Literature Review

SHAN ZHOU, ROGER SIMNETT, AND WENDY GREEN Does Integrated Reporting Matter to the Capital Market? Integrated reporting () is an emerging international corporate reporting initiative to address limitations to extant corporate reporting approaches, which are commonly criticized for being both voluminous and disjointed. While is gaining in popularity, current momentum has been limited due to a lack of clear evidence of its benefits. Utilizing the most suitable setting currently available, being discretionary disclosures made by listed companies on the Johannesburg Stock Exchange, this study provides evidence that analyst forecast error reduces as a company’s level of alignment with the framework increases. Further, the improved alignment is associated with a subsequent reduction in the cost of equity capital for certain reporting companies. The results are obtained after controlling for factors relating to financial transparency and the issuance of standalone non-financial reports, which suggests that is providing incrementally useful information to the capital market over and above existing reporting mechanisms. Key words: framework; Analyst forecast dispersion; Analyst forecast error; Cost of equity capital; Integrated Reporting. Businesses, investors, capital markets, and the broader economy all depend upon the provision of high-quality, value-relevant information from companies to ensure the efficient and effective allocation of resources, to encourage a vibrant climate for investment, and to facilitate transparent, ethical, and sustainable business practices. While there have been a number of attempts by individuals and groups to expand or enhance the value-relevance of the information produced by companies to aid decision-making, a recent initiative called Integrated Reporting () has the potential to change the landscape of corporate reporting. The International Integrated Reporting Council (IIRC), which is a ‘global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs’ (IIRC, 2013), has played a pivotal role in raising the international profile of, and developing a global framework for, . The aim of an integrated report is SHAN ZHOU ([email protected]) is a Lecturer at the University of Sydney Business School. ROGER SIMNETT is Academic Director, Scientia Professor of Accounting and Macquarie Group Foundation Chair and the University of New South Wales (UNSW) Australia Business School. WENDY GREEN is an Associate Professor at the UNSW Australia Business School. This paper has benefited from thoughtful comments from Mike Bradbury, Jeffery Cohen, Peter Easton, Karla Johnstone, Stewart Jones, John Roberts, Jianfeng Shen, Ann Tarca, Greg Trompeter, Ann Vanstraelen, Chris van Staden, Norman Wong, and participants at the 2015 AFAANZ conference, the University of Sydney Business School, and the 2013 AFAANZ Doctoral Symposium. We gratefully acknowledge financial assistance from an Australian Research Council linkage grant, with CPA Australia and the Chartered Institute of Australia and New Zealand. ABACUS, Vol. 53, No. 1, 2017 doi: 10.1111/abac.12104 94 © 2017 Accounting Foundation, The University of Sydney bs_bs_banner to provide a concise, holistic account of company value and performance by reporting a comprehensive range of financial as well as human, intellectual, environmental, and social factors that impact on a company’s short-, medium-, and long-term capacity for value creation. As such, it incorporates but goes beyond the types of information currently reported in companies’ financial statements (IIRC, 2013). Organizations have increasingly utilized mechanisms beyond financial statements to satisfy increased stakeholder demands for information about their organizations, the chief conduit for which has been standalone sustainability reports (Simnett et al., 2009; Cohen et al., 2012). While the practice of issuing standalone sustainability reports is now a mainstream business practice (KPMG, 2013), one of the major criticisms of this practice is the sheer volume of information produced, often without identification of strategic or financial implications or relation to information contained in the Annual Report, which has rendered it of little use to information users, especially providers of financial capital (Eccles and Krzus, 2010; Eccles and Serafeim, 2014). One aim of is to reduce the clutter of current corporate reporting by promoting conciseness. claims to do this by having a different materiality lens whereby directors disclose what they consider to be material to the value-creating activities of the organization. A further claimed benefit of is that it combines the most material elements from an organization’s separate reporting strands into a concise, coherent report. In so doing, it not only reports the most strategically relevant information, which is important for investors’ investment decisions (Cheng et al., 2015), but also shows the connectivity between these elements and explains how they affect the ability of an organization to create and sustain value in the short, medium and long term (IIRC, 2013a), addressing the potential short-termism of current reporting practice.1 has gained significant momentum since the establishment of the IIRC in 2011, culminating in the release of the framework in December 2013 (IIRC, 2013a). The significance of is further evidenced by the increased interest in the IIRC Pilot Programmes2 as well as an increasing number of regulatory initiatives around the world that are consistent with the principles of . 