Web viewThere is no previous research to risk reporting in the Netherlands. Before the financial...

Erasmus University Rotterdam

Erasmus School of Economics

Section Accounting, Auditing and Control

Master’s thesis

Risk ReportingThe influence of the financial crisis on the risk paragraph of Dutch listed companies.

Author: J.P.D. MertensStudent number: 294593Thesis supervisor: Mr. R. van der WalCo-reader:Date: 25-03-2011

Risk Reporting: The influence of the financial crisis

Preface and acknowledgements

This paper presents the results of research on the influence of the financial crisis on the risk

paragraph of Dutch listed companies. With this thesis, I will finish my Master in Accounting, Auditing

and Control at the Erasmus School of Economics in Rotterdam.

During my study the financial crisis played an important role. The crisis started in 2006 with the

housing bubble and the liquidity shortfall in the United States banking system. In 2008 the world

economy experienced a financial crisis. Then a series of negative events followed. During this period,

questions arose about the risk management practices by companies. Did managers understand the risks

they were facing and how did they manage these risks?

There is no previous research to risk reporting in the Netherlands. Before the financial crisis the

regulation regarding risk reporting was not sufficient to support transparency, but during the crisis,

stakeholders were asking for more risk information. Because of the growing demand for risk

disclosures and the effect the financial crisis has on the whole population, it is interesting to examine if

the financial crisis has influence on risk disclosures. It is a recent topic, because the financial crisis had

not yet ended when this investigation was done, and no one has examined this relationship before.

First of all, I would like to thank my supervisor at the Erasmus University, Mr. Van der Wal, for

all his advice during the writing process of this thesis. I would also like to thank Ernst&Young for

giving me the opportunity to write this thesis at the Rotterdam office. Most of all, I would like to thank

my family and friends for all their support during my entire study.

Dominique Mertens

Rotterdam, March 2011

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Executive summary

The concept of risk management becomes more and more important. The reason that companies

decide to disclose additional risk information is to satisfy the demand for information and transparency

by the capital market. Because the financial crisis played an important role during the last couple of

years and because there is no prior research regarding risk disclosures in the Netherlands, this study

examines the influence of the financial crisis on risk disclosure practices within annual reports of 18

non-financial AEX-listed Dutch companies. The research period is from 2006-2009, divided into two

periods, before and during the financial crisis. The risk disclosure index classifies and analyses the risk

information in annual reports and results are explained with the positive accounting theory. The

relations between risk disclosures and control variables (company profitability, level of risk and type

of industry) are tested with correlations. The empirical results show that there is a significant

difference between risk disclosures before and during the financial crisis. However, none of the

control variables is statistically significant associated with risk disclosures. The subjectivity of the risk

disclosure index and the fact that just a few variables are used are limitations of this research. It is

important to take this into account for further research.

Keywords: Risk management, Risk disclosures, Annual reports, Financial crisis, Positive

accounting theory

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Table of Contents

Preface and acknowledgements.............................................................................................................2

Executive summary3

1 Introduction....................................................................................................................................61.1 Background..................................................................................................................................61.2 Motivation and relevance............................................................................................................71.3 Research objectives.....................................................................................................................81.4 Research question........................................................................................................................91.5 Scope...........................................................................................................................................91.6 Outline.......................................................................................................................................10

2 Background risk disclosures.......................................................................................................112.1 Introduction...............................................................................................................................112.2 Types of disclosures..................................................................................................................112.3 Positive accounting theory........................................................................................................122.4 Motives and constraints for voluntary disclosures....................................................................14

2.4.1 Capital market transactions hypothesis (Information asymmetry)...................................142.4.2 Increased analyst coverage hypothesis.............................................................................152.4.3 Corporate control hypothesis............................................................................................152.4.4 Stock compensation hypothesis........................................................................................152.4.5 Management talent signaling hypothesis..........................................................................152.4.6 Limitations of mandatory disclosures...............................................................................162.4.7 Litigation cost hypothesis.................................................................................................162.4.8 Proprietary cost hypothesis...............................................................................................162.4.9 Agency cost hypothesis....................................................................................................172.4.10 Political cost hypothesis....................................................................................................17

2.5 Measuring voluntary disclosures...............................................................................................182.5.1 Subjective ratings..............................................................................................................182.5.2 Disclosure index studies...................................................................................................192.5.3 Textual analysis................................................................................................................202.5.4 Content analysis................................................................................................................21

2.6 Risk reporting............................................................................................................................222.6.1 Definition of risk...............................................................................................................222.6.2 Enterprise Risk Management framework.........................................................................232.6.3 Risk categories..................................................................................................................25

2.7 Requirements for risk reporting.................................................................................................262.7.1 IFRS..................................................................................................................................272.7.2 Dutch Corporate Governance Code..................................................................................29

2.8 Financial crisis...........................................................................................................................312.8.1 Causes of the crisis...........................................................................................................312.8.2 Consequences of the crisis for risk disclosures................................................................32

2.9 Summary....................................................................................................................................33

3 Literature review.........................................................................................................................363.1 Introduction...............................................................................................................................363.2 Lajili and Zéghal (2005)............................................................................................................363.3 Linsley and Shrives (2006a)......................................................................................................373.4 Abraham and Cox (2007)..........................................................................................................383.5 Amran, Bin and Hassan (2009).................................................................................................393.6 Review of the literature.............................................................................................................40

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3.7 Summary....................................................................................................................................42

4 Research design............................................................................................................................434.1 Introduction...............................................................................................................................434.2 Sample selection........................................................................................................................434.3 Research approach.....................................................................................................................44

4.3.1 Risk disclosure index........................................................................................................444.3.2 Control variables...............................................................................................................46

4.4 Hypotheses development...........................................................................................................474.4.1 Risk disclosure and the financial crisis.............................................................................474.4.2 Risk disclosure and company profitability.......................................................................474.4.3 Risk disclosure and level of risk.......................................................................................484.4.4 Risk disclosure and type of industry.................................................................................49

4.5 Summary....................................................................................................................................50

5 Results...........................................................................................................................................515.1 Introduction...............................................................................................................................515.2 Risk disclosure scores................................................................................................................515.3 Statistical analysis.....................................................................................................................53

5.3.1 Descriptive statistics.........................................................................................................535.3.2 Normal distribution...........................................................................................................545.3.3 Hypothesis 1.....................................................................................................................555.3.4 Hypothesis 2.....................................................................................................................575.3.5 Hypothesis 3.....................................................................................................................585.3.6 Hypothesis 4.....................................................................................................................60

5.4 Interpretation of the results........................................................................................................615.5 Summary....................................................................................................................................61

6 Conclusion....................................................................................................................................636.1 Conclusion.................................................................................................................................636.2 Limitations.................................................................................................................................656.3 Future research..........................................................................................................................67

Reference list.........................................................................................................................................68

Appendix I Empirical studies on risk reporting................................................................................73Appendix II Final sample.....................................................................................................................76Appendix III Decisions rules on risk reporting.................................................................................77Appendix IV Risk disclosures categories............................................................................................78Appendix V Risk disclosure index model...........................................................................................79Appendix VI Risk disclosure scores....................................................................................................80AppendixVII Relation between number of pages and risk disclosure scores.................................81Appendix VIII Financial risk category...............................................................................................82Appendix IX Risk management system and in-control system........................................................83Appendix X Dataset..............................................................................................................................84Appendix XI Normal distribution.......................................................................................................86

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1 Introduction

1.1 BackgroundIn recent years, risk has become an important business topic. Because of various financial and

accounting scandals in companies as Enron, Worldcom, Parmalat and Ahold, shareholders have

questioned the readability of annual reports. Companies do not provide enough risk and risk

management information; it is too brief, not sufficient forward looking and not adequate enough for

decision-making purposes (Beretta and Bozolan, 2004). That’s why investors loose confidence in the

annual reports and why accounting bodies are more interested in risk reporting. Because of the

increasing complexity of business strategies, operations and regulations, there is need for effective risk

management, internal control and transparent risk reporting (Lajili and Zéghal, 2005). It is important

for companies to take proper action in order to create a more reliable risk management system and

transparent risk reporting.

In times of financial uncertainty, capital markets are tighter and this might influence the amount

of disclosure about risks. In these times, it is important for managers to be transparent by disclosing

reliable and relevant information. Investors can assess the risk profile of a company only if relevant

risk information is provided (Linsley and Shrives, 2006). Whereas risk reporting originally was a

particularity in the banking and insurance sectors, the current financial crisis gave rise to risk

disclosures in non-financial sectors as well (Dobler, 2008). As a result of the increasing losses in 2008

and 2009, firms have to report more about their risks in the annual reports to dominate these risks

(Groot, 2008). Further, managers have to be alert on the timely recognition of risk. With the

introduction of the financial crisis, the question arises if companies did warn the investors about their

risks before the crisis. Or did the financial crisis come as a total surprise?

Nowadays, there are a lot of debates about risk management and risk reporting. One significant

aspect of the debates is that it relates to the communication of risk information between companies and

their stakeholders. Companies should provide more detailed risk disclosures rather than general

statements about the risk management policy in their annual reports. This would reduce the risk

information gap, thus improving the transparency and enabling good judgment about the firm’s

performance (Linsley and Shrives, 2006a; Abraham and Cox, 2007). As a result of these debates

narrative risk disclosures are more and more required in periodic reports, both annually and quarterly.

Risk disclosures have some advantages. Information asymmetry between the firm’s

management and shareholders will decline and there is a positive effect on the shareholders’

confidence in management, leading to a better assessment of the firm’s future performance. The

consequences of these advantages are a decline in the cost of capital (Lajili and Zéghal, 2005; Linsley

and Shrives 2006a; Abraham and Cox, 2007) and a reduction of financial failure (Beretta and

Bozzolan, 2004). However, creating and distributing timely and accurate risk information is

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time-consuming for the management and there is the possibility of litigation when discussing if certain

information should be disclosed (Deumes, 2008). Despite these disadvantages of risk disclosing,

companies are recommended to be transparent about the risks they face.

Until recently there was no explicit regulation as far as risk management and risk reporting was

concerned (Groenland et al., 2006). Risk management used to be examined within the boundaries of

the firm (Lajili and Zéghal, 2005), but since the worldwide financial crisis, starting in 2008, corporate

governance and risk reporting have become important issues, resulting into more research attention for

risk management and control from an external point of view. More specific, the stakeholders’ view

(Lajili and Zéghal, 2005). This growing attention resulted into more regulation. Risk management has

become part of corporate governance. The US incorporated the Sarbanes Oxley Act in 2002. Section

404 prescribes that annual company reports should include an internal control report. A lot of

European companies have reported regulation for corporate governance as well. The Institute of

Chartered Accountants in England and Wales (ICAEW) in the UK stimulated companies to report

about internal and external risks. In Germany a Corporate Governance Code was incorporated after a

publication by the ‘Commission Cromme’ and in the Netherlands the Corporate Governance Code (in

Dutch: ‘Code Tabaksblat’) was published. This was used for the first time in the annual reports of

2004 and it replaced the forty recommendations of the ‘Commission Peters’ from 1997. The Dutch

Code assumes the principle of comply or explain. The risk paragraph for Dutch companies is

voluntary, so it is interesting to examine what kind of information about risks they will report. After

the introduction of the Corporate Governance Code in the Netherlands, 76% of the listed companies’

annual reports include a risk paragraph. The most important risks mentioned were market risks,

regulation risks, structure of the company and technology risks (Groenland et al., 2006). In 2009, the

compliance with the measures on internal risk and the application by AEX-companies is around 95%.

The Monitoring Commission Corporate Governance note that a large number of AEX-companies

already describe the most important risks1.

So far only a few studies examined risk reporting. Several authors encourage filling in the gap

in literature concerning empirical risk reporting research (Linsley and Shrives, 2006a; Beretta and

Bozzolan, 2004). Most of these studies cover a period of only one research year. This thesis will

contribute to the research area of risk reporting by examining the influence of the financial crisis on

risk reporting for the Netherlands covering more than one research year.

1 www.commissioncorporategovernance.nl

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1.2 Motivation and relevance

Financial reporting and disclosures, in this case risk disclosures, are very important for

managers when communicating firm performance and governance to outside investors (Healy and

Palepu, 2001). Especially since the financial crisis, stakeholders and investors have been asking for

more forward-looking information regarding company risks and uncertainties. Regulators like

US GAAP and IFRS are asking for more detailed and quantitative information regarding risks as well

as uncertainties, but they do not prescribe exactly what kind of risks companies should disclose in

their annual reports, apart from financial risks. It is interesting to know what kind of risk information

companies will report in their annual reports and also if the current financial crisis influences the

amount and content of the risk paragraph.

Although risk reporting is an important subject, there is not that much prior research about risk

disclosures. Corporate transparency about risk is vital for the well-functioning of capital markets.

Confident and well-informed investors are necessary for an adequate valuation of the stock price

(Hutton, 2004). When companies are not clear about the risks and uncertainties towards their

stakeholders, it can cause reputation damage and damage to the long-term health of a company (Fuller

and Jensen, 2002). This is the reason that more companies are focused on company risks and on

disclosing information about these risks. Some authors of prior research find an existing gap between

the information needs of users of annual reports on the one hand and the amount and type of risk

disclosures reported by companies on the other (Schrand and Elliot, 1998; Solomon, et al., 2000;

Linsley and Shrives, 2006a).

This study is useful for users of Dutch annual reports. There are different types of users. This

study will focus on investors or stakeholders; they want to know if reliable and relevant information is

given in the annual reports. To examine the risk paragraph in annual reports has a contributing value

for company managers as well, because they are responsible for preparing this. If they know about the

limitations, they can make amendments and strive for more transparency. Apart from that, the

management’s motives for disclosing particular risk information are interesting as well.

Compared with prior research a new aspect in this thesis is that it will focus on the influence of

the financial crisis on risk reporting. Is there a positive relationship between the two of them?

1.3 Research objectives

This research examines if the financial crisis influences the risk paragraph by looking at the

difference between the quantities of the risk paragraph in annual reports before and during this crisis.

Although there is no previous study about a subject comparable with the subject in this paper, a study

conducted by Linsley and Shrives (2006a), who examined the content of the risk paragraph in annual

reports of 79 non-financial UK listed companies, is used as a basis for this paper. This study is used by

many other researchers (Linsley et al., 2006b; Abraham and Cox, 2007; Amran et al. (2009). Also, the

risk categorization by Linsley and Shrives (2006a), is very broad and quite similar to the risk

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categorization made by Dutch companies in the risk paragraph in their annual reports. While the paper

of Linsley and Shrives (2006a) serves as a basis, the implementation will be different.

The main objectives of this thesis are:

To determine if the financial crisis affects the quantity and content of risk disclosures;

To examine the content of the risk paragraph, using a content analysis in combination with a

risk disclosure index;

To test if there is a significant relationship between the quantity of risk disclosures and the

company specific characteristics: profitability, level of risk and type of industry.

1.4 Research question

The aim of this study is to examine if the financial crisis has influence on the risk paragraph in

the annual reports of non-financial listed companies in the Netherlands. To examine the different

research objectives it is necessary to formulate a research question. This question is as follows:

What is the influence of the financial crisis on the quantity of risk reporting in the annual reports of

Dutch listed companies?

To give an answer to this research question, the following sub-questions are formulated:

1. Why do firms voluntary disclose information?

2. What is the definition of risk and how has risk reporting developed?

3. What is the influence of the financial crisis on risk reporting?

4. Which company characteristics influence the quantity of risk disclosures?

1.5 Scope

This study concentrates on the annual reports of non-financial companies in the Netherlands,

listed on the AEX-index. The expectation is that the twenty-five companies listed on the AEX-index

face more risks than companies on other indices of the AEX. They will feel more pressure from

stakeholders to report about their risks and uncertainties. Financial companies are excluded from this

research, because it could distort the research findings. The legislation is different from the regulation

for non-financial companies, it is more extensive and they will make a different type of risk

disclosures (Linsley and Shrives, 2006a).

Companies in the Netherlands have to report risk disclosures according to the International

Financial Reporting Standards (IFRS 7) and the Dutch Corporate Governance Code (‘Code

Tabaksblat’), which is prepared by national regulatory bodies.

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The company discloses information regarding risks and uncertainties in the risk paragraph,

which is shown in the annual report. In this research, the financial crisis has an important role. To

examine the influence of the crisis on the risk paragraph, it is useful to compare the annual reports

published in the years preceding the financial crisis with those published during the crisis. This study

covers a research period of four years. The years before the crisis, 2006 and 2007, will be compared

with two years during the crisis, 2008 and 2009. The quantity of risk disclosures will be measured by

the risk disclosure score. This score is achieved by a risk disclosure index. The information used for

this model is hand collected from the risk paragraphs in annual reports. The data for the control

variables are collected from the ThomsonOneBanker database.

1.6 Outline

The structure of this paper is as follows. Chapter 2 gives a background for risk disclosures.

After a short introduction in paragraph 2.1, the different types of disclosures will be discussed in

paragraph 2.2. Disclosures can be explained by the positive accounting theory. This theory will be

described in paragraph 2.3. Then, in paragraph 2.4 motivations for disclosing particular information

are given. The methods to measure these disclosures will be discussed in paragraph 2.5. When the

term disclosures is explained, it is important to know something more about specific disclosures, in

this thesis risk disclosures. Paragraph 2.6 gives a definition of ‘risk’, the Enterprise Risk Management

framework will be explained, as well as the risk categories. Paragraph 2.7 describes the requirements

for risk reporting as shown by the International Financial Reporting Standards (IFRS) and the Dutch

Corporate Governance Code. Finally, this chapter will give some information about the rise of the

financial crisis and the subsequent influence on risk reporting. The chapter is concluded by a

summary.

In chapter 3 prior research on risk reporting will be discussed. The chapter opens with a short

introduction in paragraph 3.1, then four relevant studies will be described in more detail (paragraph

3.2-3.5). Paragraph 3.6 gives a review of prior studies, comparing them and discussing the parts that

are useful for this paper. A summary concludes this chapter.

Chapter 4 will explain the research design. This chapter starts with an introduction, then it will

discuss the sample selection (sample size and sample period). Paragraph 4.3 explains about the

research approach, consisting of the risk disclosure index and the control variables. The chapter ends

with the formulated hypotheses and a summary.

Then, chapter 5 will discuss the results of this paper. It starts with a short introduction, then it

explains the results of the risk disclosure index in the second paragraph. The third paragraph contains

the statistical analysis. This section starts with the descriptive statistics (5.3.1), then it will explain the

normal distribution (5.3.2). In the paragraphs 5.3.3 to 5.3.6 the four hypotheses will be tested by using

different statistic methods, and an interpretation of the results will be given in paragraph 5.4. Chapter

5 is concluded with a summary.

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Finally, in chapter 6 the conclusion will be given by answering the research question. As in

almost every research, this product includes restrictions as well as recommendations for further

research. These will be discussed at the end of this study in chapter 6.

