maximize shareholders’ wealth by working in the best interest of the firm's owners. As the former bear most of the wealth effects and the latter have the control of the firm (i.e. separation of ownership and control), a fundamental conflict arises between self-interested managers and shareholders. Both seek to maximize their utility of wealth by achieving their own goals. This issue draws the agency problem and results in agency costs.

Agency costs arise because managers have more information available than shareholders (creating information asymmetry), and shareholders cannot directly ensure that managers are always acting in their best interest (Jensen & Meckling, 1976; Healy & Palepu, 2001). A problem

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arising from information asymmetry is that once a shareholder has invested funds in a business, the self-interested manager has an incentive to make decisions that expropriate shareholders’ funds. For example, if shareholders acquire an equity stake in a firm, the manager can use those funds to acquire perquisites, pay excessive compensation, or make investment or operational decisions that are harmful to the interest of shareholders (Jensen & Meckling, 1976). Consequently, shareholders are continuously seeking ways to align interest and reduce information asymmetry (Healy & Palepu, 2001).

2.1.1 Association between Information Asymmetry, Agency Costs, and Free Cash Flow

One way in which shareholders’ wealth maximization can be jeopardized is when managers fail to pay out free cash flow. Free cash flow is cash flow in excess of that required to fund all projects that have positive net present value (NPV) when discounted at the relevant cost of capital. When firms generate positive free cash flow, the following options are available: distribution to investors as dividend or repurchase stock, distribution to debt holders (buy back debt and pay interest), and/or retention within the firm as financial assets (cash balance increases). These discretionary options create major conflicts of interest between shareholders and managers, especially when organisations generate substantial free cash flow (Jensen, 1986).

Managers with substantial free cash flow can increase dividend or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted. The problem is how to motivate managers to distribute the cash rather than investing it at below the cost of capital or wasting it on organisation inefficiencies (Jensen, 1986). The finance profession's views toward the benefits and costs of free cash flow have been shaped largely by two dominant and often conflicting paradigms of corporate finance.

First is the agency costs explanation of Jensen (1986), where free cash flow is costly, because of a conflict between managers and shareholders. Managers want to retain free cash flow and invest in projects that increase managerial benefits like compensation or power and reputation (e.g. Avery, Chevalier & Schaefer, 1998). Shareholders want managers to pay out free cash flow because the projects that increase managerial benefits may often be negative NPV projects (meaning they over-invest). Thus, Jensen argues, leverage increasing transactions that bond the firm to pay out free cash flow increase shareholder value and mitigate the conflict of interest between shareholders and managers.

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The second paradigm is the asymmetric information approach typified by Myers and Majluf (1984). In that approach, free cash flow is beneficial, because managers loyal to existing shareholders are assumed to have information the market does not have. The main claim is that managers will sometimes decline new positive NPV investment opportunities when investing requires issuance of undervalued securities to the under-informed capital market. The financial slack provided by large amounts of free cash flow prevents this socially (and privately) undesirable outcome.

2.2 Stakeholder Theory

In this study, the stakeholder theory will supplement the agency theory in formulating hypotheses for the impact of Integrated Reporting on managers’ behaviour. Unlike the agency theory, the stakeholder theory focuses on a broader range than only on shareholders; this includes employees, customers, suppliers, communities and governmental officials (Jensen, 2010).

The traditional definition of a stakeholder is “any group or individual who can affect or is affected by the achievement of the organisation’s objectives” (Freeman, 1983, p. 46). The stakeholder theory argues that managers bear a fiduciary duty to all stakeholders. The interest of all stakeholders deserve attention for its own sake and not only because of its ability to represent the interest of stakeholders (Donaldson & Preston, 1995). With regard to this, a major objective of firms is attaining the ability to balance the conflicting demands of various stakeholders of the organisation (Ansoff, 1984).

The stakeholder theory, inter alia, establishes a framework for examining connections or lack of connections between stakeholder management practice and the achievement of various corporate performance goals. Firms with stakeholder management practice and thus socially responsible firms will be relatively successful in conventional performance terms such as profitability and growth (Donaldson & Preston, 1995). Kotter and Heskett (1992) argue that this could be due to the fact that almost all managers of the invested company strongly care about people who have a stake in the business-customers, employees, stockholders, suppliers and others. Considering the above, Jensen (2010) similarly claims that a firm cannot maximise value if it ignores the interest of its stakeholders. Hence, the purpose of the organisation should be to manage stakeholders’ interest, needs and viewpoints, which is meant to be fulfilled by the managers of a firm (Friedman, 2006). This outcome of the stakeholder theory is therefore aligned with managers serving stakeholders’ primary interest (Donaldson & Preston, 1995).

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By failing to honour the engagement of more transparency to its stakeholders and improving company performance, the company takes a media risk of reputation damage i.e. firstly taking expectations expressed by various stakeholders into account, secondly restoring the complexity of management via widening the field of stakeholders and via taking away the horizon of decisions, and thirdly integrating expectations of stakeholders into strategic methods (Fontaine et al., 2006). Therefore, managers are increasingly under pressure to respond to various stakeholder expectations as explained by the stakeholder theory.

