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This chapter discusses the different previous studies pertaining to voluntary disclosure. As few studies have been conducted on risk management disclosure practices across firms, a rather general description will be provided of previous studies on voluntary and mandatory disclosure. These studies are the bases in creating a framework that provides the insights and expectations on the relationship between the various firm specific characteristics and risk management disclosures. The hypotheses formulated later on, in chapter 4, are based on the researches discussed in this chapter.
There are various approaches in conducting a research in the field of (risk) disclosures. First of all is by concentrating on the demand side of information, a behavioral accounting research perspective. The second approach focuses on the supply side of information using several firms' specific characteristics such as firm size, leverage, ownership structure, and profitability.
Behavioral Accounting Research
This approach is taken from the needs and preferences of users of financial information, focusing on the demand side of disclosures. Solomon et al. (2000) report a gap between the demands and the supply of the risk information. They state that firm risk reporting practices do not satisfy the demands of users of financial statements. In this research, Salomon et al. aim gain an insight in the attitude of institutional investors toward risk disclosure in relation to their portfolio investment decisions and whether the level of risk information disclosed is adequate. The research is carried out by having a questionnaire survey completed by 552 institutional investors from the four main types of investment institutions: pension funds, investment trusts, unit trusts and insurance companies. They investigate what information firms should disclose, where it should be disclosed and what format/presentation should be applied. The questions deliberated in the survey are clustered around:
- Environment (voluntary or required?);
- Level of risk disclosure (is the current state of risk disclosure adequate? would increased disclosure help investment decision-making?);
- Risk disclosure preferences (should all types of risk be disclosed, or do users have a preference?);
- Form of risk disclosure (should risks be reported separately, or should they be grouped in a general statement?);
- Investor attitudes (do attitudes depend on investment horizons, type of investor, etc.?)
The study is performed in 1999 and most of the questions in the survey required respondents to record a score from 1 (strongly disagree) to 7 (strongly agree) in order to indicate the extent to which they agree with certain assertions. Other questions were more specific and required respondents to tick one of several boxes that contained specific detail.
Results are found by analyzing chi2 correlations between the answers that were provided by respondents. Referring back to the six elements of the framework, Solomon et al. (2000) conclude that institutional investors prefer a voluntary framework for risk disclosures, where more (specific) disclosures are being made then at present. Investors have a higher preference for financial risk disclosure, but state that all relevant types of risks should be disclosed, and reported separately, because general risk statements contain little information. Preferences are however influenced by the type of investor and time horizon.
Despite the interesting results that can be obtained when using this research method, I do not adopt the behavioral research perspective, as it is not suitable to analyze the relations between the risk disclosure practices and firms specific characteristics and also due to high degree of subjectivity, provided that the results are gathered using questionnaires. These answers are influenced by personal preferences and perceptions.
Firm specific characteristics
This section discusses various studies focusing on the supply side of information, the disclosure studies. It is divided according to the various firm specific characteristics.
As mentioned in chapter 2, firm voluntary accounting and disclosure choices are aimed to manage the interest conflicts among shareholders, debt holders, and management. According to past studies, the extent of these interest conflicts differs with certain firm characteristics (Watts & Zimmerman, 1986). Since 1961, accounting researchers have investigated associations between firm specific characteristics and disclosures in annual reports (Ahmed and Curtis, 1999).
In general studies has been conducted on the overall disclosure level to test for relationships between certain firm characteristics and the amount and extent of disclosure of the firm. In addition to it, some authors have concentrated on more specific categories of information: interim reporting (Leftwich et al., 1981), segment information (Mitchell et al., 1995, Prencipe, 2004), communication on R&D (Entwistle, 1999), ratio disclosure (Watson et al., 2002) and risk reporting (Beretta & Bozzolan, 2004; Linsley & Shrives, 2006).
Lang and Lundholm (1993) consider the firm specific characteristics as determinants for firm disclosure practices. They distinguish the firm specific characteristics into three categories: structure-related, performance-related and market-related variables. The structure-related variables are: firm size, leverage and ownership structure. According to Wallace et al. (1994), structure-related variables tend to remain stable over time. Performance related variables relate to earnings, return on equity, profit (margin) etc. As opposed to the structure-related variables they tend to flux more over time and represent information that is of interest to users of financial statements (Wallace et al., 1994). Finally, market-related variables are considered to be qualitative/categorical variables and do not take a quantitative value in a certain scale like structure and performance-related variables (Wallace et al., 1994).
