An Empirical Research on Financial Reporting and Disclosure Decisions


According to Healy et al. (2001), how capital markets function efficiently relies on corporate disclosures. Firms provide disclosure through regulated financial reports, including the financial statements, footnotes, management discussion and analysis, and other regulatory filings" (Healy et al, 2001). Managers make use of financial reporting and disclosure decision to inform investors of the performance and control of the firm. Other than the mandatory disclosures, managers have the option as well to engage voluntary disclosures, which consist of such things as management forecasts, analysts' presentations and meetings, press releases, internet sites, and other corporate reports.

Managers' options for disclosing come in the form of either mandatory or voluntary disclosures. Consistent to the literature on managerial disclosure decisions, the section two of this paper has been split into two parts; a) focusing on positive accounting theory and b) voluntary disclosures. Positive accounting theory deals with more on the mandatory financial disclosures and looks at the financial reporting choices of managers that affect the financial reports. Whereas empirical evidence on motivation for managers to voluntarily disclose looks more at the stock market implications of disclosure, examining six hypotheses for why managers disclose voluntarily.

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This paper will focus on evaluating the current literature and empirical evidence on managerial reporting and disclosure decisions. In addition, it will address the questions on manager disclosure decisions found in the review of disclosure literature by Healy et al. (2001). Discussion will be given to the factors that motivate management's disclosure decisions, and explanation will be given to the relationship between disclosure, corporate governance, and management incentives. Brief consideration is given to the role of boards and audit committees in making the disclosure process more credible. The available evidence on managerial disclosure decisions is dominated by the studies of US firms. To supplement US evidence discussion will be given on results in Hong Kong and any future opportunities for study on managerial disclosure decisions.

Here comes the basic outline of this paper. In Section 2, literature review on positive accounting theory and accounting choice are explored, then in Section 3 the empirical evidence is described on voluntary disclosures. In Section 4, the evidence of managerial disclosure decisions is established. In Section 5, a review on any possible opportunities for future empirical disclosure research in Hong Kong whereas the conclusion lies in Section 6.

2. Literature Review on Positive Accounting Theory Literature

The literature review on positive accounting theory is mainly concerned with the motives behind managerial decisions that go with a particular form of accounting choice. According to Fields et al. (2001), "an accounting choice is any decision whose primary purpose is to influence (either in form or substance) the output of the accounting system in a particular way, including not only financial statements published in accordance with generally accepted accounting principles (GAAP), but also tax returns and regulatory filings". Research into the implications of accounting choice date as far back as the 1960's and the relevant literature can be categorized by the following goals or motivations; a) agency costs, b) information asymmetries, and, c) externalities affecting non-contracting parties. (Fields et al., 2001)

By aligning the incentives of managers and shareholders, the agency costs could be reduced by using the contracts such as executive compensation arrangements and debt covenants. In other words, contracts are entered into so that the agent behaves as if he or she were maximizing the welfare of the principal. However, it is apparent that ex-post accounting choices can be made that increase executive compensation and avoid violation of debt covenants (Fields et al., 2001). Say for an example, managers may choose one form of measuring inventory over another or various other accounting choices that increase reported earnings and, hence, provide them with personal benefits from earnings-based compensation. Alternatively, the opposite may be done so as to reduce the present value of taxes.

Although, certain forms of accounting choice may provide opportunities for managers to bridge the information gap about the magnitude, timeline, and risk of future cash flows. Information asymmetries stem from markets that do not aggregate the information sets held by managers and shareholders. It is often alleged that managers act purely on self-interest and instead prefer to have higher earnings prevail so that they can be remunerated accordingly and to increase their reputation. For example, managers can make certain choices to assure they meet an analyst forecast in an attempt to avoid negative stock price reactions (Levitt, 1998; cited in Fields et al. 2001).

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Lastly, external parties are deemed not to be the actual and potential owners of the firm, rather organizations such as the Inland Revenue Department (IRD), or government regulators, suppliers, competitors and/or labor unions. Managers through their accounting choices hope to influence external parties in a way that will be beneficial to them. For example, the information obtained from the accounting numbers may help managers to lobby for an accounting standard that reduces compliance costs of the firm. The following paragraphs elaborated more on accounting choice is structured around the goals and motivations for accounting choice described above.

