Prior evidence and hypotheses
Based on the theoretical framework primarily concerning information asymmetry, agency problem, signalling theory and political costs theory, many previous studies have attempted to formulate and test several hypotheses on the influencing factors of the company disclosure level. This section will review the findings of several prior researches as well as establishing hypotheses for the current study.
(1). One of the most remarkable features of Chinese capital market is assumed to be its unique market structure, which comprises of three major segments: A shares which are only sold to domestic citizens in domestic currency; B shares which are only issued for foreign investors in foreign currency, but traded in domestic exchange markets; and H shares which are traded in SEHK in foreign currency.
Given their different characteristics, such as listing market, listing requirements, accounting standards and reporting environment, their disclosure behaviours and disclosure policies are expected to vary systematically. Therefore, one of the basic intentions of the current study is to test whether companies, of which shares are belongs to the three different market segments, exhibit different disclosure patterns.
At a glance, foreign listing status is a major feature that distinguishes H shares-issuers from the other companies issuing only A or A+B shares. For this feature alone, compliance with Chinese GAAP and IFRS is mandatory for these Chinese firms that issue both A and H-shares. Accordingly, the IFRS-based annual report must be audited by an internationally recognized auditor; while the Chinese GAAP-based annual report may be audited by local accounting firms, and any difference in net incomes between these two sets of accounting information must be reconciled and presented in the financial statement. In that case, companies with A and H shares are subject to additional listing requirements as well as disclosure rules, consequently greater information disclosure can be expected from these companies than the other firms listed only in the domestic market.
Apart from regulatory requirement, H-share companies are also under greater market pressure to disclose more information. Assuming the primary objective for Chinese firms listing on international stock exchanges is to obtain capital at the lowest possible cost, they need to compete with the other SEHK-listed firms of which the westernized corporate governance systems are generally believed to be effective in terms of assuring a high quality financial report through proper internal control systems. Hard to deny that, comparing with other SEHK-listed firms, H-share PRC firms are commonly assumed to have significantly greater adverse selection and moral hazard problems due to their lack of prior trading history, the limited transparency of corporate governance and management control system, and foreign investors’ concern about the magnificent state ownership.
Given these disadvantages raised from information asymmetry and the potential economic consequence of increased discount rate, H-share firms should have greater incentives to commit to more intensive information disclosure in order to reduce their agency cost. Previous empirical study by Ferguson, et. al(2002) found that companies with both A and H-share issuing disclose substantially more financial information than purely domestically listed PRC firms as well as other SEHK listed companies.
On the other hand, it is generally observed that companies only listed on the domestic exchanges (including companies with only A shares and companies with both A and B shares) tend to adopt a relatively more secret disclosure policy, which exhibit little voluntary disclosure if any information beyond the exchange requirements (Haw et al., 2000). Ferguson, et. al (2002) offer several explanations: Firstly, the concept of public information disclosure is relatively new to both the investors and corporate managers in PRC where the basic systematic accounting standard was first promulgated since 1992.
Given the less developed market-oriented accounting system and the weak disclosure culture, Tang (2000) points out that comparing to other exchange markets with mature accounting systems, accountability to outside investors is less concerned by most Chinese corporate managers; also, the majority individual investors are unfamiliar with the evaluation and use of financial statement disclosures. Secondly, Ferguson, et. al (2002) argue that because the current capital market is experiencing the transformation from the formerly state-controlled economy to the new market model, there remains some old concerns of investors emphasizing on the state plan.
That is, local investors still tend to focus on “inside” information such as anticipated actions by the controlling government entities rather than relying on public information like financial statement disclosure (DeFond et al., 1999). Hence, corporations’ incentives and investors’ desire for information disclosure appear to be less strong for companies only listed on domestic market than firms listed on foreign exchanges; consequently, greater extent of information disclosure is expected for companies issuing both A and H shares than firms listed only on domestic market. The resulting hypothesises are as following:
H1: Companies with both H shares and A shares tends to disclose more information than companies issuing only A shares;
H2: Companies with both H shares and A shares tends to disclose more information than firms issuing both A and B shares.
