An Assessment of Quality of Financial Reporting in India

Abstract

Financial reporting is the most important medium of communication between firm, its stakeholders and capital markets. It is useful for firm valuation, efficient functioning of capital markets, contracting decision and governance of firms. The recent financial reporting frauds, the East Asian crisis and cross-country accounting research have exposed the ramifications of weak legal institutions and poor financial reporting quality on stock markets, trading volume, foreign direct investment and access to capital. However, it is difficult to assess the quality of financial reporting (FRQ) . The shift from rule-based accounting regime to principle-based accounting regime will make it more difficult. Hence, it becomes important to know and assess the quality of the financial reporting information. In this study, we attempt to conceptualize the FRQ based on the objective of financial reporting and qualitative characteristics of decision useful information, which is largely missing in the literature. Accruals earning management is used as a catch all proxy for earning quality, accounting quality and FRQ. Also, it is assumed that earning management is opportunistic in nature, whereas evidence exists on the efficient use of earning management (EM). Our research attempts to fill this gap in literature using a sample of listed non-financial firms in India. We focus on earning quality to assess FRQ. We take a comprehensive perspective to assess FRQ by estimating accruals EM, specific accruals like revenues, and real EM, and identifying whether such EM is efficient or opportunistic. In addition to this, we examine the determinants of financial reporting quality such as firm characteristics, corporate government like ownership structure, board characteristics and auditor, and reporting incentives. We examine whether these determinants lead to efficient or opportunistic use of EM in emerging economy like India. We use eight models to estimate EM (both accruals and real EM). We find that the sample firms engage in opportunistic accruals EM and efficient real EM. Thus, discretion over accruals is used to conceal real firm performance and discretion over real decision is used to convey decision-useful information. The second part of the research focusses on the determinants of FRQ. We find that large firms have higher accruals quality and are less susceptible to manipulate discretionary expenses. Firms with high leverage use accruals EM to avoid violation of debt covenants, while they are not inclined to use real EM. Firms with higher performance have higher accruals quality, while firms with higher growth opportunities have lower accruals quality. Such firms are more likely to resort to real EM. Board size, board independence, Companies Act of 2013, affiliation with a business group, CEO duality busyness and audit committee independence have a negative relationship with accruals EM, while promoter holding, board meetings and period post-Satyam have a positive relationship. Board independence, Companies Act of 2013, board meetings and audit committee size have a negative relationship with EM, while institution holding, affiliation with a business group, CEO duality, board busyness and audit committee independence have a positive relationship. We also examine the moderating effect of the determinants to identify whether a determinant lead to efficient or opportunistic EM. We find that large firms and firms with high performance engage in opportunistic accruals EM and efficient real EM. Firms with high leverage and growth opportunities and manufacturing firms engage in opportunities EM. Firms with business group affiliation; promoter presence on board; CEO duality; institutional holding use accruals EM efficiently and real EM opportunistically. Board independence, audit committee independence and reforms post Satyam fiasco have resulted in efficient use of accruals and real EM, while the Companies Act of 2013 shows insignificant result. Board meetings and audit committee meetings are effective in case of real EM and not accruals EM. Promoter holding, board diligence, board size, board busyness, audit committee size and promoter influence on audit committee show mixed results. We find efficient use of accruals EM and opportunistic use of real EM to meet last year’s earnings. We do not find any conclusive evidence for zero earnings except for discretionary revenues. Our findings contribute to the literature on EM, ERQ, earnings quality and financial statement analysis. We contribute by refuting the widespread perception that EM is always opportunistic and is a catch-all proxy for measuring FRQ. We extend the extant research on determinants of FRQ in emerging economies by examining their moderating role in improving FRQ. Our findings have implications for regulatory authorities and investors. It will help regulatory authorities in devising regulations and policies for the effective monitoring of listed firms, improve disclosure and corporate governance practices, and protect the interests of minority shareholders. The findings provide important insights to the investors whether they can rely on earning reported by a firm and evaluate the effectiveness of corporate governance mechanisms in improving FRQ.