2.1 Contractual Motivations

Results suggest the presence of incentives to increase manager compensation and reduce the likelihood of violating bond covenants (Fields et al., 2001). Many researchers have studied whether such contracts provide managers with an incentive to use specific accounting choices in an attempt to reach desired financial reporting objectives. Often management compensation contracts and bond covenants that are used to mitigate the internal and external agency conflicts are based on reported financial accounting numbers.

2.2 Internal Agency Conflicts - Executive Compensation Contracts

A large number of studies beginning with supported the idea that allowing compensation contracts where managers get to hold equity in the company would closely align the managerial interests with that of shareholders (Jensen and Meckling, 1976). Resulting increases in the use of incentive compensations as a form of remuneration meant that empirical research into executive compensation contracts has been vast. Manager's remuneration is generally made up of a base salary and incentive compensation.

The presence of accounting choice in compensation contracts explained by efficient contracting creates a trade-off. According to Watts and Zimmerman (1986) even though financial reporting discretion provides incentives to increase executive compensation, it should be weighed up against improved alignment of the two parties' interests. Despite the negative aspects flowing from accounting discretion, the higher earnings that increase compensation can in turn create higher share values and lessen the chance of breaching bond covenants.

It is a common belief of researchers that managers sometimes become opportunists. Healy (1985) introduced the argument that managers use discretionary accruals to receive bonuses in both current and the following period. The work conducted by Healy (1985) discusses how managers shift income from period to period in order to stay within the confines of upper and lower earnings bounds to receive bonuses. This study became the benchmark for many other studies on compensation. Following Healy (1985), research by Gaver et al. (1995) found that managers only used discretionary accruals when earnings slipped outside the lower bounds and did not apply them when earnings moved above the upper bound. Research suggested otherwise, where he explained the use discretionary accruals are in fact a case of income smoothing.

Numerous studies show us that when a new CEO is about to take over there is the incentive to reduce the current years' earnings so that in the succeeding years earnings appear inflated and enhance the reputation of the incoming CEO (Strong and Meyer, 1987; Elliot and Shaw, 1988; Pourciau, 1993; Francis et al., 1996). Along the thinking logic, Dechow and Sloan (1991) cited in Fields et al. (2001) established that when a CEO is close to finishing, less is invested in research and development due to the short-term incentives that bonus contracts present.

In summary, the literature review on executive compensation contracts suggests that managers may use accounting choices to work in their favor because of the incentives created by bonus plans. That is to say, accounting based contracts have the potential to induce managers to act in ways that will increase their personal gain at the expense of overall shareholders' benefits.

2.3 External Agency Conflicts - Bond Covenants

Along with executive compensation contracts, debt contracts are another contractual form that received widespread attention. Researchers opted for two approaches to testing the impact of bond covenants on accounting choices. The first is best known as the 'debt hypothesis' and it originates from the idea that managers make accounting choices to avoid violating covenant abuse. The second involved researchers investigating the firms that are more likely to be adversely affected by mandated accounting changes, however, this form of testing lost support in the 1980's.

A study conducted by Sweeney (1994) shows that when firms are in close proximity to defaulting on their debt covenants, they react by selecting accounting choices that increase income. In addition to this study, DeFond and Jiambalvo (1994) also confirmed the 'debt hypothesis'. However, their results showed that leading up to and immediately following the violation of debt covenants the sampled firms manipulated accruals rather than making specific accounting method changes, this is thought to be because it is less expensive to manipulate accruals than to make complete accounting method changes.

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According to Fields et al. (2001) the confirmation that accounting choices are motivated by debt covenant concerns is inconclusive. The studies conducted on debt contracts support the theory of 'debt hypothesis', however, Fields et al. (2001) points out that the majority of these studies are also consistent with other hypothesis. Despite it being difficult to derive the exact impact of debt covenants on accounting choice, there are a large number of studies that show some form of relationship between accounting choice and violation of debt covenants cannot be ignored.