The most important difference between A share and B share is that A-shares can only be owned and traded by Chinese citizens in Chinese currency, while B-shares can only be owned and traded by foreign investors in either Hong Kong currency or US dollars. Accordingly, the accounting regulations applicable to firms issuing only A shares is Chinese GAAP; while, for companies issuing both A and B shares are required to apply with Chinese GAAP as well as IFRS. The IFRS-based annual report must be audited by an internationally recognized auditor, while the Chinese GAAP-based annual report may be audited by local accounting firms, and the discrepancy between the two sets of audited financial reports needs to be reconciled with the IFRS and displayed in the annual report for domestic investors.
Because of the different regulatory requirements, companies with both A-share and B-share issuing are expected to disclose more information than firms with only A shares. Since comparing with smaller CPA firms, which are assumed to be more sensitive to client demands due to the economic consequences associated with the loss of a client, larger and international well-known auditing firms have a greater incentive to maintain independence from clients' pressure for limited disclosure because of the economic consequences associated with potential damages to their reputation (Chow and Wong-Boren, 1986).
Therefore, larger CPA firms have a greater incentive to require adverse disclosures by the client, consequently increasing the level of information disclosure (Patteon and Zelenka, 1997). In contrast, accounting information audited by domestic auditing firms may be considered noisy because of sloppy information environment and inadequate regulation. (Fox, 1998; Rask, Chu, & Gottschang, 1998). Prior to 1996 no auditing standards existed with the exception of a few guidelines from the sponsoring governmental agencies; and until 1998 all domestic auditors were public employees, who tend to act as government agents and bore little responsibility for any improper behaviour due to the lack of litigation against them.
Thus, auditors usually were affiliated with their clients and lacked motivation to be independent from them, consequently information disclosure may be subject to management’s selective bias.
Despite of the recent institutional changes such as the reformation of the accounting-information system and the introduction of new auditing standards, which aims to impose stricter disciplinary rules, more intensive monitoring and sanctions, the effective implement of regulatory is still doubt by the market (Haw, 2008). Therefore, companies with only A shares are likely to make less information disclosure than companies with both A shares and B shares of which annual reports are influenced by internationally recognised auditing firms. The resulting hypothesises is:
H3: Companies with only A shares are likely to make less information disclosure than companies with both A shares and B shares.
(Ferguson, Lam and Lee, 2002)
2.4 Disclosure by PRC-listed Firms
PRC firms listed on the two domestic exchanges voluntarily disclose little, if any information beyond the exchange requirements (Haw et al., 2000). Explanations include (1) the lack of sophistication with respect to financial reporting on the part of both investors and corporate managers, and (2) investor reliance on “inside” rather than public information. Public financial statement disclosure is relatively new to the PRC. The first basic accounting standard was promulgated in 1992 and, of the 30 standards proposed in the intervening years, only eight have been adopted.
Thus, accountability to outside investors is new to most corporate managers, and most individual investors are unfamiliar with the evaluation and use of financial statement disclosures (Tang, 2000). Institutional investment in the PRC is in a fledgling state. Local investors are also likely to place greater weight on factors such as anticipated actions by the controlling government entities than on financial statement disclosures (DeFond et al., 1999). Thus, demand for, as well as supply of additional disclosures may be limited in the PRC domestic exchanges. The disclosure practices of PRC firms listed on international exchanges, in which they face sophisticated financial statement users with diminished access to inside information, have not been examined.
2.5 Hypotheses: Disclosure by H-Share Firms on the SEHK
Theory (Spence, 1973; Grossman, 1981) indicates that voluntary disclosure can be used to alleviate information asymmetry problems, including moral hazard and adverse selection. A rational strategy to avoid deep discounting of share prices is to disclose additional information to investors to signal firm value (Watts and Zimmerman, 1986). Compared to other SEHKlisted firms, H-Share firms are likely to present significantly greater adverse selection and moral hazard problems. In contrast to the westernized corporate governance systems in place in most SEHK-listed firms, many PRC SOEs still operate in a “vacuum” with respect to corporate governance and management control (World Bank, 1995).
