COMPLIANCE WITH DISCLOSURE REQUIREMENTS FOR INVESTMENT PROPERTIES: A COMPARATIVE STUDY BETWEEN SPAIN AND UK

Transcription

1 126a COMPLIANCE WITH DISCLOSURE REQUIREMENTS FOR INVESTMENT PROPERTIES: A COMPARATIVE STUDY BETWEEN SPAIN AND UK Marta de Vicente Lama ETEA, UNIVERSIDAD DE CÓRDOBA Horacio Molina Sánchez ETEA, UNIVERSIDAD DE CÓRDOBA Jesús N. Ramírez Sobrino ETEA, UNIVERSIDAD DE CÓRDOBA Area temática: A) Información Financiera y Normalización Contable Keywords: Mandatory disclosure, Investment properties, accounting choice, recognition vs. disclosure 1

2 COMPLIANCE WITH DISCLOSURE REQUIREMENTS FOR INVESTMENT PROPERTIES: A COMPARATIVE STUDY BETWEEN SPAIN AND UK Abstract The primary aim of this study is to analyse the extent to which listed companies in Spain and the United Kingdom (UK) comply with the disclosure requirements under International Accounting Standard 40 (IAS 40) for investment properties and to what extent corporate characteristics are associated with compliance with this standard. Our results suggest that disclosure regulation acts as a benchmark more than as a minimum level of information, and companies react to the information s overload with a relaxation on fulfilment. 2

3 INTRODUCTION The primary aim of this study is to analyse the extent to which listed companies in Spain and the United Kingdom (UK) comply with the disclosure requirements under International Accounting Standard 40 (IAS 40) for investment properties and to what extent corporate characteristics are associated with compliance with this standard. We focused on the case of Spain and UK because they were the most dynamic real estate markets in Europe at the time of the mandatory adoption of International Financial Reporting Standards (IFRS) and where the boom of housing prices could have had a greater impact on financial statements. We analysed 2005 and 2008 annual reports in order to compare the determinants of the extent compliance with disclosure requirements for investment properties on a pre and post-crisis period and to determine if there has been an improvement in the quality of disclosure between these two periods. For our knowledge disclosure on investment properties has never been studied in this way before, particularly in Spain and UK. IAS 40 allows two alternative treatments to measure investment property after initial recognition: either a cost model, disclosing the fair value of the investment property in the notes, or a fair value model recognizing the changes in the fair value of investment property in the income statement. The choice afforded under IAS 40 represents primarily an accounting choice (between cost and fair value). Secondly, it is a choice between recognition and/or disclosure of the financial information and, finally, an election between two characteristics of the financial information such as relevance and reliability. Disclosure requirements under IAS 40 could be sorted by three types: (1) disclosures applicable to all investment properties, (2) disclosures applicable to investment properties carried according to the fair value model and (3) disclosures applicable to investment properties valued according to the cost model. Within the first category, firms are required to disclose information about their business model (such as rental income and direct costs) and, on the other hand, firms are required to disclose information regarding the reliability of the fair value amounts (such as to what extent the fair value of investment property is based on valuations of independent appraisers or not, the latter having also to be declared, the methods used and important assumptions applied in determining the fair value of investment properties). Disclosure requirements under the second and third categories are similar to those of other fixed assets investigated in some manner by previous researchers. In our study, we focused on the disclosure requirements for all investment properties since IAS 40 provides us with a unique setting to investigate disclosure compliance. Chavent et al (2006: 191) argue that, although studies on mandatory disclosure could appear 3

4 illogical, researchers have found some flexibility in the way firms report their financial information. As argued by Schipper (2007), one of the purposes of disclosure that present an alternative measurement attribute is to mitigate the effects of accounting choice on the comparability of financial reporting providing users sufficient information for a comparative analysis. In this sense, IAS 40 results in an asymmetric treatment of disclosure requirements because the cost model requires the disclosure of the fair value of the investment property whereas the use of the fair value model does not require firms disclosure on historical cost amounts. Firms using the cost model are obliged to disclose fair value amounts to enable users to carry out a comparative analysis. However, in our view comparability can not be achieved since users can not obtain the annual impact on the income statement because the difference between the fair value and the depreciated cost reflects solely the cumulative effect of the years during which the asset is under control and not just the last year gain or loss. Obviously, this lack of information is more striking when the rationale for choosing the fair value is that the management of these assets can not be understood without considering the gain from holding the asset (Barlev y Haddad 2003). On the other hand, firms valuing their investment property under the fair value model are not required to disclose information on the historical cost amounts or the cumulative depreciation that these assets would have generated. The latter shows the implicit preference of the standard setter upon the fair value model 1. Schipper (2007: 308) also argues that the clearest conceptual message that disclosures should present relevant but less reliably measured items does not seem to capture the purpose of some existing disclosure requirements. This is the case under IAS 40 for at least two reasons: firstly, although the fair value model seems to be the standard setter s preferred presentation for investment property as stated above 2, alternative treatments are a free choice; and secondly, disclosure requirements applicable to all investment properties, regardless of the accounting choice, intend to mitigate reliability concerns. IAS 40 disclosure requirements applicable to all investment properties concern: the value measurement of the investment property (historical cost versus fair value), 1 2 The Exposure Draft 64 (IASC 1999) published in 1999 by the International Accounting Standards Committee (from 2001 IASB) proposed the fair value model as the unique accounting treatment available for investment properties. However, on the basis of the comment letters received by respondents, the IASC decided to introduce, additionally to the fair value model proposed, an alternative: the cost model but requiring disclosure on fair value amounts of investment properties. The recent publication of IFRS for SME (IASB 2009) also reveals this preference for the fair value model. The new standard eliminates the alternative treatment and requires investment property being carried according to the fair value model. 4

