Provisions and Contingent Liabilities A

comparison between Portugal and the United

Kingdom

Laura Nunes dos Reis

Dissertation submitted as partial requirement for the conferral of

Master in International Management

Supervisor:
Professor Doctor Ana Isabel Lopes, Professor, ISCTE Business
School, Accounting Department

November 2015
 Provisions and Contingent Liabilities A Comparison between Portugal
and the United Kingdom
Laura Nunes dos Reis
- Spine -

i
RESUMO

O objectivo desta dissertao comparar empresas portuguesas e britnicas

relativamente divulgao de passivos contingentes e ao reconhecimento de provises,
dado que estes so considerados fontes de contabilidade criativa e, estabelecer um
paralelo entre as diferenas encontradas e o sistema cultural de cada pas. Os dados
foram recolhidos de base de dados e manualmente dos Relatrios de Contas de
empresas cotadas, desde 2010 a 2013. Os resultados mostram diferenas
estatisticamente significativas nos montantes divulgados de contingncias ou
reconhecidos em provises pelas empresas portuguesas versus britnicas. Contudo, no
confirmam a tendncia para um maior reconhecimento em Portugal ou preferncia pela
divulgao no UK como sugerido por Gray em que, elevado secretismo (transparncia)
e elevado conservantismo (optimismo) em pases com elevada (diminuta) averso
incerteza, como Portugal (UK), favorecendo prticas mais associadas contabilidade
criativa em Portugal. Adicionalmente, os resultados evidenciam que as provises e
contingncias tm uma associao negativa com a cotao das aces, apenas
estatisticamente significativa para contingncias. No entanto, as provises revelam-se
significativas aps a adaptao do modelo para captar o efeito de um comit de risco no
Board de Directores. A existncia deste comit valorizada pelos investidores, sendo
porm esta valorizao mitigada quando considerando Portugal em relao ao universo
da amostra. Finalmente, o estudo conclui que os investidores valorizam as provises
diferentemente das contingncias, sendo isto no aplicvel quando as empresas tm
comit de riscos, caso em que os investidores atestam a mesma confiana a
reconhecimentos e divulgaes, assumindo menos prticas de contabilidade criativa.

Palavras - Chave: Contabilidade Criativa; Provises; Passivos Contingentes; Cultura

JEL class system: M41 Accounting; Z19 Cultural Economics-Other

ii
ABSTRACT

The main objective of this dissertation is to compare companies from Portugal and UK
concerning disclosure of contingent liabilities and recognition of provisions, since these
are considered a source of creative accounting and to drive a parallel between
differences found and the culture system of each country. Data was retrieved from
databases and hand collected from financial statements of listed companies covering
2010 to 2013. Findings reveal that there are statistically significant differences on the
amounts disclosed as contingencies or recognized as provisions by Portuguese versus
British companies. However, they do not confirm the tendency for higher recognition in
Portugal or a preference for disclosure in UK as Grays hypotheses for high secrecy
(transparency) and high conservatism (optimism) in countries with high (low)
uncertainty avoidance as Portugal (UK) suggest, giving rise to practices more associated
with creative accounting in Portugal. Furthermore, findings expose that provisions and
contingencies have a negative association with share prices, yet only statistically
significant for contingencies. However, provisions reveal to be statistical significant
after adapting the model to comprehend the effect of a risk committee on board of
directors. Besides, the existence of this committee is value relevant to investors but this
relevance is notwithstanding mitigated when considering Portugal against the total
sample. Lastly, the study concludes that investors do value provisions differently from
contingencies, yet this is not applicable when companies have a committee for risks, in
which case they place a similar trust to both recognized and disclosed items assuming
less creative accounting practices.

Keywords: Creative - Accounting; Provisions; Contingent - Liabilities; Culture

JEL class system: M41 Accounting; Z19 Cultural Economics-Other

iii
ACKNOWLEDGMENTS

First of all, I would like to express my sincere gratitude to my supervisor, Dra. Ana
Isabel Lopes, for her guidance and recommendations, as well as for all the availability
and encouragement throughout all this work. Without her this work would not be
possible.

Secondly, I thank my family, in particularly my parents and sister, who have gave me
the opportunity to make this work, and who have always expressed their trust,
sympathy, inputs and patience towards me.

Lastly, I thank all the others who have somehow listened to my despairs and who made
me fought for this achievement.

To all, I am deeply thankful.

iv
INDEX

RESUMO.................................................................................................................................................. II

ABSTRACT ........................................................................................................................................... III

ACKNOWLEDGMENTS ...................................................................................................................IV

GLOSSARY .......................................................................................................................................... VII

1. INTRODUCTION .......................................................................................................................... 1

2. LITERATURE REVIEW ............................................................................................................. 3

2.1. CREATIVE ACCOUNTING ............................................................................................................ 3

2.1.1. The Significance Of The Term ........................................................................................................ 3
2.1.2. Other Terms ........................................................................................................................................... 4
2.1.3. Motivations And Reasons For The Use Of Creative Accounting..................................... 6
2.1.4. How It Is Practised.............................................................................................................................. 8
2.1.5. The Impacts Of Its Use ................................................................................................................... 12
2.2. CONTINGENT LIABILITIES ....................................................................................................... 13
2.2.1. Significance And Origin ................................................................................................................. 13
2.2.2. Disclosure Vs Recognition ............................................................................................................ 15
2.2.3. The Criteria And Subjectivity....................................................................................................... 16
2.2.4. Disclosure V. Recognition And Impacts On Financial Statements .............................. 16
2.3. THE ROLE OF CULTURE IN ACCOUNTING ...................................................................... 21
2.3.1. International Clustering ................................................................................................................. 22
2.3.2. Hofstede And Cultural Dimensions ........................................................................................... 23
2.3.3. Portugal And UK - Cultural Country Comparison ........................................................... 26
2.3.4. Grayss Cultural Accounting Framework .............................................................................. 29
3. PROBLEM STATEMENT AND HYPOTHESES ...............................................................35

4. DATA ANALYSIS .......................................................................................................................39

4.1. SAMPLE SELECTION AND RESEARCH DESIGN ............................................................ 39

4.1.1. Sample Selection ............................................................................................................................... 39
4.1.2. Research Design, Model Specification And Variable Definition .................................. 39
5. FINDINGS AND DISCUSSION ...............................................................................................43

5.1. DESCRIPTIVE STATISTICS AND CORRELATION ANALYSIS ................................. 43

5.2. RESEARCH FINDINGS AND DISCUSSION ......................................................................... 45
5.3. SENSITIVITY ANALYSIS ............................................................................................................ 54
6. CONCLUSION .............................................................................................................................55

7. STUDY LIMITATIONS AND FUTURE RESEARCH ......................................................56

8. REFERENCES ............................................................................................................................57

v
LIST OF FIGURES

TABLE 1 - POTENTIAL GAINS AND LOSSES FROM MANIPULATING ACCOUNTS. .................... 12

TABLE 2 - DESCRIPTIVE STATISTICS ................................................................................................. 43
TABLE 3 - CORRELATION MATRIX .................................................................................................... 45
TABLE 4 - INDEPENDENT AND PAIRED SAMPLE T-TEST FOR PROVISIONS AND FOR
CONTINGENCIES ............................................................................................................................ 47
TABLE 5 - FINDINGS FOR ORDINARY LEAST SQUARES MODELS ............................................... 49

FIGURE 1 - CREATIVE ACCOUNTING TECHNIQUES AND PRODUCED EFFECTS... 11

FIGURE 2 - INTERNATIONAL CLUSTERS 22
FIGURE 3 - HOFSTEDE'S CULTURAL DIMENSIONS SCORES ..26
FIGURE 4 - GRAYS' CULTURAL ACCOUNTING FRAMEWORK..29

vi
GLOSSARY

EC- European Commission

ECB - European Central Bank
IMF International Monetary Fund
FTSE 100 London Stock Exchange
IAS International Accounting Standard
IAS 10 - Contingencies and Events Occurring After the Balance Sheet Date
IAS 37 - Provisions, Contingent Liabilities and Contingent Assets
IASB - International Accounting Standard Board
IASC - International Accounting Standards Committee
IFRS International Financial Reporting Standards
PSI 20 Portuguese Stock ndex
PT Portugal
TROIKA - A decision group formed by the EC, the ECB and IMF.
UK United Kingdom

vii
1. INTRODUCTION
This study is inserted in the area of creative accounting and focuses at provisions and
contingent liabilities, particularly within companies from Portugal and the United
Kingdom. This dissertation is timely and pertinent for at least three motives. Given past
financial scandals, creative accounting is a key subject whenever discussing about
stability and credibility of accounting deliverables in financial statements. Also, there is
an enlarged interest in this topic by the scientific community, visible by the crescent
number of publications since it was first heard of till present days. Thirdly, the detection
of creative accounting is still an issue that raises interest in market participants and
users given the consequences of such practices. Therefore, this study augments current
research both at a national and international level.

The main objective of this dissertation is to compare listed companies from Portugal
and UK concerning disclosure of contingent liabilities and recognition of provisions,
since these are considered a source of creative accounting and to drive a parallel
between differences found and the culture system of each country.

This work focuses in two particular countries. I chose Portugal because being
Portuguese makes sense to me to give a modest contribution for the scientific
community of my own country that, due to its size, lack of relative importance and other
factors, has many times a deficit on research about itself. However, being a master
student of an International Management programme, made me want to complement this
research by establishing a comparison with one other country. United Kingdom is not
only a pioneer in accounting systems, due to its emancipation in the Industrial
Revolution, but also a country adopter of the International Financial Reporting
Standards (IFRS) making it possible to drive conclusions from two countries that have
companies applying the same core of international accounting standards.

This study indicates an experts judgment as a possible source of creative accounting,

both in Portugal and in the United Kingdom, which can negatively impact companies
performance in the long run, as well as mislead several stakeholders (future investors,
shareholders, creditors) to whom financial statements are a basic source of information
and key influence for decision making. The International Accounting Standard 37
(IAS), which focuses at Provisions and Contingent Assets and Liabilities, involves a

1
considerable degree of judgement related to both the recognition and disclosure of
liabilities (the focus of this dissertation). Basing on the differences, culturally related,
demonstrated by preparers when making judgments, the application of the standard is
biased by culture and, reveals a window of opportunity for those who wish to practice
creative accounting through an inaccurate judgement. For most users, it is implicit that
financial statements intend to accurately reveal a companys situation, favouring
transparency concerning financial and accounting statements, making creative
accounting a concern.

Although there are some grey areas in accounting, there is a concern from organizations
leaders and management to avoid the repercussions of being implicated and involved in
creative accounting situations, demonstrating interest to commit to regulations and
responsibilities to all parties.

After section 1, this introduction, the dissertation follows with the literature review in
Section 2, where I present and explain the concepts of creative accounting, provisions
and contingent liabilities, and their links with the role of culture in accounting, as well
as introducing previous studies on these subjects. Afterwards, Section 3 covers the
definition of the problem in study, stating the main objective of this dissertation and it is
here where I pose the hypothesis, as well as give some ideas of what is expected from
the results. Then, in Section 4, I describe the data used for this study, the sample used in
the study and the methodologies used. Section 5 presents and discusses the main
findings and results of this dissertation. Subsequently, within Section 6 are posed the
main conclusions of the dissertation. Next, in Section 7 are mentioned the study
limitations and a possible scope for future research. Lastly, Section 8 presents all the
bibliography used in this dissertation.

2
2. LITERATURE REVIEW
2.1. CREATIVE ACCOUNTING

2.1.1. THE SIGNIFICANCE OF THE TERM

The term Creative Accounting is a concept that has various interpretations and its
meaning may differ according to the individual that is using it and within different
contexts. This means that despite the fact that it is a popular term, there is much less
agreement or consent on its exact definition. There are two types of definitions - a wider
definition used in United States and adopted by Mulford and Comiskey (2002), and a
narrower definition as adopted in United Kingdom. According to Jones (2010, p. 5) the
wider US definition sees creative accounting as including fraud whereas the UK
definition sees creative accounting as using the flexibility within the regulatory system,
but excludes fraud.

The concept of Creative Accounting refers to accounting practices within organizations

that may follow, or not, the principles, rules and standards established and accepted, yet,
diverging from the path those strict rules would lead to. In this dissertation, it will be
considered that Creative Accounting involves a transformation or preparation of
financial statements using accounting choices, estimates and other practices allowed by
accounting regulation.

The practice may be distinctive for excessive complication and perhaps for its use of
innovative ways of characterizing income, assets and liabilities. Therefore when
referring to creative accounting in a wider-range, users of financial statements may use
terms such as income smoothing, earnings smoothing, earnings management, window
dressing, financial engineering, aggressive accounting, innovative accounting or,
cosmetic accounting. All of these terms can be used as synonymous or as specific types
of creative accounting.

In 1968, Copeland stated that creative accounting involves the repetitive selection of
accounting measurement or reporting rules in a particular pattern, the effect of which is
to report a stream of income with a smaller variation from trend than would otherwise
have appeared. About 20 years later, Naser (1992) declared that Creative Accounting
is the transformation of financial accounting figures, from what they actually are to

3
what preparer desires, by taking advantage of the existing rules and/or ignoring some or
all of them.

