Accounting Conservatism, Block Ownership Concentration and the
Quality of Risk Disclosure
Combined master thesis in Accountancy and Controlling
University of Groningen, Faculty Business and Economics
20-01-2020 Bas Niezing Student Number: S2704781 Kortenaerstraat 8a 9726HK Groningen Phone Number: 0031 653471201 Email: b.p.niezing@student.rug.nl Number of words: 10,818 Supervisors: Karaibrahimoglu, Y. and Porumb, V.A.
Abstract: In 2010, the International Accounting Standards Board (IASB) revised the conceptual framework and removed the term prudence. This study researches whether the removal caused a significant decrease in the degree of conservatism and if the revision of the IASB framework had consequences for the financial risk disclosure. The quality, length and coverage of the financial risk disclosure were investigated for the pre-period and the post-period of the conceptual framework. The study further investigated whether block
concentrated ownership influences the quality of financial risk disclosure. This research found evidence that less conservative firms have a significantly higher quality of IFRS 7 risk
disclosures. The literature indicates that conservative firms report more verifiable
information, which can deteriorate the information relevance. The IASB removed prudence and reliability from the conceptual framework, and firms indeed became less conservative. It can be assumed that a conceptual framework without conservatism can provide a higher quality of financial risk disclosure. Other findings indicate that conservatism is negatively associated with the length and coverage of financial risk disclosure before the revision of the conceptual framework but significantly positive after the change in the framework. This result indicates that conservative firms try to compensate for a lower degree of conservatism by disclosing more risk information with more risk categories. Another reason may be a cautious attitude of conservative firms to disclose new regulations. Block concentrated owners
negatively influence the length and quality of financial risk disclosure. A reason for this statement is the greater power of block owners, who perceive information as a private benefit. Keywords: IFRS 7, accounting conservatism, block ownership concentration, IASB conceptual framework, quality of financial risk disclosure
1. INTRODUCTION
There is a continuous debate about the relevance of financial information, especially for financial risk-related information. The rules for risk disclosure are reported in the
International Financial Reporting Standards (IFRS) 7, in which the regulator has introduced many standards related to the different types of risks. Information about risks is recognized as an important part of overall financial reporting. Particularly for investors, risk disclosure makes financial reporting more useful for value estimation (Mokhtar and Mellett, 2013). A higher quality of risk disclosure leads to higher confidence for investors (LaFond and Watts, 2008), which results in a lower bid-ask spread for investors (Easley and O'Hara, 2004) and better stock valuation (Bushee and Miller, 2007). Due to financial risk reporting, insight can be gained into the future performance of a firm (Ismail and Abdul Rahman, 2011), and the decrease in information asymmetry ensures that investors are warned earlier about risks. Critical assumptions and changes that are uncertain as well as material events that have an impact on the financial position must be clarified for stakeholders. The agency costs can therefore be reduced due to the decrease in a conflict of interest, which increases the efficiency of the market (Hassan, 2014). Andersen, Häger, Maberg, Næss and Tungland (2011) have even suggested that the most important solution for preventing a financial crisis is managing and disclosing all types of risks.
Although research has revealed that risk reporting is important, many companies do not report sufficient information about financial risks. Practitioners indicate that financial risk
information remains insufficient for stakeholders to analyze the overall risk profile (PwC, 2008; KPMG, 2009). The literature has determined some evidence of this insufficiency of risk information. Hellman, Carenys and Gutierrez (2018) have demonstrated that the average amount of published risks is 49%; in this case, more than half of the risks are not published. In addition, only 6% of the risks disclosed have a significant interest in decision-usefulness because of the idea of quantity over quality (ASB, 2009). Sample companies did not disclose the possible impact of the risks, which is important for decision-makers. Financial risks are often not based on evidence but primarily on managerial judgment. Thereby, disclosures contain too little information about the present and future periods (Hellman et al., 2018). The IFRS 7 is seen as only ticking boxes, and most companies present only general irrelevant risk information. Financial risk information becomes uniform, equal and intertemporal and referencing the actual state, meaning that there is no view of future firm performance (Agyei-Mensah, 2017; Hellman et al., 2018). Stakeholders can easily make the wrong decisions because of the difficulty for stakeholders to distinguish important and less important risks and to find and understand these risks (Hellman et al., 2018).
The International Accounting Standards Board (IASB), which establishes the financial reporting rules, has attempted to solve the problem of insufficient financial disclosure by changing the conceptual framework. In recent years, there has been a discussion about
whether prudence should be included in the conceptual framework of the IASB. Prior to 2010, prudence was still characterized in the conceptual framework, but the discussion arose that this term was contrary to the neutrality of information. Prudence ensures that losses are recognized in a timely fashion but, on the other hand, can give an unfair overview of an organization (Barker, 2015). Because of the possibility of an unfair overview in the financial disclosure, the IASB decided to delete prudence from the conceptual framework. Much resistance arose, and the discussion continued when the IASB announced in 2014 that prudence had returned to the conceptual framework. Due to the contradictory adjustments of the conceptual framework, it seems that the IASB is still seeking an appropriate level of the quality of information disclosure. According to Barker (2015), prudence is a form of
conservatism, and because conservatism is seen as verifiable, accurate and less optimistic, this term is highly associated with prudence (Ball, 2001; Zhong and Li, 2017; Basu, 2005). This research therefore uses the term conservatism.
Not only does the IASB have an issue determining how to disclose the appropriate level of disclosure quality, but the literature is also contradictory about this question. The literature indicates that conservatism has advantages and disadvantages. Some researchers highlight that conservatism can complement the quality of information (Bauer, O'Brien and Saeed, 2014; Barker and McGeachin, 2015; Balachandran and Mohanram, 2011), while others emphasize that it will disrupt the quality of information (Gigler and Hemmer, 1998; Davern, Gyles, Hanlon and Pinnuck, 2019). Uncertainties are more likely to be disclosed by firms with more accounting conservatism than firms with less accounting conservatism (Barker, 2015). Because the IFRS 7 is highly associated with uncertainties, but by nature focuses on risk exposure, this is an appropriate setting to test the usefulness of the changed IASB framework. This article explores whether accounting conservatism leads to a higher quality of financial risk disclosure, and analyzes the differences in the degree of conservatism between the pre-period and post-period of the revised IASB conceptual framework in 2010.
