Voluntary water risk disclosure and accounting implications : evidence from earnings management

Abstract

Water pollution and scarcity combine to create a formidable business risk. Yet many corporations based in the United States do not disclose water risks. This dissertation addresses the question: What are the effects of water risk disclosure on earnings management? The question is answered by investigating publicly traded, U.S. companies requested to respond to the 2010–2022 annual water security survey conducted by CDP (formerly known as the Carbon Disclosure Project). Drawing on information, voluntary disclosure, and signaling theories, as well as ethical considerations, the current study predicted and found that firms that voluntarily disclose water risk experience less earnings management than firms that do not disclose. Further, the extent and quality of the disclosure matters. Superior-performing firms present more complete and meaningful water risk information, publicizing signals difficult to copy by firms with lower water risk disclosure. Better performers are likely to act in a socially responsible manner by responding to demands for increased transparency. This suggests that water risk disclosure leads to reduced information asymmetry by supplementing financial reports, hence decreasing opportunities for earnings manipulations. Further investigated are the moderating effects of top management commitment, corporate governance, and external assurance. A higher degree of top management commitment, or the tone set by the upper echelon, was posited and found to enhance the negative association between water risk disclosure quality and earnings management. Strength of corporate governance was also hypothesized and found to magnify the negative effect between water risk disclosure quality and earnings management. With strong monitors in place, managers’ discretion is minimized, thereby reducing manipulations. Lastly, the procurement of external assurance was predicted and found to enhance the negative relationship between water risk disclosure quality and earnings management. Credible disclosures, assured through a third party, verify the validity of a company’s reported information, both financial and nonfinancial. Understanding how water risk disclosure affects financial reporting quality has implications for users of corporate information, such as auditors, investors, and policymakers. Overall, this research may incentivize corporations to voluntarily disclose water impacts and mitigation efforts as mainstream praxis as water risk increases over time.