Risk Factor Disclosures and the Cost of Private and Public Debt

Abstract

This study examines the relationship between Risk Factor Disclosures (RFDs) in the annual 10-K report and the cost of debt in both the private and the public debt markets. We examine this relationship from two perspectives- the direct effect of RFDs on cost of debt and the indirect effect through Abnormal Risk Factor Disclosure (ARFD). ARFD is a new measure proposed to capture managerial discretion in risk factor reporting and is measured as the residual from the regression of RFD on its determinants. To measure RFDs, we use the total number of words in item 1A-RFD, and the aggregate and categorical risk words developed by Campbell, Chen, Dhaliwal, Lu & Steele (2014). Using automated content analysis method to extract RFDs from company filings in the Electronic Data Gathering, Analysis, and Retrieval Systems (EDGAR) database, we find that firms with higher RFDs have higher cost of debt in both the private and the public debt markets. This finding supports previous research findings that RFDs reflect the risk profiles of firms. We also find that firms in the private debt market are rewarded for transparency with lower cost of debt when risk factor disclosure is higher than expectation. The findings in this study suggest RFDs are both informative and useful to other audiences (borrowers and lenders) outside equity investors.

Keywords: Risk Factor Disclosure, Private Debt, Public Debt

JEL Classification: M38, M41, K20