Disclosure About Provisions and Contingencies in Spain, Implications for Risk Reporting

6

Disclosure about provisions and contingencies in Spain, implications for risk reporting

Ignacio Ruiz Albert

Joaquina Laffarga Briones

Sergio M. Jiménez Cardoso

University of Seville

1- Introduction

In order to offer a true and fair view, financial statements must report on provisions and contingencies. This information is relevant since it not only provides an estimate for liabilities but also indicates the assessment methods and the hypotheses underpinning those estimates. Lately, there is a growing demand for more information on risks but currently, it is disclosed only on a voluntary basis. However, our knowledge on the motivating elements or factors that affect the disclosure of this information is still shallow.

The aim of this research study is to describe the information disclosed about risk and to contrast the effect of the obligatory nature of the information and the features of the firm among the quantity of information discloses. This would make it possible to know to which extend this demand for traditional information is met. Furthermore, it would be useful for estimating the success of future demands for information on risks. The sample is made up by the yearly report of 60 non financial listed companies with significant provisions for liabilities.

2.- Recognition, measurement and disclosure of provisions and contingencies.

In the response of the American Accounting Association to IASC ED “Provisions, contingent liabilities and contingent assets” [Linsmeier et al., 1998] “based on the findings of the accounting research” reference is made to the following:

-  The findings suggest that market participants treat provisions and contingent obligations as liabilities when valuing firms, even when such obligations are not yet formally recognised in financial statements

-  Disclosures about provisions and contingencies provide relevant information to capital markets and others decision makers.

-  Disclosures about the critical components of accounting estimates are relevant for equity valuation (and a provision and contingent liability is a an estimate with a high degree of uncertainty).

-  Capital markets react negatively to the existence of uncertain potential obligations of firms. However, the capital markets react less negatively when firms are voluntarily forthcoming with reliable information about uncertain potential obligations.

Other accounting institutions [FASB, 1980 par. 87; ASB, 1995 par. 4.42 and AECA, 1999 par. 169] have proposed information disclosures about risk in certainty terms, because it provides users with a false sense of infallibility with regards to the figures included in financial statements.

Currently, Spanish firms must disclose a minimum set of information on provisions and contingencies in their annual reports, and they are allowed to hold from disclosing only what they consider not be significant (p. 7.a. of the annual report drafting regulations) or whatever can damage their position in disputes with other groups (IAS n# 37: par. 92).

Recently, the demand for information on risks is exceeding the scope of just provisions and contingencies. This same position has been defended by the “Operating and Financial Review” [ASB, 1993], the report “Improving Business Reporting – A customer Focus” [AICPA, 1994], the IOSCO [1998], the OECD [1999] in its document “Principles for firm governance” or the ICAEW [1998], which in its “Financial reporting on risk”, has opened a debate on the "risk statements that should be included in annual reports". These new information demands will generally have to be met with voluntary disclosures.

The demand for more voluntarily disclosed information about risks occurs at the time that our knowledge of the factors affecting the disclosure of this information is still shallow and it seems difficult to make solid forecasts on the basis of existing empirical information, due to the unprecise hypotheses proposed up to now with regards to the motivating factors and consequences of voluntary information disclosure, and the difficulty of measuring all the variables involved [Healy and Papelpu, 2000].

The selection of the voluntary disclosure strategy could be considered as a cost/benefit analysis. Within the costs we should consider direct ones, resulting from information production and disclosure and indirect ones, caused by its effects, among which the following have been proposed: potential erosion of the firm's competitive position stemming from the disclosure of information to its competitors [Verrechia, 1983; Scott, 1994], the impact of information considered to be negative [Skinner, 1994; Richardson, 1998] and shareholder litigation [Skinner, 1994; Francis et al., 1994]. Among the benefits proposed [Diamon y Verrecchia, 1991; Lev, 1992; Botosan, 1998 and Healy and Papelpu, 2000] we could mention those resulting from the reduction of asymmetry between insiders and the markets as an adverse selection problem, the increase of liquidity and market value of its equity, lower capital costs, increased participation of institutional investors in the firm and a better firm reputation.