For example, audit committees and shareholder litigation are nonexistent and independent; outside directors are not required (DeFond et al., 1999). Thus, in addition to H-Share firms’ lack of prior history, important investor concerns include management quality, the potential for asset stripping or misappropriation, de-capitalization through excessive wage increases, and the role of the government as a major shareholder (Chen and Firth, 1999). Therefore, ceteris paribus, H-Share firms face significantly greater incentives to voluntarily disclose additional information.
Proprietary costs, however, also affect disclosure (Verrecchia, 1983).
The benefits of voluntary disclosure must be weighed against the costs of providing information that may invite or assist competition or regulation. Compared to other SEHK-listed firms, H-Share firms also face significantly lower proprietary costs. Most operate in industries deemed by the PRC government to be of strategic importance and are hence shielded from international competition (Lin et al., 1998). Thus, additional disclosure by H-Share firms is also likely to be less costly. This potential for greater incentives and lower disclosure cost leads to our first hypothesis:
Hypothesis 1a: Voluntary disclosure by H-Share firms will be greater than that by other SEHK-listed firms.
Further, as the primary objective for PRC firms listing on international stock exchanges is to raise capital at the lowest possible cost, we expect that H-Share firms’ incentives will mainly affect disclosure of additional strategic and financial information. Such incentives will have little impact on the disclosure of additional non-financial, social accountability information.
Political costs are borne primarily in firms’ local operating environments and are driven by local norms. H-Share firms operate solely in the PRC and political costs within this environment are virtually non-existent. Thus, we expect that differences in disclosure will only be observed for financial and strategic rather than social accountability information:
(Sami and Zhou, 2004)
In the emerging A-share and B-share markets, however, the value relevance of accounting information has been questioned. Accounting information based on domestic standards may be considered noisy because of sloppy accounting, inadequate regulation, and crony capitalism (Fox, 1998; Rask, Chu, & Gottschang, 1998). Besides, accompanying the rapid development of securities markets are some inevitable problems such as lagging legislation issues and multiple regulatory authorities (Liu & Zhang, 1996). However, the institutional changes in emerging markets, including the reform of the accounting-information system, could increase market liquidity, reduce transaction cost, and improve pricing efficiency (Feldman & Kumar, 1995).
In this study, we directly investigate the relative value relevance of accounting information in the two segments to provide further evidence on the value-relevance issue in the emerging market. Our basic intention is to test whether the two market segments differently value the major accounting information disclosed by the same company.
Under these regulations, listed companies prepare their financial statements based on the Chinese GAAP, as well as the IAS if they also issue B-shares. They should have their annual reports audited by authorized CPAs and submit copies to government agencies, such as state-owned-asset management agencies, tax authorities, securities regulatory agencies, and banks. They are also required to have copies available for investors.
In addition, listed companies are required to publish their annual reports in at least one of the authorized securities’ publications before April 30th the following year.10 For companies with both A-shares and B-shares, the audited annual reports for B-share investors are published in Hong Kong on the same day as those for A-share investors in China. The reconciliation information on the two sets of accounting statements is released to only A share investors, but not to B-share investors.
When there is a discrepancy between the two sets of audited financial reports, companies issuing both A shares and B-shares need to reconcile their accounting statements with the IAS for domestic investors. Because the IAS is considered to be of higher quality than local GAAP, and international auditors such as Big Five (Big Four) firms are thought to provide higher quality audits than their Chinese counterparts (Chui & Kwok, 1998; DeFond et al., 2000; Lam & Jing, 2000), the accounting information in the B-share market should be more relevant to the pricing process, compared with its counterpart in the A-share market.
(Sami and Zhou, 2008)
To shed light on the economic consequences of the implementation of new auditing standards, we investigate the Chinese emerging market where a set of auditing standards was introduced in a situation where, previously, no auditing standards existed with the exception of a few guidelines from the sponsoring governmental agencies.
In addition, in the information environment of an emerging market such as China, where the accounting disclosure was criticized for its low quality and quantity, the economic consequences of increased accounting disclosures due to the implementation of a set of auditing standards should be significant.
Moreover, auditors played the role of government agents and bore little responsibility for any improper behavior (Xiang, 1998). Because it was common practice to have a company audited by an auditing firm affiliated with the same level of government, auditors bent the rules under pressure from local government officials and company managers to pursue their own interests (Xiang, 1998; Graham, 1996). Additionally, there was no litigation against auditors (Graham,
1996; DeFond et al., 2000; Gul et al., 2003). Thus, auditors usually were affiliated with their clients and lacked motivation to be independent from them. Therefore, Zhou (2007) concludes that the implementation of new auditing standards helps reduce information asymmetry in an emerging market.
