Do Mandatory Risk Factor Disclosures Predict the Level of Future Cash Flows and Stock Returns? Evidence from Tax Risk Factor Disclosures
55 Pages Posted: 13 Sep 2016 Last revised: 25 Aug 2017
Date Written: August 24, 2017
Prior research finds that mandatory risk factor disclosures are informative in that they increase investors’ assessments of the volatility of a firm’s cash flows. However, the literature is silent as to whether these disclosures provide information about the level of future cash flows and, ultimately, their implications for firm value. We address this question by examining the association between Form 10-K risk factor disclosures and future cash flows levels and stock returns. We use the setting of taxes because it is easy to identify the specific income and cash flow statement line items to which these risks relate, and offer two main results. First, we find that tax risk factor disclosures are positively associated with future cash flows. This suggests that, on average, managers take reasonable levels of risk, as risky tax positions are rewarded with future tax savings. Second, we find that investors do not fully incorporate this relation into stock prices at the time of the risk factor disclosure. Instead, investors do not fully impound this information into stock prices until the implications of risk factor disclosures on future cash flows are more saliently disclosed in the following year’s Form 10-K. Overall, our results suggest that risk factor disclosures provide information about the level of a firm’s future cash flows, that the risks discussed in these disclosures are – on average – value-increasing, and that investors do not fully incorporate this information into current stock prices.
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