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Risk management in accounting practices: An international
comparison of Chinese and Dutch listed companies regarding
uniform accounting standards.
Master Thesis
Name: Vera Zieleman
Student number: 1781510
University: University of Groningen
Faculty of Economics and Business University of Uppsala
Faculty of Social Sciences
Master Program: Double Degree MSc in International Business and Management
Specialization: International Financial Management
Telephone number: +31(0)630291271
Email: verazieleman@hotmail.com
Supervisor: Dr. W. Westerman
Co-assessor: Dr. N. Brunia
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Risk management in accounting practices: An international
comparison of Chinese and Dutch listed companies regarding
uniform accounting standards.
Master Thesis Vera Zieleman
Abstract
This study examines whether there are differences in accounting practices – focusing on risk management reporting – between the Netherlands and China. I hypothesize that Dutch risk paragraphs are more extensive, better readable, have a higher frequency of words that indicate possible risks, and in general disclose more information about the risks they are facing. Statistical analyses confirm the hypotheses, and interviews conducted with two Chinese accounting experts complement these conclusions.
The results suggest that implementing one single set of accounting standards for the whole world is difficult to accomplish. Moreover, they show that each country has its own specifics and characteristics and that two countries can be very different in terms of culture, politics and
economy, and that a one-size-fits-all prescription in relation to accounting rules is therefore likely to be impracticable.
Keywords
4 PREFACE
Proudly I present to you the results of five months of intensively conducting research and its commensurate reporting. With this study – conducted in the light of my master graduation – I attempted to combine literature, a statistical part and interviews in order to increase our understanding of the feasibility of international accounting standard harmonization. The past couple of months have been a challenging and valuable experience to me. Analyzing this issue, which has gained increased attention in the past decade, has proven to be extremely interesting and has kept me passionate and driven until the end of the research process.
Acknowledgements
First of all, I am grateful to dr. W. Westerman. With his reviews and constructive feedback, he made a significant contribution to this paper. Moreover, my thanks are indebted to co-assessor dr. N. Brunia, for reviewing and assessing this thesis. Furthermore, I want to thank Ernst & Young for the opportunity they have given me to write my thesis. Specifically, my thanks go to my supervisor at Ernst & Young, mr. H. Wanningen, for critically reviewing this paper and giving me constructive feedback. Moreover, I would like to thank mr. E. Gulpen for helping me to get in touch with the interview respondents, and I am also thankful to the interview respondents
themselves. Finally, I thank my family and friends for their support during the past couple of months.
5 TABLE OF CONTENTS 1. INTRODUCTION 7 1.1 Relevance 9 1.2 Research objective 11 1.3 Research questions 12 1.4 Structure 14 2. LITERATURE REVIEW 15 2.1 Accounting principles 15 2.1.1 IFRS 15 2.1.2 China 17 2.1.3 The Netherlands 20
2.2 Influence of culture on financial reporting 21
2.2.1 Accounting values 21
2.2.2 Culture in relation to this study 24
2.3 Risk management reporting 25
2.4 Risk management reporting & IFRS 28
2.4.1 Risk management reporting – China 28
2.4.2 Risk management reporting – The Netherlands 29
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4. RESULTS 37
4.1 Statistical analyses 37
4.2 Interviews 43
4.3 Analysis of results 44
5. CONCLUSION & DISCUSSION 46
6. REFERENCES 50
7 CHAPTER 1. INTRODUCTION
Enron, WorldCom, Parmalat, Royal Ahold. These companies are just four examples of a long list of companies involved in business scandals during the last decennia. Many other financial scandals can be added to this list, over time and in many countries, in which accounting and auditing were deeply implicated (Tinker, 1985). What these companies all have in common is a list of practices including corporate fraud, unethical management behavior, and questionable financial reporting. Moreover, most of these companies used incentive-based compensation schemes, which provided the incentives for fraudulent financial reporting (Rockness & Rockness, 2005).
In response to the business scandals and fraudulent practices, more and stricter accounting rules and standards have been introduced the last decennia. Rules and guidelines, such as the International Financial Reporting Standards (IFRS), were introduced to guide companies in their reporting practices. Additionally, International Standards on Auditing (ISAs), introduced by the International Auditing and Assurance Standards Board (IAASB), aim to guide accountants in their work.
According to Rockness and Rockness (2005), Enron’s failure has been a turning point in professional accounting regulation and corporate financial reporting. Moreover, it has been the driving force behind the Sarbanes-Oxley Act (SOX) legislation. The main objective of implementing SOX was to restore public confidence in both public accounting and publicly traded securities. In the example of WorldCom, so the authors state, unethical behavior was encouraged by WorldCom’s corporate culture. This was done in one way by appealing to individuals’ sense of promoting the greatest common good for the workers, shareholders, and community, and in a second way by raising fears of losing their jobs if they did not comply with requests to falsify records.
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It is clear that these events evoked reactions throughout the world. As mentioned, one of them is the increased attention on IFRS. The goal of the IFRS Foundation and the IASB is to develop, in the public interest, a single set of high-quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles (www.ifrs.org). Following the changes in IFRS, we see countries either adopting IFRS in full, or converging their local
GAAP1 towards IFRS. The question coming to mind is whether the goal of the IFRS Foundation
is more than just wishful thinking; will it be possible to reach the globally accepted accounting standard?
More specifically, this study focuses on risk management reporting practices, and the fact whether these practices are similar between two countries. The importance of risk management and reporting has become obvious and increasingly important after the Enron and WorldCom scandals, where risks were not sufficiently presented in the financial statements and therefore have misled the stakeholders for years.
This study addresses this question, by selecting two countries which are different in respect of culture, infrastructure, and political system, the Netherlands and China. The study consists of different components; first literature is going to be reviewed in order to construct four hypotheses. Thereafter, these hypotheses are tested by means of a quantitative study constituting of comparing and measuring the level of disclosure of risk paragraphs as included in the financial statements of listed Chinese and Dutch companies. Furthermore, in order to strengthen the quantitative results, qualitative research is conducted, existing of two interviews; one with a Chinese accountant (senior manager) who is currently working at Ernst & Young Shanghai, and one with a Chinese financial controller (former accountant at Deloitte), who is working at an international chemical company, based in Shanghai. These respondents are selected based on their working experience in China. These interviews are intended to give more clarity and serve as an explanation after having interpreted the quantitative part of the study.