Although the disclosure strategy decided by the company will depend from its particular circumstances (costs and benefits) it is intended to discover the general characteristics that are related to the decision of disclosing or not. Thus, Scott [1994] identified significant positive correlations between the information disclosed about pension plans and the average weekly wage rate and the pension funds/total assets ratio, and negative ones for the annual plan costs/pension funds, the strike incidence and the profit level. Linsmeier et al. [1998] indicated that the information about environmental liabilities increase with a) regulatory pressure, b) capital market concerns (i.e., if the firm perceives that the market overestimates the firm's liabilities) and c) potential cost recovery through rate regulation. Brown and Deegan [1998] found a relation between the amount of environmental information disclosed by firms in an industrial sector and the attention devoted by the media to the environmental impact of those industries. Depoers [2000] pointed out that voluntary information increases with firm size and decreases when it can endanger competitive advantages or when labour pressures grow.

In this context the objectives of our work are as follows:

-  Describing the information about risks currently being disclosed by Spanish firms.

-  Assessing the potential effect of the establishment of regulations determining the amount of information to be disclosed. This will let us know the degree of compliance with current minimum standards and predict the amount of voluntary information to be disclosed in the future.

-  Finding out the intensity of the relationship between the amount of information about risks disclosed and the following features: firm size; materiality of provisions; existence of regulated prices degree of foreign activity.

3.- Sample selection and data collection

The sample includes the annual reports published by the National Stock Market Commission (CNMV) of publicly traded non-financial companies with provisions for liabilities of more than 500 million pesetas or exceeding 15% of their equity at the end of 1998. At the time the sample was selected (2nd quarter 2000) the Sabe database (marketed by Informa) included data from 169 listed non-financial firms. Although 69 of them met the initial requirements, one of the annual reports provided by the CNMV was illegible, and therefore the sample included 68 firms. The firms included are listed in table 1 attached. Table 2 shows some of the relevant characteristics of the 100 non-financial firms which were not included.

Since the balance does not acknowledge any guarantee or contingency, we could not use a similar strategy to select a representative sample. Therefore, we considered that the above sample was a set as good as any other to analyse the information contained in the annual report on these issues. Since a priori we ignore the existence of contingencies and guarantees (and therefore the obligation of disclosing this information) we will be able to assess only the extent of data disclosed, if there is any, and never the failure to meet their information disclosure obligations.

With the purpose of instrumenting data collection we listed the information about risks considered to be relevant by:

-  The General Accounting Plan (PGC).

-  The AECA document "Accounting Principles. Provisions, contingencies and events after closing date".

-  The NIC # 37 of the IASC: “Provisions, contingent liabilities and contingent assets”.

-  Castrillo Lara [1996].

A review of Spanish literature did not evidence any demand for information about risks in addition to that included in the above documents, which also included those listed as relevant by the American Accounting Association [Linsmeier et al., 1998].

In order to collect all the information needed to perform the analysis we also considered adequate to register the following characteristics of each firm:

-  Final value of assets, equity and of all provisions for liabilities.

-  Current or past existence of regulated prices.

-  Exports/total revenues ratio.

-  Equity held by significant foreign shareholders.

-  With regards to the "Provisions for other trade operations", if they were end-of-work provisions /typical in construction firms).

-  With regards to "Guarantees to third parties", if there were any additional guarantees in report chapters different from those specifically devoted to these events.

The first two columns of table 3 include all the information considered to be relevant for each risk and the highest level document stating the need to disclose them. The frequency of information disclosure can be found in the last column. Tables include the statistics of information disclosed about the different provisions and they have been ordered according to the final settlement and differentiating between voluntary and mandatory disclosures.

In our opinion there should be no assessment mistakes after the control processes performed. These controls were as follows: a) each evaluator made a double search (by paragraphs and looking different terms in the annual report computer databases ), b) drafting a definition and explanation table and b) comparing, discussing and solving all discrepancies arisen among evaluators on a regular basis.

