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Prior period adjustments and information
asymmetry: The case of Iran
Vahid Biglari
UCSI University, Kuala Lumpur
vahid@ucsiuniversity.edu.my
Frankie Goh Song Peng
UCSI University, Kuala Lumpur
FrankieGoh@ucsiuniversity.edu.my
Nasrin Azar
University of Malaya
nasrin.azar@siswa.um.edu.my
Abstract
This paper investigates the relationship between Prior period adjustments and
information asymmetry. The prior period adjustments are used in the financial
statements. However, their possible role in diminishing information asymmetry is not
clear. The main purpose of this paper is to examine whether information asymmetry
among investors is affected by companies’ prior period adjustments. In order to
accomplish this aim, Prior period adjustments are obtained from statement retained
earnings (losses); and information asymmetry is measured by spread.
Financial statements of 62 firm listed in Tehran Stock Exchange in period 2007-2014
are investigated. The findings indicate that there is no significant relationship between
information asymmetry at a particular period and Prior period adjustments of the next
period. Furthermore, study results show that the level of information asymmetry
doesn’t change in proportional to the changes of Prior period adjustments.
These findings can contribute to understanding of the nature of Prior period
adjustments of financial statements.
Keywords: prior period adjustments, information asymmetry, informed investors
and uninformed investors.
1. Introduction
Prior period adjustments (hereafter PPA), refers to adjusting accumulated income
(loss) of beginning of the year, and restatement of comparative items of financial
statements for last year(s). PPA is arising from: a) Change in accounting procedure
(policy), or (b) Prior period errors (IAS, 8).
The primary explanation offered by management for the use of PPA is to better reflect
the investment and operating environment of the firm. This common justification by
management is consistent with the tenor of accounting standards that allows for PPA.
Holthausen and Leftwich (1983) and Healy and Palepu (1993) suggest that discretion
over accounting methods enables managers to convey more value-relevant
information to the market. However, PPA decreases the consistency in financial
reporting and may impede a user’s ability to accurately assess a firm’s financial
performance relative to prior years. Furthermore, skeptics maintain that managers use
such discretion over accounting methods to manipulate earnings to influence
contractual agreements or the value of equity securities (Fields, Lys, & Vincent,
2001). Dharan and Lev (1993) use a “buy and hold” strategy for firms that engage in
changes in accounting principles and estimates. This strategy results in a negative
return over a five year holding period. The authors interpret their findings as evidence
that accounting changes portend poor future performance.
Bishop and Eccher (2000) provides a direct test of investor valuation of accounting
changes in the years subsequent to the change. They regress returns on earnings
components to assess how investors value these changes in the year they occur and
the subsequent two years. Results suggest that investors: (a) discount the positive
effect of useful life increases in the year of the revision, (b) value the negative effects
of useful life decreases in the year of the revision, and (c) consider the earnings effect
of these accounting changes when valuing the firm in subsequent years. Hodge et al
(2002) examine how an audit qualification of an accounting change affects investor
assessments of the firm's current and future financial performance, and the
representational faithfulness of the change. They investigate this issue for income-
increasing and income-decreasing accounting changes, and across four apparent
reporting strategies: reporting aggressively, taking a bath, creating hidden reserves,
and employing no apparent strategy. Their results show that when an income-
increasing accounting change is qualified, investors decrease their assessments of
current and future financial performance and when an income-decreasing accounting
change is qualified, investors’ assessments of financial performance are either
unaffected or decreased depending on the apparent reporting strategy. Thy also find
evidence that assessments of representational faithfulness relate positively
(negatively) to assessments of financial performance when accounting changes are
income increasing (decreasing), and under all conditions qualifications reduce
investor assessments of representational faithfulness.
Sajjadi (2004) examined the relation between PPA, stock price, size and life period of
the firms listed in Tehran Stock Exchange. His findings indicate a positive
relationship between PPA and stock price and also the size of the firm; but do not
confirm the relationship between PPA and life period of the firms. Azad and Kazemi
(2010) and MoshirFatemi (2007) show that financial statements of the majority of
firms listed in Tehran Stock Exchange have PPA. Kordestani et al (2011) investigate
the materiality of PPA in financial statements of the companies listed in Tehran Stock
Exchange. Their empirical findings indicate that amount of PPA is grater than
materiality threshold at overall prior period financial statements. Therefore awareness
of financial statements users from effects of PPA can influence their decisions.
Existence of PPA in financial statements may signal that financial statements in prior
periods were unreliable and misleading.
