Information asymmetry (between managers and investors; between different types of investors) raises the demand for corporate information which is critical for the efficient allocation of available resources therefore for the functioning of an efficient capital market. Companies provide information thorough several forms such as regulated financial reports (mandatory and audited), voluntary communications and disclosures (e.g. press releases, media, company’s website, and presentations for analysts). In addition financial intermediaries (e.g. financial press, analyst, experts) also provide information about companies. (Healy and Palepu, 2001; Bushman and Smith, 2001; Figure 2.2)
Figure 2.2: Financial and information flows in a capital market economy
source: Healy and Palepu, 2001, p408
Thus, beside other forms, companies provide information thorough their mandatory and audited financial reports. (Healy and Palepu, 2001; Bushman and Smith, 2001) However, considerable managerial discretion and a great deal of professional judgement was / is allowed how the accounting standards were / are applied by the companies in generating
financial reports. Companies with different characteristics apply different accounting policies. (Watts and Zimmerman, 1986; Jensen and Meckling, 1976)
IFRS 8 sets out disclosure requirements for the companies. However, the application of the standard, the compliance with its requirements and the disclosure of any voluntary segment information (together the company’s disclosure practice) depend on the companies’ disclosure policy. The managers’ perceptions of advantages / benefits and disadvantages / costs associated with segment disclosure influence their interpretation of segment disclosure standards and the level of segment disclosure (quality, compliance) they provide.
“…a single universally accepted basic accounting theory does not exist at this time. Instead, a multiplicity of theories has been – and continues to be – proposed” (AAA, 1977, p3)
“Disclosure is inherently a complex phenomenon, and a single theory can only give a partial explanation”. (Hope, 2003a, p220)
Disclosure studies suggested several theories to explain the motivations behind the companies’ disclosure practice. Agency, signalling, capital need, political cost, proprietary and regulation theories are the most common theories to explain the differences in disclosure practice of companies and in their level of compliance with IFRSs. (Figure 2.3) These theories and findings of previous empirical studies (Section 2.4) are used to develop hypotheses in this thesis as well. (Section 5.4 and Section 6.2.) A brief summary of the above mentioned theories is provided in the following part of this section.
Agency theory
Jensen and Meckling (1976) define “an agency relationship as a contract under which
one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authorities
to the agent”. (p5) They argue if the parties are utility maximisers the agents (managers)
do not always act in the best interest (maximise the welfare) of the principals (owners, creditors). Agency costs incur to solve this “agency problem”. However, these costs can be reduced by audited accounting reports and information disclosed in these reports. Financial accounting information provides input to both internal (e.g. managerial incentive plans) and external (e.g. shareholder and debt holder monitoring, competition,
laws protecting outside investors) control mechanisms. (Jensen and Meckling, 1976; Bushman and Smith, 2001) It can be argued that increased disclosures reduce agency costs (negative relationship).
Figure 2.3: Theories to explain the motivation behind the companies’ disclosure practice
Segmental reporting is an important source for users to better understand and evaluate the performance of diversified companies. However, managers have both the incentives (the importance of segment disclosures to investors, lower cost of capital, reduced market riskiness, better prediction of future earnings etc.; Section 2.4.5) to disclose better quality segmental disclosure7 and the opportunity to hide (segment definition, materiality level, cost allocation between segments etc.) unresolved agency problems (e.g. poorly performing business or geographical segments, managerial empire building). (Section 2.4.3) Research found evidence that managers use segment aggregation (Berger and Hann, 2002 and 2007; Wang et al., 2011) and segment level earning management (Hann and Lu, 2009) when disclosing segment information. More disaggregated information can
7 e.g. more disaggregated, more items by segments, higher level of compliance etc.
