This chapter describes the methods and procedures that will be use in this study. The purpose of this study is to explore and evaluate the financial disclosure practices in local government of Malaysia towards harmonization.
It is divided into five (5) main subsections. The first subsection elaborates on the dependent and independent variables developed in the framework of this study. This is then followed by the detail definition and conceptualization for each of the variable. The third subsection provides the list of hypotheses developed for the study to quantify the relationship between the financial disclosures attributes towards harmonization. The following subsection explains on source of the data, size and period of samples used in this study. The next subsection details out on the measurement used for each dimension representing the respective variables. Finally, it mentions on the method of analysis to be adopted in examining the correlation of the variables.
3.1 Research Framework
The independent variables for this study consist of the structure related variables (status, size), performance related variables (surplus or deficit of income, liquidity) and timely information variables (management lag, audit lag) whilst harmonization of financial disclosure of local government is the dependent variable. The study uses mandatory disclosure index on the financial disclosure to measure the dependent variab
3.2 Hypotheses Development
The research hypotheses will examine the factors of independent variables towards the harmonization of financial disclosure of local government. In this study, prior research and literature were used to identify whether these independent variables will lead to the harmonization of financial disclosure of local government.
3.2.1 Status of Local Government and Harmonisation of Financial Disclosure
Status of local government can be classified into city council, town council and district council (Azmi, 2001; Mohamed, 2004). The criteria that determine the status of local government by the Ministry of Housing and Local Government is classify as follows:
City council - when the local government is having more than 100,000 population and generate more than RM80 million of yearly income.
Town council - when the local government is having more than 100,000 population and generate income more than RM20 million of yearly income.
District council - when the local government is having less than 100,000 population and generate income less than RM5 million of yearly income.
However for this study, city council and town council will be group together under one category as propose by Engku Ismail (2010), Siti Zabedah et al. (2004) and Mohamed and Combs (1997).
Cooke (1989) drew attention to the likelihood that leading firms operating in a particular industry could effect on the level of disclosure adopted by other firms working in the same industry. Added to this, Wallace et al. (1994) suggested that disclosure is more likely to differ among different industries, reflecting their unique characteristics. Cooke (1992) empirically examined the relationship and found Japanese manufacturing firms tend to provide more information than other non-manufacturing firms. Morever, in surveying the depth of disclosure in daily published Egyptian newspapers, Mahmood (1999) pointed out that industry type has an impact on the level of information presented. In a similar vein, Camfferman and Cooke (2002) provided almost identical results with relation to manufacturing firms in the UK and the Netherlands. In opposition to these findings, Wallace et al. (1994) observed that the industrial classification of a firm has no bearing on the level of disclosure level. Stanga (1976) reported a positive relationship between industry type and the extent of financial disclosure, while Wallace et al. (1994) and Owusu-Ansah (1998) found no significant relationship between industry type and extent of financial disclosure.
The above discussions can be applied to the local government status. Positive accounting research shows that firms with different characteristics will adopt different disclosure and measurement practices (Watts and Zimmerman, 1986). This is because, the local government status may have different activities such as in the administrative structure, autonomy power, development opportunity and prestige which may be the reason for the diversity in both the amount and type of financial disclosure among the local governments. Therefore, this may have an implication on the harmonization of financial disclosure among the local governments.
Base on the above discussion, the hypothesis will be as follows:
H1: Different status of the local government is positively associated to the harmonisation of financial disclosure of the local government.
3.2.2 Size of Local Government and Harmonisation of Financial Disclosure
Much evidence from prior studies has supported the existence of a positive relationship between firm size and the extent of accounting disclosure (see Zarzeski, 1996; Ahmed, 1995; Wallace et al., 1994). Large companies tend to disclose greater amount of information for a number of reasons:
They are more exposed to public scrutiny than small firms, therefore, they are most likely to disclose more information;
Revealing more information allows the large firms to obtain new funds at lower cost (Botosan, 1997);
Large firm possess sufficient resources for collecting, analyzing, and presenting extensive amount of data at minimal cost; and
The agency cost is higher for large firms because shareholders are widespread, therefore, additional disclosure helps reduce the potential agency cost (Watts and Zimmerman, 1983).