3 Anecdotal and 1 Examples of best practice can be found on the examples database, at http://examples. integratedreporting.org/home 2 The IIRC currently runs three main Pilot Programmes, namely, the IIRC Pilot Programme Business Network, the IIRC Pilot Programme Investor Network, and the Public Sector Pioneer Network. For detailed information on these see http://www.theiirc.org/companies-and-investors/ 3 For example, the Johannesburg Stock Exchange (JSE) became the first stock exchange to incorporate the move toward into its listing rules in 2010. A number of other stock exchanges, including those of Sao Paulo, Singapore, Kuala Lumpur, and Copenhagen are calling for a ‘report or explain’ requirement (IIRC, 2014a). In addition, support for a review by the IIRC and International Accounting Standards Board in relation to making corporate reporting more conducive to long-term investment has been noted by the B20 (B20, 2014). The International Federation of Accountants (IFAC) has also recommended that the G20 formally signal its support for the work being undertaken by the IIRC (IFAC, 2014). Moreover, the European Commission passed legislation in 2014 which will require around 6,000 European entities to provide disclosures on non-financial and diversity information (IIRC, 2014a). DOES INTEGRATED REPORTING MATTER TO THE CAPITAL MARKET? 95 © 2017 Accounting Foundation, The University of Sydney survey evidence indicates that brings internal benefits to a company in the form of accelerating integrated thinking within organizations, which leads to better management decision-making (IIRC and Blacksun, 2014). This new type of reporting is aimed at ‘providers of financial capital’ as its primary audience (IIRC, 2013a). If the reporting initiative is indeed helpful to such providers in assessing the prospects of companies, it is expected that some capital market benefits will accrue to the reporting companies such as enhanced reputation and increased transparency, which could result in a lower cost of capital (IIRC, 2011; IRCSA, 2011; PwC, 2014). However, empirical evidence substantiating the benefits of remains sparse. Therefore, this study aims to provide empirical evidence to answer the question ‘Does matter to the capital market?’ In doing so, it first examines whether information contained in integrated reports is useful to sophisticated capital market participants such as analysts by examining the effect of companies producing integrated reports more aligned with the framework (referred
to as higher integrated reports) on sell-side analysts’ earnings forecast properties. The study then considers the potential flow-on effect of the improved information environment by examining whether companies producing higher quality integrated reports enjoy the benefit of a reduced implied cost of equity capital (ICC). With their significant emphasis on the corporate governance environment, the South African JSE became a forerunner in the adoption of by being the first stock exchange globally to incorporate the move toward into its listing rules, under its King Code on Corporate Governance (JSE, 2015). However, it is worth noting that the concept of is mandated on an ‘apply or explain’ basis, and full alignment with the framework may well take companies a number of years (KPMG, 2012). In the early years of application, companies choosing to apply the concept have significant discretion as to what they disclose and how they disclose it. This discretion creates significant variations in the alignment of the integrated reports with the framework, and therefore the quality of the integrated reports produced by the South African companies. For example, as a first step toward integration, some companies simply stapled their Corporate and Social Responsibility (CSR) reports with their Annual Reports (a combined report, rather than an integrated report) while others have gone much further in adopting the framework to communicate the strategic intentions, the business model, the risks and opportunities faced by the company, and how these factors interact with each other to affect the value-creation ability of the company. As a result, although all of the various reports are titled ‘Integrated Reports’, the level of alignment with the framework differs significantly across companies. In addition, the framework is principles-based in order to strike an appropriate balance between flexibility and prescription that recognizes the wide variation in individual circumstances of different organizations while enabling a sufficient degree of comparability across organizations to meet relevant information needs (IIRC, 2013a). It is recognized within the framework that those responsible for the preparation and presentation of the integrated report need to exercise judgement, given the specific circumstances of the organization to ABACUS 96 © 2017 Accounting Foundation, The University of Sydney determine which matters are material and how they are best disclosed (IIRC, 2013a). It is therefore the difference in the level of alignment arising from managements’ discretion, and changes in alignment within a company over the years, that this study is capturing to test whether it makes a difference to the capital market. Nonetheless, the South African experience in adopting the