Company's disclosure practice Regulation & Enforcement Capital need theory Signalling theory Political cost theory Proprietary theory Agency theory
attract greater external monitoring by revealing a company’s diversification strategy, resource allocation between segments, and underperforming segments. (Berger and Hann, 2002 and 2003) Earning management of segment profits (by e.g. allocating overhead cost between segments, Hann and Lu, 2009; cross-segment resource transfers, Wang and Ettredge, 2014) could limit the monitoring usefulness of segment disclosures by concealing information from users. It can be argued that when segmental disclosure quality is reduced the shareholders ability to monitor managers and their actions decreases as well. (Hope and Thomas, 2008)
Proprietary theory
The purpose of disclosure is to reduce information asymmetry. Agency, signalling, capital need and political cost theories generally suggest that companies are motivated to disclose more information in their financial statements and to comply with mandatory disclosure requirements of accounting standards. However, disclosures to external users may also include proprietary information (“information whose disclosure reduces the
present value of cash flows of the firm endowed with the information”; Dye, 1986, p331)
which could be also observed and used by the company’s current and potential competitors or any other party (e.g. dissident shareholders, employees, tax authority) to the disadvantage of the disclosing company. Therefore, when deciding how much information to disclose, companies face a trade-off between the benefits of disclosing information to capital markets (incentives to reveal) and the cost of revealing proprietary information (incentives to conceal). (Dye, 1986; Hayes and Lundholm, 1996; Leuz, 2004)
However, capital market benefits and proprietary costs depend on whether the information is available elsewhere or not. Information on segments usually is not available elsewhere than in the companies’ financial statements. (Leuz, 2004)
Segment disclosure provided by companies is affected by the managers’ incentive to avoid potential harm and maintain competitive advantages. Segment disclosure studies indicate that the level / quality of segment disclosure is limited by the proprietary cost associated with the disclosure of more detailed information to the market. Companies use less detailed and lower quality segment disclosures (e.g. greater segment aggregation, Berger and Hann, 2002, Botosan and Stanford, 2005; less item per segment, Pisano and Landriana, 2012; smaller cross-segment variability of reported profits, Ettredge et at.,
2011; greater difference between aggregated segment earnings and corporate level income, Wang and Ettredge, 2014; smaller percentage of revenues disclosed by individual foreign countries, Tsakumis et al., 2006; non-disclosure of information about major customers, Ellis et al, 2012) to protect proprietary information and deter entry by competitors (Nagarajan and Sridhar, 1996; Schneider and Scholze, 2011). Additionally, there seems to be a positive relationship between the levels of competition on the market and the level / quality of segmental information disclosed by the companies. Thus, companies operating in more (less) competitive industries more likely to provide more (less) segmental information because the higher (lower) level of competition may decrease (increase) the competitive harm associated with segment disclosure (e.g. Hayes and Lundholm, 1996; Harris, 1998; Botosan and Stanford, 2005; Birt et al., 2006; Pisano and Landriana, 2012) (Section 2.4.4)
Regulation and Enforcement
Accounting and accounting profession are subject to many regulations such as Accounting Standards, Companies Act, Stock Exchange regulations, EU Regulations etc.. Since 01 January 2005 all group financial statements of listed companies in member states of the EU must comply with the IASs / IFRSs set by the IASB and endorsed by the EU. The IASB adopted a principles based approach where the basic question is whether the accounting policy applied by a company complies with the intention behind the regulation or not. (Gaffikin, 2005) The regulatory requirements will not result in quality financial reporting if the companies do not comply with the rules. Thus, de facto compliance with the requirements of an accounting standard is just as important as the accounting standard itself.
Researchers suggested that the monitoring and enforcing mechanism (effective company control systems, independent auditor, oversight body) of IFRSs requirements are important components of the implementation of accounting standards. (e.g. Brown and Tarca, 2005; Street and Bryant, 2000; Glaum and Street, 2003; Prather-Kinsey and Meek, 2004; Hodgdon et al., 2009) However, the question is how effective is the enforcement of the regulations?
It is well documented by research that there is considerable non-compliance with IASs / IFRSs requirements. The results from these studies also indicated that the compliance with IASs / IFRSs requiring the disclosure of more proprietary information was usually
below the average level of compliance. (Street and Bryant, 2000; Al-Shammari et al., 2008; Tsalavoutas, 2011) Segmental reporting is one of the areas of particular concern. (Street and Bryant, 2000; Street and Gray, 2001 and 2002; Al-Shammari et al., 2008; Tsalavoutas, 2011; Crawford et al., 2012a; Nichols et al., 2012; Pisano and Landriana, 2012; Pardal and Morais, 2011; Mardini, 2012) Thus, the implementation of high quality global standards many not necessarily lead to high quality, comparable reporting.