In addition, this article explains the role of block ownership concentration. Most large firms have block concentrated owners who control the firm (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1998). These owners can use power for private purposes. Furthermore, the information asymmetry can lead to a difference in risk disclosure, whereby other owners and stakeholders can be falsely informed about the financial risks. Several researchers have provided evidence for a lower quality of financial reporting with a higher block ownership concentration. Concentrated owners have more influence on the disclosure of information and perceive this information as private benefits (Rubin, 2007). Other researchers have highlighted the voluntary disclosure of financial risk information with a lower ownership concentration (Chau and Gray, 2010). This article explores whether block ownership concentration influences the quality of financial risk disclosure.
This research contributes to the literature in several ways. First, much research is being done into the extent of the disclosure of risk information, but less is being done about the quality of risk information (Agyei-Mensah, 2017). Many studies have traditionally measured the number of words and the number of risks disclosed. However, the Accounting Standards Board (2007 and 2009) and Linsley and Shrives (2006) have provided evidence that financial risk disclosures are general and irrelevant. There is demand for more research about relevance-oriented qualitative risk disclosure (Elshandidy, Shrives, Bamber and Abraham, 2018; Hellman et al., 2018; Beretta and Bozzolan, 2004). This paper extends to the literature of qualitative risk reporting and investigates the progress of the quality of financial risk reporting. Moreover, this article is specifically about the disclosure of risks arising from IFRS 7. Some research has been done about conservatism or ownership concentration in voluntary disclosure but not with mandatory standards. Second, this study complements the research of Barker and McGeachin (2015) with the question of whether accounting standards require conservatism. Furthermore, this research extends the study of Balachandran and Mohanram (2011) who researched conservatism and the relevance of financial reporting before the revision of the IASB conceptual framework. Third, this research contributes to the discussion about conservatism in the conceptual framework of the IASB. Following this research, it can be determined whether prudence has a positive or negative influence on the quality of
financial risk disclosure. Fourth, no research has yet addressed the specific relationship between block ownership concentration and the quality of financial risk reporting. Block owners can play an important role in information disclosure; as a result, different stakeholders can obtain less information.
The article is subdivided into different sections, starting with the literature review. Section 3 details the research methods, and the results are presented in Section 4. In Section 5, the findings, implications and limitations are explained in the discussion. Finally, the
conclusion is described in Section 6.
2. LITERATURE REVIEW
The literature review discusses the regulation of financial risk disclosure, the IASB framework, the theoretical background of accounting conservatism and block ownership concentration.
IFRS 7 regulation
Since 1 January 2005, listed European organizations were required to comply with the IFRS. This adoption meant a major change in the reporting of financial information. Earlier country-specific Generally Accepted Accounting Principles (GAAP) were changed in the European regulation. This new regulation not only ensures full reporting but also makes it more efficient for investors to compare different companies. One of the components of the new regulations is IFRS 7 (IFRS 7, 2005). The aim was to give stakeholders more insight into (the risks of) financial instruments, whereby future performance could be better predicted. The regulator made IFRS 7 rules public in 2005, and the effective date of IFRS 7 started on 1 January 2007. IFRS 7 comprises two parts (IFRS 7, 2005):
1. The first part concerns the significance of the financial instruments for financial position and performance.
2. The second part specifies the nature and extents of the risks arising from financial instruments and how to manage these risks.
IFRS 7 can therefore also be classified into both quantitative and qualitative financial risk disclosure (Elliot and Elliot, 2013). Quantitative disclosure indicates the extent of financial risks in an organization, while qualitative disclosure concerns the goals that the management has about financial risks and the associated measures and processes. This research specifies the financial risks that are revealed in IFRS 7, including market risk, liquidity risk and credit risk (IFRS 7, 2005). Market risk is the risk of market changes due to adjustments in market prices and is split into interest risk, currency risk and other price risks. The liquidity risk is defined as the risk that payment obligations can no longer be met (IFRS 7, 2005). The credit risk is the risk that one party cannot meet its payment obligations because debtors have no liquidity. According to the regulator, these are the major financial risks faced by companies exposed to financial instruments (IFRS 7, 2005). Operational risk was intentionally left out of the IFRS 7. In the introduction of IFRS 7, the reason was that measuring this risk is still in a developmental stage and that operational risk is not necessarily associated with financial instruments. In 2010, the IASB implemented several changes to the risk disclosure process in IFRS 7 (Amendments of IFRS 7, 2010). The amendments must be applied for the financial year starting on 1 January 2011 (Amendments of IFRS 7, 2010). The improvements include a new paragraph, which clarifies that qualitative disclosures in the context of the quantitative disclosures should be encouraged. The IASB has argued that stakeholders form a clearer overall picture of the extent and nature of the financial risks. In the following part, the literature background of the concepts of the IASB framework, accounting conservatism and block ownership concentration are described.
IASB conceptual framework
While prudence and reliability still belonged to the framework before 2010, the IASB removed the terms in the revised framework. The term reliability was replaced with faithful representation (IASB, 2010), and faithful representation was subdivided into the terms neutral, freedom from error and completeness. Faithful representation was characterized as a more weighted information provision and had a clearer description than reliability (Barker and McGeachin, 2015). The term faithful representation has caused a change to the estimation
of items over more reliable conservative figures. According to Barker (2015), it is a misconception that conservatism has been removed and that important terms such as
conservatism have been eclipsed. Consequently, the resistance by constituents has caused the IASB to change the conceptual framework again for 2020. Although reliability did not return to the framework, prudence was referred to as the sub characteristic of the term faithful representation. Prudence’s conflict with neutrality, which caused the removal from the conceptual framework of 2010, was suddenly no longer an issue. The IASB argued that the two terms were more complementary to each other (Pelger 2019). This article examines whether conservatism has become lower after the change in the IASB conceptual framework in 2010 based on the following question:
Has accounting conservatism decreased after the revision of the IASB conceptual framework in 2010?
Accounting conservatism
Accounting conservatism is one of the most influential aspects for valuation in reporting (Sterling, 1967). According to Haller and Eierle (2004), conservatism serves as the protection for creditors but is also valued by other stakeholders as a characteristic of accounting
mechanisms. Auditors, shareholders, suppliers and customers demand more conservatism in accounting (Zhong and Li, 2017). Smalenbach (1959) has found that overstated profits could pose a greater risk than understated profits and has emphasized that conservatism should be preserved.