International framework4 presents the most suitable setting to examine our research questions because (i) it is the only exchange that has embraced and encouraged over a period of time which thus allows changes and any associated impacts in the reporting quality to be observed, (ii) it is the only exchange where listed companies have the explicit goal to align with the framework, and (iii) the announcement to incorporate the move towards into the listing rules in South Africa presents an exogenous shock to companies, thereby offering a natural experiment setting which is particularly beneficial in reducing the potential endogeneity bias usually present in studies examining the economic consequences of voluntary disclosures (Gipple et al., 2015). To further address potential endogeneity concerns, additional measures, including the lead–lag approach, the changes specification, and Heckman’s two-stage analysis are also employed in the study. Using a sample of 443 company-year observations listed on the JSE from 2009 to 2012, we find that the level of alignment of an integrated report with the framework is negatively associated with analyst earnings forecast error and weakly negatively associated with analyst earnings forecast dispersion, suggesting that information contained in an integrated report is useful for analysts in assessing the future financial performance of companies. Further, we identify a negative relationship between the level of alignment of integrated reports with the framework and both the ICC and the realized market returns, which is consistent with previous studies (Jones et al., 2007; Hong and Kacperczyk, 2009) and the proposition that investors are willing to accept a lower rate of return as a result of reduced information risk from the improved information environment for these companies. Sub-sample analysis suggests that the benefit of ICC reduction is more evident among companies with a low analyst following, since the benefit is expected to be less significant for those with better information environments, that is, those companies with a larger analyst following (Botosan, 1997; Griffin and Sun, 2014; Merton, 1987). The results from this study are obtained after the company-level characteristics relating to financial transparency and the issuance of standalone CSR reports are controlled for, suggesting that information contained in an integrated report is incrementally useful to analysts and investors in addition to current reporting practices. This is further evidenced from the results of additional analyses that indicate that it is mainly those components containing new information in an integrated report that are driving the results identified. Taken together, the evidence suggests that 4 The Integrated Reporting Committee of South Africa (IRCSA) announced its endorsement of the International framework in March 2014. Before that, companies relied on the guidelines provided in the discussion paper of the IRCSA issued in 2011 in preparing their integrated reports. The IRCSA shares information with the IIRC with the aim of ensuring that local guidance is in line with international guidance issued by the IIRC (IRCSA, 2011, p. 5). DOES INTEGRATED REPORTING MATTER TO THE CAPITAL MARKET? 97 © 2017 Accounting Foundation, The University of Sydney the quality of integrated reports matters to capital market participants. Specifically, integrated reports with a higher level of alignment with the framework bring the benefit of an improved information environment for reporting companies, evidenced by improved analyst forecast accuracy. This improved information environment in turn brings the benefit of a lower ICC to reporting companies. This paper has several contributions. First, there has been debate on whether has real benefits or is just a passing fad. By documenting empirical evidence on whether is value-enhancing to reporting companies, this study assists in moving the debate forward and provides incentives for the voluntary adoption of . Second, is increasingly on the agenda of regulators around the world (IIRC, 2014a). At the international level, support for has been received from influential corporate forums such as the B20 (B20, 2014) and the International Federation of Accountants (IFAC). At the national level, many countries are revising their corporate reporting regulations in a manner consistent with the principles of . 5 The results from the current study are therefore expected to have practical regulatory implications. In particular, the experience and lessons from companies listed on the JSE can provide valuable guidance for regulators in other jurisdictions about the costs and benefits of adopting . Finally, this study extends the testing of voluntary disclosure theory which to date is limited to either only financial information (Beyer et al., 2010; Healy and Palepu, 2001) or only non-financial information (Dhaliwal et al., 2011, 2012, 2013) into a new and distinctive realm of voluntary corporate reporting, one that goes beyond current corporate reporting practices and which may become the norm for corporate reporting in the near future (IIRC, 2013a). THEORY AND LITERATURE REVIEW Information Quality and Analysts’ Earnings Forecasts As outlined above, this study examines whether the different levels of alignment with the framework in co
