Mortal Kombat? The interplay between managers’ and
auditors’ risk disclosures
Hanna van den Berg 2558106*
h.van.den.berg.10@student.rug.nl
University of Groningen, MSc Accountancy and Controlling Vlad-Andrei Porumb
v.a.porumb@rug.nl
University of Groningen, Supervisor
January 21, 2019 7660 words
Abstract
This study examines whether the International Financial Reporting Standard (IFRS) 7 financial instrument disclosures are of importance to investors in the United Kingdom (UK). Given the efforts of standard setters to increase the usefulness of financial reporting, it is important to inquire whether the implementation of IFRS 7 brings information to equity holders. This paper adds to the current literature by providing the first empirical analysis of IFRS 7 risk disclosures in a non-financial setting. Using hand-collected IFRS 7 data for a sample of 411 premium listed UK firms during the 2010-2016 period, I find that managers’ risk disclosures are positively priced by investors. In addition, the positive price reaction to IFRS 7 risk disclosures is stronger for more leveraged firms, relative to less leveraged firms. Further, I investigate whether managers’ risk disclosures influence investors’ price reaction to disclosures in the expanded audit report. I perform this test because the disclosure of entity-level risks of material misstatement (RMMs) provides investors information, which could potentially signal the incapability of managers to control the firm and inability to produce reliable financial information. I find that the negative equity market reaction to entity-RMM disclosures is reduced when managers disclose more IFRS 7 information. Overall, the findings are consistent with the notion that investors price both managers’ and auditors’ risk disclosures and regard them as complements in providing information.
Keywords: IFRS 7, Expanded audit report, Risk of material misstatements, UK,
non-financial firms
I. Introduction
The underestimation of firms’ risk exposures contributed largely to causing the financial crisis of 2007 to 2009 and led to an increased demand for firms to report their exposure to risks in annual reports (Hope, Li and Lu, 2009). Accounting standard setters answered these calls by developing the International Financial Reporting Standard (IFRS) 7, which requires that listed firms with financial instruments would report on risk exposures arising from their financial instruments (IFRS 7, 2005, 1). Specifically, IFRS 7 describes that financial instruments of firms are commonly exposed to market, liquidity, and credit risks (IFRS 7, 2005, 20).1 The standard aims to reduce information asymmetry between management and investors as “the board believes that the introduction of IFRS 7 will lead to greater transparency” (IASB, 2005, 1), and “(…) will provide better information for investors and other users of financial statements to make informed judgements about risk and return” (IASB, 2005, 1). However, managers’ risk disclosures its effect on information asymmetry between firms and shareholders is not a priori clear (Kravet and Muslu, 2013). On the one hand, IFRS 7 risk disclosures can decrease information asymmetry as it enhances investors’ understanding of risk exposures, which enable them to make more informed stock price investments (Deumes, 2008; Linsmeier et al., 2002). On the other hand, it can increase information asymmetry when risk disclosures reveal new risks and uncertainties, which increase investors’ perceptions of the extent of risk exposure (Kravet and Muslu, 2013). The manner in which investors incorporate IFRS 7 risk disclosures remains an empirical question, which my study comes to answer.2
Current literature argue that the requirement to disclose information as mandated under IFRS 7 suggests investors have a lack of knowledge about firms’ risk exposures (Heinle, Smith and Verrechia, 2018). As a result, this raises the question of how investors incorporate this risk
1IFRS 7 applies to both financial as well as non-financial entities with any financial instruments to disclose information about the significance of, and risks arising from their financial instruments (IFRS 7, 2005, 5).
information in their assessment of firm value. Nevertheless, many studies conducted in the area of financial instruments focus on the financial industry, since the balance sheets of these firms are mostly comprised of financial instruments (Gebhardt, 2012). However, Gebhardt (2012) shows that financial instruments have a high importance to non-financial firms. As the IFRS 7 standard applies to both financial and non-financial entities, this study is coming to address this gap by investigating the equity market effects of IFRS 7 risk disclosures in a non-financial setting.
To test my hypotheses, I use hand-collected IFRS 7 risk information from the annual report of 411 premium listed firms for the 2010-2016 period. Further, I split managers’ risk disclosures into six categories. More specifically, I include the number of (1) total IFRS 7, (2) interest, (3) currency, (4) other price, (5) liquidity and (6) credit risks words in my tests. Investors’ price reaction is captured as the stock price return over a one-day and three-day window.
The results show that equity investors price IFRS 7 risk disclosures. More specifically, I find that the total number of IFRS 7 words are positively priced by investors suggesting that managers’ risk disclosures decrease information asymmetry between firms and shareholders. In addition, I find that liquidity risk disclosure is an important category as this information is positively priced by the equity market. Moreover, the positive price reaction to IFRS 7 risk disclosures is stronger for more leveraged firms compared to less leveraged firms, indicating that managers’ risk disclosures are more relevant for these firms. Overall, the results show that investors positively react to IFRS 7 risk disclosures in which managers discuss the financial instrument risks and how they manage and control these risks.
In the second part of the paper, I assess the equity market effects of the interaction between managers’ and auditors’ risk disclosures. To that aim, I exploit the recent adoption of the audit report in the UK. In 2013, the UK’s regulatory body Federal Reporting (FRC)
implemented new requirements to the audit reporting model in an attempt to enhance the informational value for investors by providing firm-specific information obtained throughout the audit (PCAOB, 2013). Central to the expanded audit report (EAR), formalized in the International Standard of Auditing (ISA) 700, is the requirement for auditors to disclose risk of material misstatements (RMMs) (Brasel et al., 2016). By doing this, auditors express their opinion about the most significant risks related to the audited firm (Lennox, Schmidt and Thompson, 2018). Auditors’ risk disclosures related to the entity could potentially reveal management’s ineffective internal control over the firm and their inability to prepare reliable financial reports (Doyle, Ge and McVay, 2007; Kim, Song and Zhang, 2011). Given that investors use company-specific audit information (Menon and Williams, 2010), questions arise whether auditors’ disclosure of entity-RMMs interact with IFRS 7 risk disclosures. I choose to do this because the information prepared by managers may not be perceived as credible by investors, given managers’ potential to skew disclosures for their own benefit (Kothari, Li and Short, 2009). The external auditor thus plays a critical role in assuring the reliability and credibility of firm disclosures by the issuance of the audit report (Francis et al., 2017).