However, the above argument is not without flaws. Jensen and Meckling (1976) provided a cogent argument for an opposing claim. They assumed that large firms, on the contrary, might have the incentive for withholding value-relevant information to avoid the political costs in terms of tight regulation and increasing tax and social obligations.
Classical theories of financial information disclosure predict a positive and significant relationship between size and financial disclosure (Zimmerman, 1977). Legitimacy theory also propounds a positive relationship between size and financial disclosure. However, larger size of local government may disclose more information than small local governments (Gray et al., 1995; Hossain et al., 1995) since larger size of local government may have greater amount and activities than the smaller size of local government. This may lead to greater variability in the practices among them as they have more to disclose in their financial statement and used a variety of accounting practices. In this study, size of the local government is measured by the total assets of the local government as suggested by previous studies such as Barton (1999), Syed Soffian et al. (2001) and Ryan et al. (2002).
Therefore, the hypothesis will be as follows:
H2: Size of the local government is positively associated to the harmonization of financial disclosure of the local government.
3.2.3 Surplus or Deficit of Income and Harmonization of Financial Disclosure
For the business world, numerous studies analyse the relationship between disclosure and financial features. Singhvi and Desai (1971) argued that companies with the best performance in financial terms, such as profitability, sales or profits, will have a greater interest in publishing their financial information, in order to present a better image to their shareholders or potential investors. However, the concepts such as profitability, sales or profits cannot be easily applied to public administration such as local government, but there exist numerous indicators of performance (Behn, 2003).
Further to the above, private sector use profitability in measuring their company's performance. Prior empirical studies (see Wallace and Naser, 1995; Inchausti, 1997; Owusu-Ansah, 1998) have shown that profitability influences the extent of disclosure in annual reports. Inchausti (1997) argued from the perspective of agency theory that management of a very profitable firm will use information in order to obtain personal advantage
Profit margin is calculated by relating operating profit to net sales. Singhvi and Desai (1971) claimed that higher profitability might induce management to supply more information to illustrate its ability to maximize the shareholder's value and to increase its managerial compensation. Similarly, management of a profitable firm may feel proud of its achievement and wish to disclose more information to the public to promote positive impression of its performance. In contrast, management experiencing low profitability may feel threatened and wish to obscure poor resulting by disclosing less information (Richard ,1992).
Wallace et al. (1994), however, found no relationship between profitability and disclosure, and Land and Lundholm (1993) suggested that the direction of the relationship is not clear., However, it is more likely that the management of a profitable enterprise will voluntarily disclose more to the market to enhance the value of the firm. Empirical results provide mixed evidence at best. For example, a study of McNally et al. (1982) showed no link between profitability measures and the extent of voluntary disclosure in New Zealand. Unexpectedly, Camfferman and Cooke (2002) found a significantly negative relationship between the British's firm's profit margin and the extent of disclosure. Similarly, Wallace et al. (1994) observed no significant relationship between the comprehensiveness of disclosure and the profit margin.
From the above discussion, financial performance of the public sector such as the local government can be percept as similar to the private sector which is determine through the financial disclosure of financial report. In the public sector such as the local government, it is reflected by surplus or deficit of income (net income) as shown in the income statement of the local government, which would have an effect on the balance of fund. If the income statement on that particular year was deficit, this will reduce the fund balance. On the other hand, if it is surplus, it will add to the fund balance. Surplus or deficit of fund will be part of the indicator for financial performance of the local government (Robert, 2006).
Therefore, the hypothesis will be:
H3: Local government with surplus net income is more likely to disclose harmonise financial information than those with deficit.
