Investors Prefer It When Corporations Are Specific about the Risk They Face
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Policy Sep 1, 2017

Investors Pre­fer It When Cor­po­ra­tions Are Spe­cif­ic about the Risk They Face

The mar­ket val­ues detailed risk dis­clo­sures. But exec­u­tives should be cau­tious about oversharing.

A woman fills out an SEC risk disclosure form.

Lisa Röper

Based on the research of

Ole-Kristian Hope

Danqi Hu

Hai Lu

The 2007 finan­cial cri­sis arose, in part, from over­lever­aged banks and cred­it agen­cies under­es­ti­mat­ing mar­ket risk. Which begs the ques­tion: Is there a bet­ter way to com­mu­ni­cate risk? If, for instance, com­pa­nies had to dis­close spe­cif­ic risks in cor­po­rate fil­ings, would the mar­ket find this useful?

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There is already a vehi­cle to do just that. Each year, cor­po­ra­tions must fill out the Secu­ri­ties and Exchange Com­mis­sion (SEC)-mandated 10-K form, which includes an open-end­ed sec­tion on qual­i­ta­tive risk. But firms are giv­en broad lat­i­tude in terms of how much detail they present. Instead of sim­ply report­ing that sales are reliant upon a lim­it­ed num­ber of cus­tomers, for instance, a firm might offer the names of three spe­cif­ic cor­po­rate cus­tomers that togeth­er account for 40 per­cent of sales.

Since the finan­cial cri­sis, the SEC has called for more speci­fici­ty in these reports. Yet many ana­lysts believe this sort of fil­ing-based risk dis­clo­sure is of lim­it­ed value. 

So in recent research, Dan­qi Hu, an assis­tant pro­fes­sor of account­ing man­age­ment and infor­ma­tion at the Kel­logg School, set out to learn the extent to which the mar­ket val­ues speci­fici­ty. She teamed with coau­thors Olé-Kris­t­ian Hope of Uni­ver­si­ty of Toron­to and Hai Lu of Uni­ver­si­ty of Toronto. 

The researchers uncov­ered a link between risk-relat­ed speci­fici­ty in the 10-Ks and increased mar­ket activ­i­ty such as trad­ing vol­ume, along with more reli­able ana­lyst forecasting. 

We believe speci­fici­ty is impor­tant and valu­able to the mar­ket,” Hu says. 

Yet what is good for the mar­ket, which likes to see trans­paren­cy in cor­po­rate deci­sion-mak­ing, is not nec­es­sar­i­ly good for the cor­po­ra­tion. While these find­ings show that investors and ana­lysts may ben­e­fit from more spe­cif­ic risk report­ing, exec­u­tives need to con­sid­er the poten­tial down­sides of over-spec­i­fy­ing risk, Hu says. 

The Debate about Risk Reporting

While a great deal of atten­tion is paid by the mar­ket and researchers to the finan­cial-per­for­mance sec­tions of the 10-K and sim­i­lar fil­ings — such as infor­ma­tion relat­ed to earn­ings and assets — risk-relat­ed infor­ma­tion tends to be less of a focus. 

There’s debate about whether the risk-report­ing sec­tions of some cor­po­rate fil­ings are of any use at all,” Hu says. She notes that many ana­lysts think it is pure­ly boil­er­plate” information. 

Finan­cial per­for­mance is inter­est­ing, of course,” Hu says, but we want­ed to see what we could learn from risk information.” 

We believe speci­fici­ty is impor­tant and valu­able to the market.” 

The researchers were espe­cial­ly inter­est­ed in the lev­el of detail pro­vid­ed in the 10-K on risks. How many details did firms offer, for exam­ple, about the nature and inten­si­ty of their com­pe­ti­tion, liq­uid­i­ty prob­lems, poten­tial tech­nol­o­gy dis­rup­tions, or the chal­lenges of doing busi­ness in polit­i­cal­ly unsta­ble parts of the world? 

Many finan­cial man­agers do update the sec­tion with any­thing mate­r­i­al,” Hu says, so it’s not tru­ly boilerplate.”

Cap­tur­ing Risk Specificity

To study the impact of risk speci­fici­ty in cor­po­rate fil­ings, the researchers ana­lyzed near­ly 15,000 10-Ks filed with the SEC from 2006 to 2011

They defined speci­fici­ty as using names (such as Microsoft”), loca­tions (“Chi­na”), num­bers (“25 per­cent of rev­enues”), dates, and oth­er infor­ma­tion in the dis­clo­sure of qual­i­ta­tive risk. The good exam­ples we saw in fil­ings used lots of spe­cif­ic infor­ma­tion, such as com­peti­tors’ names and the per­cent of busi­ness exposed to the chal­lenges of spe­cif­ic emerg­ing mar­kets,” Hu says. 

The team used a com­put­er algo­rithm to assess the speci­fici­ty of the rel­e­vant sec­tion in the 10-K. Then they com­pared risk speci­fici­ty with mar­ket activ­i­ty, ana­lyst fore­casts and sce­nar­ios, and oth­er measures. 

It Is a Trade-off

As they had pre­dict­ed, the researchers found that greater speci­fici­ty in risk dis­clo­sure was relat­ed to increased mar­ket activ­i­ty and ana­lysts’ accuracy. 

The idea is that more speci­fici­ty helps investors to incor­po­rate a wider range of risk infor­ma­tion in deci­sion-mak­ing,” Hu says, result­ing in a stronger short-term mar­ket reaction. 

The find­ings rep­re­sent an inter­est­ing trade-off for cor­po­ra­tions, accord­ing to Hu. From a com­pa­ny per­spec­tive, if you want your audi­ence to under­stand more about the risk your busi­ness faces, be more spe­cif­ic,” she says. 

But all firms may not want to empha­size such transparency. 

If the goal is not to pro­mote under­stand­ing in the mar­ket, then firms are more like­ly to use boil­er­plate risk infor­ma­tion,” Hu says. 

For cor­po­ra­tions, she points out the down­side of over-spec­i­fy­ing risk: Infor­ma­tion that’s too spe­cif­ic may sig­nal some­thing neg­a­tive to com­peti­tors or investors. Investors might think you’re too risky or have too high a cost of cap­i­tal or cost of equity.” 

Thus, the research points to the need for a strate­gic approach to risk speci­fici­ty on the part of exec­u­tives. While pre­sent­ing more spe­cif­ic infor­ma­tion will ben­e­fit ana­lysts and investors, senior man­agers should think care­ful­ly about their objec­tives when com­mu­ni­cat­ing risk, and poten­tial downsides. 

Exact­ly what goes into the risk sec­tions of cor­po­rate fil­ings may become even more crit­i­cal because the SEC is con­sid­er­ing reduc­ing the length of cor­po­rate fil­ings for simplicity. 

That means it will be even more impor­tant to pro­vide the most spe­cif­ic, rel­e­vant infor­ma­tion, depend­ing on your goals,” Hu says. 

Featured Faculty

Danqi Hu

Assistant Professor of Accounting Information & Management

About the Writer

Sachin Waikar is a freelance writer based in Evanston, Illinois.

About the Research

Hope, Ole-Kristian, Danqi Hu, and Hai Lu. 2016. “The Benefits of Specific Risk-Factor Disclosures.” Review of Accounting Studies. 21(4): 1005–1045.

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