More recently, Jones (2010, p. 9) concluded that accounting is creative when Using the
flexibility within accounting to manage the measurement and presentation of the
accounts so that they serve the interests of preparers. This current year, Jaward & Xia
(2015, p. 61) defined creative accounting as the process through which the accounting
specialists use their knowledge in order to manipulate the figures included in the annual
accounts.

In the present study, it will be disregarded any association with fraud. However, from a
wider perspective, a possible definition might be Any and all steps used to play the
financial numbers game, including the aggressive choice and application of accounting
principles, both within and beyond the boundaries of generally accepted accounting
principles, and fraudulent financial reporting. Also included are steps taken toward
earnings management and income smoothing (Mulford & Comiskey, 2002, p. 15).

It is commonly accepted and heavily mentioned by the scientific research community,

throughout the last two decades, that preparers of financial statements are in a position
to manipulate the perception of economic reality presented in the statements according
to the interested parties to whom they shall be presented. To Gowthorpe and Amat
(2005) there are two distinct categories of manipulative behaviour. A macro
manipulation consists on the lobbying of regulators persuading them to produce
regulation favourable to prepares interests. A micro manipulation occurs when the
accounting figures are managed to create a biased view at the entity level (Gowthorpe
& Amat, 2005, p. 55). Despite the difference, in both categories occur clear attempts by
preparers to manipulate financial statements.

2.1.2. OTHER TERMS

There are several other terms which are used in association with creative accounting.
Some of these are discussed further below.

2.1.2.1. Income Smoothing

Income Smoothing is a technique to eliminate instability in earnings by levelling off the
ups and downs of earnings over a period of years. The purpose is to moderate income

4
variability by reducing income during well successful years hence deferring them for
use throughout the bad years (Beidleman, 1973). This is a common accounting practice
that can be stretched over several years. Term used to describe a method of earnings
management designed to remove peaks and valleys from a normal earnings series,
including steps to reduce and store profits during good years for use during slower
years (Mulford & Comiskey, 2002).

2.1.2.2. Earnings Management

Earnings management is pointed as the main technique for manipulating financial

information () extensively documented in both research and practice of accounting
and auditing (Vladu & Pelinescu, 2014, p. 75), which is used by companies in order
for to manipulate accounting information and achieve a specific objective. For instance,
it is usual for analyst to predict companies performance and issue profit forecast from
listed companies trading on stock exchanges. It is also common that companies prefer to
meet these forecasts or else, their share prices tend to fall. As a result, companies that
are falling short of their targets seek to manage their profits. According to Shafer (2015)
it is possible to categorize earnings management in two basic types: the accounting
manipulations and the operating manipulations. The first type involves situations that
generally violate accounting principles in order to achieve the desired results whereas
operating manipulations involve modifying earnings, for instance by delaying
expenditures for repairs and maintenance to reduce current year expenses, or running
sales promotions near year end to boost reported sales and income. In contrast does not
violate accounting rules and regulations. For many authors, earnings management is
considered as a synonym keyword for creative accounting, being more used in
scientific research, for instance in the USA, whereas the term Creative Accounting,
more used in Europe and Australia (Adrian, et al., 2012).

2.1.2.3. Aggressive Accounting

It is a forceful and intentional choice and application of accounting principles done in an

effort to achieve desired results, typically higher current earnings, whether the practices
followed are in accordance with GAAP or not (Mulford & Comiskey, 2002). Managers
perceive tax departments as profit centres (Frank, et al., 2009), considering them
responsible for aggressive tax reporting, by managing cash flows and earnings resulting
in aggressive financial reporting expense (Dhaliwal, et al., 2004).

5
2.1.2.4. Impression Management

Also known as creative disclosure, it means an attempt by the management of a

company to provide users an impression of the company as they want to be perceived. It
is usually associated with presentational issues, and might be found in corporate annual
reports under forms of distortion of narratives of numerical and graphic manipulation
(Jones, 2010) (Vladu & Matis, 2010).

2.1.3. MOTIVATIONS AND REASONS FOR THE USE OF CREATIVE ACCOUNTING

Literature has examined what are the management motivations towards Creative
Accounting behaviour. Among researchers, tax is being mentioned as a significant
motivator, like the existence of tax levies based on income [(Hepworth, 1953); (Mulford
& Comiskey, 2002)]. Across a multitude of countries, such as Japan (Hermann & Inoue,
1996), Portugal (Costa, 2010) or Finland (Niskanen & Keloharju, 2000) tax is a
common reason pointed out for creative accounting.

Early empirical studies showed that companies report smooth income to give
shareholders and creditors the impression that they are low-risk companies (Beidleman,
1973). In fact, Beidleman (1973) observes the positive effects of income smoothing on
expectations, securities valuation and some elements of risk reduction for analysts.
Similarly, Amat and Blake (1996) highlighted stabilizing income as a reason for
companys management to meddling with the accounts, and, Trueman and Titman
(1988) mention managers motivations to reduce the perception of variability in primary
economic earnings of the company. Accordingly, managers can also understate
earnings to make reported earnings appear less volatile than the firms actual
fundamental performance (Huang, et al., 2008, p. 470). Furthermore, a bias that is
common, called big bath accounting (Amat & Blake, 1996), happens whenever a
company makes a bad loss and seeks to exploit the reported loss in that year so that
future years will look better.

Fox (1997) mentions how accounting policies in several companies are planned, within
accounting standards, to tie in reported earnings to profit forecasts. Firms, when selling
products, defer to future years, a great part of the profit to cover probable upgrade and
customer service expenses. This highly conservative accounting policy tips that future
earnings are easy to predict (Blake, et al., 1998).

6
Eventually, creative accounting might impact share prices, both by diminishing the
seeming levels of borrowing, enabling the company to look less risky, and by boosting a
positive profit trend. Consequently, this permits the company to raise capital from new
sources, propose their own shares in takeover bids, as well as resist takeover by other
firms. Mulford & Comiskey (2002) clustered some rewards from managing profits, and
mentioned the Share Price effect. The objectives and benefits that companies try to
achieve within this category are as follows: higher price share, reduce share price
volatility, increase firm value, lower cost of equity capital, and increase the value of
stock options. Examples of other categories of rewards are the Borrowing Cost Effects,
the Political Cost Effects and the Management Performance Evaluation Effects
(Mulford & Comiskey, 2002), being this last one intimately related with the Share Price
Effect, since the ultimate objective is to have increased bonuses which, in turn, are
based on Profits or Share Prices.

More recently, Adrian et al. (2012) pointed how preparers engage in creative accounting
to make certain arrangements resulting in profit maximization or earnings per share
maximization, in order to improve the companys image and liquidity, or simply to
reduce costs or debt ratios.

In fact, Healy (1985) studies the effect of bonus schemes on accounting decisions. He
examines managers motives for earnings manipulations where executive compensation
is linked with income measurement. Also, Stolowy & Breton (2004) when pointing out
some of the potential gains and losses from manipulating accounts identified, within the
scope of managers, the possibility to manage their remuneration, and within the scope
of shareholders and bondholders, the possibility to increase the market value of their
bonds.

Furthermore, Beaudoin et al., (2015) mention the relation between the use of
discretionary accruals and impacts on income with managers incentives. When
managers have incentives to defer earnings, discretionary accruals tend to be income
decreasing, whereas when the incentives are to accelerate earnings, discretionary
accruals tend to be income increasing. According to various authors, this behaviour may
be undertaken to avoid falling short of a bonus or earnings target or to improve the issue
price around an IPO [(Beaudoin, et al., 2015); (Chung, et al., 2005); (Cohen, et al.,

7
2008); (Guidry, et al., 1999); (Healy, 1985); (Holthausen, et al., 1995); (Matsunaga &
Park, 2001); (Shaw, 2003); (Teoh, et al., 1998)].

Accordingly, Jones (2010) presents a way to distinguish motivation into two sets of
general incentives. In one hand he presents the personal incentives that in his opinion
relates to managers. He explains that there might be the wish to increase salaries,
bonuses and share options, which lead them to manipulate accounting in order to
maximise their own personal benefit. On the other hand, managers might want to fulfil
the city expectations, which means that whenever their business does not deliver the
expected profits it is probable that the share price will be penalized. Thus, managers
would try to meet these incentives and expectations and engage on creative accounting
techniques.

Lastly, it is also frequent from management to hold onto information. Whenever

management delays its release to the market, or provides it through accounting
narratives, or delivers it through an impression management way, is, thereby, gaining
opportunity to benefit from inside knowledge. Narrative accountings are used by
managers for, say, deliver bad news with a high degree of technical terms and
incomprehensive language, broadcast the positive and soften the negative, or even
imputing faults to the environment for poor performance. Too, annual reports are
presented in the way companies which to be perceived (Jones, 2010). This impacts the
market since timing and knowledge are crucial factors to success among any kind of
business environment.

Nonetheless, it is salient that, in an efficient market, analysts are difficultly deceived by

cosmetic accounting, due to their ongoing accompaniment of companys path. Indeed,
literature exposing scandals on companies is increasing, and the attention of many
groups, as practitioners, investors, auditors, regulators, governments, and organisations
is also growing.

2.1.4. HOW IT IS PRACTISED

Several researchers have dedicated time to investigate how exactly creative accounting
can be performed. To Jones (2010) there are four main approaches to engage on creative
accounting, namely: increasing income, decreasing expenses, increasing assets and
decreasing liabilities.

8
Increasing income has to do with maximizing revenues. Usually, it involves an early
recognition of sales or the maximisation of other source of income, for instance interest
receivable or non-operating profit. Generally, this can be accomplished by exploiting
the flexibility within accounting rules. It can happen too, the fabrication of fictitious
sales. There are reports of extreme acts, engaging on fictitious trading subsidiary and
constructing and lease drilling machines, as seen in the McKesson and Robbins fraud
scandal, discovered in 1937 in the USA and in Flowtex white-collar scandal in
Germany in 2000, correspondingly.

Decreasing expenses aim for the natural raise of profit. Expenses might be decreased in
several ways. One example is creating provisions on more profitable years so that in
less profitable years these provisions can be reversed, reducing expenses and increasing
profits. Other ways might be to capitalise expenses such as interest payable, to lengthen
assets lives, to reduce debts or by increasing the closing inventory. Simultaneously,
several of these tactics used to decrease expenses will increase assets. Accordingly, by
lengthening depreciation and capitalizing interest, fixed assets will increase, whereas
reducing debt will raise accounts receivable. Still, further strategies may increase assets,
such as heightened goodwill in value and include it in the accounts, and the same for
other intangible assets.

To decrease liabilities also means increase net assets. A common way is to get off-
balance sheet finance, by allocating debt in a subsidiary company that is not
consolidated. This strategy was used by Enron, which has hidden debt on several not
consolidated subsidiaries, a practice that currently is not so used given changes in
accounting standards. Another way is by reclassifying debt as equity hence reducing the
apparent levels of debt.

Earlier in time, Smith (1998) revealed accounting manipulations by 208 (two hundred
and eight) of the largest listed UK companies and identified the 12 (twelve) different
techniques commonly used, all changing Profit and Loss, thus impacting Balance Sheet.
These specified techniques may be specified as follows:

Extra ordinal and exceptional items

Pre-acquisition write down
Deferred consideration on acquisition

9
 Disposals profits on sales of assets taken above the line and deconsolidation of
subsidiaries in anticipation of sale
Brand accounting capitalization of assets
Off balance sheet finance
Contingent liabilities
Changes in depreciation policy (method)
Capitalization of costs (interest and R&D)
Currency mismatching between borrowing and depositions
Pension fund surplus used to reduce annual charge
Convertible with premium put options or variable rate preferred stocks.

Cosmin (2010) provides an insight of some elements and corresponding mechanisms on

how to impact the balance sheet. These elements are tangible assets and equity, minority
interests, loans and customer claims. The mechanisms to impact the balance sheet are
also wide, from lease-backs, revaluation of assets, or discounting of tickets order.

There are a few principal potential areas for creative accounting (Blake, et al., 1998);
(Amat & Blake, 1996). The regulatory flexibility is identified as one main driver. This
is because even in extremely regulated accounting environments as, for instance, in the
USA, a good deal of flexibility is presented (Largay, 2002) (Mulford & Comiskey,
2002). It is often permitted a choice of policy, say, regarding asset valuation or between
choosing to write off or capitalize R&D costs. Secondly, management has considerable
scope for estimation since some entries in accounting involve an unavoidable degree of
estimation, judgment and prediction. According to Blake, et al. there can be bias in the
accounting estimates and an example here might concern the estimate made for an
asset life for depreciation purposes (2000, p. 137) . Naturally, these estimations are
made within the company creating the opportunity window for the preparer to be more
or less cautious or optimistic regarding these estimates. If it is the case of an outside
expert employed to make the estimates, it is also natural that the creative accountant
could manipulate the valuation both by the way how the expert is briefed and by
choosing an expert known to take a pessimistic or an optimistic view, as the accountant
prefers. A third area relates to artificial transactions which might be registered both to
manipulate balance sheets and to move profits between accounting periods. This is
accomplished by entering into two or more related transactions with an obliging third
party, normally a bank. An example can be a supposing arrangement to sell an asset to a

10
bank to then lease it back for the rest of its useful life. The established price for the 'sale
and leaseback' has the possibility to be above or below the current value of the asset, as
the difference can be offset by increased or reduced rents. On the other hand, some
extraordinary but genuine transactions can be planned in order to provoke the desired
impression in the accounts. An investment recorded at a low historic cost is easily sold
for the updated, higher current value, providing managers with a way to increase profit
whenever they wish to improve their accounts.

