Audited financial reporting and voluntary disclosure: International evidence on management earnings forecasts

• Author: Albert Tsang,Rubing Liu,Ziyao San,Xiangting Kong
• Date: 01 July 2018
• Published date: 01 July 2018
• DOI: http://doi.org/10.1111/ijau.12118

ORIGINAL ARTICLE

Audited financial reporting and voluntary disclosure:

International evidence on management earnings forecasts

Rubing Liu

1

|Xiangting Kong

2

|Ziyao San

3

|Albert Tsang

3

1

Accounting School, Guangdong University of

Foreign Studies, Guangzhou, Guangdong,

China

2

Sun Yat‐Sen Business School, Sun Yat‐Sen

University, Guangzhou, Guangdong, China

3

Schulich School of Business, York University,

Toronto, ON, Canada

Correspondence

Professor Albert Tsang, Schulich School of

Business, York University, 111 Ian Macdonald

Boulevard, Toronto, ON, M3J 1P3, Canada.

Email: atsang@schulich.yorku.ca

In this paper, we extend prior research on the link between audited financial reporting and

voluntary disclosure by examining international differences in the relationship between

commitment to higher levels of audit verification of actual financial outcomes and manage-

ment earnings forecasts (our proxy for voluntary disclosure), using firm‐level data from 30

non‐US countries. Our evidence that commitment to higher levels of audit verification

(proxied by the choice of a Big 4 auditor, the amount of audit fees, and excess audit fees)

is positively associated with the incidence and frequency of management forecasts, and

with stock market reactions to such forecasts, supports the notion that aud ited financial

reporting and voluntary disclosure of managers' private information are complements in

countries around the world. We further find that the relation between audited financial

reporting and management earnings forecasts is weaker for firms in countries with relatively

stronger capital market development or with higher levels of investor protection, suggesting

that audited financial reporting plays a more important complementary role in voluntary dis-

closure in countries with less‐developed institutions. Overall, our findings suggest that firm‐

level commitment to better audited financial reporting and the strength of country‐level

institutional characteristics play substitute roles in corporate voluntary disclosure decisions.

KEYWORDS

Audit fees, audit quality, audit risk, auditor choice, disclosure

1|INTRODUCTION

The research question we investigate in this study is whether commitment

to higher levels of audit verificationcanserveasaneffectivemechanism

in enhancing the perceived credibility of voluntary disclosure, which in

turn affects a firm's voluntary disclosure decisions (Ball, Jayaraman, &

Shivakumar, 2012) in countries outside the USA. More importantly, we

also investigate the extent to which the influence of audited financial

reporting on voluntary disclosure differs across economic settings.

There are several competing views on whether and how audited

financial reporting can affect firms'future‐oriented voluntary disclosure

in an international setting.We argue that auditedfinancial reportingmat-

ters moreto a firm's voluntarydisclosure in countrieswith stronger insti-

tutionalcharacteristics. That is, the strengthof country‐level institutions

complements the role that firm‐level commitment to higher levels of

audit verificationplays in voluntary disclosureby enhancing the credibil-

ity‐enhancing/signalingrole of such commitment on voluntarydisclosure

in countries with better developed capital markets and higher levels of

investor protection.

1

To the extent that commitment to higher levels of

audit verification signals the credibility of a firm's voluntary disclosure,

especially given the more important role of auditing in countries with

better‐developed institutions, we predict a strengthened relationship

between audited financial reportingand the perceived informativeness

and decisionsof a firm's voluntary disclosure.

However, one can also argue that the strength of country‐level insti-

tutions can play a substitutive role in the relationship between audited

financial reporting and voluntary disclosure, and thereby weakens the role

that commitment to audited financial reporting plays in a firm's voluntary

disclosure. Given the presence of a strong institutional infrastructure

and legal institution that plays a positive role in enhancing/signaling

the credibility of voluntary disclosure, any firm‐level mechanisms, such

as commitmentto higher levels of audit verification,will play a relatively

limited role and ultimately have little effect on a firm's voluntary

disclosure decisions (Choi & Wong, 2007; Durnev & Kim, 2005).

2

This

Received: 30 March 2017 Revised: 15 January 2018 Accepted: 7 March 2018

DOI: 10.1111/ijau.12118

Int J Audit. 2018;22:249–267. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 249

alternative view thus predicts a weakened link between a firm‐specific

mechanism, in our case audited financial reporting, and the perceived

informativeness and decisions of a firm's voluntary disclosure.

We examine these competing hypotheses and test the possible vari-

ations on the relationship between audited financial reporting (proxied

by the choice of a Big 4 auditor, the amount of audit fees, and excess audit

fees; i.e., the residual of the regression of total actual audit fees on major

firm‐level determinants identified by prior studies) and firms' voluntary

disclosures across countries by focusing on a sample of management

earnings forecasts (our proxy for voluntary disclosure) from 30 non‐US

countries covered by CapitalIQ COMPUSTAT during the period 2004–

2010. Our evidence confirms the complementary role between audited

financial reporting and voluntary disclosure in countries around the

world. Specifically, we find a consistently positive relationship in our

sample between all three proxies of commitment to higher levels of audit

verification and the likelihood and frequency of management earnings

forecasts and stock market reaction to those forecasts. More importantly,

we find this positive relation decreases as the capital market development

or strength of investor protection in a country increases. This finding

suggests that firm‐level commitment to higher levels of audit verification

will have a stronger (weaker) effect on firms' voluntary disclosure practices

when country‐level institutions are weak (strong). These results are robust

to various country‐level measures of capital market development and level

of investor protection, to either standalone or bundled earnings forecasts,

to inclusion and exclusion of various countries in the sample (such as

removing the three countries with the largest number of observations),

to conducting a country‐by‐country regression, and to one‐way firm‐level

or two‐way firm‐year‐level clustering of standard errors.

