More or less IFRS 7 risk disclosure: The role of conservatism and prudence

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More or less IFRS 7 risk disclosure:

The role of conservatism and prudence

Master Thesis, MSc Accountancy

University of Groningen

Robert Steenbergen

Student number: S3857441

January 20, 2020

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ABSTRACT

Prudence was one of the main concepts in IASB framework from 1989. IASB and FASB argued that prudence and conservatism are not desirable qualities of financial reporting information. Therefore, IASB introduced the 2010 Conceptual Framework where no explicit reference to prudence or conservatism is included. This research seeks to discover whether as a result of the removal of prudence within the IASB Conceptual Framework in 2010, firms disclose more or less risks in IFRS 7 risk disclosure. The research will proceed further to examine the association between the educational background of the CFO and the quantity of IFRS 7 risk disclosure. CFOs with accountant backgrounds are associated with more conservative outcomes and greater degree of risk aversion which could influence IFRS 7 risk disclosure. This research draws on UK non-financial firms with a premium listing on the London Stock Exchange during the period 2007 – 2016. Evidence implies that since the removal of prudence in the Conceptual Framework, the quantity of risk disclosure in IFRS 7 has increased. Further, evidence shows that there is no association between the educational background in accounting and the quantity of IFRS 7 risk disclosure.

Keywords: IFRS 7, conceptual framework, prudence, conservatism, risk disclosure, United

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I. Introduction

In august 2005, the IASB issued ‘IFRS 7 Financial instruments’, which replaced IAS 30 and carried forward the disclosure requirements in IAS 32 financial instruments: disclosure and presentation (IASB, 2005). One aim of this standard is to reduce information asymmetry between management and investors. The IASB believes that the introduction of IFRS 7 will lead to greater transparency (IASB, 2005). The object of IFRS 7 is to (1) require entities to provide disclosures in their financial statements that enable users to evaluate the significance of financial instruments for the entity’s financial position and performance together with (2) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks (IASB, 2005). IFRS 7 describes that financial instruments of firms are commonly exposed to credit risk, liquidity risk and market risk (IASB, 2005). IFRS 7 is a mandatory standard that is based on principles which means firms can use a lot of judgement. As result of this judgement, firms their decisions in which risks should be considered can be biased by several factors.

This research will focus mainly on the factor named accounting conservatism. The aim of this research is to examine the influence of accounting conservatism on IFRS 7 risk disclosure. In particular the change in the IASB framework which led to the removal of explicit reference to prudence. Prudence was one of the main concepts in IASB framework from 1989. In a discussion paper on an improved framework (IASB, 2006a), IASB and FASB discussed the role of conservatism or prudence. Reasons for this discussion were the role of conservatism in both frameworks of IASB and FASB. They argued that prudence and conservatism are not desirable qualities of financial reporting information. Consistent conservatism (e.g. consistent undervaluation of net assets) would conflict with the quality of neutrality. Besides, understating assets in one year often leads to overstating financial performance in upcoming years. Not only will investors be provided by poor information in this particular year, it can also be used to hide deterioration in upcoming years. Therefore, IASB introduced the 2010 Conceptual Framework where no explicit reference to prudence or conservatism is included as an aspect of faithful representation because including either would be inconsistent with neutrality (IASB, 2010). Although, IASB decided to reintroduce prudence in the conceptual framework of 2018 through the confusion that the IASB perceived to have been caused when they abandonment prudence in the framework of 2010. In the 2018 framework they stated that prudence is the exercise of caution when making judgements under condition of uncertainty (IASB, 2018).

Accounting standards like the IFRS usually include conservatism principles such as lower of cost or market accounting for the valuation of assets on the balance sheet. Basu (1997) interprets conservatism as capturing accountants’ tendency to require a higher degree of verification for recognizing good news than bad news in financial statements. Basu (1997) his interpretation of conservatism is that earnings reflects bad news more quickly than good news. A traditionally used example of conservatism in practice is the tendency of accountants to anticipate no profits but anticipate all losses. During this research the principle of requiring higher degree of verification of good news than bad news will be used as explanation on why accounting conservatism can play a role in IFRS 7 risk disclosure.