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2 Background risk disclosures

2.1 Introduction

This chapter discusses the theories regarding disclosures, risk reporting, the financial crisis and

the relation between these topics. The first paragraphs will give some information about disclosures in

general. Paragraph 2.2 gives a description of the different types of disclosures, then in paragraph 2.3

the positive accounting theory will be further explained, paragraph 2.4 discusses the motives and

constraints for companies to disclose information, and finally, paragraph 2.5 describes the different

ways to measure disclosures. This part gives an answer to the first sub question; Why do firms

disclose information? The second part focuses on specific risk disclosures. Paragraph 2.6 gives a

definition of risk based on prior research, including the Enterprise Risk Management framework and

the different risk categories, paragraph 2.7 describes the requirements for risk reporting according to

IFRS and the Dutch Corporate Governance Code. In this part, an answer to the second sub question is

given. The last part of this chapter provides information about the financial crisis (paragraph 2.8). This

section describes causes and consequences of the financial crisis in relation to risk reporting. With this

information, an answer is given to the third sub question. The last sub question ‘which company

characteristics influence the quantity of risk disclosures?’ concerns control variables and these will be

formulated in the hypotheses in chapter 4. The results of these hypotheses are analyzed in the next

chapter. A short summary will conclude this chapter.

2.2 Types of disclosures

Before making researches into risk disclosures it is useful to know what kind of disclosure it is.

There are three different types of disclosures (Scott, 2003). The first one is mandatory disclosure by

regulation. Some regulatory bodies are well known, such as the International Accounting Standards

Board (IASB), the Financial Accounting Standards Board (FASB) and the Securities and Exchange

Committee (SEC). In addition to these regulatory bodies, national governments are making rules

concerning mandatory disclosures and financial reporting as well. The mandatory disclosures should

be presented in annual reports, which include management discussion and analyses (MD&A),

financial statements, footnotes, and other reports. Especially disclosing information about financial

risks is required by regulation, but for non-financial companies, there is not that much regulated for

risk disclosures. Non compliance with these rules has serious consequences.

Another type of disclosure is a recommended disclosure. A regulatory body can give some

recommendations about disclosing information. Companies are not required to disclose the

information, but they may feel pressure from their stakeholders to do so. The recommended disclosure

is an in between form of mandatory and voluntary disclosures.

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The final form of disclosure is voluntary disclosure by management. Because of the

fundamentally changing nature of business– technological innovation, the emergence of network

organizations, changes in the business economics of audit firms and financial analysts and the

globalization of capital markets, there is an increasing need for more information that is non-financial

and forward-looking (Healy and Palepu 2001). Because of this, the term voluntary disclosure arises.

The information is not required by the reporting standards, but managers are free to decide which

additional information they report (Scott, 2003). The need for voluntary disclosures is the consequence

of information asymmetry and agency conflicts between the management of the firm and their

stakeholders (Healy and Palepu 2001). The ‘information problem’ occurs when one party has more

relevant information than another party. This means inefficiency on the market because not all parties

have enough information for decision-making processes. An increase of voluntary disclosures reduces

the information asymmetry, which results into a lower cost of capital and influences the stock price

(Healy and Palepu, 2001). Voluntary disclosures consist of both financial and non-financial

information. The annual report will be used most to disclose this kind of information, but there are

many other ways to disclose voluntary information, such as half-year and quarterly reports,

sustainability or corporate social responsibility reports, conference calls, internet sites, press releases,

interviews, etc.

The most important type of disclosures on which this paper is focusing is voluntary disclosure.

It examines the quantity of risk information. Before knowing which information is voluntary

disclosed, it is useful to know which information is required by regulation. In paragraph 2.7 the

requirements for risk disclosures will be discussed.

2.3 Positive accounting theory

Voluntary disclosures can be studied from different perspectives. In examining risk disclosures

it is important to take into account two different aspects: the demand side, which concentrates on the

behavioral accounting research perspective, and the supply side of information, explained by the

positive accounting theory.

The behavioral accounting research approach focuses on the needs and preferences of users of

financial information. According to Solomon et al. (2000), risk reporting practices do not satisfy the

needs of users of the financial statements. However, decision usefulness is really important. If

investors do not get reliable risk information, they cannot make good investment decisions. The

demand for financial reporting results from information asymmetry and agency conflicts. This

approach is highly subjective. The results are gathered from questionnaires, whereas the answers are

influenced by personal preferences and perceptions from the people who are interviewed.

Where disclosures are concerned, important questions are why managers disclose certain

information when it is not required and which factors can explain the behavior of the management

regarding voluntary disclosures? The positive accounting theory (PAT), developed by Watts and

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Zimmerman (1986) and others, focus on management’s motives for risk reporting and concern the

way in which managers respond to new requirements for risk reporting. The PAT explains and

predicts accounting practices. For observed practices, the PAT can give reasons, but for unpredicted

items, it can predict only the occurrence. This theory is ‘positive’, because it assumes how things

work, whereas the normative theory is about prescriptions about how things should work (Whitley,

1988). The central economics-based assumption that all individuals’ action is driven by self-interest

and that individuals will always act in an opportunistic manner to the extent that the actions will

increase their wealth (Deegan and Unerman, 2006). Verrecchia (2001) mentions that the PAT

‘examines how managers and/or firms exercise discretion with regard to the disclosure of

information’. Key to explaining managers’ motives is the agency theory. This theory focuses on the

relationship between principals and agents, which created much uncertainty due to various information

asymmetries. An example of such a relationship is the relation between stakeholders (principal) and

managers (agents) (Deegan and Unerman, 2006). The agency theory accepts that transaction cost and

information cost exist. This means that managers have to take into account the stakeholders’ demand,

because they are the ones responsible for preparing the risk paragraph in the annual reports. The PAT

would predict that audit and monitor are required. If not, managers would not report the relevant risks

(Deegan and Unerman, 2006).

If there are semi-strong efficient markets, significant cost in writing and enforcing contracts,

and political cost of the whole regulatory process, then the PAT focuses on the incentives for

managers when making accounting choices (Watts and Zimmerman, 1986). This theory examines the

role of contracting and political considerations to explain management accounting choices in the case

of existing agency cost and information asymmetry. There are two types of contracts. First, there are

contracts between the firm and its creditors (debt contracts) and the other type is a contract between

management and shareholders (compensation contracts). Political considerations may cause concern

with management about explicit or implicit taxes, or about regulatory actions (Healy and Palepu,

2001). Apart from contracts, there are also other mechanisms to solve the information asymmetry

problem. For example, Watts and Zimmerman (1986) mention the role of reputation as a mechanism

to deal with information asymmetry. They assume that agents simply cannot do without incentives to

provide information that best reflects the underlying performance of the entity. When they fail, this

will affect their reputation (Deegan and Unerman, 2006). Some studies focus on the choice of

accounting and disclosure as part of the contracting process, while most of the studies are more

interested in analyzing post-contracting opportunistic accounting choices (Healy and Palepu, 2001).

Though interesting results can be obtained when using the behavioral accounting research

approach, this study highlights the issue of risk disclosures from the positive accounting theory. The

positive accounting theory plays an important role, when examining if the amounts and contents of

risk paragraphs in annual reports before and during the financial crisis differ. As management decides

which information will be disclosed, it is interesting to know why managers do or do not disclose

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specific risk information. In the next paragraph the different motives for disclosure decisions will be

further explained.

2.4 Motives and constraints for voluntary disclosures

Risk reporting depends on disclosure incentives (Dobler, 2008). Disclosure studies assume that

managers always have superior information to outside stakeholders on the firm’s expected future

performance, even when the capital market is efficient (Healy and Palepu, 2001). Not all disclosed

information is required by regulatory bodies, but there is no general answer as for which information

is exactly voluntary. Mandatory disclosures can stimulate companies to voluntary disclose more

information, but too much regulation may have an unintended effect (Broberg et al., 2009). Mostly all

reported information, which is not described as information made mandatory by regulatory bodies, is

treated as voluntary disclosures. This paper assumes that all rules regarding disclosures as described in

IFRS 7 and the Dutch Corporate Governance (see paragraph 2.7) are considered to be mandatory

disclosures. This research presents disclosures as complementary to mandatory disclosures. Other

researchers (Broberg et al., 2009), make this assumption as well. A consequence of the tension about

voluntary disclosures is that some managers have limited incentives of disclosing private risk

information, while others have many motives to disclose information to outsiders (Healy and Palepu,

2001). It is interesting to examine these motives and constraints. Literature has identified different

motives for voluntary disclosures. This paragraph combines the motives mentioned by Healy and

Palepu (2001) with those mentioned by Graham et al. (2005). Some of them are a drive for voluntary

disclosure decisions: capital market transactions, increased analyst coverage, corporate control, stock

compensation, management talent signaling, and limitations of mandatory disclosures. However, there

are constraints for voluntary disclosures as well: litigation cost, proprietary cost, political cost, and

agency cost. First, the different motives will be discussed.

2.4.1 Capital market transactions hypothesis (Information asymmetry)There is information asymmetry if managers have superior information to outside investors

regarding the firm’s future prospects. When this asymmetry cannot be solved, these firms will make

public debt or equity offers in order to be valuable for existing shareholders. The reason why

managers who are anticipating in capital market transactions have incentives to provide voluntary

disclosures, is that they reduce the information asymmetry problem (Healy and Palepu, 2001). As a

result, the firm’s cost of external financing will be reduced (Myers and Majluf, 1984) and the liquidity

of a firm’s stock will increase (Diamond and Verrecchia, 1991 and Kim and Verrecchia, 1994). Barry

and Brown (1986) and Merton (1987) report that if managers have more information than outsiders,

investors demand a risk premium for the information risk they bear. Reducing this information risk by

making more voluntary disclosures managers can reduce the cost of capital and make earnings more

‘predictable’. Graham et al. (2005) interviewed some CFOs, who stated that the primary goal of

voluntary disclosures is to adjust investors’ perceptions about the current or future performance in a

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correct way. Especially large firms are concerned about these perceptions and the reducing cost of

capital, while small firms are more interested in the liquidity of their stock (Graham et al., 2005).

2.4.2 Increased analyst coverage hypothesis

Not all private information from the management is fully disclosed by required disclosures

(Lang and Lundholm, 1996). However, the consequences of voluntary disclosures are a lower cost of

information acquisition for analysts and an increasing amount of information available to analysts.

Voluntary disclosures will attract more analysts, which is especially true for small firms (Graham et

al., 2005).

2.4.3 Corporate control hypothesis

Managers are hold accountable for the current stock performance by the boards of directors and

investors. Because managers don’t want to lose their job as a result of low stock and poor earnings

performance, they make use of voluntary disclosures to reduce the likelihood of undervaluation and to

explain the poor earnings performance. A limitation of this incentive is that it excludes multi-period

considerations. This means that a manager cannot be hold accountable for poor performance for other

than the current period (Healy and Palepu, 2001).

2.4.4 Stock compensation hypothesis

Managers are directly rewarded by using a variety of stock-based compensation plans. These

plans provide motives for managers to voluntary disclose information as well. Take managers who are

interested in trading their stock holdings for an example. By disclosing private information, they meet

the restrictions imposed by insider trading rules and the liquidity of the firms’ stock will increase. The

incentives to provide voluntary disclosures for managers acting in the interests of actual shareholders

are to reduce contracting cost associated with stock compensation for new employees.

Firms that make more use of stock compensation are likely to provide more disclosures to reduce the

risk of mis-valuation (Healy and Palepu, 2001).

2.4.5 Management talent signaling hypothesis

This hypothesis implies that talented managers have an incentive to disclose earnings forecasts

to make their type public (Trueman, 1986). The market value of a firm consists of the investors’

perceptions of the managers’ capacity to anticipate and respond to future changes in the economic

environment of the firm. The earlier the investors get information from the management, the more

favorable the investors’ perceptions will be, resulting into a higher market value. However, there is no

evidence for this hypothesis (Healy and Palepu, 2001). Graham et al. (2005) interviewed some CFOs ,

but none of them explicitly mentioned the role of talent signaling. Therefore this motivation is more

important for managers of smaller and high growth companies.

16


2.4.6 Limitations of mandatory disclosures

Another reason to voluntary disclose information is that these disclosures will fill the gap

between the information provided and the information needed by investors. The CFO’s, who were

interviewed by Graham et al. (2005), stated that this mainly applied to large, high-growth, highly

levered and well covered firms. Most of the mandatory financial information disclosed by firms lacks

timeliness, because it is reported only once a quarter. Providing more information by voluntary

disclosures will solve this problem. This motivation for voluntary disclosures does not get much

attention in prior research.

As mentioned earlier, managers can decide not to disclose particular information. However, the

litigation cost hypothesis can be both a motive for disclosing information as a constraint for not

disclosing the information. This hypothesis and other constraints are discussed below.

2.4.7 Litigation cost hypothesis

Firms will increase their voluntary disclosures as a result of legal actions against managers for

inadequate or untimely disclosures. The other effect of litigation is that it reduces the managers’

motives to voluntarily disclose information, especially forward-looking information (Healy and

Palepu, 2001). Skinner (1994) has examined the first effect and argues that managers of firms with bad

earnings news have a motive to disclose this information earlier to reduce the cost of litigation. When

there is no litigation, managers will have an incentive to time the disclosure of bad and good news

symmetrically. The second effect, that litigation reduces the incentives to provide voluntary

disclosures, occurs if managers believe that the legal system punished forecast which are made in good

faith. In practice, it is hard to make an effective distinction between unexpected forecast errors and

management bias made by intention (Graham et al., 2005). There is mixed empirical evidence for this

hypothesis. Skinner (1994) argued that firms with bad earnings news are more likely to pre-disclose

their bad performance than other firms with good news. Firms with negative earnings news are more

likely to be subjected to litigation, but he finds only weak evidence that litigation cost are lower for

firms that are disclosing earning forecasts earlier. However, Francis et al. (1994) mentioned that there

is no relation between pre-disclosures and litigation. Finally, empirical researchers, like Miller and

Piotroski (2000), conclude that litigation risk is not only relevant for firms with bad news, but for

firms with good news as well. It is not known which effect has a bigger impact upon voluntary

information disclosures.

2.4.8 Proprietary cost hypothesis

Proprietary cost are loss in profits as a consequence of increasing competition (Wagenhofer,

1990). According to the proprietary cost hypothesis voluntary disclosed information can damage the

competitive position in product markets (Verrecchia, 2001; Dye, 2001). Even if it makes it more costly

17


to raise equity, managers do not disclose information if it reduces the competition position. The

respondents interviewed by Graham et al. (2005), strongly agree that an important barrier to more

voluntary disclosures is the fact of giving away company secrets. Especially small firms are worried

about proprietary cost. Managers do not want to disclose sensitive proprietary information to their

competitors, even if this information can be inferred from other sources. They are afraid that the

information negatively affects the competitive position (Verrecchia, 2001). In giving an explanation

for voluntary disclosures there is a big difference between this hypothesis as compared with others.

This hypothesis is based on the assumption that there are no agency conflicts between managers and

stakeholders. As a consequence the credibility of voluntary disclosures is always very high.

2.4.9 Agency cost hypothesis

In the event of agency cost, full disclosures cannot be reached (Nanda et al., 2003; Berger and

Hann, 2003). Career concerns and external reputation are important for the need to meet earnings

benchmarks and to voluntarily disclose information, but managers do not say, or at least do not like to

admit, that they limit voluntary disclosures to avoid unwanted attention from stakeholders (Graham et

al., 2005). However, some respondents interviewed by Graham et al. (2005), argue that they limit their

voluntary disclosures in order to avoid follow-up questions about other, unimportant items.

2.4.10 Political cost hypothesis

The role of political cost in accounting and disclosure decisions is very important in the positive

accounting theory (Watts and Zimmerman, 1986). Large companies are more complex, so they get

more attention from regulators and the media. When these companies do not act in accordance with

the regulation and society’s need, they are exposed to political cost. Further, bad media attention

results into a decreasing competitive position and reputation. However, Graham et al. (2005) do not

find evidence for this. Most of the respondents agree with the hypothesis that avoiding unwanted

attention from regulators is not a significant barrier for voluntary disclosures. It is hard to make a

conclusion, because managers might not be willing to voluntarily disclose information that regulators

could use against them.

The desire to avoid setting a precedent that is difficult to maintain in the future is another reason

for not voluntarily disclosing particular information (Graham et al., 2005). Because this is not

recognized in other literature, it will not be further discussed.

One of the most important limitations of voluntary disclosures is the difficulty of measuring

their extent (Healy and Palepu, 2001). This will be discussed in the next paragraph.

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2.5 Measuring voluntary disclosures

In prior literature there are several methods known to analyze the narratives in annual reports.

To make a comparison between different researches and to choose a suitable method for this research,

it is necessary to discuss the different ways to measure voluntary disclosures.

Figure 1: Approaches to the analysis of narratives in annual reports (Beattie et al., 2004)

From the article of Beattie et al. (2004) appears that there are different models to measure

disclosures. They made a distinction between subjective and semi-objective. The models the article

mentions are subjective ratings, disclosure index studies and textual analyses. The first one is

subjective, where the other two methods are semi-objective. Textual analyses can be split up into three

subgroups: thematic content analysis, readability studies and linguistic analysis. What is being

measured varies across approaches. Further in this section, each of the five models will be explained.

2.5.1 Subjective ratings

These ratings are based on analysts’ perceptions rather than on direct measures of actual

disclosures and provide an overall measure of corporate communications with investors. The rankings

are separate ratings for the way in which the information is disclosed (annual, quarterly or other

reports). The Association of Investment Management and Research (AIMR) in the US used this

approach, but discontinued the disclosure rankings in 1997. In other countries these ratings are not

routinely available at all. Critics mention that the ratings are influenced by the personal bias of the

analysts’ perceptions of the disclosure. Healy and Palepu (2001) are critical as well. They mention the

lack of clarity; do the analysts on the panels take the ratings seriously?, it is not clear how firms are

selected for inclusion, and they discuss the potential biases by analysts as well. (Beattie et al 2004).

19


This method is not suitable for this paper. It is too difficult to find enough analysts to ask for their

perceptions. Further this research does not really examine management’s incentives to disclose

voluntary information, it focuses on how much they report in their annual reports and wants to know

if they have disclosed different or more information in the years of the financial crisis. Asking analysts

to answer these questions, would make the outcome too subjective.

2.5.2 Disclosure index studies

This model measures the level of disclosure, whereas the amount of disclosures is used as a

proxy for the quality of disclosures (Marston and Shrives, 1991; Botosan, 1997). They make use of

predefined information items. A coding scheme can be a simple binary coding, showing the presence

or absence of an item (presence scores 1 and absence scores 0) or it can be an ordinal measure

consisting of three levels. Quantified disclosures score 2, qualified disclosures score 1 and no

disclosures score 0. According to Botosan (1997) it is important to disclose quality, but this is very

difficult to assess. Researchers argue that quantity and quality are positively related.