The relationships among firm characteristics and between them and the amount of information disclosed is listed in tables 4 and 5 .

4.- Results

Data suggest that possibly the first conclusion to be drawn from the information disclosed is that the accounting or classification selected are not generally accepted. This has resulted in a small (but significant) proportion of public listed firms audited and supervised by the CNMV and the financial press.

Furthermore, in general public traded firms: a) only report systematically on the settlement of each budget item and on the changes experimented over the year, b) do not provide relevant information on the accounting criteria used, c) do not describe the risks provisioned for beyond the general definitions of the PGC, and d) report on risks in terms of certainty. These imperfections should not be considered minor ones, since empirical evidence suggests that markets and other decision-makers consider this information to be relevant. Furthermore, firms make a systematic use of the opportunity to not disclose information that might endanger their position in disputes with other groups.

Despite of the fact that not even the firms with larger provisions for risks and expenditures do fully meet their obligations, we have verified that the minimum amount included in reports is a great conditioning factor for the information disclosed. In the best of cases (Provisions for Pensions) voluntary information is disclosed with a significantly lower frequency, and in the worst ones (Provisions for other trade operations and Other provisions in group I), voluntary information does not exist. These data forecast little success for the documents fostering the disclosure of voluntary information or establishing the disclosure obligations in such an ambiguous way that they indeed allow societies to interpret the scope of their obligations. We could exclude from the above the issues receiving an extensive media coverage or the costs that could be incorporated to the calculation of regulated prices.

The information disclosed in the annual reports on guarantees to third parties is generally restricted to the existing warrants. Unfortunately they are so vaguely expressed that when reading the notes on these issues we cannot conclude that all the guarantees given have been declared.

The term contingency was mainly used with the meaning of provisionable risk. Only 5 firms disclosed information on contingencies in this sense. Due to their low frequency it was impossible to conduct any analysis.

The firm characteristics we have studies can be grouped statistically into three categories: firm size (Assets, Equity, Provisions for pensions, Other provisions of group 1 and Regulated Prices), weight of provisions for pensions (Provision for Pensions, Provision for Pensions / Assets and Provision for Pensions / Equity) and weight of Other provisions of group 1 (Other provisions of group 1, Other provisions of group 1 / Assets and Other provisions of group 1 / Equity). The variables of foreign involvement (Foreign shareholders and Exports / Total Revenues) do not have a significant statistical relation.

With regards to the relationship between amount of information disclosed and firm characteristics, we have observed that:

-  The amount of information disclosed is not significantly correlated to the presence of foreign shareholders or to the export ratio.

-  The variables related to firm size show a significant correlation with the amount of information disclosed on Provisions for pensions, but not with the information disclosed on Other provisions of group 1, which is almost non-existent.

-  The variables related to the weight of provisions show significant correlations with the amount of mandatory information disclosed on the corresponding provisions.

-  Firms that operate or that until recently have operated with regulated prices disclose more voluntary information on Provisions for pensions and mandatory information on Other provisions of group 1, and although this could be due to the correlation detected in the sample between this variable and firm size and relative weight of Other provisions of group 1.

-  Evidence seems to validate with regards to risk what Linsmeier et al. [1998] stated about disclosure of information on environmental "liabilities".

-  On the one hand, the information disclosed on Provisions for trade operations, Provisions for pensions and Other provisions of group 1 are coherent with the influence of regulatory bodies. On the other hand, the existence of regulated prices is positively correlated with voluntary information disclosed on Provision for Pensions and mandatory (and single) information on Other provisions of group 1.

-  The massive disclosure of information on the Y2K bug (all firms reported extensively on it and finally concluded that it would not have any impact on the course of the firm and that the costs, provisions, investments and commitments made were irrelevant) is coherent with: a) the increase of information disclosed when firms estimate that markets overestimate their obligations [Linsmeier et al., 1998], and b) with the relationship detected by Brown and Deegan [1998] in the disclosure of environmental information between the amount of information received about any issue and its media coverage.