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5 The importance of risk disclosure can be found in the agency theory. Agency theory is a widely used theory for research on reporting. Agency theory gives an insight on several agency problems between the agents and principal. One of these problems is the asymmetry of information between the owners of the company and the management. One of the main solution that can reduce the agency problem is by reduction of the information asymmetry, which can be done by risk disclosure. Thus, IFRS 7 risk disclosure can be used to reduce the information asymmetry. Moreover, IFRS 7 risk disclosure can enable investors to make more informed stock price investments. (Deumes, 2008; Linsmeier et al., 2002).

The chief financial officer can play an important role in the disclosure of risks due the fact that the chief financial officer is responsible for the financial reporting of the company. The chief financial officer (CFO) is primary responsible for managing the company’s finances where they oversee the financial reporting, manage internal controls and ensure compliance with accountant regulations. Furthermore, they oversee budgeting and influence the spending of the cooperation (investment expenditures and operating costs). The treasurer of a firm is responsible under the supervision of the CFO for implementing hedging policy. Hoitash, Hoitash and Kurt (2016) examined whether CFOs with accounting backgrounds are associated with more conservative outcomes. They find that CFOs with an accounting background are associated with more conservative outcomes.

A lot of research that is focused on accounting conservatism has been conducted (e.g. Watts (2003), Kwon et al (2001), Basu (1997), Khan & Watts (2009), Ball et al (2000), Kang et al (2004) and more). Although, research on risk reporting and accounting conservatism are scarce. The aim of this research is to examine the influence the changes in the IASB 2010 conceptual framework on IFRS 7 risk disclosure. This paper contributes to the existing literature on the topic of accounting conservatism and the effect of accounting conservatism on risk disclosure. The first aim of this research is to examine the influence of removing the reference to prudence in the 2010 IASB conceptual framework. Watts (2003) and Ball and Shivakumar (2005) examined the effect of accounting conservatism on managerial incentives. They argue that accounting conservatism decreases managerial incentives to make negative net present value investments. Furthermore, Kravet (2014) found out that more conservative accounting decreases managerial risk-taking. My expectation is that the removal of prudence will lead to less conservative accounting and therefore more risk-taking behavior of managers. I expect that because firms will face more risks, subsequently have more disclosure regarding this risks. Therefore, I think this will lead to an increase in the quantity of IFRS 7 risk disclosure. As result the following research question has been formulated:

Research question 1: To what extent does the removal of prudence from the IASB conceptual framework influenced the quantity of IFRS 7 disclosures

The second aim of this research is to examine the influence of the chief financial officer’s educational background on the quantity in IFRS 7 risk disclosure. My expectation is that firms with a CFO that has an education background in accounting leads to more conservatism and subsequently decreases the quantity in IFRS 7 risk disclosure. CFOs with an accounting background are more conservative and could lead to less risk-taking behavior. Therefore, I expect there will be less disclosure due the less risks being taken. As result the following research question has been formulated:

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6 Research question 2: To what extent does accountant background of the CFO influence the quantity in IFRS 7 risk disclosure?

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II. Regulatory background

IFRS 7 RISK DISCLOSURE

In august 2005 the IASB issued IFRS 7 financial instruments, the objective of IFRS 7 is to require entities to provide disclosures in their financial statements that enable users to evaluate (1) the significance of financial instruments for the entity’s financial position and performance; and (2) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks (IASB, 2005). Hence, operational risk disclosures are not within the scope of IFRS 7. IFRS 7 describes that financial instruments of firms are commonly exposed to credit risk, liquidity risk and market risk (IASB, 2005).

Credit risk refers to the risk a firm will suffer if the counterparty fails to pay its obligations (e.g. a lender that may not receive the owed loan repayment). This will create a financial loss for the other party. Liquidity risk is kind of the opposite to the credit risk, it is the risk that a firm itself cannot meet the obligations from financial liabilities. Market risk refers to the risk of fluctuation in future cash flows and fair value from financial assets or financial liabilities. There are a few components based on the causes of these fluctuations existing out currency risk, interest rate risk and other price risk (e.g. changes in commodity prices or equity prices). With each type of risk the firm should disclose both the qualitative and quantitative dimension of the risk. Qualitative disclosure describes how the firm is exposed to the risks and how these risks arise and how these risks are managed (IASB, 2005). Quantitative disclosure provides a summary of quantitative data about the exposures to the risk at the end of the reporting year which means that IFRS 7 requires specific quantitative disclosure for each type of risk (IASB, 2005).