The most frequently used variable in past research with disclosure practices is firm size. Foster (1986) noted that the variable most regarded as significant in studies examining disclosure practices across countries is firm size. Large firms mostly issue more information than small ones. According to the agency theory, large firms are more complex, have higher agency costs and are more sensitive for political costs (Watts & Zimmerman, 1986). These reasons suggest that bigger firms should have more incentives for voluntarily disclosing information than smaller ones. Regarding past research, strong evidence is found supporting this agency theory repercussion.
Besides, Firth (1979) argued that larger firms could and would afford the relatively high expenses of collecting and disseminating information. Small firms may find disclosing additional information puts them in a competitive disadvantage with other larger firms. Therefore, they will be more reluctant in disclosing additional information.
Chow and Wong-Boren (1987) studied disclosure practices of Mexican corporations and its relation with firm size, financial leverage and proportion of assets in place. For this non-Anglo American nation a significant positive relation was found between firm size and extend of financial disclosure, as the extent of voluntary disclosure seemed to increase with firm size.
Another factor explaining the positive association between firm size and extend of voluntary disclosure is the demand of information by financial analysts. Large firms tend to have more analyst followings than smaller firms and thus are subjected to a greater demand for information (Lang and Lundholm, 1993). Also, they have incentives to voluntarily disclose more information in order to enhance their market value and also because non-disclosure might be perceived as bad news by the investors. Wallace et al., (1994) research on Spanish firms supports this conclusion.
Hossain et al. (1995), find a positive relation between firm size and voluntary disclosure for the sample of 55 publicly quoted New Zealand enterprises. Their results also support the assumption that voluntary disclosures are used as a means to reduce agency costs as firms grow in size and increase leverage.
Meek, Roberts and Grey (1995) investigated voluntary accounting disclosures at the transnational level. They examined disclosure practices of multi-national companies (MNCs) in the U.K., U.S. and Continental Europe. They distinguish voluntary disclosures in three groups: strategic, non-financial and financial information. According to them larger MNCs disclose significantly more information in their annual reports than smaller ones. However, this relation does not stand for strategic information disclosure. The European companies in the sample seemed to disclose more strategic information than companies in the UK or US. Besides, differences in disclosure practices across regions were identified. Raffounier (1995) founds that firm size was a strong determinant for level of disclosure for Swiss firms.
Ahmed and Courtis (1999) conducted a meta-analysis of the relation between corporate disclosure level and firm size, listing status, leverage, profitability and audit firm size. For firm size they found a significant association with disclosure level in the overall and moderator variable test results.
They also identified a couple of reasons explaining these results. According to them, larger firms have to report about a diverse portfolio of activities, they have to respond to information expectations of a wider spread of ownership, mostly have an advanced internal data-gathering and reporting system and are in possession of financial means to afford more disclosures (Ahmed and Courtis, 1999). They concluded that larger companies follow better disclosure practices in developed countries and in developing and Newly Industrialized Countries (NICs), but a wide variation in results exists.
Furthermore, in non-Western countries firm size has been investigated as a determinant of firm disclosure practices. Japan is sometimes considered to have a unique business environment and culture (Cooke, 1992). Cooke studied disclosure practices of Japanese companies in 1992 and found a significant relationship between firm size and level of disclosure. Earlier, he had found that firm size proved to be an important variable influencing the extent of disclosure for Swedish companies (Cooke 1987).
Beattie et al., (2004) found a positive size-disclosure relation for their sample of U.K. firms. In that same year, Beretta and Bozzolan found a positive association between firm size and volume of risk disclosures in their sample of Italian companies. Linsley & Shrives (2006) conducted a content analysis on risk disclosures of 79 U.K. non-financial companies. Consequently, they carried out a correlation analysis to test for relationships between the amount and extent of risk disclosures and several firm specific characteristics. They found that larger firms tend to make more risk disclosures, as well as on financial risks, as on non-financial risks than smaller firms. These results suggest that a positive relation between firm size and disclosure also exist for certain types of disclosure, in this case, risk disclosure.
It can be concluded that past literature has found strong evidence suggesting a positive relation between firm size and disclosure practices. In addition, the research conducted by Linsley & Shrives (2006) suggests a positive relation between risk disclosures and firm size.