Figure 1 - Creative Accounting Techniques and Produced Effects.

Increase or Increase or Manipulation of

Reclassification
Decrease of Decrease of memory, management
of assets or
income and Assets and information and auditing
Liabilities
expenses Liabilities information

Differences Differences on Assets and

on Income Liabilities

Variation on the diagnosis of issues such as liquidity, indebtedness, financial

independence, or profitability

Differences in companys value, its chances of bank debt, government incentives or fixed
prices for regulated services.

Source: Adapted from Amat & Blake (1996)

Later, Gowthorpe and Amat (2005) asserted that the focus of creative accounting
manipulation is normally in the type that takes place at the level of individual business
entity, remembering that at a macro perspective prepares are also engaged in managing
disclosures to their own ends, and provided real examples. The macro-manipulation
case presented took place in the United States and illustrates the highly significant
policy decision by the principal accounting regulator confounded by successful prepared
lobbying, on the topic of goodwill accounting. The second case, in Spain, examines
micro-manipulation of earnings figures in an overt way. To these authors, macro-
manipulation (lobbying) is unethical since the preparers attempt to prevent changes on

11
regulation favouring their interests. On the other hand, they recognize the importance of
regulations being promulgated considering the common good of the whole society, not
favouring any specific group of individuals.

2.1.5. THE IMPACTS OF ITS USE

For every player in a companys quotidian there are potential gains and losses from
manipulating accounts. Stolowy & Breton (2004) provided a summary of the impacts
for each player, and some are presented in the following table.

Table 1 - Potential Gains and Losses from Manipulating Accounts.

Players Gains Losses

Managers Reducing the cost of capital
Keeping their job
Manage remuneration
Respect debt covenants
Official Examination
Minimization of income tax
Gain tax advantages
Improve stakeholders
Avoid political costs
Shareholders and Increase market value of bonds
Bondholders Control employees claims
Employees Keeping their jobs
Increase remuneration
Suppliers Keeping a client
Clients Continuous services
Warranty respected
Government Tax to collect
Jobs for population
Bankers Repayment of loans
Society Keeping jobs
Production of wealth
Job and reputation at stake
Wealth transfer to the actual
shareholders
Job (if the company goes
bankrupt or dismisses personal)
Money from unexpected
bankruptcy
Services interrupted
Warranties not provided
No more tax to collect
Unemployment increases
Money from unexpected
bankruptcy
Job losses
Resources wasted

Source: Adapted from Stolowy & Breton (2004)

12
Literature provides evidence that creative accounting exists and is still practiced.
Companies look for the best graduates and professionals who know the law and
accounting regulation by heart and still find ways to make the organization look good
and attractive for investment. While opinions on the acceptability of accounting
manipulation vary, it is often perceived as morally reprehensible since it involves unfair
exercise of power, unfairness to users and foments the weaken of authority of
accounting regulations (Gowthorpe & Amat, 2005). On the other hand, sound
statements, such as the book opening of Ian Griffiths, were made regarding the topic,
making creative accounting an issue relevant worldwide. From the business journalist
perspective, at the time and concerning UKs economy, he observes: Every company
in the country is fiddling its profits. Every set of accounts is based on books which have
been gently cooked or completely roasted. The figures which are fed twice a year to the
investing public have been changed in order to protect the guilty. It is the biggest con
trick since the Trojan horse. Any accountant worth his salt will confirm that this is no
wild assertion. There is no argument over the extent and existence of this corporate
contortionism, the only dispute might be over the way in which it is described. Such
phrases as cooking the books, fiddling the accounts, and corporate con trick may
raise eyebrows where they cause people to infer that there is something illegal about this
pastime. In fact this deception is all in perfectly good taste. It is totally legitimate. It is
creative accounting (1986, p. 1).

2.2. CONTINGENT LIABILITIES

2.2.1. SIGNIFICANCE AND ORIGIN

As previously mentioned, it is found, in a study performed in UK companies (Smith,

1998), that there are about 12 different creative accounting techniques, that may cause
differences in the Balance Sheet, specifically on Profit and Loss account, being one of
them, the use of Contingent Liabilities and Provisions.

According to the International Accounting Standards 37 Provisions, Contingent

Liabilities and Contingent Assets (IAS 37), a Contingent Liability is (1) a possible
obligation that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity or (2) a present obligation that arises from past events
but it is not recognised because:

13
 a) It is not probable that an outflow of resources is embodying economic benefits
will be required to settle the obligation;

b) The amount of the obligation cannot be measured with sufficient reliability.

There is much confusion between the definition of contingent liabilities and

provisions. Quoting the standard IAS 37, a Provision is defined as liabilities of
uncertain timing or amount, being a liability a present obligation of the entity arising
from past events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits. So, contingent liabilities are not
present obligations and thus are not recognized in the Balance sheet (but only disclosed
in the Notes), while provisions are recognized as an element of the liability section of
the balance sheet.

Both provisions and contingencies have led to significant creative accounting within
financial statements. Consequently, the IAS 37 objective is to ensure that an
appropriate recognition criteria and measurement bases are applied to provisions,
contingent liabilities and contingent assets and that sufficient information is disclosed in
the notes to enable users to understand their nature, timing and amount.

The IAS 37 was issued by the International Accounting Standards Committee (IASC) in
September 1998. It replaced parts of IAS 10 Contingencies and Events Occurring After
the Balance Sheet Date (issued in 1978 and reformatted in 1994) that dealt with
contingencies. In April 2001, the International Accounting Standard Board (IASB), as
successor to the IASC, resolved that all standards and interpretations issued under
previous constitutions would continue to apply unless and until amended or withdrawn.
Before IAS 37, the recognition of a provision could be based in the intention to incur
expenditure rather than an obligation to do so, causing impact on verified profits after
provisions. Thus, IAS 37 updated the existing Standard at the time IAS 10 and bans
illegalities such as the use of provisions where no obligation to a liability exists or the
use of provisions to smooth profits. Also, the Standard requires more disclosure in
relation to provisions in order to aid the users understanding as well as present a true
and fair view.

According to Deloitte (s.d.), the key principle established by the Standard is that a
provision should be recognised only when there is a liability, meaning, a present

14
obligation resulting from past events. The Standard thus aims to ensure that only
genuine obligations are dealt with in the financial statements planned future
expenditure, even where authorised by the board of directors or equivalent governing
body, is excluded from recognition.

However, at this point, it is worth to clarify that this Standard covers the current
definition of provision, linking this term to a liability of uncertain timing or amount.
One must be aware, however, that in past general accounting terminology, it was
common for provision to be applied for:

i) Provision for depreciation,

ii) Provision for doubtful debts, or

iii) Provision for impairment.

In such cases, the term provision refers to an adjustment, decreasing the carrying
amount of the asset, and not a liability of uncertain time or amount1.

2.2.2. DISCLOSURE VS RECOGNITION

An inappropriate use of the standard regulation can be due to the misinterpretation and
eventual confusion about when is it required or not to recognise a Provision, or when it
is only required to disclose a contingent liability in the financial statements of an entity
by the end of the reporting year.

Therefore, it is also fundamental to establish the key differences between a provision

and a contingent liability. Basically, to recognise a provision, certain criteria have to be
met, and in case one or more of those arent met a contingent liability occurs. Thus,
Provisions require:

A present obligation from a past event

A probable outflow of economic benefits
A reliable evaluation of timing and amount.

So, a Contingent Liability occurs when one or more of the conditions for a provision are
not met, i.e. either:

1
These cases are out of the scope of this work.

15
 A possible obligation from past event exists
And/or an outflow of economic benefits is not probable
And/or a reliable estimate of outflow cannot be made.

If all the conditions for the recognition of a provision are satisfied, then this amount will
be recognized at the Balance Sheet, as well as in the Income Statement of the year for
every change in that amount. If not, contingent liabilities will not be stated in the
balance sheet neither in the income statement; they will be disclosed, also accordingly
to requirements of the Standard, on the Notes, which is also a Financial Statement.

2.2.3. THE CRITERIA AND SUBJECTIVITY

It is perceptible that experts or management treat future outflow/inflow of economic

benefits in the accounts as terms directly related with the perception of the words
Possible, Probable and Remote. The IAS 37 refers to probability whenever an
event is more likely than not to occur, meaning that something is probable if the
probability to occur is greater than the probability of not occurring. The other terms,
Possible and Remote, are left to the experts interpretation and consciousness.
Therefore, it is each entity and its expert opinion that will dictate whether there is the
need to recognize or disclose an event, or if it is acceptable to hide it. Some authors
argue that This explicitly indicates that a 51 per cent likelihood is probable. If not
probable, a contingent liability is disclosed (as possible), unless the likelihood is
remote, in which case nothing is reported at all (Alexander, et al., 2014, p. 440).

It seems that the area of subjectivity is wide; therefore leaving a window of opportunity
for an entity to perform creative accounting, using a Contingent liabilitys disclosing
technique. In summary, the IAS 37 makes the entities actions depend on experts
opinions, suggesting that there is a loophole in accounting standards for the use of
creative accounting, even when actions are according to the law and respecting
International Standards principles.

2.2.4. DISCLOSURE V. RECOGNITION AND IMPACTS ON FINANCIAL STATEMENTS

Financial statements deliver information that enable assessing a companys performance

throughout an economic period and guidance on economic decision making.
Accounting regulation exists to ensure that information is produced on a consistent

16
basis and in accordance to rules, making it reliable for users. However, activities of
financial statement preparers, may deliberately distort the communication and message
delivered by financial statements (Gowthorpe & Amat, 2005).

Moreover, each organization dedicates a substantial part of their financial reporting to

Notes to the financial statements, also known as Final Notes. The information that is
communicated by means of required disclosures is significant and has been increasing
over time. However, they are not fully understood. Thus, it is important to consider the
possible impacts of distorted disclosure and recognition in financial statements, in
particular, diminished values of debt or augmented values of debt, an illusion of
stability within the organization.

From a preparers perspective, there are several studies made to conclude whereas
factors as preparers seniority, being a public or a private company, the auditing
company involved or value estimation differences, whether it concerns a disclosure or
recognition of a contingency, influence the recognition/disclosing process. For instance,
a study made by Clor-Proell & Maines (2014) revealed that preparers efforts and extent
of strategic bias affect the liability estimate that is reported in the financial statements.
This study finds that public-company financial managers report a higher value when
recognizing a contingent liability than when disclosing, whereas private-company
managers report similar values nonetheless disclosing/recognition. Nevertheless, latest
studies have a tendency to conclude that public companies have more quality in
recognizing earnings when comparing to private companies [(Hope, et al., 2013);
(Burgstahler, et al., 2006)].

The significant impacts these provisions cause are reflected in the Income Statement
(the expense with annual provision) and also in Statement of Financial Position, also
known as Balance Sheet, in the liability section (the accumulated value along the years).
As previously said, experts opinions can be inaccurate and final outcomes can reveal
themselves highly costly for the organizations. Therefore, final accounting reports, in
particular, Balance Sheet and Income Statements, might have their final results
heightened, and therefore Debt be undervalued or, on the contrary, final results being
reduced and debt be overvalued if a provision is recognized in excess.

17
Unrealistic debt recorded incentives managers to adopt decisions based at the illusion of
the organizations stability. When a company is solvent, managers might opt to leverage
more on the capital structure of the organization, to adopt significant investment
policies, among other managerial and finance decisions. The consequences for
inaccurate recorded debt through misuse of provisions and contingent liabilities, after an
increase of materially relevant liabilities, are a drawback on investment decisions, and
an unprepared capital structure aggravating the companys day to day operations and its
performance both on short and long run.

Shareholders, in particular, show great concern for the reliability they can have on
financial statements. If a company reveals inaccurate information the investments
outcome do not meet expectations and the firms credibility is severely damaged.
Transparency is, thus, most appreciated. From the investors perspective, the firms
capacity to generate profit and pay dividends, as well as its stability in the long run, are
determinant criteria to assess investment decision.