2.4 Asset Pricing Motivations

A further category of accounting choice literature looks at the relationship of accounting numbers to stock prices, testing whether accounting choice affects a firm's cost of capital. Managers could be using various forms of accounting choice such as smoothing earnings; avoiding losses; or avoiding earnings decline that influence stock prices (Fields et al. 2001).

A number of studies conducted have examined broadly at the relationship of share prices with earnings management. Erickson and Wang (1999) found that when firms use stock as a form of payment, the firm is more likely to manage earnings upwards so that when the acquisition takes place it will not involve as many shares. A study conducted by Kasznik (1999) shows that in times when managers issue an earnings forecast they tend to manage reported earnings towards the initial forecast. In addition, numerous studies provide the belief that opportune managers will manage earnings (Perry and Williams, 1994; DeAngelo, 1986).

2.5 Motivation Due to Impact on Third Parties

In times when external parties to the firm rely on accounting numbers, managers have an incentive to select accounting choices that influence their disclosures and hence have a positive affect for them on third parties. It is commonly agreed that the motivation behind such practices is to either reduce taxes or to defer them to later periods, and to avoid the introduction of new regulation otherwise known as political costs.

The involvement of multiple incentives and multiple accounting methods make it difficult to interpret the results of research into both tax and regulations. There is however, overwhelming evidence that managers implement accounting choices that will reduce their tax burden (Guenther, 1994; Dhaliwal and Wang, 1992). Results for tax incentive research are not surprising because reducing the tax burden is likely to be at the forefront of the manager's mind and the opportunity to reduce tax through accounting choice is not likely to be missed.

A study into the affect of accounting choice on regulation has tended to take an industry-specific approach. For example, Han and Wang (1998) investigate the oil and gas industry and they found that in times of rising gas and oil prices managers are likely to use accounting choice to reduce their income and often hold back on reporting good news. In addition, Blacconiere and Patten (1994) looked at the impact of disclosure levels for chemical firms on stock prices at the time of a chemical leak. They found that the firms that choose to have higher levels of environmental disclosures before the chemical leak were not affected as much as the firms with limited environmental disclosures.

3. Voluntary Disclosures

The research of voluntary disclosure investigates the motives that stock markets create for managerial accounting and disclosure decisions and provides support to the positive accounting literature (Healy et al., 2001). Studies have shown that information asymmetries prevail and that often managers have access to superior knowledge than the current and potential investors. When imperfect markets exist "managers trade-off between making accounting decisions and disclosures to communicate their superior knowledge of firm's performance to investors, and to manage reported performance for contracting, political or corporate governance reasons" (Healy et al., 2001). Empirical research hypothesis also unveiled capital market transactions, stock compensation, litigation cost, corporate control contest, management talent signaling, and proprietary cost as six motives behind disclosure decisions for capital market reasons.

3.1 Capital Market Transactions Hypothesis

Close to the time when firms are about to issue public debt or in mergers and acquisitions, what the investors perceive can be extremely important and it is therefore not unlikely for managers to increase voluntary disclosures to close the gap caused through information asymmetries, subsequently lowering the cost of external finance (Healy et al., 2001).

Various studies detailed the voluntary disclosure approaches of managers at times when new capital is issued. Lang and Lundholm (2000) investigated the corporate disclosure activity around seasoned equity offerings and its relationship to stock prices. They found that firms that maintain a consistent level of disclosure experience price increases prior to the offering, and only minor price declines at the offering announcement relative to the control firms, suggesting that disclosure may have reduced the information asymmetry inherent in the offering. Firms who increase their voluntary disclosures 6 months prior to the issue date also experience price increases prior but much larger declines afterwards. This is perceived to be because the voluntary disclosures used were to hype the stock and the market later corrects the price.

3.2 Stock Compensation Hypothesis

It is very common for executives to be compensated with a base salary and on stock prices too. Core and Guay (2001) produce figures that show stock options as a form of executive remuneration more than doubled in the late 1990's from what they were in the 1980's. Management incentives to voluntarily disclose information are justified firstly to reduce contracting costs and secondly to meet the restrictions imposed by insider trading.