2.3 Integrated Reporting

Haller and van Staden (2014) stress that traditional annual reports in the form determined by most regulations is not sufficient in explaining how the enterprise influences stakeholders and how much value it generates for society, employees, and others. Not only does traditional financial reporting give an incomplete account of business activities (Gray & Bebbington, 2001), but it also fails to adequately present the economic performance and business value of a firm (Yongvanich & Guthrie, 2006). These reports are generally retrospective and do not offer future prospects or crucial risks that may be relevant in the future (Jensen & Berg, 2012). The global financial crisis in 2008 radically changed the world’s economy and increased awareness of business risks. Subsequently, there is growing concern on how companies disclose risks and the impact on performance (Mia & Al-Mamun, 2011). Companies can voluntary disclose information to reduce these concerns (Ienciu, 2014). Hence, shareholders and other stakeholders require public companies to disclose information regarding their future prospects, as the economic environment is too dynamic to rely only on retrospective information (Menicucci, 2013).

To complement the traditional financial statements, an increasing number of companies issue separate Corporate Social Responsibility (CSR) or Sustainability Reports over the last years (Albu et al., 2013). Hereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a - usually - voluntary basis (European Commission, 2001). Based on this engagement, companies are more transparent of their activities and try to fulfil the needs of stakeholders to obtain the necessary resources for both their survival and development. The legitimacy of the company to use these resources depends on the correspondence of its behaviour to rules and values recognised by society, implying the company will obtain a “license to operate” on the condition of not being considered a predator of the natural and social environment (Fontaine et al., 2006). Specifically, companies demonstrate to society as a

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whole and to stakeholders in particular the appropriateness of their corporate behaviour regarding social and environmental aspects (Lozano & Huisingh, 2011).

This additional reporting may appear to be a solution, yet previous studies (Albu et al., 2013; Boerner, 2013) find that companies use various sustainability reporting standards or develop their own reporting frameworks starting from the existing ones; there is emphasis on the lack of comparability regarding standards, guidelines and frameworks, questioning their utility or even a disconnection between the financial and non-financial reports, and the strategy of the company. Besides, Jensen and Berg (2012) assert that it does not make sense to present separate reports, while the strategy of both are interrelated. Therefore, separate non-financial reports create information dissemination and confusion for the stakeholders (Ioana & Adriana, 2014).

Like in the case of financial reporting, Bonsón and Bednárová (2014) express the need for an internationally accepted framework that could lead to uniformity. Moreover, companies should not only introduce the CSR strategy, but also present the report on such activities and results by combining financial and non-financial information (Haller & van Staden, 2014). Prior problems are intended to be solved by ‘integrated thinking’, which is a vision promoted by the International Integrated Reporting Council (IIRC) in their work on Integrated Reporting (Albu et al., 2013; Boerner, 2013; Haller & van Staden, 2014).

The goal of Integrated Reporting is to provide a broader explanation of performance than the traditional approach, which describes the company’s dependence on different resources, its relationships and its access to and impact upon them (García-Sánchez & Noguera-Gámez, 2017a). One report integrates financial and non-financial information (Cheng et al., 2014). This should enable providers of financial capital to assess whether, and to what extent and also how an organisation’s business model affects the wider context that supports or threatens value creation, including financial value, in the short, medium and long term. A clear and concise statement is provided of how the organisation operates and how it creates and maintains value (IIRC, 2011). More specifically, Integrated Reporting in short, medium, and long term highlights the opportunities and challenges that may occur and their possible effect on the organisation’s financial and non-financial performance (Kılıç & Kuzey, 2018).

The IIRC emphasizes the importance of cohesive and multi-dimensional reporting, which communicates the factors that influence organisational value over time (Atkins & Maroun, 2015). They released their International <IR> Framework in December 2013, following multi-stakeholder input. This framework aims to simplify company reporting and improve its effectiveness by focusing on value creation ‘‘as the next step in the evolution of corporate

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reporting’’ (IIRC, 2015). More specifically, in order to, inter alia, align the interest of managers and shareholders and create value over time, the <IR> Framework’s goal is to improve information for outside providers of financial capital and improve internal decision-making. The IIRC claims that Integrated Reporting is a more effective reporting approach because it focuses on value creation through the lens of six capitals (i.e. financial, manufactured, intellectual, human, social and relationship, and natural) rather than sustainability reporting’s focus on environmental and social impacts through the lens of stakeholder materiality (Nugent, 2015).

The IIRC (2013) argues that given the framework’s emphasis on disclosing how a firm’s strategy is reflected in its business model, managers and boards of directors could change their views and start to see the business and its long-term prospects in a different light. This is linked to the concept of ‘integrated thinking’. This process of preparing an Integrated Report will affect managers’ internal decisions by directing them to focus more on the firm’s long-term sustainability than on its short-term financial performance, which will result in comprehensive disclosures (De Villiers et al., 2017).

Healy and Palepu (2001) and Shroff et al. (2013) found that additional voluntary information showing managers’ actions - other than traditional statements - improves the welfare of both shareholder and manager. It reduces information asymmetry and agency costs by increasing information disclosure, leading to a change of managers’ behaviour. Consistently, García-Sánchez and Noguera-Gámez (2017a) find that voluntary disclosure concerning Integrated Reporting reduces information asymmetry, facilitates corporate decision-making and mitigates the agency problem. Consequently, it implies that these ﬁrms experience an improvement in cost of capital, ﬁnancing and liquidity.

