AAA Spark Meeting of the Regions

Voluntary Water Risk Disclosure and Accounting Implications: Evidence from Earnings Management

• In Event: Topics in Corporate Disclosure

Abstract

Water pollution and water scarcity combine to create a formidable business risk. Yet many corporations based in the United States do not disclose water risks. In partnership with the Big 4 accounting firms, the World Economic Forum (2020) produced a report outlining metrics to enable companies to measure and disclose meaningful information about their water impacts. This paper addresses the research question: What are the effects of water risk disclosure on earnings management? Investigated are corporations headquartered in the United States that responded to an annual survey regarding water security. Drawing on information, voluntary disclosure, and signaling theories, this research study hypothesizes that firms that voluntarily disclose water risks experience higher financial reporting quality than firms that do not disclose. This study proposes that water reporting supplements existing information in financial reports and leads to reduced information asymmetry between managers and stakeholders, hence decreasing earnings management.
This study also hypothesizes that higher quantity and quality water risk disclosure leads to better financial reporting quality. Better performing firms publicize signals envied by firms with lower disclosure quality regarding company water initiatives. This suggests that responding to stakeholder demands for greater transparency and accountability can help make a company’s reported information more complete and meaningful, leading to enhanced reporting quality.
The present study further investigates the effects of top management commitment, or the “tone at the top” set by the upper echelon, and corporate ethical culture in firms’ implementation of water-related initiatives and policies. Higher degrees of executive involvement and support are posited to enhance the negative association between water risk disclosure and earnings management behaviors. The strength of corporate governance is also hypothesized to enhance the negative effect between the quality of water risk disclosure and earnings management. With strong monitors in place, managers’ discretion is minimized, thereby reducing earnings manipulation. Lastly, external assurance is predicted to enhance the negative relationship between water risk disclosure quality and earnings management. Credible disclosures, assured through a third party, can legitimize the validity of a company’s reported information, both financial and nonfinancial.
The importance of understanding how water risk affects financial reporting quality has implications for users of corporate information, such as auditors and policymakers. Overall, this research has implications to reveal increased incentives for corporations to voluntarily disclose their water risks and mitigation efforts to investors and other stakeholders.

Author

• Melissa Nelson, University of Wisconsin–Whitewater