One definition of conservatism is the use of the lowest value of the net assets where historical costs determine the value (Penman and Zhang, 2002). In this context, only the balance sheet approach is considered. Another more complete definition by Ball, Kothari and Robin (2000, p2) gives the definition based on the income statement approach: "the extent to which current period accounting income asymmetrically incorporates economic losses, relative to economic gains." These firms use the lowest value for asset valuation and the highest value for liability valuation (Ball et al., 2000). In practice, this means that losses are disclosed more quickly and profits are disclosed more slowly so that uncertainties are included in the firm’s performance. Losses decrease the net assets when bad news is
disclosed, but gains do not increase the value of assets when good news is disclosed (Barker and McGeachin, 2015). Hence, a less optimistic view is assumed in a conservative firm compared to a non-conservative firm. This method of valuation provides reliable and verifiable information disclosure to stakeholders because gains are only recognized if these match with collected gains (Basu, 2005). However, a trade-off is identified between the verifiability and timeliness of information (Barker and McGeachin, 2015). Verifiable information is in general not timely disclosed and vice versa. Specific to conservatism, a higher degree of verifiability leads to a delayed recognition of gains but a faster recognition of losses (Guay and Verrecchia, 2006). The objective here is to mitigate subjectivity and the opportunistic disclosure of gains. This improvement of credible information on gains and losses can be realized because of conservative accounting systems (Guay and Verrecchia, 2006). The previous literature reveals that conservatism is associated with a higher degree of the reliability of information, due to the verifiability, accuracy and improved disclosure of underlying information.
Conservatism and the quality of risk disclosures are mostly recognized as
complementary characteristics of information. Although Francis and Schipper (1999) have argued that financial reporting has lost relevance over the last decades, Balachandran and Mohanram (2011) have demonstrated that the quality and relevance of financial disclosure does not exist without conservatism. Balachandran and Mohanram (2011) have highlighted that the higher degree of conservatism even causes an increase in the quality of financial information. Zhang (2011) has discussed financial information disclosure because of the information asymmetry between managers and stakeholders. He has argued that the quality of information would be negatively affected by this information asymmetry, whereby the
reporting mechanism would become implausible. Due to this information asymmetry and the moral hazard problem, organizations should be required to use a minimum degree of
conservatism to deliver reliable information (Bauer et al., 2014). With a neutral attitude, companies mostly provide knowledge of the moral hazard problem but do not control the problem. Conservatism, on the other hand, would actively work against the moral hazard through a cautious attitude (Latridis, 2011). In this way, uncertain conditions could be
processed more efficiently and reliably in financial reporting. Bauer et al. (2014) have argued that when conservatism fades away, the relevance and quality of information disclosures will disappear immediately because of the subjectivity of information. Bauer et al. (2014) have provided information that timeliness is not possible because the audited statements are always delayed, meaning that the timeliness of useful information does not exist.
However, a negative association between conservatism and the quality of financial reporting can also be assumed. Davern et al. (2019) have demonstrated that the market has a significant demand for specific and understandable financial disclosures and has significant concerns about the timeliness of the information. They have argued that late information is considered irrelevant. Moreover, there is evidence that companies with a lower degree of conservatism disclose more details of financial information about the future (Davern et al., 2019). Hence, Gigler and Hemmer (2001) have indicated that less conservative firms disclose risks faster than more conservative firms. Gigler and Hemmer (1998) have argued that even if managers have suitable information about the future, stakeholders do not know which data or model is used. Better future information can be more subjective but can improve risk
disclosure by issuing more forward-looking risk information to stakeholders. Risks have an uncertain nature and are therefore not always verifiable. Michels (2012) has found that unverifiable information matters, and investors also need this information for a firm’s
overview. Conservative firms provide more verifiable information, which means that financial risk disclosure can also be deteriorated. The failure to disclose risks occurs at the expense of the risk disclosure quality. Moreover, conservative firms have more risk-averse mechanisms with earlier loss recognition and therefore do not disclose other ways to manage risks (Ho, Li, Tam and Zhang, 2014). Risk information disclosure about managing risks as hedging
activities cannot be disclosed. Two streams of literature reveal that conservatism and the
quality of risk disclosure can be positive and negative, resulting in the following question:
Are the risk-related IFRS 7 disclosures of higher quality for conservative firms compared to less conservative firms?
Block ownership concentration
Block ownership concentration is a well-researched subject. Like the relationship between conservatism and risk disclosure, the relationship between block ownership concentration and financial risk disclosure is also exposed to information asymmetry. According to Fama and Jensen (1983), information asymmetry can be lower in a firm with a block ownership structure due to the greater power of the investors in the publication of figures.
Concentrated owners can put more pressure on the management team because of an effective mechanism to influence management (Barako, Hancock and Izan, 2006). Moreover, concentrated owners are more interested in the results of the organization. Because of their greater stake in the organization, firm performance is also more important for block concentrated owners (Kim and Lee, 2003). The reduction of the agency conflict provides lower information asymmetry; however, more influence on the information disclosure does not automatically mean a higher quality of risk disclosure. Concentrated owners can perceive the information as private gains and are not willing to share these gains with other investors or stakeholders(Rubin, 2007). Company information is seen as a benefit over other stakeholders.
Furthermore, a widely spread ownership structure ensures that managers want to disclose more information. Because more shareholders demand financial information, management also feels obliged to disclose this information (Craswell and Taylor, 1992). In addition, researchers have demonstrated that a wider ownership structure has a positive relationship with voluntary disclosure (Chau and Gray, 2010). This evidence substantively shows the point of view of managers regarding their willingness to disclose figures in a widely spread ownership structure. This article examines which ownership structure influences the quality of the mandatory risk disclosure based on the following question:
Is block ownership concentration associated with the quality of IFRS 7 risk disclosures?
3. METHODOLOGY This research consists of two models. The first model measures the degree of conservatism
before and after the IASB framework was effective. The second model measures accounting conservatism, block ownership concentration and the quality of financial risk disclosure. Before the models are explained in detail, the sample of the dataset is described.