In order to test my expectations, I draw on a hand-collected dataset consisting of EAR disclosures for the years 2013 to 2016. Specifically, I use RMM information for 411 premium listed non-financial firms.3 Results show that entity-RMM disclosures are negatively priced by investors. However, this negative price reaction is less strong for firms that provide more IFRS 7 risk disclosures, which underlines the positive price effect of managers’ risk disclosures. Overall, the results indicate that managers’ and auditors’ risk disclosures are both priced by equity investors and can therefore be seen as complements in providing information to investors.
3 More specifically, I include RMMs related to the company (i.e., entity-RMMs) in the tests. Entity-RMM is computed as a dummy variable and reflects the risks that are related to the going concern assumption, fraud and/or management override of control.
This paper contributes to the existent literature in several ways. First, this study provides evidence on the importance of IFRS 7 risk disclosures for investors in a non-financial setting. Extent studies provide evidence of the impact of financial instruments information for financial firms (e.g., Fiechter, 2011, Gebhardt and Novotny-Farkas, 2011). Nevertheless, current studies highlight the need for research on the importance of financial instrument disclosure in a non-financial setting (Gebhardt, 2012). Answering to this call, this is the first study that investigates the relationship between IFRS 7 disclosures and investors’ reaction. Second, this study provides early evidence on the effects of the expanded audit report. Specifically, this adds to existent literature, which examines the impact of RMMs using an equity perspective (Gutierrez et al., 2018; Lennox et al., 2018; Reid et al., 2015) and a debt-market perspective (Porumb et al., 2018). In addition to other studies, this paper investigates the influence of managers’ risk disclosures on the equity market reaction to RMMs. Overall, results suggest that investors use both managers’ and auditors’ risk disclosures and can therefore be seen as complement channels for providing information. Third, the results are of interest to regulators and standard setters. Results show that IFRS 7 risk disclosures are effective in reducing information asymmetry between companies and investors. Standard setters could improve the effectiveness of the standard by asking more comprehensive risk disclosures. Finally, managers can benefit from this study as the results indicate that IFRS 7 risk disclosures have a positive stock price effect, especially for more leveraged firms. In addition, the managers’ risk disclosures can hamper the negative price reaction to auditors’ risk disclosures.
The rest of the paper is structured as follows. Section II presents the regulatory background of IFRS 7 and the EAR. Section Ⅲ provides the theoretical background and the formulation of hypotheses. Section Ⅳ contains the research methodology whereas sections Ⅴ includes the results and robustness tests. Section Ⅵ concludes this paper.
II. Regulatory Background IFRS 7 Financial Instruments
The IFRS 7 Financial Instruments: Disclosures standard requires both financial and non-financial firms with any financial instruments to provide financial statement users with quantitative and qualitative information regarding their instruments (IFRS 7, 2005). Accounting standard setters aim to enhance the transparency of financial instrument risks. In turn, this has to contribute to investors’ understanding of these risks, which will enhance their decisions-making process (IASB, 2005). The standard can be divided into two main sections where management has to disclose information on (1) “the significance of financial instruments for the entity’s financial position and performance” (IFRS 7, 2005, 5). In addition, managers have to report on (2) “the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks” (IFRS 7, 2005, 5).
The standard describes that financial instruments are generally exposed to credit, liquidity and market risks (IFRS 7, 2005). According to IFRS 7, credit risk is the risk that another party related to a financial instrument fails to meet their obligation which creates a financial loss for the other party. The risk of failing to meet obligations associated with financial liabilities, which are settled by the delivery of an asset is called liquidity risk. Market risk is composed of interest, currency and other price risk and, it is the risk of fluctuation in financial instruments’ future cash flow because of changing interest rates, exchange rates or other market prices (IFRS 7, 2005). For each risk, managers have to report the extent of risk exposure and the strategies to manage and measure the risks (IFRS 7, 2005). These risk disclosures are given “through the eyes of management”, and reflect the manner in which firms control and manage their risks (PwC, 2010, 2). The standard allows managers to show their internal control measures and their ability to manage risks (PwC, 2010).
Appendix A provides a summary of the IFRS 7 standard whereas Appendix B shows an example of managers’ disclosures related to credit, liquidity, and market risk.
Expanded Audit Report (EAR)
The traditional audit report is argued to be a pass/fail model in which auditors only express their opinion on whether financial statements are presented in a fair manner (unqualified opinion), or not (qualified opinion) (Lennox et al., 2018). This standardized manner of communicating audit opinions is therefore criticized for a lack of informational content since it does not communicate firm-specific information (Church, Shawn and McCracken, 2008; PCAOB, 2013).4 A reason for lacking informational value is that audit reports have not changed significantly since 1940 (Porumb et al., 2018).
In an attempt to enhance the information content of the audit report for financial statement users, standard setters (e.g., the PCAOB, IAASB and the FRC) proposed new requirements for auditors to report their audit findings. The UK formalized these proposals into ISA 700, which applies to all auditors of firms with a premium listing on the London Stock Exchange (LSE) on and after October 1, 2013 (Gutierrez et al., 2018; Lennox et al., 2018). All proposals have the same requirement to disclose risk of material misstatements (RMMs), which are the risks that had a major effect on the audit (Lennox et al., 2018).5 RMMs can be divided into entity-level and account-level RMMs (Lennox et al., 2018). Entity-level RMMs are risks related to the company as a whole whereas account-level risks relate to firms’ financial statement accounts.
4 For example, Lennox (2005) show that almost all publicly listed companies receive an unqualified opinion.
5 RMMs are defined as “those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period” (ISA 701, 3). Besides disclosure of RMMs, auditors are mandated to disclose (a) the scope of the audit and, (b) the applied materiality level (ISA 700, 2013). Similar to FRC’s objective and content of RMMs, the PCAOB (2013) requires auditors to disclose Critical Audit Matters (CAMs) whereas the IAASB (2013) requires to report on Key Audit Matters (KAMs) (Lennox et al., 2018).
Appendix C provides an example that differentiates between account-level and entity-level RMMs.
