Accounting Conservatism and Risk Disclosures

Abstract

This thesis adopts a broad view of conservative financial reporting—managers can use two ways to communicate business uncertainties to outsiders, namely, conservative accounting via timely loss recognition and narrative risk disclosures about a firm’s downside risk. I posit that managers trade off conservative accounting and risk disclosures because they both can alleviate information asymmetry about downside risk and reduce shareholder litigation, and they both impose significant costs on firms. Using a sample of U.S. industrial firms from 1995 to 2018, I find support for this substitutive (trade-off) relation when narrative risk disclosures were voluntary but not when they were mandatory in annual reports. Moreover, I hypothesize and find evidence that firms have stronger incentives to make such trade-offs in order to reduce overall reporting cost, when they are planning seasoned equity offerings, are closer to debt covenant violations, face higher proprietary costs, or have greater needs for debt financing. Additional tests show that external monitoring, by financial analysts or by shareholders through litigation threats, constrains firms’ flexibility in making such trade-offs. For the period after 2005 when the U.S. Securities and Exchange Commission (SEC) has mandated risk factor disclosures in annual reports, I find firms with lower analyst following or lower litigation risk exhibit a significant substitutive relation between these two accounting choices. Stock return tests show that, while investors fully anticipated managers to make such trade-offs when risk disclosures were voluntary, they reacted negatively to firms that appear to have made trade-offs between these two choices in the period after the SEC has mandated risk disclosures. Collectively, my research suggests that firms trade off conservative accounting recognition and risk disclosures, especially in the period when qualitative risk disclosures were voluntary, even though investors appear to prefer consistent information between quantitative accounting numbers and qualitative risk disclosures.