García-Sánchez and Noguera-Gámez (2017b) confirm a negative relationship between the cost of capital and the disclosure of an Integrated Report. The reduction of the cost of capital as a result of the disclosure of an integrated report is especially relevant to those companies that need to increase their basic funding, as they have considerable problems with asymmetric information or they operate in markets with limited protection for investors. Moreover, Integrated Reports promote greater transparency regarding the company by means of providing the information needed by stakeholders to assess long-term prospects in a clear and concise form (García-Sánchez et al., 2013). It focuses more on future perspectives in comparison to the annual report which concentrates on company historical data and performance (Branswijck & Everaert, 2012). Hassanein and Hussainey (2015) find an association between change in forward-looking financial disclosure and change in firm earnings performance. In addition, the change in forward-looking

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financial disclosure is more positively associated with poorly performing firms compared to well-performing firms. Consistently, Garanina and Dumay (2017) find that Integrated Reporting may have value relevance to a company due to its significant amount of forward-looking non-financial information, by which it reduces information asymmetry. Such reports reveal long-term consequences of decision-making in all relevant aspects (Jensen & Berg, 2012). Therefore Kennedy and Perego (2016) state that Integrated Reporting is making its mark not only as an external communication tool, but above all a genuine agent for internal change within firms.

Nevertheless, Stubbs and Higgings (2014) find that Integrated Reporting raises new challenges compared to sustainability reporting as - according to the definition of Integrated Reporting - it is more closely tied to business strategy and how an organisation creates value. This suggests a more prominent role for finance and strategy teams in understanding and disclosing non-financial information. Moreover, Eccles and Saltzman (2011) stress that even though Integrated Reporting may be a solution to many preceding problems, it is not a panacea for improving resource allocation decisions or a silver bullet for solving contemporary problems with financial and non-financial reporting.

The next section discusses Integrated Reporting’s effect on information asymmetry and agency costs associated with investment, financing and operating cash flow activities. Thereafter, a summary is given in Table 1 on the most important papers used in this study.

2.4 Relationship between Integrated Reporting and Managers’ Behaviour

Disclosure is the revelation of an item of generally unknown information on a financial statement or in the accompanying notes. It aims to improve the quality of information, and to promote a more cohesive and efficient approach to corporate reporting (Dye, 1985). Due to the broader perspective of Integrated Reporting which is in correspondence with the stakeholder theory (Ansoff, 1984) by taking all stakeholders into account, it creates value through six capitals focusing on both financial and non-financial information. This ensures shareholders to better monitor managers and consequently improve quality of information.

Integrated Reporting’s framework emphasizes the importance of cohesive and multi-dimensional reporting (i.e. combining financial information with ESG information) which communicates the factors that influence organisational value through the six capitals over time (Atkins & Maroun, 2015). Churet and Eccles (2014) find a strong relationship between Integrated Reporting and environmental, social and governance (ESG) quality of management, which has

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become a useful indicator of the overall effectiveness of management in creating value over the long term. Mervelskemper and Streit (2015) conclude that Integrated Reporting is associated with superior outcome compared to a stand-alone report for composite ESG and corporate governance performance, focusing on the Integrated Reports adopted in the year 2013. Fatemi et al. (2017) find that ESG strengths increase firm value and ESG weaknesses lead to a decrease. Furthermore, Knauer and Serafeim (2014) identify that engaging in Integrated Reporting and ‘integrated thinking’ backed up by enhanced transparency and ESG performance attract long-term investors. Accordingly, Churet and Eccles argue that investors might find Integrated Reporting useful, as it could turn out to provide a reliable manner to identify high-quality businesses.

Prior studies (e.g. Leuz & Verrecchia, 2000; Bushman & Smith, 2001; Verrecchia, 2001) show that higher-quality financial disclosure can enhance investment efficiency by mitigating information asymmetries between firms and stakeholders. If higher-quality financial disclosure increases shareholder ability to monitor managerial investment activities, it can be associated with investment efficiency by reducing information asymmetry.

Extensive academic literature in corporate finance finds a relationship between investment expenditure and cash flow (e.g. Fazzari, Hubbard & Petersen, 1988; Hubbard, 1998), despite that in theory, firm level investment should not be related to internally generated cash flow (Modigliani & Miller, 1958). Blanchard et al. (1994) find that the relation between corporate financing and investment is inconsistent with the perfect capital markets model. This means that even if investment opportunities are not attractive, managers may decide not to pay out cash flow. In other words, managers in firms with free cash flow engage in wasteful expenditure, i.e. over-investments (e.g., Jensen 1986). This evidence supports the agency model of managerial behaviour, in which managers try to ensure the long-term survival and independence of the firms with themselves at the helm, rather than acting in the best interest of shareholders. Managers of these firms choose to keep the cash windfall within the firm rather than distribute it to investors in the form of dividend, share repurchase, or debt reduction. If anything, they typically borrow more after the windfall (Blanchard, 1994).

However, there could also be another interpretation for this positive relation; it could also be consistent with market frictions inhibiting the ability of the firm to raise capital externally and not necessarily an indication of over-investment (Harford, 1999; Opler et al. 2001). Hence, this relation could also reflect capital market imperfections, where costly external financing creates the potential for internally generated cash flow to expand the feasible investment opportunity set (e.g., Fazzari, Hubbard, & Petersen, 1988).

