The Information Content of Mandatory Risk Disclosures? Evidence from the Finnish Stock Market 2006-2009
Aalto University - School of Business
December 14, 2010
Purpose – To fill the gap in empirical knowledge about the information content of mandatory risk disclosures in annual reports, this paper examines the association between stock returns and quality of risk disclosure in a highly regulated risk disclosure environment. More specifically, our purpose is to provide evidence of whether risk disclosure of low quality associates with cumulative abnormal returns in the capital markets, and whether risk information asymmetry influences the usefulness of earnings information as measured by firms’ earnings response coefficients. Finally, we analyze whether the riskiness of the stock markets and firms influence the relevance of annual risk reviews.
Design/methodology/approach – This paper examines the research questions by using OLS regression analysis as the main test. Association tests have been done in a four year panel covering years 2006-2009. Firms’ quality of risk disclosure is examined along two dimensions, quantity and coverage. Principal component analysis has been used to compute a composite measure for the quality of risk disclosure. To avoid the endogeneity problems, we control the impact of the following factors: earnings quality, firm riskiness, media coverage and the extent of annual reports.
Findings – We document that the quality of mandatory risk disclosures influences cumulative abnormal returns and earnings response coefficients. First, high quality of risk disclosure is found to be negatively associated with cumulative abnormal returns. Second, we demonstrate that low quality of risk disclosure strengthens investors’ reactions to short-term positive earnings news. Third, we show that investors’ reactions to low quality of risk disclosure are stronger if the risk information is provided by risky firms. Finally, we provide evidence that balanced descriptions on firms’ major risks are more relevant to investors than disclosure on single risk topics.
Research limitations/implications – Finland belongs to the Scandinavian institutional setting where investor protection is lower than in the Anglo-Saxon countries but higher than in southern Europe. More research will be needed to obtain evidence on the differences in the value-relevance of annual report risk disclosure across countries.
Practical implications – Narrative annual report risk disclosures are often useless to investors if they contain a lot of boiler plate disclosure on a very general level. We demonstrate that investors find high-quality risk information useful and encourage regulators to provide firms with detailed guidance on improving their risk disclosures.
Originality/value – This paper is the first to explore the information content of mandatory overall risk reviews provided in a highly regulated and guided information environment. It contributes to the literature by extending prior analyses of the value-relevance of market risk disclosures by US firms to the analyses of the information content of mandatory overall risk reviews by firms in a continental European country. The results have implications for regulatory bodies evaluating different strategies to reduce information asymmetry in the capital markets. Also firms and investors benefit from the findings.
Keywords: risk reporting, efficient securities markets, abnormal returns, earnings response coefficient, regulation
JEL Classification: M41, M48working papers series
Date posted: November 10, 2011
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