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To resume, this research does not study the direct influence of culture on financial reporting. It rather questions whether the Chinese and Dutch risk management disclosure practices are alike and it intends to come up with explanations for possible differences, of which culture may be one.
1.1 Relevance
In general, the international harmonization of accounting standards is a highly debated topic these days. The business scandals referenced above and the globalization of investment markets and the world economy have highlighted the need for uniform reporting standards, based on the fact that, in the global world of today, business is increasingly done between countries from all over the world. In order not to be able to fool investors and prevent business scandals as described above to occur, it is important that there are clear reporting standards which are followed by companies from all countries. Therefore, it is relevant to compare two seemingly different countries, and observe whether their reporting practices are in fact similar.
Furthermore, the selection of China and the Netherlands as countries of focus is based on several reasons.
Selecting the Netherlands as one of the sample countries is based on the fact that it is a well-developed Western country and therefore serves as a good comparison country, of which the results might be applicable to more countries. Furthermore, the Netherlands is an important player in the international economy concerning the fact that the Port of Rotterdam is the largest port in Europe, and was until 2002 the world’s busiest port. Moreover, there are several Dutch companies that make a significant contribution to the world economy, for instance Unilever and Royal Dutch Shell. All of this signifies the meaning of the Netherlands in the world economy, and therefore it is relevant to include the country in this study’s sample.
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Moreover, China is an important player in the world economy. As such, it is interesting to study whether their accounting framework becomes more like the developed countries systems, using the Netherlands as a proxy. It was predicted in 2003 by Goldman Sachs that China’s economy would surpass Germany in the next few years, Japan by 2015, and the United States by 2041. In fact, China’s economy overtook Germany’s economy in 2007 (a year earlier than expected) and overtook the Japanese economy in July 2010. Now, Goldman Sachs believes that the Chinese economy will overtake the USA economy by 2027 (Majumder et. al, 2012).
The reason for choosing China and the Netherlands as a comparison is that both countries more
or less comply with IFRS. China still uses its own accounting standards, the New PRC GAAP2,
but these standards have converged more and more with IFRS during the last couple of years. The European Commission has made reporting according to IFRS since 2005 compulsory for firms listed on a European exchange. The version of IFRS used in the Netherlands is the version adopted by the European Union, which for the far majority of the non financial institution reporters is identical to IFRS as issued by the IASB.
The specific focus of this study on risk management and its difference between countries is different from what most of the previous studies did. They concentrated mainly on corporate governance and the differences between different countries (Hermes, Postma & Zivkov, 2006; Cheng & Cheng, 2007).
Focusing on risk management and its disclosure is highly relevant since it is a recent concern of accounting bodies that companies do not disclose enough information in their annual reports about the risks they encounter, and the management approaches they employ to handle these risks. Additionally, results of many studies indicate that risk management is an important factor in a firm’s value. Therefore, it is important to consider how the risk paragraph should be interpreted. Moreover, this research is more recent than the existing studies, with annual reports of 2011 being used for the quantitative part of this study.
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This study adds to the existing literature in a couple of ways. First of all, where a lot of previous comparative research on this topic has been done on countries within the EU, USA or Asian countries as a whole, this research takes a different approach by choosing two opposite countries in terms of culture. Moreover, this research not only indicates whether there are differences in the disclosure of risk information between different countries, but it also tries to give explanations for these differences by interviewing two native Chinese experts who are working in China.
1.2 Research objective
The objective of this research is threefold. First of all, literature about accounting standards, China, the Netherlands and risk management reporting is reviewed. Thereafter, it is quantitatively researched whether there are differences in reporting practices, focusing on risk management, between listed Chinese and Dutch firms. Finally, I attempt to explain the possible differences resulting from the first part of the study. As an example, which factors may cause a lower level of disclosure by Chinese firms in comparison with Dutch firms.
By analyzing accounting practices of companies from two different countries regarding culture, political system and infrastructure, the overall objective of this paper from an academic point of view is, despite of the introduction of global accounting standards (IFRS), to enhance our understanding of the presence of differences in accounting practices throughout the world and come up with possible explanations for these differences.
Therefore, the core research question of this study is:
What are the differences between the accounting practices, focusing on risk management, of Chinese listed companies and Dutch listed companies? What possible explanations exist for these differences?
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different countries and be more critical when interpreting risk management paragraphs of different companies.
1.3 Research questions
In order to answer the above stated question as accurately as possible, the primary research question will be decomposed in several research questions. The first five research questions are going to be answered by reviewing literature. Research question six is answered after having compared Chinese and Dutch risk management paragraphs and conducted statistical tests, which is the quantitative part of this study. At last, the seventh research question is answered by conducting interviews, constituting the qualitative part of the study.
First of all, an overview of IFRS, its foundation and the international harmonization of accounting principles will be addressed. Therefore, the first research question is:
RQ1: How has IFRS been established and what opinions do exist about the international harmonization of accounting standards?
Next, it is important to separately investigate the Chinese accounting practices as well as the Dutch, see how those standards evolved in history and examine their convergence with IFRS. This will enable the reader to understand the background of both sets of standards.
RQ2: How is the accounting practice regulated in China and the Netherlands, and to what extent has it been converged with IFRS?
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RQ3: What is the influence of culture on financial reporting and what are the results of earlier studies?
Since this study focuses on the disclosure of risk management reporting specifically, it is critical to consider the importance of risk management nowadays, and what the accounting rules for risk disclosure are. To this extent, the following two research questions have been identified:
RQ4: How is the importance of disclosure of information on risk management considered?
RQ5: What are the current accounting guidelines for risk management disclosure?
To answer the primary research question, it is important to compare annual reports’ risk paragraphs of listed Chinese and Dutch firms, which constitutes the quantitative part of my study. This comparison will be based on the measurement of several key words of the risk paragraphs, and the readability of these paragraphs. The following research question therefore is:
RQ6: What are the differences in risk management disclosure between Chinese listed and Dutch listed companies?
The answer to this question provides a summary of differences in accounting practices related to risk management. This would provide valuable insight for users of the financial statements when relying on the information presented therein. The research will aim to provide possible explanations and reasons for the differences, which is done by conducting interviews. The seventh and last research question therefore is:
RQ7: Which factors explain the differences between Chinese and Dutch accounting practices?
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influence of culture on financial reporting. It concludes with a general description of risk and risk management, and its importance to business nowadays.