3.2.4 Liquidity and Harmonisation of Financial Disclosure
Liquidity refers to the firm's ability to fulfill its short-term liabilities. Although it should be noted that no single measure could adequately reflect all aspects of liquidity, current ratio was selected as a proxy for liquidity. Accordance to Cooke (1989), firms enjoying a sound financial position, more specifically higher liquidity are more inclined to disclose more information than those suffering low liquidity. Hence, it could claim that weak liquidity might induce firms to amplify their disclosure to mitigate fears and notify shareholders that management is aware of the problems (Wallace et al., 1994). As such, firms with a low liquidity position might disclose more information to justify their liquidity status. Wallace and Naser (1995) further argued that regulatory institutions, as well as investors and lenders, are concerned with the going concern status of companies. Hence, a firm's ability to honour its short-term obligations as they fall due, without recourse to selling other assets-in-place, is expected. Empirical evidence on the relationship is also totally puzzling. For example, Belkaoui and Kahl (1978) found that no relationship exists between liquidity and the extent of disclosure. Cooke (1989) suggested that the soundness of the firm as portrayed by high liquidity is associated with greater levels of disclosure. Conversely, Wallace et al. (1994) observed a significantly negative relationship. On the other hand, Camfferman and Cooke (2002) postulated that liquidity of Dutch firms is significantly positively related to the extent of disclosure while the relationship is insignificantly negatively correlated with respect to the United Kingdom firms.
Similarly in public sector, liquidity and solvency problems are also part of the challenge in managing their cash flows. Government or local government is responsible for its payable, suppliers, employees, grantees and other creditors. The lack of complete, reliable, comparability and timely information about financial obligation weakens the debtor government's ability and incentive to discharge its responsibility. Government collection effort and its ability to convert these resources into cash to pay the liabilities show the ability to solve liquidity and solvency problems of government (Chan, 2006). Governments hold different kinds of financial resources of varying liquidity and have different types of economic resources. Similarly, government has financial obligations of varying definitiveness and maturity.
Even though the above discussions explain on the private sector scenario, it is also applicable to the public sector such as the local government. This is because liquidity might also have an influence on harmonization of financial disclosure in the local government.
Therefore, the hypothesis is:
H4: The higher the liquidity of the local government, the higher the level of harmonization of financial disclosure of the local government.
3.2.5 Management Lag and Harmonisation of Financial Disclosure
Management lag is measured by the difference between fiscal year end until the account of local government is submitted to the Auditor General (May, 1971; Cho, 1987; Al Ajmi, 2008). Management lag is part of the process in delivering audited financial report of local government. Therefore, it shows the effectiveness of management of local government contributing to the process of delivering the financial report. We can assume that the ability and efficiency of management will contribute to the harmonization of financial disclosure. The more time it takes to prepare financial statement to submit to the auditor, the more it will takes to contribute to the management lag. This might have a negative effect on the harmonization of local government.
The hypothesis will be:
H5: Management lag is negatively associated to the harmonization of financial disclosure of local government.
3.2.6 Audit Lag and Harmonisation of Financial Disclosure
Audit Lag on the other hand is measured from the time of fiscal year end to the date of audit report by the external auditor (Ashton, 1987). The audited financial statement in the annual report is likely to be the only reliable source of information available to the public (Levebtis et al., 2005). Timely and reliable information is important in making a decision and hence assuring reliability of the financial information to the users (Enrique, Bonson-Ponte, 2008; Lee et al., 2008).
Cashew and Kaplan (1991) stated that company size and income significantly affect audit lag. Therefore, the external auditor and the Auditor General must play a significant role in helping to promote harmonization of financial disclosure by reducing the audit lag (Cohen et al., 2004). Conflicts possibly might arise between the auditor and the local government which might contribute to the delay of releasing the annual report and therefore might affect the harmonization of financial disclosure.
The hypothesis therefore is as follows:
H6: Audit lag is negatively associated with harmonization of financial disclosure of local government.
3.3 Research Methodology
3.3.1 Research Design
This study will utilize the approach of collecting data based on secondary information which are stated in the local governments' financial statement. The approach on using survey is not adopted because all the information with regard to the variables is available in the financial statement of local government.
220.127.116.11 Unit of Analysis
The unit of analysis for the purpose of this study will be base on all the local governments in West Malaysia (excluding Sabah and Sarawak).
3.3.2 Sample and Data Collection
This study will focus on the local government in West Malaysia for the year 2008. The population that will be used in this study are all the local government in West Malaysia for the year 2008. The total number of local governments for the year ended 2008 is 99 (please refer to Table 3.1 and Table 3.2 below). The year 2008 was chosen due to the availability of the data and the current status of the data.