Studies show that the occurrence of management forecasts is positively associated with insider trading. In addition, firms withhold good news and instead release bad news earlier when approaching stock option award periods. The accelerated disclosure of bad news is consistent with the stock compensation hypothesis because such disclosures are made to increase the personal gains of managers through stock-based compensations (Noe, 1999; Aboody and Kasznik, 2000; cited in Healy and Palepu, 2001).

3.3 Litigation Cost Hypothesis

The literature proposes two effects of threats from shareholders of litigation against management. Firstly, voluntary disclosures may be used to remove opportunities for legal actions against managers for inadequate or untimely disclosures. Conversely, the possibility of litigation could cause the manager to withhold disclosures of forward-looking knowledge (Healy et al., 2001).

Healy et al. (2001) note that the majority of research is into the first of the two effects on litigation. Skinner (1994) cited in Healy et al. (2001) investigated manager attempts to remove litigation risk. Results strongly suggest that bad news firms are more likely to make early voluntary disclosures than firms who will disclose good news, firms presenting reduced earnings are more likely to be sued, and even pre-disclosing information will not reduce the costs of litigation.

3.4 Corporate Control Contest Hypothesis

The board of directors in some cases can be held responsible by investors based on stock price performance. Additionally, corporate takeovers have been linked to poor stock price performance. With this in mind, corporate control contest hypothesis explains that managers use voluntary disclosures such as early recognition of an anticipated poor earnings performance to avoid possible job loss. According to Healy et al. (2001) there has been little empirical evidence to support this theory except to say that voluntary disclosures emerge more often in times of contested takeover bids.

3.5 Management Talent Signaling Hypothesis

Corporate managers frequently release an internally generated forecast of quarterly or annual earnings announcement. The market value of the manager's firm is a function of investors' perceptions of the manager's ability to anticipate future changes in the firm's economic environment and alter the firm's production plan accordingly. The earlier that investors infer that the manager has received information, the more favorable will be their assessment of the manager's ability to anticipate future changes and the higher will be the firm's market value and the level of the manager's compensation. In other words, managers have incentives to increase their voluntary disclosures in an attempt to signal their talent and increase their individual remuneration packages (Trueman, 1986). This is however no empirical evidence so far to confirm or deny this hypothesis (Healy et al., 2001).

3.6 Proprietary Cost Hypothesis

Several academics hypothesize that managers are likely to reduce voluntary disclosures because they believe to disclose too much information would significantly affect the firm's competitive edges in the market even if this means that the cost of added finance increases. The proprietary cost hypothesis is considered to be separate from that of the previous five as it assumes that the interests of shareholders and managers are the same. There is little direct empirical evidence to support the proprietary cost hypothesis (Healy et al., 2001).

In summary of the credibility of voluntary disclosures, the degree to which voluntary disclosures assist in bridging the gap caused by information asymmetries is dependent on the credibility of such disclosures. Given the vast range of incentives that can influence a managers disclosure decisions becomes hard to interpret the levels of credibility possible.

The literature review assumes two possible ways to provide credibility to voluntary disclosures. Firstly, third-party intermediaries can provide assurance on voluntary disclosures. Secondly, past voluntary disclosures can be validated through financial reporting itself. Say for an example, checking if earnings match management earnings forecasts. Most of the confirmation of credibility look at the accuracy of management forecasts and there affect on stock prices. At this point, auditors play an important role in this area as research "suggests management forecasts have comparable credibility to audited financial information" (Healy et al., 2001).

4. Evidence in Hong Kong

Hong Kong presents the general legal and financial reporting framework and identifies the major institutional players within the regulatory framework of Hong Kong. Being an international financial centre in Asia, Hong Kong differs from other Asian Pacific economies in that it exhibits both the Anglo-Saxon type of open market characteristics and the conventional type of Chinese family-orientation in ownership plus control in corporations. The legacy of the British rule after 1997 is still prevalent in business, accounting, financial and legal regimes. The government officials of the Hong Kong Special Administrative Region (HKSAR) have been vigilant in making the stock market more transparent and fairer to all investors, local or overseas, in order to upkeep and further promote Hong Kong as a financial centre (being the 2nd largest in Asia outside Japan).