mpanies’ integrated reports arising from managements’ disclosure discretions matters to the capital market. Owing to the discretionary nature of the disclosures at this early stage of the journey, we employ voluntary disclosure theory in developing our hypothesis. Voluntary disclosure theory asserts that voluntary disclosures help to improve the information environment of companies by enhancing analysts’ understanding of companies’ prospects (e.g., Beyer et al., 2010). Following the theory, empirical 5 For example, the reporting requirement of the annual Operating and Financial Reviews (OFRs) in Australia, and the Strategic Report and Directors’ Report Regulations in the United Kingdom which came into force on 20 September 2013 to enable a simpler framework for narrative reporting by reducing the burden on companies that are currently producing large, complex reports that often lie unread by investors (UK FRC, 2009; The Companies Act 2006 Regulations 2013; UK National Archives, 2013). Also, the European Parliament’s legislative resolution that requires certain large European countries to disclose non-financial and diversity information which creates an underpinning for and stimulates sustainable thinking and practice (Huggins and Simnett, 2015; European Parliament, 2014). ABACUS 98 © 2017 Accounting Foundation, The University of Sydney studies generally document a positive relationship between disclosure quality and analysts’ earnings forecasting properties, such as lower forecast error and dispersion (Barron et al., 1999; Barth et al., 2001; Bradshaw et al., 2008; Hope, 2003; Lang and Lundholm, 1993; Plumlee, 2003). The general argument from these studies is that better disclosure quality enhances analysts’ understanding of the company’s performance and future outlook and helps analysts interpret the disclosures in an informed and similar manner, which in turn results in an improved forecast accuracy and a lower forecast dispersion (Hope, 2003; Lang and Lundholm, 1996). Moreover, better disclosures lower the costs of processing and interpreting the disclosures, and thus enhance analysts’ ability to correctly incorporate all pertinent information, which in turn results in improved earnings forecasts (Lehavy et al., 2011). Evidence from prior literature also reveals that analysts use non-financial information in their earnings forecasting (Dhaliwal et al., 2012; Nichols and Wieland, 2009; Orens and Lybaert, 2007; Simpson, 2010). The supply of non-financial information is beneficial in reducing analyst earnings forecast error and dispersion (Dhaliwal et al., 2011, 2012; Nichols and Wieland, 2009) and analysts issue more optimistic recommendations for companies with higher CSR ratings (Ioannou and Serafeim, 2015). In fact, considerable evidence shows that analysts use financial information and non-financial information interactively in their earnings forecasting (Coram et al., 2011; García-Meca and Martinez, 2007; Ghosh and Wu, 2012; Maines et al., 2002; Orens and Lybaert, 2010; Pflugrath et al., 2011; Simpson, 2010). This means that both types of information are integral to analysts’ earnings forecasting. Theoretically, the ability of analysts to forecast earnings should improve with the amount of disclosure (regardless of whether disclosures are financial or non-financial) as long as they help analysts to assess companies’ future performance. However, analysts are known to have cognitive limitations in information processing and the complexity of the task is found to adversely affect analyst earnings forecast error and dispersion. For example, analysts’ forecasts have been found to be less accurate if they are associated with complex changes to tax laws (Plumlee, 2003), and more complex accounting choices can negatively affect forecast accuracy and increase dispersion (Bradshaw et al., 2008). Further, although analysts exert extra effort in generating reports when analyzing companies that produce less readable 10-K filings, these less readable 10-Ks are still associated with greater dispersion, lower accuracy, and greater overall uncertainty in analyst earnings forecasts (Lehavy et al., 2011). Thus, if such problems exist for analysts relying on complex financial information, then adding non-financial information into their decision-making processes could exacerbate the adverse effects. This is especially the case when the correlation between non-financial information and financial information is not well articulated, which adds significantly to the total task complexity and thus the issue of ‘overload’ for analysts. Empirical evidence shows that analysts tend to underreact to information in non-financial measures (e.g., customer acquisition cost, average revenue per user) even though those measures can have significant predictive ability for future earnings (Rajgopal et al., 2003; Simpson, 2010). Furthermore, the relevance of the information format has also been well documented in psychology and accounting studies, revealing that the way information is DOES INTEGRATED REPORTING MATTER TO THE CAPITAL MARKET? 