Note: Some States have been accorded "city" status on meeting specific criteria: City halls of Kuala Lumpur and City Councils of Alor Setar, Ipoh, Johor Bahru, and Shah Alam.
Source: Ministry of Housing and Local Government (2009)
3.3.3 Research Instrument
All the attributes for the variables are chosen after deliberating them based on past literatures. The information on the attributes is reliable because the local governments are providing the information for regulatory purposes.
3.3.4 Operational Definition and Measurement of Variables
18.104.22.168 Measurement for Independent Variables
Table 3.2 and Table 3.3 below provide the measurement for the independent variables and the dependent variable.
For consistency in terms of the time of the release of the data, the proxies will be chosen that are readily available from a single document, in this case the financial report of the local government.
22.214.171.124 Measurement for Dependent Variable
Table 3.3: Summary of Dependent Variable Measurement
Harmonisation of financial disclosure
The words "comparability" and "harmony" will be used as synonyms for financial disclosure harmony.
Is measured by the Index of Financial Disclosure
The harmonization of financial disclosure can refer either to the degree of disclosure or to the accounting method to be applied. Harmonization of the extent of disclosure will be called disclosure harmonization, while harmonization of the applied accounting methods will be called measurement harmonization (Van der Tas, 1988). Thus, this study is concerned with the harmonization of financial disclosure in respect of items disclose in the financial statement (balance sheet, income statement, cash flow statement and notes the account), which implies an increase in the degree of comparability of financial statement.
Harmonisation of financial disclosure measurement is determine in the degree of comparability which means that local government in the same circumstances disclose the same accounting items to an event or give additional information in such a way that the financial reports of local government can be made comparable. The words "comparability" and "harmony" will be used as synonyms for financial disclosure harmony.
This is based upon the number of financial reports which are comparable in respect of an item: for example, disclose of fixed assets. It is presumed here that two financial reports are either comparable or not comparable in respect of one time. Comparability increases when the result of the choice that local government make between alternative accounting disclosure becomes concentrated on one or on only a limited number of accounting items, even where the number of available items remains the same. Thus, comparability can be considered as an increase in the degree of consensus concerning the choice between the alternative items of accounting for an item in financial statement. Kirpatrick (1985) suggests that a reduction in the number of alternative accounting practices contributes to harmonization. However, the degree of harmony depends not only on the number of alternative accounting items used, but also on the extent to which each item is applied.
The first tool used in this study is the index created by Cooke (1989). This is because this disclosure index provides a single figure summary indicator of the entire content of the financial statement (example Ahmed and Courtis, 1999; Coy and Dixon, 2004). As such, the financial statements are now closer to the private sectors (Condor, 2002). Therefore, this method can be used in the public sector in developing to analyse the financial statements. However, some modifications will have to be done to reflect the particularities.
There are items that ought to be included in the financial statements to conform to the index. This is because Treasury Circular 15/94 and FRS are the best way to achieve harmony. Table 3.4 shows the 19 itwms selected, some of them divided, bringing the maximum score to 26.
Disclosure Index (DI) = âˆ‘ i=1â€¦., n Xi
Where X = 1 if the item Xi is disclosed and 0 if not.
This study will make some modifications to the index, in the same way as Cooke (1989). This is to eliminate those aspects that a local government did not have to disclose. This is because the index might include items like provisions and contingent liabilities. Therefore, the total index will be:
Total index (TI) = ID/Z
Where Z I = the number of items applicable to each local government.
The constructed index will allow us to reflect which local governments have disclosed the information of their financial statements according to the content of the Treasury Circular 15/94 and FRS and also to verify which local governments disclose more information.
The formula will be applied to all the items listed on the score-sheet. For each item, the index will be range between "0" (no comparability) and "1" (all local government using the same method).
