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 company’s 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. We’ve lost the plot. Nobody understands it and nobody even looks at it and it costs a fortune to do these disclosures every year. It’s 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 they’re a complete irrelevance. And nobody has ever asked me a question on it, and there’s nobody to my knowledge has even read it. And even the auditors say it’s 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 don’t 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 q’s 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 don’t 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?