III. Theoretical Framework and hypotheses development Theoretical background
Agency theory is widely used in accounting research to justify an expected relationship to exist (Smith, 2017). The theory argues that, due to a separation between ownership and control, problems arise between firms’ management (the agents) and firms’ owners (the principals). Agency theory assumes that managers are self-interested and therefore problems arise when management has conflicting interests relative to investors (Bosse and Philips, 2016). In turn, the agent may not always act to the benefit of the principal (Healy and Palepu, 2001). Furthermore, the theory describes that managers are mostly involved with firms’ day-to-day operations and they have access to valuable, company-specific information that is not available to the investor (Healy and Palepu, 2001). This situation, where companies are more informed relative to shareholders, is called information asymmetry (Jensen and Meckling, 1976) and it is the fundamental problem between managers and investors (Bosse and Philips, 2016). Information asymmetry is fundamental to agency problems since managers’ information advantage creates possibilities (or increases the likelihood) that they will not act in line with the interests of investors (Bosse and Philips, 2016). Investors are aware of managers’ opportunistic incentives and therefore price this information problem in their assessment of firm value (Beyer et al., 2010; Healy and Palepu, 2001).
Since this information gap has economic consequences for firms, various studies have focused on ways in which firms could reduce information asymmetries between management and investors. One mechanism to reduce the information gap is to disclose firms’ private
information to investors (Jensen and Meckling, 1976).6 The underlying premise is that disclosure of information reduces information asymmetry between companies and shareholders.
The consequences of risk disclosures are extensively debated in literature (Elshandidy et al., 2018; Ryan, 1997, 2012a) and the results remain inconclusive on whether risk disclosures decrease or increase information asymmetry between managers and investors (Kravet and Muslu, 2013). Since investors are not involved in firms’ operations on a daily basis, they may not be fully aware of the risk exposures. The disclosure of these risks contributes to investors’ understanding of the extent of risk exposure and enables them to make more informed and accurate stock price investments (Deumes, 2008; Kravet and Muslu, 2013). In this way, risk disclosures decrease information asymmetry since it enhances investors’ understanding of risk exposures and management (Linsmeier et al., 2002; Rajgopal, 1999). However, the disclosure of risk information can also reveal new risks and ambiguity to investors. In this manner, managers’ risk disclosures increase information asymmetry as it increase investors risk perceptions of the firm (Campbell et al., 2014; Kravet and Muslu, 2013).
Moreover, since management has opportunistic incentives to manipulate information for their own benefit (Healy and Wahlen, 1999), managers’ risk disclosures may not be viewed as credible by investors (Healy and Palepu, 2009; Kothari et al., 2009) and thus, it would not be effective in reducing the information gap between managers and equity investors. Therefore, the independent external auditor plays a critical role in the verification of financial statement information in terms of credibility and accurateness (DeFond and Zhang, 2014; Francis et al., 2017). This makes managers able to credibly disclose information provided in the annual report, which could decrease or increase information asymmetries (Kothari et al., 2009).
The audit report can further be an information source for investors that could be useful for their stock price decision. Although the traditional audit report is criticized for a lack of informational value (e.g., Church et al., 2008), several studies (Fleak and Wilson, 1994; Menon and Williams, 2010) show that equity investors find non-standard audit opinions to be useful.7 Prior to the introduction of the expanded audit report, this was the sole way of providing firm-specific information (Chen et al., 2016). This suggests that investors use company-firm-specific information obtained from audit reports as input for their decisions.
Hypotheses development
Current empirical research is inconclusive on whether risk information decreases or increases information asymmetry between management and investors (Kravet and Muslu, 2013). For example, Kothari et al. (2009) observe a rise in firms’ volatility and wider analysts forecast dispersion because of managers’ risk disclosures. Campbell et al. (2014) show that the length of risk disclosures are associated with low bid-ask spreads. Kravet and Muslu (2013) find that more risk sentences in annual reports result in higher values of several proxies for information asymmetry suggesting that more risk disclosures cause an increase in information asymmetry. These studies argue that risk disclosures reveal new and unknown risks that increase investors’ risk perceptions of firms. In turn, investors price this increased information asymmetry in their decisions.
In contrast, Hope et al. (2016) show that more specific risk disclosures result in higher cumulative abnormal returns. Rajgopal (1999) shows an association between disclosure of market exposure risks and stock return sensitivities. Furthermore, Linsmeier et al. (2002) find that market risk disclosures reduce sensitivities in trading volume. These papers argue that
7 In addition, Chen et al. (2016) provide additional evidence that lenders use modified audit opinions as an input for their lending contracts.
managers’ risk disclosures contributes to investors’ understanding of risk exposure and management of these risks. In turn, investors prices this decreased information asymmetry in their investment decisions.
Based on prior research, it is not a priori clear how IFRS 7 risk disclosures are priced by equity investors. In accordance with the aim of standard setters, managers’ risk disclosures can be positively priced by equity investors if risk information contributes to investors’ understanding of risk exposures and risk management. In contrast, investors can negatively react to the disclosure of IFRS 7 risk information when it communicates unknown and new risks to shareholders, thereby increasing investors’ perceptions of firms’ risk exposures. The first hypothesis is concerned with whether IFRS 7 risk disclosures are priced by investors. Therefore, I formulate the following (non-directional) hypothesis:
Hypothesis 1: The disclosure of IFRS 7 information is priced by equity investors.
Firms with higher amounts of leverage are likely to be more risky and speculative (Elshandidy, Fraser and Hussainey, 2013). According to financial theory, higher levels of leverage increase firms’ risk of bankruptcy and therefore make firms more risky (Miihkinen, 2010). Because firms are more vulnerable to risks, investors’ perceptions of firm risk exposures increase (Kravet and Muslu, 2013). Therefore, it is argued that the price reaction to managers’ risk disclosures is stronger for more leveraged firms as the discussion and management of risks are more relevant for these firms (Campbell et al., 2014).
However, banks have a monitoring role in which they monitor and evaluate the creditworthiness of borrowing firms (Porumb et al., 2018). This monitoring role shapes the content of debt covenants which are used to restrict firms during financial distress, actions during merger bids, in their investments choices and in their financing policy (Armstrong, Guay and Weber, 2010; Chava, Kuma and Warga, 2009). This role of lenders can be viewed as
information gathering (Allen, 1990) where creditors act on behalf of shareholders to obtain information about the borrowing firms. Because lenders restrict firms in their actions, banks decrease the risks associated with a higher level of leverage.