After having established an understanding of the main topics of this research, risk paragraphs of Chinese and Dutch listed firms will be reviewed and compared, to explore the differences between the two countries’ accounting practices. Finally, this study seeks to identify factors that explain differences in accounting reporting between Chinese and Dutch companies, in order for managers to know better how they should interpret risk management paragraphs from different countries, and for investors to be more cautious and aware of possible differences between risk paragraphs of companies of different countries.
1.4 Structure
This paragraph describes how the remainder of this paper is structured.
Chapter 2 is the theoretical section of this research. Previous literature is reviewed in order to define the main concepts of this paper. Literature about IFRS, international accounting standards harmonization, accounting practices in China and the Netherlands, and risk management reporting is reviewed and discussed. The goal of the literature study is to provide the basis for the development of propositions which will be studied in the empirical investigation.
15 CHAPTER 2. LITERATURE REVIEW
A lot of literature is observed in this section, due to the fact that quite some literature is available about the subjects of this study. However, the literature on itself is not always that focused and specific, which leads to considering a lot of literature in order to gain sufficient knowledge about the different subjects, before constructing the hypotheses.
2.1 Accounting principles
2.1.1 IFRS
IFRSs are developed and published by the International Accounting Standards Board (IASB), which is an independent standard-setting body, under oversight of the IFRS Foundation. The IFRS Foundation is an independent, not-for-profit private sector organization working in the public interest. Its principal objectives are developing a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRS) through its standard-setting body, the IASB (www.ifrs.org).
The IASB became an independent international standard setter in 2001. Since then, the use of international standards has progressed rapidly. As of 2009, the European Union and over 100 countries either require or permit the use of IFRS issued by the IASB or a local variant of them (www.fasb.org).
The Financial Accounting Standards Board (FASB) and the IASB have been working together since 2002 to improve and converge U.S. generally accepted accounting principles (GAAP) and IFRS. As of August 2008, more than 113 countries around the world, including all of Europe, currently require or permit IFRS reporting and 85 require IFRS for all domestic, listed companies (www.sec.gov).
Supporters & opponents of international accounting standards harmonization
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for a single set of financial reports is to achieve global harmonization, thereby creating an open and accountable world.
It is only within the last two decades that the international harmonization of accounting standards has gained widespread and effective acceptance (Cooper, Neu & Lehman, 2003). Chand (2005) argue that, although the move to harmonize accounting standards throughout the world is politically intricate, theoretically complex, and operationally uncertain, the drive to do so has strong impetus.
Furthermore, the IASB argues that convergence attracts investment through transparency, reduces the cost of capital, increases worldwide investment and reduces costs. Also, it is suggested by Taplin et al. (2002) that a country’s need to access capital markets may increase the trend towards harmonization and country compliance. Bayless, Cochrane, Harris and Leisenring (1996) and Tang (2000) state that a global set of accounting rules will avoid duplicative costs of national and international standards. Other authors argued that a global set of accounting standards eases the comparability and interpretations of financial statements by users, and help them make informed business decisions (Wahlen, Boatsman, Herez, Jonas, Palepu et al., 2000), and that it reduces the cost of preparing two or more sets of financial statements (Cheng et al., 1999).
However, not everyone is as supportive of a global set of accounting rules as the authors mentioned above. Opponents argue that a single set of standards may not be suitable for all settings and thus may not uniformly improve value relevance and reliability due to differences among countries (Soderstrom & Sun, 2007). Saravanamuthu (2004) complements this view by stating that the IFRS project is an aura of objectivity by transcribing complex ‘local reality’ into universal recognizable and acceptable information. Due to this apparent disparity between nations, it is rather a naive view of the IASB that a single regulatory framework can be established that meets the financial reporting needs of all societies.
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large scale of international differences in financial reporting (Ampofo & Sellani, 2005; Nobes & Parker, 2004; Radebaugh & Gray, 2002; Saudagaran, 2004; Schultz & Lopez, 2001). In addition to this, McGregor (1999) already stated that a global set of accounting standards is too simplistic as a solution to a complex set of problems since differences in national sovereignty, politics, culture, language, economic and business environments are not fully addressed, which will impact the usefulness of such a global set of rules. Another view against a single set of accounting standards, reflected by Graham and Neu (2003), considers how developed nations have imposed their policies and standards on developing nations, because the developed ones benefit most from the imposition. Therefore, it is important to explore the convergence and harmonization process to determine whether those accounting structures satisfy the needs of all users or whether they satisfy only a selected group of users, without consciously addressing the needs of others (Hopwood & Miller, 1994; Lehman, 2005; Miller & O’Leary, 1994).
After having evaluated and discussed the existence of IFRS and international accounting harmonization, now the first research question can be answered.
The establishment of IFRS has mostly been described as an attempt to improve the understandability and comparability of company accounts across international boundaries. From 2001 onward, the use of international standards has been progressing rapidly and its convergence has been promoted since. It was stated that increasingly, countries are permitting or requiring IFRS reporting for their domestic companies.
All in all, it has been observed that contradictory views exist about the international harmonization of accounting standards, and that no single conclusion can be drawn. The supporters argue that transparency and worldwide investments may increase while at the same time costs (of capital) may be reduced. From the opponents’ views, there is criticism whether a single set of accounting standards for all countries is really possible.
2.1.2 China
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With the founding of the People’s Republic of China (PRC) in 1949, all resources in the country came under state ownership. The accounting rules and regulations back then, characterized by their uniformity and rigidity, were known as ‘fund accounting’; all economic activity was controlled by the state and the only business entity was the state-owned enterprise. These rules and regulations were predominantly used for two reasons; on the one hand for establishing an information and reporting system for the implementation of state economic policies, and on the other hand for maintaining administrative control of assets of the state. The first attempt in history to move away from the fund accounting principles appeared in 1979, with the promulgation of the Joint Venture Law. It was with this event that a separate set of accounting rules was formulated to govern the preparation of financial statements by enterprises. Alongside economic reform and the ‘open door policy’ adopted since the beginning of the 1980’s, foreign investors were allowed to set up enterprises and conduct business in China. A separate set of accounting regulations, only applicable to foreign investors, was developed and implemented. However, the purpose of this set of regulations was rather to ascertain the amount of tax an enterprise should pay than to ascertain the truthfulness and fairness of financial statements (www.lehmanbrown.com).