This study provides new extensions to a few lines of research in the

literature. First, by examining the heterogeneity in the relation between

audited financial reporting and management earnings forecast practices

in countries around the world, our study contributes to the literature

on management earnings forecasts, which has primarily focused on US

firms (Hirst, Koonce, & Venkataraman, 2008), and adds to the broad

literature on cross‐country determinants of corporate transparency (e.g.,

Bhattacharya, Daouk, & Welker, 2003; Chaney, Faccio, & Parsley, 2010;

DeFond, Hung, & Trezevant, 2007; Lang et al., 2012). For example, one

interesting result from our study is the positive relation between the num-

ber of earnings announcements in a year and the likelihood and frequency

of management forecasts. Given the variations in the number of financial

statements mandated by the disclosure requirements of each country

and the subsequent earnings announcements issued by firms from differ-

ent countries, we believe that our study has implications for global regula-

tors and policy‐makers when setting disclosure requirements.

3

Second, studies have shown that commitment to higher levels of audit

verification is positively related to firms' voluntary disclosure practices (e.g.,

Ball et al., 2012; Chen, Srinidhi, Tsang, & Yu, 2016). Although studies have

shown the importance of firm‐level credibility‐enhancing mechanisms in

affecting the perceived informativeness of voluntary disclosure, which in

turn has an effect on managers' voluntary disclosure incentives, evidence

from a single country such as the USA provides limited insight into whether

such a finding can be generalized to other countries. By extending studies

that analyze the relation between audited financial reporting and firms' vol-

untary disclosure (e.g., management earnings forecasts or nonfinancial

corporate social responsibility reporting) from the USA to an international

setting, our research confirms the important role that audited financial

reporting plays in firms' voluntary disclosure in countries around the world.

In addition, while most research to date on corporate transparency

in the international setting has either focused on mandatorily reported

information or has studied general information disclosure without

distinguishing between voluntary and mandatory disclosures, our study

attempts to examine and emphasize the intertwined relation between

mandatory and voluntary disclosures by investigating the relationship

betweenaudit verificationof actual financial outcomesand a firm's man-

agement earnings forecasts (Ball et al., 2012; Beyer, Cohen, Lys, &

Walther, 2010; Dutta & Gigler, 2002; Lennox & Park, 2006). Our findings

suggest that the perceived credibility of voluntary disclosure and its sub-

sequent effect on firms' voluntary disclosure decisions is jointly deter-

mined by both firm‐level commitment to better audit verification and

the level of country‐level capital market development and/or investor

protection in the country where a firm is located. As such, our study not

only responds to calls for research on the effects of management earnings

forecasts in international contexts (Bushman, Piotroski, & Smith, 2004;

Francis & Wang, 2008; Hirst et al., 2008), it also tests the possible interac-

tion between voluntary and mandatory disclosures, which is important for

a better understanding of firms' disclosure decisions (Beyer et al., 2010).

Finally, our research also adds to the number of accounting and

finance studiesthat have found that firm‐level governance mechanisms

and country‐level institutional environments are substitutes (e.g., Choi

& Wong, 2007; Langet al., 2012; Lang, Lins, & Miller, 2003; Lang, Lins,

& Miller, 2004). Important practical implications can be drawn fromthis

finding. For example, in light of the importance of trust‐building

between firms and their stakeholders in general, and shareholders in

particular,our finding suggests that whenmaking decisions on the level

of commitment to audit verification of actual financial outcomes for

signaling purpose, managers shouldtake into consideration the strength

of institutional infrastructure in the country where the firm is located.

The remainder of this paper is organized as follows. In Section

2 we provide further discussion of the two competing views on the

relation between commitment to higher levels of audit verification

and firms' voluntary disclosures, and develop our hypotheses.

Section 3 describes the sample, data, and empirical models. Our

findings are presented in Section 4. Section 5 concludes the paper.

2|DEVELOPMENT OF HYPOTHESES

In mostcountries around the world,management earningsforecasts rep-

resent one of thekey forms of voluntary disclosurethrough which firms

communicateprivate informationto market participants(Healy & Palepu,

2001), thereby affecting shareholders' decision‐making (see Hirst et al.

(2008) for a review of the management earnings forecasts literature).

However, management earnings forecasts tendto be future orientated

and subject to few reporting guidelines. Therefore, the information

provided by management earnings forecasts is difficult for market

participantsto verify ex ante, which in turn increasesmarket participants'

concernsabout the credibility of firms' voluntarydisclosures. As a result,

mechanisms by which managers can signal the truthful disclosure of

private information are important to both managers and market

participants(Hirst, Koonce, & Venkataraman,2007).

250 LIU ET AL.