IASB Conceptual Framework 2010

The Conceptual Framework for Financial Reporting (Conceptual framework) describes the objective of, and the concepts for, general purpose financial reporting. The purpose of the Conceptual Framework is to (1) assist the IASB to develop IFRS standards that are based on consistent concepts, (2) assist preparers to develop consistent accounting policies when no standard applies to particular transaction or other event, or when a standard allows a choice of accounting policy and (3) assist all parties to understand and interpret the standards (IASB Framework ,2010). Financial statements may appear similar in a certain country compared to other countries, variety of social, economic and legal circumstances cause differences. These different circumstances led to difference in definitions of elements in financial statements (e.g. equity, assets, liabilities, etc.). This caused different criteria for the recognition of items in the financial statements (e.g. revenue recognition) and different measurements. By introducing a conceptual framework, the IASB narrows these differences and is developed so it is applicable to a wide range of accounting models and concepts of capital and capital maintenance.

In 1989 the IASB introduced the “framework for the Preparation and presentation of financial statements”, also known as the “1989 Framework”. In the 1989 Framework, prudence is one of the concepts related to reliability. Over the years international accounting standards have become more future-oriented. Decision usefulness of information has become one of the most important characteristic and conservatism has become less of a governing accounting

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8 principle. There were different views on the explicit reference to prudence because the reference to prudence could lead to conservative bias and would be inconsistent with neutrality. Therefore, IASB introduced the 2010 Conceptual Framework where no explicit reference to prudence or conservatism is included as an aspect of faithful representation because including either would be inconsistent with neutrality (IASB,2010).

In March 2018 the IASB introduced “2018 Conceptual Framework”. The IASB reintroduced the reference to prudence in the framework as part of neutrality, one of the sub aspects of faithful representation. Paragraph 2.16 of the framework stated that neutrality is supported by the exercise of prudence. Further, they stated that prudence is the exercise of caution when making judgements under condition of uncertainty. The definition of prudence in the framework of 2018 is the same as the 1989 framework only is now positioned differently. The removal of the reference to prudence in 2010 led to further confusion amongst users and as a reaction the IASB reintroduced the reference to prudence.

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III. Theoretical framework and hypothesis development

Agency theory

Agency theory is a widely used theory for research on reporting. Agency theory gives an insight on several agency problems between the agents and principal. Jensen and Meckling (1976) defines an agency relationship as a contract under which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. Jensen and Meckling (1976) insinuates that if both parties to the relationship are utility maximizers there is a good reason to believe that the agent will not always act in the best interests of the principal. Given the fact that the theory suggests that agents will behave in a self-interested manner (Eisenhardt, 1989; Jensen and Meckling, 1976), conflicts with the principal(s) will occur. In this research agents can be defined as the directors/managers of the company and the principals are the shareholders and/or the users of the financial statements.

There are several ways to align the interests of the principal(s) and its agent, one way to align the interest of both parties is through incentives such as stock ownership. Jensen and Meckling (1976) described that increasing firm ownership of managers decrease managerial opportunism. However, CEOs that hold equity or options to buy equity can aggravate the agency problem (Sanders & Hambrick, 2007). Stock ownership can influence agent(s) to maximize the value of the firm. Although, this can also be an incentive for the agent to take actions that unethical or illegal especially involving financial reporting. Increased firm ownership can decrease the risk behavior of the firm which can cause less risk reporting because there will be less managerial opportunism. One of the main problem is the asymmetry of information between the owners of the company and the management. Asymmetry of information causes agency costs. Jensen and Meckling(1976) defines agency costs as the sum of (1) the monitoring expenditures by the principal, (2) the bonding expenditures by the agent and (3) the residual loss. Agency costs caused by information asymmetry can be counteracted by a monitor mechanism (Fama, 1980; Fama & Jensen, 1983; Jensen & Meckling, 1976). CEO’s behavior can be made more visible by implanting a monitoring device (Bosse and Philips, 2016). Information asymmetry is one the main concepts of this research, users of the financial statements are not involved in the operations of the firm and thus may be not fully aware of the risk exposure. One way to decrease the asymmetry of information is through disclosures like ‘IFRS 7 risk disclosure’. Increases in risk disclosures are associated with increased stock return volatility (particularly negative returns) and trading volume around the filings (Kravet and Muslu, 2013). Agent(s) of the firm can have the incentive to manipulate risk reporting of financial instruments (IFRS 7) because more extensive disclosure are perceived riskier by investors.