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In February 2006, the MOF issued a new set of accounting standards, commonly known as New PRC GAAP. The New PRC GAAP has been adopted per 1 January 2007 by all A-share listed companies, some non-listed financial enterprises and large state-owned enterprises. Within the next few years from now on, New PRC GAAP is expected to be adopted by all medium and large-sized enterprises. Once that target is achieved, the MOF will abolish the Accounting Regulations for Business Enterprises and other related rules (KPMG, 2011, 2012).
Convergence with IFRS
During the development of New PRC GAAP, the China Accounting Standards Committee (CASC) involved the International Accounting Standards Board (IASB) in confirming the extent to which New PRC GAAP converged with IFRS. The new standards now cover most of the topics of the IFRS, although there all still some differences. For this study, it is most relevant whether there still are large differences between New PRC GAAP and IFRS regarding risk management, which will be elaborated further upon in paragraph 2.4 about risk management reporting and IFRS. The subjects of derivatives and hedge accounting were not addressed under Old PRC GAAP, and no requirements about how to account for them were present. With the current regulation, these two subjects have to be on the balance sheet. Moreover, hedge accounting has to be handled with as is stated in IAS 39 (Pacter, 2007).
While there are still some differences between Chinese Accounting Standards (CAS) and IFRS, the Ministry of Finance has plans to further converge CAS with IFRS in the near future.
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2.1.3 The Netherlands
In the history of the accounting practice in the Netherlands, the Dutch Institute of Accountants (the oldest and most important organization of accountants in the Netherlands) plays a significant role. The Dutch abbreviation of the organization is NIVRA, and its members in particular were the ones who insisted on legislation for the accounting profession (Hen et. al., 1995), which has been accomplished in 1967.
There are three stages to accounting regulation in the Netherlands. The first is the Civil Code, the second is the Enterprise Chamber and the third is the Council for Annual Reporting. The last one is not part of the formal legal system but is an essential element in the implementation of the law. Moreover, the Council acts on behalf of the Foundation for Annual Reporting and comprises representatives of three interest groups – users, preparers and auditors. The Council for Annual Reporting reviews the accounting principles which are applied in practice and gives its opinion on the acceptability of those principles within the framework of the law. Part of the work of this Council is to give opinions on IASB Standards. The Council’s opinions have no statutory backing, although they do provide an important frame of reference for the auditor and for the courts in arriving at views on the application of accounting policies. It contains a range of interest groups working together to achieve a consensus.
Originally, the Netherlands is a country classified as a ‘codified law’ country, with financial reporting being based on reliable representation of companies’ performance. Separate regulations exist for financial reporting and profit calculation for taxation purposes. Regulations concerning reporting can be found in the law, however the interpretation of those regulations is issued by the Council for Annual Reporting. Additionally, the auditing bodies themselves have high influence on the standards for valuation and presentation (Roberts et al., 2005).
Convergence with IFRS
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called ‘regulated’ European exchange.3 The IFRS are required for consolidated financial statements of listed companies and permitted for company only / separate financial statements. The version of IFRS used in the Netherlands is the IFRS version adopted by the European Union. IFRS are since 1 January 2005 required for consolidated financial statements prepared in the European Union countries. They include the older IAS (International Accounting Standards) which did not disappear, but were extended and elaborated further with IFRS. Basically, IAS is the old naming convention of what is now called IFRS, just like the IASC is the predecessor entity of the IASB. From this date on, listed companies in the European Union had to change their accounting practices to create uniformity throughout Europe, and to stress the quality of profits instead of the level of profits. For the Netherlands specifically, this meant that the listed companies now had to comply with IFRS instead of the NL-GAAP. The NL-GAAP were the Dutch accounting standards to be followed by Dutch companies before the compliance with IFRS.
An answer can be given on research question three now. It has been observed that the accounting regulation in the Netherlands consists of three components: the Civil Code, the Enterprise Chamber, and the Council for Annual Reporting. Moreover, it is worth mentioning that the auditing bodies themselves have quite some influence on the valuation and presentation standards. With the obligation to comply with IFRS for firms of the European Union in 2005, listed Dutch companies now have to prepare their consolidated financial statements according to IFRS.
2.2 Influence of culture on financial reporting
As indicated in the introduction, I expect that differences in financial reporting between countries may result from differences in (accounting) culture. This paragraph investigates the relation between culture and financial reporting, and reviews some previous studies on this topic.
2.2.1 Accounting values
The best known and most cited author concerning culture is Geert Hofstede (1980). Although criticized as well, his work is the most prominent work about culture in the world, and serves as
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the basis for a lot of studies about culture and financial reporting. Culture has been defined by Hofstede (1980, p. 43) as ‘the collective mental programming of the people in an environment.’ Based on an extensive six year lasting survey across 40 independent nations, Hofstede developed four dimensions of national culture: individualism-collectivism; masculinity-femininity; power distance and uncertainty avoidance. Later on, the fifth dimension, long-term versus short-term orientation, was added.
Hofstede’s study itself however does not explain cultural differences in financial reporting. Gray (1988) attempted to do this by developing four accounting values that were deemed to relate to the accounting subculture with the intention that the accounting values would then be directly linked to Hofstede’s societal values. Gray’s dimensions are the following: professionalism-statutory control; uniformity-flexibility; conservatism-optimism; secrecy-transparency.
The first two describe attitudes towards regulation, in particular towards the type of control system and the level or extent of control that is preferred. The third accounting value addresses attitudes towards measurement, with attitudes towards uncertainty being particularly important. The final value addresses attitudes towards disclosure, and is therefore the most relevant value for this study. Gray argued that conservatism and secrecy influenced the practice of accounting in terms of measurement system adopted and disclosures made.
Gray’s study dates from 1988, which increases the likelihood that developments like the implementation of IFRS, have caused differences such as those described by Gray, to decrease. This assumption can be derived from the research of Barth et al. (2008) who studied the quality of financial reporting under IFRS. They concluded that financial reporting’s quality is higher in countries complying with IFRS.
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between different countries, the model is relatively weak in explaining professional and regulatory structures based on culture.
Gray and Vint (1995) empirically tested the relationship between culture and accounting disclosures in an international context. Using a comprehensive data base of disclosure practices covering 27 countries, the results support the hypothesis proposed by Gray that secrecy and its impact on disclosure behavior is a function of Hofstede’s cultural values.