99 © 2017 Accounting Foundation, The University of Sydney systematically presented affects the way people think about that information. Informationally equivalent disclosures that vary only in their ease of processing can have differential effects on market prices (Hopkins, 1996; Hodge, 2001; Hodge et al., 2006; Kelton et al., 2010; Koonce and Mercer, 2005). The insights from these studies suggest that even if is simply an improved re-formatting of information currently required, it could still beneficially impact upon users’ information processing, including sophisticated users like financial analysts. By incorporating material non-financial information with financial information into one report, can increase the salience of those material non-financial information items, which users may ignore if they are reported separately (Agnew and Szykman, 2005; Hirshleifer and Teoh, 2003). To summarize, disclosure theories and associated empirical evidence demonstrate that both financial and non-financial information have the potential to improve analysts’ forecasting abilities if they are value-relevant and/or they help to reduce information acquisition and processing costs. Studies using psychology theories suggest that analysts’ earnings forecasting abilities could be hindered by voluminous reporting and by their failure to fully incorporate non-financial information into their decision making. Information Quality and the Cost of Equity Capital Theoretical studies have established both direct and indirect links through which financial information can affect the cost of equity capital. The direct links include risk sharing (Merton, 1987) and the reduction of estimation/information risk (Barry and Brown, 1984, 1985; Brown, 1979; Coles et al., 1995). This line of research suggests that providing better information will reduce the estimation risk and therefore the cost of capital. The indirect links include the effect on market liquidity and information asymmetry (Baiman and Verrecchia, 1996; Diamond and Verrecchia, 1991; Easley and O’Hara, 2004; Verrecchia, 2001) and the effect on companies’ real decisions (Lambert et al., 2007). Despite theoretical conjecture on the negative link between discretionary disclosures and the cost of equity capital, the empirical evidence on the link is less consistent and robust for a definitive and unambiguous conclusion to be drawn (Beyer et al., 2010; Botosan, 2006; Core, 2001; Healy and Palepu, 2001; Kothari, 2001; Leuz and Wysocki, 2008). However, overall, the empirical studies generally provide support for the theoretical negative link between the level/quality of discretionary disclosures and the cost of equity capital, although the results appear to be sensitive to many factors such as the presence of market intermediaries (Botosan, 1997; Griffin and Sun, 2014), the types and frequency of disclosures (Botosan and Plumlee, 2002; Kothari et al., 2009), missing control variables such as earnings quality (Francis et al., 2008), and countries’ institutional factor
s (Chen et al., 2009; Francis et al., 2005; Hail and Leuz, 2006, 2009). With the increasing trend of supplementing financial information disclosure with non-financial information disclosure, research has extended voluntary disclosure theory to non-financial information, with the assumption that this non-financial information is value-relevant (Margolis et al., 2009; Margolis and Walsh, 2003; Orlitzky et al., 2003). Following this line of thought, a number of studies have ABACUS 100 © 2017 Accounting Foundation, The University of Sydney examined the impact of CSR disclosures/performance on the cost of equity capital and have generally documented a negative relationship6 (Dhaliwal et al., 2011, 2013; El Ghoul et al., 2011; Plumlee et al., 2015). While these recent studies on CSR disclosures/performance yield useful insights into how non-financial information affects investor behaviour, they suffer from some limitations. First, these studies generally examine the issuance status of the CSR report (issued or not issued) without further distinguishing between the difference in the quality of those reports. Second, while the issuance of a CSR report signals progress toward expanding current corporate reporting to include environmental, social, and governance issues, there are criticisms that these reports are not easily related to a company’s strategy and business model, and are thereby less effective in communicating the company’s performance to investors (Eccles and Krzus, 2010; Serafeim, 2014). Despite ample evidence suggesting an interconnected relationship between non-financial information and financial information, most existing research examines them in isolation. Indeed, this propensity reflects the current bifurcated state of corporate reporting. The concept of aims to advance and enhance corporate reporting by placing emphasis on the interconnections between different types of information currently reported in separate strands. is still an emerging phenomenon so therefore empirical research about it is both recent and sparse. Among the limited empirical studies on , Serafeim (2014) provides evidence on the value of this form of reporting by examining the investor base of companies that practice . Using the data on Thompson Reuters Asset4 database to proxy for , Serafeim notes an association between and the investor clientele in terms of the investment horizon, but he also notes that it is not clear how investors change capital allocation decisions based on the information within integrated reports. Furthermore, as the data from the Asset4 database do not provide links to the content elements of integrated reports, Serafeim is not able to determine which elements of are most effective in attracting long-term investors. Our study advances the literature by examining two direct outcomes of