How to measure the quality of voluntary disclosure in annual reports

The goal of voluntary disclosure is to give more information than required of reporting standards. This to create more disclosure (Scott, 2009, p.109). Although voluntary disclosure provides more information than required, the earnings quality can be questionable. Earnings quality can be defined as the extent to which reported earnings faithfully represent Hicksian income (Schipper and Vincent, 2000). The Hicksian income corresponds to the amount that can be pay out as dividend without damaging the firm (Hicks, 1939, p.176) and the definition of faithfulness means “correspondence or agreement between a measure or description and the phenomenon that it purports to present” (FASB Concepts Statement, No. 2, para. 63).

The quality of the financial reporting are interesting for investment decision making. Low-quality earnings provide an incomplete allocation of resources. Also contracting of decisions based on low-quality will induce unintended wealth transfers (Schipper and Vincent, 2000).

Schipper and Vincent (2000) consider four earnings quality constructs:

- Time-series properties of earnings

- Relations among income, accruals, and cash

- Selected qualitative characteristics in the FASB’s conceptual framework

- Implementation decisions

Time-series properties of earnings

Time-series properties of earnings include persistence, predictive ability and variability. Persistence decide to which extent the innovation in the current period becomes a permanent part of the earnings series. From an investors view, high persistent earning numbers is the same as sustainable. It is more permanent and less temporal. Although persistence does not mean faithfulness. Persistence does not provide a representational faithfulness of the reporting earnings to Hicksian income. Within the accounting standards it is possible to transform the earnings stream to provide a better picture. Also if the value of assets are chosen randomly, the Hicksian income will not result in persistence.

Predictability is a compilation of the words predictive and ability, which means the capacity of the entire financial reporting package to improve the ability to forecast items. On the basis of past earnings, investors make predictions of future earnings. Also predictability is not faithful. The reported earnings depend on choices in the reporting, economic factors, and entity’s business model. Because of the choices this results in a lack of predictive ability.

Smoothness results because of an absent of variability. Smoothness is often associated with higher quality of the reported earnings. Although the quality of the earnings does not increase, because of the noise which is added by the management. But to test the smoothness a couple of measurements are developed. One of them is the correlation between changes in accruals and in cash flows. Innovation in the unmanaged earnings series can be traced back in the changes in the cash flow (Schipper and Vincent, 2000).

Relations among income, accruals, and cash

Earnings quality derived from the relation between accruals and cash component are discussed in this section. The ratio of cash from operations to income is one of the measures of earnings quality. The relation is expressed as the ratio of cash flow from operations to earnings. This measurement gives an idea that if the company stay close to the money it result in higher quality of reported earnings. Three other earnings quality constructs are described below. They identify a specific part of accruals and not in total. The total accruals decreases the quality of the reported earnings, because of the general view.

First changes in the total accruals is an approach to measure the earnings quality. Changes in total accruals measure managerial manipulations and provide an inverse measure of earnings quality.

The second approach is the direct estimation of abnormal accruals using accounting fundaments. Direct estimations uses accounting fundaments to determine the accruals which are not manipulated.

The third approach is direct estimation of accruals-to-cash relations. This approach results in a relation between the accruals and the cash flow (Schipper and Vincent, 2000).

Selected qualitative characteristics in the FASB’s Conceptual Framework

The Conceptual Framework uses terms as relevance, reliability, and comparability for assessing the quality of decision usefulness. It is not possible to assess the three components separately. High-quality of financial reporting are achieved when the financial numbers are relevant, reliable, and comparable. These three elements combined or separated gives an indication if the Financial Accounting Standard Board (FASB) are met. However researchers work with reported numbers and not the standards of the FASB (Schipper and Vincent, 2000).

Implementation decisions

This part focuses on the incentives and expertise of the auditors. This contains of two perspectives. First, the preparation of the financial reporting play a crucial role in the quality of the earnings. The more it is based on facts the higher the quality will be. The second approach is the advantage of the requirements to subvert the intent of the standards which influence the quality of the reported earnings. Earnings management can be indicators of the quality of the reported earnings. One way to detect earnings management is to look for incentives. Another way to detect the earnings management is that the earnings targets are not logical set (Schipper and Vincent, 2000).

Although voluntary disclosure provides more information it does not mean that the information is better. There are four earnings quality constructs to assess the quality of the reported earnings.

Suggestions to improve quality assessment of voluntary disclosure in annual reports

The following suggestions (might) contribute to improve quality assessments of voluntary disclosure by investors in the future.

