The relationship between the outside financing and the quality of financial reporting: evidence from Iran
| Date | 04 January 2016 |
| DOI | https://doi.org/10.1108/JABS-04-2014-0027 |
| Pages | 20-40 |
| Published date | 04 January 2016 |
| Author | Behzad Kardan,Mahdi Salehi,Rahimeh Abdollahi |
| Subject Matter | Strategy,International business |
The relationship between the outside
financing and the quality of financial
reporting: evidence from Iran
Behzad Kardan, Mahdi Salehi and Rahimeh Abdollahi
Behzad Kardan,
Mahdi Salehi and
Rahimeh Abdollahi are all
based at the Ferdowsi
University of Mashhad,
Mashhad, Iran.
Abstract
Purpose –This study aims to investigate the impact of outside financing (equity and debt financing) on
the quality of financial reporting in Iran.
Design/methodology/approach –Sample includes the companies listed on the Tehran Stock
Exchange – 152 companies in a period of four years during 2010-2013. Data were analyzed by using
multiple linear regressions with the benefits of the combined data.
Findings –The results indicates that there is a positive relationship between the quality of financial
reporting based on the qualitative characteristics of the theoretical principles of the Iranian Financial
Accounting Standards Board and debt financing. Moreover, there is a negative relationship between
the quality of financial reporting based on the Dechow and Dichev (2002) model and debt financing.
Additionally, there is a negative relationship between the quality of financial reporting (based on the
qualitative characteristics of the theoretical principles of the Iranian Financial Accounting Standards
Board as well as the Dechow and Dichev models) and equity financing.
Originality/value –Financial statements as the output of the accounting system has always been
considered by the investors, the creditors and the government; nonetheless, its dependability in making
decisions has always been doubted because of using the accrual principle in the calculation of the
reported figure in the statements and, consequently, the possibility of being manipulated by the
managers as well as the likelihood of conflict of interest among the managers and the shareholders.
Keywords Capital markets, Financial markets, Financial system
Paper type Research paper
1. Introduction
Enterprises and organizations increasingly need correct and timely information for use in
the decision-making process. In general, accounting information is a qualitative
characteristic that can be used in the decision process. Having formed a separation
between the ownership and the management and forming the conflict of interest among the
owners and managers, providing financial statements for external financial reporting
purposes and evaluating the quality of the intended statements are among the interesting
matters for the creditors, the owners, the governments and even the managers. The main
objective of the financial statements is to provide the appropriate information regarding
financial and operating position to make sound decisions by the investors and creditors. If
the financial statements truly meet such objectives, they will have the required quality
(Aboody et al., 2005); nonetheless, two factors including the conflict of interest and the
information asymmetry among the managers and owners would make the managers to
distort the information included in the financial statements (Rajgopal and Venkatachalam,
2011). Therefore, the managers attempt to manage earnings and report the shareholders’
expected earnings to maintain their job security as for increasing their own salaries and
advantages. Applying the earnings management does not disclose the financial
statements of the company’s real status, making it impossible to appropriately decide
based on such statements. Consequently, the financial reporting quality will be decreased,
Received 9 April 2014
Revised 7 February 2015
15 May 2015
Accepted 8 July 2015
PAGE 20 JOURNAL OF ASIA BUSINESS STUDIES VOL. 10 NO. 1, 2016, pp. 20-40, © Emerald Group Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-04-2014-0027
bringing about a decrease in the quality of financial reporting (Habib et al., 2011). A
growing body of accounting research concludes that higher financial reporting quality
reduces the negative effects of financing constraints on investment by mitigating
information asymmetry (Biddle et al., 2009;Biddle and Hilary, 2006;Verdi, 2006;Hope et
al., 2009).
Bushman et al. (2004) states that financial reports can affect the stock market brought in
three ways:
1. It helps financial results; good or bad investments is recognized that this risk
assessment and therefore reduces the cost of capital.
2. Higher-quality financial reports provided to investors distinguish between good and
bad managers, thus helping reduce agency costs and capital cost.
3. Obscure accounting reports and economic realities undermines the relationship
between accounting figures, and information asymmetry is inevitably increased.
Ghosh and Moon (2010) state that debt financing is among the factors which influence
earnings quality. Concerning the relationship between debt financing and earnings quality,
various viewpoints have been proposed, including the direct linear relationship, the
reversed linear relationship and the non-linear relationship. The direct linear view indicates
that, as the debt level increases, the quality of the financial statements increases due to the
fact that the creditors require audited financial statements for providing credits and as the
quality of the required information goes higher, providing credit will be done easier,
accordingly. In this way, a considerable control is applied on the debtors, making them to
provide accurate and high-quality information (Armstrong et al., 2010). The reversed linear
view suggests that the managers are inclined to manipulate the companies’ financial
information, as well as display more optimum financial position to receive credit.
Consequently, with the increase of the debt level, the quality of the information falls (Dichev
and Skinner, 2002;DeFond and Jiambalvo, 1994). The non-linear view suggests a kind of
share-like relationship between the debt financing and the quality of financial reporting
which is a combination of the two views of the direct linear and reversed relationships
(Ghosh and Moon, 2010). In this study, the relationship between outside financing (equity
and debt) on the quality of financial reporting of the manufacturing companies listed on the
Tehran Stock Exchange was examined to explore the relationship between debt financing
and the quality of financial reporting which is observed in three modes in Iranian stock
companies, by making use of the Dechow and Dichev (2002) scale of measuring quality as
well as examining the quality based on theoretical concepts on the quality characteristics
of the Iranian financial accounting standards based on the timeliness and dependability.
Additionally, this research was aimed at exploring whether there is any relationship
between the quality of financial reporting and equity financing.
2. Theoretical issues and literature
2.1 Hypotheses development
There are various theories concerning the selection of financing resources (debt and
equity) proposed by the researchers. They can be listed as follows.
2.1.1 The traditional theory. This method revolves around the existence of an optimum
structure of the capital company’s value using the leverage. In fact, the method suggests
that the capital cost, first, decreases due to the higher use of debt and then it would rise
due to the increase of equities’ cost (Mollanazari et al., 2009).
2.1.2 Modigliani and Miller’s theory with the assumption of lack of tax. Modigliani and Miller
(1958), the two thinkers who introduced the modern theory of capital structure in their
research (the MM theory), rejected the traditional theory while pointing out that the
company’s capital cost would not change under certain circumstances (the nonpayment of
the income tax and the lack of tax costs) with the company’s change of the capital
VOL. 10 NO. 1 2016 JOURNAL OF ASIA BUSINESS STUDIES PAGE 21
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