In early research on disclosures of contingencies, Hennes (2014) examined litigation

contingency disclosure under existing accounting rules. She looked for any signals of
managements assessment of the expected loss, providing evaluation of the contingency
for investors and to standard-setters and other stakeholders, evaluating potential
incremental changes to the reporting for contingencies, as well as to statements used
attempting to parse the existing disclosures. Findings were that the text of disclosures
provides qualitative clues about the probability of loss, despite quantitative details.
Specifically, the study found evidence that statements about the inestimable nature of
loss or firms willingness to consider a settlement are related to higher probabilities of
loss and higher loss amounts; and statements regarding accrual for loss and warnings
about materiality reflect higher likelihood of a nontrivial loss. Desir et al. (2010)
analysed 51 disclosures of adverse litigation outcomes from 2007. Findings revealed
that 8% of their sample makes no reference to the litigation in the financial statements
of the period prior to the loss recognition. Whereas, the firms that disclose in advance,
describe the nature of the claim but less than half reveal or anticipate amounts for the
loss.

Among the many purposes of required disclosures identified by research, reduce

uncertainty is indicated as an important one. For instance, Linsmeier et al. (2002)

18
mentions risk related disclosures reduce uncertainty and diversity of opinions on equity
values in case of changes of market interest rates, foreign exchange rates, and
commodities prices. For contingent liabilities purposes, companies disclosures foment,
too, the reduction of uncertainty for financial statement users, in particular, investors.
Nevertheless, there are proven reliability differences on disclosed and recognized items.
Disclosed amounts are considered less reliable than recognized amounts, and these
differences can be due to the preparation and auditing of disclosed amounts versus
recognized (Schipper, 2007). However, Choudhary (2011, p. 91) concludes that
recognized values are more likely to be underestimated. From a manager perspective,
research on whether managers opt to disclose less reliable items is misled for factors as
incentives not directly related with reliability. As an example, Aboody, et al., (2004)
concluded that the organization size and several incentive related factors could
influence voluntary decisions favourable to the recognition (as opposed to disclosure) of
the fair value of share-based payments to employees, including capital market
participation, CEOs and board shares ownership and bonus arrangements that are not
as influenced by companys earnings. From an auditor perspective, Libby et al., (2006)
conclude that auditors might allow additional misstatement in a disclosed item (fair
value of shared-based payments) than in a recognized item (balance sheet amount for a
capital lease), being this difference partially due to an auditor perception that the errors
made in disclosed amounts are less material2. Such behaviour might be directly related
with the perception of reliability. From a user perspective (investor particularly), there
are different types of attitudes and views on recognised versus disclosed items,
depending on how investors process information and depending on its availability or
ease of use. One possible type of investors attitude characterizes the investor as
rational, knowledgeable, and not constrained by cognitive limitations and not ascribing
any meaning to how information is presented (Schipper, 2007). This investor sees no
difference among information once an item enters the financial statements, and the way
its presented or where it is presented do not play a role, since all the communications
are processed according to their informational properties. This perspective is
exemplified by Aboody et al. (2004, p. 127): in an efficient market, the decision to
recognize a disclosed amount conveys no new information. A second perspective
relates to the items location and implies that it reveals something about its utility for

2
Materiality considered in terms of what would affect the judgment of a reasonable person (that is, a
financial statement user).

19
decision making. The perspective is consistent with users who look to financial
reporting requirements to reveal pertinent information characteristics of disclosed
versus recognized items. This rational view of recognition and disclosure suggests that
the regulators decision about the location of the information reveals something about
that informations reliability. Another view is that recognition and disclosure
distinctions derive from users intrinsic characteristics. It is consistent with users who
ignore or minimize disclosed items, or consider them differently from recognized items,
for cognitive reasons, as for example, lack of problem-solving ability, knowledge, and
ability and willingness to process disclosed items thoroughly.

Schipper (2007) tried to provide rational for why would users of financial reports treat
recognition and disclosure items differently. She mentions two human behavioural
causes, being competence (knowledge, effort and ability) and certain features of how
humans process information that can be intrinsic, i.e. not significantly affected by
incentives or expertise. Supported by previous research [Imhoff et al., (1995); Dietrich
et al., (2001); and Hirst et al., (2004)], Schipper mentions that users of financial
statements depend on salient and promptly available information in order to think and
infer faster. In the conclusion, the researcher states there is no systematic evidence that
standard setters act as if they believe that users cannot understand and use disclosed
items as easily as they understand and use recognized items. However, research
suggests that users do in fact process disclosed items differently from, and probably less
thoroughly than, recognized items. It is unclear what causes this difference, and how
much the difference might matter for capital market outcomes (Schipper, 2007, p.
324).

Libby and Brown (2013) analysed the effects of disclosure, specifically on

disaggregating expense items on the income statement and found that this significantly
decreases the amount of error that auditors will accept, by 17 percent on average.
However, it increases the variance in responses significantly. They also concluded that
this effect is significantly lower if these line items are moved to notes, eliminating their
relevance as materiality benchmarks, as was the case for some auditors. Accordingly,
the study shows that the effect on materiality judgements decreases significantly when
the disaggregated amounts are included in the notes. Their study also gave some
evidence on the widespread disagreement of experts on the interpretation of admittedly
confusing current auditing standards related with the issue.

20
Nevertheless, according to Conover et al., (2008), the voluntary disclosure of
accounting information mitigates information asymmetry and improves the
communication amongst managers, shareholders, and creditors.

Overall, research results emphasize firms strong resistance to quantitative disclosures

and that qualitative disclosures generally reflect the probability of realizing a loss.

2.3. THE ROLE OF CULTURE IN ACCOUNTING

It is commonly accepted that a convergence between accounting systems would be ideal

due to the increasing needs of globalized and interconnected markets and organizations.
However, there has been much diversity among the accounting systems from one
country to another country and it is natural to question why accounting norms and
standards do vary so much among different accounting systems.

Accounting is not an exact science; instead it has its roots from the social sciences
branch that adjusts to the type of information demanded by society from companies.
From this perspective, the accounting norms from a determined country may be
influenced by a multiplicity of factors. The accounting procedures are the result of a
combination of inputs such as culture, political systems, religious and economical
environments of a given country.

Many were the studies that have showed the existence of own circumstances,
characterizing the process of drafting accounting information of each country and
allowed to establish certain correlations between the different accounting systems.
These systems have evolved, according to Gonzalo & Ta (1998, p. 49) by internal
causes, for instance, culture or social values change, external causes, with increased
relevance and impact of multinationals, or mixed causes, such as succeeded with the
European Union, where each country had to adapt its standards to the Community
legislation. In several papers, Nobes (2011) and Kvaal & Nobes (2010; 2012) suggest
that international differences in the adoption and application of international standards
are explained by national influences on IFRS practice through legal system, taxation
and enforcement.

21
2.3.1. INTERNATIONAL CLUSTERING
Nobes (1996, p. 13) and later an Amaral adaptation (2001, p. 38) present a summary
table where main cultural differences can be seen between two diverse country clusters:
the Anglo-Saxon (with a corresponding Class A accounting system) and the Continental
(class B correspondent accounting system). Class A versus Class B systems refer to the
classification based on the relative strength of outsider-equity financing [(Nobes, 1998),
(Nobes, 2008)].

Figure 2 - International Clusters.

Anglo-Saxon Cluster Continental Cluster

1 Antecedents
British Law Roman Law
Ancient profession, of big dimension Still recent profession, of small
and strong dimension and weak
Strong Equity Markets Small Capital Markets

2 Generic Accounting Characteristics

Oriented to the truth and Legally Oriented
appropriated image Creditor Oriented
Investor oriented Little Disclosure
Plenty disclosure Fiscal regulation dominates the
Separation from accounting and accounting rules
fiscal rules Governmental standards
Professional standards predomination and form over
predomination and substance over substance
form
3 - Specific Accounting Characteristics
Method of Finished Percentage Method of Finished Contract
Amortisation mensuration according Amortisation mensuration according
to useful lifetime periods to fiscal rules
Non-existent legal reservations Existence of legal reservations
Non-existent taxes provisions Existence of provisions for taxes
Cost recognition of charges related Capitalization of the expenses with the
with first establishment first establishment

4 Some Examples of Countries

Australia Germany
Canada Belgium
Denmark France
USA Greece
Netherlands Italy
New Zealand Portugal
UK Japan

Source: Adapted from Amaral (2001, p. 38)

22
As previously mentioned, the study focus in UK and Portugal and points the cultural
influence of each country on accounting, particularly on disclosure and recognition
processes. Thus, it is necessary to determine some background on the accounting
building systems for each of these countries. Despite IAS/IFRS are mandatory both for
UK and for PT due to requirements made by the Commission and Parliament of
European Union, UK is singular on its characteristics as a country, far from similar to
Portugal. As it can be seen in Figure 2 both countries belong to distinct clusters and
interesting conclusions can be found from a cluster comparison.

Extensive literature had justified differences in legal systems as the main reason why
preparers and users can play different roles in assessing financial information to take
decisions (e.g., La Porta et al. (1998) and Shleifer et al et al. (2008) are used by a
countless numbers of authors). Common Law and Roman law legal systems are cited as
drivers of cultural differences affecting accounting differences on reporting [Nobes
(1996); (1998)]. Nonetheless, the rational between legal systems and accounting
systems has not been exhaustively addressed in the literature, which had led to further
inquiring of the validity of accounting system classification based on legal system
(Lindahl & Schadewitz, 2013).

There are some studies made to address creative accounting and the role of culture on
the practice. A few studies have looked at creative accounting in an international
context by associating earnings management of several countries to country-specific
institutional factors, as e.g., Darrough, et al., (1998); Kinnunen & Koskela (2003);
Bhattacharya, et al., (2003). Factors identified in prior research as potential
determinants of earnings management include debt contracting costs, political costs, and
ownership and management incentive compensation plans. These researches, however,
have not highlighted the likely effects of cultural values on creative accounting. This
link will be addressed here by identifying measures of cultural values and linking these
measures to creative accounting. In the next section, some further empirical research on
cultural differences will be analysed, favourable to the comparison between the UK and
Portugal.

2.3.2. HOFSTEDE AND CULTURAL DIMENSIONS

Geert Hofstede (1980) gathered more than 116 thousand questionaries from workers of
large multinational organizations in 72 countries and became the founder of

23
comparative intercultural research. His study identified four factors Power Distance,
Individualism, Masculinity and Uncertainty Avoidance that originate differences in
countries cultural values. Later, Hofstede & Bond (1988) furthered the study and
adding one other dimension called Long Term Orientation. A sixth dimension,
Indulgence, was more recently introduced. However, these last two dimensions will be
theoretically introduced here but, due to lack of relevance for this paper, are out of
consideration.

Power Distance

This dimension deals with the fact that all individuals in societies are not equal; it
expresses the attitude of the culture towards these inequalities amongst individuals.
Power Distance is defined as the extent to which the less powerful members of
institutions and organisations within a country expect and accept that power is
distributed unequally. It can also be explained as, the degree of tolerance for inequality
of wealth and power indicated by the extent to which centralization and autocratic
power are permitted. People in large power distance societies accept a hierarchical order
in which everybody has a place which needs no further justification. People in small
power distance societies strive for power equalization and demand justification for
power inequalities (Robock & Simmonds, 1989) .

Individualism

The fundamental issue addressed by this dimension is the degree of interdependence a

society maintains among its members. It has to do with whether peoples self-image is
defined in terms of I or We. In Individualist societies people are supposed to look
after themselves and their direct family only. In Collectivist societys people belong to
in groups that take care of them in exchange for. Individualism (versus collectivism)
can also be explained as the extent to which the individual expects personal freedom
versus the acceptance of responsibility to family, tribal, or national groups, i.e.
collectivism (Robock & Simmonds, 1989).

Uncertainty Avoidance
The dimension Uncertainty Avoidance has to do with the way that a society deals with
the fact that the future can never be known: should we try to control the future or just let
it happen? This ambiguity brings with it anxiety and different cultures have learnt to
deal with this anxiety in different ways. The extent to which the members of a culture

24
feel threatened by ambiguous or unknown situations and have created beliefs and
institutions that try to avoid these is reflected in the score on Uncertainty Avoidance. It
can also be explained as the extent to which society avoids risk and creates security by
emphasizing technology and buildings, laws and rules, and religion. Weak uncertainty
avoidance societies maintain a more relaxed atmosphere in which practice counts more
than principles and deviance is more easily tolerated (Robock & Simmonds, 1989).

Masculinity
A high score (Masculine) on this dimension indicates that the society will be driven by
competition, achievement and success, with success being defined by the winner / best
in field a value system that starts in school and continues throughout organisational
life. A low score (Feminine) on this dimension means that the dominant values, in
society, are caring for others and quality of life. A Feminine society is one where
quality of life is the sign of success and standing out from the crowd is not
admirable. The fundamental issue here is what motivates people, wanting to be the best
(Masculine) or liking what you do (Feminine). It can also be defined as the extent to
which society differentiates roles between the sexes and places emphasis on masculine
values of performance and visible achievement. Femininity stands for a preference for
relationships, modesty, caring for the weak, and the quality of life (Robock &
Simmonds, 1989).