Stakeholder theory

Dr F.Edward Freeman, a professor described first in his book “Strategic Management: A stakeholder Approach” the stakeholder theory. He suggests in his book that shareholders are merely one of the many stakeholders in a company. Freeman (1984) defined a stakeholders as ‘any group or individual who can affect or is affected by the achievement of an organization’s objectives’. These groups consist out of customers, employees, suppliers, political action groups, environmental groups, local communities, media, financial institutions and more. Due the information needs of these groups firms are mandated to disclose certain information.

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10 IFRS 7 risk disclosure is an example of mandated disclosure. Risk reporting of financial instruments discharges the accountability towards the stakeholders.

Hypotheses development

Prudence was one of the main concepts in IASB framework from 1989. Different views on prudence are implemented because prudence could lead to conservative bias and would be inconsistent with neutrality. It systematically adopts a pessimistic look on economic transactions. In a discussion paper on an improved framework, the IASB and argued that a conservative bias is not desirable qualities of financial reporting information (IASB, 2006a). They argued that a consistent undervaluation of net assets should not be considered to be the adequate way to deal with uncertainty. Subsequently, the characteristic of prudence were removed in the framework of 2010. More conservative firms will require a higher degree of verification of good news than bad news (Basu, 1997). I expect that a conservative bias has an influence on the risk perception of firms due the fact they recognize bad news more quickly. Credit, market and liquidity risks could be overestimated what could subsequently result in less risk-taking behavior which could lead to less hedging activities, allowance of doubtful accounts and more. On the other hand, recognizing bad news less quickly could also mean that risks are recognized less quickly and subsequently result in less risk disclosure.

Kravet (2014) researched the association between accounting conservatism and acquisition decisions of managers. He found out that more conservative accounting decreases managerial incentives to make riskier acquisitions. I interpret this as risk-averse behavior of managers which can influence the risk disclosure of financial instruments. Kanagaretnam, Yeow Lim and Lobo (2014) studied the links between national culture and accounting conservatism and risk-taking. They argued that accounting conservatism leads to less risk-taking of banks. This research has no focus on risk behavior of firms but possible changes in behavior could have an influence on the quantity of IFRS 7 risk disclosure by nature. Removal of prudence in the IASB framework could lead to less conservatism and subsequently lead to less risk-taking behavior.

A negative relationship can be hypothesized on the basis that less prudent financial reporting could lead to less quickly disclosure of risks and therefore leads to a negative influence on the quantity of IFRS 7 risk disclosure. A positive relationship can be hypothesized on the basis that recognizing risks less quickly could lead to more riskier behavior. Furthermore, prior research shows that more conservatism leads to less risk-taking behavior which could subsequently leads to less risk disclosure by nature. My expectation is that there will be a positive influence on the quantity of IFRS 7 risk disclosure which means more risk disclosure after implementation of the new conceptual framework. Therefore, I formulated the following hypothesis:

Hypothesis 1: Removal of prudence has a positive influence on the quantity of risk disclosure of financial instruments (IFRS 7)

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Hoitash, Hoitash and Kurt (2016) examined whether CFOs with accounting backgrounds are associated with more conservative outcomes. They build on the premise that accountant managers are more risk averse than non-accountant managers. This premise is based on the avoidance of uncertainty and risk by accountants (Brief, 1975; Helliar et al., 2002; Newton, 1977). This is not completely surprising due the fact accounting training and regulation focuses on prudent and accurate financial reporting. The results of this research suggest a greater degree of risk aversion for firms with CFOs with an accountant background in comparison with CFOs without an accountant background (Hoitash, Hoitash and Kurt, 2016). Hence, a CFO exposed to uncertainty will attempt to lower that uncertainty. Financial instruments risks are very uncertain. Furthermore, due the fact CFOs are more conservative they require a higher degree of verification of good news than bad news (Basu,1997), bad news regarding for example the market (risk) will be adopted sooner in comparison with good news. Moreover, CFOs that are more risk averse will work harder to improve the quality of reporting system and thereby reduce the risk he is exposed to (Friedman, 2016). Further, CFOs with accounting backgrounds are associated with higher financial reporting quality (Aier et al., 2005).