Marston and Shrives (1991) examined the use of disclosure indices in accounting research,

especially in companies’ annual reports. In this context, the distinction between mandatory and

voluntary disclosures is taken into account. The disclosure index score “can give a measure of the

extent of disclosure but not necessarily the quality of disclosure”. This score has proved to be a

valuable research method that also in future times will be used when studying company disclosures,

despite the subjectivity involved. (Marston and Shrives, 1991). The index is separated in a weighted

and an un-weighted part. The weighted part is a result of a survey to determine the importance of

specific items. The disadvantage is that the weighted and unweighted scores give the same results if

there are many items (Beattie et al. 2004). Besides the distinction in a weighted/unweighted part, a

distinction in nested and un-nested items is possible as well. This means that the items can be grouped

into hierarchical categories (Beattie et al., 2004). However, the disadvantage is that the indices provide

a measure of the quantity of disclosure rather than the quality of disclosure (Marston and Shrives,

1991). The disclosure index, which was used by Cooke (1989a;1989b) compares the actual level of

disclosure with the possible level of disclosure, which is determined per research. The disclosure index

can be summarized as follows:

m n

Risk disclosure index = Actual disclosure / Total possible disclosure = dt / dtr-1 r-1

Where d = 1 if item is disclosed

0 if item is not disclosed

m = number of items disclosed

n = maximum number of disclosure items possible

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Companies can disclose a large number of items, so researchers are focusing on a sub-set of

items, such as social and environmental disclosures, mandatory disclosures or risk disclosures. Most

studies using disclosure index scores examine either inter-company or inter-country differences. Only

few studies make use of wide-ranging measures of general disclosures; it is too complex and time-

consuming (Beattie et al., 2004).

To measure the voluntary disclosure level it is also possible to create one’s own disclosure

index model. Botosan (1997) constructed her own index, in which the items were derived from

recommendations provided in the Jenkins report (AICPA, 1994), the SRI International survey (1987)

and the CICA (1991). They described five categories of information: background information,

summary of historical results, key non-financial statistics, projected information, and management

discussion and analysis. The index consists of 35 elements spread across these categories. Further,

Robb, Single and Zarzeski (2001) made an index for non-financial disclosures also based on the

Jenkins report. A total of 65 items were grouped into three forward looking topics (environment

around the company, strategy and management, and company trends) and three historical topics

(environment of the company, production, and customers). They made use of an ordinal coding

scheme, so each item could score a 1 (no disclosure), 2 (some disclosure) or 3 (extensive disclosure).

2.5.3 Textual analysis

Another method to measure disclosures is the textual analysis, for which the whole text has to

be examined. In this type of analysis three categories can be distinguished: thematic content analysis,

readability studies and linguistic analysis.

The thematic content analysis is based on reviewing the content of accounting narratives (Jones

and Shoemaker, 1994). They examine the entire content or focus on specific sections of the annual

report. Most studies make use of ‘themes’, which may be longer or shorter than a sentence. To be

exact, this approach does not examine the amount of text or at the way it is presented, but it examines

the message within the text. It is a less reliable semi-objective method since different people might

find a different message in the same text. The themes of studies are of interest and they are recorded

into units that are analyzed. According to the FASB (2001b) a prescribed list of detailed disclosures

that is unique to each industry should be examined when using this method. The FASB report makes

no attempt to quantify the amount or nature of disclosures in these topic categories. The list was made

to represent good practice (Beattie et al. 2004). Since this approach ignores the amount of text, it is not

a good measure for this research.

Readability studies examine the degree of difficulty of the text and judge the length of the

sentences and the difficulty of the words. The readability formula, such as the Flesch index, is used to

analyze it. The scores are compared to external benchmarks to evaluate the degree of difficulty. It is

questionable if this is a good measurement for the quality of a disclosure, because there is no attention

for the reader’s level. Despite the objectivity and reliability of annual report narratives, there are many

21


problems with the application of readability scores. Measures for children’s writings are inappropriate

for adults, technical writings and readability scores focus on word and sentence-level features, not on

the whole text (Jones and Shoemaker 1994). Finally, there is no attention for the reader’s interest and

motivations. Because of the many problems of this model, this research will not use a readability

studies to measure the content of risk disclosures.

Linguistic analyses are using a texture index that captures a much richer set of text

characteristics than readability formulas (Sydserff and Weetman, 1999). There is much attention for

many different aspects of the text. This analysis requires further research of users’ weightings for each

text characteristic. Unfortunately, this analysis is not very useful for determining the quantity of

disclosures. Studies show that a higher texture score did not necessarily mean a better disclosure

(Beattie et al., 2004) and more research still has to be done on which criteria are representative for the

quantity of disclosures. For that reason this analysis will not be used in this research.

Beattie et al. (2004) argued that current approaches have two fundamental limitations. The first

is that they are one-dimensional, whereas disclosure is a complex, multi-faceted concept. Only one

aspect of the text like absence/presence or topic length is discussed instead of the combination of

different aspects. Further, there is little attention for the type of disclosure in relation to the topic. The

second limitation is that they focus on partial items instead of the entire content of the annual report.

None of the methods give a detailed analysis of the whole content of the entire annual report. Beattie

et al. (2004) therefore introduce ‘a four-dimensional framework’, which involves three terms: time-

orientation, financial orientation and quantitative orientation. The topic analysis is based upon the

comprehensive model of business reporting proposed in the Jenkins report (AICPA, 1994). This

framework is multi-dimensional and analyses every section of the annual report that is voluntary

disclosed (Beattie et al., 2004).

2.5.4 Content analysis

Content analysis is a method of codifying texts into various categories based on selected

criteria, which is useful when a large amount of data must be analyzed (Holsti, 1969). It is important

that the classification process is reliable and valid. Reliable means that different people will code the

text in the same way and valid is that the variables generated from the procedure are what the

researcher intended to present (Weber, 1985). Krippendorff (1980) describes three types of reliability

used for determining the classification of text units. The first one is stability, which means the extent

to which the same coder is consistent over time when coding the same content. The second type is

reproducibility (or inter-coder reliability); the extent to which different coders produce the same

results when coding the same content. Last, accuracy is important as well. This is the extent to which

the classification of text corresponds to a standard or norm. The most used measure is reproducibility,

because stability is a weak measure of reliability and a standard or norm seldom exists (Beattie et al.,

2004). According to Milne and Adler (1999), content analysis involves two activities:

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“the construction of a classification scheme and devising a set of rules about ‘what’ and ‘how’ to code,

measure and record the data to be classified”. Content analysis can either be computer-aided or

human-coded (Beattie et al., 2004). The last one has the advantage, because it allows the quantitative

assessment of achieved reliability whereas the machine counting of words still requires subjective

inputs in relation to the identification of key words (Smith and Taffler, 2000).

Content analysis is a widely used method in prior accounting research. According to Linsley

and Shrives (2006a), there are several possibilities in choosing a coding and counting unit: words,

page proportions or sentences. Milne and Adler (1999), Beretta and Bozzolan (2004), Linsley and

Shrives (2006a) and Abraham and Cox (2007) use sentences for coding and measuring risk

disclosures. It is not useful to look at single words only. Without a sentence they have no meaning at

all. More reliable results will be achieved by looking at the words in their proper context. Nor is it

easy to decide which words are describing risk disclosures. However, a limitation of using sentences is

that companies have the possibility to use a particular style of writing to influence the disclosure

measurement’s outcome (Abraham and Cox, 2007).

Another weakness of content analysis is that it is a subjective method. Because of this, Linsley

and Shrives (2006a) argue that there is need for a reliable and valid coding scheme. Some other

studies, such as Bowman (1984), suggest that more than one person should read and code the

document in order to decrease the subjectivity of the analysis. Despite its limitation, a content analysis

is used for this research. When comparing this paper with prior research, it is essential that the

research method is the same as in other researches. If not, it would not be possible to make a reliable

comparison between these studies. Because of some limitations of the content analysis, it is useful to

combine a content analysis with another measure of voluntary disclosures. The contributing value of

this paper is that it combines a content analysis (measure the number of sentences) with a risk

disclosure index.

2.6 Risk reportingIn recent years, the concept of risk will get more considerable attention (Power, 2004). Before it

is possible to examine the amount and content of risk reporting it is important to know what is meant

by risk reporting. This paragraph reviews several definitions of risk as described in literature, then it

explains the Enterprise Risk Management framework and it ends with a description of the different

risk categories used in prior research.

2.6.1 Definition of risk

In everyday language ‘risk’ is a very broad concept, synonymous for example for hazard, threat or

harm (Lupton, 1999). There is no clear definition of ‘risk’. The dictionary describes ‘risk’ as “danger

for loss or damage”. This is in accordance with the negative association most people have with the

term ‘risk’. This is an one-sided concept. Risk just measures the potentials for downside outcomes or

23


losses. However, a risk can be positive as well. The two-sided concept consists of both downside

(negative) and upside (positive) components. Firms should be able to make use of the upside risks to

control risk exposure and minimize the effect of the downside risks. For investors it is important to

identify the companies that have done so (Lajili and Zéghal, 2005). The two-sided concept is part of

the modern view of risk, contrary to the pre-modern period, when risks were considered to be bad

(Linsley and Shrives, 2006a).

There are more definitions of risk than the dictionary’s. Risk is considered to be synonymous

for uncertainty, which exists in situations where probabilities were not available. Finance textbooks

define ‘risk’ as “a set of outcomes arising from a decision that can be assigned probabilities whereas

‘uncertainty’ arises when probabilities cannot be assigned to the set of outcomes” (Watson and Head,

1998). The ASB and the ICAEW define ‘risk’ as the “uncertainty as to the amount of benefits. The

term includes both potential for gain and exposure to loss” (ICAEW, 1998). The definition by Linsley

and Shrives (2006) is more extensive: “any opportunity or prospect, or any hazard, danger, harm,

threat or exposure, that has already impacted upon the company or may impact upon the company in

the future or management of such opportunity, prospect, hazard, harm, threat or exposure”. This broad

definition includes both ‘good’ / ‘bad’ risks and ‘uncertainty’. This is in accordance with Lupton’s

(1999) notion that risk is a very broad concept. The definition of Linsley and Shrives (2006a) is used

in this thesis. When examining the influence of the financial crisis on the risk paragraph, it is useful to

look at both the positive and the negative components of risk. Finally, Beretta and Bozzolan (2004)

defined risk disclosures as “the communication of factors that have the potential to affect expected

results”.

2.6.2 Enterprise Risk Management framework

Now the definition of risk is clear, the meaning of risk management must be explained as well. Risk

management has become a serious part of the company’s internal control and governance, because of

the increasing complexity of doing business (Amran et al., 2009). In 2004 the Committee of

Sponsoring Organizations of the Treadway Commission (COSO) published a new framework placing

it within the broader context of Enterprise Risk Management (ERM): ‘Enterprise Risk Management –

an Integrated Framework (COSO II). This model is the sequel of the ‘Internal Control – an Integrated

Framework’, which was released in 1992 also by the COSO. This model served as a fundament when

seriously discussing internal control. Managers had to take measures to ensure the effectiveness and

efficiency of operations, reliable financial reporting, and legal and regulatory compliance. The total of

these actions formed the process of internal control, which was defined as ‘the sum of the tools and

techniques used by management to ensure it achieves its objectives’ (Gauthier, 2006). COSO II

defines Enterprise Risk Management as ‘a process effected by an entity’s board of directors,

management and other personnel, applied in strategy setting and across the enterprise, designed to

identify potential events that may affect the entity, and manage risk to be within its risk appetite,

24


to provide reasonable assurance regarding the achievement of entity objectives. This process

necessarily involves both individual units within an organization and the organization as a whole’

(Gauthier, 2006).

Figure 2: COSO II Framework

The ERM framework looks at activities at all levels of the organization. This framework uses the

three basic managerial objectives from COSO I (operations, reporting and compliance), identifies a

new category of strategic objectives and has eight interrelated components (Gauthier, 2006), which a

company has to consider. The components are as follows:

Internal environment (identification of an entity’s tolerance for loss or risk appetite)

Objective setting (providing the context for risk assessment, given that a risk is defined as

something that could prevent an entity from achieving its objectives)

Event identification (distinguish between opportunities and risks)

Risk assessment (inherent risk)

Risk response (decisions to reduce, share, or accept inherent risk so that any remaining or

residual risk is consistent with the entity’s risk appetite)

Control activities (concrete steps taken to respond to risk)

Information and communication (specifically to include a provision for ‘upstream reporting’

in the case of management override)

Monitoring

COSO II does not replace COSO I, but expands the elements of internal control as set out in

COSO I. The emphasis on risk management is stronger than COSO 1, whereby the value of this model

is more useful for managers. They can make clear statements about which risks are relevant, what is

needed to control these risks and the cost of doing so. Nowadays, corporate governance codes are

becoming increasingly important. A good framework for managing internal control is necessary.

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According to Amran et al. (2009), accounting regulatory bodies should compel companies in a

developed country to disclose about their risk management. However, in many countries risk

management disclosures are still voluntary.

2.6.3 Risk categories

In general, companies report mostly about the financial risks they face. Nowadays, especially

since the current financial crisis, also other risks have become important for users of financial

statements. Companies should disclose more about other risks, such as operational, strategic and

empowerment risk. To get a better understanding of risk reporting these different types of risk have to

be identified. The risk classification schemes in prior research, can vary across researchers. To choose

a suitable categorization model for this paper some of these models are now reviewed.

Jorion (1997) categorized a company’s risks into three groups. The first type of risk is business

risk, which is the risk related to the company’s internal skills or competitive advantage. This type of

risk arises from technological innovations, product design and marketing. Then, there are strategic

risks, which are related to basic changes in the economy or the political environment. Financial risks

constitute the last category. These are related to possible losses in the financial markets.

One of the professional accountancy firms, Arthur Andersen, developed another risk model,

which is used by ICAEW (1998), Kajüter (2001), Linsley and Shrives (2006a) and Amran et al.

(2009). This model divides risk into two categories: external risks (general environment) and internal

risks (process risks, which are split up into financial and non-financial risks). A financial risk has an

immediate effect on monetary assets and liabilities. All other risks are non-financial, in other words

indirect financial risks. They affect the business and the comparative position and are noticeable in the

long term. The indirect financial risks correspond to the business risk category of Jorion (1997); the

external risks are similar to the strategic risks; and the financial risks are called the same. But the sub

categories, which belong to the category of financial risks are different. The ICAEW (1998) considers

liquidity risk, market risk and credit risk to be financial risks, but Jorion also includes operational risk

and legal risk to the financial risk category.

Besides the widely used model of Arthur Andersen, Cabedo and Tirado (2004) used a quite

similar risk classification. They divided risk into three major categories: external risks (general factors

in the environment in which the company operates); business risks (nature of the company’s business);

and financial risks (direct impact on net cash flows). Further, Crouhy et al. (2006) grouped the risk

factors into eight categories. Market risk, credit risk, liquidity risk, operational risk, legal and

regulatory risk, business risk, strategic risk and reputation risk. The first three categories constitute the

financial risk. According to Crouhy et al. (2006), there are three types of operational risks: technology

risk, fraud risk and human factor risk. Finally, the last three risk categories can be grouped together as

business risk, which refers to the typical risks a company faces.

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The models of the different researchers are quite similar, although there are small differences.

For this paper, the model of Linsley and Shrives (2006a) is used. It is the most recent and complete

risk categorization scheme, which contains all other classifications. The six risk categories are

financial risk, operations risk, empowerment risk, information processing and technology risk,

integrity risk and strategic risk. The financial risks will be explained in the next paragraph. Further,

operation risks are related to potential losses due to inadequate or failing internal processes, people

and systems or resulting from external events (Ridder, 2007). Some examples are product

development, efficiency and performance, product and service failure, and health and safety. The third

risk category, empowerment risk, concerns the power inside the company. All companies have a

management that is responsible for the company’s policy. In practice, it is very important to outsource

some responsibilities to the lower levels in the company. Further, a lack of good communication

between lower and upper levels, and in between a level will led to empowerment risk as well. The last

sub category of empowerment risk is change readiness: If people are ready to do their job in a new

environment has more effect than only the training the employees will get. Then, information

processing and technology risk implies the risks involved with information access, information

availability, and infrastructure (Linsley and Shrives, 2006a). The fifth risk category as described by

Linsley and Shrives (2006a) is integrity risk. This type of risk covers management and employee

fraud, illegal acts by persons involved in the company, and reputation risk, which becomes more

important in recent years, mainly because of the many accounting scandals. The last type of risk is one

of the most important risk categories. Strategic risk refers to the risk of significant investments for

which there is a high uncertainty about success and profitability (Crouhy et al., 2006). Further, the

risks a company faces in the industry in which it is operating and the competitors are strategic risks as

well. Even regulatory risks are a strategic risk. Appendix III will show the different categories and

their sub-categories as described by Linsley and Shrives (2006a).

2.7 Requirements for risk reporting

In the past few years there is more frequent discussion about risk disclosures and corporate

governance has increased as a result of some major corporate financial scandals, such as Enron,

WorldCom and Ahold. Corporate governance is the framework of rules and practices to ensure

accountability, fairness and transparency in the company’s relation with all stakeholders (Business

Dictionary). The confidence in the capital market and in companies has been damaged. Another reason

for the loss of confidence by stakeholders is the current financial crisis. Companies are trying to

restore the trust. To achieve this, it is necessary to disclose information to their stakeholders in order to

keep them informed about the company’s main activities. Since the introduction of IFRS in 2005 risk

reporting has become less voluntarily for all listed companies in Europe. Companies must provide

adequate information about the risks and uncertainties they are facing and will face in future,

especially for the financial risks.

27


This paragraph describes the different rules and regulation regarding risk reporting, which is

necessary for this research. Listed companies in the Netherlands have to comply with the International

Financial Reporting Standards (IFRS) and the Dutch Corporate Governance Code.

2.7.1 IFRS

The international Financial Reporting Standards (IFRS) are the accounting rules for all stock

listed companies in Europe since January 2005. IFRS presents no extensive standard for risk reporting,

but there are several rules regarding risk reporting. Almost all regulation concerning risks focuses on

financial risk. The same applies for IFRS, where the rules regarding risk reporting are included in

IFRS 7: Financial Instruments: Disclosures. IFRS 7 needs to be applied by all entities since 1 January

2007. However, the extent of disclosure that is required depends on the extent of the company’s use of

financial instruments and its exposure to risk. Earlier application is encouraged, so if a company

applies IFRS 7 earlier than 1 January 2007, it shall disclose that fact. Important in this study is that the

research period already starts in 2006. In this year, companies are disclosing according to IAS 32:

Financial Instruments: Disclosure and Presentation or IFRS 7. This may influence the results.

The IFRS requires disclosure of:

(a) the significance of financial instruments for the entity’s financial position and performance. These

disclosures incorporate many of the requirement previously in IAS32.

(b) qualitative and quantitative information about exposure to risks arising from financial instruments,

including specified minimum disclosures about credit risk, liquidity risk and market risk. The

qualitative disclosures describe management’s objectives, policies and processes for managing

those risks. The quantitative risk, based on information provided internally to the entity’s key

management personnel. Together, these disclosure provide an overview of the entity’s use of

financial instruments and the exposures to risks they create.