Sudarwan and Fogarty (1996) also tested Gray’s accounting values by using ‘structural equation modeling’ (SEM). They found in their study only evidence for four of Gray’s thirteen hypotheses, meaning that they found an insufficient amount of evidence to support Gray’s framework.
In contradiction, by not only looking at culture being a determinant of financial reporting but also at the requirements of the (international) owners of companies, Zarzeski (1996) concluded that there is an influence of culture on financial reporting. Specifically, she concluded that a higher level of secrecy within a culture is related to the level of disclosure. Wingate (1997) investigated in 39 countries whether a relation between culture and disclosure existed. She found that, unlike Gray’s hypotheses, the power distance dimension was not significantly correlated with disclosure.
In their study, Jaggi and Low (2000) observed the relation between culture, disclosure of reporting, other environmental factors and the legal system. They observed three ‘codified law’ countries and three ‘common law’ countries. They concluded that Gray’s hypotheses concerning the secrecy-transparency dimension did not hold. Their findings suggest that culture has little or no influence on the disclosure level when taking the legal system into account.
Hope (2003) investigated, in response to the research of Jaggi and Low, the relative roles of legal origin and national culture in explaining firm-level disclosure levels internationally. He documented that both legal origin and culture are important in explaining firm disclosure. Neither legal origin nor culture dominated with respect to overall explanatory power for variations in disclosure levels. Consequently, Hope argued that it is premature to write off culture as an important factor in the financial reporting environment.
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countries can be interpreted as cultural influences. However, Salter and Lewis (2011) found in their study about conservatism in reporting that individualism is a powerful explanatory factor of conservatism in financial reporting. At the same time they recognized that the framework of Gray still has predictive power with respect to differences in financial reporting.
This brings us to answering the fourth research question. A significant amount of research has been conducted on the relationship between culture and financial reporting. Previous studies differ however in their conclusions. As such, I conclude that although the expectation is that cultural differences have (and continue to) influence(d) financial reporting, we have not been able to corroborate this through literature.
2.2.2 Culture in relation to this study
The importance of culture for this study results from the key research question: What differences exist between the risk management reporting practices of Chinese listed and Dutch listed firms? Although in both countries, reporters need to comply with more or less the same standard (explained further below), differences in their reporting are expected as there are significant cultural differences between China and the Netherlands. These differences can be demonstrated by taking a look at Hofstede’s cultural dimensions for these two countries. Figure 1 in the appendix displays the scores for both China and the Netherlands, leading to a comparison of both countries.
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However, both countries have adopted IFRS for the listed segment, so it is interesting to study whether the differences still remain, or whether IFRS does really work in making the accounting practice more alike throughout the world.
As stated in the introduction as well, this research does not study the direct influence of culture on financial reporting. It rather studies whether there are differences in risk management disclosure between two different countries, and then gives possible explanations for these differences, of which culture may be one.
2.3 Risk management reporting
The importance of risk management reporting will be explained in this paragraph. Before the focus shifts towards risk management reporting however, first risk and risk management are explained.
Risk
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) defines risk as the possibility of the occurrence of a particular event or circumstance, leading to the failure of attaining a goal. Additionally, two other views can be distinguished about risk. The first one, an uncertainty-based view, defines risk as randomness or uncertainty of future outcomes that can be expressed numerically by a distribution of outcomes (Knight, 1921). The second one, a target-based view, defines risk as the potential deviation from a benchmark or target outcome (Borch, 1968).
Either way, risk relates to a distribution of future outcomes (Corby, 1994; Doherty, 2000) and it arises in any decision where there is some doubt about at least one of the possible outcomes. To minimize the impact of risks on future outcomes, companies attempt to manage risks.
Risk management
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Miihkinen (2012) defined risk management in his study about drivers of firm risk disclosure quality as: “all information that firms provide in the risk reviews they present in their annual reports”. In a business context, risk can be driven by several external and internal factors, all of them potentially affecting an entity’s future performance. Examples of risk factors are politics, regulation, market, as well as finance, business process and personnel (Dobler, 2008). Corporate risk management continuously aims at identifying risk factors, analyzing and evaluating their potential impact on future outcomes, and addressing the distribution by means of risk handling where appropriate (Williams, Smith, & Young, 1998). Given an effective risk management system, a manager can be assumed to have better information on risk factors, corporate risk management, and their potential impact on the entity's future performance, than outsiders, who have no access to internal information sources. Disclosure of risk information can reduce this information asymmetry (Linsley & Shrives, 2000; Lajili & Zéghal, 2005) by satisfying an information function and more specifically, an early-warning function for outsiders.
Risk management reporting shall provide risk information that allows outsiders to assess the risks of an entity’s future economic performance (Dobler, 2005; Linsley & Shrives, 2006).
Risk management reporting
Risk disclosure is information that describes firms’ major risks and their expected economic impact on future performance. This includes forward-looking information that helps external investors build up a point estimate of future cash flows, information on the sources of uncertainty surrounding forecasts of the firm’s future cash flows, and information on the sources of non-diversifiable risk that should be included in cost of capital. In addition, historical information about actions taken to face risks, and forward-looking information on programs planned to face risks are taken into account (Miihkinen, 2012).
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the information as it currently stands is too brief, not sufficiently forward looking and not wholly adequate for decision-making purposes (Helliar et. al., 2002; Beretta & Bozzolan, 2004; Cabedo & Tirado, 2004). This has motivated accounting bodies to take greater interest in the oversight of risk, and in ensuring that firms collect and disseminate a greater body of risk information (Sarbanes-Oxley, 2002; ICAEW, 2002; Linsley & Shrives, 2006). More recent literature supports these views by stating that the growing demand for better reporting of business risks which has emerged in recent decades, is based on the belief that improved understanding of business risks by investors and other users of corporate reporting should lead to better stewardship of companies and to a more efficient allocation of resources. In addition, the widely-shared underestimation of risk before the financial crisis of 2007 and beyond has reinforced calls for improved risk reporting, in the expectation that it should help make future crises less likely (ICAEW, 2011).
Another important reason for the focus on risk management disclosure is that risk management is an important factor in firm value. Allayannis and Weston (2001) found in their study about the relationship between risk management and firm value that firms using foreign currency derivatives had, on average, almost a 5% higher firm value than nonusers. A positive relationship between risk management and firm value is also found by other researchers (Bartram, Brown, & Conrad, 2009; Carter, Rogers, & Simkins, 2006; Graham & Rogers, 2002; Nelson, Moffitt, & Affleck-Graves, 2005).