Based on prior research, it is not clear how equity market participants react to IFRS 7 risk disclosures of more leveraged firms. Given that IFRS 7 risk information is priced by investors (e.g., Kravet and Muslu, 2013; Linsmeier et al., 2002), this price reaction could be stronger for highly leveraged firms because investors find the risk disclosures more relevant. However, the monitoring role of banks could decrease the risks associated with higher leverage and lower information asymmetry between firms and investors. This would result in no stronger price reaction. In the second hypothesis, I examine whether investors’ price reaction to IFRS 7 risk disclosures is stronger for more leveraged firms. Therefore, I formulate the following hypothesis in alternative form:
Hypothesis 2: IFRS 7 risk disclosures of leveraged firms are priced more strongly relative to the IFRS 7 risk disclosures of less leveraged firms.
In addition to managers’ risk disclosures, investors use firm-specific information in audit reports to evaluate firms and for decision-making purposes (Chen et al., 2016; Fleak and Wilson, 1994; Menon and Williams, 2010). Doyle et al. (2007) show that users discriminate between account-level and entity-level information in audit reports. Results suggest that entity related internal control weaknesses (ICW) cause lower accrual quality. Kim et al. (2011) find that lenders demand a higher loan rate for firms with entity-wide ICWs compared to firms with account-level ICWs. Both papers rely on the argument that users negatively price entity-level information since these disclosures potentially reveal management’s ineffective internal control and their inability to disclose reliable information. Account-level information is
however “auditable” and does not materially affect the reliability of financial numbers (Doyle et al., 2007; Kim et al., 2011).
The disclosure of RMMs increase the perceived riskiness of a firm and users price this uncertainty in their decisions (Porumb et al., 2018). I therefore expect that investors negatively react to firms with entity related RMMs. Since investors price both management’s and auditors’ disclosures (Kravet and Muslu, 2013; Linsmeier et al. 2002; Manon and Williams, 2010), I expect that IFRS 7 risk disclosures will moderate this price effect. Therefore, I formulate the following hypothesis:
Hypothesis 3: The disclosure of IFRS 7 information moderates the negative price effect of entity-RMMs disclosures.
IV. Methodology Sample selection
This study draws on hand-collected annual report data from non-financial firms with a premium listing on the LSE. Financial firms are excluded because this study tries to capture the equity market effects in a non-financial setting.8 This resulted in a sample of 411 premium listed firms. In order to test my contentions, I use two sets of hand-collected data for different periods. In the first part of this study, I use IFRS 7 annual report data for the years 2010 to 2016. All annual reports are obtained from firm websites and for every annual report, I hand-collect the (total) number of words of (all) IFRS 7 risk categories and the fair values for level 1 – 3.9 The number of words are determined by the use of Word Count and registered in the
8 In addition, most financial firms differ significantly in terms of financial characteristics (Gebhardt, 2012). In turn, these firms could make significantly different risk disclosures (Linsley and Shrives, 2006) which could bias results.
9 IFRS 7 (paragraph 27A) requires disclosures of how financial instruments are calculated by references to the ‘fair value hierarchy’. This hierarchy shows which inputs management has used to calculate the fair values of financial instruments. For both financial assets and liabilities, the hierarchy has three different levels of inputs. Level 1 are market prices for similar assets and liabilities, Level 2 are all inputs other than level 1 that are (in)directly observable, Level 3 refer to inputs that are not observable in the market (IFRS 13.72).
database. This resulted in 1577 observations for each risk category and 1374 observations for each fair value level respectively.
In the second stage, I use hand-collected EAR data for the 2013-2016 period.10 For each reported RMM, the description of the risk is qualitatively described in the database. This gives the opportunity to determine whether the RMM is related to the entity or to the financial accounts. This resulted in 251 observations. Firms’ stock price data and other financial data are retrieved from DataStream.
Empirical model
This study uses GLS panel regression with random effects to investigate my expectations. The panel data set, for which observations are collected for the 2010-2016 period, reduces collinearity among the test variables (Hsiao, 2007). Hausman test reveals that random effects is an appropriate choice, which allows me to analyse the time-constant variables. I estimate the empirical model by the use of the following regressions:
Price = ß0 + ß1IFRS 7 disclosures + ß2Controls
+ (Year Dummy + Industry Dummy) + ε
(1)
Price = ß0 + ß1IFRS 7 disclosures + ß2 Entity-RMM
+ (ß3IFRS 7 disclosures*Entity-RMM) + ß4Controls + (Year Dummy + Industry Dummy) + ε
(2)
10 ISA 700 applies to all audit firms who have clients with a premium listing on the LSE with fiscal years ending on and after October, 1 (Lennox et al., 2018).
where Price represents investors’ stock price reaction using a one-day and three-day window. IFRS 7 disclosures represents the quantity of IFRS 7 risk information. Entity-RMM represents RMMs that are related to the entity. All variables are defined in table 1.
[Insert table 1 about here]
The dependent variable of interest, Price, is computed using a one-day and three-day window.11 Specifically, I calculate the stock price reaction around the date the annual report became public to financial statement users over a one-day and three-day period. I follow Gutierrez et al. (2018) by calculating stock price returns as (1) stock pricet=1 minus stock price t-1 divided by stock pricet-1 and, (2) stock pricet=3 minus stock pricet-1 divided by stock price t-1.12
IFRS 7 disclosures and Entity-RMM are the two main independent variables of interest
in this study. In line with Miihkinen (2010), IFRS 7 disclosures is calculated as the natural logarithm of the number of risk words. I split managers’ risk disclosures into six categories. Specifically, I use the natural logarithm of the number of (1) Total risk, (2) Interest rate risk, (3) Currency risk, (4) Other price risk, (5) Liquidity risk, and (6) Credit risk words in my tests. In addition, I discriminate between Non-diversifiable and Diversifiable risks, which are computed as the sum of (i) Interest and Currency risk and, (ii) Liquidity and Credit risk, respectively.13
Entity-RMM is computed based upon Moody’s ranking for credit firms (Doyle et al.,
2007). More specifically, I follow Lennox et al. (2018) for differentiating between RMMs
11 Defining event windows longer than the specific event data (i.e., publication of the annual reports) allows me to examine the period surrounding the date (MacKinlay, 1997). Therefore, I choose to define a one-day and three-day period to investigate the effects on the stock price using multiple windows.
12 Daily stock prices are used to compute the stock price reaction (Brown & Warner, 1985; MacKinlay, 1977). 13 Subsequently, I take the natural logarithm of the sum of the risk categories.
categories. Entity-RMM is a dummy variable where one represents RMMs related to fraud, the going concern assumption and/or management override of internal control and, zero otherwise.