Sample
The research is based on the disclosure of financial risks after the adoption of IFRS 7, which started on 1 January 2007 (IFRS 7, 2005). The first year of adoption is difficult because of less experience with the new regulation; therefore, this year is excluded from the sample. This research concerns the data between 2008 to 2016. Data collection ended in 2016 due to data availability. According to Francis, LaFond and Olsson (2004), the use of a minimum six-year period is sufficient. The study uses the risk disclosure of premium-listed firms on the London Stock Exchange. The sample consists of 318 firms, with 1,612 firm-year observations. Data about qualitative risk disclosures have been gathered from Karaibrahimoglu and Porumb (2019), which was hand-collected within the research project funded by the International Association for Accounting Education and Research (IAAER) and IASB. Other firm-specific financial and non-financial data were gathered from Datastream and Orbis. The information
of independent variables from Datastream and Orbis and the hand-collected quality disclosure information were matched with the specific International Securities Identification Number (ISIN) and processed using Stata. All variables were tested on outliers, where 1% of the top and the bottom have been removed. The outcomes are presented in Chapter 4.
Model 1
Basu’s (1997) model is often used for the measurement of the degree of conservatism. Ball and Shivakumar (2005) have also used this model and have mentioned a relationship between changes in net income in the current year and the prior year. The extent to which the change in the current net income is caused by a negative or positive change in net income of the prior year is examined. A negative change in net income means bad news, and a positive change in net income means good news. To measure conservatism, a relationship is assumed between bad news and timely loss recognition. Timely loss recognition causes a lower net income following year. Accounting conservatism is higher when a higher negative change in net income in the following year has been observed as a result of bad news in the prior year. To test the hypothesis of whether accounting conservatism has decreased over time, the
multivariate test is used as the regression analysis. The regression model is as follows: ΔNIₜ = α₀ + α₁ΔNIₜ₋₁ + α₂DΔNIₜ₋₁ + α₃ΔNIₜ₋₁ x DΔNIₜ₋₁ + α₄Dummy₂₀₁₁ + α₅ΔNIₜ₋₁ x Dummy₂₀₁₁ + α₆DΔNIₜ₋₁ x Dummy₂₀₁₁ + α₇ΔNIₜ₋₁ x DΔNIₜ₋₁ x Dummy₂₀₁₁ + e
The dependent variable is the current-year change in net income. The use of the net income change as a dependent variable has two advantages, namely the use of the non-permanent characteristic of income change and a lack of issues with a survival bias (Ball and
Shivakumar, 2005). The independent variables are the prior-year change of the net income, a dummy for a negative change in net income and these two variables multiplied. The dummy gives 1 for a negative change, which signifies bad news, and 0 for a positive change, which signifies good news. The descriptions of the variables are listed in Table 1. Financial
reporting is more conservative if α₃ is significantly lower than 0 (Ball and Shivakumar, 2005). When α₇ is greater than 0, losses are recognized more slowly (Ball and Shivakumar, 2005). The test is subdivided into a sample from the years 2008–2016 and a sample from the years 2011–2016. If α₃ is positive and α₇ is negative, this indicates that the entire sample is more conservative than the sample from the period 2011–2016. In this case, conservatism is higher in the pre-period (2008–2010) of the framework. Thus, this model makes it possible to demonstrate if the degree of conservatism was higher in the pre-period or the post-period of the revised IASB framework.
Table 1: Variable descriptions of model 1
Variable Description
ΔNIₜ Change in net income in year t divided by total assets, (NIₜ - NIₜ₋₁)/ total assets
ΔNIₜ₋₁ Change in net income in year t-1 divided by total assets, (NIₜ₋₁ - NIₜ₋₂)/ total assets
DΔNIₜ₋₁ The dummy for the change in net income in year t-1, 1 if the
change in net income is negative and 0 when the change of net income is positive
Dummy₂₀₁₁ Dummy for fiscal years 2011–2016
Model 2
Model 2 describes whether conservatism and block ownership concentration have an
influence on the quality of financial risk disclosure. To reveal if the IASB framework has an influence on risk disclosure, the entire period 2008–2016, the pre-period 2008–2010 and the post-period 2011–2016 of the framework has been measured. To test if conservatism and block concentrated ownership are associated with the quality of the financial risk disclosure, the following model is used:
Quality = α₀ + α₁Market-to-book + α₂ Blockholders + α₃Length + α₄Coverage + α₅Size + α₆Leverage + α₇Liquidity + α₈Dummy Industry + α₉Dummy Year + e
The measurements of the dependent, independent and control variables are described below.
Dependent variable
The dependent variable is the quality of the financial risk disclosure. The quality of the financial risk disclosure of stock-listed firms in the UK captures the extent to which each risk has been disclosed. The IASB (2017) has researched the important characteristics of
disclosure quality in risk reporting and has found that the quality of risk information is dependent on the information about (1) sensitivity analyses, (2) collateral and derivative information, (3) information about hedge activities, (4) quantitative risk exposure information and (5) the materiality of financial instruments. This research utilized the quality disclosure index of Karaibrahimoglu and Porumb (2019) as stated in Table A1 in the Appendix. The aforementioned important information parts of the IASB (2017) are included in the quality disclosure index. The index contains 13 different items, which are checked in annual reports with a checklist for each firm-year. As indicated in the quality disclosure index in Table A1, various points are assigned to the different items. Ratios have been created of firm-year specific scores divided by the total score that can be achieved. A higher ratio signifies a higher quality of IFRS 7 risk disclosure.
Independent variables
The extent of conservatism is measured according to the definition of Ball et al. (2000). This definition is extended to the measurable definition of Khan and Watts with the market-to-book ratio (2009). Furthermore, Feltman and Ohlon (1995) and Givoly and Hayn (2000) have measured conservatism based on the market-to-book ratio. According to Khan and Watts (2009), the market-to-book ratio is directly related to conservatism because the gains and losses are the understatement for the value of assets. This value of assets is compared to the market value. Moreover, conservatism has a positive relationship with the market-to-book ratio. The market-to-book ratio is associated with more growth options, which are positively associated with agency costs (Khan and Watts, 2009). Because conservatism is a reaction of corporate governance to agency costs, a positive relationship can be assumed. Khan and Watts (2009) have demonstrated that the market-to-book ratio is directly positively associated with conservatism because of the conservatism of stocks, whereby the market value is not
Block ownership concentration is measured based on the Orbis independence
indicator. This indicator reveals whether a company has no shareholders with more than 25% of the total stocks, a shareholder who has stocks between 25% and 50% and a shareholder who has more than 50% of the total stocks. Table 2 presents the descriptions of the
independent variables.