5 measurement uncertainty (source and methods in determining fair value amounts), management of investment property (rental income and direct costs) and the economic risks derived from its management (capital commitments). Disclosure regulation represents a benchmark on the level of disclosure but not the minimum information to be disclosed, perhaps trying to avoid an overload in the amount of financial reporting information (Schipper 2007). Why firms do not fully comply with disclosure requirements? Regulated financial disclosures are informative to investors and, in our study, we argue that different levels of compliance are the result of: (1) economic reasons or a firm s proactive attitude towards its own specific characteristics and (2) a reactive response of the firm to the cultural environment. Under the framework of the signalling theory, the present study identifies size, profitability, leverage and the cumulative impact of the fair value of investment properties over total assets as the economic determinants of the level of compliance. It also provides further evidence on the influence of cultural variables such as industry and the country of origin showing that firms tend to follow the best disclosure practices in the real estate industry and that prior local accounting standards have an impact on the level of compliance with mandatory disclosures by firms from different countries. The remaining of the paper is organized as follows. Section 2 shows the institutional background in Spain and UK focusing on the topics of accounting and disclosure requirements for investment properties. Section 3 reviews prior studies addressing the determinants of disclosure compliance and the value relevance of recognition versus disclosure. In Section 4 we present our hypotheses concerning compliance with the disclosure requirements of IAS 40. Section 5 describes the methodology of our investigation and the sample used. Empirical results are presented in Section 6 being analysed and discussed in Section INSTITUTIONAL BACKGROUND Prior to implementation of IAS 40, accounting for investment properties was governed by the General Accounting Plan (PGC 1990) and SSAP No. 19 (ICAEW 1981) in Spain and UK respectively. The accounting treatment for investment properties in Spain under PGC 1990 was the cost model and they were presented within the rest of tangible assets on the balance sheet. In addition neither disclosure of fair value amounts nor lessor s disclosure for operating leases were required. In 2007, Law 1514/2007 of 16 November established the new General Accounting Plan (PGC 2007) under which investment properties are 5

6 recorded under a separate hedging of non-current assets and continued being valued at historical cost without requiring disclosure of fair value amounts. According to UK regulation, SSAP No. 19 required that investment property assets had to be accounted for under the revaluation model. Changes in fair value 3 were recorded through equity, as a revaluation reserve, rather than directly to the income statement. As IAS 40, the standard did not require the valuation being made by qualified or independent appraisers but it explicitly stated that if investment properties represented a significant proportion of the total assets of a major enterprise, valuation would normally be carried out annually by appraisers who held a recognised professional qualification and had recent experience in the location and category of the investment property being valued. The statement, apart from the information about the appraiser, also required disclosing the valuation method and assumptions in determining the fair value. To summarize, domestic accounting standards prior to the adoption of IFRS and, in the case of Spain, also after the implementation of IFRS varied considerably across the two countries being studied. 2. RELATED PRIOR STUDIES Empirical disclosure literature is very extensive (see Healy and Palepu 2001 for a review). Most researches focus on voluntary items and examine the relationship between a number of firm-specific characteristics and a general disclosure level under the framework of the agency, signalling and proprietary costs theories. However, according to the objective of our study, we concentrate on several studies addressing mandatory disclosure or IAS adoption (Cooke 1989a, 1992; Wallace et al 1994; Giner 1997; Chen and Jaggi 2000; Jaggi and Low 2000; Glaum and Street 2003; Ali et al 2004). These researchers found that the level of disclosure is influenced by cultural factors (Jaggi and Low 2000) and some firm-specific characteristics such as size, industry, listing status, profitability, auditor and, as Chen and Jaggi (2000) found, the number of independent non-executive directors. Regarding to leverage, previous researchers could not obtain significant evidence to support its relationship with the level of compliance. With respect to the methodology, the majority of disclosure studies use a selfconstructed disclosure index (weighted or unweighted) as a proxy of disclosure quality 3 SSAP No. 19 used the open market value as the valuation criteria for investment property. Its definition was similar to fair value under IFRS. 6