Following the studies of Gutierrez et al. (2018) and Lennox et al. (2018), it is necessary to control for other variables that could have an influence on investors’ price reaction to the publication of the annual report. In accordance with this research, I include market-to-book ratio (MTB) which controls for firms’ growth opportunities, Leverage, to control for different amounts of debt and agency problems and Size to control for differences in firms’ size. In addition, I control for firms’ information environment by including Subsidiaries whereas Loss controls for firm performance. Current ratio is included to control for firms’ ability to meet their short-term financial obligations. In order to prevent results to be biased by the confounding effect of IFRS 9, I control for fair value measurement values by the use of hand-collected data (Fa_11–Fl_l3).14 Auditor opinion is included to control for the effects of receiving a qualified opinion. Year dummies and Industry dummies are included to control for year effects and differences in firm risks, respectively. O-score controls for the likelihood of firms to go bankrupt (Ohlson, 1980). Last, I include audit dummies to control for differences in audit quality (DeAngelo and Elizabeth, 1981). Before testing, I winsorize all the necessary variables at a 1% and 99% interval to reduce the influence of outliers.
V. Results Summary Statistics
Table 2 provides an oversight of the descriptive statistics for all the variables used in this study.
14 Firms using (more) level three inputs indicate that management has to determine the values based upon their human judgement and managerial estimates. This is because level three inputs are not observable to the market. In turn, managers have more room to determine financial instruments’ values, which can influence investors’ price reaction, as they are aware of the opportunistic incentives of management (Beyer et al., 2010; Healy and Palepu, 2010). Moreover, Roggi and Gianozzi (2015) find that investors react to the different fair value level inputs. Since IFRS 7 incorporates the fair value measurement of IFRS 9, I include this variable in all regressions to control for this influence.
[Insert table 2 about here]
Table 3 presents Pearson correlations for all the used variables. All correlations are below the accepted benchmark of 0.7, which indicates no multicollinearity issues, except for
Currency (0.704) and Liquidity (0.740) with Total. Because Total number of words is
composed of Currency and Liquidity risk, both variables will be used in the tests. The correlation between two measures of IFRS 9 (Fl_12 and Fa_12) are above the standard of 0.7. VIF test is another test to check for multicollinearity problems. Untabulated results show that for all variables values are below 10 suggesting that multicollinearity is not a problem. Nevertheless, all models are re-estimated without these variables in robustness tests to validate the results.
[Insert table 3 about here]
IFRS 7 risk disclosures
Table 4 provides the results of the regression for estimating IFRS 7 risk disclosures on investors’ stock price reaction. More specifically, Column (1) contains the stock price reaction to the total number of IFRS 7 words using a one-day window. Specifically, Total has a positive and non-significant coefficient (0.003, p>0.10) suggesting that investors do not price managers’ risk disclosures over a one-day period.
Column (2) presents investors’ price reaction to the total number of IFRS 7 words over a three-day window. Specifically, the coefficient of Total is positive and significant (0.008, p<0.10), indicating that a higher amount of total IFRS 7 words are positively priced by
investors. This supports the notion that managers’ risk disclosures reduce information asymmetry between companies and equity market participants.
[Insert table 4 about here]
Table 5 shows the results of the regression of the IFRS 7 risk categories combined on the stock price reaction over a one-day and three-day window. Specifically, Column (1) presents the effect of interest, currency, liquidity and credit risk words on the stock price reaction one day after the publication of the annual report. Specifically, Interest shows a negative, non-significant coefficient (-0.002, p>0.10) while the coefficient of Currency is positive and non-significant (0.002, p>0.10). Liquidity has a negative and non-significant coefficient (-0.000, p>0.10) whereas Credit has a positive, non-significant coefficient (0.003, p>0.10). This suggests that investors do not price the different IFRS 7 risk categories over a one-day window.
Column (2) contains the equity market reaction to interest, currency, liquidity and credit risk words using a three-day window. Specifically, Liquidity has a positive and significant coefficient (0.005, p<0.05), suggesting that more words spend on liquidity risks result in a positive stock price reaction. Interest shows a non-significant, negative coefficient (-0.001, p>0.10) whereas Currency and Credit have positive, non-significant coefficients (0.001, p>0.10 and (0.005, p>0.10).
Overall, Table 4 and 5 show that IFRS 7 risk disclosures are priced over a three-day window. Subsequently, it can be concluded that investors price managers’ risk disclosures. This confirms Hypothesis 1, which states that the disclosure of IFRS 7 risk information is priced by investors. The results reveal a positive equity market reaction, which is in line with
the notion that risk disclosures decrease information asymmetry between companies and shareholders.
[Insert table 5 about here]
IFRS 7 risk disclosures and Leverage
Table 6 provides the one-day and three-day stock price reaction to IFRS 7 disclosures for leveraged firms. More specifically, Column (1) and (2) show the stock price effect of Total interacted with Leverage over a one-day and three-day period. Specifically, the interaction of
Total with Leverage has a positive and significant coefficient over a one-day window (5.039,
p<0.05) and three-day window (5.635, p<0.05), suggesting that the stock price reaction to IFRS 7 risk disclosures is stronger for firms with a higher level of leverage.
In Column (3) and (4), the interaction terms of Diversifiable and Leverage are shown. More specifically, the interaction coefficients are positive and significant for a one-day and three-day window (3.560, p<0.01 and 2.916, p<0.10), indicating that more words spent on liquidity and credit risks result in stronger stock price reactions for leveraged firms, relative to less leveraged firms.
Column (5) and (6) presents the interaction coefficients of Non-diversifiable and
Leverage. Specifically, the interaction coefficient for Non-diversifiable and Leverage is
positive and significant for a one-day window (3.145, p<0.10), but positive and non-significant using a three-day window (0.189, p>0.10).
Overall, Table 6 suggests that the stock price reaction to risk disclosures is stronger for more leveraged firms relative to less leveraged firms. This support the notion that IFRS 7 risk are more important for leveraged firms, which result in a stronger price effect. This confirms Hypothesis 2.