Source: IFRS 7.IN 5 (Main features of the IFRS)

An entity shall disclose information that enables users of its financial statement to evaluate 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 applies to all kind of risks arising from all financial instruments. For this research, the

most important part is the risk related paragraph of the requirements, The nature and extent of risks

arising from financial instruments. In this paragraph, IFRS 7 made a distinction between two different

types of disclosures: qualitative and quantitative disclosures. Qualitative disclosures are necessary to

complement the required quantitative disclosures and provide a better understanding of the company’s

risk management activities by the users of the financial statements. In the table below, the

requirements for qualitative disclosures are described.

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For each type of risk arising from financial instruments, an entity shall disclose:

(a) the exposures to risk and how they arise;

(b) its objectives, policies and processes for managing the risk and the methods used to measure the

risk; and

(c) any changes in (a) or (b) from the previous period.

Source: IFRS 7.33 (Qualitative disclosures)

Quantitative disclosures provide information about the extent to which a company is exposed to

risks based on the information available to key management personnel. For this kind of disclosures, it

is necessary to motivate changes.

For each type of risk arising from financial instruments, an entity shall disclose:

(a) summary quantitative data about its exposure to that risk at the end of the

reporting period. This disclosure shall be based on the information provided

internally to key management personnel of the entity’s (as defined in IAS24

Related Party Disclosures), for example the entity’s board of directors or chief executive officer.

(b) the disclosure required by paragraphs 35-42, to the extent not provided in (a),

unless the risk is not material (see paragraphs 29-31 of IAS 1 for a discussion of materiality).

(c) concentrations of risk if not apparent from (a) and (b).

If the quantitative data disclosed as at the end of the reporting period are unrepresentative of an entity’s exposure

to risk during the period, an entity shall provide further information that is representative.

Source: IFRS 7.34-7.35 (Quantitative disclosures)

The IASB made some amendments for the quantitative disclosures mentioned in IFRS 7, which

entities shall apply in their annual reports from 1 January 2011. As this study examines the years from

2006 to 2009, these amendments are not further discussed.

Just like other regulations, IFRS 7 focuses on financial business risks as well. This type of risk

can be categorized into six categories: credit risk, currency risk, interest rate risk, liquidity risk, market

risk and other price risk (IFRS 7, appendix A). More detailed requirements are only given for credit

risk, liquidity risk and market risk.

Credit risk is defined as ‘the risk that one party to a financial instrument will cause a financial

loss for the other party by failing to discharge an obligation’ (IFRS, appendix A). For each class of

financial instruments, IFRS 7 requires disclosure of the amount that best represents its maximum

exposure to credit risk. The collateral held or other credit improvements are not taken into account, but

a description is necessary. Further, a company shall disclose some information about the credit quality

of financial assets that are not past due or impaired. The amount of the financial assets that would be

past due or impaired have been renegotiated (IFRS 7.36).

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Liquidity risk is defined as ‘the risk that an entity will encounter difficulty in meeting

obligations associated with financial liabilities that are settled by delivering cash or another financial

asset (IFRS, appendix A). IFRS 7 requires that an entity shall disclose a maturity analysis for both

non-derivative and derivative financial liabilities showing their remaining contractual maturities.

Finally, a description of how companies manage those liquidity risks is required (IFRS 7.39).

Market risk is defined as ‘the risk that the fair value or future cash flows of a financial

instrument will fluctuate because of changes in market prices’. This type of risk can be divided in

three other categories: currency risk, interest rate risk and other price risk (IFRS, appendix A).

Companies are required to disclose a sensitivity analysis for each type of market risk to which a

company is exposed during the period. This analysis should give a description of how profit or loss

and equity would have been affected by changes in the relevant risk variable that was possible on that

date. Further, they have to give a description of the methods and assumptions used for preparing the

analysis. The changes from the previous period in the methods and assumptions used, including an

explanation for these changes, should be disclosed as well (IFRS 7.40). When a company uses a

sensitivity analysis, for example a value-at-risk, then this method can be used instead of the analysis of

IFRS 7.40. If a company decides to make use of this kind of sensitive analysis, they have to give an

explanation for the analysis, the main parameters and assumptions, the objective of the method and

the limitations (IFRS 7.41). Finally, there is a possibility that the sensitivity analysis is

unrepresentative for a risk inherent in a financial statement. If so, the company should disclose the fact

and the reason why it believes that the analysis is not representative (IFRS 7.42).

IFRS just gives a broad description of the biggest risks and uncertainties a company faces, such

as financial risks. There are no detailed requirements given about other types of risks, as mentioned by

previous research.

2.7.2 Dutch Corporate Governance Code

Regulation concerning risk disclosures in the Netherlands can be found in the Dutch Corporate

Governance Code (‘Code Tabaksblat’). Since this study examines companies listed on the AEX-index,

it has to be explained further.

The content of this code is regulated in the Dutch national law (art. 2:391 BW). Art. 2:391 lid I

BW states that the annual reports should give a description of the principal risks and uncertainties the

company faces and art. 2:391 lid 3 BW states that goal and policy of risk management on the use of

financial instruments have to be reported as well. Further, companies have to pay attention to the

price, credit, liquidity and cash flow risks they face. This is incorporated in the guidelines for annual

reporting (‘Raad voor de Jaarverslaggeving (RJ)’290.0). The code is not only binding for listed

companies, but practice shows that especially listed companies pay attention to this subject. The Dutch

Corporate Governance Code does not have explicit rules regarding risk reporting, such as IFRS.

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In 2003, the ‘Code Tabaksblat’, also known as ‘Code 2003’ was presented as the new Dutch

Corporate Governance Code as a substitute of the ‘Code Frijns’. From January 1, 2009, the code has

been transformed into a new: ‘Code 2008’. Because this study examines the years from 2006 to 2009,

two codes have to be considered. The first code will be used for the years 2006-2008 and ‘Code 2008’

will only be used for the last year, 2009. Before conclusions can be made, it is important to know if

there are big differences between these two codes. The importance of a good risk management and

control system and the way companies have to report about this are included in the best practice

provisions II.1.3, II.1.4, II.1.5 and II.1.8 (Ernst and Young, 2008).

According to ‘Code 2003’, “the company shall have an internal risk management and control

system that is suitable for the company” (BP II.1.3). In their annual report, the company’s

management shall declare that the internal risk management and control systems are adequate and

effective and they have to prove this. Further, the management should describe significant changes

that have been made and the major improvements which are planned as discussed with the audit

committee and the supervisory board (BP II.1.4). BP II.1.5 states that the management shall give a

review of the sensitivity of the company results to external factors and variables. Finally, BP II.1.8

states that the supervisory board shall discuss the corporate strategy and the company‘s risks as well as

the results of the assessment of the structure and operation of the systems at least once a year.

There are no big differences between the two codes with regard to risk reporting. BP II.1.3 is

identical for both ‘Code 2003’ and ‘Code 2008’. BP II.1.4 is quite similar in both codes. The earlier

code gives a description of adequacy and effectiveness of internal risk management and control

system, while ‘Code 2008’ only gives a description of the main risks related to the company’s strategy

and the systems’ design and effectiveness. The rest of BP II.1.4 is identical in both codes. However,

BP II.1.5 shows differences. The new code states that internal risk management and control system

should provide a reasonable assurance that the financial reporting shows no substantial errors. The

management board should give enough evidence of this. In ‘Code 2003’ the reasonable assurance is

described under BP II.1.4, but there is nothing mentioned about substantial errors. BP II.1.5 of ‘Code

2003’ is identical to BP II.1.6 in the new code. BP II.1.8 only shows a small difference. Instead of the

systems’ structure and operation, the new code speaks of design and effectiveness. The conclusion is

that the codes are approximately identical, on the understanding that ‘Code 2008’ is more extensive.

When companies report about their risks, they have to take into account three components. First,

a risk profile of the company. This is an exposition of the most important operational, strategic,

financial and compliance risks a company faces. It can be concluded that annual reports should define

only relevant risks. However, the risk paragraphs in most annual reports is a list of all risks a company

faces, regardless of the probability and the possible impact of the risk. In fact, every company has to

think about how relevant the endless list of risks is. The actual goal of risk reporting is creating

transparency, but with an endless list of risks the reader has to determine which risks are actually

relevant. Some parties, like VEB (Dutch investors’ association) and Eumedion (a Dutch representative

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body for institutional investors in the field of corporate governance) state that every company should

give a brief summary. For example a top-5 most relevant risks for their business. The second

component is a description of the risk management system. And finally, the in-control statement

should be included in the risk paragraph as well (Groot, 2008).

It is interesting to examine how non-financial companies deal with IFRS 7 and the Dutch

Corporate Governance Code. In accordance with an growing attention for regulations, an increase in

the disclosures is to be expected.

2.8 Financial crisis

This paragraph will discuss the problems of the financial crisis. First, a description of the causes

of the crisis will be given and then it will explain the consequences this has for risk disclosures.

2.8.1 Causes of the crisis

For the first time since the last crisis in 1930s, in 2008 the world economy experienced a

financial crisis. The whole crisis started in 2006 with the housing bubble and the liquidity shortfall in

the United States banking system. In September 2008, the international financial system was close to a

collapse of large financial institutions and downturns in stock markets around the world. After this, a

series of negative events followed, like failures by major financial institutions and government

interventions in financial systems around the world. The main reason for the big expansion of this

crisis is the failure by the key business and the decrease of consumer’s wealth.

From the beginning of the 21st century, the stock markets were increasing due to growth in the

internet sector. The ‘dot com bubble’ in the US in 2001 was the first trigger of the financial crisis.

On March, 10 2000, the bubble burst, because of speculation in stocks and widely available venture

capital. The central bank of the US (Federal Reserve) decided to bring back the interest rate from 6%

to 1.75%. They wanted to avoid a crisis by restoring the investors’ trust. As a result of the low interest

rates, people could lend ‘cheap’ money. Excessive risk taking by banks led to granting mortgages with

low interest rates to people who did not have enough income to cover them. A lot of Americans

bought a house, which they could not afford. They got ‘subprime’ mortgages, based on the premise

that housing prices would rise. In general, the crisis is the result from an period of excessive

borrowing, lending and investing encouraged by a series of economic and regulation factors, which

arose in the market for subprime residential mortgages in the US in 2005 and 2006. However, this was

not limited to the US; it had an impact on almost every market, it was noticeable on a global level.

The whole process of excessive borrowing and lending is empowered by excessive investments

from a wide range of investors around the world, in which ‘securization’ was an important link. This is

‘a transaction structure in which loans (such as loans secured by residential real estate – i.e.,

mortgages) are pooled together as collateral underlying the issuance of securities, mainly debt

securities’ (Arner, 2009). This process permits banks of assets to convert a future stream of revenue

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into a current value pool of capital, which is then used to sustain further lending. It requires investors

to purchase the securities to be sure the process is successful. This structure is frequently used in the

US and other Common Law countries.

In 2006, real estate prices in the US and in some other western countries had reached

unsustainable levels. Central banks raised interest rates as a result of global economic growth. 80% of

the issued mortgages were adjustable-rate mortgages, so the monthly charges increased in line with the

interest rates. Mortgage borrowers in the US got difficulties meeting their obligations. Failures in

loans began to rise. Securities lost their values since lenders expected that price appreciations were

high. The securities were held by financial firms from all over the world and the consequence was a

large turndown in the capital of different banks (Arner, 2009). Because of the high real estate prices,

purchasers stopped entering the markets, resulting into rapidly decreasing real estate prices for the first

time since years. Borrowers who had a financial problem couldn’t sell their property to solve this

problem. This resulted into a decline in stock prices of financial firms and a lot of banks got liquidity

problems. Mistrust between banks arose, so they were unwilling to lend money to each other.

Government interventions were unavoidable. This downward spiral led to the crisis in the U.S (Arner,

2009).

All listed banks in the US and the biggest insurers receive government support. The

securitization process makes it possible that securities will easily be spread around the world. Various

institutions did not know from whom they were buying and what the risks were. The bankruptcy of

Lehman Brothers on September, 15 2008, triggered the financial crisis in the US and by this time,

European banks were involved in the US crisis as well (Arner, 2009).

The combination of debt capital market technology, regulatory incentives, excessively low

interest rates and excessive global investor demand meant the beginning of the crisis (Arner, 2009).

2.8.2 Consequences of the crisis for risk disclosures

As a result of the crisis the governments of the US, the European Union, and Switzerland,

focused on taking action to prevent the financial crisis from becoming a financial collapse. Some

methods they used were interest rate cuts, massive liquidity infusions, capital injections, guarantees,

and asset purchases. Unfortunately this was not enough to prevent major adverse economic

consequences. Significant changes are needed in both domestic and global financial regulation to

prevent future credit crises (Arner, 2009).

Central failure in the crisis, concerns the financial institution corporate governance. Financial

institutions did not manage their own risks or businesses well. As a consequence, all companies were

facing increasing losses, which can be attributed to operational risks (Arner, 2009).

Because of the volatile environment in times of a financial crisis, questions arose about the

companies’ risk management practices. Although the crisis arose with financial companies, these

questions were important for non-financial companies as well. ‘In this new risk culture, everyone

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needs to consider hem of herself a risk manager with a shared understanding of the organizational risk

appétit underpinned by a clear governance structure for managing risks’ (KPMG, 2009).

Research shows that the financial reporting by firms has deficiencies, especially with respect to

the risk-paragraph (Sundmacher, 2008). Because of this, there is an increasing awareness among

managers to understand the risks faced by the firm and to understand how these risks can be managed.

Risk taking is the fundamental business in the financial services sector. Appropriate risk disclosures

helps investors and other stakeholders to make more informed decisions and can be highly valuable

for companies (Sundmacher, 2008).

The nature of risks varies from sector to sector. The telecommunication sector is transforming

as a result of technological changes, while other sector are facing more strategic business risks.

However, this does not mean that one sector is less or more risky than another. The most severe risk

all sectors face is the credit crisis. The banking and insurance sector faces direct threats from the

financial crisis, while other sectors are under pressure by a tighter credit environment. In these

turbulent times not only the companies’ reputations themselves are damaged, but the credit crisis

weakens the public trust in the entire sector as well (Arner, 2009).

Another failure in the crisis was that disclosure requirements were not sufficient to support

transparency and market discipline (Arner, 2009). Paragraph 2.7, where the requirements for

disclosures are discussed, states that voluntary disclosures became more and more mandatory, because

of the growing importance of risk disclosures.

The credit crisis was triggered by a lot of different factors, and in the aftermath of the crisis

most sectors have to deal with a tight credit environment.

2.9 Summary

This chapter gave some background information regarding disclosures in general and risk

disclosures in specific. The chapter started with an introduction. Then, the three types of disclosures

were discussed: mandatory, recommend and voluntary disclosures. This research focuses on voluntary

disclosures, which can be explained with the positive accounting theory (PAT) in the third paragraph.

The PAT explains and predicts accounting practices. It shows how things works, not how things

should work (Whitley, 1988). This theory focuses on the supply side of information. It explains the

managers’ motives for risk reporting (Watts and Zimmerman, 1986) and focuses on the relationship

between principals (stakeholders) and agents (managers). The demand for information arises from

information asymmetry between these two. Both parties have different interests, which results in

agency conflicts. Voluntary disclosures are useful to fill this gap (Deegan and Unerman, 2006).

The fourth paragraph discussed managers’ motives and constraints for disclosing or not

disclosing information. Managers can reduce the cost of capital by reducing information asymmetry

by more voluntary disclosures. Other consequences of voluntary disclosures are lower information

acquisition cost and an increasing amount of information available to analysts (Graham et al., 2005).

34


Further, managers don’t want to lose their job as a result of low stock and poor earnings performance.

Other reasons are that managers are directly rewarded by using a variety of stock-based compensation

plans (Healy and Palepu, 2001) and talented managers have the incentive to disclose earnings

forecasts to make their type public (Trueman, 1986). The litigation cost hypothesis can be both a

motive and a constraint. Managers with bad earnings news have a motive to disclose this information

earlier to reduce the cost of litigation, while litigation reduces the incentives when managers believe

that the legal system punished forecasts which are made in good faith (Skinner, 1994). Despite the

motives for disclosing information, voluntary disclosed information can damage the competitive

position (Verrechia, 2001; Dye, 2001) and in the case of agency costs, full disclosures can not be

reached (Nanda et al., 2003; Berger and Hann, 2003). No evidence is found for political costs (Graham

et al., 2005).

The fifth paragraph described the different methods for measuring disclosures. The methods are

subjective ratings, disclosure index studies and textual analyses. The last two methods are important

for this research. When using disclosure indices, the amount of disclosures is used as a proxy for the

quality of disclosures (Marston and Shrives, 1991; Botosan, 1997). They make use of predefined

information items and the coding scheme can be a simple binary coding or an ordinal measure.

Textual analysis reviews the content of accounting narratives, especially when a large amount of data

needs to be analyzed (Jones and Shoemaker, 1994). It is a method for codifying text into various

categories depending upon selected criteria (Holsti, 1969). There are several possibilities, varying per

research, for choosing a coding and counting unit : words, page proportions or sentences.

After discussing disclosures in general, the other paragraphs were focused on specific risk

disclosures. Paragraph 2.6 mentioned the different definitions of ‘risk’. In this research the definition

of Linsley and Shrives (2006a) is used, because it includes both the positive and the negative side of

risk. Further, it explains the Enterprise Risk Management (ERM) framework (COSO II). With this

framework, clear statements can be made about which risks are relevant, what is needed to control

these risks and the cost of doing so. A good framework is necessary because corporate governance

codes are becoming more important. This paragraph ends with the classification scheme developed by

Arthur Andersen, also used by Linsley and Shrives (2006a) as well as other researchers.

The seventh paragraph of this chapter discussed the requirements for risk reporting. Recently,

risk reporting of financial risks became mandatory for listed companies in the European Union.

Companies must provide adequate information about the risks and uncertainties they are facing and

will face in the future. Because listed companies in the Netherlands have to comply with the

International Financial Reporting Standards (IFRS 7) and the Dutch Corporate Governance Code,

these requirements are described in this paragraph. In IFRS 7 the requirements concerning risk focuses

especially on financial risks (credit risk, currency risk, interest rate risk, liquidity risk, market risk and

other price risk). For the other risk categories no additional information is required, just a broad

description of the biggest risks and uncertainties is sufficient.

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The Dutch Corporate Governance Code (‘Code Tabaksblat’) does not give explicit rules regarding risk

reporting. The Code prescribes that the company should have an internal risk management and control

system that is adequate and effective (‘in-control statement’). Also that the management should give a

review of the sensitivity of the company results to external factors and variables and that the

supervisory board should discuss the corporate strategy and the company’s risks.

Finally, the last paragraph focused on the financial crisis. Since this study examines the

differences in the risk paragraphs before and during the crisis, it is important to know something about

the origins of the crisis and its consequences for risk reporting. A combination of debt capital market

technology, regulatory incentives, excessively low interest rates and excessive global investor demand

meant the beginning of the crisis. But main reasons were the failure of the key business and decreasing

consumer wealth (Arner, 2009). The methods as used by the governments in the US, the European

Union, and Switzerland, were not enough to prevent major adverse economic consequences. One

problem is that financial institutions did not manage their own risks or businesses well. Research

shows deficiencies in the financial reporting of firms, especially with respect to the risk paragraph

(Sundmacher, 2008). Another failure in the crisis was that disclosure requirements were not sufficient

to support transparency and market discipline. To prevent future credit crises, significant changes in

both domestic and global financial regulation are needed (Arner, 2009).

