Annual-Report Risk Disclosure Decision Usefulness: Views of Users and Preparers

1
Annual-Report Risk Disclosure Decision
Usefulness Views of Users and Preparers

• Santhosh Abraham, Claire Marston and Phil Darby
• School of Management and Languages, Heriot-Watt
  University
• Funded by ICAS

2
4 Research themes

• Risk Information Requirements of Investment
  Analysts
• Comparison of Annual-Report Risk Disclosure
  Practices with Risk Information Requirements of
  Investment Analysts
• Risk Reporting Preparer Perspective
• The Effect of Regulatory Policy Initiatives on
  Risk-Reporting Practices

3
Prior Literature on Risk Reporting

• financial risk-reporting changes in relation to
  new regulatory requirements (Adedeji and Baker,
  1999 Bamber and McMeeking, 2010),
• assessing the type of risk information provided
  (Linsley and Shrives, 2006 Abraham and Cox,
  2007 Bamber and McMeeking, 2010)
• investigating the factors associated with risk
  disclosure (Linsley and Shrives, 2006 Abraham
  and Cox, 2007)
• examining risk-reporting practices on an
  international basis (Marshall and Weetman, 2002
  Woods et al., 2009)
• use of discretionary disclosures to manage
  reputation risk (Linsley and Kajuter, 2008)

4
Research Approach

• Interviews with investment analysts and
  annual-report preparers
• Short questionnaire for analyst interviewees
• 32 interviews, 35 analysts
• 21 buy-side, 11 sell-side
• 16 preparers (8 FTSE-100, 7 FTSE-250, 1 AIM)
• Content analysis of company annual reports.
• 18 Food Beverage 2009

5
Coding scheme

• Risk-Detail captures two dimensions of
  disclosure the category of information
  disclosed, and the characteristics of the
  information disclosed.
• 8 categories and 50 subcategories
• characteristics are whether or not the disclosure
  contains monetary information, the time frame of
  the disclosure (past, future or no time frame)
  and the tone of the disclosure (good, neutral or
  bad news)

6
Coding scheme (cont)

• Risk-Overview the explicit disclosure of
  significant risk factors.
• summary of the risks reported by individual
  companies. Number of risks in the risk section
  and no. for which no mitigations are in place.

7
Findings Risk Information Sources

• General Information Sources
• Importance ranked 1-5
• Information source Mean
• Meetings with management 4.5
• Results announcements 4.2
• Trading statements 4.1
• Peer companies 4.0
• Annual report accounts 3.9
• Industry experts 3.8
• Analysts 3.6

8

• Information source Mean
• Interim statements
• quarterly reports 3.6
• Interim reports and accounts 3.4
• Market news 3.2
• Newspapers 3.0
• Financial news channels 2.8
• Internet bulletins 2.3

9
Risk Information Sources Within the Annual Report

• Annual-report section Mean
• Cash flow statement 4.5
• Balance sheet 4.5
• Income statement 4.4
• Segmental information 4.3
• Accounting policies 4.3
• Notes to the accounts 4.1
• Financial risk factors 4.1

10

• Annual-report section Mean
• Directors profile 2.9
• Risk management internal control 2.9
• Shareholder information 2.8
• Company profile (What we do) 2.8
• Compliance with combined code 2.6
• Other - Corporate governance report 2.6
• Corporate social responsibility report 2.2

11
Risk Factor Statements

• Annual-report risk disclosure is very general and
  therefore provides no additional relevant
  information
• A smaller number of analysts note that the annual
  reports are useful because occasionally a risk
  factor that they had not considered is
  highlighted by management.
• A minority of analysts note that annual-report
  risk factor statements are very useful in
  evaluating the key risks involved in their
  investment. They point out that a large list of
  risk factors is helpful in evaluating the broader
  risks affecting the company.

12
Remuneration

• Analysts are interested in understanding how
  remuneration criteria affect managerial behaviour
  and hence the overall risk of an investment. They
  wish to identify whether the remuneration
  criteria are aligned to the companys overall
  strategy.
• The annual report provides most of the
  information they need on remuneration.

13
Face-to-Face Meetings

• Analysts were asked about the importance of
  face-to-face meetings to overall risk assessment.
  
• Face-to-face meetings are very important in
  understanding the overall risk to an investment.
• But a few of the analysts are sceptical about the
  value added by face-to-face meetings.

14
Findings Summary of Annual-Report Coding Results

• Risk-Detail
• The number of risk items disclosed in the 18
  annual reports ranges from 200 to 1,651, with an
  average of 786. This is dominated by information
  in tables since each cell counts as one piece of
  information. The average is reduced to 198 (57 -
  418) if only narrative disclosure is included.