My expectation is that the CFO with an accountant background will be more risk-averse and therefore minimize the risks they are taking. I also expect that accounting conservatism causes overstating the estimation of the potential risks of the financial instruments the firm possesses which could lead to less risk-taking behavior and subsequently leads to less risk disclosure by nature. Therefore, I formulated the following hypothesis:

Hypothesis 2: CFOs with an accountant background has a negative influence on the quantity of IFRS 7 risk disclosure.

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IV. Methodology

Sample

This research draws on UK non-financial firms with a premium listing on the London Stock Exchange during the period 2007 – 2016. In 2007 firms are mandated to implement IFRS 7 which explains the start date 2007. The data for IFRS 7 risk disclosure quantity is gathered from Karaibrahimoglu and Porumb (2019) which is hand-collected within the research project funded by IAAER and IASB. Financial firms are excluded from this research because the big differences in characteristics that will influence risk disclosure of financial instruments (Gebhardt, 2012). Hand-collected annual reports which contains no words or were impossible to count the words of IFRS 7 are excluded which resulted in 2693 firm year observations. BoardEx provided for each firm year observation based on ISIN and year the DirectorID of the CFO in each year. In some cases there was no CFO but almost a similar function like a financial director and will also be recognized as CFO. To be sure this will make no differences a dummy is created. After identifying the DirectorIDs out of BoardEx, BoardEx provided the educational background of the CFOs based on the DirectorIDs and lastly Compustat provided the control variables based on ISIN and year.

Empirical model

This research will use the GLS panel regression with random effects. Hausman test reveals that the random effects model is most appropriate and therefore will be used to analyze the hypotheses. Whether the removal of prudence has an influence on the quantity of IFRS 7 risk disclosure the following equation has been developed:

(1) IFRS7_Quantity = ß0 + ß1CFprepostD+ ß2ROA + ß3Leverage+ß4HardscoreD+ß5Size+

ß6IndustryD + ß7YearD+ ε

Whether CFOs with an accountant background has a positive or negative influence on the quantity of IFRS 7 risk disclosure the following equation has been developed:

(2) IFRS7_Quantity = ß0 + ß1EducationD+ ß2ROA + ß3Leverage+ß4HardscoreD+ß5Size+

ß6IndustryD + ß7YearD + ε

Variables

The dependent variable IFRS7_Quantity can be explained as the total words in the risk disclosure of IFRS 7. The total words are all collected from hand-collected annual reports. The first main independent variable CFprepostD describes the pre-post dummy that has been made for the implementation of the IASB Conceptual Framework in 2010. The period 2007 – 2010 will be assumed as the pre-period and will be zero because the Conceptual Framework has been implemented in the end of 2010 and 2011-2016 is the post-period and will be one. The second main independent variable EducationD describes the dummy if the CFO has an accountant background in education. Hereby there will be looked if the CFO has an qualification (e.g. chartered accountant) that shows an educational background in accounting. When the CFO has no education in accounting this will be represented as zero, and otherwise one. All data regarding this variable is obtained from BoardEx.

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13 ROA describes the return of assets and is used to measure the performance of the firm. This variable will be used to control for firm performance and is often used by many researchers (e.g. Miihkinen, 2012). Data for calculating this variable is obtained from Compustat.

Leverage describes and controls the capital structure of the firm. Capital structure of a firm relates negatively to risk disclosure quantity (Dobler et al., 2011; Healy & Palepu, 1993; Troberg et al., 2010). The reasoning behind that, is that leveraged firms are less risk transparent due the fact that leverage increases risk of bankruptcy. When the firm provides less risk information it can hide the vulnerability of the firm regarding for example financial risks. All data is obtained from Compustat for calculating the capital structure of the firm.

HardscoreD describes the dummy if the IFRS 7 risk disclosure section contains any tables.

When the section contains any tables this will be represented as one, and otherwise zero. Tables can influence the word count because it can represent information in a more summarized way.

Size describes the size of the firm. Size is measured by the total assets of the firm. Beretta and Bozzolan (2004) examined the relation between firm size and risk disclosure. Beretta and Bozzolan found a positive relationship between the quantity of risk disclosure with firm size. Futhermore, this variable is often used as control variable by many researchers (e.g. Abraham & Cox, 2007; Botosan, 1997; Roberts, & Gray, 1995) and will be therefore used in this research.