Control variables
The results of prior research are used as control variables. The control variables are firm size, leverage, liquidity, length of the risk disclosure part, coverage of risk categories, year
dummies and industry dummies (Khan and Watts, 2009; Agyei-Mensah, 2017; Hossain, Tan and Adams, 1994). The specific controls for conservatism are leverage and firm size (Khan and Watts, 2009). According to Agyei-Mensah (2017), firms’ size and liquidity influence the quality of financial risk disclosure and are used as specific controls for the dependent variable. Furthermore, this research controls for the length of the disclosure part, coverage of risk categories, industries and years. The descriptions of the control variables used in regression model 2 are displayed in Table 2.
Table 2: Variable descriptions of model 2
Variables Description
Quality A ratio of the quality score of risk disclosure of each firm-year divided by a total score that can be achieved, based on the quality disclosure index.
Length The log of the number of words in the risk disclosure part.
Coverage The coverage of risk categories, whereby the following formula
was used to measure the coverage:
Coverage = (1/ H-index) / number of categories disclosed
Where H-index = (number of words in each specific risk category/ total number of words in IFRS 7 disclosures)2.
Market-to-book ratio The ratio of market value divided by the book value. Block ownership
concentration
1= No shareholders with more than 25% of the company shares. 2= One shareholder with shares between 25% and 50% of the company.
3= One shareholder with more than 50% of the company shares and indirect power.
4= One shareholder with more than 50% of the company shares and direct power.
Firm Size The log of total assets.
Leverage The ratio of total debt divided by total equity.
Liquidity The ratio of non-current liabilities divided by total liabilities.
Dummy Industry Dummy for each industry.
Dummy Year Dummy for each year.
Dummy₂₀₀₈ Dummy for fiscal years 2008–2010.
4. RESULTS
The results are divided into a descriptive analysis, correlation analysis and regression analysis.
Descriptive analysis
The sample consists of firms from different industries, and the percentages per industry are listed in Table 3. The three largest industries in the sample are industrial (37.03%), consumer services (26.18%) and consumer goods (13.03%). These three industries together account for 76.24% of the entire sample.
Table 3: Industry percentages
Industry Freq. Percentage
Basic Materials Consumer Goods Consumer Services Health Care Industrials Oil & Gas Technology Telecommunications Utilities 113 210 422 63 597 91 58 24 34 7.01 13.03 26.18 3.91 37.03 5.65 3.60 1.49 2.11 Total 1612 100
The sample consists of multiple years from 2008 to 2016. The percentages and frequencies per year are listed in Table 4, and the percentages are between 9% and 15% per year.
Table 4: Year percentages
Year Freq. Percentage
2008 2009 2010 2011 2012 2013 2014 2015 2016 243 240 150 148 149 161 185 166 170 15 15 9 9 9 10 11 10 11 Total 1612 100
The mean, standard deviation, minimum and maximum of Model 1 are presented in Table 5. The total sample consists of 1,612 firm years. Because of the use of lagged figures, the
variables have a lower sample of firm years. The mean of DΔNIₜ₋₁ is 0.44, which signifies that more firms in the entire sample have a positive change in net income. For 2011–2016, the mean is 0.34, which is lower than the mean for the entire sample. The mean for the ΔNIₜ₋₁ x DΔNIₜ₋₁ (–0.023) is lower compared to ΔNIₜ₋₁ x DΔNIₜ₋₁ in 2011–2016 (–0.018). The lowest ΔNIₜ₋₁ was –1.022 for the entire sample and for the data between 2011 and 2016. The maximum ΔNIₜ₋₁ in the entire sample was 1.093.
Table 5: Descriptive Analysis – Degree of Conservatism
Variable Obs. Mean Std. Dev. Min. Max.
ΔNIₜ ΔNIₜ₋₁ DΔNIₜ₋₁ ΔNIₜ₋₁ x DΔNIₜ₋₁ ΔNIₜ₋₁ x Dummy₂₀₁₁ DΔNIₜ₋₁ x Dummy₂₀₁₁
ΔNIₜ₋₁ x DΔNIₜ₋₁ x Dummy₂₀₁₁
1295 994 994 994 994 994 994 0.000 -0.001 0.444 -0.023 0.002 0.346 -0.018 0.103 0.090 0.497 0.064 0.086 0.476 0.062 -1.194 -1.022 0 -1.022 -1.022 0 -1.022 1.039 1.093 1 0 1.093 1 0
The total quality of the risk disclosure consists of different information parts. This research divided the quality of risk disclosure into information about hedging activities, information about collateral and derivatives, information about risks in a sensitivity analysis and
information about the credit risk. The total risk disclosure is the overall disclosure of the parts together. Thereby, the length of the disclosure part and the coverage of risk categories have measured. Table 6 presents the descriptive data for the years of the entire sample (2008– 2016), the pre-period of the IASB framework (2008–2010), the post-period of the framework (2011–2016) and the differences between the pre-period and post-period of the IASB
framework. The differences are measured by t-tests and indicate the significance level for each variable. The means of information about the hedge activities, collateral and derivatives, sensitivity analysis and credit risk for 2008–2010 are respectively 26%, 32%, 45% and 31%. The percentages for 2011–2016 are 25%, 33%, 42% and 34%. The means of the hedge activity information and sensitivity analysis information are significantly higher in the pre-period. The information about credit risk is significantly higher in the post-pre-period. The total disclosure percentages for the two periods are respectively 30% and 31%, which imply that there is almost no progression in the overall quality of the financial risk disclosure.
Furthermore, the mean of the coverage of risk categories is lower in the pre-period than the post-period, like the mean of the length of the risk reporting part. These two variables have a significant difference of less than 1%. The quality of the total risk disclosure had a minimum score of 0 and a maximum score of 0.8. The information about hedging, collateral and derivatives, sensitivity analysis and credit risk are the minimum 0 and maximum 1. The minimum and maximum scores of the coverage of risk categories were respectively 0.615 and 10.559. The minimum and maximum logs of the length of the risk disclosure part are
respectively 5.656 and 8.400.
Table 6: Descriptive analysis - Risk disclosure pre and post period IASB framework
Variable 2008–2016 2008–2010 2011–2016 Difference
Mean Std. Mean Std. Mean Std. Mean Std.