15
Table Risk-Detail summary of risk disclosure
items by category

• Category Total
• Financial 5,245
• Strategic 3,441
• Empowerment 2,599
• Operations 2,269
• Historical performance/Economic cycles 269
• Targets 235
• Integrity 42
• Information processing and technology 26
• Total 14,126

16
Risk-Overview

• 17 out of 18 provided statement
• 12 risks on average (max 31, min 5)
• Tends to be general with some company-specific
  information
• Mitigation strategies given by 14
• Risk rankings not disclosed
• 2 give external risk ranking
• Location usually in Business review

17
Findings Risk Reporting Preparer Perspective
(16 interviews)

• Importance of Annual Reports and Other Disclosure
  Vehicles
• RNS, conference calls, 1-1s
• Annual report important but mainly for the
  private investor
• Key Audience for Risk Information
• analysts and professional and retail investors
• But the fact that nobody asks us about it makes
  you wonder whether anybody ever even looks at it.
  I mean .. is this a box-ticking exercise

18
Findings Risk Reporting Preparer Perspective
(cont.)

• Usefulness of Risk Reports
• Generic/specific?
• How many?
• Care/effort
• my CEO and I write every word of it every year
  because we see it as part of our mission to
  communicate with the 70-year-old who owns our
  shares on a private basis. (FD4)

19

• Usefulness of Financial Instrument Disclosures
• Difficult to understand
• Does anyone read them?
• Mark-to-market can be positively misleading (in
  case of 1 company)

20

• Do you feel that disclosures about FIs in the
  notes are important disclosures? (Interviewer)
• No, completely irrelevant. Weve lost the plot.
  Nobody understands it and nobody even looks at it
  and it costs a fortune to do these disclosures
  every year. Its a complete waste of money the
  accountancy profession has just lost leave of its
  senses. Completely and totally. They may be
  important for a bank or for a financial business,
  but for an industrial business like ours theyre
  a complete irrelevance. And nobody has ever asked
  me a question on it, and theres nobody to my
  knowledge has even read it. And even the auditors
  say its a complete waste of time. (FD4)

21
Debt Covenant Disclosures

• Useful, analysts ask if it is not in annual
  report
• Detailed disclosure not needed if not running up
  against the limits
• Banks dont want them to disclose
• Public debt covenants in the prospectus
• Impending breach disclose to RNS
• Otherwise general disclosure about headroom

22
Internal control disclosures

• Variety of views
• Useless boiler plating
• Taken seriously by the Board
• Some qs received about ICs
• Suggestion that disclosure of what when wrong
  could be interesting
• Mixed views on the idea

23
Boundaries to disclosure

• Commercial sensitivity an issue for some
• Others feel this an excuse
• Need to avoid information overload
• Unlimited demand for information
• Peer group disclosures compared to establish best
  practice

24
Findings Effect of Regulatory Policy Initiatives
on Risk-Reporting Practices Preparer and User
Perspectives

• Views on preparers on Enhanced business Review
  and safe harbour provision
• No step-change in disclosure of forward looking
  information
• Most felt new provision not v helpful
• Some felt it is helpful

25
Views of Analysts

• General issues
• Information has increased
• Regulation effective in theory but difficult in
  practice
• Still problems of litigation risk
• Some negative views e.g. ineffective and having
  unintended consequences

26

• Internal Control Disclosures
• Not important for sell-side
• Buy-side mostly agree but some read them
• On possible disclosure of what went wrong the
  views are mixed
• they would always pick up things which tend to
  prove that they are very good and once again the
  ability to understand that, to check that would
  be very small.

27
Financial Instrument Disclosures

• Useful for some sell-side analysts
• Feeling of buy-side is that they are important
  but difficult to understand
• Sensitivity analysis read by some analysts but
  difficult to understand. Need to talk to company
• How am I to tell whether in fact the answer
  might look good but I dont know actually whether
  the assumptions are valid, and well, frankly,
  sometimes it could almost be a finger in the
  air. (SS7)

28
Pensions Disclosures

• Mentioned by 6 interviewees
• 2 said difficult to understand
• 1 said causes distortions

29
Constraints on Disclosure

• Some comments on constraints on disclosure
• Releasing information to competitors
• Segmental reporting
• Confidentiality of covenants
• many top-level managers of large companies are
  aggressive and therefore that it is not in their
  nature or interests to describe failings in the
  business (BS20)

30
Key Findings with Recommendations and Policy
Implications

• Risk reporting used by analysts as part of their
  decision making
• Danger of managerial remuneration packages
  leading to abusive behaviour
• Liquidity risk important but disclosure currently
  inadequate
• One-to-one meetings still important
• IC disclosures have had little impact

31

• Need for more forward-looking information
• Clear layout of risks and mitigations
• Extra risk information on web-site?
• Frequent updates
• Plain language explanations of FI disclosures on
  web-site?