Long-Term Orientation
This dimension describes how every society has to maintain some links with its
own past while dealing with the challenges of the present and future, and
societies prioritise these two existential goals differently. Normative societies, which
score low on this dimension, for example, prefer to maintain time-honoured traditions
and norms while viewing societal change with suspicion. Those with a culture which
scores high, on the other hand, take a more pragmatic approach: they encourage thrift
and efforts in modern education as a way to prepare for the future.

Indulgence

One challenge that confronts humanity, now and in the past, is the degree to which
small children are socialized. Without socialization we do not become human. This
dimension is defined as the extent to which people try to control their desires and

25
impulses, based on the way they were raised. Relatively weak control is called
Indulgence and relatively strong control is called Restraint. Cultures can, therefore,
be described as Indulgent or Restrained.

2.3.3. PORTUGAL AND UK - CULTURAL COUNTRY COMPARISON

Figure 3 - Hofstede's Cultural Dimensions Scores

99
89

66 69
63
51

35 35 33
31 28
27

Power Individualism Masculinity Uncertainty Long-Term Indulgence

Distance Avoidance Orientation

Portugal United Kingdom

In figure 3, the scores given for each dimension are retrieved from the Hofstedes
Centre Country Comparison Tool. It is worth to mention, according to what is
displayed in the website, that the scores attributed to the 5th dimension are based on the
latest research of Minkov (2010, pp. 255-258).

Culturally speaking, Portugal and United Kingdom appear to be very different,

concerning the Hofstedes Dimension. On Power distance dimension, Portugal scores
63 while the UK ranks 35. The Portuguese score shows that hierarchical distance is
accepted and those holding the most powerful positions are admitted to have privileges
for their position, whereas the lower ranks of UK demonstrates that the society believes
that inequalities amongst people should be minimized. This index appears to be
incongruent with the historical British class system. However it demonstrates this
society sense of fair play - despite of birth rank one should not be limited on how far he
can travel in life. The power dimension is especially relevant for Portugal, in
organizational terms, since it reflects the importance of management controls, i.e. the
person in charge requires information from his subordinates and these expect their boss

26
to control them. A lack of interest towards a subordinate could be interpreted as if he is
not relevant in the organization and unmotivated the employee. It is also very distressful
for an employee to provide to his superior negative information (negative feedback)
and, consequently, the people in charge might need to look for certain signals in order to
discover real problems, knowing that employees face that difficulty. Individualism is
another cultural dimension where these two countries truly differentiate. Portugal
scores 27 on individualism and is therefore a Collectivist society, with a long term
commitment to the member group (family, extended family or extended relationships).
Loyalty is paramount and over rides most other societal rules and regulations. The
society fosters strong relationship where everyone takes responsibility for fellow
members of their group. In collectivist societies, employer/employee relationships are
perceived in moral terms, like a family link, hiring and promotion decisions take
account of the employees in-group, management is the management of groups.
Conversely, UK scores 89 on this dimension. It is amongst the highest of individualist
scores (beaten only by some commonwealth countries as Australia and USA). The
British are a highly Individualist and reserved people. They are taught from an early age
to think for themselves and to find out what their unique purpose in life is and how they
uniquely can contribute to society. Individualism is characterized by personal fulfilment
and strengthens the me culture. Furthermore, United Kingdom is highly success
oriented and driven, ranking the country with 66 points for a masculine society.
Masculine societies live in order to work and have a clear performance ambition. Status
is an achievement for masculine societies. On the contrary, Portugal is characteristic for
a society where the focus is on working in order to live, scoring 31 on masculinity. In
a Feminine country as Portugal, consensus is a key word and polarization is not well
considered or excessive competitiveness appreciated. Organizationally speaking,
management strives to achieve consensus and values as equality, solidarity and work
life balance among their workers. Conflict solving is based on compromise and
negotiation and workers favour incentives such as flexibility and free time since the
focus is on well-being. However, there is no better dimension to define Portugal than
Uncertainty Avoidance, since it scores 99 on this dimension. This demonstrates a very
high preference for avoiding uncertainty and some intolerance of unorthodox behaviour
and ideas. Countries with high UA maintain rigid codes of belief and behaviour, their
society demonstrates an emotional need for rules, even if they are not applied, and
security is an important element in individuals motivation. On the contrary, UK has a

27
low score on UA, ranked at 35. This translates on the fact that the society is happy to
face challenges and feel comfortable in ambiguous situations, in accordance with their
very British expression muddling through. There are not many rules to be followed
but the ones that exist are adhered to. In work terms this will result in planning that is
not detail oriented, the process is fluid and flexible to emerging and changing
environments, but instead goal oriented (High Masculinity). The result of a highly
individualist and curious nation is a high level of creativity and a strong need for
innovation what is different is more attractive. This emerges throughout the society in
both its humour, heavy consumerism for new and innovative products and the fast
highly creative industries it thrives in advertising, marketing, financial engineering.
Another very distinctive cultural dimension for Portugal and UK is indulgence. Portugal
scores 33, indicating a restrained society, with tendency to cynicism and pessimism,
whereas UK scores 69 indicating that the British Culture is classified as Indulgent. In
contrast with indulgent societies, the restrained do not put much emphasis on leisure
time and control the gratification of their desires. People with this orientation have the
perception that their actions are restrained by social norms and feel that indulging
themselves is somewhat wrong. On the contrary, peoples in indulgent societies exhibit a
willingness to realise their impulses and desires with regard to enjoying life and having
fun. They possess a positive attitude and have a tendency towards optimism. In
addition, they place a higher degree of importance on leisure time, act as they please
and spend money as they wish. Long term orientation does not play a significant when
distinguishing both countries. Portugal scores 28 and UK 51, meaning that a dominant
preference in British culture cannot be determined.

28
 2.3.4. GRAYSS CULTURAL ACCOUNTING FRAMEWORK
Figure 4 - Grays' Cultural Accounting Framework

External Influences
Forces of nature
Trade
Investment
Conquest

Societal Values
Institutional Consequences
Individualism
Structure and financing of
Power Distance institutions:
Uncertainty Legal System
Ecological Influences Avoidance
Corporate Ownership
Geographic Masculinity
Capital Markets
Economic
Professional Associations
Demographic
Education
Genetic/Hygienic
Religion
Historical
Technological
Urbanization Accounting Values
Secrecy vs
Transparency
Conservatism vs Accounting
Optimism Systems

Grays (1988) article entitled Towards a Theory of Cultural Influence in the

Development of Accounting Systems Internationally was pioneer in the spreading of
the idea that culture can impact accounting decisions. The study proposed a theoretical
link of societal and accounting values that brought together constructs of the social
sciences and international accounting literature.

In figure 4 it is visible the framework through which Gray3 based the argument that
culture influences accounting. This framework numbers several factors supposedly
influencing societal values, or cultural dimensions, an in turn these societal values

3
Herafter, Gray refers to Gray (1988), unless noted otherwise.

29
lead to institutional consequences on the structure and functioning of the institutions
like education, capital markets, political and legal systems and corporate ownership.
Moreover, when functioning, these systems should reproduce and reinforce societal
values as illustrated in the bottom arrow/loop of the figure 4. The structure is
hypothetically constant and changes are due to major external influences (for instance,
trade or investment) and at a national scope.

As previously mentioned, Gray proposes a connection between his framework and

Hofstedes (1980) cultural dimensions by showing how accounting practices could
influence and reinforce societal (or cultural) values. Grays theory illustrates cultural
values at the national level pervading through occupational subcultures, comprising the
accounting profession, with variable degrees of integration. The value systems of
accountants derive from their own social values due to work-related and accounting
values influencing accounting practices. Therefore, conditional to the varying degrees of
external and ecological forces shaping societal values, different accounting systems
develop, mirror and reinforce these values. Gray proposed that this framework could be
used to explain international differences in accounting practices and furthered suggested
that there should be a close match between cultural areas and patterns of accounting
systems. Therefore, it is implicit a connection between Hofstedes Dimensions and
countries clustering with countries financial reporting systems. In detail, the study
identifies four accounting values in accountant practitioners (professionalism,
uniformity, conservatism and secrecy) and posits that they are original on the individual
cultural values, also known as Hofstedes cultural dimensions. Accounting values, in
turn, impact the development of the countries reporting systems.

Concerning the impact that national culture might have in comparisons of financial
statements prepared in different countries, conservatism and secrecy are the accounting
values with more significance, excluding, therefore, professionalism and uniformity
from this dissertations scope. Conservatism means a preference for a cautious approach
to measurement and Secrecy a preference for confidentiality and the restriction of
disclosure of information about business, and both values have implied a cautious
approach to corporate financial reporting in general. Gray supports this notion by noting
that conservatism would be a relevant accounting value since it is arguably the most
ancient and probably the most pervasive principle of accounting valuation (1988, p.
10). Moreover, he wrote that secrecy, or confidentiality, in business relationships is a

30
fundamental accounting attitude (1988, p. 11). Thus, conservatism (as opposed to
optimism) and secrecy (as opposed to transparency) are values that can possibly
manifest themselves, through an accountants decision, in a set of financial statements
and.

The hypotheses posed, concerning a relationship between conservatism and secrecy

with Hofstedes Cultural dimensions, are:

The higher a country ranks in terms of Uncertainty Avoidance and the lower it ranks
in terms of individualism and masculinity, the more likely it is to rank in terms of
conservatism.
The higher a country ranks in terms of Uncertainty Avoidance and Power Distance
and the lower it ranks in terms of individualism and masculinity then the more likely
it is to rank highly in terms of secrecy.

The majority of research that tests Grays hypothesis [Eddie, (1990); Salter &
Niswander (1995); Gray & Vint (1995); Sudarwan & Fogarty (1996); Zarzeski (1996);
Wingate (1997); Jaggi & Low (2000); Hope (2003)] explored a relationship, at a
country level, between financial statement data and Hofstedes cultural dimension
scores and one or more features of countries financial reporting systems.

Grays Secrecy hypothesis have been submitted to a bigger number of tests, eventually
as available disclosures indexes turn it an easy accounting value to work with. These
researches give high support for Grays hypothesized relationship of Hofstedes cultural
values and Secrecy. Yet, fewer studies have observed the relation between culture and
Conservatism. Among these there is some lack of consent. For instance, Eddie (1990)
found support for Grays conservatism proposition, while Salter & Niswander (1995)
and Sudarwan & Fogarty (1996) got diverse results for Grays posed relationships
between Hofstedes cultural dimensions and conservatism. Diverse results might be
provoked by the difficulties of establishing a country level measure of a financial
reporting system attribute like conservatism (Tsakumis, 2007). As an example, annual
reports might be moderately easy to use and to develop disclosure measures, but are
limited in developing a country-level conservatism measure. There were other studies
that developed Grays model at the individual level, instead of at country level.
MacArthur [(1996); (1999)] concluded that comment letters submitted to the IASC by

31
managers and accounting lobbyists from various countries reveal tendencies for
conservatism and secrecy consistent with Grays hypotheses. Roberts & Salter (1999)
give overall support for Grays proposition in that Hofstedes cultural dimensions truly
influence accountants attitudes towards the homogeneity of accounting rules. Schultz
& Lopez (2001) prove that accountants from countries with higher uncertainty
avoidance decide warranty expense estimates with further conservatism than
accountants from countries with lower uncertainty avoidance. Furthermore, Doupnik &
Richter (2004) show that German accountants reveal conservatism bias when
interpreting of probability expressions. Moreover, Doupnik & Riccio (2006) found
some evidence that in a high conservatism country, accountants assign higher numerical
probability to verbal probability expressions that determine the threshold for the
recognition of items that increase income than in a low conservatism county. Also, they
found strong support about that accountants in a high secrecy country assign higher
numerical probabilities to verbal probability expressions for the disclosure of
information than accountants in a low secrecy county. This study by Doupnik & Riccio
(2006) also contributes by testing Grays theory at the individual-accountant level.

It is worth to notice that, not only these studies reinforce that accountants are influenced
by culture as Gray posed, but more importantly, they introduce the idea that Grays
framework can be tested at the individual level. Thus, it is posited that Grays cultural
accounting framework is possible to be applicable to accountants financial reporting
decisions, implying that accountants are expected to apply financial reporting principles
consistently with their own cultural values.

Just as Nobes (1996; 1998) Gray also categorized countries according to clusters by
culture area as a basis for testing the relationship between cultures and accounting
systems. For instance he classified USA, UK and Australia as countries exhibiting the
least conservatism and secrecy, belonging to the Anglo- American group. To Gray, the
Anglo-American (above referred to as Class A and Common Law) emphasize the values
of optimism and transparency. He also clustered other countries, for example the Near
Eastern (Greece, Iran), the Less developed Latin (Mexico, Colombia) or the More
Developed Latin (Spain, Italy, France) as being the ones emphasizing conservatism and
secrecy.

32
In summary, the rankings attributed by Hofstede to Portugal and to the United Kingdom
match with the accounting values assumptions from Gray to countries belonging to such
clusters. This means that, Portugal reveals higher conservatism and secrecy (a more
cautious approach towards measurement) than United Kingdom, consistent with
Hofstedes Dimension scores.

