Corporate responses to the introduction of the Australian consolidation standard: a test of disclosure cost explanations

Journal of the Academy of Business and Economics, Feb, 2003 by Jean M. Canil, Bruce A. Rosser

ABSTRACT

AASB 1024 was introduced to mandate consolidation of controlled associates, and hence disclosure of debt issued by these associates. Firms with debt-laden controlled associates faced significant disclosure costs, so therefore had an incentive to avoid consolidation. Disclosure cost arguments are used to generate hypotheses in relation to pre- and post-adoption investment structures. Corporate sell-offs and straight non-disclosure of controlled associates are found to have been significant mechanisms for reducing the impact of the disclosure provisions of AASB 1024.

1. INTRODUCTION

Watts and Zimmerman (1986, ch.12) argue that mandatory changes in accounting method present a more powerful test of contracting hypotheses than voluntary method changes because mandated changes can force costly recontracting. Mandated changes can impose costs on firms by causing renegotiation of debt, manager compensation or implicit political contracts to restore managers' original preferred outcomes. Stock price decrements are therefore expected for firms whose pre-existing set of contracts are materially affected.

Several studies of the economic consequences of mandated accounting changes have been reported, notably those by Leftwich (1981), who examines the impact of restricting application of the pooling-of-interests method for business combinations, and Collins, Rozeff & Dhaliwal (1981) who, together with Lys (1984), analyze the impact of elimination of the full-cost method of accounting for exploration costs. All examine the impact of the mandated change on debt covenants. This paper examines the disclosure consequences of AASB 1024 that mandated consolidation (and hence disclosure) of hitherto non-consolidated investments in controlled associates.

Prior to AASB 1024, controlled associates were often employed to hold debt off the consolidated balance sheet. Haddon (1992, pp.64-66) describes how the Adelaide Steamship/David Jones group, which ran up accumulated debts of $7 billion, was characterized by a network of cross-holdings at or just below the 50% level which enabled the group to avoid consolidation of debt-laden controlled associates. Hence, firms that had already issued significant debt through non-consolidated associates potentially faced the highest recontracting costs to maintain their non-disclosure, so are expected to have the most incentive to alter their investment/financing policies in anticipation of the introduction of AASB 1024. The disclosure provisions of AASB 1024 can be avoided by restructuring the firm's investment portfolio such that the levels of equity ownership are altered to avoid these provisions. However, portfolio restructuring is not only costly, but may also signal the high debt level that the restructuring was possibly designed to conceal. In short, the higher (lower) are the disclosure costs induced by AASB 1024; portfolio restructuring is (is not) expected.

We document the empirical relation between investment/disinvestment decisions and accounting disclosure choices, and test hypothesized relationships between pre- and post-adoption disclosure choices. Firms with pre-existing debt issued by controlled associates could have followed any one of several alternative responses either to avoid or accommodate the impact of AASB 1024. Avoidance can be affected by investment/disinvestment decisions that change the degree of equity ownership in order to convert the associate to an incorporated joint venture, or sell-down, sell-off or liquidate the investment. Alternative accounting disclosure choices comprise straight non-disclosure of controlled associates, or non-compliance by not consolidating a controlled associate. Evidence of significant pre-adoption sell-off activity relative to the post-adoption period, and post-adoption non-disclosure relative to the pre-adoption period, is presented. Thus, full disinvestments in tandem with straight non-disclosures are the major observed choices. This result implies that investment/disinvestment decisions and accounting policy choices are substitute mechanisms in firms' establishment of new corporate structures consequent (and often in anticipation of) the introduction of AASB 1024.

The plan of the paper is as follows. Section 2 reviews the regulatory changes surrounding AASB 1024. The hypotheses are formulated in section 3. The sample construction and measures are described in section 4. Descriptive statistics are presented in section 5, and tests in section 6 indicate the evidence is consistent with the hypothesis that the costs of restructuring investment portfolios are less than the disclosure costs imposed by AASB 1024, indicating that mandatory changes in regulation can cause firms to alter their financing and operating policies. Section 7 concludes the paper.

2. THE REGULATORY CHANGES

Prior to AASB 1024: Consolidated Accounts, a controlled associate was consolidated when the firm, directly or indirectly, owned 50% or more of the voting shares. Under this regime, it was possible for corporate structures to be created allowing firms with debt-laden subsidiaries to hold less than 50% of the voting shares while simultaneously retaining control. AASB 1024 (Para. 9) defines control as "the capacity of an entity to dominate decision-making, directly or indirectly, in relation to the financial and operating policies of another entity so as to enable that other entity to operate with it in pursuing the objectives of the controlled associate". The investment is classified as an associate entity and by virtue of AASB 1016 only the net carrying amount of the associate is disclosed by the firm or investor.