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Review of Accounting Studies

Erschienen in:

01.03.2014

The information content of mandatory risk factor disclosures in corporate filings

verfasst von: John L. Campbell, Hsinchun Chen, Dan S. Dhaliwal, Hsin-min Lu, Logan B. Steele

Erschienen in: Review of Accounting Studies | Ausgabe 1/2014

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Abstract

Beginning in 2005, the Securities and Exchange Commission (SEC) mandated firms to include a “risk factor” section in their Form 10-K to discuss “the most significant factors that make the company speculative or risky.” In this study, we examine the information content of this newly created section and offer two main results. First, we find that firms facing greater risk disclose more risk factors, and that the type of risk the firm faces determines whether it devotes a greater portion of its disclosures towards describing that risk type. That is, managers provide risk factor disclosures that meaningfully reflect the risks they face. Second, we find that the information conveyed by risk factor disclosures is reflected in systematic risk, idiosyncratic risk, information asymmetry, and firm value. Overall, our evidence supports the SEC’s decision to mandate risk factor disclosures, as the disclosures appear to be firm-specific and useful to investors.

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Some firms voluntarily provide risk disclosures in MD&A if they also provide forward-looking statements about future performance. That is not our focus. We focus on the newly created risk factor disclosure section because it is mandatory for all firms, and throughout all of our tests, we explicitly control for MD&A risk disclosures (and their risk related keywords). We acknowledge that some firms may have moved their voluntary risk disclosures from MD&A to the risk factors disclosure section after it was mandated. Thus, for these firms, the newly created section may not provide completely new information. Nevertheless, our tests are designed to incorporate investors’ expectations of risk disclosure and suggest that the newly created disclosures are informative.

We acknowledge that it is possible for firms to provide risk factor disclosure that describes a negative/pessimistic event that is actually less negative/pessimistic than the market expects it to be. Thus, for our market tests, we explicitly control for investors’ expectations of risk factor disclosure. See Sects. 3.1 and 3.3.

Appendices 1 and 2 describe our text analysis procedures and our methods for classifying key words into the five risk subcategories. We first classify key words into financial, tax, and legal risk subcategories. With the remaining words, we classify them as “other-systematic” if they relate to economy-wide risk and “other-idiosyncratic” if they relate to firm-specific risk. As shown in Table 2, 69 % of keywords in the average risk factor disclosure are comprised of words that fall into the “other” categories.

Cornwell et al. v. Credit Suisse Group et al., No. 08 Civ. 3758, 2010 U.S. Dist.

We acknowledge that short-window returns at the 10-K release date could be a function of changes in either (1) firms’ expected future cash flows, or (2) the assessment of firm risk. We interpret our results as being related to firm risk. For more assurance regarding this interpretation, in Table 8 we control for both firms’ earnings surprise and changes in analysts’ estimates of future earnings, as well as other variables in prior literature that could indicate a change in firms’ cash flows. Our tests suggest that the inferences with respect to abnormal returns reflect a change in investors’ perception of firm risk.

In our main tests, we only use qualitative disclosure information from Item 1A “Risk Factors” and Item 7 “Management’s Discussion & Analysis of Financial Condition and Results of Operation” (MD&A). In sects. 4.1 and 4.3, we also control for disclosures in “Quantitative and Qualitative Disclosures about Market Risk” (Item 7A) and our results are unaffected.

Alternative methods to measure changes in textual risk disclosures include the rate of change in the frequency of specific words used within text or the frequency of word groups within a sentence (Brown and Tucker 2011; Nelson and Pritchard 2007). We choose an expectations model as our proxy for changes in risk factor disclosure due to its relative empirical simplicity and since it explains approximately 80 % of the variation in risk factor disclosures (see Table 9).

We acknowledge that there is no consensus in the literature as to which key word list is most appropriate. There are two other relevant studies that report their list of key risk words. Nelson and Pritchard identify 75 risk factor terms, and Kravet and Muslu (2013) identify 20 risk-related keywords based on their reading of 100 randomly selected annual reports. Our key word list includes the vast majority of these identified key words but is expanded considerably using the Latent Dirichlet Allocation method described in the paper.

Specifically, the trading industry includes the following firm descriptions: “security and commodity brokers,” “closed-end management investments,” “trusts,” and “unit investment trusts.”

Throughout the analysis, we evaluate the effects of multicollinearity with variance inflation factors (VIFs). In their textbook, Kutner et al. (2004) indicate that multicollinearity is not a problem when VIFs are less than 10. The results indicate that multicollinearity is not a serious concern in any of our multivariate regressions. Thus, for expositional purposes, we do not tabulate or discuss these results for each model.

Since each left-hand side variable is specified as a percentage of the total key words in the risk factor section, and since the sample (and dependent variables) are the same across all regressions, the coefficients for a particular risk proxy are comparable across all of the regressions and indicate the percentage increase in total key words resulting from that risk proxy.

We acknowledge that we do not explicitly control for the MD&A tone. As noted by Kothari et al. (2009), this is not easy to do as it requires software-reading technologies that are not particularly accurate. However, we follow prior literature that assesses the tone of MD&A (Tetlock 2007; Kravet and Muslu 2013) and count the number of words that relate to risk, assuming that the context of these words is negative/pessimistic (i.e., our variables MDA_DISC, MDA_SYS, MDA_IDIO, MDA_FIN, MDA_LIT, and MDA_TAX).

The fog index is defined by Li (2008b) as (words per sentence + percent of complex words) * 0.4.

As before, we also add financial risk to each of these measures since prior literature shows that financial risk affects both systematic and idiosyncratic risk. Similarly, we do not include legal or tax risk in either of these categories since it is difficult to determine whether these risks are firm-specific, and prior literature does not provide much guidance in this respect.

For comparison purposes, Kothari et al. (2009) examine the effect of negative/pessimistic disclosure across three sources of disclosure (corporations, analysts, business press), and their results suggest that moving from the 25th percentile to the 75th percentile increases firms’ cost of capital by 2.0%. However, as previously mentioned, they find no such relation when the source of the disclosure is the corporation itself.

To ensure that the removal of plain text filings does not bias our sample, in Sect. 3, we compare our sample to the overall universe of Compustat firms. We find that our sample is generalizable across industries and years. In addition, we include industry and year fixed effects in all of our multivariate analyses.

We consider whether our final sample is biased as a result of this sample size reduction by comparing our sample to the Compustat universe of firms in Sect. 3 and in Table 1.

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Titel: The information content of mandatory risk factor disclosures in corporate filings
verfasst von: John L. Campbell
Hsinchun Chen
Dan S. Dhaliwal
Hsin-min Lu
Logan B. Steele
Publikationsdatum: 01.03.2014
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 1/2014
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-013-9258-3

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