user decisions, that is, the impact on analysts’ earnings forecasting tasks and the change in reporting companies’ cost of equity capital. Further, examining the level of alignment of companies’ integrated reports with the framework allows for a more in-depth analysis of the relationship between the disclosure quality of the integrated report and the associated economic outcomes. HYPOTHESIS DEVELOPMENT and Analyst Earnings Forecast Accuracy and Dispersion The preceding literature review suggests analysts’ earnings forecasting ability could be improved in three ways: (i) by having new value-relevant information; (ii) by 6 Richardson and Welker (2001) find a positive association between social disclosures and the cost of equity capital, which they attribute to either a lack of credibility for the social statements or to the perceptions of a negative cash flow impact from current spending on social projects. DOES INTEGRATED REPORTING MATTER TO THE CAPITAL MARKET? 101 © 2017 Accounting Foundation, The University of Sydney having better disclosed information, which reduces information acquisition costs, and/or a cognitive effect in processing and interpreting the information; and (iii) by having better presented information, which facilitates the incorporation of all relevant information into the user decision-making process. places emphasis on narrating companies’ value-creation stories during the short, medium, and long term by providing information relating to corporate strategy, business model, and future outlook (IIRC, 2013a). The long-term focus of corresponds well to the information demands of analysts with their long-term earnings forecasting horizon. In addition to current corporate reporting requirements, the integrated report can also provide new information, which is supported by the findings from an investor survey that was undertaken, and is described in the methodology section. Thus, the integrated report is expected to provide both new and useful information to analysts for their earnings forecasting tasks. The principles of mean that it provides more than additional value-relevant information. In particular, the key underlying principles of are materiality, conciseness, and connectivity (IIRC, 2013a). The materiality principle helps to declutter the report by including only substantial matters affecting a company’s value-creation ability. This in turn reduces the costs of information acquisition and processing, thereby relieving information overload faced by analysts. The conciseness principle stresses the need for cross-referencing between elements of the report and shifting detailed standard information to other platforms/documents. This helps to reduce the cognitive effort exerted by analysts in analyzing and interpreting the information. The connectivity principle means that the relationships among key elements included in the report are explicitly and clearly presented and articulated. This is not only useful in enhancing analysts’ ability to incorporate all value-relevant information into their decision making, but also in easing analysts’ information analyzing processes. In sum, the combined aim of these principles is to alleviate the information overload problem encountered by users by de-cluttering the report and highlighting the connections between different parts of the reports. Accordingly, the integrated report not only potentially contains new valuerelevant information which is helpful in assessing the long-term prospects of companies, but also information that is easier to process, thus enabling analysts to incorporate all pertinent information. In this way, analysts can have a better understanding of the company’s performance and future outlook and thus make improved forecasts. However, the effectiveness of is dependent on the quality of the integrated report, and more specifically on how well the prescribed principles are followed. In this sense, integrated reports that are more closely aligned with the principles are expected to be more helpful to analysts. This discussion leads to the first set of hypotheses to be tested in this study: H1a: Companies producing integrated reports more aligned to the framework have lower analyst earnings forecast error. ABACUS 102 © 2017 Accounting Foundation, The University of Sydney Following on from the previous discussion, if the integrated report contains useful value-relevant information, which is easy to understand and interpret, the reduced level of ambiguity will enhance the consensus among analysts during their earnings forecasting tasks. This effect is hypothesized as follows: H1b: Companies producing integrated reports more aligned to the framework have lower analyst earnings forecast dispersion. and the Cost of Equity Capital The literature outlined earlier suggests that the cost of equity capital can be affected by reducing the information asymmetry between the company and its investors (Healy and Palepu, 1993; Verrecchia, 1983; Lambert et al., 2012). could help reduce information asymmetry through at least three channels: (i) Signalling the quality of the company. requires a clear vision and commitment to sustainable value-creation activities and helps to identify risks and opportunities within the business. Thus, to report in an integrated manner