[Insert table 6 about here]
IFRS 7 risk disclosures and Entity-RMMs
Table 7 shows the influence of IFRS 7 risk disclosures on the stock price reaction to the disclosure of entity related RMMs. The coefficient of interest is Interaction, which captures the moderating impact of three IFRS 7 variables on the stock price reaction to entity-RMMs. Specifically, Column (1) and (2) assess the impact of the total number of IFRS 7 words on the stock price reaction to entity-RMM disclosures a one-day and three-day window. The interaction coefficient of Total and Entity-RMM is significant and positive for a one-day window (0.044, p<0.01), and positive but non-significant for a three-day window (0.001, p>0.10).
In column (3) and (4), the interaction coefficients of diversifiable risks and entity-RMMs are shown. Specifically, the interaction coefficient of Diversifiable and Entity-RMM is positive and significant for a one-day period (0.031, p<0.10), but negative and insignificant for a three-day window (-0.002, p>0.10).
As shown in Column (5) and (6), I assess the impact of non-diversifiable risks on the equity market reaction to entity related RMMs. The interaction coefficient of Non-diversifiable and Entity-RMM is significant and positive for a one-day window (0.024, p<0.05) and positive but non-significant for a three-day window (0.006, p>0.10).
The results suggest that investors negatively price firms with entity related RMMs.15 This is in line with the notion that entity-RMMs signal ineffective management control and inability to generate reliable financial reports. However, the positive interaction coefficients
suggest that this negative price effect is less strong for firms with more IFRS 7 disclosures. This underlines the positive price effect of IFRS 7 risk disclosures. Overall, the results support the view that investors use both managers’ and auditors’ risk disclosures, confirming Hypothesis 3.
[Insert table 7 about here]
Additional analysis
Diversifiable vs. non-diversifiable risk category
Given that IFRS 7 risk disclosures are useful to investors, I assess whether investors discriminate between diversifiable and non-diversifiable risk categories. Non-diversifiable (systematic) risks are the risks that cannot be diversified by holding a diversified security portfolio. In contrast, diversifiable (i.e., unsystematic) risks are firm-specific and can be reduced by diversification (Heinle, Smith and Verrechia, 2018; Montgomery and Singh, 1984). Several studies highlight that non-diversifiable risks are more relevant to investors as they can diversify unsystematic risk by holding a well-diversified equity portfolio (Lambert, Leuz and Verrechia, 2007; Heinle and Smith, 2018). Linsmeier et al. (2002) show that investors price systematic risk disclosures. Moreover, Heinle and Smith (2018) find that only diversifiable risk disclosures will have an impact on the allocation of capital. Thus, it can be expected that diversifiable IFRS 7 risk categories (i.e., liquidity and credit risk) are less relevant to investors relative to non-diversifiable IFRS 7 risk categories (i.e., interest, currency and other price risk).
Untabulated results suggest that investors do not price non-diversifiable risk categories. More specifically, Non-diversifiable shows a non-significant coefficient when interacting with investors’ price reaction. This is not in line with the expectation that non-diversifiable risks are useful to investors. In contrast, Diversifiable has a positive and highly coefficient indicating
that a higher level of this type of disclosure results in a positive equity market reaction. These findings contrast the expectations, but support the findings in table 5.
Robustness tests
This section provides the robustness tests to ensure that the results are not driven by particular choices I made. All coefficients are re-estimated and reveal that the main findings are not significantly different compared to the results as discussed below.
First, I re-calculated the stock price reaction with another price variable. Daily stock prices are used in the main analysis while return indices are used for robustness tests.16 Results suggest that the findings are partially robust for this choice. More specifically, untabulated results show that the interaction coefficient of Total and Leverage is positive and significant at a 1% significance whereas the coefficient of Diversifiable x Leverage remains positive and significant at a 5% confidence level. In contrast, Non-diversifiable x Leverage is positive, but no longer significant. These findings are largely in line with the results presented in Table 6. The coefficients of Total, Diversifiable and Non-diversifiable interacted with Entity-RMM remain positive and at the same level of significance. This supports the findings in table 7. With respect to Hypothesis 1, untabulated results show that the coefficients are no longer significant. However, the sign remains consistent with the notion that managers’ risk disclosures are positively priced by investors.
In addition, I used several variables in Table 6 and 7 to validate the results. The tables incorporate three different variables to investigate the influence of IFRS 7 risk information for leveraged firms and entity-RMMs, respectively. As shown in the main results, all coefficients
16 In accordance with related research, daily stock price data is used as the first choice to compute stock price returns (Brown & Warner, 1985; MackKinlay, 1977).
show a positive sign.17 This supports the qualitative argument that risk disclosures reduce information asymmetry between investors and shareholders.
The Pearson correlation test reveal that the correlation between Fl_l2 is Fa_l2 is slightly higher than accepted. This correlation potentially bias the results and therefore I re-estimate all coefficients for all models to control for this influence. With respect to Hypothesis 1, untabulated findings suggest that the coefficient of Total is still positive and significant at a 10% level. In contrast, the multivariate analysis of all IFRS 7 categories combined is no longer significant but the sign remains positive. Given Hypothesis 2, the untabulated interaction coefficients of Total and Diversifiable with Leverage remain positive and significant at a 5% and 10% level, respectively. The coefficient of Non-diversifiable and Leverage lose significance but remains positive. With reference to Hypothesis 3, the coefficients of the interaction effect of Total, Diversifiable and Non-Diversifiable with Entity-RMM have the same sign and significance level. This suggests that the findings in all models are robust for my choice to include the correlated variables, except for table 5. Although the results in this table lose significance, the sign again remains the same.
Industry dummies are not used in the main analysis because the variable dropped the number of observations from 354 to 222. To check if this choice does not influence the main results, I re-estimate all models including the industry dummy. With respect to Hypothesis 1, untabulated results show that the coefficient of Total number remains positive and significant at a 5% level whereas multivariate regressions reveal non-significant, positive coefficients. With respect to Hypothesis 2, untabulated findings show that the coefficients in all models are positive but no longer significant. In contrast, the coefficients of the interaction effect of Total,
Diversifiable and Non-diversifiable with Entity-RMM are still positive and significant at a 1%,
17 Except for Table 7, Column (4).
10% and 1%, respectively. Overall, the results are partially robust to the inclusion of an industry dummy.