IndustryD describes the industry dummy based on the SIC codes and will control for effects

caused by the differences between industries.

YearD describes the year dummy 2007-2016 and will control for effects caused by year.

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14 Table 1

Variable Description

Dependent variable

IFRS7_Quantity Total numbers of words in IFRS 7 risk disclosure.

Independent variable PrePost

Education

A dummy variable which takes the value of 1 for pre-period and 0 otherwise.

A dummy variable which take the value of 1 when CFO has an educational background in accounting.

Control variables

ROA The ratio net income to assets

Leverage The ratio total liabilities to assets

Hardscore A dummy variable which take the value of 1 when IFRS 7 section

contains any tables and 0 otherwise. Size

Industry dummy Year dummy

Total assets of firm.

A dummy variable that controls for industry effects A dummy variable that controls for year effects

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V. Results

Descriptive statistics

Table 2 shows the descriptive statistics of the variables that has been used to calculate the first hypothesis, the influence of the implementation of the IASB Conceptual framework in 2010 on the quantity of IFRS 7 risk disclosure.

Table 2

Variable Obs Mean Std.Dev. Min Max

Dependent variable IFRS7_Quantity 2441 1666.969 910.926 92 5803 Independent variable PrePost 2441 .627 .484 0 1 Control variables ROA 2441 .05 .101 -1.324 .638 Leverage 2441 .581 .225 .026 2.072 Hardscore 2441 .861 .346 0 1 Size 2441 5491.612 22068.47 4.057 300000

Variables that has been used for analyzing the second hypothesis whether the educational background of the CFO has an influence on the quantity of IFRS 7 risk disclosure are described in table 3.

Table 3

Variable Obs Mean Std.Dev. Min Max

Dependent variable IFRS7_Quantity 2346 1677.627 913.824 92 5803 Independent variable Education 2346 .643 .479 0 1 Control variables ROA 2346 .05 .099 -1.324 .638 Leverage 2346 .586 .223 .039 2.072 Hardscore 2346 .867 .339 0 1 Size 2346 5629.781 22483.58 8.737 300000

All variables are winsorized on level 1% and 99%, except dummy variables PrePost, Education and Hardscore.

Correlation matrix

Table 4 presents Pearson correlation coefficients used for variables in hypothesis 1 and 2. All correlation coefficients are below the accepted benchmark of 0.7 which could indicate that there are no multicollinearity issues. VIF-test results show that all variables are below 10 which also suggests no multicollinearity issues.

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16 Table 4: Correlationmatrix Variables (1) (2) (3) (4) (5) (6) (7) Totalwords (1) 1.000 PrePost (2) 0.136 1.000 Size (3) 0.258 0.012 1.000 ROA (4) -0.019 -0.035 -0.022 1.000 Leverage (5) 0.103 -0.040 0.029 -0.055 1.000 Hardscore (6) 0.340 0.121 0.031 -0.054 -0.050 1.000 Education (7) -0.098 0.001 -0.123 0.027 -0.003 0.001 1.000 All variables presented above are described in Table 1 on page 14.

Regression

Table 5 provides the results of the GLS panel regression with random effects for estimating the introduction of IASB framework 2010 on IFRS 7 risk disclosure quantity. In the first hypothesis I expected that the removal of prudence would have a positive effect on the quantity of IFRS 7 risk disclosure. The reasoning behind the positive influence is due the decrease of conservatism which could lead to more assurance/hedging activities by firms because firms will take more risks. Furthermore, firms could act less prudent in uncertain situations regarding financial instruments which could lead to more risks and risk management (disclosure). Table 5 gives a significant positive effect (P<0.01) which shows evidence to support that after the IASB framework change in 2010 the quantity of IFRS 7 risk disclosure has risen. Therefore, the following hypothesis can be accepted:

Hypothesis 1: Removal of prudence influences has a positive influence on the quantity of risk disclosure of financial instruments (IFRS 7)

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17 Table 5: Regression results

(1) Totalwords PrePost (Pre=0,Post=1) 0.755*** (0.070) ROA -0.003 (0.012) Leverage 0.091*** (0.034) Hardscore 0.598*** (0.076) Size 0.176** (0.082) _cons -1.018*** (0.097) Observations 2441

Industry Dummy Yes

Year Dummy Yes

R-squared 0.3402

*** p<0.01, ** p<0.05, * p<0.1 Standard errors are in parenthesis. All regression variables are standardized to have a mean of zero and standard deviation of one.