The mandatory disclosure index (MDI) is chosen over some other concentration measures due to its simplicity and its ability to provide more information than just calculating the frequencies of the accounting items applied, especially when more than two alternative accounting items are involved (Van der tas, 1988). Prior to the study by Van der Tas (1988), Hermann and Thomas (1995) argued that there was no single quantifiable measure to assess harmonization. Majority of the studies relied primarily on descriptive statistics in assessing harmonization (e.g. Choi and Bavishi, 1982; Evans and Taylor, 1982; McKinnon and Janell, 1984). The application of the MDI and its other versions could be observed, among others in Archer et al. (1995) and Hermann and Thomas (1995).
Since accounting practices encompass many disclosure and measurement items, which are grouped under several categories, there is a need for comparative techniques to measure comprehensively the level of harmony in respect of each category and for several such categories. First, it introduces methods to compare comprehensively accounting practices of all local governments by categories of items of disclosure. And second, it investigates the associations between practice harmony and specific characteristics.
Comparison of accounting practices between all local governments will be carried out by categories of mandatory disclosure items. A matching coefficient known will be used to measure accounting practice harmony. Coefficient is useful in measuring the degree of likeness between two sets of binary observations (Krzanowski, 1990). Coefficients will be use to compute for each category of disclosure and measurement items. The first will measured the extent of likeness between the disclosure practices that is adopted by all local governments, and the other will measure the degree of likeness for items that is not adopted by all local governments.
The disclosure date for 2008 financial reports for all local governments were primarily mandatory in nature as they were based mainly on statutes and mandatory requirements. Mandatory disclosure data will be collected using the instrument of Engku Ismail (2010), that includes requirements of the relevant acts and accounting standards that exist in 2008. The instrument will only include only those requirements for which information will normally be available from the annual reports. Appendix 1 shows the main categories used in the study. The mandatory categories are created on the basis of the Federal Treasury Circular No. 15, 1994 and the Malaysian Accounting Standard Board (MASB).
126.96.36.199.1 Association between Firm-Specific Characteristics and Practice Harmony
The association between firm specific characteristics and accounting practice harmony will be evaluated by ascertaining whether the aforementioned coefficient is independent of the firm characteristics. The firm characteristics (independent variables) are divided into five variables: status, size, surplus or deficit of income, liquidity, management lag and audit lag.
For every category of disclosure and measurement items, coefficients are computed for each characteristic type for every characteristic. Then for every characteristic, the category types will be rank by the value of their coefficients for each category of disclosure and measurement items. Chi-square tests will be conducted to see whether the rankings for the categories are independent of the characteristic types. If the ranking is found not independent of the types for characteristics, it will be inferred that accounting practice harmony is associated with that firm characteristic.
Method of Data Analysis
This study will utilize both descriptive and inferential analysis in explaining the correlation of all the variables.
This method provides descriptive statistics of mean and standard deviations for all the variables. The rationale for using this approach is to transform the data into more meaningful and easy to interpret. The output data describes about the dispersion of the data for all local governments.
Another approach used to analyze the correlation of the variables is inferential analysis. There are two (2) methods adopted to describe the relationship of the variables. They are correlation analysis and multiple regressions. The explanation is provided below:
The study employs Pearson correlation method to determine the strength and direction of the variables. The result reflects the correlation of the independent variables and the harmonization of financial disclosure. If the value is positive then it shows a direct implication of the independent variable on the dependent variable and vice versa. The test on the significant of the variable is performed at 1, 5 and 10 percent confidence level. The relationship is very significant when the value is closer to 1.
This technique is more sophisticated and capable to provide the relationship between groups of independent variables on a single dependent variable. In addition, it facilitates the hypotheses developed in section 3.3. At the same time, it can examine the variance of harmonization of financial disclosure explained by the independent variables.
In order to use this method, there are a few assumptions that need to be considered. They are as follows:
Linearity of independent and dependent variable - It assumes the regression coefficient for the independent variables is constant.
Constant variance of error terms (Homoscedasticity) - The variance of the error terms is constant over the values of independent variables.
Independent of error terms - The error terms are independent and related to other predicted values.
Normality of the error terms - The error terms are normally distributed.
This study will identified those independent variables based on the past literatures explained in chapter 2. The data collection will be gathered from the information disclosed in the annual reports of the local government for the year 2008. The data will be analyzed using the analytical tool i.e. SPSS in order to provide additional insights on the relationship.