How has the financial crisis changed disclosure of impact


Background, context

Companies listed on the stock-exchange are dependent on external capital from investors. The investors premier source for information regarding a company are the financial reports, and it is therefore of importance that the company there discloses as much information regarding the business and its environment as possible (Linsley & Shrives 2006). Over the last 15 years, the topic that is risk reporting has gained increased attention, which is something that has been reflected in reporting practise, regulation and international research. This is also illustrated by the results of studies showing that risk management today is at the top of a CEO's list of priorities (Waymaker, 2006). Risk reporting has moved away from being a particularity of the financial-service sector, which has been of importance for maintaining market discipline, into gaining centre stage in many non-financial companies (Linsley & Shrives 2006, Helbok and Wagner 2006, Dobler 2008). Non-financial companies are now focusing on their exposures to a greater extent than they have ever been before and risk management has become an essential part of the corporate governance structure (Ernst & Young, 2006, Power 2004, ). Risk reporting standards have been issued by a range of professional organisations, including the Association of Insurance and Risk Managers (2002) and the Institute of Chartered Accountants in England and Wales (200?), which has spurred the interest for the development of risk management systems further.

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A changing economic and regulatory environment, more complex business structures, usage of complex financial instruments, an increase in international activities and sudden failures of large corporations, are some of the underlying causes that have given rise to risk reporting in the non-financial sphere (Dobler, 2008). Although there has been a significant improvement in the quality of risk reporting, many still argue that the level of risk reporting in present time is not enough to satisfy the needs of investors (Abraham & Cox 2007, Ernst & Young 2006, Fewer 2004, Dobler 2008) To understand why reliable and extensive risk reporting is something that investors want, the term "risk" needs to be defined. The accounting standards board (1998) defines risk as;

"Uncertainty as to the amount of benefits. The term includes both potential for gain and exposure to loss."

On the basis of this definition, risk reporting is seen to be any information that the company discloses that will facilitate the assessment of the amounts of future cash flows. The principle of risk-return trade-off is a cornerstone in all well functioning capital markets, where there is a strong relationship between potential rewards of an investment and the risk required to realise those rewards. This is because it is reasonable to assume that investors will seek to make investment decisions that yield high returns with low risk, resulting in risk and return being two indelibly linked concepts (Ghysels, et al 2006). However, inadequate risk reporting inhibits investors from being able to assess the level of risk that an investment poses, i.e. undermining the relationship that exists between risk and reward. How are investors seeking to choose the level of exposure their portfolios supposed to be able to make investment decisions when they only have half the story?

In a survey conducted by Ernst & Young, a majority of investors state that they avoid investing in companies whose risk management they perceived to be lacking, and close to half had de-invested where risk management performance was insufficient. Results from the same survey also indicated that a large majority of investors thought that there was a premium available to companies that were able to demonstrate good risk management practices and transparency (Ernst & Young, 2006).

Equally, the credit rating agency Standard & Poor state that financial reports are their primary source for information on a company's financial situation and they emphasise the important role of the leaderships risk management (Standard & Poor 2008).

Inadequate financial reporting may affect market confidence, which can reduce market participation, translating into a reduced availability and a higher cost of capital (FSA, 2011).

Although many authors have accentuated that increased risk reporting is beneficial to companies, leading to both a lower cost of capital (ICAEW 1999, Ernst & Young 2006, Solomon et al 2000) and the improvement of risk management and governance (Linsley & Shrives 2000), research has shown that these incentives have not convinced companies to voluntarily report on risk (Beretta & Bozzolan 2004). Even under disclosure rules, large variations and deficits in risk reporting exists (Ewert & Wagenhofer). Research conducted by Dobler (2008) suggests that the above stated incentives for risk reporting not being necessarily true and that companies have many reasons to hold back information, although he admits that as his study was the first of its type and that it might be challenged in the future. Holding back risk information, even under regulated disclosure rules is possible due to its largely unverifiable and subject nature.

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If the above stated incentives for risk reporting are correct, it would be expected that as a result of the changed conditions in the world economy, due to the recent financial crisis, the level of risk communication from companies to have become higher. It is therefore interesting to examine and explain to which extent that the risk reporting quality and scope in 2010 is different compared to 2007 by companies listed on the FTSE 100 index. As no one has compared risk reporting before and just after a period of economic turbulence this report seeks to show the effects that a financial crisis can have on businesses risk reporting. A focus will also be placed on investigating if there is an apparent connection between the level of risk disclosure and the share prices of the individual companies. This would verify the "premium" that investors have said to be willing to pay for companies that report transparently on their risk management procedures.

Literature Review

This review outlines the methodology and focus behind past studies that have attempted to assess the level of risk reporting in annual reports, it looks at studies that have researched the correlation between share price and level of risk disclosure and will show how my research aim would fill a gap that currently exists in our knowledge on this subject.

Level of risk reporting assessment

Research on the correlation between share price and level of risk disclosure

Gap in the research

As no one else has before researched companies risk reporting before and just after a period of economic turbulence, the intention of this