Corporate risk reporting: a content analysis of narrative risk disclosures in prospectuses.

This study examines whether companies report risk-relevant information to protective investors. While corporate risk communication is importantant for the well-functioning of capital markets, our current understanding of risk reporting practices is limited. The sample consists of Dutch companies raising capital on the Amsterdam Stock Exchange in the late 1990s. In this setting, companies had much discretion in writing the risk section of the prospectus. After a detailed content analysis of the risk sections, the author demonstrates that a measure of risk extracted from these texts successfully predicts the volatility of companies' future stock prices, the sensitivity of future stock prices to market-wide fluctuations, as well as severe decline in future stock prices. Overall, these results support the view that prospectuses of Dutch companies provide adequate information about material investment risks.

Keywords: corporate reporting; narratives; risk; new issues; content analysis

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Our history of substantial net losses may continue indefinitely and make it difficult to fund our operations.

VersaTel Telecom International N.V. (1999, p. 12)

This excerpt comes from the so-called "risk factor" section in the initial public offering prospectus of VersaTel Telecom International. It provides an example of warnings (risk factors) that corporate managers communicate to buyers of shares in companies going public. Offering prospectuses are legal documents, describing an enterprise to prospective investors. The risk factor sections in these documents are intended to provide investors with a clear and concise summary of the material risks to an investment in the issuers' securities. As such, these sections have the potential to alter investors' risk judgments and promote sound investment decisions. Because there is little empirical evidence on the information content of the risk factor sections, the aim of this article is to explore if these texts actually contain risk-relevant information for investors. For this purpose, I use a sample of 90 prospectuses of Dutch companies and perform a detailed content analysis of the textual information in the risk factor sections. Next, I examine to what extent an aggregate risk measure extracted from the information in the texts successfully predicts future volatility of stock prices, the sensitivity of stock prices to marketwide fluctuations, as well as large declines in future stock prices.

To facilitate linking the study to the communication practices of corporate managers and their advisors, I assume a financial communication perspective in this article. (1) Foremost, studying current risk disclosure practices can make clear to financial communication practitioners if risk reporting in prospectuses can be viewed as an area of best practice for corporate risk communication. The latter has been suggested by professional bodies like the Institute of Chartered Accountants in England and Wales (ICAEW), who see great merit in better risk reporting (ICAEW, 1999). Based on an exploratory study of a small number of prospectuses and annual reports of U.K. companies, the ICAEW put forward that companies provide limited risk information in annual reports but make more extensive risk disclosures in prospectuses. Following up on this research, this study more formally tests the claim that risk disclosure in prospectuses provides risk-relevant information to investors.

While this article views risk disclosure in prospectuses through a financial communication lens (focusing on shareholder relations and shareholders' concerns about investment risk), two issues need to be stressed before proceeding. First, corporate communication is part of larger organizational systems (Suchan & Charles, 2006). Other business functions traditionally involved with financial communication include finance and accounting (Argenti, 1996). Beside corporate communication research, I therefore draw on research in these disciplinary areas to study risk disclosure practices in prospectuses. Second, the broader topic of risk communication that this paper deals with clearly links to other subfunctions of corporate communication, including media relations, employee relations, community relations, and crisis communication. Within the field of public relations research, for example, many studies have focused on employees' and communities' concerns about health, safety, and environmental risks. Palenchar and Heath (2007) provide a concise summary of this growing branch of risk communication research, in which the stakes for participants in the communication process are evidently high (Kostelnick, 2007).

The remainder of this article is organized as follows. The next section discusses the motivation of the article and summarizes prior research. Section 3 provides a brief background and formulates the research question. Section 4 outlines the research design. Section 5 presents the results. The final section summarizes the results, discusses certain limitations, and considers potential implications of the study.

MOTIVATION AND PRIOR RESEARCH

Studying risk disclosure is important because corporate transparency about risk is vital for the well-functioning of capital markets. To achieve and maintain an accurate valuation of a company's stock, confident and well-informed investors are necessary. Lacking adequate disclosure, managers have superior information to outside investors, who may not fully understand the underlying risks and rewards of a firm's business (Hutton, 2004). By providing investors with information about the risk associated with pursuing the company's strategic goals, managers can increase transparency and eliminate disparities between what investors understand and expect and what management can deliver. This disclosure enables investors to make more accurate corrections for risk when they value their investments, thereby preventing stock prices from becoming unhinged from intrinsic business value (i.e., prevent them from becoming critically higher than they would be if the market had the information that is available to managers). (2) According to Fuller and Jensen (2002), "Trying to mask the uncertainty that is inherent in every business is like pushing on a balloon; smoothing out today's bumps means they will only pop up somewhere else tomorrow, often with catastrophic results" (p. 43). Consequently, being clear about the risks and uncertainties involved can prevent severe damage to the reputation and long-term health of a company that may otherwise result from overvalued corporate equity (Fuller & Jensen, 2002).

Recognizing the potential benefits of risk disclosure to investors and the long-run health and reputation of a company, an important question becomes whether managers are forthright about the underlying risks in their firms' business. On the one hand, they may understand the benefits of risk disclosure and realize that markets will penalize companies that provide inadequate information relative to their peers. As a result, an increasing number of managers may perceive that risk disclosure is a competitive advantage in attracting capital. Furthermore, managers may fear litigation and reputation costs if they do not provide sufficient risk information to investors (Skinner, 1994, 1997). On the other hand, being candid about risk can cause the stock price to fall to a more sustainable level in the short run. Short-sighted managers may not recognize that the associated pain of this is slight compared to that arising from colluding in myth-telling (Fuller & Jensen, 2002). Additionally, disclosure is not a costless undertaking (Botosan, 1997). First, creating and distributing timely and accurate risk information consumes valuable management time. Second, managers may perceive that there is a cost imposed on the firm by competitors who exploit the information to the detriment of the disclosing firm. Third, there is the possibility of litigation in connection with a disclosure. Finally, companies may be afraid to set a disclosure precedent they cannot stick to (Hutton, 2004).

Prior Research

Corporate reporting has generated broad interest from business communication researchers. Whereas some studies have investigated graphical presentations of financial information (e.g., Courtis, 1997; Frownfelter-Lohrke & Fulkerson, 2001) and photographs (Anderson & Imperia, 1992), many studies have examined narrative portions of annual reports, mostly the president's letter to shareholders and management's discussion and analysis. The focus in these studies varies considerably and includes analyses of readability (Courtis & Hassan, 2002; Subramanian, Insley, & Blackwell, 1993), positive and negative words and negative messages (Crombie & Samujh, 1999; Hildebrandt & Snyder, 1981), thematic differences (Kohut & Segars, 1992), linguistic structures (Thomas, 1997), rhetorical elements and symbolic meaning (Hyland, 1998; Prasad & Mir, 2002), verbal tone (Ober, Zhao, Davis, & Alexander, 1999), and genre (Rutherford, 2005). Focusing on different aspects, several researchers have investigated if past or current performance of a company is reflected in the texts of corporate reports (Hildebrandt & Snyder, 1981; Kohut & Segars, 1992; Rutherford, 2005; Thomas, 1997). Contributing to this literature, I investigate to what extent texts of corporate reports reflect future outcomes.