Following the premise that accountants are influenced by cultural values, accountants
financial reporting decisions should differ across countries, because of differences in the
cultural values of the accountants applying the rules, especially those rules that require
the application of judgment (Tsakumis, 2007, p. 31).

Moreover, Hofstede (2001) suggests that as more judgment an activity involves it is

consequently further ruled by values and (more) influenced with culture. So, he
concludes that accounting regulation and the way it is applied should vary along cultural
lines.

The relationship between financial reporting (and implied decisions as recognition and
disclosure that requires experts judgments) and countries that have accounting values
(secrecy and conservatism) that are likely to differ, creates a new refined
Gray/Hosftede framework and a niche for research.

The IAS 37, as demonstrated in the previous section, is a standard that requires a
considerable degree of judgement and is related to both the recognition and disclosure
of contingent assets and contingent liabilities. It is an ideal example of a financial
reporting decision task under the influence of this cultural relationship. Nobes (2006, p.
233) mentions the survival of international differences under IFRS and says there are
motives and opportunities for international differences of practice to exist within IFRS
usage. Some of the original motives for international accounting differences may still be
effective in an IFRS context. Moreover, he indicates IAS 37 as standard that
encourages accounting differences as being both an example of estimation based
standard Best estimate of provisions based on percentage likelihoods of outflows (para.
40) (p. 239) and as an example of covert options or vague criteria in IFRS
Recognition of a provision based on probability of outflow of resources (para. 14) (p.
241). Therefore, IAS 37 addresses both measurement and disclosure of accounting

33
information, which makes it suitable to explore both secrecy and conservatism
hypotheses.

To establish a direct comparison between country culture and both secrecy and
conservatism reflected in accounting it is imperative to have country scores in these
dimensions. Moreover, this scoring enables establishing relationships such us country-
specific practices and creative accounting. Due to the lack of scoring, Guan & Pourjalali
(2010) did not test the accounting values relationship with earnings management. Yet,
they concluded that their results provide evidence that cultural values have significant
effects on the earnings management behaviours in different countries.

34
3. PROBLEM STATEMENT AND HYPOTHESES

With the ongoing globalization of financial markets and business activities, there is
common agreement that accounting information ought to be immediately comparable
across the global economy. Efforts to establish standards that achieve this goal have
been underway for several decades and are enduring.

As previously mentioned in section 2.2, IAS 37 provides the regulation concerning

recognition and disclosing of provision and contingent liabilities, respectively, and all
companies that have shares traded in a stock exchange must comply with it, dedicating a
section of theirs financial statements and final reports notes to these accounts.
However, many financial statement users have complained that existing disclosures are
inadequate or ineffective in assisting financial statement users in assessing the
likelihood, timing, and amounts of loss contingencies (Hennes, 2014, p. 32). Similarly,
Wayne Carnall 4 , who is the chief accountant for the SECs Division of Corporate
Finance, provided critics on how companies produce pages of disclosures on
Contingent Liabilities that say little, as cited by Leone (2010). Shipper adds that the
amount of financial reporting information that is communicated by means of required
disclosures is significant, and has been increasing over time, with no sign of abatement.
Despite their abundance, required disclosures are not well understood raising a set of
questions regarding standard-setters orientation to disclosure items. Yet, Adrian, et al.
(2012, p. 668) confirm that everything resumes to the skill and imagination of the
operator that uses the knowledge and experience in the field combined with an optimal
dose of ingenuity, but also the gaps within legislation.

It is clear that there are serious consequences driven by an erratic recognition or

disclosure, urging to know why these errors happen, what can be their causes and what
are factors that can be influencing these occurrences.

The main objective of this dissertation is to compare companies from Portugal and UK
concerning disclosure of contingent liabilities and recognition of provisions, since these

4
Wayne Carnall , chief accountant for the Securities and Exchange Commissions (SEC) Division of Corporation
Finance - Comments from an accounting-industry conference sponsored by the New York State Society of Certified
Public Accountants on 27September 2010, as quoted by Marie Leone (2010).

35
are considered a source of creative accounting and to drive a parallel between
differences found and the culture system of each country.

During initial literature research and data collection, some questions have risen to which
I ought to explore further:

Are there significant differences between Portugal and the United Kingdom, in
the amount of provisions recognized versus contingencies disclosed?
Is it possible to detect a trend on the way companies make their disclosures,
different in Portugal or UK?
Does the market differently value recognition versus footnote disclosure?
How do investors value companies? In particular, do they value firms who
communicate a higher attention to risks and litigations?
Does one country favours recognition to footnote disclosure than the other?

After much consideration regarding both similarities and differences that can emerge, in
terms of accounting, between Portugal and the United Kingdom, it is appropriate to
present the hypothesis driven from the reflection upon the literature review. Therefore,
firstly this work will assess if financial statements present differences in the amounts
recognized in the balance sheet in both countries and the amounts just presented in
notes disclosures also in both countries. The first two hypotheses expect to show
differences in the recognition and disclosure between the two countries, since the
difference of both items is based on judgement. Judgment can differ for companies
belonging to countries that appear to be more conservative and based on more secrecy
(Portugal) as opposed to countries showing more optimism and more transparency
(UK). With the first two hypotheses (H1 and H2), I expect that both countries present
differences in the recognition and disclosure practices, according to the following:

Hypothesis 1 (H1): The value of the provisions recognized in the Balance Sheet in
Portugal is different from the value of recognized provisions in the Balance Sheet in
UK.

Hypothesis 2 (H2): The value of the contingencies disclosed in the final notes in
Portugal is different from the value of disclosed contingencies in the final notes in UK.

Afterwards, it is adequate to understand if there are differences within each country of

analysis regarding the process of recognition versus disclosure. The following

36
hypotheses will focus on the propensity of recognizing over disclosing, or the opposite,
and eventually find evidence of a trend/pattern that confirms previous research.
Therefore, based on Gray (1988) and Tsakumis (2007), it seems that Portugal could be
more likely to recognize amounts for provision than for contingent liabilities, according
to the inherent high conservatism and high secrecy associated with high Uncertainty
Avoidance inherent to this country. Thus, hypothesis 3 is the following:

Hypothesis 3 (H3): In Portugal there is higher propensity to recognize provisions than

to disclose contingencies, according to characteristics of conservatism and secrecy.

By opposite, it seems that in the UK there is higher propensity to disclose amounts for
contingencies than amounts recognized as provisions, according to the inherent high
optimism and high transparency associated to this country, characteristic of a country
with low uncertainty avoidance and power distance. Thus, I will construct the following
hypothesis:

Hypothesis 4 (H4): In the UK there is higher propensity to disclose contingencies than

recognizing provisions, according to characteristics of optimism and transparency.

I do not make predictions on both H3 and H4. However, if H3 is rejected, findings

might suggest more prominence for practices associated with creative accounting, since
the amounts of contingencies, as opposed to provisions, do not decrease income, leaving
the door open for earnings management. In turn, if H4 is rejected, findings can suggest
more prominence for practices associated with transparency overlapping optimism,
since preparers present all the available information instead of more hidden information
associated with contingencies.

Another line of previous research gives some hints about differences in the valuation of
provisions and contingencies. For instance, Bernard & Schipper (1994) state that if
market participants view footnote disclosures as less reliable, or not sufficiently
sophisticated to make appropriate judgements, they will likely attribute more
importance to recognized items and this is translated in greater value relevance. I try to
determine if there is a difference in the value relevance of recognition and disclosure to
the market value of companies. Also, I expect to know if this relationship is different in
Portugal. Therefore, I formulate the following value relevance hypotheses, since one of
the objectives aims to establish relationships between companies valorisation with

37
Provisions and Contingencies. Consequently, because provisions and the potential effect
of contingencies increase liabilities, I expect to find a negative association between
Provisions and Contingencies with Share Prices.

Hypothesis 5: Provisions and contingencies are negatively associated with Share Prices.

Hypothesis 6: The association of provisions and contingencies with the Market Value is
different in Portugal.

However, the market value of a given company is dependent of several factors, such as,
its operational income, its detained assets or as I try to suggest, the existence of
provisions and contingencies. When retracting data from companies financial reports, I
noticed the existence of a committee or department for the identification of risks or
litigations, in some of the companies. The expectation is that users give importance to a
committee concerned with the risks and litigations of companies (intimately related with
disclosure of contingent liabilities and recognition of provisions). Thus, I find it
important to know if financial statements users valorise this special feature of certain
companies and if it reflects on these particular companies market valuation. Therefore,
the following posed hypothesis intends to assess if a Committee might be a new criteria
of market valorisation.

Hypothesis 7: There is an association between the existence of a Committee for

detecting risks and their mitigation and the market value of the company.

Finally, there are early studies in accounting literature that defend a no difference
point of view regarding the value relevance of recognized and disclosed items (e.g.,
Dhaliwal (1986)) and some recent research that proves that firms treat recognized
values and disclosed values differently [e.g. Choudhary (2011)]. Therefore, this study
will determine whether recognized provisions and disclosed contingencies are priced
differently, according to the following hypothesis:

Hypothesis 8: Disclosed contingencies are priced by the market differently from

recognized provisions.

38
4. DATA ANALYSIS
4.1. SAMPLE SELECTION AND RESEARCH DESIGN

4.1.1. SAMPLE SELECTION

There were several sources of data used for this work. The main source was the
DataStream database. Data from the 4 year period 2010-2013 was used to test the
defined hypotheses and infer conclusions. Data was limited to two countries, Portugal
and United Kingdom. The sample consisted of 192 firm-year observations across these
two countries. The sample is constituted by a random selection of listed companies.
These companies were randomly retrieved from among all the companies listed in the
Portuguese Stock Index (PSI 20) and the 100 most important companies from the
London Stock Exchange (FTSE 100). Financial companies (SIC 6), due to their
different way of operating, were excluded of the original population.

There was a manual pool of data from consolidated companys yearly reports to obtain
data concerning disclosed amounts for Contingent Liabilities on the Final Notes of
Financial Statements. In case the amounts were not estimated by the company, the focus
was to understand what did companies voluntarily disclosed about their contingencies.
Moreover, the amounts recognized in the Balance Sheets for provisions were retrieved.

The sample used in the study follows a normal distribution. According to the central
limit theory, in a sufficiently large sample (n = 30) the sample mean will be distributed
around the population mean, approximately in a normal distribution (Cooper &
Schindler, 2001).

4.1.2. RESEARCH DESIGN, MODEL SPECIFICATION AND VARIABLE DEFINITION

Research analysis was conducted by performing a series of statistical tests, using data.
Specifically, Independent T-Tests were performed, as well as Paired Sample T-Test.
Correlation and descriptive statistics are also presented further in the study.

To test hypotheses 1 and 2, I used the t-Test for the significance of the difference
between the means of two independent samples. This is a widely used and known
statistic test. In the first hypothesis the amount of provisions recognized in Portugal is
compared with the amount of provisions recognized in UK. In the second hypotheses

39
the method is the same, but for contingencies instead of provisions. To test hypotheses 3
and 4 I used paired sample t-test, since the main objective is to compare the amount of
provisions with the amount of contingencies within Portugal, and then within UK.

Concerning hypotheses 5 to 8, an accounting based valuation model was constructed in

order to test whether provisions and contingencies are associated with the Market Value
of the company. This accounting based valuation model will thus be used to test the
relative value-relevance of recognized and disclosed liabilities between the two
countries in focus. Value relevance studies usually use an Ordinary Least Square model
[(e.g., Ohlson, (1996)] to measure the firms market value as a function of the book
value of its earnings and its equity, considering also other information that is included in
the model. Following other studies, the book value can be then separated out into
distinct components so as to examine the impact of different variables of interest. The
base regression model is as follows:

MVA = + 1 + 2 + (1)

Where:

MVA = Market Capitalization

BVA = Book Value of Equity
NIA = Net Income

Market value of a given company is said to be affected by numerous factors

surrounding the company, as for instance its social, cultural, political, legal, and
economic environment. Prior literature suggest that provisions and contingencies can be
one of those influences, since a lot of judgement is used by managers to figure out the
amounts included in financial statements, that are then used by investors to take
economic decisions. Hypothesis 5 focuses on the effects of provisions recognition in the
balance sheet and contingent liabilities disclosure on the Notes on market value. In
order to analyse the association of provisions and contingencies on firms market value,
and to find results to our hypothesis 5, the equation (1) is changed to add the variables
that will capture the effect of provisions and contingencies on market prices,
considering also some control variables used in prior research. The modified equation,
testing hypothesis 5, is the following:

40
 = 1 + 2 + 3 + 4 + 5 + 6 + 7 4 +
8 + 9 + 10 + (2)

Where:
BVAdj = Book value of equity, excluding the amount of provisions recognized
in the Balance sheet
NIA = Net Income
PROV = Amount of provisions recognized in the Balance Sheet;
CONT = Amount of Contingencies disclosed in final notes;
LEV= Leverage (Debt Ratio)
Size = Size of the company measured as a logarithm of companies assets
BIG 4= Dichotomy variable, assuming 1 if the company is audited by a BIG 4,
and 0 otherwise;
Year and SIC = fixed effects for year (2010 to 2013) and the Standard Industry
Classification (SIC 1 to SIC7, excluding SIC6), respectively;
XLIST - Dichotomy variable, assuming 1 if the company is listed in more than
one stock exchange, and 0 otherwise

Both variables PROV and CONT indicate a loss (related with provisions) or a probable
loss (related with contingencies) for the company and therefore, the coefficient outcome
3 and 4 is expected to be negative towards its association with MVA.