Table 6 provides the results of the GLS panel regression with random effects for estimating if an CFO with an educational background in accounting effects the quantity of IFRS 7 risk disclosure. In the second hypothesis I expected a negative influence on the quantity of IFRS 7 risk disclosure when the CFO has an accounting background. Accounting training and regulation focuses on prudent and accurate financial reporting. CFOs with an accountant background are more risk-averse and therefore minimize the risks they are taking. Table 6 shows that there is no evidence that CFOs with an background in accounting has a significant influence. Therefore, the following hypothesis can be rejected:

Hypothesis 2: CFOs with an accountant background has a negative influence on the quantity of IFRS 7 risk disclosure.

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18 Table 6 : Regression results

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Totalwords

Education (No background=0, Background=1) 0.007

(0.045) ROA -0.005 (0.013) Leverage 0.090*** (0.035) Hardscore 0.600*** (0.076) Size 0.173** (0.081) _cons -1.007*** (0.111) Observations 2346

Industry Dummy Yes

Year Dummy Yes

R-squared 0.3436

Additional tests

The first additional test will examine whether the quantity of IFRS 7 risk disclosure is due new information. It could be possible that firms disclose information that is actually similar information in comparison with the years before. Therefore, a different proxy has to be used to measure dependent variable IFRS7_Quantity. In this model (net) total words will be calculated by adding up (net) increase of novelty words:

Totalwords (t-1) + (Novelty_percentage * totalwords)= Net_totalwords

GLS panel regression with random effects will be used with a different measure of IFRS7_Quantity. Table 7 below present my findings. Results show that in post-period of implementation there is still a significant (P<0.01) positive effect on quantity of IFRS 7 risk disclosure.

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(1) (2)

Total words Net total words

PrePost (Pre=0,Post=1) 0.755*** 0.571*** (0.070) (0.079) ROA -0.003 -0.012 (0.012) (0.015) Leverage 0.091*** 0.087** (0.034) (0.039) Hardscore 0.598*** 0.303*** (0.076) (0.096) Size 0.176** 0.316*** (0.082) (0.060) _cons -1.018*** -0.492*** (0.097) (0.121) Observations 2441 1594

Industry Dummy Yes Yes

Year Dummy Yes Yes

R-squared 0.3402 0.3095

Second analysis will test whether there is a significant difference in effect when the sample only contains firms with a CFO function. In some cases there was no CFO function but almost a similar function like a financial director. To be sure this makes no difference an GLS panel regression with random effects is executed where the sample only contains firms with a CFO function. Results in table 8 show that this make little to no difference and therefore can be concluded this makes no significant influence.

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Total words Total words

Education 0.007 0.022 (0.045) (0.048) ROA -0.005 -0.004 (0.013) (0.018) Leverage 0.090*** 0.103** (0.035) (0.052) Hardscore 0.600*** 0.689*** (0.076) (0.116) Size 0.173** 0.115 (0.081) (0.100) _cons -1.007*** -0.698*** (0.111) (0.158) Observations 2346 1066

Industry Dummy Yes Yes

Year Dummy Yes Yes

R-Squared 0.3436 0.4839

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VI. Conclusion and discussion

Effect of IASB framework 2010 on IFRS 7 risk disclosure

Different views on the explicit reference to prudence led to a change in Conceptual Framework 1989 because the reference could lead to a conservative bias and would be inconsistent with neutrality. Therefore, IASB introduced the IASB framework 2010 where no explicit reference to prudence or conservatism is mentioned. Previous research regarding conservatism shows that conservatism has an influence of the risk behavior of firms. Firms that are more conservative are associated with less riskier acquisitions (Kravet, 2014). Kanagaretnam, Yeow Lim and Lobo (2014) found out that conservatism leads to less risk-taking of banks. Therefore, I made the assumption that after introducing the new framework in 2010 firms will be less conservative and subsequentially engage in more risk-taking behavior. As proxy to measure the increase in risk-taking behavior I used the quantity of IFRS 7 risk disclosure. Results suggests indeed that in the post-period of implementation firms disclose more risks regarding financial instruments and are in line with my expectations. Furthermore, another proxy has been used for dependent variable IFRS7_Quantity. There is a possibility that quantity of words has been risen not due increase of new information, but through information that is similar in comparison with previous year. Therefore, total words of IFRS 7 risk disclosure is recalculated by looking at ‘net words’. In this model increase of net words will be added up on total words of previous year. This additional test resulted still in an significant positive influence of the implementation of IASB framework 2010.