7 and then apply regression techniques (mainly linear and OLS regression) with unranked and/or ranked data. Chavent et al (2006) after summarizing the objective, research design and main results of 49 disclosure studies (both voluntary and mandatory), introduce a divisive clustering method complementary to the disclosure index commonly used in such studies and with the aim of analysing disclosure patterns as well as disclosure levels. As mentioned before, IAS 40 also represents a choice between recognition and disclosure of financial information. In fact, a good part of the literature analyzes the relationship between recognition and/or disclosure and the reliability of the financial information. The research on this field focuses on a specific context (primarily United States) and in particular accounting standards. Indeed, some authors take the opportunity of comparing the perception in the market about the reliability of financial reporting immediately before and after a new standard, which requires recognition whereas it only required disclosure before, was adopted. Davis-Friday et al (2004), in relation to the accounting change that occurs in the US with the adoption of Statement of Financial Standards No 106 (SFAS 106) which relates to the accounting treatment of liabilities for retiree benefits other than pensions (other benefits such as health or life insurance) find that market considers disclosed liabilities (prior to the adoption of SFAS 106) as less reliable than recognized liabilities (subsequently to adoption of SFAS 106). In addition they conclude that reported amounts of recognized liabilities are more accurate than disclosed liabilities. This finding suggests that recognition increases the reliability of financial reporting. Ahmed et al (2006) argue that the investigation of these authors suffers from a weakness, which is that the nature of the information and the different valuation criteria used before and after the adoption of the new standard. To mitigate this problem, the authors consider an ideal setting to analyze how investors value financial derivatives depending on whether they are being revealed or recognized and focus their investigation on the accounting regulatory change that occurs in the treatment of derivatives with the adoption of Statement of Financial Standards No 113 (SFAS 113). Their results are consistent with those of Davis-Friday et al (2004) suggesting that market does not perceive recognition and disclosure as substitutes. In respect of investment properties, Muller et al (2008) show that investors do not consider as substitutes disclosure and recognition of fair value amounts of investment properties 4. 4 Additionally, So and Smith (2009) find that, in Hong Kong, presenting changes in fair value of investment properties is more value-relevance compared to reporting changes through equity (as a revaluation reserve). 7

8 In this study, we also analyse if there is an improvement in the quality of disclosure between 2005 and Leuz and Verrecchia (2000) argue that prior empirical studies which try to analyse the economic benefits of increase disclosure are varied and suggest that one of the reasons could be that the majority of these studies are focused in the United States, country where local GAAP already required to disclose extensive financial information. For this reason, the authors investigate the economic benefits of increasing disclosure from the adoption of international standards (US GAAP or IFRS) on a sample of German companies for which local GAAP established fewer disclosure requirements. The authors use the bid-ask spread and trading volume as a proxy for measuring information asymmetries and conclude that increases in disclosure reduce information asymmetries and consequently, according to the economic theory, the cost of capital. Finally and regarding the auditor behaviour with respect to the reliability of disclosed items, Libby et al (2006) conclude that, in relation to the disclosure requirements and accounting treatment of stock compensation and leases in the United States, auditors are more likely to allow more misstatements in disclosed than in recognized items and they do so intentionally because they consider as lower the materiality level of the recognized amounts. Therefore, the authors suggest that the decision of the standard setters to relegate some items into the notes to the accounts could reduce the perceived reliability of these items while, on the other hand, recognition implies that auditors would exercise a greater pressure on their clients to avoid or correct the misstatements increasing the reliability of the financial information. 3. HYPOTHESES DEVELOPMENT In order to investigate the determinants of the level of compliance with IAS 40 disclosure requirements, we developed our hypotheses according to the prior literature addressing disclosure compliance while introducing specialties in the topic of investment properties. We used the theoretical framework of the signalling theory and argue that the flexibility with which firms comply with mandatory disclosures rely on a two-faced behaviour. First of all, firms will have a proactive attitude towards its own performance and specific characteristics (size, leverage, profitability, accounting choice and the impact of fair value accounting) and they will intend to signal the market their reporting quality. Secondly, companies will also be influenced by cultural factors (country of origin, prior domestic accounting standards, industry and auditor) and will have a reactive behaviour trying to comply with the best practices. 8