For corporations, information on risk can help to manage change, lower costs of capital, and instruct on the future trajectory of the business (ICAEW, 1999; Cabedo & Tirado, 2004). For investors, information on risk can help to determine the risk profile of a company, the estimation of market value, and accuracy of security price forecasts.
As stated in the first chapter as well, the importance of risk management and reporting has become even more obvious after the Enron and WorldCom scandals, since these companies did not sufficiently present risks in their financial statements and therefore have misled the stakeholders for years.
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value is supported by several authors. In addition, several studies concluded that information about risks can lower costs. The importance of risk disclosure can also be found in the fact that accounting bodies nowadays are concerned that companies do not disclose enough information. Now that the importance of disclosing information on risk has been shown, the focus shifts toward current accounting guidelines for risk management disclosure, with a specific focus on China and the Netherlands.
2.4 Risk management reporting & IFRS
The International Financial Reporting Standards have increased in risk reporting requirements since 2007, when IFRS 7 was introduced. IFRS 7 is the accounting standard handling with disclosure of financial instrument, IAS 39 with measurement and recognition, and IAS 32 is the standard covering classification. The definition of a financial instrument is stated in IAS 32 par 11: A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
As of January 1, 2007 IFRS 7 was effective for all reporters, with the objective to enable the users of financial statements to evaluate the significance of financial instruments on the entity’s financial position and performance. Additionally, it enables users to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed, and in which way the entity manages those risks. By implementing the IFRS 7 disclosures, the users of financial statements will be able to understand the type of instruments being held, which exposures are present at the balance sheet date and what impact a change in the environment could have on the value of the instruments held.
2.4.1 Risk management reporting – China
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Reporting Standards), which are identical to IFRS, including all recognition and measurement options, but have in some cases different effective dates and transition requirements. From this it can be concluded that there are still some differences between IFRS and New PRC GAAP, but the same practices exist regarding disclosure.
2.4.2 Risk management reporting – The Netherlands
The business scandals mentioned in the introduction also had their effect on the Netherlands. Relating to the introduction of SOX in the USA, the Dutch Corporate Governance Code (‘Code Tabaksblat’) was introduced in 2003 for listed companies, meaning that from 2004 on, these companies had to set up their financial statements according to this code.
The code indicates how a company’s board needs to be constructed, for example that directors can be assigned for a period no longer than four years. Additionally, the code prescribes procedures about the accountability of the board, oversight on the board, position of the shareholders, and requirements for an external auditor. One of the main goals is more transparency of companies’ financial statements.
Listed companies are not obligated to comply with the code; a ‘comply or explain’ provision exists, meaning that as long as there is an explanation in their annual report about the non compliance with the code, it is possible not to adhere to the code (www.rijksoverheid.nl).
Along with the introduction of the code, a Monitoring Commission Corporate Governance Code was established. This Commission checks whether and how listed companies live up to the code. Every year a report of the Commission is published, including their conclusions. Moreover, every year the Commission examines the actuality and usefulness of the Code. Their findings are reported to the Ministry of Finance, Ministry of Justice, and the Ministry of Economic Affairs (www.commissiecorporategovernance.nl).
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Having taken into account the accounting guidelines for risk disclosure, an answer can now be provided on the fifth research question. The specific IFRS standard for disclosure on financial instruments (IFRS 7) has been reviewed and compared with the Chinese and Dutch accounting standards on risk disclosure. It has been concluded that for both countries IFRS 7 is used, making the comparability in this study easier and making this study’s outcome even more relevant.
2.5 Hypotheses
Based on the literature review, answers are given on the first five research questions. Moreover, hypotheses can be drawn from this review. These hypotheses are necessary to be able to draw conclusions about possible differences between Chinese and Dutch risk management reporting practices. The statistical analyses’ results provide a basis for either confirming or rejecting the hypotheses. The confirmation or rejection of the hypotheses are thereafter complemented by the results of the interviews.
In general, both supporters and opponents of international accounting standards harmonization are present. Several opponents argue that, due to differences among countries, a single set of standards may not uniformly improve value relevance and reliability. Moreover, opponents argue that supports of harmonizing international accounting standards forget the complexity of each separate country on itself.
With regard to culture, it has been observed that China and the Netherlands differ significantly. China for example has a lower score on uncertainty avoidance. Relating the lower score on uncertainty avoidance of China to risk disclosure, it is expected that Chinese companies disclose less information about their risks and risk management.
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Moreover, the foundations of both accounting systems are very different. The foundation of the Chinese uniform and rigid accounting system, and the fact that the only existing Chinese business entity in history was the state-owned enterprise, lead to the expectation that Chinese companies do not disclose as much information about risk as Dutch companies do. Additionally, when regarding the readability of the risk paragraphs, it is expected that the Chinese paragraphs are harder to read and that they are less extensive.
All of this leads to the following four hypotheses:
H1: Risk paragraphs of Dutch listed companies are easier to read than risk paragraphs of Chinese listed companies.
H2: The frequency of words indicating (possible) risks is higher in risk paragraphs of Dutch listed companies than in risk paragraphs of Chinese listed companies.
H3: Risk paragraphs of Dutch listed companies are more extensive than risk paragraphs of Chinese listed companies.
H4: Dutch listed companies disclose more information about the (possible) risk they face than Chinese listed companies.
32 CHAPTER 3. RESEARCH DESIGN
This chapter describes the design for the empirical research conducted in this paper. First the research method used in this study is presented and motivated. Thereafter it is described how the sample is selected and how the data are obtained. Finally the methods used to interpret the data are described.
3.1 Methodology
A tradition can be noticed of people doing research by counting words. This procedure is positively evidenced by Unerman (2000), who states that words can be counted with a high degree of accuracy. This method is mostly used by researchers in the direction of Corporate Social Responsibility (CSR). In this area, content analysis has often been used by previous researchers, with many empirical research studies analyzing the content of corporate reports for disclosures in respect of one or more categories of social, environmental and/or ethical matters. Table I in the appendix displays numerous studies which have used a form of content analysis as a research method. More recently, content analysis has also frequently been used in the intellectual capital disclosures area (Unerman, 2008). Table 2 in the appendix gives an overview of intellectual capital disclosure studies that have been conducting content analyses. The two tables together indicate the wide variety of studies using content analysis as research method. In addition to the area of CSR and intellectual capital, content analysis has also been used many times in studies about corporate governance. Hermes, Postma and Zivkov (2006) for example studied whether corporate governance codes in the European Union were driven by external or domestic forces. Hermes et al. (2006) checked in their study whether countries’ corporate governance codes were in accordance with a guideline implemented by the European Commission. When there was accordance, they simply put a ‘yes’ on a checklist, otherwise they put a ‘no’.