VI. Conclusion
Accounting standard setters developed IFRS 7 financial instrument disclosures in a response to an increased demand for risk reporting. Given the lack of research of these risk disclosures in a non-financial setting, this study investigates investors’ price reaction to IFRS 7 risk disclosures using non-financial premium listed firms. To test my assumptions, I use hand-collected IFRS 7 annual report data for 411 listed firms for the 2010-2016 period. Results suggest that managers’ risk disclosures are positively priced by investors. In addition, I find a positive equity market reaction to liquidity risk indicating that investors find this category important. Moreover, the positive stock price reaction to IFRS 7 risk disclosures is stronger for leveraged firms, relative to less leveraged firms. The results are in line with the notion that managers’ risk disclosures reduce information asymmetry between companies and investors, which result in a positive price reaction to these risk disclosures.
In the second part of this study, I investigate the impact of IFRS 7 risk disclosures on the stock price reaction to entity related risk disclosures. Entity-RMMs could reveal inadequate internal control over the firm and managers’ inability to produce reliable financial statements. Using hand-collected RMM information for 411 premium listed UK firms for the years 2013 to 2016, I find that investors negatively react to entity-RMM disclosures. However, the negative stock price effect is less strong for firms disclosing more IFRS 7 information, which underlines the positive price effect of IFRS 7 risk disclosures. Overall, this suggests that investors use both managers’ and auditors’ risk disclosures and can therefore be seen as complement sources in providing information.
The contributions of this study are as follows. First, answering the call for investigating the implications of financial instrument disclosures for non-financial firms, this paper is the first that empirically investigates investors’ price reaction to IFRS 7 risk disclosures in a non-financial setting. Second, this study adds to the emerging stream of research that examines the effects of the expanded audit report by examining the equity market reaction to entity-RMM disclosures and the moderating impact of managers’ risk disclosures. In addition, this study contributes to the knowledge of regulators and standard setters by providing evidence that IFRS 7 risk information is effective in reducing information asymmetries between firms and investors. Finally, management may benefit from disclosing more IFRS 7 risk information as this is positively priced by investors, especially for leveraged firms. Moreover, managers’ risk disclosures can hamper the negative stock price effects of entity-RMM disclosures.
The study has the following limitations, which provide input for further research. Although small windows are chosen to reduce the confounding effect on the stock price reaction, there might be a possibility that other variables unrelated to the event influenced the stock price effect. In addition, this study uses company returns as a proxy for investors’ price reaction. Future research could measure the equity market reaction by including abnormal returns and abnormal volume trading, which adjust for normal performance and individual investor expectations. This study takes the quantity of IFRS 7 information as a measure of managers’ risk disclosures. It is interesting to develop this study by incorporating other measures of IFRS 7 risk disclosures (e.g., the quality of IFRS 7 risk disclosures). In addition, this study investigates the effects of managers’ risk disclosures for the primary users of the annual report. A possible avenue for future research is to investigate the importance of IFRS 7 risk disclosures from a debt-market perspective. Although I control for the confounding effect of IFRS 9, it is interesting to investigate whether investors discriminate between the different fair value levels and how IFRS 9 influences investors’ reaction to IFRS 7 risk disclosures.
Furthermore, IFRS 9 level three demands subjectivity as managers have to use judgement and estimates to value their financial instruments. In turn, it is interesting to investigate how this relates to entity-RMMs, which includes the assessment of management override of internal control. Finally, this study uses RMM data for the 2013-2016 period, which is directly after the introduction of the expanded audit report. Future research could perform the same study with more recent data to provide the implications of entity-RMMs for the current period.
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Table 1
Definition of variables
Variables Definition
Price
The stock price reaction around the publication of the annual report, calculated over different periods. Company returns over a one-day windows are calculated as the (stock pricet=1 minus stock pricet-1)/(stock pricet-1). Three-day windows are
calculated as (stock pricet=3 minus stock pricet-1)/ stock pricet-1) (from DataStream);
Total The natural logarithm of the total number of words firms devote to their discussion
of financial instrument risks (hand–collected);
Interest The natural logarithm of the number of words firms devote to their discussion of
interest risks (hand–collected);
Currency The natural logarithm of the number of words firms devote to their discussion of
currency risks (hand–collected);
Other The natural logarithm of the number of words firms devote to their discussion of
other price risks (hand–collected);
Liquidity The natural logarithm of the number of words firms devote to their discussion of
liquidity risks (hand–collected);
Credit The natural logarithm of the number of words firms devote to their discussion of
credit risks (hand–collected);
Non-diversifiable The natural logarithm of the number of words firms devote to their discussion of
non-diversifiable risks (sum of interest rate risk and currency risk) (hand–collected);
Diversifiable The natural logarithm of the number of words firms devote to their discussion of
diversifiable risks (sum of liquidity risk and credit risk) (hand–collected);
Entity-RMM
A dummy variable where 1 represents disclosed RMMs related to either the going concern assumption, fraud or management override of internal control and, 0 otherwise;
Current ratio The ratio of firm’s current total assets divided by current liabilities (from
DataStream);
O-score
O-score is Ohlson’s (1980) predictor of whether firms are likely to go bankrupt. It is calculated in the following way: O-score = -1.32 - 0.407 (ln(total assets) + 6.03 (total liabilities / total assets) - 1.43 (working capital / total assets) + 0.076 (current liabilities / current assets) - 1.72 (1 if total liabilities > total assets and 0 otherwise) - 0.521 ((net income t - net income t-1) / ((absolute value of net income + absolute value of net income t-1)) (from DataStream);
MTB The ratio of firm’s equity market value to shareholders’ equity (from DataStream); Size The natural logarithm of firms’ total assets (from DataStream);
Leverage The ratio of firms’ total debt to total assets (from DataStream); Subsidiaries The natural logarithm of firms’ number of subsidiaries;
Loss Dummy variables that takes the value of 1 when firms’ net income is positive, 0 when it is negative (from DataStream);
Fa_l1- Fl_l3 The value of fair value levels 1 to 3 for financial assets (Fa) and financial liabilities
(Fl), millions of pounds (hand-collected);
Auditor opinion Dummy variable that takes the number of 1 when firms’ receive an unqualified
opinion and, 0 otherwise;
Audit firm
Dummy variable that takes the number of 1 when an audit is performed by a BIG-4 audit firm and, 0 otherwise.