9 3.1. ECONOMIC DETERMINANTS OF COMPLIANCE: A PROACTIVE BEHAVIOUR Size The previous empirical research suggests that large companies disclose more information than small companies (Cooke 1989a, 1992; Wallace et al 1994; Giner 1997; Ali et al 2004). According to the signalling theory, there is a major demand on the part of large firms to provide extensive disclosure for stakeholders and, as argued by Watson et al (2002: 297), larger corporations may have greater benefits to be gained by better disclosure in terms of easier marketability of securities as a result of reduced uncertainty. However, regarding to the proprietary cost theory, Healy and Palepu (2001) relate that several researchers conclude in their studies that firms tend to not disclose information if such disclosure can damage their competitive position. It is also likely that larger firms will have the ability to disclose more information since compliance with disclosure requirements for investment properties implies to incur in significant costs for small companies or requires sufficient experience and resources (such as the case of the external appraisal s fees or the internal estimation of fair value amounts). We test the following hypothesis: H1: The extent of compliance with IAS 40 disclosure requirements is higher for larger firms. The independent variable considered as measure of size is total assets (TOTAL_ASSETS). Profitability Profitability has been identified as a determinant of disclosure compliance in Spain (Giner 1997). However, the results were opposite to those predicted and show a negative relationship between the level of compliance and profitability. The author argue that the results are consistent with the hypothesis that firms will disclose more information when they report a low profitability ratio and use disclosure to explain the bad news. According to the signalling theory, we argue that companies with higher profitability are more likely to provide more information signalling the market and providing assurance to investors. We test the following hypothesis: H2: The level of compliance with IAS 40 disclosure requirements is higher for more profitable companies. The variable ROA is measured as of the ratio net income to total assets. 9

10 Leverage The relationship between capital structure (leverage) and the level of disclosure is unclear as none of the studies, which hypothesized a positive relationship between these two variables, report empirically consistent results. However, in our study, we cannot ignore that property assets are the main guarantee for lending operations, especially in the real estate sector in which companies depend greatly on debt financing. A good part of disclosure items regarding investment properties are required with the aim of increasing the reliability of the fair value estimations. This fact suggests that there may be a positive relationship between leverage of firms and disclosure compliance. H3: The level of compliance with IAS 40 disclosure requirements is higher for firms with a high rate of leverage. In this study we use the total debt to total equity as the measure of leverage (LEV). Accounting choice We assume accounting choice for investment properties as a determinant of the disclosure policy. Companies choosing the fair value model under IAS 40 show their preference for relevant and timely financial information and increasing or complying with disclosure requirements improve the reliability of accounting information and, as argued by Barlev y Haddad (2003), the transparency which fair value provides in itself to financial information. Moreover, the fair value measurement of investment property introduces greater volatility in the income statement and affects the risk perceived by actual and prospective investors. Following this reasoning, managers incentives to comply with disclosure requirements will be greater if the company recognizes its investment properties under the fair value model and, even more, when the cumulative impact of fair value is very significant. We propose the following two hypotheses: H4a: The extent of compliance with IAS 40 disclosure requirements is higher for companies that choose fair value model than for those choosing the cost model. To test H4a we have used the variable CHOICE as a dummy variable (1 = Fair Value Model, 2 = Cost Model). H4b: The extent of compliance with IAS 40 disclosure requirements is higher as greater it is the cumulative impact of fair value accounting. 10

11 The independent variable employed is the ratio: Cumulative impact of Fair Value to Total assets (FV_CI_TOTALASSETS) CULTURAL DETERMINANTS OF COMPLIANCE: A REACTIVE RESPONSE Country of origin We argue that the level of disclosure is associated to the country of origin. As shown by Jaggi and Low (2000) over a sample of 401 companies from six countries, common law countries as UK are associated to higher level of disclosure rather than code law countries such as Spain. Also, as discussed previously in section 2, domestic accounting standards in Spain and UK prior to the IAS implementation varied and, in particular, disclosure requirements were more stringent and similar to IAS 40 s in UK than in Spain. Following these reasoning, we test the following hypothesis: H5: The extent of compliance with IAS 40 disclosure requirements is higher for UK companies than for Spanish companies. The variable COUNTRY is coded as a dichotomous variable (1 = Spanish firms, 2 = UK firms). Industry Several previous empirical researches on mandatory disclosure suggest that companies in the same industry tend to disclose similar information to users (Cooke 1992; Wallace et al 1994; Giner 1997). However, results were not always satisfactory and while Cooke (1992) and Giner (1997) showed a relationship between the type of industry and the level of disclosure, Wallace et al (1994) found no association between these variables. Investment properties of companies in real estate industry represent a substantial part of business activities and these amounts are subject to the scrutiny of analysts and investors. We argue that the greater the importance of investment properties over total assets, which usually occur in real estate companies, greater will be the managers incentives to fully comply with the disclosure requirements providing to the financial information with relevance and/or reliability depending on the accounting choice afforded. Furthermore, real estate companies have greater experience in dealing with fair value estimations and, as argued by Landsman (2007), valuations performed by independent appraisers represent an institutional factor for these types of companies. Under the framework of the signalling theory, companies will wish to comply and will follow the best practices in their industry (Wallace et al 2002). So it is reasonable to 11