(Peng, Tondkar, Smith and Harless, 2008)
Chinese capital market development and market segmentation
A-shares can only be owned and traded by Chinese citizens, while B-shares can only be owned and traded by foreign investors.
The accounting regulations applicable to a Chinese listed firm depend on the type of security issued, A- or B-shares or both. Firms that issue A-shares are required to comply with
Chinese GAAP, while firms that issue B-shares are required to comply with IFRS. Firms that issue both A- and B-shares are required to issue two sets of annual reports, one based on Chinese GAAP and the other based on IFRS. The IFRS-based annual report must be audited by an internationally recognized auditor, but not necessarily a Big 4 firm, while the Chinese GAAP-based annual report may be audited by local accounting firms.
Reports must be released to the public simultaneously and any difference in net incomes between Chinese GAAP and IFRS must be reconciled and presented in the financial statement footnotes. Fig. 1 and Table 1 depict the Chinese capital market segmentation and the evolution of accounting regulations for Chinese listed A-share firms as of December 31, 2005.
Compliance with Chinese GAAP and IFRS is mandatory for Chinese firms that issue both A and B-shares. However, Tay and Parker (1990) remark that “even where compliance with standards is legally required, companies may not comply if it is perceived that the consequences of non-compliance are not serious” (p. 75). Street and Gray (2001) and Xiao (1999) find evidence that Chinese listed firms' compliance with accounting regulations is high.
(Sami and Zhou, 2008)
We mention the stricter disciplinary rules, monitoring, and sanctions imposed by the Chinese Institute of Certified Public Accountants (CICPA) and the Chinese Securities Regulatory Commission (CSRC) to effectively enforce the new auditing standards. The discussant points out that less effective corporate governance systems (characterized by dominant state and legal-entity ownership) and relatively low litigation risk in China's markets (compared to those in the West) could provide opportunities for managers of listed Chinese firms to act in the best interests of the government and its representative organizations rather than report high-quality accounting information or seek quality auditing of their financial reports (Ball, Kothari, & Robin, 2000).
Thus, the discussant is concerned whether auditing standards could be effectively implemented. While we agree that the Chinese markets are emerging markets, where accounting disclosure tends to be low in quality and quantity, as we mention in our introduction,
Corporate governance systems are less effective in China's markets than those in the West. In the government-controlled economy of China, managers of listed state-owned enterprises (SOEs) are frequently appointed by the government, who is the controlling shareholder. Recent studies show that such ownership structures adversely affect the information environment of these firms, which results in a high level of information asymmetry and a low level of informativeness of accounting earnings (Fan and Wong, 2002; Haw, Hu, Hwang, & Wu, 2004).
The managers of listed Chinese firms, where state and legal-entity (mostly SOEs) ownership dominate, are strongly motivated to act in the best interests of the government and its representative organizations, and have less incentive to report high-quality accounting information or seek quality auditing for their financial reports (Ball, Kathari, & Robin, 2000). Until 1998, all domestic auditors were public employees, and there was little incentive for high-quality audits, while litigation for audit failure was infrequent.2 In such an environment, it is doubtful whether auditing standards could be effectively implemented.
(2) The following set of hypotheses is concerned with the determinants of the extent of company disclosure. By reviewing the results of prior theoretical and empirical researches as well as considering the special feathers of the Chinese market, and data availability, the current study selects 10 relevant independent variables to be included in our model, which were further organized into three (not strictly mutually exclusive) categories, following the structure by Lang and Lundholm (1993),: Structure-related variables, Performance-related variables, Market-related variables and Other Monitoring factors.
The structural variables generally refer to firm characteristics that are widely known and likely to remain relatively stable over time. Size, leverage, state ownership, and board composition are included in this category.