In addition, PPA can create Information Asymmetry (hereafter IA) between informed
and uninformed investors. Informed investors are likely to are corporate insiders, such
as managers and directors, and analysts’ and institutions given information by those
insiders (Easley & Ohara, 2004, pp. 1577-1588). Like IA in contracts, IA between
informed and uninformed equity investors creates deadweight losses (agency costs)
that reduce the firm’s expected cash flows (Watts, 2003, pp. 215-216) and increases
the equilibrium return on the firm’s equity (Easley, Hvidkjaer, & Ohara, 2002; Easley
& Ohara, 2004). Both effects reduce firm value.
Much of the IA arises from the nature of the firm’s investment opportunity set,
particularly the extent to which the firm has growth options (see Smith and Watts,
1992), but some also comes from the way in which the management formally collects
and reports information. Greater information asymmetries from growth options give
managers more opportunities to manipulate financial statements to transfer wealth to
themselves via insider trading and excess stock-price-based compensation (Corwin &
Schultz, 2012). Those attempts are costly because they divert management’s efforts
from maximizing firm value and so generate agency costs just as attempts by
managers to transfer wealth from other parties to debt and compensation contracts
generate agency costs (Jensen & Meckling, 1976).
Security markets tend to anticipate the agency costs and reduce share price. This
reduction in share value gives the management the incentive to reduce IA and the
consequent agency costs. Given that managers liability is effectively limited, the
manager is motivated to overstate performance and stock prices during his tenure and
transfer resources from both shareholders and lenders (Kim, Li, Pan, & Zuo, 2013).
The results of Kordestani et al (2011) research showed that most companies they
investigate, overstated the income of per financial period and then, tried to neutralize
those overstatements by using negative PPA. This result indicates financial number
game and earning management that consistent with manager’s motivation.
Existence of PPA in the annual financial statements indicates that, a part of relevant
accounting information is not reflected in financial statements of prior periods. Thus
insider information can be used to increase IA and reduce uninformed investors
return.
Considering what was said, we predict there is a positive relation between PPA and
IA; and PPA changes lead to IA changes. Therefore the following hypotheses are
posed.
2. Hypotheses
PPA is not reflected in prior period financial statements; therefore it creates IA
between managers, inside and Outside Investors. This reasoning provides us with two
hypotheses:
Hypothesis 1: the larger the PPA in the firm’s financial statements, the more the IA
between informed and uninformed investors.
Hypothesis 2: Changes in PPA lead to the same changes in IA.
3. Research design
3.1 Prior period adjustments
According to the accounting standards, PPA, means adjusting accumulated income
(loss) of beginning of the year and restatement of comparative items of Prior period(s)
financial statements of firms. PPA is arising from changes accounting procedures
(policies) and error correction. In other words, existence of PPA means:
(a) a company has adopted a new accounting procedure due to its predominance over
the past procedure, in terms of providing a desirable form of financial statements of
company, a change in Accounting procedures is justifiable, or changes are required by
new accounting standards or law
(b) During the current period, mistakes about one or more of the previous fiscal
period financial statements have been discovered. Such errors include mathematical
mistakes, mistakes in applying accounting principles, oversight or misuse of available
facts, use of unacceptable GAAP, and fraud.
In accordance with accounting standards, the effect of PPA should be reflected by
correction of accumulated income (loss) of the beginning of the year. Comparative
items of last year(s’) financial statements should be represented, unless this is not
practical; in such circumstances the issue should be disclosed in the explanatory notes
(Epstein & Jermakowicz, 2010, pp. 936-960; IAS, 8, pp. 151-171).
We measure PPA by obtain it from retained earnings (losses) statement.
3.2 Information asymmetry measure
To test our hypotheses we require a measure of IA between informed and uninformed
equity investors. In prior researches (Butler, Kraft, & Weiss, 2007; Leuz &
Verrecchia, 1999), bid-ask spread (SPREAD), share turnover and stock return
volatility are used as proxies for information symmetry.
The first measure, which is the bid-ask spread, is a common measure for IA. The
higher the IA, the wider the spread to cover the higher expected losses incurred by
market makers when they trade with insiders.
The second measure is the median daily share turnover (i.e., the value of shares traded
scaled by the firm’s market value of equity) for the year. Turnover indicates investors’
willingness to trade, which is negatively related to IA.
The third measure is stock return volatility, computed as the standard deviation of
firms’ daily returns over a year (Dhaliwal, Radhakrishnan, Tsang, & Yang, 2012). To
the extent that smooth movements in share prices suggest the absence of disagreement
between the firm and shareholders, or among investors, low levels of volatility
suggest lower information asymmetries.