Table 2
Descriptive Statistics
Panel A: Descriptive statistics for dependent variables
Variable N Mean Std. Dev. Min Max
Price at t=1 1,096 0.002 0.269 -0.089 0.317
Price at t=3 1,096 -0.001 0.036 -0.210 0.305
Panel B: Descriptive statistics for independent variables
Total 1,782 6.981 0.568 5.231 8.179 Interest 1,705 5.344 0.784 2.197 6.179 Currency 1,651 5.664 0.768 2.708 7.107 Other 654 4.936 0.961 2.485 6.690 Liquidity 1,672 5.496 0.777 2.996 6.855 Credit 1,701 5.431 0.641 3.045 6.779 Non-diversifiable 1,766 6.213 0.679 2.639 7.595 Diversifiable 1,771 6.159 0.629 2.995 7.511 Entity-RMM 1,210 0.207 0.405 0 1
Panel C: Frequency table
Entity-RMM Freq (%) 0 959 (79.26) 1 251 (20.74) Total 1,210
Panel D: Descriptive statistics for controls
Current ratio 2,390 1.695 1.412 0.129 21.612 O-score 1,964 -3.987 1.655 7.505 0.817 MTB 2,103 0.003 0.013 0.346 0.272 Size 2,395 13.504 1.821 8.616 18.145 Leverage 2,202 473.663 1888.19 0 59949.86 Subsidiaries 1,947 3.183 1.916 1 9 Loss 2,653 0.103 0.304 0 1 Fa_l1 1,297 21.240 101.107 0 732.405 Fa_l2 1,298 12.645 587.061 0 5074 Fa_l3 1,297 20.352 79.83 0 542 Fl_l1 1,297 29.271 181.675 0 1506.415 Fl_l2 1,298 152.906 6582.36 0 5190 Fl_l3 1,298 22.901 125.003 0 1007.94 Auditor opinion 2,446 0.989 0.100 0 1
Table 3 Correlation Matrix Variables [1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16] [17] [18] [19] [20] [21] Price [1] 1.000 Total [2] -0.026 1.000 Interest [3] -0.073 0.649 1.000 Currency [4] -0.007 0.704 0.358 1.000 Other [5] 0.052 0.545 0.305 0.227 1.000 Liquidity [6] -0.015 0.740 0.443 0.384 0.415 1.000 Credit [7] 0.056 0.645 0.226 0.380 0.379 0.381 1.000 RMM-entity [8] 0.081 -0.033 -0.007 -0.003 0.076 -0.010 -0.048 1.000 Current ratio [9] 0.044 -0.087 -0.122 0.046 0.030 -0.154 0.054 -0.001 1.000 O-score [10] 0.050 -0.098 0.042 -0.132 -0.177 -0.060 -0.144 0.121 -0.344 1.000 MTB [11] 0.016 0.035 -0.019 -0.002 -0.102 0.038 0.028 -0.076 -0.025 0.073 1.000 Size [12] -0.112 0.468 0.353 0.231 0.234 0.448 0.254 -0.039 -0.212 -0.241 -0.023 1.000 Leverage [13] -0.030 0.136 0.156 0.055 0.146 0.130 0.088 0.178 -0.062 0.147 -0.033 0.103 1.000 Subsidiaries [14] -0.039 0.306 0.091 0.302 0.131 0.168 0.141 0.010 -0.108 -0.073 0.014 0.277 -0.070 1.000 Loss [15] -0.019 0.005 0.007 -0.011 0.043 -0.028 -0.001 0.205 0.051 0.125 -0.021 -0.009 0.079 0.013 1.000 Fa_l1 [16] -0.017 0.178 0.077 0.115 0.151 0.152 0.138 -0.009 0.126 -0.181 -0.013 0.358 -0.006 0.095 0.064 1.000 Fa_l2 [17] -0.027 0.169 0.064 0.037 0.247 0.139 0.138 0.024 -0.082 -0.073 -0.016 0.334 0.127 0.135 0.024 0.183 1.000 Fa_l3 [18] -0.063 0.238 0.116 0.113 0.323 0.161 0.204 -0.050 -0.003 -0.201 -0.007 0.412 -0.017 0.029 0.030 0.362 0.407 1.000 Fl_l1 [19] 0.000 0.055 0.039 0.079 0.064 0.082 0.061 0.095 -0.064 0.057 -0.132 0.172 0.414 -0.091 0.034 0.219 0.102 0.158 1.000 Fl_l2 [20] -0.004 0.160 0.056 0.030 0.201 0.161 0.131 -0.022 -0.096 -0.059 -0.002 0.342 0.099 0.089 0.028 0.275 0.717 0.323 0.271 1.000 Fl_l3 [21] -0.033 0.131 0.011 0.062 0.178 0.099 0.157 0.032 -0.010 -0.147 -0.004 0.288 0.050 0.045 0.062 0.231 0.394 0.388 0.139 0.342 1.000 Audit opinion [22] 0.031 0.002 0.02 -0.004 -0.001 -0.003 -0.003 0.001 -0.045 -0.049 0.016 0.097 -0.002 0.011 0.035 -0.017 0.016 0.017 -0.021 -0.041 0.016 All variables are defined in Table 1.
Table 4
The impact of the total number of IFRS 7 risk words on stock price reaction
Variables Price at t=1 Price at t=3
Total 0.003 0.008* (0.004) (0.004) Current ratio 0.000 0.001 (0.001) (0.001) O-score 0.001 0.001 (0.001) (0.001) MTB -0.217 0.526 (0.648) (0.700) Size -0.004*** -0.006*** (0.001) (0.002) Leverage 0.000* -0.000 (0.000) (0.000) Subsidiaries -0.000 -0.002 (0.002) (0.003) Loss -0.005 -0.010 (0.006) (0.008) Fa_l1 0.000*** 0.000*** (0.000) (0.000) Fa_12 0.000 -0.000 (0.000) (0.000) Fa_l3 0.000 0.000 (0.000) (0.000) Fl_l1 -0.000 0.000 (0.000) (0.000) Fl_l2 -0.000*** 0.000 (0.000) (0.000) Fl_l3 -0.000 -0.000 (0.000) (0.000) Auditor opinion 0.008 -0.007 (0.016) (0.018)
Year dummies Yes Yes
Audit firm Yes Yes
Constant 0.021 0.052
(0.026) (0.037)
Observations 354 354
R-squared 0.170 0.210
*** p<0.01, ** p<0.05, * p<0.1. Robust standard errors are used in all regressions. All variables are described in Table 1.
