Incentives for risk reporting

Incentives for risk reporting –

a discretionary disclosure and cheap talk approach

Presentation at the

30th Annual Conference of the EAA

Lisbon, April 26, 2007

Dr. Michael Dobler, MBR

Ludwig-Maximilians-University Munich

University of Ottawa

Introduction

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Risk reporting

„ information on the effects risks (and opportunities) may have on an entity's future economic position (risk factors, risk

management, risk forecasts)

„ risk-related disclosure that shall help users to assess the

distribution of future cash-flows or parameters of it (verifiable, non verifiable)

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Tradeoff

„ incentives

† literature: claimed benefits for preparers and users

† evidence: variation/restrictions in voluntary risk reporting

„ regulation

† literature: call for (more) regulation

Introduction

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Research question

„ risk reporting incentives in their relation to regulation

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Research approach

„ adoption, review and discussion of discretionary disclosure and cheap talk models

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Main results

„ incentives limited by on three levels

„ regulation may partly mitigate, but not overcome incentives

† Main contribution

„ qualifying prior assessments on risk reporting

„ analytically based considerations on risk reporting rules

Background

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Risk

„ uncertainty-based vs. target-based views

„ distributions of future outcomes

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Risk reporting

„ verifiable vs. non-verifiable risk information

„ risk-related disclosure that shall help users to assess the distribution of future cash-flows or parameters of it

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Risk management

„ information source for risk reporting

Background

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Regulation

„ piecemeal approach vs. comprehensive approach

„ table 1 (p. 30)

„ managers have room to exercise discretion

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Empirical evidence

„ large variation/restrictions in voluntary and mandatory risk reporting

„ table 2 (p. 31)

„ managers do exercise discretion

Review

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Basics

„

unraveling principle

„

verifiable vs. non-verifiable disclosure

„

expected values vs. variances

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Structure

„ verified risk reporting

† disclosure models on disclosure cost

† disclosure models on uncertainty of information availability

„ unverified risk reporting

† single-period cheap talk models

Review

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Disclosure cost

„

amendment:

disclosure associated with cost C > 0

„

general results

† withholding of (unfavorable) information: low cash flows, large variances of cash flows

† disclosure less likely with increasing cost C

„

Jorgensen & Kirschenheiter (2003)

† disclosure of variances less likely with increasing risk aversion of outsiders

† mandating disclosure of variances will (weakly) increase a firm's cost of capital

Review

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Uncertainty of information availability

„

amendment:

manager only informed with 0 < p < 1

„

general results

† withholding of (unfavorable) information: low cash flows, large variances of cash flows

† disclosure less likely with decreasing probability p

„

special results

† information and disclosure precision (e.g. Penno

1996, 1997; Richardson 2001)

Review

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Single-period cheap talk

„

amendment:

disclosure not verified

„

general results

† credible communication possible, but needs noise

† favorable forecasts may be disclosed with more precision than unfavorable ones

„

Fischer & Stocken (2001)

† information and disclosure precision

Review

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Multi-period cheap talk

„

amendments:

disclosure not verified, reputation

„

general results

† diverse (e.g. Sobel 1985; Benabou & Laroque 1992;

Kim 1996; Stocken 2000; Morris 2001)

„

Stocken (2000)

† perfect public equilibrium in review phases, where a manager nearly always reports truthfully if

„ sufficient weight of long term-term incentives

„ sufficiently long review phases / interaction

Discussion

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Incentives/restrictions of risk reporting

„ manager may have no/pretend not to have information

„ manager may withhold private information because he cannot disclose credibly/can misreport

„ manager may withhold private information because he fears disadvantages

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Regulation on risk reporting

„ managerial risk information endowment

„ enforcement of (credible) risk reporting

„ mandatory risk reporting

Discussion – Information endowment

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Incentives

„ verified risk reporting

† depends on common knowledge probability of managerial information endowment

† information vs. disclosure precision

„ unverified risk reporting

† non-credible or boilerplate disclosure

† information vs. disclosure precision

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Regulation

„ minimum probability of managerial information endowment

„ still margins to withhold available risk information

Discussion – Enforcement

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Incentives

„ verified risk reporting

† cost vs. disclosure

„ unverified risk reporting

† cost vs. credibility

† cost vs. disclosure

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Regulation

„ nominal/actual value comparison ex post inadequate

„ audit (ex ante) reduces to test of plausibility

Discussion – Mandatory risk reporting

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Incentives

„ verified risk reporting

† various, most likely related to cost

„ unverified risk reporting

† various, probably related to cost (self-fulfilling prophecy)

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Regulation

„ certain costs probably demotivate regulation (verified risk reporting)

„ uncertain costs questionable (unverified risk reporting)

Discussion – Specific risk reporting rules

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Incentives

„ verified risk reporting

† uncertainty of information availability

„ unverified risk reporting

† credibility

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Regulation

„ negative reports

„ risk management reports

Conclusions

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Incentives

„ limited at (at least) three levels

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Regulation

„ may mitigate, but cannot overcome these incentives

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General assessment of risk reporting

„ adverse incentives do matter even in presence of regulation

„ caution not to overestimate risk reporting in both, an unregulated and a regulated environment

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Caveats

Contact

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Michael Dobler

„

Ludwig-Maximilians-University Munich

„

University of Ottawa