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3 Literature review

3.1 Introduction

This chapter will discuss relevant literature regarding voluntary disclosures, especially risk

disclosures. In this review the content, findings and the relevance of the different studies will be

summarized. In appendix I a short summary is given of relevant articles for this research, of which

only the most relevant ones are discussed in this chapter.

Research on risk disclosure has mostly been done in the Western countries. There are two

groups of research approaches. For the first group the entire annual report is source of content analysis

of risk, while the other group only focuses on the management discussion and analysis (MD&A)

section (Amran et al., 2009). A large number of disclosure studies have been performed in the last 30

years particularly in countries like the USA, UK, Canada, and Germany. In these countries, companies

are required to disclose more risk information than in other countries (Linsley and Shrives, 2006a).

The study by Deumes (2008) is the only study found in prior research that discussed risk

reporting in the Netherlands. This research examined whether companies reported risk-relevant

information to prospective investors in the late 1990s. His conclusion was that prospectuses of Dutch

listed companies provide adequate information about material investment risks. Because this paper

will examine the quantity of the risk paragraph in annual reports before and during the financial crisis,

the study of Deumes (2008) is not relevant for this paper. So, this research is examining a new subject

of risk reporting in the Netherlands. Besides the study of Deumes (2008), there is more literature

regarding risk disclosures. In this chapter the most recent studies on this topic are discussed. The

studies from Lajili and Zéghal (2005), Linsley and Shrives (2006a), Abraham and Cox (2007), and

Amran et al. (2009) made research to the content and volume of risk paragraphs in annual reports.

They made use of the same research method as the one chosen for this paper. However, there is no

prior literature that examines the influence of the financial crisis. At the end of this chapter, the

different studies will be compared and their contributing value for this research will be discussed.

3.2 Lajili and Zéghal (2005)

This paper examines risk information disclosures in Canadian annual reports. Lajili and Zéghal

(2005) are interested in the current risk disclosure environment, its characteristics, and the analytical

usefulness of the information disclosed to the firm’s stakeholders. The objective of this study is ‘the

way management reports the different types of risks, and which firms and industries are reporting

certain categories of risks and associated risk management strategies’. The first step in analyzing risk

disclosures is studying the intensity and nature of risk-related information, as well as the volume and

location of this information. Their goal is to know which industries and companies disclose this kind

of information, how much they are disclosing, and where they report the information. The sample

37


consists of 300 Canadian companies listed on the TSE in December 1999. They analyze the risk

information in the annual reports using a content analysis. They adopt this method mainly because risk

disclosures, especially non-financial types, are largely disclosed qualitatively. Besides the two authors

one graduate student familiar with the content analysis, codes the risk information in the annual

reports as well. This increases the reliability of the analysis, which is useful for managers, board

directors, and stakeholders. They focus on improvements of the current disclosure environment

especially in the turbulent economy where risk has a great scope. Lajili and Zéghal (2005) analyzed

both the MD&A section and the notes to the financial statements. They measure the volume of risk

disclosure by the number of words and sentences as reported in the annual reports. They used this to

calculate the frequency distribution and the descriptive statistics. The mean risk disclosure in the

MD&A is 216 words and 10 sentences. The mean disclosure in the notes to the financial statements is

204 words and 10 sentences. The main results of this research are that the risk information disclosed is

almost exclusively qualitative and is located in the notes to the financial statements and/or in the

MD&A section. Further, the most common risk categories were financial risk, commodity risk and

market risk (business risk). Also the current disclosures emphasize on downside risk, while up-side

effects and value-creating opportunities do not occur. Risk assessment and analysis is quite limited

and lacks quantitative insights. Lajili and Zéghal (2005) conclude that in the future more

comprehensive and formal risk disclosures might be useful to reduce information asymmetry between

managers and stakeholders. In future research a risk management disclosure index could be built based

on the content analysis presented in this paper, using a combination of word and sentence coding to

measure the volume of disclosure in each risk category. Another point to focus on in future is the

market relevance of derivatives and other hedging instruments in the Canadian context in comparison

to the U.S (Lajili and Zéghal, 2005).

3.3 Linsley and Shrives (2006a)

Linsley and Shrives (2006a) examine risk information disclosed by UK public companies

within their annual reports. The sample consists of 79 non-financial firms listed within the FTSE 100

index as at 1 January, 2000. They examine if there is a relation between company size or level of risk

and risk disclosures. To analyze the risk disclosures a content analysis distinguishing between

monetary and non-monetary, past and future, and good and bad disclosures was used. Linsley and

Shrives (2006a) excluded financial companies from their research, because they expected these

companies to make significantly different types of risk disclosures. They made use of a risk

classification scheme with the following risk categories: financial risk, operations risk, empowerment

risk, information processing and technology risk, integrity risk, and strategic risk. The companies in

the sample are not providing a complete profile of the risks they face. The disclosures of quantified

risk information are minimal and a significant part of the risk disclosures consists of generalized

statements of risk policy. Further, directors are mainly reporting forward-looking risk information.

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This lack of coherence in the risk narratives implies that there is a risk information gap with the result

that stakeholders cannot adequately assess the company’s risk profile. A significant association is

found between the number of risk disclosures and company size. However, there is no association

between the number of risk disclosures and the level of risk, which is measured with five different

variables (gearing ratio, asset cover, quiscore, book to market value of equity and beta factor). The

most common risk disclosures are non-monetary/neutral/non-time specific risk management policy-

financial risk disclosures and non-monetary/neutral/non-time specific policy -integrity risk disclosures.

The risk management policy disclosures excluded, the risk categories with the highest number of

disclosures are strategic risk, operations risk, and financial risk. The mean disclosure rate per report is

78 sentences with a minimum of 20 sentences and a maximum of 275. To test the association between

the number of risk disclosures and company size they made use of the Pearson correlation coefficient.

The Wilcoxon signed ranks test is used to test the hypotheses which consist of the distinction between

monetary and non-monetary, past and future, and good and bad disclosures. This means that the non-

monetary risk disclosures exceed the monetary risk disclosures for all sample companies, the number

of past risk disclosures is not significantly greater than the number of future risk disclosures, and

finally, the number of good risk disclosures is significantly greater than the number of bad risk

disclosures. As in all research, this study has limitations as well. The content analysis does not

measure the quality of risk disclosures and the subjectivity of this method cannot be wholly

eliminated, so future research has to adopt this. But despite the limitations, the research method was

still effective in making important contributions to literature. Future research has to take into account

that risk disclosures are possible in other areas as well, such as cross-country or within specific

sectors. These findings could be helpful in understanding the management motivations for reporting

risk (Linsley and Shrives, 2006a).

3.4 Abraham and Cox (2007)

This research examines narrative risk disclosures from a broad perspective: business, financial,

and internal control risk reporting within UK annual reports and their relation to institutional

ownership, board of director, and US dual-listing characteristics. Abraham and Cox (2007) use the risk

reporting classification to investigate the determinants of the quantity of narrative risk information in

annual reports. The agency theory is used to explain the different relations, which means that the

managers’ interest is different from the owners’ (Jensen and Meckling, 1976). The level of risk can

systematically differ across firms, so this study controls for size, industry, and risk variables as well.

Because Ahmed and Courtis (1999) find that audit firm size is no significant determinant of annual

report disclosure, this variable is not included in this research. As research period, the year 2002 is

used. The sample consists of 78 non-financial UK companies on the FTSE 100 Index, but missing data

resulted in a final sample of 71 firms. To quantify risk disclosures, they made use of a content analysis

to count the words within risk-related sentences. This means that they highlight each sentence if it

39


contains risk information, and ignore lack or vagueness of risk information. They followed Botosan

(1997) by drawing a list of key words for the purpose of checking the robustness of the primary

content analysis. Abraham and Cox (2007) defined a set of dummy variables to account for the

possibility that risk reporting may be influenced by the specific industry it belongs to. With the

Pearson correlation test, they found that leverage is not significant, which confirms the results of

Linsley and Shrives (2006a) and the coefficient on company size is positive and significant. Further,

there is a negative relation between corporate ownership by large-term institutions and risk reporting,

while a positive relation is found between short-term institutions and risk reporting. From the agency’s

perspective, large, long-term institutional shareholders may fulfill a monitoring function, but this does

not mean to pressure firms to increase their disclosures. When examining the firm’s board it appears

that both executive and independent directors are important in risk reporting. Dependent non-

executive directors do not provide more transparency for risk disclosures. Finally, they found that UK

firms with a US stock exchange listing do not disclose more risk information within their annual

reports than non-US listed companies. Finally, to test the different categorizations of risk, Abraham

and Cox (2007) made use of three regression analyses; business, financial, and internal control risk

reporting. A limitation of this study concerns the selection of sentences to code risk disclosures. Their

word count within sentences investigates only one dimension of risk disclosures. Future research could

consider other approaches for measuring risk reporting and build on the insights within this study

concerning the relation between risk reporting and the different variables (Abraham and Cox, 2007).

3.5 Amran, Bin and Hassan (2009)

This research provides a better understanding of risk management disclosure practices in Malaysia and

is based purely on the checklist by Linsley and Shrives (2006a). Amran et al. (2009) empirically tested

the sampled companies characteristics and compared the levels of risk faced by these companies with

the disclosures that were made. This study focused only on the non-financial part or narrative part of

the annual report. The annual reports of 100 public listed companies on the Bursa Malaysia for the

year 2005 were analyzed. The method used for this study is a content analysis. This method is chosen,

because it focuses on the extent or amount and not on the quality of risk disclosures. The total number

of sentences in this sample is very small when compared with the research done by Linsley and

Shrives (2006a) in the UK. This was expected since disclosure reporting by Malaysian companies is

still in an early stage. To ensure the reliability of the risk disclosure score, the coder had a training to

understand the checklist and the decision rules. The coder’s understanding was tested by the

verification test, in which two persons were involved. One person was the coder, the other the

researcher. Both of them analyzed a set of five annual reports. The results of the content analysis were

correlated to determine the extent of agreement. There were no significant differences between the

scores. The categorization of risk as used by Amran et. al (2009), is based on the model of Linsley and

Shrives (2006a). The most reported risk categories were strategic risk, operations risk and

40


empowerment risk. The total amount of sentences for risk management disclosure ranged from three

sentences to the maximum of 78 sentences with an average of 20 sentences. Before the correlations

were calculated, the Kurtosis and Skewness tests were used to measure the normal distribution. Both

dependent and independent variables were found not to be normally distributed. The variables were

transformed to normal scores before the multiple regression analysis in assessing the variability of the

extent of risk disclosure was carried out. To ensure the rigorousness of the regression the

multicollinearity, homoscedasticity and linearity tests were conducted. The variables that were used

for the regression are company diversification strategy, leverage, size and industry. None of the

diversification variables were significant, while the other variables were positively correlated. The

relation of company size was expected by the stakeholder theory. If a company becomes bigger, it will

have more stakeholders who are interested in the company. Finally, the nature of the industry

influences the extent of risk disclosures as well. Industries with more risk exposure, namely

infrastructure and technology industries, should report more about their risks. One of the limitations of

this research is that it is purely based on the checklist by Linsley and Shrives (2006a). For further

research it is interesting to create a local risk measurement checklist that reflects the local stakeholders

demand. Another point for future research is looking deeper into the different variables that are

involved (Amran et. al, 2009).

3.6 Review of the literature

Now that the different studies have been discussed, the similarities and differences between

them must be mentioned as well as the relevance of these articles for this research.

All articles make use of the same research method; a content analysis. The implementation of

this method is not the same in every research. Some authors measure both words and sentences, while

others measure only one of them. Because in almost all previous research the research method is a

content analysis, this research also uses this method. However, there is a difference. Lajili and Zéghal

(2005) mentioned that it is useful for future research to prepare a risk disclosure index. This research

introduces a risk disclosure index in combination with measuring the number of sentences. With this

research method it compensates for the limitation mentioned in the article by Amran et al. (2009).

Their research is purely based on the research by Linsley and Shrives (2006a). The combination of a

risk disclosure index and the measurement of the number of sentences is new, it is not present in the

article by Linsley and Shrives (2006a). Lajili and Zéghal (2005) and Amran et al. (2009) want to

ensure the reliability of the risk disclosure score. They do this by comparing the scores of a few annual

reports by two different coders with a verification test. In both cases, there were no significant

differences between the scores. As this research also makes use of a content analysis, such a

verification test must be implemented as well.

A lot of previous researchers excluded the financial companies from their research, because

they expected that these companies made significantly different types of risk disclosures. To make a

41


good comparison between this research and prior literature, this paper examines non-financial

companies as well. In all researches the article by Lajili and Zéghal (2005) excepted, the sample size is

almost the same. Whereas other articles analyze only one research year, this paper has a contributing

value to the topic of risk disclosures by examine more than one research year. However, Linsley and

Shrives (2006a) mention that cross-country testing is useful in future research. As this research has a

four year research period, testing cross-country is too time-consuming.

Although this study is based on Linsley and Shrives (2006a), it does not make the distinction

between monetary/non-monetary, past/future, and good/bad news by studying the risk paragraphs in

annual reports. In this paper is chosen for a risk disclosure index instead of measuring all sentences. It

is too time-consuming to measure all sentences in the annual reports on the basis of this distinction.

However, the different risk categories which are introduced by Linsley and Shrives (2006a) are used.

This classification is used by other researchers as well (for example Amran et al. (2009)) because it is

very broad and quite similar to the classification as used in the annual reports of Dutch listed

companies. The risk categorization by Linsley and Shrives (2006a) is used, however, the financial risk

category in this paper is more extensive. Further, Lajili and Zéghal (2005) found that the financial,

market and commodity risk categories are the most important ones, while Linsley and Shrives (2006a)

found that the companies in the sample reported mostly about the strategic, financial and operational

risk categories.

In every research control variables are used, which are varying per study. The articles in this

section use size, leverage, profitability, and industry as control variables. Size is not a good measure

for this research, because all companies are listed on the AEX-index. They have the same listing-

status, so they are comparable to one another. The other three variables, leverage, profitability and

industry are useful for this study. The results for leverage are mixed. Linsley and Shrives (2006a) and

Abraham and Cox (2007) found no significant relation between leverage and risk disclosures, while

Amran et al. (2009) found a positive relation. Further, Amran et. al (2009) found no significant

relation between risk disclosures and company profitability. For industry a significant positive relation

was found. Some researchers examine other relations as well. It is too time-consuming to use all

variables in this research, so it will not further be discussed here.

Finally, Amran et al. (2009) state that it is useful for future research to examine the local

stakeholder demand. Risk disclosures can be seen from two perspectives. First, from the managers’

perspective; what do they want to disclose? The other perspective is from the stakeholders’ view. The

stakeholders’ perspective is based on decision usefulness; what information do they need? This paper

examines annual reports from the management point of view. The central question here is whether the

management reports more about the risks and control mechanisms during the crisis than before.

42


3.7 Summary

Previous research gives a broad description of disclosures in general, but not much research was

done on risk reporting practices, especially in the Netherlands. In this chapter, the most relevant

articles for this research are discussed. For a better understanding of all literature regarding risk

disclosures, a short overview is given in appendix I.

Basis for this research is the paper by Linsley and Shrives (2006a), however some adjustments

have been made. The categorization scheme is more extensive, the way the research is done is

different, and the sample period is four years instead of one year.

As in other researches, the financial companies are excluded from the sample. This kind of

companies made significantly different types of risk disclosures. Almost all studies have chosen for a

similar sample size in their research, except for Lajili and Zéghal (2005). The verification test, used by

Lajili and Zéghal (2005) and Amran et al. (2009), is used to ensure the reliability of the risk disclosure

scores.

Finally, most of the control variables mentioned in previous literature are also used in this

research. The control variables are profitability, leverage and type of industry. Size is not used. All

companies in the sample are listed on the AEX-index. These companies have the same listing-status,

which means that they are comparable. When using size as a control variable, no differences are

expected. Therefore it is not useful to use size as control variable in this research. Previous research

gives mixed results for the relations between control variables and risk disclosures. All results are

shown in the review in appendix I.

Reviewing literature shows that this research is based on previous literature, but it reckons with

the limitations and recommendations for future research. It can be concluded that this paper has a

contributing value for the topic of risk disclosures in the Netherlands.

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4 Research design

4.1 Introduction

After studying prior literature about risk disclosures, this chapter describes the research design.

The literature review, described in the previous chapter, can be used as a basis for this research.

However, no research can be found that is similar to this paper. The paper that is closest to this study,

is the paper by Linsley and Shrives (2006a). They examine the relation between company specific

characteristics (company size and level of risk) and the amount and nature of the risk paragraphs in

UK annual reports. Their paper is generally known and it is used by a lot of other researchers as well.

This paper examines the influence of the financial crisis on risk paragraphs. This means that the

content analysis is different and also the statistical methods used are not similar. The design of this

research will be discussed in this chapter.

First, the sample selection which consists of the sample size and sample period, will be

discussed. Then the research approach which can be split up in the risk disclosure index and the

control variables, will be further explained. In the fourth paragraph the different hypotheses will be

formulated. The chapter ends with a summary.

4.2 Sample selection

As a sample non-financial companies in the Netherlands is chosen. Financial companies are

excluded from this sample, because they are expected to make a significantly different type of risk

disclosures compared to other firms (Bessis, 2002). Because they face more risks, financial companies

have to deal with more extensive legislation. The business of financial companies is totally different

from the business of non-financial companies. This will distort the research results. Therefore it is

better to study them independently. To use only non-financial companies is in line with prior research.

Considering the time-consuming process of a content analysis it is impossible to examine all

companies listed on the Euronext. Bearing in mind that small companies report less extensive risk

disclosures than large companies, this sample only consists of companies that are listed on the AEX-

index. Twenty-five companies, including financial companies are listed on this index. When

eliminating the financial companies, the sample consists of 20 companies. However, after examining

all annual reports, 2 companies, Airfrance-KLM and Arcelor Mittal, appeared to have no risk

paragraphs in their annual reports. They reported their financial risks in financial statements, but this

part of the annual report is not included in this research. This resulted into a final sample of 18

companies listed on the AEX-index on 30 September, 2010. The composition of the AEX-index is

changing every half year, but the companies that were listed at the moment this research started are

taken as references.

Because this study aims to examine the influence of the financial crisis, the annual reports of the

companies before and during the financial crisis have to be studied. To get reliable results, two years

44


before and two years during the crisis are compared. The sample period is from 2006 to 2009, in

which the years 2006 and 2007 represent the risk disclosures before the financial crisis, the annual

reports from 2008 and 2009 disclose risk information during this crisis.