Control variables as the firm size, years of the sample and leverage, cross listing and the
quality of auditing are used. Previous studies find that there is a positive association
among accounting quality and size, caused by a closer observation from both regulators
and analysts, giving large companies an incentive to keep their high level of accounting
quality (Kanagaretnam et al., (2005); Paananen, et al., (2012)). Also, firms of different
sizes and from different industries may be affected by reporting in different ways (Niu
& Xu, 2009) thus a variable regarding the SIC codes is included in the study to control
the industry effect. LEV represents the debt ratio used to measure the effect of a firm
lever because as it is an indicator of the financial structure of the company.

To test hypothesis 6, equation (2) is altered and to which is added an interaction

variable to analyse whether the association of provisions and contingencies with the
Market Value is different in Portugal in comparison with the UK. The variable PT is
thus a dichotomy variable, assuming 1 if the company is Portuguese, and 0 if it is from

41
UK. Then, is created the interaction of PT with provisions (PT*PROV) and with
contingencies (PT*CONT), turning equation (2) to the following equation (3):

= 1 + 2 + 3 + 4 + 5 + 6 + 7 4 +
8 + 9 + 10 + 11 + 12 + 13 + (3)

The expectation is to find a statistical significant value for the coefficients on 12 and 13
meaning that the association of provisions and of contingencies on share prices is
different in Portugal.

In order to see if the market prices the existence of a committee on risks, hypothesis 6 is
tested adding an additional variable, COM, which is a dichotomy variable, assuming 1
if the company has a committee dealing only with risks and litigations in the company,
and 0 otherwise. Interactions with PT are also included, coming to equation (4):

= 1 + 2 + 3 + 4 + 5 + 6 + 7 4 +
8 + 9 + 10 + 11 + 12 + 13 +
14 + 15 + (4)

All continuous variables are pondered by total assets in order to avoid bias caused by
size of the companies in analysis.

Finally, to test hypothesis 8 (H8), providing evidence whether disclosed contingencies

are valued differently from recognized provisions, a Wald test is performed to do a
diagnostic to the coefficients of both variables.

42
5. FINDINGS AND DISCUSSION

5.1. DESCRIPTIVE STATISTICS AND CORRELATION ANALYSIS

Table 2 presents descriptive statistics for the main variables included in the equations
based on the sample for periods 2010 to 2013 covering both Portugal and UK. Panel A
shows firms financials for companies pooling Portugal and United Kingdom. On
average, book value (excluding provisions) and net income are 0.337 and 0.040 of total
assets, respectively. Panel B and panel C display that these values are higher in United
Kingdom than in Portugal. Regarding recognized loss items (provisions) and disclosed
loss items (contingencies), my variables of interest, the average value of each one is
approximately the same (0.028 and 0.029 of total assets, respectively). While
contingencies represent a higher part of total assets in Portugal compared with
provisions (panel B: 0.053 vs 0.011), in UK the situation is the opposite (panel C: 0.012
vs 0.41).

Contingencies are higher on average in the pooled sample, as they represent a way of
diminishing the recognised liabilities of companies, and are allowed in the light of IAS
37, where judgment influences the way accounts are prepared.

Table 2 - Descriptive Statistics

Panel A Descriptive for Pooled sample

Minimum Maximum Mean Std. Deviation

MVA 0.012 4.272 0.800 0.859

BVAdj 0.079 0.691 0.337 0.174

NIA -0.566 0.317 0.040 0.101

PROV -0.002 0.288 0.028 0.041

CONT 0.000 0.534 0.029 0.078

43
Panel B Descriptive for Portugal
Minimum Maximum Mean Std. Deviation

MVA 0.012 0.842 0.200 0.190

BVAdj 0.079 0.643 0.249 0.165

NIA -0.566 0.132 0.028 0.101

PROV -0.002 0.081 0.011 0.014

CONT 0.000 0.534 0.053 0.111

Panel C Descriptive for United Kingdom

Minimum Maximum Mean Std. Deviation

MVA 0.331 4.272 1,27 0.885

BVAdj 0.087 0.691 0.405 0.149

NIA -0.034 0.317 0.093 0.062

PROV 0.004 0.288 0.041 0.049

CONT 0.000 0.149 0.012 0.028

Variables: MVA = Market Capitalization; BVAdj = Book value of equity, excluding the amount of
provisions recognized in the Balance sheet; NIA = Net Income; PROV = Amount of provisions
recognized in the Balance Sheet; CONT = Amount of Contingencies disclosed in final notes.

The correlations among the main continuous variables in equation (2) are reported in
Table 3. Panel A shows the correlation for the pooled sample. As expected, there is a
positive association between the measure of the market capitalization of companies and
net income and book value, which is statistical significant at the 1% level. This
percentage of significance is also found between contingent liabilities and market
capitalization, but not for provisions. When the sample is split between Portugal (panel
B) and UK (panel C), provisions are negatively correlated with the market value in UK,
and not significant in Portugal.

44
Table 3 - Correlation Matrix

Panel A Pearson correlation for Pooled sample

MVA BVAdj NIA PROV CONT

MVA 1

BVAdj .302** 1

NIA .659** .256** 1

PROV 0.091 .437** .112 1

CONT -.237** .014 -.170* -0.046 1

Panel B Pearson correlation for Portugal

MVA BVAdj NIA PROV CONT

MVA 1

BVAdj .110** 1

NIA .235* .189 1

PROV .191 .030 .085 1

CONT -.238* .162 .010 .353 1

Panel C Pearson correlation for United Kingdom

MVA BVAdj NIA PROV CONT

MVA 1

BVAdj .643* 1

NIA .742** .282** 1

PROV -.241* .467** -.275** 1

CONT -.292* .196* -.150 -.285** 1

**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).
Variables: MVA = Market Capitalization; BVAdj = Book value of equity, excluding the amount of provisions
recognized in the Balance sheet; NIA = Net Income; PROV = Amount of provisions recognized in the Balance Sheet;
CONT = Amount of Contingencies disclosed in final notes.

5.2. RESEARCH FINDINGS AND DISCUSSION

The first hypothesis, H1, compares the value of provisions recognized in the Balance
sheet in Portugal with the value of provisions recognized in the Balance sheet in UK.
The second hypothesis, H2, uses the same approach, yet instead, applies to

45
contingencies disclosed in the Notes. These two hypotheses are tested using
independent sample T-tests. Descriptive analysis presented in table 2 already revealed
differences in the means. Panel A, of Table 4, reveals that both differences of means
(-0.030 in provisions and 0.041 in contingencies, comparing Portugal with UK) are
statistically significant (sig. = 0.000), rejecting the null of equality of the means. These
findings suggest that the weight of both provisions and contingencies in total assets are
different in Portugal as compared with UK, validating H1 and H2.

However, results suggest that firms in Portugal present lower provisions than UK and
higher contingencies than UK. These results do not meet the expectations that
Portuguese companies would reveal themselves as more conservative and more secret
than companies from the UK.

Hypotheses 3 (H3) and 4 (H4), however, intend to test not the comparison between
countries but to test whether it is used the same pattern for both provisions and
contingencies within each country, namely, within Portugal and UK respectively. It is
said by former research (Gray, 1988) that accountants from countries with higher
uncertainty avoidance, such as Portugal, opt to estimate with higher conservatism than
accountants from countries with lower uncertainty avoidance, and to be equally more
secretive. This leads to the assumption that Portuguese firms would have higher
amounts on effective reporting of loss versus amounts of loss mentioned in the end
notes of financial statements. The H3 aims to test this assumption, while H4 deals with
UK.

Panel B of table 4 shows that in Portugal there is a higher propensity for disclose
contingencies when compared with the recognition of provisions (difference of means =
-0.041), while in UK is the opposite (difference of means =0.029), being the differences
statistical significant at 1% level.

46
Table 4 - Independent and paired sample T-test for Provisions and for Contingencies

Panel A: Results for independent t-test (H1 and H2)

Mean Mean Difference of
t Sig. (2-tailed)
PT UK means
H1: PROV .011 .041 -.030 -5.363 0.000

H2: CONT .053 .012 .041 3.748 0.000

Panel B: Results for paired t-test (H3 and H4)

Mean Mean Difference of
t Sig. (2-tailed)
provisions Contingencies means
H1: Portugal .011 .053 -.041 -3.270 0.002

H2: UK .041 .012 .029 6.253 0.000

Variables: PROV = Amount of provisions recognized in the Balance Sheet; CONT = Amount of Contingencies
disclosed in final notes.

These results suggest that in Portugal there is a significant difference in amounts

disclosed versus the amounts recognised in balance sheets. Specifically, and contrary to
the hypothesis established, the results suggest that provisions in Portugal are recognised
in statically smaller amounts than disclosed contingencies, not rejecting H3. These
results also point out to the fact that when possible, Portuguese companies opt to
disclose amounts whenever possible and recognize loss when necessary. As mentioned,
this behaviour can address creative accounting problems, since the amounts disclosed
do not affect the amounts displayed in statement of financial position neither the
amounts presented in income statements, which can bias financial ratios and return
indicators.

There are several reasons possible to explain why results do not match the stated H3.
Firstly, the four years included in this study (2010-2013) coincide with a strong crisis
recession period lived in Portugal, where foreign organisms (TROIKA) had to intervene
in the countrys financial state and help the government implement a solution plan. At
this time, there were major liquidity and solvency problems, negatively impacting the
entire entrepreneurial environment. Thus, the concern of keeping debt on reasonable
levels prevented companies to be over cautions when recognizing amounts for losses.
This could have led companies to reluctantly overcome their uncertainty avoidance
tendency, in which hypothesis 3 was based. Moreover, firms in crisis periods are known
to protect their leverage image and to keep financially attractive for investors. This
means that disclosing contingencies are good ways of legally alert for some eventual
companies obligations that could not be yet measurable, estimable or probable. A third

47
and connected reason is the fact that according to IAS 37, an experts judgement is what
makes a company obliged to recognize a provision for a future obligation or not.
Therefore, here lays the loophole where companies might fall towards the area of
creative accounting, particularly attracted by the financially healthy idea of a company,
vital to attract and maintain satisfied investors.

Regarding UK, also contrary to the hypothesis established, the results suggest that
provisions in Britain are recognised in statically higher amounts than disclosed
contingencies. These results also point out to the fact that when possible, British
accountants opt to recognize amounts of liabilities whenever possible and necessary. A
higher amount of contingencies would be expected from a country with low uncertainty
avoidance scores combined and low power distance.

It is important to note here that, despite all the companies in the sample use IFRS, the
existing differences on the findings are originated: a) From economical situations, that
distinguish Portugal from the United Kingdom, or; b) From analysis situation,
judgements, standard interpretations, and others, that can be summarized in the word
culture that is clearly different in both countries.

On the other hand, Hellman, et al. (2015) remark how the harmonization efforts from
Europe towards the IFRS adoption pre-2005 five period might have reduced the
differences in bottom line terms so that these differences become irrelevant.
Moreover, from 2005 up to 2010 the time line for harmonization can be arguably
sufficient to mitigate cultural differences based on former associations
(secrecy/transparency, conservatism/optimism, class A/class B, Common Law/Roman
Law). Accordingly, If this is the case, the international accounting classification
patterns may not emerge. (Hellman, et al., 2015, p. 175), which can justify the findings
the opposite conclusions found for H3 and H4.

The remaining hypotheses are tested using linear regression models to analyse the
possible associations between provisions, contingencies and market valuation. Panel A
of Table 5 provides the evidence. Column (1) gives the output for equation (3), which
tests the hypotheses 5 and 6 altogether. Column (2) gives the output for equation (4),
adding hypothesis 7 to the prior two.