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Lamont (1997) examines how investment in one division of a firm responds to shocks originating in another (unrelated) division. Their evidence is consistent with cash rich segments cross-subsidizing more poorly performing segments in diversified firms. This means that an increase in cash flow or decrease in leverage attributable to one of a firm’s divisions, translate into significant increases in the investment of other divisions. Berger and Hann (2003) find that by increasing information disaggregation - in their case due to the adoption of the new segment report introduced by the Financial Accounting Standards Board’s (FASB) – firms are induced to reveal previously ‘hidden’ information about their diversification strategies. The newly revealed information affects market valuations and leads to changes in manager’s behaviour consistent with improved monitoring after the adoption.

Bates (2005) concludes that firms retaining cash tend to invest more, relative to industry peers. Consistently, Richardson (2006) examines firm’s investment decisions in the presence of free cash flow. In addition to prior research, he finds that over-investment is concentrated in firms with the highest levels of free cash flow, across all types of investment expenditure. Harford (1999) finds that cash-rich firms are more likely to make acquisitions, which subsequently experience abnormal declines in operating performance. Coherently, Dechow et al. (2008) find that cash flow retained within the firm (e.g. by investments in financial assets) are associated with lower future operating performance and future stock returns. This performance relation corresponds with the over-investment of free cash flow found in Richardson’s paper.

Finally, Alti (2003) stresses a big point of criticism on the literature examining the relation between investment and cash flow, stating that finding a positive association may merely indicate that cash flow serve as an effective proxy for investment opportunities. Furthermore, Beyer & Guttman (2012) critically conclude that when managers voluntarily disclose information to shareholders or have large amounts of cash flow (Nwaeze et al., 2006), they may, and often do, choose to engage in suboptimal investment, financing and operating decisions in order to improve shareholders’ perception of firm value.

Based on the literature review, I assume that Integrated Reporting improves investment, financing and operating activities (by reducing information asymmetry and improving shareholders’ monitoring ability).

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2.4.1 Impact on Investment Decisions

Higher financial reporting quality could allow constrained firms to attract capital by making their positive NPV projects more visible to investors and by reducing information asymmetry. Alternatively, higher financial reporting quality could limit managerial incentives to engage in value destroying activities such as empire building in firms with sufficient capital, as explained under the agency view. Murphy (1985) argues that growth in the size of a firm increases managers’ power by increasing the resources under their control and increasing their compensation based on sales growth. Therefore, when shareholders do not have enough information to observe managers’ behaviour, managers have incentives to grow their firms beyond their optimal size. Higher financial reporting facilitates writing better contracts, which could prevent inefficient investment and/or increases investors’ ability to monitor managerial investment decisions (Verrecchia, 2001).

In accordance with the above, I expect an improvement in investment activities regarding over-investments (i.e. investing in projects with negative NPV). Hence, as Integrated Reporting increases disclosure information, and research finds that it reduces information asymmetry, I expect that this in turn changes managers’ behaviour through improvement in investment activities.

H1: Ceteris paribus, Integrated Reporting improves investment activities, relative to other disclosures

2.4.2 Impact on Financing Decisions

Shareholders often view excess cash on a company’s balance sheet and agitate for its return to shareholders in the form of cash dividend or repurchase of shares, which boosts stock value. Furthermore, management teams may want to raise capital to invest in new projects, but existing shareholders often view this as a threat. Issuing new shares can dilute existing shareholders’ stakes, and issuing debt can increase leverage risk and, therefore, the risk associated with the company’s stock (Blanchard et al., 1994). Therefore, as Integrated Reporting takes all stakeholders into account, I expect managers aligning more with shareholders and less jeopardize their wealth, which consequently boosts financing activities.

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2.4.3 Impact on Operating Decisions

Interest in the stakeholder theory has been promoted by increased sensitivity to ethical issues among individuals and organisations, such as damage to the environment. Investors and investment fund managers have begun to make investment decisions on the basis of social responsibility as well as pure economics. Heightened ethical sensitivity, increasing competition, and a hyperactive media have combined to create a very difficult management situation. Managers must devise strategies that will make their organisations competitive in the world economy; they must provide high returns for their shareholders (Harrison & Freeman, 1999).

Garanina and Dumay (2017) find that Integrated Reporting may have value relevance to a company due to its significant amount of forward-looking non-financial information, which is in accordance with one of the key guiding principles of the <IR> Framework, i.e. future orientation. Thus, Integrated Reporting helps to make organisations accountable for their future financial and non-financial performance to all of their stakeholders (Abeysekera, 2013). Consistent with the above and the underlying importance of the frameworks fundamental assumption to deliver (sustainable) value creation through the six capitals for the long term, I expect operating activity enhancement. This leads to the final hypotheses.

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2.5 Academic Literature Overview

Table 1. Table of discussed academic key papers on Managers’ Behaviour, Free Cash Flow, Integrated Reporting, and other types of disclosures. # AUTHOR(S)

(YEAR) FOCUS METHODOLOGY SAMPLE SIZE & COUNTRY KEY VARIABLES

1 Fazzari et al.

(1988) Financing Constraints and Corporate Investment: with perfect capital markets, a firm's investment decisions are independent of its financial condition

Qualitative Research;

Archival 422 U.S. firms; 1969-1984 Market value of equity; Value of debt; Replacement value of the capital; Cash flow 2 Blanchard et al.