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In this study, a same sort of checklist is consulted as the one employed by Hermes et al. (2006), but in this case it is used to tally several things of the annual report’s risk management paragraph, which will be further explained below.
Furthermore, the readability of risk paragraphs is going to be measured by using two readability formulas (explained further in paragraph 3.1.3).
After the completion of the first, quantitative, part of the study where the four hypotheses are tested with a statistical rank test, I can continue with the second part. This second part exists of two interviews; one is conducted with a Chinese senior manager of Ernst & Young Shanghai, and one with a Chinese former audit manager of Deloitte, who is now working as a financial controller for a chemical manufacturing company in Shanghai.
These interviews, which are conducted after the quantitative part of the study, are intended to give more clarity and to serve as an explanation after having interpreted the results of the quantitative part, to verify the accepted or rejected hypotheses in order to strengthen the credibility and accountability of my study. The questions of the interviews are focused on how the respondents perceive Chinese firms’ disclosure of risk management in the annual reports and how Chinese firms cope with risk. The quantitative results of the study are going to be complemented by the interviews in the discussion section.
3.1.1 Sample selection
The objects of this study are forty listed Chinese, and forty listed Dutch firms. So, primarily the selection will be based on whether the firms are listed or not. Furthermore, for the Dutch firms, a sample of the forty biggest and listed firms is going to be produced and used. This selection will be drawn from the most important Dutch market index, the Amsterdam Exchange Index (AEX), and the second largest Dutch market index, the Amsterdam Midcap Index (AMX).
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Another important practical criterion regarding the Chinese firms is whether their annual reports are written and published in English, in order to enhance the feasibility of this study.
The lists of companies selected can be found in list 1 (for the Netherlands) and list 2 (for China) in the appendix.
3.1.2 Data collection
The annual reports over the annual year of 2011 (the observation year) are selected and studied, since this is the most recent year regarding the availability of data. A list of qualified Chinese firms for this research is constructed by looking at the top forty of the list by market capitalization. The list of qualified Dutch firms for this research is constructed by selecting the twenty-five firms listed on the AEX and the other fifteen largest firms in terms of market capitalization which are listed on the AMX. The annual reports of the selected firms are collected from the websites of the firms.
For this quantitative part of the study, the risk paragraphs of the accounting statements of the selected Dutch and Chinese firms are compared. In order to be able to compare the handling of risk management between Dutch and Chinese firms’ accounting statements, several things have been measured and analyzed using the statistical program SPSS.
For the last part of this study, data is collected by means of interviews with an accountant and a former accountant who is now working as a financial controller, both of them currently working in China. The interview questions can be found in list 3 in the appendix.
3.1.3 Readability
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primarily used to assess the difficulty of a reading passage written in English. The formula calculates the readability by looking at the lengths of words and sentences.4
The second formula is the FOG index (FOG) (Lehavy et al., 2011; Li, 2008; Loughran & McDonald, 2011). This index, developed in the computational linguistics literature, determines the number of words per sentence and number of complex words in a document, providing a measure for readability. Instead of counting the number of syllables, this formula counts only words of three or more syllables, which are termed ‘complex’ words.5 According to Lehavy et al.
(2011), this objective measure can be calculated for any narrative disclosure, which allows researchers to ‘directly examine the overall syntactic complexity of firms’ written public communication, over and above its specific content.’
3.1.4 Word counting
After the readability of the risk paragraphs has been determined, the frequency of specific words of the paragraphs will be measured. Words that are counted are ´risk´, ‘risks’, ‘risk management’, ‘financial’, and ‘market risk’. These words are believed to be the most important words in a risk paragraph in relation to this study, and to be best measuring the risk paragraph’s objective (explaining a company’s main risks in the field and its measures to minimize these risks to its readers). The results of these measurements are put in Excel, after which these observations can be used for the statistical analysis.
3.1.5 SPSS
The statistical program SPSS is used in this study in order to conclude whether the differences between Chinese and Dutch accounting reporting practices over 2011 are significant.
The results of the readability formulas and counting procedures are put in columns in Excel and then implemented in SPSS. After checking for normal distributions, several univariate linear
4 The Flesch Index is calculated as Readability Ease = 206.835 – 1.015 x (total words / total sentences) – 84.6 x (total syllables / total words). The output is a number between 0 and 100.
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37 CHAPTER 4. RESULTS
In composing the lists of Dutch companies, three companies listed on the AEX were excluded. ASML and Philips were excluded, since it was not possible to copy parts of their annual reports, which was essential in order to conduct the statistical part of this study. Douwe Egberts was also excluded, because no annual report of the year 2011 was available due to the fact that in 2011, the company still belonged to Sara Lee Corporation. Three additional Dutch companies of the AMX were included in the sample (Ten Cate, USG People and TomTom), in order to still get the sample of forty Dutch listed companies. The three companies were selected based on market capitalization.
4.1 Statistical analyses
Table 3 shows the means, the standard deviations and the correlations for the variables in the regression analyses. Most of the measures of risk paragraph length are significantly positively correlated. For instance, the correlation between ´number of characters of the risk paragraph´ and ´number of words of the risk paragraph´ is 0.966. Moreover, the variables that measure the length of the risk paragraph are all highly correlated with the variables that measure the frequency of certain words.
This multicollinearity is not surprising, since all variables measure either the risk paragraph´s length or the frequency of words. For this paper, it is important to include all of the variables because each variable separately contributes to the study’s result, and including all of them gains us a better understanding of the readability of Chinese and Dutch risk paragraphs.
This is in line with Allayannis, Ihrig and Weston (2001), who also encountered high
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sentences of the risk paragraph’, it can be concluded that Chinese risk paragraphs are less extensive than Dutch risk paragraphs.