Apparently, among other possible influencing factors firm size has been the most commonly suggested variable in the disclosure literature, assumed to be positively associated with the level of company disclosure. Given the existence of information asymmetry in the capital markets and the agency problem raised from the separation between ownership and control, agency theory suggest that information disclosure can be used as a mean to reduce agency costs (Chow and Wong-Boren, 1987). According to Jensen and Meckling (1976) and Leftwich, Watts and Zimmerman (1981), larger firms with more reliance on external funds potentially are more subject to complicated conflicts among their wider range of stakeholders, consequently increasing agency costs.
Also, larger firms are assumed as more sensitive to political costs (Watts and Zimmerman, 1986). Besides, it is noted by Lang and Lundholm (1993) and McKinnon and Dalimunthe (1993) that in order to enhance firm value, large firms tend to suffer from greater pressures from analysts to disclose more information than smaller firms; as reluctance to disclosure may be interpretated by investors as unfavourable news. In that sense, larger companies have greater needs to engage in more intensive information disclosure in respect to their higher agency costs and greater disclosure demand. On the other hand, comparing to smaller companies, Singhvi and Desai (1971) argue that due to the generally better-established internal reporting systems of larger firms, the marginal cost for additional information disclosure is lower for larger companies than smaller ones.
Furthermore, larger firms are assumed to have less exposure to competitive disadvantage than smaller companies when disclosing detailed company information (Firth, 1979). Therefore, compared to small firms large firms should have additional incentives for information disclosures. This argument has been confirmed as the influence of size on disclosure has been successfully tested by studies in various countries: the US (Singhvi and Desai, 1971 and Buzby, 1975), the UK (Firth, 1979), Canada (Kahl and Belkaoui, 1981), Mexico (Chow and Wong-Boren, 1987), Nigeria (Wallace, 1988), Sweden (Cooke, 1989), Austria (Wagenhofer, 1990), Japan (Cooke, 1991), Spain (Garcia and Monterrey, 1992, and Inchausti, 1997), New Zealand (Hossain et al., 1995), Czech (Patton and Zalenka, 1997), and Greece (Leventis and Weetman, 2004). To summarize, based on all the rationales discussed by previous studies and their supporting evidences, the first hypotheses can be formulated as:
H1: firms with larger size disclose information to a greater extent than do those with smaller size.
(Patteon and Zelenka, 1997)
Several theoretical propositions from the voluntary disclosure literature support the expectation of greater financial report disclosure by larger firms: (1) lower incremental cost of producing information for larger firms (Lang and Lundholm, 1993); (2) transactions cost hypothesis (King, et a/,,1990), which suggests that incentives for private infonnation acquisition are greater for larger firms; (3) legal costs hypothesis (Skinner, 1994), which notes that damages in securities litigation are greater for larger firms; and (4) reluctance of small firms to inform competitors (Raffottmier, 1995). Although we will not be able to determine which of the above explanations is the actual cause, we expect a positive relationship between firm size and extent of disclosure.
Generally, firms with more employees are more complex and create the possibility of substantial infonnation asymmetry between the firm and market panicipants. Thus, firms with a greater number of employees might be expected to have more extensive disclosures in their annual reports.
(Malone, Fries and Jones, 1988)
- Singhvi and Desai (1971) provided several reasons why the extent of financial disclosure is different for firms of different sizes. Singhvi and Desai offered three justifications for their reasoning. First, the cost of accumulating certain infonnation is greater for small firms than for large firms. This difference is attributable to the more extensive internal reporting systems already in place in larger firms. Second, larger firms have a greater need for disclosure because their securities are typically distributed via a more diverse network of exchanges.
Last, management of a smaller corporation is likely to believe more strongly than the management of a larger corporation that the full disclosure of infonnation could endanger its competitive position.' Foster (1986, 111) suggested three possible proxies for firm size: total assets, net sales, and capitalized value of the firm. Among these, perhaps the one least subject to market fluctuations in the oil and gas industry is total assets. Sales and capitalized value of the firm are subject to relatively extreme fluctuations due to the volatility of oil and gas prices.
Total assets, although not completely unaffected by this volatility, is less affected because of the broad capital asset base that already exists in each firm.