(1994) Suppose that a firm receives a cash windfall which does not change its investment opportunity. What will this firm do with the money?

Archival 11 U.S. firms; 1980-1986 Investment in own lines of business; Dividends or open market share repurchases; Long-term debt 3 Wallace (1997) Whether compensation plans based on residual

income change managers’ behaviour Quantitative Research; Matched-pairs control 76 U.S. firms; 1985-1994 Total Assets; Return on Assets; Leverage; New Investments; Disposition; Asset Turnover; Repurchases per share; Dividends per share; Top management and board stock ownership; 4 Avery et al.

(1998) Effect of a firm's acquisitions on the subsequent career of its chief executive officer Qualitative Research; Archival 346 U.S. firms; 1986-1991 Market return; Return on common equity; Firm size; Dummy variable one if firm made at least one acquisition; Dummy variable one if firm made at least one diversifying acquisition

5 Harford (1999) Relation between cash‐richness and acquisition behavior

Archival 487 U.S. firms; 1950-1994 Cash flow from operations; Cash deviation variable; Size; Sales growth; Leverage; Market‐to‐book 6 Verrecchia

(2001) How managers exercise discretion with regard to the disclosure of information about which they may have knowledge, and preferences regarding efficiency-based disclosure

Qualitative Research; Survey - series of modeling vignettes

2001 The link between efficiency to disclosure and the link between disclosure and information asymmetry reduction

7 Berger & Hann

(2003) Effect of the Financial Accounting Standards Board's (FASB) new segment reporting standard on the information and monitoring environment

Qualitative Research; industry-based mechanical forecasting model

2,999 International

firms; 2003 Disaggregation; Cross-segment transfers; Mechanical forecasts; Forecast error 8 Bates (2005) Examines the revealed payout and retention

decisions of divesting firms Qualitative Research; Archival 400 U.S. firms; 1990-1998 Inside ownership; Cash; Cash flow; Payout decisions; The dividend indicator; Total debt 9 Richardson

(2006) The extent of firm level over-investment of free cash flow Qualitative Research; accounting-based framework

58,053

International firms; 1988-2002

Growth opportunities; Leverage; Firm size; Firm age; Level of cash; Past stock returns; Prior firm level investment

10 Dechow et al.

(2008) The sources and uses of the cash component, and consequently what drives the higher persistence of the cash component of earnings (i.e. cash flow)

Archival 392,953 ; 1950-2003 Net income; Free cash flow; Cash; Distribution to debt holders 11 Mia &

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TABLE 1. (CONTINUED) # AUTHOR(S)

(YEAR) FOCUS METHODOLOGY SAMPLE SIZE & COUNTRY KEY VARIABLES

12 Dhaliwal et al.

(2011) Voluntary Nonfinancial Disclosure and the Cost of Equity Capital Quantitative Research; Archival 294 U.S. firms; 1993-2007 Dummy variable for CSR disclosure; cost of equity capital; CSR performance; Firm size; Growth opportunities; Leverage 13 Shroff et al.

(2013) Voluntary disclosure and information asymmetry: Effect of the Reform on voluntary disclosure behaviour before equity offerings and the associated economic consequences

Quantitative Research; Difference-in‐differences

1,484 U.S. firms;

2003-2008 Factual information; Firm size; Firm age; Cash holding; Dividends paid; Growth opportunities.

14 Frias-Aceituno et al. (2013)

Influence played by certain features of the Board of Directors in the degree of information integration presented by leading non‐financial multinational firms

Quantitative Research; series or cross‐sectional data

568 International

firms; 2008-2010 Dummy variable for financial report, CSR report, and integrated report; Growth opportunities; Firm size; Board size; Board gender diversity; Industry sector; Profitability

15 Frias-Aceituno

et al. (2014) The effect of industry concentration, together with other factors, in the development of integrated reporting.

Quantitative Research;

logistic regression 1,590 International firms; 2008-2010 Dummy variable for financial statement, CSR report, and integrated report; Industry concentration; Firm size; Growth opportunities; Profitability

16 Churet &

Eccles (2014) Integrated Reporting, quality of management, and financial performance Quantitative Research; Survey 2,000 International firms; 2011–2012 Quality of overall management (proxy ESG); Industry 17 Martínez-

Ferrero et al. (2016)

The effect that voluntary information disclosure concerning corporate social responsibility (CSR) has on information asymmetry and its evidence in the stakeholder protection context

Quantitative Research; Generalized method of moments

575 International

firms; 2003-2009 Information asymmetry: analysts’ forecast accuracy (absolute value of earnings per share) - the median of forecasted earnings per share / by total share price. Degree of voluntary disclosure of information on ordinal scale 0 to 100.Financial reporting quality; Industry concentration; Size; Growth; Leverage; Return on assets 18 García-Sánchez

& Noguera-Gámez (2017a)

Relationship between integrated information disclosure and the degree of information asymmetry

Quantitative Research;

Archival 995 International firms; 2009-2013 Dummy variable for Integrated Reporting and other types; Information asymmetry; Size; Profitability; Leverage; Concentration; Growth opportunities.