Effect of educational background in accounting on IFRS 7 risk disclosure

Hoitash, Hoitash and Kurt (2016) examined that CFOs with accounting backgrounds are associated with more conservative outcomes. Furthermore, managers with an accountant background are more risk averse than non-accountant managers (Brief, 1975; Helliar et al., 2002; Newton, 1977). CFOs are more risk-averse and therefore will work harder to improve the quality of reporting system and thereby reduce the risk he is exposed to (Friedman, 2016). Therefore, I made the assumption that CFOs with an educational background in accounting will be more risk-averse and minimize the risks they are taking and subsequently there will be less IFRS 7 risk disclosure. Moreover, because of the fact conservatism requires a higher degree of verification of good news than bad news I expected that conservatism causes an overestimation of the potential risks of the financial instruments the firm possesses what could lead to less risk-taking behavior and subsequently leads to less IFRS 7 risk disclosure. Results suggests however that there is no evidence that CFOs with an background in accounting has a significant influence in contrast to my expectations.

Furthermore, in some cases there was no CFO function in the firm but instead there was a similar function like a financial director. To be sure that this makes no difference a second regression has been executed whereby the sample only contains observations with firms with an CFO function. This additional test resulted that there is still no significant influence of education accounting background on the quantity of IFRS 7 risk disclosure.

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Conclusion

After adoption of IASB framework 2010, findings show that in the post-period of adoption, the quantity of IFRS 7 risk disclosure has significant increased. This is in line with my expectation that due removal of the reference to prudence, firms could engage in more risk-taking behavior what subsequently leads to more IFRS 7 risk disclosure.

Further, CFOs with an educational background in auditing has no significant influence on IFRS 7 risk disclosure. This is in contrast with my expectation that CFOs with an accounting background will engage in less risk-taking behavior what subsequently could lead to less IFRS 7 risk disclosure.

Limitations

Some annual reports could not be collected and in a few annual reports it was not able to calculate the word count in IFRS 7 section what caused an unbalanced panel data set which could have led to biased results.

Further, during the time frame of this research a financial crisis occurred what probably could have an influence on the risk behavior and risk disclosure of firms. After the financial crisis occurred stakeholders could be demanding more risk disclosure which could influence the quantity of disclosure.

Also, this research is based on a lot of assumptions. Based on prior research, the assumption is that risk-taking behavior has direct influence on the disclosure of risks. Furthermore, this research draws on the assumption that the removal of prudence automatically leads to less prudent/conservative financial reporting. Research on the impact of the removal of prudence on the level of accounting conservatism is scarce. Conway (2014) examined the impact of removing prudence of the Conceptual Framework on accounting conservatism. Based on the two most popular measures of accounting conservatism, Market-to-Book ratio and the Basu-model (1997), Conway (2014) found a decrease in levels of conservatism since the removal of prudence from the Conceptual Framework. Although this could implicate that after the removal of prudence decreased the conservative behavior of firms, the findings in this study should be treated with caution because the sample size of the study was small and there has been a significant economic event in the same time period.

Lastly, many firms changed CFOs during the year where the person who held the position for the longest time in that specific year is designated as CFO. This could have led to bias in the results.

Further research

In March 2018 the IASB introduced a new conceptual framework. The IASB reintroduced the reference to prudence in the framework. The removal of the reference to prudence in 2010 led to further confusion amongst users and as a reaction the IASB reintroduced the reference to prudence. Further research can be conducted and examine whether there is a structural break after implementing the new framework in 2018. There should be an opposite effect in comparison with the conceptual framework of 2010 because of the reintroduction of prudence.

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23 Results show that there is no evidence that there is a significant influence of education background in accounting on the quantity of IFRS 7 risk disclosure. Further research can be conducted on the influence of other director characteristics on the quantity of IFRS 7 risk disclosure.

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More or less IFRS 7 risk disclosure: The role of conservatism and prudence