Another factor frequently studied in past disclosure literature is firm leverage. Previous studies investigating the association between leverage and extend of disclosures have not been consistent.
Leverage can be measured by book value of debt to shareholders' equity or book value of debt to total assets. Firms with a higher leverage have higher monitoring costs and they try to reduce these costs by disclosing additional information in annual reports (Jensen & Meckling, 1976).
Agency theory suggests that voluntary disclosure is an increasing function of leverage (Watts, 1977 and Jensen & Meckling, 1976). Bradbury (1992), found a positive association between leverage and extent of voluntary segment disclosure in New Zealand firms. However, Chow and Wong-Boren (1987), found no association between financial leverage and the extent of voluntary disclosure in their sample of 52 Mexican firms.
In the meta-analysis of Ahmed and Courtis (1999) on prior disclosure studies, a significantly positive association was found between leverage and disclosure levels, when leverage was proxied by debt to equity and debt to total assets.
Leverage can be seen as a possible measure of firm risk. Some researches have used this measure to proxy the risk level of a firm. According to Ryan (1997) systematic equity risk is positively associated with sources of operating risk, operating leverage and financial leverage. Firms with higher operating risk will choose a lower level of financial leverage to yield in an acceptable level of systematic equity risk (Ryan, 1997). Hossain et al., (1995) found no association between the volume of risk disclosures and the level of risk of a firm.
More recently, Linsley & Shrives (2006) found no significant association between the different risk measures and the number of risk disclosures. They used leverage as one of the measures for firm risk. As past literature was not decisive on the relation between firm risk and level of disclosures, they formulated their hypotheses concerning these relationships in the null form. However, they did find a positive correlation between their measure for environmental risk and the extent of risk disclosure. According to their results, firms with lower levels of environmental risk disclose more risk information. They also stated that a circular relationship between risk levels and risk disclosure might exist. Issuing additional information regarding firm risks makes the firm more transparent and the market understands the risk position of the firm better. Therefore, shareholders may perceive a firm as less risky; the risk level of a firm is seen as lower. However, this relation has not been demontrated. When reviewing past literature on the relation between leverage and disclosure practices, it can be concluded that no general opinion exists on this relation. The different researches up to date have shown contradictory results and therefore empirical evidence is still inconclusive.
According to the signaling hypothesis, companies with good news are more likely to disclose more information (Ross, 1979). Profitable, well-run firms have an incentive to distinguish themselves from less profitable firms in order to raise capital on the best available terms. Also, by not voluntarily disclosing information, investors may perceive it as an indication of bad news. So, profitable companies can be expected to disclose more voluntary accounting information. However, despite of these arguments suggesting a positive relation, literature is still inconclusive about the exact correlation between extent of disclosure and financial performance.
Firth (1984), studied the association between stock market performance and amount of disclosure in New Zealand. Market performance was measured by systematic risk, unsystematic risk and variance of return. No association was found between market performance and the extent of disclosure of New Zealand companies
According to Skinner (1994), the level of disclosures increases for bad performing companies as they try to limit litigation risk by disclosing more information. Contradictory, Lang and Lundholm (1995) found a positive correlation between the level of information to be disclosed and firm's financial performance. In that same year Raffounier (1995) found that more profitable firms disclosed more information in their annual reports, however this relation was not significant. Also Grossman and Hart (1980) found that managers of profitable firms had more incentives to disclose additional information to attract capital or to reduce the risk of being undervalued by the market. Another study conducted by Botosan (1997) argues that firm specific market risk (systematic risk or beta) has a great impact on the cost of capital. Disclosure is a way of mitigating this risk and thus to reduce the cost of capital.
However, Meek, Roberts and Grey (1995) did not find any significant evidence that voluntary disclosure behavior differs between profitable and less profitable companies. This confirms McNally et al., (1982) conclusion in their study on voluntary disclosures by New Zealand companies and Wallace et al., (1994) in their research of Spanish companies. More recently, Prencipe (2004) did not find any correlation between profitability and the extent of segment reporting for Italian listed companies. She explains this result by the existence of opposite affects the relationship between these two.
Past literature is still inconclusive on the relation between a firm's financial performance and its disclosure level. To investigate the effect of profitability on the extent of risk disclosures of financial conglomerates, this variable is included as a firm specific characteristic in the statistical analyses. This is further explained in chapter 4.