(Meek, Roberts and Gray, 1995)
-As noted by Foster [1986, p. 44], "the variable most consistently reported as significant in studies examining differences across firms in their disclosure policy is firm size." Generally, large firms disclose more information than small ones. Unfortunately, it is unclear what size proxies. Larger firms may have lower information production costs, or they may have lower costs of competitive disadvantage associated with their disclosures. Larger firms are also likely to be more complex and have a wider ownership base than smaller firms. Agency theory suggests that large firms have higher agency costs [Jensen and Meckling 1976; Leftwich, Watts and Zimmerman 1981]. Finally, larger firms are more sensitive to political costs [Watts and Zimmerman 1986]. All of these reasons indicate that large firms should have additional incentives for voluntary disclosures, compared to small firms. Size is positively associated with voluntary disclosure levels in all of the country studies noted above.
(Raffournier and Geneva, 1995)
There is a general agreement that a positive relationship between the size of a company and its extent of disclosure is to be expected. Several reasons have been advanced in support of this influence (Singhvi and Desai, 1971; Firth, 1979). First, disclosing detailed information is relatively less costly for large firms because they are assumed to produce this information already for internal purpose. Secondly, because their annual report is the main source of information for their competitors, smaller firms may be reluctant to make a fuller disclosure of their activities which might place them at a competitive disadvantage.
It can also be assumed that large firms which, according to Watts and Zimmerman (1978), are more sensitive to political costs, will disclose more in order to allay public criticism or government intervention in their affairs. The influence of size is well documented. All empirical studies on the content of annual reports found a positive relationship between the size of a company and its extent of disclosure. Salamon and Dhaliwal (1980) noted a similar association for segmental information and Cowen et al. (1987) for social responsibility disclosure.
It is hypothesized that the larger the firm, the more need for external funds. Therefore there will be more potential conflicts among owners, creditors and managers, and information disclosures may be used to decrease agency costs and to reduce information asymmetries between the company and the providers of funds, and potential providers of funds. Larger firms are also subject to more political costs, and disclosure may be used to reduce such costs. On the other hand proprietary costs are smaller the larger the firm, so there are less incentives to withhold information. The independent variables initially considered as measures of size are total assets and sales. However in order to avoid the problems caused by heterocedasticity natural logarithms of these variables (LASSETS and
LSALES) were calculated.'" The influence of size on disclosure has been successfully tested by studtes in various countries: the US (Cerf, 1961; Singhvi and Desai, 1971; Buzby, 1975; Salamon and Dhaliwal, 1980), the UK (Firth, 1979), Canada (Kahl and Belkaoui, 1981), Mexico (Chow and Wong-Boren, 1987), Nigeria (Wallace, 1988), Sweden (Cooke, 1989), Austria (Wagenhofer, 1990), and Spain (Garcfa and Monterrey, 1993; Wallace et al. 1994).
(Ferguson, Lam and Lee, 2002)
Research indicates that voluntary financial statement disclosure is influenced by other factors. Larger firms face higher agency costs (Leftwich et al., 1981), higher political costs (Jensen and Meckling, 1976), greater information demand from financial analysts (Lang and Lundholm, 1993), and lower information production costs (Firth, 1979; Leftwich et al., 1981). Consistent with these arguments, a positive relationship between firm size and voluntary disclosure has been found in studies of US (Firth, 1979), Swedish (Cooke, 1989), New Zealand (Hossain et al., 1995) and Japanese firms (Cooke, 1991), as well as for firms listed on multiple exchanges (Meek et al., 1995).
(Hossain, perera and Rahman, 1995)
A number of disclosure studies (e.g. Cooke, 1991, 1989) find that firm size is an important factor in explaining variability in the extent of corporate voluntary disclosure. In the agency theory literature. Chow and Wong-Boren (1987, p. 539) argue that potential benefits of voluntary disclosure are likely to increase with agency costs. Moreover, Jensen and Meckling (1976) contend that agency costs increase with the proportion of outside capital. The proportion of outside capital tends to be higher for the larger firms (Leftwich, Watts and Zimmerman, 1981).
Thus, agency theory predicts a positive association between firm size and the extent of corporate voluntary disclosure. It is also argued, in the literature, that fiirm size is a comprehensive variable which can proxy for several corporate characteristics, such as competitive advantage and information production costs (see Buzby, 1975; Firth, 1979; Le
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