Hedging
Collateral & Derivatives Sensitivity analysis Credit risk Quality Coverage Length .253 .327 .432 .324 .307 1.947 7.297 .189 .294 .318 .248 .152 1.600 .558 .264 .318 .449 .307 .304 1.574 7.221 .201 .263 .319 .242 .159 1.358 .567 .247 .333 .422 .336 .309 2.187 7.346 .182 .313 .317 .251 .147 1.695 .547 .163** -.015 .027** -.029** -.005 -.589*** -0.125*** .010 .014 .016 .013 .008 .097 .029 ***, ** and * coefficients are statistically significant with 1, 5, and 10 percent respectively (based on two-sided tests).
Table 7 lists the descriptive information about the market-to-book ratio, block owners, firm size, leverage and liquidity. The mean of the market-to-book ratio is 1.367, which indicates that the average market value is higher than the average book value. The minimum and maximum are respectively 0 and 7.174. This indicates that there is some variance in the dataset. Block owners have a mean of 1.648, which signifies that the average block owners are between 25% and 50%.
Table 7: Descriptive Analysis – Independent variables financial risk disclosure
Variable Obs. Mean Std. Dev. Min. Max.
Market-to-book ratio Firm Size Leverage Liquidity Block Owners 1611 1611 1611 1611 1611 1.367 14.102 .356 .978 1.648 1.245 1.582 .428 2.684 1.118 0 10.518 0 -11.726 1 7.174 18.315 2.59 15.331 4 Correlation analysis
Before a regression analysis could be performed, the correlations of variables were explored. The correlation test was performed with the Pearson correlation test. The results are included in Table 8. Multicollinearity exists between variables when the correlation is higher than 0.70 (Miles and Shevlin, 2001). No multicollinearity is present in the table. The highest correlation was between the total quality of risk disclosure and the number of words disclosed with an amount of 0.5408. The number of words has a strong correlation with the quality of financial risk disclosure.
Table 8: Correlation analysis
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (1) Quality (2) Number of words (3) Coverage (4) Market-to-book ratio (5) Block Owners (6) Net income (7) Firm Size (8) Liquidity (9) Dummy₂₀₁₁ (10) Leverage 1.0000 .5408* 1.0000 -.1030* .1265* 1.0000 -.0251 .0186 .0386 1.0000 -.1145* -.0847* .0239 -.0168 1.0000 .1219* .1998* -.0545 .1445* -.1194* 1.0000 .2658* .4379* -.0557* -.0424 -.1315* .4859* 1.0000 .0845* .0305 .0313 -.0766* -.0860* .0053 .0202 1.0000 .0163 .1098* .1873* .1379* .0227 -.0398 -.0115 .0207 1.0000 -.0449 .1291* -.0342 .0925* .0067 .0337 .2850* -.0733* -.0608* 1.0000 * coefficients are statistically significant with 5 percent (based on two-sided tests).
Regression analysis
A regression analysis was performed on both models, and the results are presented in Tables 9, 10 and 11.
Model 1
A regression analysis was performed for the entire sample (2008–2016) and for the post-period of the framework (2011–2016) in Model 1. The model has an R2 of 0.328 and an F-value of 40.54, which means that the variation of the net income is, for 32.8%, caused by the variables in the model. The most important variable that measures conservatism is ΔNIₜ₋₁ x
DΔNIₜ₋₁. This variable is significantly negative related to the change in net income for the whole sample 2008–2016. In this case, bad news would cause a greater negative change in the net income in the year after the bad news was published, meaning that losses are recognized more quickly and that firms are more conservative with the disclosure of earnings after bad news. This relation is significantly negative for the entire sample (β = –0.944, p = 0.000) but not for the years beginning in 2011. The variable ΔNIₜ₋₁ x DΔNIₜ₋₁ x Dummy₂₀₁₁ has a significant positive relationship (β = 0.930, p = 0.002), which means that firms become less conservative after 2011 compared to the entire sample. Losses were less likely to be incorporated into the net income after 2011. The degree of accounting conservatism was lower in 2011–2016 than in 2008–2016, indicating that the degree of conservatism was higher in the period 2008–2010. This result is in line with the framework of the IASB, which deleted prudence from the
framework in 2010.
Table 9: Regression analysis – Degree of Conservatism
Variable Coef. Std. Err. T P>t
ΔNIₜ₋₁ DΔNIₜ₋₁ ΔNIₜ₋₁ x DΔNIₜ₋₁ Dummy₂₀₁₁ ΔNIₜ₋₁ x Dummy₂₀₁₁ DΔNIₜ₋₁ x Dummy₂₀₁₁
ΔNIₜ₋₁ x DΔNIₜ₋₁ x Dummy₂₀₁₁ Intercept .128 -.026 -.944 -.002 -.858 -.013 .930 .019 .115 .015 .183 .015 .235 .017 .297 .014 1.12 -1.75 -5.17 -0.11 -3.65 -0.72 3.13 1.39 0.264 0.081* 0.000*** 0.915 0.000*** 0.469 0.002*** 0.164
***, ** and * coefficients are statistically significant with 1, 5, and 10 percent respectively (based on two-sided tests).
Model 2
Although Model 1 demonstrates the degree of conservatism, Model 2 demonstrates the relation between accounting conservatism, block concentrated ownership and the quality of financial risk disclosure. The quality of financial risk disclosure was tested with (1) only control variables, (2) the entire sample with year dummies, (3) for 2008–2010 and (4) for 2011–2016. The results are listed in Table 10. The model of the entire sample has an R2 of 0.363, which means that the variation of the market-to-book value is 36.3%, caused by the variables in the model. The regression has an F-value of 41.73 and a variance inflation factor score of 3.00. This value is lower than 4, which means that the regression has no
multicollinearity (Miles and Shevlin, 2001). The regression analysis of Model 2 has multiple significant relationships. The model for 2008–2016 indicates that the market-to-book ratio is significantly negative related to the quality of financial risk disclosure. The variable has a significant value between 1% and 5% with a coefficient of –0.005. The test was also
performed for 2008–2010 and for 2011–2016, making the difference in the period before and after the revised IASB framework visible. The results indicate that the relationship between the market-to-book ratio and quality of financial risk disclosure is not significant for 2008– 2010 (β = –0.001, p = 0.733) but significantly negative for 2011–2016 (β = –0.004, p = 0.076). The length has a significant positive relationship with the quality of financial risk disclosure (β = 0.15, p = 0.000), and the coverage of risk categories have a significant negative relationship with the quality of financial risk disclosure (β = –0.017, p = 0.000) for the entire sample. The length and coverage have a significance level lower than 1% for the entire sample, the pre-period and the post-period of the revised IASB framework. Thereby,
block owners have a significant negative relationship with the quality of financial risk
disclosure in the pre-period, post-period and the entire sample with a significance level lower than 1%. Table A2 in the Appendix presents the standard error, t-value and p-value for the quality of financial risk disclosure for the entire sample.