As Balakrishnan, Billings, Kelly, and Ljungqvist (2014) and Butler et al (2007)
argued, among the three, the bid-ask spread is the most reliable measure of IA. Share
turnover is less reliable because it’s affected by factors unrelated to information, such
as portfolio rebalancing, liquidity shocks and changes in risk preferences. Return
volatility is the least reliable measure because it is affected by many factors unrelated
to IA.
IA between security traders affects security prices. This hypothesis goes back at least
to Jack Treynor (Bagehot, 2001) who suggests information-based trading affects the
spread between bid and ask prices offered by market specialists. The greater the
relative private information, the larger the bid-ask spread and the lower the returns to
investors without private information, in particular non-insiders, and the higher the
equilibrium required returns on the stock (Amihud & Mendelson, 1986; LaFond &
Watts, 2006, p. 16). In addition Prior studies such as Venkatesh and Chiang (1986),
Muller and Riedl (2002), Libby et al. (2002), Butler et al. (2007), Armstrong et al
(2010), C. Armstrong, Guay, Mehran, and Weber (2015), Ahmadpur and Rasaeean
(2007) and Rezazadeh and Azad (2009) has shown that increasing IA among security
traders expand the spread.
Spread is a function of the abnormal order flow. The underlying assumption is that
public information is directly incorporated in prices because the market maker would
move prices to the appropriate level at the time of the information and there would not
be any trading activity. Private information generates excess buying or excess selling
pressure (abnormal order flow) depending on the nature of the information. On a day
in which bad private information arrives there are more sell orders than buy orders,
and conversely on good private information day, there are more buy orders than sell
orders (Lafond and Watts, 2006, p 26).
We measured the spread by:
(1)
Where,
is Information asymmetry, measured as Average of Bid-Ask Spread
(i.e., absolute spread divided by the sum of average bid and ask price) in a
year.
is Ask Price
is Bid Price.
3.3 Model specification
Equation 2 determines the relation between PPA and IA, so we use that to test the first
hypothesis:
(2)
Where,
is Information asymmetry, measured as Average of Bid-Ask
Spread of the previous year.
is absolute PPA divided by absolute accumulated income (loss) of
the beginning of fiscal year.
: is the control variable of firm size, which calculated as follows:
=
is a control variable that represents growth and is calculated as follows:
First hypothesis states that high PPA corresponds high level of information that was
not reflected in the financial statements of prior periods; and so the grater the IA
between informed and uninformed investors. Therefore the statistical hypothesis is the
following:
Equation 5 determines the relation between and , so we use that to test the
second hypothesis:
(5)
Where,
is changes in during the and . equals 1or 2
and t is the is the tested year. For example :
(6)
is changes in DPPA during the and . equals 0 or 1 and is
the is the tested year. For example:
(7)
According to the rationalities, the statistical expression of the second hypothesis is the
following:
3.4 Sample and data collection
To collect the sample, we start with all Tehran Stock Exchange firms in any year from
2007 to 2014. This period of time is chosen because the data needed to calculate
SPREAD before 2007 is not available. The main reason for using the firms listed in
Tehran Stock Exchange is that the Bid and Ask Prices had been recorded by brokers.
Statistical sample include 62 firms or 372 Observations. Sample selection criteria are:
1) firms exist at the Tehran Stock Exchange list from beginning of 2007 to the end of
2014; 2) firms stocks traded during the period and its trades is not interrupted over the
six months; 3) the financial period of firms is not changed; and 4) the Bid and Ask
Prices are available.
4. Findings
3.5 Descriptive Statistics
Table 1 shows the mean of spread is 0.1672 for 372 observations. It shows the
existence of IA between investors. The mean for is 0.452 that shows the
variation of IA. The Minimum and Maximum of are -0.71 and 1.11 that
indicates the growth of IA between investors. The mean of DPPA and ΔDPPA are
2.017 and 0.0452 respectively that shows the growth of PPA.
Table 1: Descriptive Statistics
Std. Deviation
Maximum
Minimum
Mean
n
0.2235
1.46
0
0.1672
372
SPREAD
7.2325
59.93
0
2.0166
372
DPPA
4.2388
42.05
0.58
11.8857
372
SIZE
6.8373
42.05
-67.83
3.5112
372
MB
0.2461
1.11
-.71
0.0452
310
ΔSPREAD
16.1680
165.09
-96.67
0.2850
310
ΔDPPA
3.6 First hypothesis test results
Using 372 observations equation 2 is run to test the first hypothesis. Table 2 reports
the regression results with spread as the dependent variable. Table 2 shows that there
is positive relationship between and; but it is not significant; so the
first hypothesis was not accepted. statistic equals 5.492 at 0.001 significant level.