4.3 Research approach

Risk information is usually communicated at three levels: internal, external, and an intermediate

level in between the first two levels. This study focuses on external reporting (or public disclosure) of

risk related information. The risk information is published in annual reports. These reports provide

qualitative and quantitative risk information in the financial statements (mainly in the footnotes) or in

the management discussion and analysis (MD&A) sections (Lajili and Zéghal, 2005). According to

IFRS, companies should report all relevant information concerning financial risks in their financial

statements. Because other risks are important as well, and it is too time-consuming to examine both

sections, only the risk paragraph in the MD&A section has been studied. In this section all risk

categories are reported, whereas in the financial statements only the financial risks are disclosed. If a

company does not have a separate risk paragraph in its annual report, it is excluded from the sample.

There are several different approaches to the analysis of narratives in annual reports. For this study a

content analysis is selected (see paragraph 2.5.4). Although the paper by Linsley and Shrives (2006a)

serves as a basis, this research is carried out differently. Here a risk disclosure index is used to

determine a risk disclosure score for every company in the sample. This will be further explained in

the next section.

4.3.1 Risk disclosure index

Because the content analysis is under a lot of criticism, a risk disclosure index has been developed

instead of coding the ‘sentences’ according to the different characteristics (see paragraph 2.5.4). Milne

and Adler (1999) emphasize the importance of mentioning which unit of analysis forms the basis for

coding decisions, because ‘reliability concerns coding errors, not measurement errors’. Further, with

this research method it is difficult to meet the three conditions of readability by Krippendorff (1980), it

is too time-consuming and the most important reason is that it is highly subjective, when done by one

single person. The subjectivity can be reduced by using a binary coding scheme with predetermined

criteria and Milne and Adler (1999) and Linsley and Shrives (2006a) state that the reliability of the

coding process can be improved by constructing decision rules that the coder can refer to (Linsley and

Shrives, 2006a). The decision rules are described in appendix III. A third method to reduce

subjectivity is to do a verification test, which means that together with the author of this paper a

second person examines the risk paragraph as well. A student of the Erasmus University Rotterdam

studied three randomly chosen annual reports. These annual reports were chosen with the

RANDBETWEEN-function in Excel. The annual reports which were randomly chosen are ASML

(2006), KPN (2009) and Randstad (2009). When both persons have examined the risk paragraph, the

45


scores are compared to each other. Both coders gave exactly the same scores to the risk categories in

the risk paragraph of ASML (2006) and KPN (2009). However, when calculating the scores for

Randstad (2006) there is a small difference. The author of this paper had a risk disclosure score of 0.7,

while the student had a score of 0.75. In the annual report a risk was described under the heading

‘operational risk’. However, the risk categorization by Linsley and Shrives (2006a), which is used in

this research, is more extensive than the risk categorization in Randstad’s annual report. The author of

this paper categorized the risk as an empowerment risk. So, the different scores can be contributed to a

different categorization of the risk categories. The student admitted that she was not fully aware that

the categorization as used in this research was not equal to the headings used in the risk paragraph.

While the other two risk disclosure indices were completely the same, the small difference for

Randstad (2009) is negligible. It can be concluded that there are no significant differences between the

findings of the author of this paper and the student’s findings. This means that the author of this paper

measures reliable risk disclosure scores. But despite of the fact that the index is calculated by more

than one person, it will always be a subjective method.

There is no predetermined standard for categorizing risk disclosures. In this research the

different risk categories are based on the risk classification scheme by Linsley and Shrives (2006a)

(Appendix IV). The choose is made for this model instead of the categorization as described in the

Dutch corporate governance (operational, strategic, financial and compliance risks). Not all Dutch

listed companies used this classification scheme and because no prior research has been done in the

Netherlands, there is no reason for using that model. However, the model of Linsley and Shrives

(2006a) is used by other researchers as well, which makes comparing less difficult. However, the

model by Linsley and Shrives (2006a) is modified. They mentioned financial risks and five other non-

financial risk categories. This paper has divided the financial risk category into five different risk

categories. The five non-financial risk categories are identical to those in the paper by Linsley and

Shrives (2006a). The risk categories are:

Financial risks Credit risk

Price risk

Liquidity risk

Interest risk

Currency risk

Non-financial risks Operational risk

Empowerment risk

Information processing and technology risk

Integrity risk

Strategic risk

Table 2: Risk categories

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An example of the risk disclosure index is added in appendix V. The risk disclosure score is developed

as follows. First, the company receives a score of ‘1’ if the risk category is mentioned and a score of

‘0’ when it is not mentioned in the risk paragraph. The second part in developing the score is the

question if the company mentioned the control mechanism for the particular risk in their annual report.

The company scores a ‘1’ if it does mention a control mechanism and the company will get a score of

‘0’ when no control mechanism is described. If the scores for every risk category are given the risk

disclosure score can be measured. To obtain this score, the total score should be divided by the total

possible score. The total possible score is the number of risk categories times the number of columns

(risk mentioned + control mentioned). For this index the total possible score is 20. When both scores

are known, the risk disclosure score can be measured:

Risk disclosure score = (Score risk mentioned + Score control mentioned) / Total possible score

4.3.2 Control variables

The level of risk disclosures may systematically differ between firms due to other factors

(Abraham and Cox, 2007). To limit these factors, this study controls for profitability, level of risk, and

type of industry. The control variables in this study are more extensive than the variables used by

Linsley and Shrives (2006a). They just take company size and level of company risk. The data of the

control variables are obtained from the ThomsonOneBanker for the 18 companies in the sample. The

rest of the paragraph describes how these variables are measured.

The profitability of a company will be measured by return on assets (ROA): the ratio of net profit

in million euro to book value of total assets in million euro. This is considered to be an acceptable

measure of company profitability (Linsley et al., 2006b).

Measuring the level of risk is much more problematical as there is no single measure. Most of the

measures focus on a specific kind of risk. The measure which is used in this research is company

leverage. A higher leverage is associated with a higher level of risk, due to higher volatility of profits.

This can be calculated with the debt/equity ratio.

In this research the type of industry is a nominal variable to measure the possibility that risk

reporting will be influenced by the general relationships that are inherent to each industry (Abraham

and Cox, 2007). Based on the Industry Classification Benchmark (ICB), there are 10 industries.

Because this paper leaves out financial companies, it is using only 9 categories. However, none of the

companies as listed on the AEX-index are active in the health care and utilities industry. So these

industries are excluded as well. The final industry classification consists of 7 categories. Therefore

seven variables are created: 1=OIGS (oil and gas), 2=BMAT (basic materials), 3=IND (industrials),

4=CONSG (consumer goods), 5=CONSS (consumer services), 6=TELEC (telecommunications), and

7=TECHN (technology).

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4.4 Hypotheses development

In this paragraph several hypotheses are formulated. With the result of the first hypothesis an

answer for the research question, as mentioned in paragraph 1.4, will be given. With the help of the

other hypotheses an attempt will be done to explain the expected differences between the risk

disclosure scores.

4.4.1 Risk disclosure and the financial crisis

The aim of this study is to examine if the financial crisis has influence on the risk paragraph of

Dutch listed companies. The question is if companies report more about the risks they face and their

risk management policy after introduction of the financial crisis. The crisis causes a tight credit

market. In such a situation, it is important for companies to gain a competitive advantage to make sure

that they obtain enough credit, but it is important that investors can assess the value of the firm as

well. One of the causes of the crisis were deficiencies in the annual reports of companies, which

resulted in an increasing awareness among managers to understand their risks and to learn how to

manage these. Further, stakeholders will ask for better financial reporting as well. With appropriate

risk disclosures they can make more informed decisions. This research expects that companies will

disclose more risk information during the crisis than before. Other researchers also suggest that when

the financial position is threatened the amount of bad news in risk disclosures will increase (Suijs,

2005). This results into the following hypothesis:

H1: Non-financial Dutch listed companies will disclose higher amounts of risk information in 2008-

2009 (during the crisis) than in 2006-2007 (before the crisis).

4.4.2 Risk disclosure and company profitability

When a company is well performing, investors are less interested in the risks the company faces

and in its risk management policy. So, they may not require extensive risk disclosures. However,

poorly performing companies may experience increased pressure for extensive risk disclosures.

According to Deumes and Knechel (2008), there is an insignificant, negative relationship with internal

control reporting. But a profitable company may have more resources available to invest in risk

management systems in order to assess and manage their risks. Another reason for providing more

detailed risk information is that they want to support their own position (Inchausti, 1997). In

accordance with the positive accounting theory, more profitable companies are more exposed to

political pressure, and therefore use more voluntary disclosures to avoid regulation and reduce their

political cost (Watts and Zimmerman, 1986). But there is a possibility that companies with a better

risk management have higher levels of company profitability and that they want to publish their

superior risk management abilities to the market via disclosures in annual reports (Linsley et al.,

48


2006b). This implies a positive relation between the company’s profitability and risk disclosures and is

in line with Holland (2005), who argued that companies disclose more voluntary information during

‘good times’, than during ‘ bad times’. So far researchers haven’t found a clear relation between these

variables. This means that there are mixed results regarding the relation between risk disclosures and

profitability (Ahmed and Courtis, 1999). One explanation for the mixed results is that disclosure is a

way to mitigate firm specific market risk, which can result into a reduction of the cost of capital

(Botosan, 1997). This paper is based on Linsley et al. (2006b), who find a positive relation between

company profitability and risk disclosures. The second hypothesis is as follows:

H2: There is a positive relation between risk disclosures in the annual reports of Dutch listed

companies and company profitability.

It is expected that the relation between company profitability and risk disclosures is not affected

by the financial crisis. So, the relation before and during the crisis will be identical.

4.4.3 Risk disclosure and level of risk

The third hypothesis tests the relation between risk disclosures and the level of risk within a

company. Companies with a higher level of risk will disclose greater amounts of risk information as

management feels more pressure from stakeholders to explain the causes of this particular risk. In

addition, the management of companies with a higher risk level have the incentive to explain that they

are monitoring and managing those risks and to ensure that they are not penalised by the market. This

results into more risk disclosures as well (Linsley and Shrives, 2006a). Therefore a positive relation

between risk disclosures and the level of risk can be assumed. The level of risk can be measured by

company leverage. For this another explanation can be given. Creditors of a company with a

disproportionately higher level of debt in its capital structure will force the company to disclose more

information to mitigate the higher risk (Ahn and Lee, 2004). However, higher risk companies may not

want to draw attention to all risks they face and they are not satisfied with disclosing significant

amounts of risk information. Companies with lower risk levels would just report about their risks,

perhaps because of the nature of their business.

It is also possible that the relationship is circular. According to the ICAEW (1999), companies

that disclose more risk information think that the marketplace has a better understanding of the

company’s risk position and the company is then less risky than before. So the increased risk

disclosure could affect the perceived level of company risk, but it is unknown to what extent. Linsley

and Shrives (2006a) tested the correlation for seven variables, but only the proxies for environmental

risk and the level of risk were positively related. So, Linsley and Shrives, together with Abraham and

Cox (2007) and Amran et al. (2009), found no significant relation between these two variables. The

49


results show that there is no clear view about the relation between risk disclosures and the level of

risk.

Taking into account the results of previous studies, the following null hypothesis is prepared:

H3: There is no relation between risk disclosures in the annual reports of Dutch listed companies and

the level of risk.

Because no relation is expected between risk disclosures and the level of risk, for this relation

applies the same as for the relation in hypothesis 2. It is expected that this relation is not affected by

the financial crisis. So, the relation will not change during the research period.

4.4.4 Risk disclosure and type of industry

Different industries show different levels of disclosure (Botosan, 1997). An industry may be

subjected to special regulations due to its nature (Amran et al., 2009). Differences in the amount and

content of risk disclosures between different industries can be expected because a risk that is relevant

for one industry is not always relevant for another industry. Because companies do not give an endless

list of all risks, the risk disclosures between industries can differ. The results of prior research are

mixed. Amran et al. (2009) found that two out of eight industry variables, the infrastructure and

technology sector, were significant at the 5 percent level. These industries have influenced the

company to disclose more risk information. This is in line with the expectation that the extent of risk

disclosures will be greater for riskier industries, such as the technology sector, compared to companies

that operate in a low-risk industry. However, Abraham and Cox (2007) found no statistically

significant relation between risk disclosures and type of industry. In prior research not much

information is given about the variable type of industry, because it is difficult to classify the different

industries based on risk and nor is it clear what the direction of the differences will be. This results

into the last hypothesis, which is formulated in the null form as well:

H4: The extent of risk disclosures will not significantly differ for each industry in the sample for Dutch

listed companies.

Before the financial crisis it was not expected that there would be any differences in the extent

of risk disclosures between the industries. Almost all companies in every industry experienced the

impact of the financial crisis, resulting in a tightened regulation in each industry. However, the

relations between the industries remain the same as before the crisis. It is expected that the differences

between industries will not be changed by the financial crisis.

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4.5 Summary

The sample of this research consists of 18 non-financial companies in the Netherlands that are

listed on the AEX-index. Because the aim of this study is to examine the influence of the financial

crisis, the sample period is from 2006 till 2009; two years before and two years during the crisis.

When examining the annual reports, only the risk paragraph in the MD&A section has been studied.

Companies that do not have a separate risk paragraph are excluded from the sample. The research

method is a content analysis. It is hard to meet the three conditions of readability of Krippendorff

(1980) with the content analysis of Linsley and Shrives (2006a). Their method is too time-consuming,

and highly subjective. Readability is improved by constructing decision rules and a verification test,

subjectivity is reduced by using a binary coding scheme with predetermined criteria. The criteria are

10 different risk categories. After completing the binary coding scheme, a risk disclosure score arises.

Further, three control variables are explained (company profitability (ROA), level of risk (debt/equity

ratio), and type of industry). These variables are tested with statistical methods, which are described in

the next chapter. In the last paragraph different hypotheses are formulated to examine the relation

between risk disclosures and the financial crisis, but also to test the relations between risk disclosures

and the control variables.

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5 Results

5.1 Introduction

As this research examines the influence of the financial crisis on the risk paragraph, it is

necessary to compare two periods; the period preceding the financial crisis (2006-2007) and the period

of the financial crisis (2008-2009). Since it was not clear that the financial crisis had come to an end at

the end of 2009, it was not possible to examine the period after the crisis.

Having explained the risk disclosure index, the variables used and the formulated hypotheses in

the previous chapter, this section will focus on the implementation of statistical methods in order to

achieve a result for this research. This study consists of two parts. First, in paragraph 5.2, the risk

disclosure scores will be calculated and analyzed. Part two, the statistical analysis is presented in

paragraph 5.3. The statistical analysis starts with the descriptive statistics, then the normal distribution

will be discussed and in the other four subparagraphs the hypotheses will be tested using different

statistical methods. When the hypotheses have been tested, paragraph 5.4 will give an interpretation

and analysis of the results. The chapter ends with a summary of the results.

5.2 Risk disclosure scores

In this section the first part of the research, the risk disclosure index, will be executed. In the

annual reports most companies give their own interpretation of their disclosures. Some of them

disclose all information in the risk paragraph in the MD&A section or in the notes to the financial

statements, while others disclose the risk information in both sections. One of the sample’s companies,

DSM, disclosed the risk information on their company website. To calculate the risk disclosure score,

only the MD&A section is examined. The final risk disclosure scores are presented in appendix VI.

Over all four years Philips has the highest risk disclosure score (0.85). The lowest score changes

during the research period. In 2006 and 2007 Reed Elsevier has the lowest score, 0.25 in 2006 and 0.3

in 2007. In 2008 DSM has the lowest score with 0.35 and in 2009 it is ASML with a score of 0.4. The

results show that the financial crisis does not influence the highest score, whereas the lowest score

became higher during the financial crisis. This means that some companies disclose more information

during the financial crisis. However, this is not enough evidence for answering the research question.

When comparing the different scores, it appears that there is no general conclusion. The annual reports

of Akzo Nobel, DSM, Heineken, KPN, Reed Elsevier, SBM Offshore, Shell, TNT, Tomtom and

Unilever disclose more about company risks and control mechanisms during the financial crisis. But

still there are differences between these companies. The risk disclosure score for DSM remains the

same for the first three years, but increases with 0.3 between 2008 and 2009. A reason for the

increasing score is that DSM reported risk information from 2006 to 2008 on their website, whereas in

2009 the top five main risks including the control mechanisms are reported in the MD&A section.

Because this research only examines the MD&A sections of the annual reports (not the website),

52


the risk disclosure score was much lower in the first years than it was in 2009. So it cannot be

concluded that the amount of risk information has increased, but the management of DSM chooses to

report more risk information in the MD&A section. Other less significant increases are with KPN and

Reed Elsevier. The risk disclosure score of KPN increases with 0.2 between 2007 and 2008, 2007

being a measure from before the crisis, whereas 2008 is at the time of the financial crisis. Finally,

Reed Elsevier has the only score that increases by the year. The differences between one year are

negligible, while the score of 2006 has increased by 0.25 till 2009. Further, there are also companies

with decreasing scores, like Ahold, Bam Group and Randstad. Their scores for 2006 and 2007 are

identical, the scores decrease in 2008 and the scores for 2008 and 2009 are also identical. Finally,

there are some companies where the risk disclosure scores do not change during the four year period.

This applies for ASML, Boskalis, Fugro, Philips and Wolters Kluwer. Although most companies have

an increasing risk disclosure score during the research period, it is not possible to draw a clear

conclusion. For this research, examining only the risk disclosure index is not sufficient. For example,

this model does not take into account the number of pages. A company scores a ‘1’ if something about

the specific risk category is mentioned, regardless of the number of sentences used. To underpin that

the amount of risk information is increasing during the financial crisis, five companies (Unilever,

TNT, Fugro, Randstad and Akzo Nobel) are closer investigated. The numbers of pages by these

companies, excluding figures and pictures, are counted and shown in the tables in appendix VII. The

results show that the number of pages has increased regardless of the direction of the risk disclosure

score. Sometimes the amount of text has decreased. This is the case for Akzo Nobel, where the

number of pages in the annual report of 2009 has decreased with one page in comparison with the

annual report of 2008. The small difference in the number of pages is the consequence of a different

layout. During the research years, companies are choosing for another font or format. Therefore an

increase or decrease by one page in the risk paragraph is negligible. It can be said that there is a

positive significant difference between the number of pages in the MD&A section before and during

the financial crisis.

Having concluded that the number of pages in the risk paragraph is increasing during the

financial crisis, it is useful to test this for one specific risk category. All companies have to deal with

financial risk and in times of a financial crisis, the financial risk category is really important. For this

risk category the numbers of sentences are counted. The results are presented in appendix VIII. For 11

companies (Akzo Nobel, ASML, BAM Group, Boskalis, DSM, Heineken, Philips, Randstad, Reed

Elsevier, SBM Offshore and Unilever) the numbers of sentences are increasing during the research

period. This means that companies are disclosing more financial risk information during the financial

crisis than before. However, for 7 other companies (Ahold, Fugro, KPN, Shell, TNT, Tomtom and

Wolters Kluwer), not any direction can be indicated. During the research period the numbers increase

and decrease or vice versa. One reason could be that during the period some companies (Ahold, KPN,

Shell and Wolters Kluwer) disclose more risk information in their financial statements. This means

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that there is no reason to assume that these companies disclose less risk information during the

financial crisis than before. For the financial risk category it can be concluded that there is a positive

significant difference between the number of sentences in the financial risk paragraph before and

during the financial crisis.

