Risk in financial reporting

Financial statement users’ judgments of risk are different from how risk is defined in economics.

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The concept of risk is pervasive in financial reporting. For example, investors must assess the amounts, timing and uncertainty of future cash flows. Companies must determine the risks associated with their market risks and disclose those in the MD&A of their annual reports.

Risk is also central to the valuation of firms. Under the capital-asset-pricing model, a firm is considered riskier to the extent that its stock returns move more than the underlying market factors; that is, the covariance of a firm’s returns with market factors is viewed as a measure of risk that, in turn, affects asset prices.

Standard-setters also require financial reports and disclosures with the aim of providing insight into the riskiness of the firm’s future cash flows. For example, in the US, the Securities and Exchange Commission requires that companies disclose both qualitative and quantitative market risk information for risks of loss arising from adverse changes in interest rates, foreign currency rates, commodity prices, and equity prices. This reporting requirement is one of the few that requires companies to disclose forward looking information about risk.

Users of financial reports also glean information about a firm’s risks from that firm’s own reporting practices and other disclosures that appear throughout the financial reports. For example, firms who use derivatives for hedging are less risky, ceteris paribus, than firms who use derivatives for speculation (Guay 1999). As another example, firms in the property and casualty industry that make discretionary revisions to their loss reserve liabilities are viewed as higher in firm risk (Petroni, Ryan and Wahlen, 2000).

Much of what we have been taught and have learned about risk in accounting and business originates from the discipline of economics. There, risk is viewed as an assessment of the severity and likelihood of the possible outcomes, usually summarized via the statistical concept of variance. Accordingly, greater potential variation in outcomes implies greater risk. Both upside and downside potential are part of this economics-based view of risk. While this measure of risk can be generated from objective, historical data, it can also be generated by asking individuals’ to subjectively assess the probability and magnitude of various outcomes. In either case, though, risk is associated with both upside and downside potential.

Despite the maintained assumption that risk is associated with variation in outcomes, an influential line of research in the health and technological areas views risk in a different fashion. Rather than relying on the concepts of probability and outcomes, Fischhoff, Slovic and Lichtenstein (1982) document that individuals think about risks in terms of two dimensions—dread and unknown. Dread is associated with the degree to which negative consequences of the risky prospect are potentially catastrophic, worrisome, voluntary and controllable; unknown is associated with how well the risk is understood, known and new versus old. Although some elements of these two dimensions have overlap with the traditional economic variables (e.g., catastrophic outcomes), they clearly differ in many ways from those economic ideas. Most interestingly, the research by Slovic also has shown that individuals do not associate variation with risk. Rather, risk is viewed primarily as downside potential.

Despite the centrality of risk to accounting and, in general, to business, there are only a handful of studies that examine how users of financial reports think about risk. One such study was conducted by Koonce, McAnally and Mercer in 2005; they report that financial statement users do not think about risk in terms of variation. Rather, they show that these users think about the risks associated with various financial and derivative instruments in terms of downside potential. Moreover, these authors propose and test a model that combines conventional variables from economics—probabilities and outcomes—with behavioral variables from psychology research by Slovic (1987), such as the extent to a financial instrument is new, causes worry and is controllable. They find that combining these economic variables with the Slovic variables of dread and unknown better explains how financial statement users think about risk than considering either set of variables alone. So, for example, they find that a short position in a put option is viewed as riskier than a long position in a commodity forward contract not only because of the differential loss probabilities and outcomes, but also because it seems more worrisome and less controllable and less well-understood.

These results are intriguing because they suggest that the risk judgments of financial statement users are based on factors beyond those traditionally considered by economists and are different than what is typically taught in professional business school education. Of course, the obvious question is do these different views about risks matter? Do they make a difference? Koonce, McAnally and Mercer also explored this question in their 2005 study. To do so, they designed an experiment in which participants evaluated sensitivity risk disclosures like those now commonly found in the MD&A section of firms’ annual financial reports. They provided study participants—MBA students with a background of five years of work experience in business, engineering and liberal arts—with several sensitivity disclosures showing quantitative information about potential loss outcomes associated with a 10% adverse change in market rates. Participants evaluated six common financial instruments that are subject to these market risk disclosures, ranging from a long position in commodity futures to a short position in equity call options. Participants not only gave their subjective risk assessments but also detailed assessments of the economic and Slovic dimensions of risk.

The authors’ results reveal that financial statement users’ broader views—that is, broader than those considered by economics—about risk do have consequences. That is, they report that users think about factors other than loss outcomes when provided with loss-outcome risk disclosures and these other factors systematically affect how the mandated risk disclosures are interpreted. As anticipated, higher potential loss outcomes (as mandated by the risk disclosures) lead to greater perceived risk. Most interestingly, though, these researchers also find that higher loss outcome leads to greater perceived dread (i.e., concerns about controllability, catastrophic outcomes and voluntary exposure), which in turn increases the judged risk of financial instruments above and beyond what is implied by the loss-outcome disclosures.