Therefore, the regression model is significant at 99% level. Coefficient of
determination equals the 0.043 which shows that the regression line represents
approximately 0.4 percent of changes in IA. Durbin Watson statistic is equal to 1.69.
When Durbin Watson statistic is close to 2 it can be said that there is no
autocorrelation.
The findings indicate that the PPA doesn’t create IA between informed and
uninformed investors. In addition, the positive MB coefficient indicates the
relationship between IA and firm growth; therefore the relationship between IA and
MB robust the existents of IA in Tehran Stocks Exchange.
Table 2: The relation between and
p-value
t
Predicted
Sign
Beta
Variables
0.001
3.48
α
0.179
1.35
+
0.069
DPPA
0.048
1.98
0.102
SIZE
0.001
-3.37
-0.176
MB
5.492
F
0.043
R Square
0.001
Sig.
0.035
Adjusted R
Square
1.687
Durbin-Watson
3.7 Second hypothesis test results
We use the equation 5 for 310 observations to test the Second hypothesis. Table 3
reports the regression results with as dependent variable. Table 3 shows
there is positive relationship between and; but it is not significant;
so the second hypothesis was not accepted. F statistic equals the 1.6 and its significant
level is 0.18 and so it shows the regression model isn’t significant at 95% level.
Coefficient of determination equals the 0.015 which shows that the regression line
represents approximately 1.5 percent of changes in IA. Durbin Watson statistic
equivalent of 1.71 and when this number is closer to 2, there is no autocorrelation.
The findings show that, change in IA between informed and uninformed investors
was not affected by ∆PPA.
Table 3: The relation between and
p-value
t
Predicted
Sign
Beta
Variables
0.518
0.648
Α
0.083
1.741
+
0.099
ΔDPPA
0.752
0.316
0.018
SIZE
0.212
1.251
0.072
MB
1.6
F
0.015
R Square
0.18
Sig.
0.006
Adjusted R Square
1.712
Durbin-Watson
5. Conclusion and interpretation of findings
In this paper we investigate the effect of PPA on IA between informed and
uninformed investors in Tehran Stocks Exchange. The results show that there is
positive relation between IA at a particular period and PPA of the next period; but this
relation was not significant. In other words, it can be said there is not higher IA
between equity investors of the firms with larger PPA. Furthermore, study results
suggest that the changes in IA were not affected by ∆PPA; so the level of IA doesn’t
change in proportional to the changes of PPA.
The findings confirm that PPA exists; meaning that some of financial information was
not stated in prior period, but the range of IA between informed and uninformed
investors has not expanded. We argued that existence of PPA lead to IA; but the
findings doesn’t confirm that. This might be due to the nature of PPA in Iran; and also
due to existence of other sources of information. Many of Iranian firms have
adjustments of prior period taxes in PPA. Most of financial statement users know that
the tax determination process is so long and it takes more than one year. Informed and
uninformed equity investors in Tehran Stocks Exchange do not have enough
information about the final amount of the tax; because it depends on tax office’s
opinion. Thus, tax adjustments don’t affect the IA.
Furthermore, existence of PPA in financial statements means that the income of prior
period was not fairly stated. Thus important decision making indexes such as EPS and
hence PE and other financial ratios were misleading for uninformed users.
Consequently, informed users would have opportunity to use insider information. This
increases the uncertainty, creating doubts about the reliability of financial statements
and so making incentives for finding a more reliable source of information, increasing
losses due to adverse selection and ultimately shareholder rights will be violated.
Furthermore, results show that there is a positive and significant relation between IA
and the ratio of market to book value of equity (MB). This ratio represents the IA
arising from the growth opportunities. This result, confirm the existence of IA in
Tehran Stocks Exchange, and robust the results of research.
The results of Kordestani et al (2011) research showed that most Iranian companies ,
overstated the income of per financial period and then, tried to neutralize those
overstatements by using negative PPA. On the other hand, Rezazadeh and Azad
(2009) findings emphasized the importance conservatism as qualitative characteristics
of financial information and its role in reducing the IA among investors, and also
explained the role of conservative financial statements in reducing IA between equity
investors. Thus, conservatism may reduce the abovementioned effects of PPA.
The above results may be useful for research about the consequences of PPA,
information content of PPA , relationship between changes in PPA and conservatism,
review of relationship between PPA and stock returns, review of relationship between
PPA and earnings management, review of nature and composition of the main items
of PPA, review of reliability of financial statements, using the Prior period errors and
review of audit effectiveness, including topics that could complete our knowledge
about the effects of Prior period Adjustment.
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