12 think that the level of compliance with IAS 40 disclosure requirements will be higher for companies in real estate industry than in other industries. We test the following hypothesis: H6: The extent of compliance with IAS 40 disclosure requirements is higher for companies in real estate industry than in other industries. Regarding to industry, variable (IND) is coded as a dummy variable with an assigned value of 1 if the company belongs to real estate industry and 2 otherwise. Audit firm The quality of accounting information is linked to the quality and reputation of its auditor. Previous researchers have examined the relationship between size of audit firm and the level of compliance with mandatory disclosure (Wallace et al 1994; Giner 1997; Dumontier and Raffournier 1998; Glaum and Street 2003; Ali et al 2004). All the studies, except for Ali et al (2004), categorise audit firms depending on whether an auditor belongs to a Big Five (Big Six or Big Four depending on the country and year) international audit firm or not. Ali et al (2004) use audit fees and audit market concentration as a measure of the audit firm size. Giner (1997) in Spain, Glaum and Street (2003) in Germany and Dumontier and Raffournier (1998) in Switzerland found a positive association between the size of the audit firm and the level of disclosure. In contrast, Wallace et al (1994) and Ali et al (2004) found no significant relationship between these two variables. We propose the following hypothesis: H7: The level of compliance with IAS 40 disclosure requirements is higher for companies audited by Big Four auditing firms than for other firms. The variable AUD is coded as a dichotomous variable (1 = Big Four, 2 = Others). 4. RESEARCH DESIGN 4.1. SAMPLE The sample for our research concerning the disclosure of required information for investment property was selected among non-financial and non-insurance 5 listed companies on the Spanish continuous market and the London Stock Exchange in 2005 and 2008 (896 and 709 respectively in total). Companies in the sample were drawn in a 5 We did not include financial either assurance firms because of their singular characteristics which make the financial information non comparable with non-financial and non-insurance firms. 12

13 two-step procedure. First, a sample was drawn from listed companies holding investment properties at the year-end started in 2005 (106 in total). In a second step, using the sample already selected for 2005, sample was drawn from companies beginning the accounting period on This procedure reduced the size of our sample as some of the companies de-listed from de Madrid Stock Exchange or London Stock Exchange in In the case of merger after 2005, we included in our sample the acquiring company in 2005 and the merged company in The final matched sample is composed of 87 Spanish and UK listed companies (174 observations) as of 31 December 2005 and 2008 (see Appendix A). With regards to corporate reporting dates, the whole sample from Spain had 31 December reporting year-ends, whereas the majority of the companies from UK reported their consolidated accounts at March, June, September and December yearends. All the information was collected manually DISCLOSURE INDEX We started our analysis by reading IAS 40 and IAS 17 Leases 6 disclosure requirements for investment properties 7. However, as stated by IAS 40 and as we have commented before, a number of items are required regardless of the chosen accounting model (12 items), being the rest applicable on the basis of the accounting model chosen (12 items in case of fair value model and 15 items if the entity has applied the cost model). Furthermore, IAS 17 requires a total of 12 additional items to be disclosed. The purposes of disclosure requirements under IAS 40 for all investment properties could be classified into two categories: (1) mitigate concerns about the reliability of fair value estimates and (2) provide users with information about the entity business model. The major criticism of the use of fair value as a measurement attribute for investment properties comes from the difficulty for obtaining reliable estimations and, in order to enhance the reliability of the fair values reported, disclosure regarding whether the valuation has been determine on the basis of a valuation by an independent appraiser or not, the methods used and main assumptions applied in determining the fair value are required to be disclosed within disclosure requirements for all investment properties regardless of the accounting model used. Dietrich et al (2001) and Muller and Riedl (2002) concluded that fair value estimations determined on the basis of an independent appraiser, increase the reliability of the fair values reported. However, Barth and Clinch 6 7 In accordance with IAS 17, entities which hold investment properties under financial or operating lease should provide lessee s disclosure for financial leases and lessor s disclosure for operating leases. We also analysed the disclosure requirements on the basis of the International GAAP Disclosure Checklist (Ernst & Young 2009) published by the BIG4 international audit firm. 13