Table 10: Regression analysis - Quality of financial risk disclosure
Variable (1) Control (2) 2008–2016 (3) 2008–2010 (4) 2011–2016 Market-to-book ratio Length Coverage Block Owners Firm Size Leverage Liquidity Industry Dummies Year Dummies intercept -.005** -.001 -.004* .150*** .150*** .149*** .150*** -.017*** -.017*** -.017*** -.016*** -.012*** -.011*** -.012*** .003 .001 .002 .002 -.017** -.014* -.015* -.015* .004*** .004*** .004*** .004***
Yes Yes Yes Yes No Yes No No -.759*** -.714*** -.717*** -.715*** R-squared 0.363 0.363 0.360 0.361 ***, ** and * coefficients are statistically significant with 1, 5, and 10 percent respectively (based on two-sided tests).
In this research, the quality of financial risk disclosure consists of the hedge activities, information about collateral and derivatives, sensitivity analysis of the risk information and information about the credit risk. These parts were tested separately as a dependent variable for 2008–2016 and for the period after 2011. Table 11 lists the information about the different parts of risk disclosure quality for the entire sample. The market-to-book value has a
significant negative relationship with information about hedge activities in both periods. For the entire sample, the coefficient is less negative (β = –0.007, p = 0.027) than for the period after 2011 (β = –0.011, p = 0.001). The market-to-book ratio is not significantly associated with the information disclosure about collateral and derivatives in either period. The market-to-book ratio is significantly negatively associated with sensitivity analysis information of risks in both periods, with the same coefficient (β = –0.011) and a p-value between 1% and 5%. The market-to-book ratio is not significantly associated with credit risk information in either period.
Table 11: Regression analysis - Quality of financial risk disclosure
Variable Hedging Collateral & Sensitivity Credit Derivatives analysis risk
Market-to-book ratio Number of words Coverage Block Owners Firm Size Leverage Liquidity Industry Dummies Year Dummies intercept -.007** -.008 -.011* -.001 .117*** .193*** .188*** .156*** -.014*** -.017*** -.017*** -.020*** -.019*** .002 -.013* -.016*** .017*** .017*** .027*** -.030*** -.051*** -.014 -.010 .009 .002 .008*** .003 .003
Yes Yes Yes Yes No No No No -.659*** -1.200*** -1.322*** -.317***
R-squared 0.234 0.197 0.188 0.158 ***, ** and * coefficients are statistically significant with 1, 5, and 10 percent respectively (based on two-sided tests). Additional tests Additional tests were performed for the length of the risk disclosure part and the coverage of risk categories as dependent variables. The additional tests were performed with (1) only control variables, (2) the entire sample with year dummies, (3) for 2008–2010 and (4) for 2011–2016. The results for these variables are displayed in Tables 12 and 13. In this model, the market-to-book ratio is not significantly related to the length of the risk disclosure part and the coverage of risk categories for the entire sample 2008–2016 (β = 0.013, p = 0.200) (β = 0.039, p = 0.232). The market-to-book ratio is significantly negative related to the length and coverage of the risk disclosure part for 2008–2010 (β = –0.024, p = 0.093) (β = –0.300, p = 0.000) but significantly positively related in the period after 2011 (β = 0.022, p = 0.023) (β = 0.164, p = 0.000). Conservatism is thus significantly negatively related to the length of the risk disclosure part and coverage of risk categories in the period before the revised IASB framework but has a significantly positive relationship after the revised IASB framework. Tables A3 and A4 in the Appendix list the standard error, t-value and p-value for the length of the disclosure part and the coverage of risk categories for the entire sample. Table 12: Regression analysis – Length of risk disclosure part of financial risk disclosure Variable (1) Control (2) 2008–2016 (3) 2008–2010 (4) 2011–2016 Market-to-book ratio Block Owners Firm Size Leverage Liquidity Industry Dummies Year Dummies intercept .005 -.024* .022** -.022** -.022* -.020* .141*** .141*** .138*** .140*** .006 .018 .012 .004 .007 .005 .005 .006 Yes Yes Yes Yes No Yes No No
5.271*** 5.374*** 5.069*** 5.306*** R-squared 0.218 0.243 0.221 0.222 ***, ** and * coefficients are statistically significant with 1, 5, and 10 percent respectively (based on two-sided tests).
Table 13: Regression analysis – Coverage of risk categories of financial risk disclosure Variable (1) Control (2) 2008–2016 (3) 2008–2010 (4) 2011–2016 Market-to-book ratio Block Owners Firm Size Leverage Liquidity Industry Dummies Year Dummies intercept -.013 -.300*** .164*** .004 .012 .030 -.067** -.061** -.067** -.054* -.077 -.028 -.042 -.114 .023** .022* .017 .025** Yes Yes Yes Yes No Yes No No
2.610*** 2.612*** 2.702*** 2.313*** R-squared 0.027 0.079 0.052 0.044 ***, ** and * coefficients are statistically significant with 1, 5, and 10 percent respectively (based on two-sided tests).
5. DISCUSSION
The discussion consists of the findings, theoretical and practical implications and the limitations and suggestions for future research.
Findings
This research presented the degree of conservatism, and the relationship of conservatism and block ownership concentration to the quality of financial risk disclosure. The differences in the pre-period and the post-period of the IASB framework in 2010 were examined. The main modification of the conceptual framework was the removal of the term conservatism, which can cause a difference in the quality of risk disclosure between the two periods. The periods in this study were divided into 2008–2010 and 2011–2016. First, the differences in periods were made visible by means of a t-test for quality and every aspect of quality. No difference was noted in the overall quality of both periods. However, various aspects of quality exhibit a significant change in the periods. Information about hedge activities and credit risk deteriorated in the period after the change in the IASB framework. Information from the sensitivity analysis of risks improved significantly in the post-period of the revised IASB framework. In addition, the length of the risk disclosure part and the coverage of risk categories improved significantly.