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Before continuing with the main analyses, it is interesting to conduct a mean comparison for the Netherlands and China, represented in Table 4. This table indicates that the mean score for the Flesch readability formula for the Netherlands is 19,858, while the score for China is 24,336. Moreover, regarding the FOG readability formula, a mean score of 167,831 for the Netherlands is presented in Table 4, while China has a FOG score of 21,012. A lower Flesch score indicates a text which is better readable, while a lower FOG score indicates a text which is harder to read. The lower Flesch score for the Netherlands in comparison to China therefore gives a first indication that the Chinese risk paragraphs are harder to read than the Dutch risk paragraphs. Moreover, the significantly higher FOG score for the Netherlands in comparison to China confirms this result that Chinese risk paragraphs are harder to read.
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Table 5 shows the results from the univariate regression analyses used to test the hypotheses, which have been conducted for all the variables. It can be concluded from Table 5 that the independent variable (country; the Netherlands vs. China) has a significant effect on eight dependent variables, with the significance level ranging from 1% to 10%. These eight dependent variables are: ‘number of characteristics of risk paragraph’, ‘number of characteristics per word’, ‘number of syllables per word’, ‘average sentence length’, ‘Flesch’, ‘FOG’, ‘number of times financial is mentioned’, and ‘number of times risks is mentioned’.
From the results presented in Table 5, I conclude that the independent variable (‘country’) does explain the variance in several dependent variables. There are five dependent variables with a large adjusted R², ranging from 0,180 to 0,279. These five dependent variables are: ‘number of characteristics per word’, ‘number of syllables per word’, ‘average sentence length’, ‘FOG’, and ‘number of times risks is mentioned’.
Several conclusions can be drawn from Table 5. First of all, shifting from the Netherlands to China (from ‘0’ to ‘1’) has a significant negative effect on the ‘number of characters of the risk paragraph’ (at a 5% significance level), indicating that Chinese risk paragraphs comprise less characters than the Dutch risk paragraphs. At the 1% level, this movement towards China has a significant positive effect on the ‘number of characters per word’ and ‘average sentence length’, signifying that Chinese risk paragraphs comprise more characters per word and that, on average, the sentences of Chinese risk paragraphs are longer.
Another result is a significant negative effect of ‘country’ on ‘number of syllables per word’, indicating that Chinese firms use less syllables per word than Dutch firms do. Also, a significant negative effect on the 10% level can be found for the effect of ‘country’ on ‘number of times that ‘financial’ is mentioned’, which indicates that Dutch firms mention the word ‘financial’ more often than Chinese firms. The same result (at a 1% significance level) can be observed for the number of times that ‘risks’ is mentioned, meaning that Dutch firms mention the word ‘risks’ in their risk paragraphs a lot more than Chinese firms do.
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Netherlands. Since a lower Flesch score indicates a text that is easier to read, this result indicates that Chinese risk paragraphs are harder to read than Dutch risk paragraphs.
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In order to be able to consider the effect of multiple variables at the same time, a one-way multivariate analysis of variance (MANOVA) can be conducted. This test allows more than one dependent variable and one independent variable, as is the case in this sample. Table 6 shows the results from the MANOVA test. Based on the MANOVA test results derived by combining the thirteen dependent variables together, the null hypothesis should be rejected. The null hypothesis argues that there is no difference between Chinese and Dutch risk paragraphs. Based on the statistically significant result (at a 1% significance level) of the MANOVA test, I reject that the two countries (the Netherlands and China) have the same practices of risk management
disclosure. The partial eta squared value of 0,754 indicates that about 75% of the variability across all thirteen dependent variables is being accounted for by the two countries.
TABLE 6 – RESULTS MULTIVARIATE ANALYSIS OF VARIANCE (MANOVA)
4.2 Interviews
Several conclusions can be drawn from the interviews conducted. First of all, both interviewees (one being a senior manager at Ernst & Young Shanghai, and the second respondent being a financial controller at a big international chemical company based in Shanghai), have
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that a company’s risk paragraph’s content and its amount of disclosure depend on the country in which the company is operating.
It was argued by the senior manager of Ernst & Young Shanghai that the disclosure of Chinese companies mainly focuses on operational risks, while it should include more information on risks they encounter in their industry environment. In general, Chinese companies do not extensively elaborate upon their industry environment and governance in their annual reports. Additionally, she argued that Chinese companies are politically sensitive to disclose their limitations and risks.
4.3 Analysis of results
In this paragraph, the results described in the previous paragraphs are analyzed and interpreted. The first hypothesis states that risk paragraphs of Dutch listed companies are easier to read than risk paragraphs of Chinese listed companies. By comparing the FOG and Flesch scores of both countries, I found that risk paragraphs of Chinese firms are less readable than the risk paragraphs of Dutch firms. Based on the additional results of the statistical analyses outlined above,
hypothesis 1 is supported. Risk paragraphs of Dutch companies are easier to read than risk paragraphs of Chinese companies. This result is consistent with the research of Courtis (1995), who found that Hong Kong annual reports were classified as very difficult-to-read literature, while American and Canadian annual reports were only classified as difficult to read.
My findings also support hypothesis 2, stating that the frequency of words indicating risks is higher in risk paragraphs of Dutch companies than in risk paragraphs of Chinese companies. Only the word ‘market risk’ was on average mentioned more frequently in Chinese risk
paragraphs. However, only six out of the eighty observations mentioned ‘market risk’ more than ten times, indicating that this measurement is the least relevant. The four other variables
measuring word frequency all indicate a higher amount of words about risks to be found in the Dutch risk paragraphs. Moreover, the results about the length of the risk paragraphs support hypothesis 3. Risk paragraphs of Dutch companies are more extensive than risk paragraphs of Chinese companies, so I accept the third hypothesis as well.
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Dutch risk paragraphs, and Dutch risk paragraphs are more extensive than their Chinese counterparts. Following from this, hypothesis 4 can also be supported, stating that Dutch
companies disclose more information about (possible) risks they face than Chinese companies do. Now, the sixth research question can be answered. The question was: ‘Are there any differences in risk management disclosure between Chinese listed and Dutch listed companies?’ Following from the analyses outlined above and the fact that all four hypotheses have been supported, the answer on this question is that there are in fact differences in risk management disclosure between Chinese listed and Dutch listed companies.
This finding is confirmed by the interview results, where the Chinese respondents both stated that there are differences between Chinese annual reports and annual reports of other countries. More specifically, differences in the risk and financial parts between different companies were