signals to readers that sustainability is an integrated part of a company’s daily business conduct and significant risks and opportunities are well managed. (ii) Expanding the information set of the company’s disclosure. has the ability to expand the information set so as to include all value drivers of the company (e.g., financial, environmental, social, and human) into one report and to connect them to describe the value-creation activities. In this way, it not only saves users’ information search costs and therefore helps increase liquidity, but more importantly creates new information content not necessarily captured in the current corporate reporting suite, such as corporate strategy, the company’s business model, and future-oriented information. More importantly, it highlights the links among all these value drivers, which in turn reduces information asymmetry between the company and investors. (iii) Reducing uncertainty in assessing the company’s performance. Many CFOs interviewed by Graham et al. (2005) revealed that reducing uncertainty about the company’s prospects is the most important motivation for making voluntary disclosures. The principles of place emphasis on the disclosure of corporate strategy, the company’s business model, and forward-looking information, with the aim of reducing the uncertainty around the company’s long-term performance. Thus, if the principles of are followed, an integrated report could help reduce the uncertainty relating to the company’s long-term performance and therefore the information risk of the company, resulting in a lower cost of equity capital. Collectively, theoretical arguments support the notion that could help reduce the cost of equity capital if the principles of are adequately followed, which is formally hypothesized as follows: H2: Companies producing integrated reports more aligned to the framework have a lower cost of equity capital. DOES INTEGRATED REPORTING MATTER TO THE CAPITAL MARKET? 103 © 2017 Accounting Foundation, The University of Sydney It is recognized that companies’ annual reports are not the only avenue through which companies disseminate information to stakeholders. Companies use other channels such as websites, conference calls, management forecasts, and media to communicate with information users. Nonetheless, market intermediaries, such as analysts, play an important role in analyzing, processing, and disseminating information about companies. The theoretical model of risk sharing noted by Merton (1987) suggests that disclosures by lesser known companies can make investors aware of their existence and therefore enlarge their investor base, which in turn improves risk sharing and lowers the cost of capital. In this sense, such an effect is likely to be less relevant for large companies, which are likely to have advanced information-sharing mechanisms such as a larger analyst and investor following. Voluntary disclosure theory also posits that the benefit of additional disclosure depends on the company’s information environment (Diamond and Verrecchia, 1991; Lambert et al., 2007; Verrecchia, 1983). This is particularly relevant to our study as the disclosures in annual reports may be more important for some companies than others. This asymmetric effect has been identified empirically (e.g., Botosan, 1997; Griffin and Sun, 2014). Our study is similar to Botosan (1997) in that we use disclosure in annual reports as a proxy for companies’ overall disclosure quality. Thus, the effect of on the cost of equity capital could differ between companies with different information environments. This is formally hypothesized as follows: H2a: The association between the level of alignment of the integrated report with the framework and the cost of equity capital is more significant for companies with a smaller analyst following. EMPIRICAL ANALYSIS Sample and Data The sample selection process started with all listed companies on the JSE with fiscal years ending in 2009 to 2012 that are also included on Global Compustat. This list of companies was then merged with corresponding analyst data from I/B/E/S. The annual fundamental data, market data, and exchange rate data were obtained from Global Compustat. All data were downloaded from Wharton Research Data Services (WRDS). After filtering for analyst data and required control variables, the final sample consisted of 443 company-year observations over four years (132 unique companies) for analyst forecast error7 and dispersion analysis and 430 company-year observations (130 unique companies) for cost of equity capital analysis. 7 To eliminate the possibility of one analyst poorly estimating earnings and thereby skewing the consensus figure, and to allow for a meaningful measure of dispersion, we retained only observations with more than one forecast in the sample. This filter is consistent with other academic studies (e.g., Cheong and Thomas, 2011), and in practice (e.g., Thomson First Call at http://help.yahoo.com/ 1/us/yahoo/finance/tools/research-03.html). ABACUS 104 © 2017 Accounting Foundation, The University of Sydney Research Model Hypotheses 1(a) and 1(b) are tested by estimating the following OLS regression: ΔFCERRORi;tþ1¼ β0þβ1ΔIR TOTALi;t þ β2ΔSIZEi;t þ β3ΔVAREARNi;t þ β4ΔLnANANOi;t þ β5ΔFFINi;t þ β6ΔLOSSi; þ β7ΔHORIZONi;t þ β8ΔCSRi;t þ ∑INDi;t þ ∑YEARi;tþεi;t (1) ΔFDISPi;tþ1¼ β0 þ β1ΔIR TOTALi;t þ β2ΔSIZEi;t þ β3ΔVAREARNi;t þ β4ΔLnANANOi;t þ β5ΔFFINi;t þ β6ΔLOSSi; þ β7ΔHORIZONi;t þ β8ΔCSRi;t þ ∑INDi;t þ ∑YEARi;t þ εi;t (2) The models follow those used in