Beside the mentioned results more conclusions can be drawn when taking the Dutch Corporate

Governance Code into account (see paragraph 2.7.2). The risk paragraph is a sum-up of different risk

categories, but not all companies used the classification categories in their annual reports of 2006 and

2007. However, in the years during the financial crisis, all companies made use of risk categories. The

most used categories are strategic risk, operational risk, financial risk and compliance risk.

Further, 15 out of 18 companies gave a description of the risk management system in the annual

reports from 2006 till 2009. An in-control statement is not always included. Akzo Nobel and Bam

Group didn’t have an in-control statement, while Tomtom didn’t disclose the in-control statement until

2006. However, Shell and ASML didn’t report anything about the risk management system and the

control system. It could be that companies are disclosing the information about the risk management

system and the in-control statement in other parts of the annual reports. Another reason is related to

the introduction of IFRS 7 in 2007, because there is one company (Tomtom), that reported both

systems, except for 2006. The Dutch Corporate Governance Code also became more important

because of the growing demand for more risk information. That almost all companies divided the risk

paragraph into these three sections is in accordance with the Dutch Corporate Governance Code. The

results are shown in appendix IX. The risk disclosure index does not examine if the risk management

system and in-control system are included in the risk paragraph. Because almost all companies report

this information, it is difficult to make clear conclusions by just giving the scores ‘1’ or ‘0’.

Finally, a lot of companies disclose information about the financial crisis, because this is a risk

for the company as well. This information is only disclosed in the annual reports of 2008 and 2009.

5.3 Statistical analysis

The hypotheses as described in the previous chapter are tested by using statistics. In this section

the statistical methods and their results are analyzed. Because this research studies the differences

between risk disclosures before and during the crisis, it has to reckon with two periods. Both periods

consist of two years, which means that for each period the averages of the risk disclosure scores, the

ROAs and the D/E ratios have to be calculated. The data, which are used for carrying out the statistical

methods, are collected from the ThomsonOneBanker database. The dataset is presented in appendix X.

5.3.1 Descriptive statistics

Descriptive statistics provide useful information about the different variables. Table 2 on the

next page presents an overview of the minimum value, maximum value, sum, mean and standard

deviation of the different variables.

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N Minimum Maximum Sum Mean Std. DeviationRiskDisclScore0607 18 ,28 ,85 10,45 ,5806 ,16798RiskDisclScore0809 18 ,40 ,85 11,33 ,6294 ,14799ROA0607 18 94826,00 27472945,00 69251700,0

03847316,6667 6692175,58511

ROA0809 18 -1453784,00 14305125,00 86937149,00

4829841,6111 4667873,60421

DebtEquity0607 18 ,00 2,43 13,52 ,7508 ,75649DebtEquity0809 18 ,00 3,36 18,67 1,0371 ,89859Industry 1,00 7,00 66,00 3,6667 1,90973Valid N (listwise) 18

Table 2: Descriptive statistics of the different variables

5.3.2 Normal distribution

Before deciding which statistical test is appropriate, it is very important to check whether the

distribution is normal. This assumption must be verified before most parametric tests are accurate. If

not, parametric tests will give incorrect results. The normality of each variable is tested with the

Kolmogorov-Smirnov test. This method determines and analyzes whether the distribution of the data

is significantly different from a normal distribution by using a normal QQ-plot. If the plot is

approximately linear, the distribution is normal (Field, 2009). For this study a normal QQ-plot is

drawn for the average risk disclosure scores of 2006-2007 and 2008-2009, and for the average ROA

and D/E ratio in both periods (see appendix XI). The variables risk disclosure score and D/E ratio are

normally distributed for the years 2006-2007 and 2008-2009 as well. The variable ROA for 2008-2009

is normally distributed, since the data are situated around the normal distribution line. However,

according to the QQ-plots, the ROA 2006-2007 is not normally distributed. A reason for non-

normality may be the presence of outliers. To solve these problems, transforming data is a possibility.

If so every score needs to be corrected. Because all scores are corrected, the relationship between the

variables won’t be changed (Field, 2009). The data are transformed by means of the log

transformation on SPSS. The normal QQ-plot of LNROA for 2006-2007 is shown in appendix XI.

Kolmogorov-SmirnovStatistic df Sig.

RiskDisclScore0607 ,128 18 ,200*

RiskDisclScore0809 ,198 18 ,060ROA0607

LNROA0607,340,242

1818

,000,018

ROA0809 ,138 18 ,200DebtEquity0607 ,182 18 ,119DebtEquity0809 ,178 18 ,134

Table 3: Kolmogorov-Smirnov test

Table 3 shows that the risk disclosure score of 2006-2007 has a significance value of 0.2 and for

the risk disclosure score of 2008-2009 this is 0.06. For 2008-2009 the significance value of the ROA is

0.200, for 2006-2007 the D/E ratio is one of 0.119 and 0.134 for 2008-2009. With a significance level

of 5%, not any variable is significant, because P>0.05. The distribution for all variables is not

55


significantly different from a normal distribution, except for ROA 2006-2007. The variables are

approximately normally distributed.

For 2006-2007 the variable ROA has a significance value of 0.000, which means that P<0.05.

The distribution is significantly different from a normal distribution, the ROA for 2006-2007 is non-

normally distributed. Therefore the variable is converted to a natural logarithm to minimize the impact

of extreme values and to improve approximation of the variables to a normal distribution (Linsley and

Shrives, 2006a; Abraham and Cox, 2007). The variable LNROA 2006-2007 is significantly different

from the normal distribution with a significance level of 5% (0.018<0.05). Both outcomes are

identical. However, when a significance level of 1% is used, then the LNROA 2006-2007 is normal

distributed (P>0.01). For the consistency of this research, a 95%-confidence interval is used for all

variables. Since both the ROA 2006-2007 and the LNROA 2006-2007 lead to the same conclusion

with regard to the normal distribution, for this research the ROA 2006-2007 is used. The results of the

Kolmogorov-Smirnov test are in line with the normal QQ-plots(appendix XI).

Another method of testing the normality is the Skewness (S) and Kurtosis (K) of a variable. 2 The further the value is from zero, the more likely it is that the data are not normally distributed (Field,

2009). In the table below, the results of this test are showed.

N Skewness KurtosisStatistic Statistic Std. Error Statistic Std. Error

RiskDisclScore0607 18 ,075 ,536 -,743 1,038RiskDisclScore0809 18 ,128 ,536 -1,488 1,038ROA0607 18 3,098 ,536 9,922 1,038ROA0809 18 ,536 ,536 -,630 1,038DebtEquity0607 18 1,282 ,536 ,834 1,038DebtEquity0809 18 1,221 ,536 1,151 1,038Valid N (listwise) 18

Table 4: Skewness and Kurtosis test

The results show that the distribution of the ROA0607 is different from the normal distribution

(>0), which is similar to the Kolmogorov-Smirnov test.

5.3.3 Hypothesis 1

This study examines the influence of the financial crisis on the risk paragraph of Dutch listed

companies. According to hypothesis 1, it is expected that the risk disclosure scores during the crisis

will be higher than the ones before the financial crisis. As just analyzed, the risk disclosure scores are

normally distributed, so it is possible to do a parametric test. For this research is chosen for a paired-

samples t-test, because there are two experimental conditions (before and during the financial crisis)

and the same participants (18 Dutch listed companies) took part in both conditions of the experiment

(Field, 2009). To perform the paired-sample t-test the average risk disclosure score of a company in

2 The Skweness value is an indication of the symmetry of the distribution, while the Kurtosis value will give information on

the ‘peakedness’ of the distribution (Amran et al., 2009).

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the first period (2006-2007) is paired with the average risk disclosure score of the same company in

2008-2009.

The results will show whether the difference between the means of the two conditions was large

enough to not be a chance result (Field, 2009). The hypotheses which are tested are as follows:

Ho: The means of the two groups are not significantly different

H1: The means of the two groups are significantly different

Paired Differences

t DfSig. (2-tailed)Mean

Std. Deviation

Std. Error Mean

95% Confidence Interval of the

DifferenceLower Upper

Pair 1

RiskDisclScore0607 –

RiskDisclScore0809

-.04889 .09560 .02253 -.09643 -.00135 -2.170 17 .045

Table 5: Paired-sample t-test

The mean difference between the risk disclosure scores in 2006-2007 and 2008-2009 is -.04889.

The significance value is 0.045, which means that t is significant (p<0.05) and Ho will be rejected.

The means of the two groups are significantly different, but although it is significant, the difference

between the two groups is very small. The significant value of 0.045 does not differ much from 0.05.

That the t-value is negative means that the first risk disclosure score of 2006-2007 (0.5806) had a

smaller mean than the second risk disclosure score of 2008-2009 (0.6294), so the risk disclosures

scores in 2008-2009 are higher than in 2006-2007. The result of this test is that the annual reports

contain significantly more disclosed risk information during the financial crisis than before.

Hypothesis 1 is accepted.

So far no research was done to the influence of the financial crisis. Almost all researchers

examined only one research year. However, Helbok and Wagner (2006) found an increase in the

operational risk disclosures in the annual reports of banks in Asia, Europe and North-America between

1998 and 2001. Further, Kajüter and Winkler (2003) found a positive relation for risk disclosures in

German annual reports of non-financial listed companies between 1999 and 2001. Because these

articles are far from recent and because they did not study the influence of the financial crisis, it is

difficult to compare this research with the findings of these researchers. It can be said that the results

of this hypothesis are in line with the statement of Suijs (2005). The amount of bad news will increase

when the financial position is threatened. This research did not examine the content (good or bad

news) of risk information, but it can be concluded that the amount of news has increased.

The increase in the risk disclosure scores can be explained by the financial crisis. Deficiencies

in the annual reports were a cause of the financial crisis. As a result of this, the awareness among

57


managers to understand their risks and how to manage these risks increased. When companies are

disclosing more risk information, the cost of capital will reduce, which makes it easier to attract

capital. Because of the small sample size, it is not possible to generalize this result for all companies.

One should think of the possibility that other factors could influence the quantity of risk disclosures as

well. The increasing risk disclosures could be the result of an increase in the demand of risk

disclosures by regulatory bodies (see paragraph 2.7.2) and stakeholders. Nowadays, stakeholders are

asking for more transparency to make better informed decisions.

5.3.4 Hypothesis 2 To test hypotheses two, the bivariate correlation between risk disclosures and company

profitability will be calculated. Correlations measure the linear relation between two scale variables

and can be measured with the Pearson correlation test, which is a parametric test or the Spearman’s

rho test, a non-parametric test. The first method is used when there is a normal distribution, otherwise

the Spearman’s rho test will be used. The correlation coefficients have been calculated by using SPSS.

The coefficients can take any value between -1 and +1. A value below 0 means a negative

relationship, whereas a value above 0 means a positive relationship between the variables tested. A

value close to 0 means a weak or no linear relation or it may indicate some form of non-linear relation

between two variables. The significance of the possibility relations is measured with the p-value. The

relation is statistically significant when this p-value is smaller or equal to 5%. A 95%-confidence

interval for measuring correlations is in line with prior research (Linsley and Shrives, 2006a+b;

Abraham and Cox, 2007; Amran et al., 2009).

The company profitability is measured with the return on assets (ROA). Data are obtained from

the ThomsonOneBanker (appendix X). As analyzed in paragraph 5.3.2, the ROA for 2006-2007 is not

normally distributed, while the ROA for 2008-20009 is normally distributed. This means that for the

first period the Spearman’s correlation coefficient is used, whereas for the second period the Pearson

correlation coefficient must be calculated. For this hypothesis a one-tailed test must be selected,

because there is a directional hypothesis (the relation between risk disclosures and company

profitability is expected to be positive) (Field, 2009).

Spearman's rho RiskDisclScore0607ROA0607 Correlation Coefficient ,052

Sig. (1-tailed) ,419N 18

Table 6: Spearman’s rho correlation coefficient for 2006-2007

The Spearman’s correlation coefficient is 0.052. There is a positive relation between the risk

disclosure scores in 2006-2007 and the ROA in this period. The significance value is 0.419, which is

more than 0.05. Therefore it can be concluded that that there is no statistically significant relation

between risk disclosures in 2006-2007 and company profitability.

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RiskDisclScore0809

ROA0809 Pearson Correlation -,386Sig. (1-tailed) ,057

N 18Table 7: Pearson correlation coefficient for 2008-2009

The Pearson correlation coefficient in 2008-2009 is –0.386. The company‘s profitability

measure is negatively correlated with the risk disclosure score of 2008-2009. Companies with higher

profitability disclosed less risk information than companies with lower profitability. More profitable

companies disclose less risks to hold their superior risk management secret for others. However, the

significance value is 0.057, which means the relation is not statistically significant (p>0.05). For this

research no statistically relation is found between risk disclosures in 2008-2009 and company

profitability.

Hypothesis 2 is rejected for both periods as no significant support for a positive relation is

found. This is in line with Linsley and Shrives (2006b), who found no statistically significant

association between profitability and risk disclosures for Canadian and UK banks, and with Deumes

and Knechel (2008), who didn’t find a significant, negative relationship either. According to prior

literature a positive relation was expected between risk disclosures and company profitability. This

assumption was based on the fact that companies with a better risk management will have higher

levels of profitability, so they want to publish their superior risk management abilities to the market

via disclosures in their annual reports (Linsley and Shrives, 2006b). However, in this research no

significant relation is found. It is possible that the argument of Linsley and Shrives (2006b) is still

plausible, but that other factors cause awareness among the management when deciding which risk

information they want to disclose, e.g. proprietary cost, that places a company at a competitive

disadvantage. The conclusion is that some companies believe they have a good risk management

system that positively influences the financial results, but more profitable companies do not want to

express their risk management system, because of the advantage of lower cost of capital, which does

not compensate the negative costs as a consequence of the possibility that other companies use the

information to improve their risk management system as well (Healy and Palepu, 2001; Linsley and

Shrives, 2006b). The assumption of Holland (2005) that companies are disclosing more voluntary

information during ‘good times’ than during ‘ bad times’ does not hold in this research.

5.3.5 Hypothesis 3

For the third hypothesis, the level of risk is measured with the debt/equity ratio. The data are

obtained from the ThomsonOneBanker (appendix X). To test the relation between risk disclosures and

59


the level of risk the correlation must be calculated. The working of a correlation coefficient is

explained in the previous paragraph. As analyzed in paragraph 5.3.2 the debt/equity ratio for both

2006-2007 and 2008-2009 is normally distributed.

This means that the Pearson correlation coefficient has to be calculated. This coefficient is one of the

most used methods in statistical analysis. For this hypothesis the two-tailed test is used, because the

nature of the relationship cannot be predicted (no relation is expected between risk disclosures and

level of risk) (Field, 2009).

RiskDisclScore0607DebtEquity060

7Pearson Correlation ,105


Table 8: Pearson correlation coefficient for 2006-2007

RiskDisclScore0809DebtEquity0809 Pearson Correlation ,311


Table 9: Pearson correlation coefficient for 2008-2009

The Pearson correlation coefficient is 0.105 in 2006-2007 and 0.311 in 2008-2009, so the level

of risk is positively correlated with the risk disclosure scores in both periods. However, the

significance values are 0.678 and 0.209. For both values is P>0,05. The variable level of risk, as

measured with the D/E ratio, does not have significant influence on the risk disclosure scores. 3 Therefore, hypothesis 3, that there is no relation between risk disclosures in the annual reports of

Dutch listed companies and the level of risk, is accepted. This applies to both periods. So, it can not be

said that riskier companies give confidence to the marketplace by disclosing greater amounts of risk

information.

This confirms the results of prior literature (Linsley and Shrives, 2006a+b; Abraham and Cox,

2007; Amran et al, 2009). However, Linsley and Shrives (2006a) found a correlation between risk

disclosures and the level of environmental risk, but this part of risk is not examined here. For the other

measurements of risk was found no correlation, so it can be concluded that the results by Linsley and

Shrives (2006a) are in line with the results of hypothesis 3.

A reason for the absence of a relation between these variables could be that companies wish to

keep their risk information private. The desire for privacy can be related to the issue of proprietary

cost (Linsley and Shrives, 2006b). Other reasons could be that the debt/equity ratio was not an

appropriate proxy for measuring the level of risk or that there is not a linear relation between these

variables. A third possibility could be that other factors influence this relationship. This relation must

be certainly be researched further.

3 Note that the debt/equity ratio of 2006-2007 is almost significant at the 90% significance level.

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5.3.6 Hypothesis 4

This hypothesis test if there is a relation between type of industry and risk disclosures. Type of

industry is the only nominal control variable in this research. As described in paragraph 4.3.2, the

industries are classified into 7 different categories, which means that there are more than two possible

outcomes. Therefore, a one-way ANOVA test is carried out for both the risk disclosure scores of

2006-2007 and for 2008-2009.

Sum of Squares df Mean Square F Sig.

Between Groups ,165 6 ,027 ,957 ,495Within Groups ,315 11 ,029

Total ,480 17

Table 10: one-way ANOVA for 2006-2007

Sum of Squares df Mean Square F Sig.

Between Groups ,149 6 ,025 1,222 ,365Within Groups ,223 11 ,020

Total ,372 17

Table 11: one-way ANOVA for 2008-2009

Table 10 shows that the F-value for the risk disclosure scores of 2006-2007 is 0.957, which is

close to 1. This implies that there are no differences in means between the different industry

categories. The significance value is 0.495, which is bigger than the p-value of 5%. The result of the

one-way ANOVA test is not significant. The type of industry does not have a significant influence on

the risk disclosure scores of 2006-2007. The F-value for the risk disclosure scores of 2008-2009 is

1.222 (table 11), which is not that close to 1. However, the significance value is 0.365. Again there is

no significant relation between the risk disclosure scores of 2008-2009 and type of industry (P>0.05),

so hypothesis four is accepted. The assumption that the extent of risk disclosures will be higher for

riskier industries, such as the technology sector, compared to companies that operate in a low-risk

industry does not hold. It was expected that almost all companies in every industry would experienced

the impact of the financial crisis. Because the impact is noticeable in all industries, the differences

between the industries should not change by the financial crisis. This means that splitting the control

variable type of industry into seven categories does not add any information. However, it is important

bear in mind that each category does not have many companies and that the industries are not equally

represented in the sample.

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5.4 Interpretation of the results

Hypothesis Prediction Result Accepted/ OutcomeRejected

H1: Risk disclosure + sign + sign Accepted The annual reports contain significantly score more disclosed risk information during

the financial crisis than before.

H2: Company + sign not sign Rejected There is no significant relation between profitability risk disclosures and company profitability

H3: Level of risk not sign not sign Accepted There is no significant relation between risk disclosures and the level of risk.

H4: Type of industry not sign not sign Accepted There is no significant relation between risk disclosures and type of industry.

Table 12: Summary of hypotheses testing

Table 12 shows the results of the statistical analysis. The second hypothesis is the only

hypothesis that was rejected. For the variable company profitability a positive significant relation was

expected, while the results showed that there was no significant association. It is possible that the

financial crisis is not the only factor which has influence on risk disclosures, other variables have an

impact on risk disclosures as well. For this research it was expected that next to the financial crisis,

company profitability has influence on risk disclosures as well. This is not the case.