First, a limitation of voluntary disclosure is that the information asymmetry between the entrepreneur and the investors still exist, despite of the disclosure of information beyond the minimum requirement of General Accepted Accounting Principles (GAAP) and other reporting standards (Scott, 2009). Therefore, investors still have problems to assess the quality of voluntary disclosure in annual reports. One solutions is to draw up optimal contracts between entrepreneurs and investors, which provide incentives for full disclosure of private information and mitigating wrong valuations by investors (Kreps, 1990). Another solution of the information asymmetry problem is regulation that requires managers to fully disclosure their private information (Healy and Palepu, 2001). Finally, Akerlof discussed two solutions for the information asymmetry problem: screening and signaling. Screening refers to a strategy of combating adverse selection, one of the potential decision-making complications in cases of asymmetric information. Signaling is the idea that the agent conveys some meaningful information about itself to the principal (Akerlof, 1970). Optimal contracts GAAP enforcement, screening and signaling are four suggestions to improve the quality assessment of disclosure in annual reports.

Second, the effectiveness of disclosure regulation in solving market imperfections is still questionable according to Healy and Palepu (2001). As a result, the opportunity for investors to make quality assessments is also questionable. Future research on this area is highly recommended, to improve quality assessments of voluntary disclosures in annual reports. Healy and Palepu (2001) identified four areas where additional research on the role of standard setting is warranted. First, the question is to what extent the current accounting standards provide timely information for investors or simply confirm information that is already available to investors through other sources. Second, studies that evaluate the benefits of alternative reporting methods, under consideration by standard, are more likely to provide useful evidence if they examine costs and benefits of all the alternatives considered. However outsiders do not have access to all inside information and therefore do not know what the best alternative reporting method is. This limits the quality assessment of reports. A third area for future research in the standard setting arena is to access which types of standards are likely to be most useful for investors and other stakeholders. The question is to what extent are the disclosure regulations important for the investors, to make good investing decisions. Finally, future research on standard setting can examine optimal standards across countries. Global standards makes it easier for investors to make good investing decisions. The above raised questions suggest future research, which will potentially lead to improve quality assessments of voluntary disclosures by investors in the future (Healy and Palepu, 2001).

Third, the effectiveness of auditors should be improved, as a means of increasing the credibility of voluntary disclosures and uncovering new information (Healy and Palepu, 2001). Available evidence suggests that auditor qualifications do not provide timely signals to the capital market. This evidence suggests that audit qualifications at best confirm information already available to investors (Dodd, 1984; Dopuch, 1986). One explanation for these limited credibility is that auditors act in the interest of the managers, rather than the interest of the investors (Watts and Zimmerman, 1981). Second, auditors provide formal assurance only on the annual report, which make it difficult for them to provide timely signals. A third explanation is that auditors are concerned about minimizing their legal liability, in stead of enhancing the credibility of financial reports. Future research is required to reveal the limitations of audit committees and increase the credibility of audit reports. This will improve the quality assessments of voluntary disclosure by investors in the future (Healy and Palepu, 2001). Three main conclusions in order to improve the effectiveness of auditors are important to mention. First of all, effective interrelationships among corporate boards, audit committees, financial management, the internal auditor and the external auditor will result in valuable annual reports for investors. Second, the integrity and transparency of financial reporting drives investor confidence in securities markets. Intensifying the role of the auditors by progressive recommendations will help ensuring financial stability. Finally, strengthening oversight in the annual reporting process of public companies will reduce instances of outright fraud and other practices that result in lower-quality reporting practices. These benefits clearly justify certain burdens and costs imposed on public companies and will improve the quality assessments of voluntary disclosure by investors (Davidson and Brad, 2000).

Fourth, the effectiveness of financial analysts should be improved. Studies noted that financial analysts have incentives to make optimistic forecasts (Lin and McNichols, 1998) and cover firms (Lang and Lundholm, 1993). Also studies noted that analysts forecast accuracy is affected by innate ability, company assignments, brokerage affiliation and industry specialization (Jacob, 1999). The credibility of financial analysts forecasts is therefore questionable, which limits the quality assessment of voluntary disclosure by investors. Financial analysts should therefore provide assurance about the quality of management’s disclosures, to increase the credibility of voluntary disclosures (Healy and Palepu, 2001).

Finally, three recent macro-economic forces create several new opportunities for future research to improve voluntary disclosure. These macro-economic forces are rapid technological innovation, increase of network organizations and globalization. The traditional financial reporting model appears to do a poor job of capturing the economic implications of many of these changes in a timely way. This makes it hard for investors to make good investing decisions. There is, therefore, an opportunity for future disclosure research to examine how financial reporting and disclosure adapt to changes in business and capital market environments. The results might improve the quality assessments of voluntary disclosure in annual reports by investors (Healy and Palepu, 2001).

The above described suggestions are important contributions to further improve the quality assessment of voluntary disclosure in annual reports in the future.

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