Risk disclosure literature
Stanton and Stanton's (2002) research on 70 disclosures studies published in the period 1990-2000 shows that there is none of which specifically pertains to risk disclosures. However there are a number of risk-related papers published that study the effect of the Securities and Exchange Commission (SEC) Financial Reporting Release (FRR) Number 48 on Derivative and Market Risk Disclosures. The rationale underlying the development of this SEC Release was that disclosure of market risk information would be useful to shareholders for assessing firms' derivatives exposures (Linsmeier and Pearson, 1997).
Hodder et al. (2001) study this aspect of FRR 48 and their study results in three conclusions. First of all, how investors evaluate risk is a complex matter. Then, FRR 48 allows three alternative disclosure formats but investors will assess a firm's risk quite differently dependent upon the format used. Finally, the disclosure requirements require insufficient quantitative information to be disclosed with the outcome that investors will not be able to understand the firms' derivative risk exposures. These important problems are compounded when firms do not fully comply with disclosure requirements, and in the case of FRR 48 Roulstone (1999) finds significant non-compliance occurring. These papers studying FRR 48 examine risk disclosures only in the discrete area of market risk.
Subsequently, Linsley and Shrives (2000) review risk reporting requirements alongside a discussion of the merits and demerits of disclosure of risk information within annual reports, and they discuss similar issues but within the context of financial firms. The most important potential benefit arising from improved risk disclosures by firms is a reduction in the cost of capital (Linsley and Shrives, 2000). That is, if risks are disclosed providers of capital may remove a part of the premium that is incorporated in the cost of capital to cover for uncertainty concerning the firm's risk position.
Linsley and Shrives (2000, 2005) also suggest that the provision of forward-looking risk information would be especially useful to investors. Dietrich et al.'s (2001) experiments provide support for the usefulness of releasing forward-looking risk information, concluding that overt risk disclosures lead to improved market efficiency. The two major obstacles to increased risk disclosures that Linsley and Shrives (2005) consider are the reluctance of directors to release risk information they deem too commercially sensitive and their reluctance to provide forward-looking risk information without safe harbor protection.
In addition to discussing the requirements of German Accounting Standard (GAS) 5 'Risk Reporting', Kajuter (2001) reports upon empirical findings of a study of risk disclosures in a sample of German companies. GAS 5 requires German companies to report on risk for financial years commencing after December 31, 2000 and the Kajuter (2001) paper examines risk disclosures for a sample of 82 non-financial companies. The conclusion reached is that the companies do not adopt a systematic approach to risk reporting and the risk information disclosed is restricted. Woods and Reber's (2003) pilot study examines risk disclosures of six German companies and compares them to six UK companies for the years 2000 and 2001.
An increase in risk disclosures for the German companies post-GAS 5 is observed with the implication that the Standard had a positive effect upon risk reporting. This conclusion is tentative however, not only because of the sample size, but also because of the method used to identify risk disclosures. That is, sentences were identified as risk disclosures only if they contained the word 'risk'. The results also indicate minimal reporting of forward-looking risks and of the size of risks, although this information is highly relevant for decision-making (Linsley and Shrives, 2005).
Beattie et al.'s (2004a) extensive study of disclosures across three industry sectors is not focused solely upon examining risk disclosures, but because it analyses the entire annual report narrative for a sample of 27 companies provides risk-related disclosure information. Significantly, forward-looking information comprises only 813 (6.6%) of the 12,293 text units analyzed and of which forward-looking 'risk/opportunity' information is a mere 291 text units (2.4% of total disclosures). Moreover, of these 813 forward-looking disclosures only 7% are quantified.
The most extensive risk reporting study to date is Beretta and Bozzolan's (2004) analysis of the Management's Discussion and Analysis (MD&A) section of the annual report for a sample of 85 companies listed on the Italian Stock Exchange. A key conclusion is that firms focus upon disclosing information on past and present risks, rather than future risks. Where future risks are disclosed, directors are reluctant to indicate whether the impact is likely to be positive or negative. Additionally, directors have a predisposition to self-justification when reporting on risk; that is they feel compelled to attribute risks with negative outcomes to external events. Ascribing the cause of negative outcomes to factors that are beyond directors' responsibilities suggests that attribution theory (see for example Aerts, 1994) may be a factor in risk reporting.