20 García-Sánchez & Noguera-Gámez (2017b)

Integrated information and the cost of capital Quantitative Research;

Archival 995 International firms; 2009-2013 Dummy variable for Integrated Reporting and other types; Cost of Capital; Size; Leverage; Return on Assets, Growth opportunities; Industry

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3 Research Methodology

This chapter discusses the research design, data collection and sample selection, the variables, the sensitivity analysis and thereafter the empirical models for testing the hypotheses. The purpose of this study is to examine whether the adoption of Integrated Reporting (independent variable) influences managers’ behaviour (dependent variable) consistent with the interest of shareholders. The changes in managers’ behaviour between the pre and post-adoption periods are analysed. In order to test this, initially three different models are used; one for each hypothesis. Subsequently, the sensitivity analysis tests each hypothesis with another proxy. The hypotheses are tested with an ordinary least squares (OLS) regression that includes an indicator variable (IR) for treatment or control firms and four additional control variables.

3.1 Research Design

The empirical tests in this study rely on an interrupted time-series design. The goal of the analysis is to detect whether adoption of Integrated Reporting (the treatment) has the predicted effect on managers’ behaviour. If adoption has an effect, I should observe differences in the observations before and after the treatment, i.e. an ‘interruption’ in the time series. As Integrated Reporting is a reaction to the lack of traditional reports, I identify the control group as pre-adoption period and the treatment group as post-adoption. The <IR> Framework is introduced per fiscal year 2013, therefore I identify the post-adoption period from fiscal year 2013-2017 and the pre-adoption from fiscal year 2006-2012.

Two major validity threats to the analysis of an interrupted time series are the possibility that (1) some event other than the treatment (a history threat), or (2) natural changes in a firm through time (a maturation threat) cause the change in the time series (Cook & Campbell, 1979). The use of a properly selected control group diminishes these threats since both treatment and control firms are subject to potential omitted variables and primarily differ based on the partitioning variable.

3.2 Data Collection and Sample Selection

In order to gather all needed data on managers’ decision-making outcome for European companies, I will use DataStream, which is available through the University. Furthermore, I will

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hand-collect companies which disclose an Integrated Report. A dummy variable will be used to measure this (i.e. 1 if the company discloses an Integrated Report and 0 if not).

The research sample is composed of European companies which have adopted the practices recommended by the <IR> Framework for (at least) three consecutive years (post- adoption period), and in order to lessen validity threats, they are matched with companies that do not follow the <IR> Framework (pre-adoption period). Among the IIRC companies, it is argued that it is currently impossible to clearly distinguish between ‘sustainability’ and ‘integrated’ reports, because the way in which companies label them does not reflect their content (Fasan & Mio, 2017). Fasan and Mio have encountered this during their study on the determinants of materiality disclosure among International Integrated Reporting Council (IIRC) Pilot Program companies implementing the <IR> Framework. Hence, I will first focus on all companies which joined this program, as they will have the same adoption period. Thereafter, in accordance with Bratu’s (2017) research, I will consult the companies listed on the database ‘IR Datastream Example’ through the examples.integratedreporting.org website. They reveal all firms complying with the <IR> Framework, content elements and/or fundamental concepts in the corresponding years. Subsequently, if releases for certain years are missing, which breaks up the consecutive years, I will manually look into the companies Integrated Report to verify compliance with the <IR> Framework for the absent years. This will only be sufficient if companies state their compliance with that specific framework.

As it is time consuming to hand-collect data on companies claiming to comply with the <IR> Framework in their annual report, I will have a rather small sample size for the treatment group. In order to lessen the validity threat of getting a rather smaller sample at a later stage, I first confirm whether there is data on all the needed proxies for at least a sample size containing 200 observations. Furthermore, I will not exclude companies when Datastream reveals there is no data on a certain proxy if I can either use another database or am able to hand-collect the data through the annual reports and measure it the same way as Datastream.

My aim is to examine European companies that consecutively follow the <IR> Framework for three years. I start off by focusing on the 100 global companies which joined the IIRC Pilot Program, and consistently complied with the <IR> Framework for the fiscal year 2013. Thereafter, I exclude 52 non-European firms which joined the IIRC Pilot Program. To complement this group, I consult the database ‘IR Database Example’ which consist of 237 global companies using the <IR> Framework somewhere between 2013 and 2017. I focus on 168 European companies which have not yet participated in the IIRC Program and - as described above - manually verify whether they claim compliance with the <IR> Framework for three

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consecutive years. This leads to an additional 36 companies. Furthermore, I manually examine whether all Pilot Program companies comply with the <IR> Framework for three consecutive years. As a result, I exclude 8 companies. Subsequently, I follow Maniora (2017) and Richardson (2006) by excluding all 32 companies from the financial services industry (i.e. banks and insurance companies with ICB codes 8000-8995). This is because this industry has unique regulations and characteristics which are completely different from firms in other industries. Furthermore, I remove 10 companies which cannot be identified by Datastream as publicly listed on stock exchanges. Last, I exclude 4 firms for which no data is available for the proxy ‘ESG score’. This proxy is calculated by Datastream through a unique method, which cannot be reproduced in the same manner by neither myself, nor does another database use the exact same method. Hence, my final size for the treatment group consists of 30 companies (107 observations) over the period 2013-2017, with the footnote that the panel is unbalanced due to not having data on all variables for each year. The table below provides an overview on the sample determination.