14 (1998) found little evidence to support a significant difference between assessments made by external or internal appraisers 8. Due to the importance of the information required to all investment properties, in our study we focus on these items rather than on the disclosure requirements applicable for investment properties carried out according to one of the two alternative treatments allowed by IAS 40 and which are similar to those of other fixed assets already investigated in some manner by previous researchers. In the present study, we have developed a checklist comprising the 12 items 9 in total to be disclosed for all investment properties. Instead of selecting a list of items, we considered all the items applicable in order to reduce subjectivity. The disclosure index developed is an unweighted index and then it scores each item equally. Since not all of the 12 items are applicable to all companies because a part of them depends on the business model of the firms 10, in a first step we assigned a value of one if the item was applicable and zero if it did not apply to the specific company and so the firms were no penalised for non-disclosure. As Beretta and Bozzolan (2008) relate there is no conclusive evidence to support whether an unweighted or a weighted index better represents the quality of disclosure. However many researchers are in favour of unweighted indexes because they reduce additional subjectivity (Chavent et al 2006). In a second step, we also used a dichotomous procedure to develop our disclosure index in which an item scored a value of one if it was disclosed and zero otherwise (Cooke 1989a, 1989b). The determination of the index was obtained as follows: CIndex j = n j 1 n j Σ d i i = Landsman (2007) justified the different results obtained arguing that the investigation of Muller and Riedl (2002) is more powerful, though Landsman (2007: 24) notes that this conclusion must be made with caution because the Muller and Riedl (2002) sample of firms is limited to a specialised industry, investment property firms, where external appraisals are an institutional feature The number of items is limited due to the scope of our study. Previous research was also carried out on a small number of items (Prencipe 2004; Chavent et al 2006). Investment properties, as defined by IAS 40, are land and/or buildings held for rentals or for capital appreciation. Three of the items considered in the development of our index regard to information about rental income and direct cost of this activity. In the case of a firm holding its investment properties for capital appreciations these items would no be applicable. 14

15 where I j is the unweighted disclosure index for the company j, n j is the total number of items expected to be disclosed by company j and d i is the number of information items disclosed by the company j (Beretta y Bozzolan 2008). 5. RESULTS 5.1. DESCRIPTIVE STATITISCS Table 1 contains descriptive statistics for the independent variables (except for industry 11 ). The findings show that Spanish companies which hold investment properties are larger in size (measured by total assets amount) than UK firms, with an average of Spanish 7.23 and million euros and UK firm s average size of 3.76 and 3.37 million euros in 2005 and 2008 respectively. Profitability figures show that, in 2005, UK companies are on average 1.78 times more profitable than Spanish firms. However, descriptive statistics for this variable in 2008 show that, on average, UK firms are almost seven times less profitable than Spanish firms. This fact is not surprising considering the downturn in the housing market from 2005 to 2008 and taking into account that the accounting treatment for investment properties (see descriptive statistics for CHOICE variable) for the 70.4% of UK companies in both years was the fair value model (in contrast, 12.1% in 2005 and 24.2% in 2008 of the Spanish firms used the fair value model). Regarding to leverage, descriptive statistics in table 1 show that the rate of financial leverage is greater on average for Spanish companies than for UK companies and, considering the whole sample, the ratio increases significantly from 2005 to This is consistent with the majority of UK firm s fair value accounting for investment properties. During the property bubble, as in 2005, the valuation at fair value of investment properties increased the net income and equity reported by firms, thus reducing their leverage. However, the decline of real estate market and housing prices experienced in 2008, results on higher leverage in the companies that account their investment property under the fair value model. In respect to the auditor, 75 and 77 companies in total are audited by BIG 4 firms and 12 and 10 are audited by other firms. According to the accounting choice, table 1 shows that almost half of the companies chose the firm value model and the other half the cost model. However, if we analyse cross-country descriptive statistics for this variable, the findings show that the majority of the firms that account their investment property under the fair value model are 11 Our total sample is composed of 37 real estate firms (9 and 28 Spanish and UK, respectively) and 50 companies which belong to other industries. 15

16 domiciled in UK. In Spain, the firm s accounting choice has been mainly for the cost model. Table 1: Descriptive statistics for independent variables Panel A: Descriptive statistics of explanatory variables in 2005 (by country and total sample) Spain UK Total (n = 33) (n = 54) (n = 87) Variable Mean St. Dev. Mean St. Dev. Mean St. Dev. TOTAL_ASSETS (000) 7, , , , , , ROA LEV FV_CI_TOTALASSETS IP_TOTALASSETS Dichotomous (Dummy) variable n =1 n = 2 n =1 n = 2 n =1 n = 2 AUD CHOICE Panel B: Descriptive statistics of explanatory variables in 2008 (by country and total sample) Spain UK Total (n = 33) (n = 54) (n = 87) Variable Mean St. Dev. Mean St. Dev. Mean St. Dev. TOTAL_ASSETS (000) 12, , , , , , ROA -2, LEV FV_CI_TOTALASSETS IP_TOTALASSETS Dichotomous (Dummy) variable n =1 n = 2 n =1 n = 2 n =1 n = 2 AUD CHOICE EMPIRICAL RESULTS Descriptive results One of the objectives of our study is to analyse if there has been an improvement in the level of compliance with disclosure requirements for investment properties between the two periods considered (2005 and 2008). In Table 2 we report overall average, minimum and maximum values as well as standard deviation of the compliance index (Cindex, dependent variable). We also show the same statistics for Spanish and UK firms considered solely as well as for real estate companies or firms belonging to other industries. The average compliance level is 61.9% and 69.8% for the whole sample in 2005 and 2008 respectively. This finding shows an improvement in the level of compliance from 2005 to 2008, the difference is significant at p< (t = and df = 86). Four 16

