Essays on accounting quality

Abstract

This thesis comprises of four empirical essays on the decision-usefulness of reported accounting information in the United Kingdom (UK). In the first essay, we examine the efficacy of the EU Accounting Directive’s (AD) deregulatory agenda in the UK capital market. The main purpose of the AD was to simplify firms’ accounting requirements to reduce their administrative burdens, with a special emphasis on lowering the business costs of small firms. Using a sample of UK firms, we find that reported business costs are lower post AD adoption. Further analysis reveals that the benefits of this cost reduction are lower in small firms than non-small firms. A second goal of the AD was to ensure that the simplification and flexibility offered in its reporting provisions must not undermine accounting quality. In this regard, we find that the post AD adoption period coincides with a period of lower earnings persistence, lower conservatism, increased smoothing and lower value relevance for UK firms. There also appears to be a shift from accruals management towards real activities manipulation during this period. This decline in accounting quality is exhibited in both small and non-small firms. Overall, we find that the AD regulatory agenda has been partially attained in the UK. Our results should assist policy makers in assessing the efficacy of the AD provisions for UK firms. In the second essay, we contribute to the literature on the externalities of firms’ financial reporting practices on their peer firms’ investments. If managers use their peer firms’ financial disclosures for investment decisions, it is plausible that their investments are related to peer accounting quality. Consistent with this argument, in a sample of FTSE All-Share Index firms, we find that the investment level and investment efficiency are both positively associated with peer accounting quality. We also argue that managers’ use of peer disclosures for investment decisions is related to their firm’s financial leverage, dividend payout and profit performance. Consistent with this argument, we find that the association between investment efficiency and peer accounting quality is more positive with increased financial leverage but less positive with increased dividend payout and increased profitability. Our results suggest that managers under greater pressure to invest efficiently are more likely to rely on peer disclosures. Additional analysis reveals that the association between investment efficiency and peer accounting quality is more positive in industries with a relatively small number of peer firms. Finally, we find that firms’ investment efficiency is positively associated with the industry accounting quality, and that the firm’s leverage, dividend payout and profitability moderate this relationship. In the third essay, we contribute to the literature on the externalities of firms’ financial reporting practices for their peer firms’ dividend policies. Specifically, we examine how the level of conditional conservatism in peer firms’ financial disclosures are related to managerial decisions to pay dividends. Peer firms’ financial disclosures are a relevant source of information for managers and capital providers faced with incomplete information for decision-making. More conservative peer disclosures lower information asymmetry, improve reporting transparency, and provide financial information users with reliable accounting numbers for assessing peer performance, and consequently, firm performance, thereby improving decision-making. Hence, increased peer conservatism empowers investors to negotiate more efficient contracts with managers, restricting inefficient investments and increasing dividend payments. Consistent with our argument, in a sample of FTSE All-Share Index firms, we find that firms with higher peer conservatism pay more dividends. We also find that this positive association is more pronounced for firms with higher information asymmetry, free cash flow problems and shareholder monitoring. Additional analysis reveals that peer conservatism mitigates the underpayment of dividends, but not overpayment of dividends. Our results are robust to alternative variable measurements and model specifications. In the fourth essay, we contribute to the externalities of firms’ financial disclosures for their peer firms’ capital structure. Specifically, we argue that if capital providers view peer firms’ financial disclosures as relevant sources of information to make financing decisions about their own firms, then it is plausible that peer accounting quality is related to the firm’s optimal capital structure. Using a sample of FTSE All-Share Index non-financial firms, we find that increased peer accounting quality is associated with higher deviations from the firm’s optimal capital structure, after controlling for the firm’s accounting quality. This suggests that increased peer accounting quality generates negative externalities for the firm’s capital structure. Further analysis reveals that peer accounting quality is positively associated with underleverage but exhibits no alignment with overleverage. In additional analysis, we examine the moderating role of management performance in this relationship, as capital providers have incentives to assess management performance before making their financing decisions. We find that in efficiently (inefficiently) managed firms, the association between peer accounting quality and deviations from the optimal capital structure is less (more) pronounced. Subsample analysis suggests that management performance positively moderates the link between peer accounting quality and overleverage but appears to be unrelated to underleverage.