Table 2. Sample Determination

Firms Database ‘IR Database Example’ 2017 237

Firms IIRC Pilot Program 2013 100

Firms Excluded (307)

o Non-European

o Overlap between IIRC Program and ‘IR Database Example’ o No 3 consecutive years of Integrated Reporting

o Financial Service Industry o Not identified by Datastream

o No data on ‘ESG Score’ or other proxies

(103) (18) (140) (32) (10) (4) Final Firm Sample Treatment Group

Final Firm Sample Control Group Total Observations

30 30 613

I follow Wallace (1997) and match each treatment firm to a control group, based on a four-digit ICB Code and firm size. This sample size will be consistent with the treatment group, i.e. 30 firms for the control group. First, I collect a list of all the market constituent stocks for Europe (Datastream mnemonic G#LTOTMKER). This leads to an initial sample of 1,742 firms. Subsequently, I collect the categorical variable representing the industry of each treatment company and match it to a control group on the most detailed industry level (i.e. on the four-digit ICB Code). In two cases, I am not able to find a match on that detailed level, as there are no sufficient peer firms. These firm are matched on a three-digit ICB Code. I verify whether the

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control group has data on all the needed proxies. If not, another firm – based on the same method as described above – is selected. Last, firms closest in size are chosen based on total assets in the year prior to the treatment firms adoption of an Integrated Report, also considering the currency difference. In order to verify that the control firms do not follow the <IR> Framework, I match them to the ‘IR Database Example’. This results in a total sample size of 60 companies (613 observations).

Although an effort was made to match firms as closely as possible, treatment firms differ by definition in that they have self-selected to adopt Integrated Reporting. The factors that lead treatment firms to choose Integrated Reporting may not be present in control firms, e.g. control firms may have found other means of mitigating potential agency costs. In order to mitigate this, several control variables are chosen, which will be discussed in the next section. Table 3 contains a list of each treatment firm, along with its matched-pair control. This table also includes the year the treatment firm first disclosed an Integrated Report and each firm’s ICB Code.

Table 3. Descriptive statistics of sample firms. Adoption

YearA ICB # Industry Treatment Firm Control Firm

2013 1357 Specialty Chemicals AKZO NOBEL N.V. CLARIANT

2013 2357 Heavy Construction KONINKLIJKE BAM GRP BALFOUR BEATTY

2013 1353 Commodity Chemicals BASF SE LINDE AG

2013 7573 Gas Distribution ENAGAS SA SEVERN TRENT PLC

2013 0537 Integrated Oil & Gas ENI GROUP TOTAL SA

2013 5373 Broadline Retailers MARKS & SPENCER DEBENHAMS PLC

2013 4577 Pharmaceuticals NOVO NORDISK A/S ROCHE HOLDING AG

2013 0537 Integrated Oil & Gas REPSOL SA OMV AG

2013 7573 Gas Distribution SNAM SPA CENTRICA PLC

2013 6535 Fixed Line Telecommunications TELEFONICA S.A. TELECOM ITALIA

2013 7535 Conventional Electricity TERNA SPA A2A SPA

2014 6535 Fixed Line Telecommunications KONINKLIJKE KPN NV BT GROUP PLC

2013 4535 Medical Equipment KONINKLIJKE PHILIPS SMITH & NEPHEW PLC

2014 1737 Paper MONDI PLC UPM-KYMMENE OYJ

2013 2357 Heavy Construction ACCIONA SA HOCHTIEF

2013 1775 General Mining ANGLO AMERICAN PLC BHP BILLITON

2014 3537 Soft Drinks COCA COLA HBC AG BRITVIC PLC

2014 3535 Distillers & Vintners DIAGEO PLC PERNOD RICARD SA

2014 2357 Heavy Construction FERROVIAL SA EIFFAGE SA

2013 7535 Conventional Electricity IBERDROLA SA ELECTRICIT DE FRANCE

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TABLE 3. (CONTINUED) Adoption

YearA ICB # Industry Treatment Firm Control Firm

2015 1357 Specialty Chemicals KONINKLIJKE DSM N.V. WACKER CHEMIE

2014 5337 Food Retailers & Wholesalers KESKO OYJ JERONIMO MARTINS SA 2015 0573 Oil Equipment & Services SBM OFFSHORE NV PETROFAC LIMITED

2015 1775 General Mining BOLIDEN AB KAZ MINERALS PLC

2014 3728 Home Construction CREST NICHOLSON

HOLD

REDROW PLC

2014 5550 Media VIVENDI SA WPP PLC

2015 2353 Building Materials & Fixtures TITAN CEMENT CO. GEBERIT 'R' 2014 1755 Industrial Metals & Mining KGHM POLSKA MIEDZ SALZGITTER AG

2014 7535 Conventional Electricity FORTUM OYJ SSE PLC

A_{Adoption Year represents the year in which the treatment firm first adopted the <IR> Framework.}

3.3 Variables

The purpose of this study is to examine whether the adoption of Integrated Reporting influences managers’ behaviour consistent with the interest of shareholders. These variables, with corresponding proxies, are selected from previous studies (e.g. Wallace, 1997; Churet & Eccles,

2014). To establish the dependent variables, the following section will elaborate on the various

representative determinants of mechanisms designed to protect shareholders’ interests. Table 5 provides an overview on the independent and dependent variables, proxies and measurement details. Finally, the several control variables covered in the regression analyses are discussed, including factors that correlate with Integrated Reporting, with the likelihood of managers’ investment, financing and operating decisions, or both. The table below gives an overview on the expectations of the dependent variables per proxy. This will be clarified in the following sections.