17 companies provided all the required disclosures in 2005 (Cindex = 1) and ten in 2008 which also shows an increase in the number of companies that fully comply with requirements. In both years, the degree of compliance of 34 companies was under the overall average. Table 2: Descriptive statistics for the dependent variable Panel A: Descriptive statistics of the dependent variable in 2005 (by country and industry) Variable n Mean St. Dev. Minimum Maximum Cindex all firms Cindex - Spanish firms Cindex - UK firms Cindex - Real Estate firms Cindex - Non Real Estate firms Panel B: Descriptive statistics of the dependent variable in 2008 (by country and industry) Variable n Mean St. Dev. Minimum Maximum Cindex all firms , Cindex - Spanish firms Cindex - UK firms Cindex - Real Estate firms Cindex - Non Real Estate firms Table 2 also shows that Spanish firms display a lower level of compliance than UK companies (0.509 and versus and in 2005 and 2008 respectively). However, the level of compliance in both countries increases from 2005 and 2008 and the differences are significant at p < (t = and df = 53) in the case of UK and at p < (t = and df = 32) in Spain. These results are consistent with cultural influences, such as the domestic accounting standards prior to the adoption of IFRS, in firm s reporting decisions. Moreover, the majority of UK firms have chosen the fair value model in accounting for investment properties and a greater fulfilment of disclosure requirements (and particularly the items included in the disclosure index developed for this study) introduces reliability to fair value estimates. In the same manner, results on the average level of compliance of real estate firms (78% in 2005 and 86% en 2008) which is significantly higher than firms belonging to other industries (50% and 58% in 2005 and 2008, respectively) could also be attributable to cultural factors and to the fair value model as the preferred presentation for investment properties within the European real estate industry Determinants of compliance with IAS 40 disclosure requirements Firstly, we run a multivariate linear regression model [1] in order to test the relationship between the disclosure level and the different metric variables according to our 17

18 hypotheses concerning the economic determinants of compliance (H1, H2, H3 and H4b). Secondly, we use the Exhaustive Chi Squared Automatic Interaction Detector (Exhaustive CHAID) in order in order to analyse which independent variables better predict or are associated with the level of compliance Linear regression For the multivariate regression model, the equation is formulated as follows: CIndex it = β 1 TOTAL_ASSETS it + β 2 ROA it + β 3 LEV it + β 5 FV_CI_TOTALASSETS it [1] We test multicollinearity among the independent variables via VIF (variance inflation factor). Results do not show collinearity between the variables included in our model (the highest VIF calculated was for ROA in 2005 and for LEV in 2008) and all of them were included in the final model. Table 3 presents the results from our model trying to determine which factors are associated with the level of compliance with IAS 40 disclosure requirements in Spain and UK in 2005 and Table 3: Multivariate regression results Variable Predicted sign Coeff. T-value Coeff. T-value TOTAL_ASSETS *** *** ROA *** * LEV ** FV_CI_TOTALASSETS *** *** Adjusted R 2 Model's F-value Model's significance level The adjusted R 2 is satisfactory, approximately 69% in 2005 and 50% in The F- values of and in 2005 an 2008 respectively are significant at p < 0.000, meaning that the entire model is well specified. The results confirm the validity of the hypothesis related to size in 2005 and 2008 (both significant at the 0.01 level) and they are consistent with those obtained by Wallace et al (1994) and Giner (1997) in Spain, Cooke (1989a and 1992) in Switzerland and Ali et al (2004) in India, Pakistan and Bangladesh. Profitability proved to be positively related to disclosure compliance in 2005, with a coefficient that is significant at the 0.01 level. The majority of previous researchers could not confirm the hypothesis related to profitability except for Giner (1997) who found a negative relationship between the level of disclosure and profitability in Spain. 18

19 Accordingly, we also obtained a negative association in 2008 (although significance is low, at the 0.10 level). The different sign of the coefficient obtained in 2005 and 2008 could be explained by the economic situation. In 2005 real estate markets, particularly in Spain and the UK, experienced an extraordinary growth with a constant increase of housing prices. However, in 2008 the housing bubble generated from 2005 exploded and this fact together with the international financial crisis led to a sharp slowdown in the construction activities, the number of real estate transactions and, consequently, a strong decrease of housing prices. According to the results, firms with higher profitability in 2005 use disclosure compliance as a way of signalling the market. However, results in 2008 show that the extent of compliance is higher for firms with lower profitability probably to explain better to users the bad news 12 (Giner 1997). Leverage was found not to be significantly related to disclosure compliance in In contrast, the results in 2008 confirm that the level of compliance is higher for firms with higher leverage ratios (significant at the 0.05 level). The results are not surprising as in 2008 most of the real estate firms were in the process of negotiating refinancing of their debt facilities due to the situation of the real estate market, practically inactive. Also the cumulative impact of fair value was found to be significantly related to the level of disclosure compliance, with a coefficient which is significant at the 0.01 level. The relationship is positive as expected, confirming that Spanish and UK firms use disclosure to provide users sufficient information to assess the reliability of property estimates Exhaustive CHAID Analysis We use the Exhaustive CHAID (a tree-based model) in order to analyse which independent variables better predict or are associated with the level of compliance. Firstly, we discretized the dependent continuous variable (Cindex it ) into a categorical variable (Cindex it _CAT) by the grouping low, medium and high level of compliance with disclosure items. We have selected all the dependent variables (metric and categorical) as hypothesized in section 4 in order to determine which of them more strongly predicts the degree of compliance. In a first step, CHAID analysis makes a first segmentation which is the selection of the variable (predictor) that best predicts the level of compliance with disclosure items for 12 During the reading of the 2008 annual reports, we have observed that a significant number of firms (the majority in the real estate industry) disclose in 2008 information about the historical cost amounts of their investment properties even though the accounting choice has been for the fair value model and IAS 40 does not require disclosure on historical cost amounts under such model. 19