Dhaliwal et al. (2012) with the addition of the issuance status of a standalone CSR report as a control variable, which was examined in Dhaliwal et al. (2012) and found to help reduce analyst forecast error. All variables are analyzed in their changes form8 rather than levels form to address the potential endogeneity concern (Dhaliwal et al., 2011), as this approach controls for unobserved company characteristics (whether constant or time-variant) which might be correlated with analyst forecast properties. Further, to ensure that the results are not driven by the potential endogenous relation between changes in and ICC, all independent variables are lagged by one year. Hypothesis 2 is tested by estimating the following OLS regression: ΔICCi;tþ1¼ β0 þ β1ΔIR TOTALi;t þ β2ΔSIZEi;t þ β3ΔBMi;t þ β4ΔLEVi;t þ β5ΔLTGi;t þ β6ΔDISPi;t þ β7ΔBETAi;t þ β8ΔABS DAi;t þ β9CSRi;t þ ∑IND þ ∑YEAR þ εi;t (3) Equation (3) is developed from Dhaliwal et al. (2011) and similarly, all variables are analyzed in their changes form and a lead–lag approach is used in the model to ameliorate endogeneity concerns. To test Hypothesis 2(a) on the role of the information environment in the relationship between and ICC, the sample companies are partitioned into high versus low analyst sub-samples based on the sample median number of analysts following the company. The regression in equation (3) is run separately for the two sub-samples. Variable Definition–Dependent Variables Analyst forecast error (FCERROR) Consistent with Dhaliwal et al. (2012), the analyst forecast error is used as an inverse measure of forecast accuracy. Forecast error is defined as the average of the absolute errors of all forecasts for target 8 The results on the levels form of variables are displayed in Table 4 (columns 1–2) and Table 5 (columns 1–3) and are discussed in Heckman’s two-stage sensitivity analysis. DOES INTEGRATED REPORTING MATTER TO THE CAPITAL MARKET? 105 © 2017 Accounting Foundation, The University of Sydney earnings made in the 12 months after the fiscal year end of the integrated report, scaled by the share price9 at the fiscal year end: FERROR Yð Þi;t ¼ 1 N ∑N j¼1 FCY i;t;j EPSY i;t





=Pi;t Subscripts i, t, and j denote company i, year t, and forecast j, respectively. Indicator Y takes three values—zero, one and two—to denote whether the target earnings and forecasts are for current year, one-year ahead, or two-years ahead.10 FC is the analyst ea
rnings forecast for time t, and EPS is the actual earnings per share for time t. For consistency, both FC and EPS are obtained from the I/B/E/S database. The forecast horizon is restricted to a maximum of two years for the same reason noted in Dhaliwal et al. (2012): analysts typically do not make forecasts for periods beyond the third fiscal year. Further, as the sample period of this study is from 2009 to 2012, the sample size significantly decreases for three-year-ahead forecasts. Only forecasts made after the fiscal year-end month (1 to 12)11 are used to allow analysts to incorporate the information contained in the integrated reports into their forecasts. The natural logarithm of analyst forecast error (FERROR) is used in the regression to remove the skewness in the data as shown by the Skewness/Kurtosis tests, and the histogram suggests that the analyst forecast error is significantly right skewed. This approach is similar to that adopted in Lehavy et al. (2011). Analyst forecast dispersion (FDISP) Following Lang and Lundholm (1993), Hope (2003), and Lehavy et al. (2011), analyst forecast dispersion is defined as the standard deviation of analysts’ EPS median forecasts scaled by the share price at the fiscal year-end. For the same reason noted for forecast error, only forecasts made after the fiscal year-end month (1 to 12) are used. Implied Cost of Capital (ICC) The ICC in this study is calculated in the first instance using the PEG model from Easton (2004), namely ICC_PEG. A number of different models are available to calculate the cost of equity capital, and there is still significant debate as to which are the best measures (Botosan and Plumlee, 2005; Easton and Monahan, 2005; Botosan and Plumlee, 2011). The PEG model is used in this study 9 The share price is one of the most commonly used denominators in measuring forecast error. For a detailed explanation of the advantages of using share price as the denominator over others see Cheong and Thomas (2011). Other popular denominators include the actual/forecast earnings. Sensitivity analyses using these alternative denominators do not qualitatively change the results. 10 For brevity, in the main analyses, only the results of one-year-ahead analyst earnings forecast error and dispersion are reported. Results on the current year and the two-year-ahead analyst earnings forecast properties can be found in the additional analysis section. 11 The average of months 1 to 12 is used because it is impossible to specify the exact month in which analyst forecast ability is mostly affected by the information contained in the integrated report. This approach is consistent with previous studies on analyst forecast error, such as Lang and Lundholm (1996) and Dhaliwal et al. (2012). A similar approach is adopted in Hope (2003), but months 4 to 12 are used. Using months 4 to 12, analyst forecast horizon does not qualitatively change the results. ABACUS 106 © 2017 Accounting Foundation, The University of Sydney