These research results are particularly relevant to regulators and standard-setters—that is, those who design risk disclosures for financial reporting purposes. Why? They suggest that what regulators and companies believe they are communicating, in fact, may not be all that is communicated. The potential problem is that those who design risk disclosures in the financial reporting domain may not realize that those who consume the risk disclosures think about risk in a fashion different (or more complex) than intended. These differences in views about risk are powerful as they may have unintended consequences for the communication of risk in financial reporting.

At first blush, it might seem surprising that regulators and standard-setters would think about risk differently than financial report users. That is, aren’t the objectives of regulators to protect investors and promote stability in the financial markets by enforcing laws? Aren’t the objectives of standards-setters to provide information to allow current and potential investors to assess the amount, timing and uncertainty of future cash flows? If so, aren’t regulators and standard-setters providing disclosures that adequately allow investors, creditors and others to make these judgments?

The answer to this question could very well be “no.” A follow-on 2008 study by Koonce, Lipe and McAnally shows that these same sensitivity, loss-only disclosures that companies use to describe their risks actually cause investors to assess the same level of risk for firms with very different underlying exposures. That is, by describing only the downside associated with a potential market risk exposure, financial-statement users apparently infer that any potential (and undisclosed) upside benefits are relatively small. By not having information in the mandated disclosures regarding the potential upside associated with a change in underlying market risks, these users infer that such benefits are minimal—an inference that was probably not intended by regulators. Koonce, Lipe and McAnally also explore the possible risk-judgment repercussions if financial-statement users were to be presented with the potential upside as well. These users’ risk judgments vary dramatically depending on the size of that upside potential and, importantly, effectively allow them to distinguish among firms using different risk-management strategies.

More evidence of unintended consequences from existing risk disclosure also comes from this same 2008 Koonce, Lipe and McAnally study. Their research documents that the labels firms use to describe their financial instruments and derivatives can have a dramatic impact on how financial statement users assess the risks associated with economically equivalent instruments. For example, they show that merely adding the word “hedge” to a description of financial instruments (i.e., variable rate debt combined with a variable-to-fixed interest rate swap) dramatically changes how its risk is perceived. Their results indicate that financial statement users associate the word “hedge” with insurance, or a reduction of most risks, even when additional risks are still present. Although the authors sometimes also provided study participants with information about these additional, remaining risks, the financial statement users were still very strongly affected by the label (i.e., the word “hedge”).

So is there something specific about accounting and the disclosure of risk that causes such unintended consequences? The answer is no. Researchers in fields other than accounting (or even business) have long known that how preparers of risk disclosures think about risk is rarely the same as how users of risk reports think about risk and, thus, interpret risk disclosures. For example, information communicated about global warming from scientists from around the world is not always accepted nor interpreted as intended. Indeed, many individuals do not trust those who report about climate change and thus, completely disbelieve those risk communications.

There are several likely reasons for these sorts of risk communication problems. Commonly, those who determine the content of risk disclosures, such as environmental scientists, are experts in the technical field to which the risk relates. As a consequence, their technical training typically leads them to think about risk in terms of statistical concepts, such as probabilities and outcomes. In contrast, most recipients of risk disclosures are less well versed in the technical aspects of the risks and so think about risks in ways that are less technical and more personal to their lives (e.g., fear of unknown risks and catastrophic, dreaded outcomes). Moreover, those who develop the risk disclosures often fail to think about how the recipients of those disclosures are likely to react to them; thus, they generate risk communications with the mind-set that users will think about risk in the same way as they, the experts, think about it. In other words, they fail to entertain the notion the recipients are unlikely to appreciate or even believe what is being communicated to them.

In summary, although there is a relative paucity of research on how financial statement users think about risk, what we do know is that their judgments of risk are different (i.e., broader) than how risk is typically defined in economics. Understanding this is important as it can provide important input to standard-setters and regulators as they grapple with the important topic of risk communication within financial reporting.


Lisa Koonce (CPA, PhD) is the Deloitte & Touche endowed chair professor in Accounting and the Regents’ Distinguished Teaching Professor at the University of Texas (Austin).

Technical editor: Karim Jamal, FCA, PhD, chair of the department of Accounting, Operations and Information Systems, School of Business, University of Alberta

References

Fischhoff, B., P. Slovic, and S. Lichtenstein. (1982). Lay foibles and expert fables in judgments about risk. The American Statistician: 240-255.

Guay, W. (1999). The impact of derivatives on firm risk: An empirical examination of new derivatives’ users. Journal of Accounting and Economics: 319–351.

Koonce, L., M. Lipe, and M. McAnally. (2005). Judging the risk of financial instruments: Problems and potential remedies, The Accounting Review: 871-895.

Koonce, L., M. McAnally, and M. Mercer. (2005). How do investors judge the risk of financial and derivative instruments? The Accounting Review: 221-241.

Petroni, K., S. Ryan, and J. Wahlen. (2000). Discretionary and non-discretionary revisions of loss reserves by property-casualty insurers: Differential implications for future profitability, risk and market value. Review of Accounting Studies: 95–125.

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