20 investment properties (dependent variable). The selection of the best predictor is based on the results of the Chi-Squared Test. In a second step, for each segment formed in the previous step, the exogenous variable with the most powerful prediction ability for the behaviour of the dependent variable is selected. Subsequently, successive classifications occur in the same manner as the previous step for each subgroup formed by the immediately preceding segmentation procedure. As illustrated in Figure 1, CHAID found that the best explanatory variable of compliance disclosure in 2005 was industry (significant at the 0.01 level). Figure 1 shows that, in 2005, real estate firms present a higher level of compliance (75,7% with a high degree of compliance) with disclosure requirements for investment properties than firms belonging to other industries (12% with a high level versus 50% with a low level of compliance). Figure 1: Exhaustive CHAID results in

21 As hypothesized, firms within the same industry tend to disclose similar information to users and as the fair value model is the preferred presentation for investment properties for the firms in the European real estate industry (Muller et al 2008) the level of compliance results higher for real estate firms than for other industries. At a second level of partitioning, Exhaustive CHAID did not find a statistically significant predictor for real estate firms. However, it was found that the firm s country of origin was the most explanatory variable (at the level of 1%) of firms in other industries (nonreal estate firms). Figure 1 also shows that, as hypothesized, Spanish non-real estate firms show a lower degree of compliance with investment property disclosure requirements than UK companies. These results confirm the ones obtained by Jaggi and Low (2000) and also reveal the influence of the previous domestic accounting standards on disclosure compliance as we argued in section 4. At the third level of splitting no statistically significant predictor was found. In relation to the accuracy of the model in 2005, we obtained that CHAID would correctly classify a 72.4% of the firms according to their disclosure index (dependent variable). We also used CHAID to analyse our sample in 2008, those results are illustrated in Figure 2. In 2008, CHAID founds, consistently with the results in 2005, that industry is the independent variable that more strongly predicts the level of disclosure companies (at a level of 1%). 21

22 Figure 2: Exhaustive CHAID results in

23 In addition, comparing information in node1 and node2 between 2005 and 2008, an improvement in the level of compliance disclosure is observed in real estate firms as well as in other industries. At a second level and regarding to non-real estate firms, results are also similar to those obtained in the model for 2005 and show a significant association (at a level of 1%) between non-real estate companies and the country of origin. A comparative analysis between 2005 and 2008 reveals that although UK companies continued presenting a higher level of compliance than Spanish firms, confirming our hypothesis, there has been an improvement of disclosure compliance in non-real estate companies in both countries. Regarding to real estate firms, results at a second level show a significant association (at a level of 5%) with the cumulative impact of fair value accounting. As disclosure practices within the same industry tend to be similar, an economic variable results to be the best predictor for the level of compliance. These results are very interesting because they show that once cultural factors influence is controlled, firms use mandatory disclosure to signal the market. The latter confirms that disclosure regulation represents a benchmark on the level of disclosure but not the minimum amount of information to be disclosed. This variable was also found to be significantly associated to the level of compliance in our results from the multivariate regression run. CHAID confirms those results for real estate companies. The global accuracy of the model is acceptable and CHAID classify correctly a 65.5% of the firms. 6. CONCLUSION In this study we found that Spanish companies display a lower level of compliance with mandatory disclosure of investment properties than UK firms although there has been an improvement in the degree of compliance in both countries from 2005 to Mandatory disclosures are informative to investors for decision making but the amount of required information is very extensive and has been increasing over the years (Schipper 2007). Firms show some flexibility in the level of compliance with disclosure requirements (Chavent et al 2006) and a highest level of disclosure is firstly associated with cultural pressures to reveal (proactive attitude) and later with communicative purposes (reactive response). These results suggest that disclosure regulation acts as a benchmark more than as a minimum level of information, and companies react to the information s overload with a relaxation on fulfilment. 23