On the other hand, the cultural environment in which Hong Kong firms operate (being dominated by Chinese people) does not encourage voluntary disclosure of corporate information (Chau and Gray, 2002; Chow, Chau and Gray, 1995). The influence of conservatism and tendency to secrecy of Chinese family-controlled firms, the growing demand for transparency, and the desire for internationalization of the market jointly make Hong Kong the ideal setting for empirically examining how firms behave in corporate governance disclosure within an open economy and the impact, if any, of such voluntary disclosure on firm's valuation.

Ho and Wong (2003) performed a survey of 98 preparers, it was found that preparers are more inclined to satisfy the information needs of external institutional finance suppliers than those of individual investors and financial analysts or stockbrokers. CFOs and CEOs have more influence on corporate disclosure policies and decisions than board chairmen and company directors. Although only a small percentage of preparers felt that the current disclosures were either effective or very effective in serving investors' needs, only a small number of them agreed to have more financial reporting and disclosure regulations. To close the communications gap and improve market efficiency, they suggested instead an improvement in investor relationships, developing more industry-specific disclosure guidelines and more voluntary disclosures.

For firms applying for a new stock exchange listing, earnings forecasts represent a substantial proportion of the information available about the organization to the public. However, provision of such earnings forecasts varies, with inclusion being rare in the United States and in Hong Kong.

5. Future Empirical Disclosure Research in Hong Kong

Studies that have been used in the US should be adopted and replicated in Hong Kong to see if the findings hold true for Hong Kong managers. For example, does the litigation cost hypothesis have applications in Hong Kong? Given the presence of the securities exchange commission (SEC) and strong threat of shareholder litigation in the US it is not surprising that managers would have incentives to voluntarily disclose poor performance earlier to avoid litigation. However, it is less likely that a manager in Hong Kong will be litigated against and therefore the litigation cost hypothesis becomes questionable in Hong Kong accounting setting.

Studies in the United States to date appear to investigate by singling out specific accounting issues and testing them in separate industries. Suggestion that in the future research in Hong Kong adopts an approach that considers prior US knowledge on the managerial motives behind particular accounting choices to help develop accounting standards that produce high quality information. Especially that Hong Kong is so close to adopting international accounting standards (IAS's). Healy et al. (2001) establishes some questions that are left unanswered and research in Hong Kong could be aimed at filling the information gap these create. For example, studies could be designed to determine the effectiveness of financial reporting and disclosure in Hong Kong or who should be given the job of validating voluntary disclosures?

Auditors play an important role in providing credibility for mandatory financial disclosures through the verification of financial statements. In my opinion, it is outside the scope of the auditor to determine the credibility of voluntary disclosures. As the literature review has shown, managers have various incentives for introducing voluntary disclosures. It would be beneficial if studies could address the credibility of voluntary disclosures and perhaps find a way to validate them so that investors are not having the wool pulled over their eyes, so to speak. Particularly now, as increasing social and environmental reporting has resulted in environmental disclosures that can be often difficult to quantify and interpret.

6. Conclusion

Manager discretion with respect to selecting accounting choices has received large interest in US accounting literature but investigations in Hong Kong are limited. Studies to date have focused on what motivates managers to choose one accounting option over another and the reasoning behind increased voluntary disclosure.

The underlying theme of managerial reporting and disclosure decisions is that managers have available to them the opportunities and incentives to employ personally beneficial accounting choices. For example, the contractual agreements involving executive compensation packages often remunerate managers on earnings or stock prices; hence managers have incentives to select accounting methods or choices that are likely to raise earnings or stock prices and their own compensation.

Motivation behind voluntary disclosure has led to the development of six hypotheses based on the incentives created by stock markets. Empirical research has been undertaken on these hypotheses and results show that managers are often likely to voluntarily disclose information to do things such as signal their talent, avoid the threat of litigation, or increase stock compensation.

Studies in Hong Kong have done little to support US evidence. In the future adopted and replicated studies of US corporations need to be undertaken in Hong Kong to determine if findings on managerial reporting and disclosure decisions hold true for Hong Kong firms. There are gaps in our information on management disclosure and many unanswered questions. I propose that the future should see that Hong Kong studies establish the effectiveness of financial reporting and disclosure in Hong Kong and to help organize accounting standards that produce higher quality information.