Political cost theory
Along with other theories political cost hypothesis is suggested to explain the financial disclosures of the companies. Watts and Zimmerman (1978) argue that politicians have the power / authority to affect the wealth re-distribution of the companies by taxes, regulations, contributions etc. (political costs). The authors argued that politicians and government bureacrats are responsible for regulating financial reporting and they are influenced by the likelihood of being blamed for any future crisis. Many crises have led to changes in corporate regulation and, in particular, to increased regulation in financial reporting (e.g. the Sarbanes-Oxley Act 2002 in the US was a reaction to a number of high profile corporate and accounting scandals including e.g. Enron and WorldCom). Additionally, certain groups of people have incentives to lobby for the “nationalisation,
expropriation, break-up regulation of an industry or corporation”. (p115) This provides
incentives to politicians to suggest these actions in order to reduce the pressure. The expected degree of political costs is subject to a company’s size, profitability and its industry. It is argued that larger, more profitable companies and companies belonging to special industries (e.g. oil and gas companies) are more politically visible and are subject to potentially greater wealth transfers from government interventions. Therefore, to reduce the expected political costs, the managers of these companies (among other things such as social responsibility campaign in the media, lobbying, selection of accounting policies etc.) have greater motivation to disclose more information than the managers of smaller, less profitable companies and companies in other industries. (Watts and Zimmerman, 1978, 1986, 1990) This suggests a positive relationship between political costs and disclosure quality.
However, Wallace et al. (1994) and Wallace and Naser (1995) argued that comprehensive disclosure may trigger political action. Additionally, it can be argued that the preparer’s desire to conceal the companies’ tax avoidance can also negatively influence the companies’ disclosure quality. (Hanlon and Heitzman, 2010; Hope et al., 2013) Thus,
companies may disclose less information to limit political interest and actions. It makes difficult to predict the sign of the relationship between the company’s disclosure quality and political costs.
Signalling theory (Legitimacy theory)
Signalling theory shows how information asymmetry can be reduced by the party with more information providing it to others. (Morris, 1987) Signalling through Financial Statements can be used by managers to signal their expectations and intentions, to reassure the market and to distinguish themselves from lower quality firms (Hughes, 1986, Lev and Penman, 1990, Watson et al., 2002). Companies may disclose information to sustain and legitimise corporate actions and relationships by presenting themselves as responsible corporate citizens (legitimacy theory). (Adams and Roberts, 1995) Watson et al. (2002) argue that “signalling theory can borrow from legitimacy theory the notion
of signalling legitimacy”. (Watson et al., 2002, p293) Thus, in this study legitimacy
theory is not considered as a separate theoretical background to explain the companies’ disclosure quality.
Capital need theory
Companies compete in the capital market to raise capital (equity or debt instruments) as cheaply as possible. Capital need theory suggests that one of the main motives of financial disclosure is to address the information needs of the capital market users (shareholders, debt providers, financial analysts etc.) and reduce their uncertainty with respect to the company’s present and future. Research suggests that the precision, the quality, the quantity and the timeliness of disclosed financial information reduces the cost of equity capital by reducing information asymmetry (reduced information risk, estimation risk, transaction costs and enhanced stock market liquidity). (Choi, 1973 and 1974; Dhaliwal, 1979; Dhaliwal et al., 1979; Elliott and Jacobson, 1994; Botosan, 1997; Leuz and Verrecchia, 2000; Botosan and Plumlee, 2002; Easley and O’Hara, 2004; Botosan, 2006; Cheng et al., 2006; Lambert et al., 2007; Saini and Herrmann, 2011) Companies disclose more information to reduce investor’s uncertainty with respect to the company’s present and future.
Theories, and the findings of prior literature, can help to derive possible factors associated with the companies’ segment disclosure practice and their compliance with the disclosure requirements of IFRS 8 and from testable hypotheses (Section 5.4 and 6.2).
The theories summarised in this section were used by most of the researchers to study the companies’ segmental disclosure practice and to explain variation in segmental reporting disclosures. However, in these studies generally more emphasis is given to agency (Section 2.4.3), proprietary (2.4.4) and regulation (5.2) theories than to signalling, capital need and political cost theories. The studies and their findings are introduced in the next section. (Section 2.4)