48
Table 5 - Findings for Ordinary Least Squares Models

Panel A: Findings for hypothesis 5 to 7

Column (1) Column (2)
Variables Predicted sign Sig. (p-
Sig. (p-value)
value)

Independent:
Intercept 3.864 0.000 2.897 0.000
BVAdj + 0.257 0.000 0.749 0.000
NIA + 3.213 0.000 1.956 0.000
PROV - -1.368 0.366 -3.832 0.004
CONT - -3.554 0.056 -4.021 0.011
PT ? -1.046 0.000 -0.919 0.000
PT*PROV ? 3.830 0.410 6.952 0.081
PT*CONT ? 3.533 0.068 4.039 0.015
COM + 0.859 0.000
PT*COM ? -0.873 0.000

Control:
LEV Included Included
SIZE Included Included
XLIST Included Included
BIG4 Included Included
SIC Included Included
YEAR Included Included

N 183 183
R2 0.677 0.768
Panel B: Findings for hypotheses 8
Chi-square p-value Chi-square p-value
Wald test:
PROV vs CONT: 3 = 4 5.820 .001 2.557 0.100
PROV vs COM: 3 = 14 36.120 0.000
CONT vs COM: 4 = 14 7.916 0.004

Variables: BVAdj = Book value of equity, excluding the amount of provisions recognized in the Balance sheet; NIA
= Net Income; PROV = Amount of provisions recognized in the Balance Sheet; CONT = Amount of Contingencies
disclosed in final notes; LEV= Leverage (Debt Ratio); Size = Size of the company measured as a logarithm of
companies assets; BIG 4= Dichotomy variable, assuming 1 if the company is audited by a BIG 4, and 0 otherwise;
Year and SIC = fixed effects for year (2010 to 2013) and the Standard Industry Classification (SIC 1 to SIC7,
excluding SIC6)), respectively; XLIST - Dichotomy variable, assuming 1 if the company is listed in more than one
stock exchange, and 0 otherwise.

According to the displayed results, both columns (1) and (2) exhibit high R2 values,
indicating that approximately 68% (column 1) and 77% (column 2) of the total variation
of the dependent variable, MVA, can be explained by the independent variables in the
model. The not tabled ANOVA (p = 0.000) indicates that, overall, the regression model
statistically significantly predicts the outcome of the market value of the company.
Durbin Watson statistic is also used to test for the presence of serial correlation among
the residuals and, theoretically ranges from 0 (strong positive correlation) to 4 (strong
negative correlation). It is accepted that the residuals are uncorrelated when the statistic
is approximately 2, and this statistic (not tabulated) reveals no serial correlation
problems.

49
In both columns (1) and (2) the coefficients for NIA and for BVAdj, the main variables
of the model, are consistent to the literature (column (1): 1 = 0.257; 2 = 3.213; column
(2): 1 = 0.749; 2 = 1.956) and statistically significant at 1% level.

Column (1) also shows that both coefficients for provisions and for contingencies are
negative, suggesting a negative association with the market value of the companies, as
expected. Nevertheless, this negative association is only statistically significant at 10%
level for contingencies (4 = -3.554, p-value = 0.056) but not for provisions (3 = -3.554,
p-value = 0.366), suggesting that separate information about contingencies disclosed in
the Notes of the set of financial statements are value relevant. When dealing with data
for Portugal using interactions, it is possible to see that the negative effect of provisions
and of contingencies with the market price is mitigated since the coefficients of both
interactions (PT*PROV and PT*CONT) are of opposite signs when compared with the
main variables, but again not statistically significant for provisions (PT*PROV: 12 =
3.830; p-value = 0.410; PT*CONT: 12 = 3.533; p-value = 0.068). Overall, the findings
suggest that provisions and contingencies have a negative association with share prices,
but this negative association only has statistical significance for contingencies. This
negative impact of the contingencies disclosed in the Notes is mitigated in Portugal,
suggesting that the market do not penalise those companies that judge on the disclosure
of a contingency over the recognition of a provisions.

Jaafar and McLeay (2007) defend the need of comparative international accounting
research to give attention rather more to harmonization across industries. The presented
argument is that accounting diversity is the outcome of differences in the business
environment and thus, harmony should refer to when () firms operating in similar
circumstances adopt the same accounting treatment for similar transactions, regardless
of their domicile (Jaafar & McLeay, 2007, p. 157). Moreover, Kadan et al. (2012)
recall on how sophisticated users usually specialize by industry rather than by country,
which might explain the differences my expectations and enhancing the importance of
the industry dimension.

Findings presented in Column (2) are able to clarify these prior results. As mentioned in
the literature review, provisions and contingencies are measured based on managers
judgments, supported by evidence on the probability of incurrence of a liability that is
not under the control of the company. The expected coefficient for COM is positive, as

50
it makes sense that the market valorises the existence of a department in organizations
daily operations that is concerned for its risks and litigations. When the model
incorporates the effect of the impact of having a committee for risks and litigation
(consistent with H7), prior findings change, since both provisions and contingencies are
still negatively associated with share prices but now with statistical significance. The
existence of this committee has a positive impact on the market valuation of the
company, analysed through the coefficient of COM, which is positive and statistical
significant at 1% level (14 = 0.859; p-value = 0.000). However, the interaction with
Portugal reveals that, in this country, this association is reversed (15 = - 0.873; p-value
= 0.000) suggesting that the simple existence of this committee is relevant for investors
in UK but not in Portugal. The effect of including the existence of this committee in the
model is, nevertheless, higher than just looking to its association with share prices.
Theoretically, if a company has this committee, tends to be more engaged with the
identification, recognition and disclosure of situations that comply with the
requirements for provisions and contingencies under IFRS 37.

The committee is here characterized as a group of people with access to a pool of

resources and information, in the organization, that is permanently concerned in the
companys risks and that deals with its litigation and risk identification and mitigation.
Examples of real risks committees from the pool of this sample are presented.
According to Ashtead Group, The Group Risk Committee provides () a
comprehensive annual report on its activities including new legislative requirements,
details of areas identified in the year as requiring improvement, and the status of actions
being taken to make the necessary improvements (Ashtead Group , 2012). BP Group
(2013) communicates that their risk committee monitors and validates limits and risk
exposures, reviewing their incidents, validating risk-related policies, methodologies and
procedures. For instance, the risk committee in Burberry refers that the materiality of
the risk is based on financial and non financial criteria, and the probability of the risk
arising is also mapped (Burberry Group, 2013, p. 81). The expectations, in line with
the role of this committee, is to analyse in detail, what happens to the association of
provisions and contingencies with share prices if the model includes information about
the existence of such committee in the board of directors.

After including this information, it is possible to say that provisions and contingencies
are value relevant and negatively associated with the market value of the companies

51
(PROV: 3= -3.832, p-value = 0.004; CONT: 4 = -4.021, p-value = 0.011), but in
Portugal this negative association is mitigated (PT*PROV: 12= 6.952; p-value = 0.081;
PT*CONT: 12= 4.039; p-value = 0.015). So, prior results presented in column (2) are
more accurate than in column (1), suggesting that the value relevance of provisions and
contingencies for investors is stronger when the company has a committee on risks and
litigations (or equivalent), but the association with share prices is different in Portugal.

Moreover, this means that in the Portuguese context the impact of the committee is
completely mitigated when in comparison with the whole total sample. So it is possible
to say that the market in Portugal does not place as much importance to the existence of
a committee as in the group set. Several characteristics of both countries, namely, again
the culture dimensions based on high secrecy (Portugal) or high transparency (UK), can
justify the different results.

Other justifications can be appointed beyond culture, although related with it. For
instance, according to Leuz, et al., (2003, p. 507) investor protection plays an important
role in influencing international differences in corporate earnings management (and
studies on provisions versus contingencies can be here included). Accordingly, earnings
management is more pervasive in countries where legal protection of outside investors
is weak, since in such countries, insiders (management) benefit from greater private
control benefits and therefore have stronger incentives to obfuscate firm performance.
Both Portugal (Cluster 3) and UK (Cluster 1) took part of their study, representing
[cluster] (1) outsider economies with large stock markets, dispersed ownership, strong
investor rights, and strong legal enforcement (e.g., United Kingdom () and [cluster]
(3) insider economies with weak legal enforcement. The authors concluded that
countries belonging to cluster 1 (as UK) display the lowest levels of earnings
management, consistent with the valorisation of a committee for risks and litigations.
On the contrary, countries belonging to cluster 3 (as Portugal) present the highest level
of earnings management. This fact can also justify the stronger presence of disclosure of
contingencies by management (as opposed to recognition) in Portugal, and the fact that
there is still a cultural indifference for a committee that not only deals with investors
protection but as well as with litigations and general day to day risks.

Nevertheless, altogether, hypotheses 5, 6 and 7 are not rejected.

52
The last hypothesis aims at determining if contingencies are valued in a different
manner than provisions. Certainly, previous research provides evidence that the way
financial statements are presented does matter, depending on the user and on the
interpretation made from footnote disclosure. For example, there is some indication that
recognition of expenses is more value relevant than the pro forma information disclosed
in footnotes (Niu & Xu, 2009).

The findings are presented in Panel B of table 5, having used E-views 7 to do the
computation of the Wald statistic. The Wald test is performed based on coefficients
diagnostics in which is tested the coefficient restriction of equality of 3, the term for
provisions, and 4, the term for contingencies. The tests were performed using
estimations of equation (3) and equation (4), consistent with the same models presented
in column (1) and column (2) of panel A. In the first column, testing whether 3 = 4,
the extremely low probability (p = 0.001) associated with the Wald test diagnosing
coefficients of provisions and contingencies indicates that the null hypothesis is strongly
rejected. This suggests that participants in the market do distinguish between these two
different elements of financial statements and they do not attribute the same importance
to assess the market value of the company. Findings in column (2) are slightly different.
In this case, the null is not rejected (p = 0.100) unless a confidence interval at 10% is
considered. To better understand this figure, Wald tests to compare the coefficient of the
existence of a committee on risks and litigations with provisions and with contingencies
were performed. In both cases the null was rejected at 1% level (PROV vs COM: p-
value = 0.000; CONT vs COM: p-value = 0.004), suggesting that investors distinguish
the existence of a committee of risks from the amount of contingencies disclosed or the
amount of provisions recognized, and, in the presence of the committee, the participants
gave the same importance to provisions as compared with contingencies.

Overall, findings suggest that the investors value provisions in a different way from
contingencies, except when a company has a committee for dealing with risks and
litigations, placing a similar trust in the amounts recognized in the balanced sheet or
disclosed in the notes.

53
 5.3. SENSITIVITY ANALYSIS

Additional tests were done to give robustness to the findings. The dependent variable,
MVA, computed as the market valuation of the shares divided by total assets was
replaced by the market value per share. Other adjustments were done to the independent
variables to have all variables in a per share basis. Also, the control variable size and
lev were computed using different indicators for dimension and for debt ratios. All
the main results were sustained after these changes in the measurement of variables.

54
6. CONCLUSION
To sum up, and based on this study, it is possible to attest that provisions and
contingencies do play a role in market valuation. From a preparer perspective, the
manipulation of results can be made to attract investment, decrease levels of debt and to
play with the users tendency to give less value to foot note disclosures; thus a loophole
for creative accounting is here identified, despite all the concern of todays legislators.
From a user perspective it is worth to identify five main conclusions. Firstly, it is proven
that there are differences in the amounts of provisions recognized in the financial
statements from Portugal and from the United Kingdom. The same principle is proved
for contingent liabilities, since the two countries display different values too. Secondly,
there is no proven relationship, in this study, between a tendency for a higher
recognition of provisions in Portugal or, on the contrary, a higher propensity for
disclosure in the UK. This seems to contradict the theoretical approach of Grays
hypotheses for high secrecy (transparency) and high conservatism (optimism) in
countries with high (low) uncertainty avoidance as Portugal (UK). Thirdly, findings
confirm that provisions and contingencies have a negative association with share prices,
but only statistically significant for contingencies. This negative impact of the
contingencies disclosed in the Notes is mitigated in Portugal. In addition, it is possible
to confirm a positive relationship between the existence of a committee for litigation
and risks and the market value of the company. However, this valuation is mitigated
when considering Portuguese findings against the total sample. Indeed, when this
committee exists, both provisions and contingents are value relevant, being negatively
associated with share prices. Lastly, the study suggests that investors do value
provisions in a different way from contingencies, yet this is not applicable for when
companies present a committee for dealing with risks and litigations, where they place a
similar trust to both recognized and disclosed items.

55
7. Study Limitations and Future Research
It is important to mention some methodological limitations of the study involved in this
dissertation. The above results can be subject to criticism such as:

Theoretical basis. One may question if Hofstedes cultural dimensions and

Grays accounting values are appropriate for accounting research and more
specifically if it has any effects on creative accounting.
Statistical basis. For example, is the sample size representative of the number of
companies included in the test?
Missing variables. For example, shall the research include cultural variables and
economic value scores?

Such limitations can be overcome, for example, by adopting a wider sample of

companies in the study. This can increase the accuracy of the tested hypothesis
rejecting the null hypothesis, for instance when it comes to comparing the means. Also,
it would be recommendable to enlarge the period of time in the analysis. For instance, if
there would be data from provisions and contingencies disclosed for the period of years
previous to the crisis in both countries, a comparison with the four year period (2010-
2013) that I gathered would be valuable to determine cultural changes caused by the
crisis.

Moreover, this study can be enriched if there is an inclusion of more countries of

comparison with Portugal and UK to assess cultural dimensions in accounting, and
would allow proving accounting differences driven by cultural differences.

Lastly, this dissertation looks at disclosure and recognition in a single context, through
contingent liabilities and provisions. To extend the results to other disclosure and
recognition decisions and cultural areas is worth in order to attest the real impact on
comparability of culture and financial statement disclosures made in accordance with
International Financial Reporting Standards.

56
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