Table 4. Overview of all dependent variables, proxies and expectation per hypothesis.

Hyp. Dependent Variable Proxy Expectation

1(1), 1(2) Investment Decisions “New Investments” , “Disposals” Decrease resp. Increase 2(3), 2(4) Financing Decisions “Repurchase per Share”, “Dividend per Share” Increase resp. Increase 3(5), 3(6) Operating Decisions “ESG Score” , “Asset Turnover” Increase resp. Increase

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3.3.1 Independent and Dependent Variables

In order to measure the independent variable - whether or not a company issues an Integrated Report - a dummy variable will be used; that is 1 if the company discloses an Integrated Report, and 0 otherwise (IR). This method will consist of one variable, which makes it straightforward to measure. The dependent variable - to measure managers’ behaviour - will be operationalised by focusing on investment, financing and operating decisions.

I follow Wallace (1997) and Richardson (2006) by measuring ‘Net Assets from Acquisitions’, ‘Capital Expenditure’ and ‘Beginning Total Assets’ extracted from Datastream as the proxy for investment decisions. Due to Integrated Reporting, I expect managers to be more aligned with shareholders’ interest and create value for them. In order to be more aligned with shareholders and by creating value, projects must have returns in excess of the firm’s opportunity cost of capital, not merely the associated cost of debt capital. This should lead managers to become more selective in their choice of new projects following the adoption Integrated Reporting. Therefore, I assume managers will be more selective in their choice of new projects following the adoption of Integrated Reporting. Hence, in accordance with the research of Wallace (1997), I expect that new investments will decrease for firms disclosing Integrated Reports.

In accordance with Wallace (1997), the proxy for financing decisions is measured through share repurchase. This is an alternative to managers paying out free cash flow in order to increase shareholders’ wealth. This reduces free cash flow and therefore agency costs (Wallace, 1997). As my assumption is that managers want to maximize shareholders’ wealth under Integrated Reporting, I expect them to reduce their substantial free cash flow by repurchasing shares. Repurchasing of its own shares by a firm is known as share repurchases or share buybacks. If the repurchased shares are held for limited or unlimited time for future use or reselling, they are considered as treasury shares (Sabri, 2003). I measure share repurchases by dividing ‘Treasury Shares’ through ‘Common Shares Outstanding’ extracted from Datastream. This conducts a ratio of the total number of own shares purchased in a fiscal year to the number of outstanding shares at the end of the year. Hence, I expect that overall share repurchase will increase for firms with Integrated Reports.

In order to capture the proxy for operating decisions, I follow Tarmuji et al. (2016) by measuring ESG Score through Datastream. ESG Score represents an overall measure of the quality of a company’s business practices, recognising those companies that look beyond the next quarter and manage with an emphasis on creating long-term shareholder value. As described in section 2.4, the ESG quality of management has become a useful indicator of the overall effectiveness of management in creating value over the long term. The emphasis of the <IR> Framework is on

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combining financial information with ESG information, where the fundamental assumption is that each of the six capitals represents a potential source of value that must be managed for the long term in order to deliver sustainable value creation (Churet & Eccles, 2014). Therefore, I expect that ESG Score will increase for firms disclosing Integrated Reports.

Table 5. Overview of independent and dependent variables, proxies and measurement details.

Type Variable Proxy Measurement detail

IV1 Integrated

Reporting

IR Dummy variable equal to 1 if an Integrated Report is published and 0 otherwise.

DV1 Investment

Decisions

New Investment: (A) Net Assets from Acquisitions +

(B) Capital Expenditure / (C) Beginning Total Assets

(A) Represent assets acquired through pooling of interests or mergers. It does not include capital expenditures of acquired companies. (B) Represent the funds used to acquire fixed assets other than those associated with acquisitions. (C) Represent the sum of total assets, long term receivables, investment in unconsolidated subsidiaries, other investments, net property plant and equipment and other assets of previous end year.

DV2 Financing

Decisions

Repurchase per Share = (A) Treasury Shares / (B) Common Shares Outstanding

(A) Represent the number of common shares reacquired by the company. (B) Represent the number of shares outstanding at the company's year-end. It is the difference between issued shares and treasury shares.

DV3 Operating

Decisions

ESG Score Overall company score based on the self-reported information in the environmental, social and corporate governance pillars. * Symbols Datastream: DV1 =( WC04355 + WC04601) / WC02999 ; DV2 = WC05303 / WC05301 ; DV3 = TRESGS

3.3.2 Control Variables

To counter the possibility of biased results, the analysis includes the following control variables which are derived from prior research: board independence, leverage, company size, growth opportunities and industry. Table 6 provides an overview on each control variable, which will further be discussed in this section.

Board Independence (EXTDIRECT). Corporate governance mechanisms such as the board of directors play an important role in good practices of corporate social responsibility, implementing policies of stakeholder engagement, including processes to achieve holistic transparency. An independent board is considered an essential mechanism to control the actions of managers and to ensure shareholders’ goals are accomplished (Fama & Jensen, 1983). The independence of the board is often related to the presence of non-executive directors (Frias-Aceituno et al., 2013). External or non-executive board members often have a greater interest in

Impact of integrated reporting on managers’ decision-making : does it lead to maximizing shareholders’ wealth?