Causes and Consequences of Discretionary Financial Reporting: Evidence from Corporate Governance, Cost of Capital and Firm Performance

Abstract

I examine how the corporate governance structure affects the incentives of controlling owners or top managers to exercise accounting discretion allowed under GAAP and whether financial statement users anticipate the effects of corporate governance weakness on reporting incentives and thus revise their assessment of information risk and agency risk, which in turn affects the cost of capital. I employ the modified cross-sectional Dechow and Dichev (2002) model as suggested by Francis et al. (2005a) to measure the accruals quality (AQ) and decompose AQ into two components: nondiscretionary accruals quality resulted from innate economic factors (NDAQ) and discretionary accruals quality determined by discretionary financial reporting (DAQ). I find that inferior DAQ is associated with more entrenched ownership structure (as evidenced by greater divergence between cash flow rights and voting rights of controlling owners and lower holdings by institutional investors) and less independent board (as evidenced by higher proportion of board members affiliated to controlling owners and the duality of CEO and chair of board). To avoid making false inference resulted from the measurement error of DAQ, I also investigate the association between expected accounting discretion induced by corporate governance structure (DAQ_GOV) and future firm performance to further distinguish the real incentives of discretionary financial reporting (opportunism versus signaling) induced by weak corporate governance. It shows that inferior DAQ_GOV bodes for poorer future performance and DAQ_GOV is more informative about future performance than that from NDAQ. Finally, I find that inferior DAQ_GOV is associated with higher cost of debt and higher cost of equity capital and DAQ_GOV has more prominent effect on cost of capital than that from NDAQ. In sum, my findings suggest that although minority shareholders and creditors anticipate the entrenchment effect on financial reporting quality resulted from weak corporate governance and demand additional risk premiums, the adverse effect on cost-of-capital by itself does not provide sufficient incentives for entrenched controlling owners to provide quality financial reporting. Therefore, quality financial reporting needs to be complemented by an aligned corporate governance structure.