A regression analysis was performed for the degree of conservatism and the
relationship of conservatism to the quality of financial risk disclosure. The regression analysis of Model 1 demonstrated that the degree of accounting conservatism was significantly lower in the post-period of the changed IASB framework. One reason for this result could be the removal of prudence from the IASB conceptual framework. In addition, the regression analysis of Model 2 revealed that conservatism was significantly negatively related to the overall quality of financial risk disclosure for 2008–2016 and the post-period 2011–2016 of the IASB framework but not for the pre-period of the IASB framework 2008–2010. A
regression analysis was also performed for the different aspects of quality. Conservatism was significantly negative associated with information about the hedging activities and risk sensitivity analysis. No significant association was found for information about collateral and derivatives and information about credit risk. The additional analysis reveals that accounting
conservatism has a significantly negative association with the length of the risk disclosure part and the coverage of the risk categories for 2008–2010 but a significantly positive association for 2011–2016.
The results indicate that firms which are more conservative had a smaller length of the risk disclosure part and a lower coverage of risk categories before the change of the IASB framework but greater after the change of the framework. When the overall degree of conservatism was higher in 2008–2010, conservative firms were not concerned about
financial risk disclosure. However, when the overall degree of conservatism was significantly reduced by the change of the IASB framework, financial risk disclosure mattered for
conservative firms. Because firms have become less conservative over time, firms that are more conservative want to present their financial risks to stakeholders. This can mean that they want to compensate for the overall lower degree of conservatism by disclosing more financial risks. Another reason may be a cautious attitude of conservative firms to disclose new laws and regulations. The t-tests also indicate that both the length and coverage were greater after the change to the IASB framework.
However, conservatism is negatively associated with the quality of the financial risk disclosure after the change of the IASB framework, meaning that the quality of the financial risk disclosure is not improved by conservatism. Although there is much evidence that conservatism positively influences the quality of financial disclosure, this research reveals that conservatism can also have a downside. A verifiable aspect of conservatism can ensure that firms pay less attention to the relevance of risk disclosure. The uncertainty of risks can mean that it is not verifiable enough to report qualitative risks, like the disclosure of risk sensitivity analysis and hedge activities. A framework without conservative characters may improve the quality of the financial risk disclosure. This research also analyzed block concentrated owners. Block ownership concentration is negatively related to the quality and the length of risk disclosure. Concentrated owners can perceive the information as private gains and are not willing to share these gains with other investors or stakeholders, which can cause a lower quality and length of risk disclosure. Because of the block owners’ power over the management, they can use company information as a benefit over other stakeholders.
Theoretical and practical implications
This article has some theoretical and practical implications. This research attempted to clarify the contradiction in the literature of accounting conservatism and supports the literature stream of a negative association with the quality of financial disclosure. The evidence from different papers, such as Gigler and Hemmer (2001), can be supported, and the question from Barker and McGeachin (2015) of whether accounting standards require conservatism can be answered for financial risk disclosure. This results extend the paper of Balachandran and Mohanram (2011). Balachandran and Mohanram (2011) researched the association between conservatism and the relevance of financial reporting before 2011 and found no association. Also this research did not found a significant relationship before 2011 but a negative
significant association after 2011.
Although the change in the IASB framework reveals no difference in the quality of financial risk disclosure, this research assumes that a framework without conservatism can
have a positive influence on the mandatory IFRS 7 risk disclosure. Higher quality can be obtained through a lower degree of accounting conservatism. Moreover, conservative firms try to compensate the lower degree of conservatism by disclosing more risk information with more risk categories. Thereby, stakeholders of firms with block concentrated owners can expect a lower quality and length of risk disclosure. This evidence supports the literature that owners with more power have a significant influence on the financial disclosure.
Limitations and future research
This research has some limitations. This study utilized the regression model of net income by Ball and Shivakumar(2005) and the market to book ratio with specific controls by Khan and Watts (2014). A limitation is that other methods can be used to measure conservatism, which could provide a different outcome. Another limitation is that the sample only exists of listed firms from the UK and that 76.24% of the sample consists of three industries. This makes it difficult to generalize this research to other countries, not-listed companies and other
industries. The last limitation is that the information about financial risks were hand-collected by various members of the University of Groningen. Although strict instructions for
information collection were implemented, subjectivity cannot be excluded. Future research could be done with a sample from other countries and industries. In addition, a different method for measuring conservatism could provide a different outcome, which may support or contradict this research. Whether the change of the IASB framework has other implications on the level of financial disclosure could also be investigated. Furthermore, more research about the quality of financial risk disclosure should be done instead of only the quantity, because results can significantly differ.
6. CONCLUSION
The question of whether the quality of IFRS 7 risk disclosures is higher for conservative relative to less conservative firms can be answered. This research found evidence that firms that are less conservative have a higher quality of IFRS 7 risk disclosures. The literature indicates that conservative firms report more verifiable information, which can deteriorate the information relevance. The IASB removed prudence and reliability from the conceptual framework, and firms indeed became less conservative. It can be assumed that a conceptual framework without conservatism can provide a higher quality of financial risk disclosure. The additional analyses indicate that conservatism is negatively associated with the length and coverage before the revision of the conceptual framework but significantly positive after the change in the framework. This result indicates that conservative firms may try to compensate for a lower degree of conservatism by disclosing more risk information with more risk categories. Another reason may be a cautious attitude of conservative firms to disclose new laws and regulations. Block concentrated owners negatively influence the length and quality of financial risk disclosure. A reason for this statement is the greater power of block owners, who perceive information as a private benefit.
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8. APPENDIX
The Disclosure Quality Index is shown in Table A1 and used to measure the quality of IFRS 7. The Disclosure Quality Index has also been used in the research of Karaibrahimoglu and Porumb (2019). The Disclosure Quality Index demonstrates how the scores were determined. Items 1 to 5 were used for the determination of hedge activities, items 6 and 13 for collateral and derivatives, items 10 to 12 for the risk sensitivity analysis, and items 7 to 9 for credit risk.