That the three control variables are not statistically significant means that these variables don’t

have influence on the risk disclosures. So, the research question can be answered with the fact that the

increasing quantity of risk reporting is fully contributed to the influence of the financial crisis.

However, there could also be other influencing factors, which are not tested in this research. Future

research should further investigate the other variables. This is discussed in the next chapter.

5.5 Summary

This chapter, which consists of two parts, presented the results of the research. First, the risk

disclosure scores were calculated with a risk disclosure index. Although most companies had an

increasing risk disclosure score between 2006 and 2009, it was not possible to drawn a clear

conclusion. Examining the risk paragraph with only the risk disclosure score was not sufficient. To

solve this problem, the amount of pages on the risk paragraph were calculated for five companies and

for the financial risk category the number of sentences were counted. The results showed that there is a

positive significant difference between the number of pages in the MD&A section before and during

the financial crisis and between the number of sentences of the financial risk category during the

research period. Because the risk disclosure index does not examine the risk management system and

the internal control system, it is examined separately. Only a few companies did not give a description

of the risk management system and the in-control statement in the annual reports from 2006 until

2009.

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After calculating the risk disclosure scores, the statistical analysis was carried out. Before this

was done, the averages of data in both periods were calculated. First, the descriptive statistics were

given, then the normal distribution was tested using the Kolmogorov-Smirnov test and the Skewness

and Kurtosis test. The results of both tests showed that all variables were normal distributed, except

for the ROA in 2006-2007. This variable was transformed in a natural logarithm. When testing the

normal distribution for the transformed variable, the distribution was significantly different from the

normal distribution with a significance level of 5%, but not for a significance level of 1%.

After the assumption of the normal distribution had been verified, the hypotheses were tested.

The first hypothesis was tested with a paired-sample t-test. The mean of the risk disclosure scores of

2006-2007 was significantly different from the mean of the scores of 2008-2009, which meant that the

annual reports contained significantly more disclosed risk information during the financial crisis than

before. The first hypothesis is accepted. It was not possible to compare this result with other

researches, because there was no research which tested this relation. For the three control variables,

the correlations were calculated with the Pearson correlation coefficient, the Spearman’s rho

correlation coefficient and the one-way ANOVA. None of the variables (company profitability, level

of risk, and type of industry) was significant correlated with risk disclosures in both periods. This is in

line with other researches (Linsley and Shrives, 2006a+b; Abraham and Cox, 2007; Amran et al.,

2009). The second hypothesis is rejected, while the third and fourth hypotheses are accepted for this

research.

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6 Conclusion

6.1 Conclusion

In this paragraph the answers of the sub-questions as given in the other chapters and the results

of the previous chapter are used to give an answer to the research question.

This study examined the quantity of risk disclosures of non-financial Dutch listed companies

before and during the financial crisis. Prior risk disclosure research had not tested for the influence of

the financial crisis. The aim of this paper has been to extend empirical knowledge and add to prior risk

disclosure studies particularly in Dutch context, because except for Deumes (2008), no prior research

had been done to risk reporting in the Netherlands. So it is not possible to compare this research with

other researches. The article by Linsley and Shrives (2006a) is used as basis for this paper, but their

research was totally different.

Based on the theoretical framework and the empirical research an answer to the research

question can be given. The research question was:

What is the influence of the financial crisis on the quantity of risk reporting in the annual reports

of Dutch listed companies?

Chapter 2 gave some background information regarding voluntary disclosures and most of the

sub-questions are answered here. As a result of the increasing stakeholders demand, firms are

disclosing more risk information to fill the gap between the information provided and the information

needed by investors This is in line with the positive accounting theory. In times of a financial crisis,

the manager’s motive for disclosing information earlier is to reduce the cost of litigation. However,

there are constraints for voluntary disclosures as well, for example that voluntary disclosed

information can damage the competitive position. After discussing the management motives, the

different methods for measuring disclosures are explained. For this research, a content analysis is used

in combination with a risk disclosure index. Although there are different interpretations of ‘risk’, the

definition by Linsley and Shrives (2006a) is used, which considers both the positive and the negative

side of risk. Further, the Enterprise Risk Management (ERM) framework (COSO II) is explained,

together with the different risk categories. In examining the development of risk reporting, regulation

is important as well. Listed companies in the Netherlands have to comply with the International

Financial Reporting Standards and the Dutch Corporate Governance Code. According to IFRS 7

disclosing risk information is not required. A broad description of the biggest risks and uncertainties is

sufficient. The Dutch Corporate Governance Code does not give explicit rules, it only prescribes that

the company should have descriptions of the risk-profile and the internal risk management and control

system (‘in-control statement’). In this research the financial crisis plays an important role.

64


At the end of chapter 2 the causes and consequences of the financial crisis were discussed. The more

detailed results of this influence are analyzed in chapter 5.

Further, the already existing academic literature of risk reporting is discussed in chapter 3,

where the articles by Lajili and Zéghal (2005), Linsley and Shrives (2006a), Abraham and Cox (2007)

and Amran et al. (2009) are important for this research. Although none of the articles are identical to

this paper, the studies had a contributing value in preparing this research. Besides the influence of the

financial crisis on risk reporting, some factors found in prior literature influence risk disclosures as

well. This paper tests the influence of some of these factors (company profitability, level of risk and

type of industry).

In chapter 4 the research design is explained. The data used have been obtained from a sample

of 18 Dutch listed companies on the AEX-index. Financial companies are excluded and only the

companies that had a risk paragraph in their annual reports are examined. To obtain a risk disclosure

score for each company, a risk disclosure index identifying ten risk categories has been used. Because

this research studies the impact of the financial crisis, there has been chosen for a research period from

2006-2009, where 2006-2007 covers the period before the financial crisis and 2008-2009 is the period

during this crisis. This chapter ends with four hypotheses, which are formulated in order to find an

answer for the research question.

After illustrating the research design, in chapter 5 the results of this research are analyzed. First,

the risk disclosure scores are calculated. The results show that almost all companies have an increasing

risk disclosure score during the research period, but due to the limitations of the risk disclosure index

it is not possible to draw a clear conclusion. Further, the amount of pages of some annual reports are

calculated and the number of sentences of the financial risk category are measured for all annual

reports. Both the number of pages and the number of sentences of the financial risk category increase

as result of the financial crisis. With these additional methods, the conclusion that the risk disclosure

scores are increasing during the research period become more valuable. Finally, some other results of

analyzing the risk paragraph are that almost all companies apply the format as specified by the Dutch

Corporate Governance Code and that in most of the annual reports of 2008 and 2009 attention is paid

to the financial crisis.

The most important result of this chapter is that the annual reports of 2008 and 2009 contain

significantly more disclosed risk information than the annual reports of 2006 and 2007. This is in line

with the statement of Suijs (2005) that the amount of news will increase when the financial position is

threatened. So the increasing risk disclosures can be explained with the financial crisis, but other

factors may have influenced the quantity of risk disclosures as well. To test this, three control

variables are prepared. The first control variable, company profitability, did not have a significant

influence on the quantity of risk disclosures. This is in line with Linsley and Shrives (2006b) and

Deumes (2008). Maybe there are other factors that are influencing this relationship or may be that a

different measure for this variable would lead to a different outcome.

65


The second variable, level of risk, also did not have a significant relation with risk disclosures. This

confirms the result of Linsley and Shrives (2006a+b), Abraham and Cox (2007) and Amran et al.

(2009). That there is no correlation could be attributed to the wish of companies to keep their risk

information private, which can be related to the issue of proprietary cost. Because it is difficult to

measure the level of risk, it is interesting to study this variable in future research. The last hypothesis

concerned the nominal variable type of industry. The expected non-significant relation is confirmed.

Because the small sample size of this research, it is interesting as well to further investigated this in

future research.

The answer of the main research question is that the quantity of risk reporting in the annual

reports of Dutch listed companies is increased during the financial crisis. This can be explained with

the positive accounting theory and the agency cost theory. Managers are voluntary disclosing more

risk information, bearing in mind the increasing demand from stakeholders for more transparency. The

theory predicts a demand for monitor the way in which the management discloses risk information.

Although disclosing all risk information is not required according to IFRS and the Dutch Corporate

Governance Code, regulation concerning risk reporting became more and more important. When there

is no monitor system for controlling companies, it is expected that they do not want to report the

relevant risks.

However, other factors, which are not discussed here, may have influenced the increasing

quantity. This limitations is incorporated in the next paragraph, were other limitations of this research

are described as well.

6.2 Limitations

Just like other researches, this study has some limitations, which could influence the results as

well. When drawing conclusions regarding risk disclosures of Dutch listed companies, the small

sample size has to be taken into account. Adding more companies to the sample will give more

reliable results. The same applies when including financial companies. Because there has been limited

prior empirical research about risk disclosures, this research has a contributing value despite the small

sample size.

The most important limitation concerns the research method. In this paper a risk disclosure

index is calculated in combination with counting the number of pages and the number of sentences for

the financial risk category. For a combination of analyses was chosen because only one dimension of

risk disclosures is taken into account when measuring sentences or words (content analysis). For the

risk disclosure index a classification of the different types of risk is prepared. No mandatory risk

categorization scheme is included in IFRS and the Dutch Corporate Governance Code. However, a

different categorization scheme can lead to other risk disclosure scores as more or less categories are

identified and some risk categories are more important for companies in a certain industry than other

risk categories.

66


To deal with this kind of limitation it is interesting to add weight to the different risk categories when

calculating the risk disclosure scores. Classifying different risk types and calculating the

corresponding risk disclosure scores is a subjective process, which cannot completely be eliminated,

despite the fact that this research developed some decision rules and that the risk disclosure index was

carried out by two different persons. Still the research method in this research is effective in making

important contributions to the existing literature.

Next, IFRS 7 is introduced in 2007. Although this paper is doing research for the period

between 2006 and 2009, the increasing risk disclosures are not explained with the introduction of

IFRS 7. It is recommended to early adopt IFRS 7 in annual reports and there is less regulation in IFRS

regarding non-financial companies in comparison with financial companies. Because no big

differences are found between the annual reports of 2006 and 2007 the introduction of IFRS 7 is not

incorporated in this research.

This research used only three control variables (company profitability, level of risk, and type of

industry), which is not enough. Adding more variables could lead to a better explanation of the scores.

In the literature review some other variables are discussed, but in practice there could be much more

factors that influence risk disclosures. Another explanation that adding more variables is useful, is that

it is not known if the increasing scores can exclusively be contributed to the financial crisis. Maybe

there are more variables that influence the increasing scores.

Another limitation of this research is that it is focused only on what type of risk disclosures the

annual reports contain, not on why the risk information is disclosed, because a sentence-based

approach just measures the quantity, not the quality of risk disclosures. In fact, the quality of risk

disclosures is an important element in the case of risk reporting as well. However, it is too time-

consuming to discuss this element in this research.

Due to the limited time, this paper does not reflect the stakeholders demand and did not examine

differences between countries. That the stakeholder demand is not taken into account means that there

are no discussions with different professionals, for example risk managers, auditors or analysts.

Another reason why this is not included in this research is the question if interviewing a few

professionals is representative for the whole group of users of the annual report.

Finally, there is much difficulty in measuring risks. An important question is if it is more

beneficial to require risk disclosures for all types of risk by accounting standards. As discussed in

chapter two of this paper, IFRS requires companies to disclose only the financial risks in their annual

reports. All other risk information is voluntary. The Dutch Corporate Governance Code does not

require any of the risk categories, however, they recommend companies to incorporate financial risks

in their risk paragraph. However, even if it would become mandatory to incorporate risk information

in annual reports, evidence suggests that it is not sufficient to fill the gap between stakeholders and the

company (Lajili and Zéghal, 2005; and Linsley 2006a).

67


6.3 Future research

There is considerable scope for future research on the topic of risk reporting. First of all, it is

useful to examine the quality of the risk paragraph in the annual reports as well. However, measuring

quality is difficult, because there is no clear definition for ‘quality’. Before quality can be measured,

more research has to be done.

The risk classification as used in this research, is used by a lot of other researchers as well.

However, developing a local risk measurement checklist will help researchers to better reflect on the

findings in the local context.

An important study for future research is a behavioral study, which focuses on the demand side

of information. Risk information is of importance for stakeholders and investors. This study can be

done to examine whether increased risk disclosures lead to better decisions and judgments by users of

annual reports. This will reduce the gap in literature identified by Shrand and Elliot (1998) and

Solomon et al. (2000). Although it is not possible to close the whole gap between companies and their

stakeholders, future research is necessary.

This research examines the influence of the financial crisis, but due to the fact that the financial

crisis had not come to an end yet when writing this paper, the only possibility to study the influence of

the financial crisis was to compare risk paragraphs before and during the financial crisis. For a

complete investigation future research to the risk paragraph during and after the crisis is necessary.

Then the differences before, during, and after the financial crisis can be compared. Further, it is not

known if the increasing scores can exclusively be contributed to the financial crisis. It is possible that

more variables had influence on the risk disclosures. Another important element for future research is

to further investigate the different variables that may be involved, and to take into account cross-

country and industry-specific risk disclosure studies. These studies are helpful in understanding the

managers’ motives to disclose risk information.

Because this study examines the influence of the financial crisis on the risk paragraph of Dutch

listed companies, it does not say anything about the capital market and the cost of capital. To measure

if the capital market becomes more efficient and the cost of capital declines due to increased risk

disclosures is an appropriate study for future research. But when examining annual reports, the

question arises if the annual report is the most appropriate place for reporting risk information?

Annual reports focus on past information and are published only once a year (Linsley and Shrives,

2006b). Because risk alters over time, it might be better to publish the risk information somewhere

else. However, it always remains possible that users of annual reports may interpret the information

differently.

Finally, future research is necessary to provide empirical evidence for the results of this

research.

68


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Appendix I Empirical studies on risk reporting

This table gives a short summary of the studies discussed in chapter 3 (Literature review).

Author(s) Sample Methodology ResultsBeretta and 85 annual reports Content analysis; 1. Strong level of association between the type of measures adopted inBozzolan of Italian listed disclosure index and external communication and sources of risk.(2004) non-financial regressions 2. Disclosed items are more focused on the present and the past than on the

Companies future.Period: 2001 3. Risk communication of Italian listed companies is very poor.

4. There is no relation with company size.5. The percentages of information disclosed in each category in different industries are not statistically different.

Lajili, K. 300 annual reports of Content analysis 1. Risk information is mainly qualitative and is located in the notes to the and D. Zéghal Canadian listed financial statements and/or in the ‘management discussion and analysis’ (2005) companies, section.

both financial and 2. The most frequently used risk categories are financial risk, commodity and non-financial. market risk.Period: 1999 3. Downside risk, up-side effects and value-creating opportunities are absent.

4. Voluntary risk disclosures

Groenland, J., 125 annual reports of Content analysis 1. Risk paragraph consist of 3,5 pages (average)Daals, R. and Dutch listed companies and regressions 2. 76% of the companies does have a risk paragraphH. Von Eije both financial and 3. No significant association between individual risk categories and (2006) non-financial. profitability of the companies.

Period: 2004 4. Only when company wrote down something about the risk management- and control system there was a significant association with profitability.

Linsley, P.M. 79 non-financial UK Sentence analysis- 1. There is a positive correlation between the volume of risk disclosures with and P.J. Shrives companies listed on approach both company size and the level of risk.(2006a) the FTSE 100 2. The number of non-monetary risk disclosures is significantly greater

Period: 2001 than the number of monetary risk disclosures.3. The numbers of good and bad risk disclosures do not significantly differ.4. There is no general statement for all companies about the relation between past riskdisclosures and future risk disclosures.

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Linsley, P.M., 18 annual reports of Content analysis 1. There is no association between levels of risk disclosures and either bank and P.J. Shrives Canadian and UK banks profitability or the level of risk within the bank.(2006b) Period: 2001 2. There is a positive association between levels of risk and both

bank size and the number of risk definitions3. There is no statistically significant difference in the risk disclosure levels of the Canadian banks when compared to the UK banks.4. Quantitative and future risk information are disclosed much less often than qualitative and past information.

Abraham S. FTSE 100 annual reports Content analysis and 1. Corporate ownership by long-term institutions is negatively related to risk and P. Cox from UK non-financial regressions reporting and is positively related by short-term institutions.(2007) companies (agency perspective) 2. Executive and independent directors are both important in risk reporting.

Period: 2002 3. Dependent non-executive directors do not contribute to transparency.4. US-listed UK firms do disclose more risk information in their UK annual report than non-US-listed UK firms.5. Positive relation with level of risk.

Deumes, R. 90 prospectuses of Content analysis and 1. Prospectuses of Dutch firms contain risk-relevant information for (2008) Dutch companies on regressions prospective investors.

the AEX, both 2. An aggregate measure of risk obtained by the content analysis predictsfinancial and successfully the future total return risk, future systematic risk, and thenon-financial. likelihood of severe declines in stock prices in the 30-month period after Period: 1997-2000 publication of the prospectus and held when controlling for several other

factors (firm size, type of industry, type of offering, cross-listing at a foreign exchange, and the language).3. Information from the paragraph is more useful than market information on past risk.

M.K. Hassan 41 annual reports of Content analysis, 1. Company size is positively correlated to the risk disclosure index, but (2008) United Arab Emirates disclosure index model insignificant. The companies have an open business environment. They operate

listed companies, and regressions freely within the government regulatory framework.both financial and 2. There is a negative and insignificant relation between CRD levels and non-financialnon-financial. reserves. They do not disclose a high level of risk information.Period: 2005

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Amran, A., 100 annual reports of Content analysis and 1. Most of the companies disclose their risk information in the chairman’s Bin, A. and listed non-financial regression statement.B. Hassan Malaysian companies (stakeholder perspective) 2. Extra effort in providing separate sections to discuss risk management(2009) Period: 2005 3. Total number of sentences of risk information is less than compared to

Linsley and Shrives (2006). Disclosure reporting at Malaysian companies is at the beginning stage.4. Size is proven significant by the regression results.

Broberg, P, 431 annual reports of Disclosure index model 1. There is a positive relation between the debt ratio and voluntary disclosures.Tagesson, S., non-financial companies (agency theory and 2. Corporations where management has a large scale share of ownership disclose and Collin, S. listed on the Stockholm positive accounting theory) less voluntary information in general.(2010) Stock Exchange 3. There is a positive relationship between foreign ownership and voluntary

Period: 2002 and 2005 disclosure information.4. Both agency theory and signaling theory supports the idea that corporations disclose more risk information during ‘good times’ than during ‘bad times’.5. Firm size is positively correlated with voluntary disclosure information.6. Industry is a variable that affects voluntary disclosure information.7. The implementation of IASB standards has had a positive effect in general.8. Economic theories based on the assumption of self-interest have a strong explanatory power regarding voluntary disclosures.

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Appendix II Final sample

AEX-index Industry

Ahold Consumer Services

Akzo Nobel Basic Materials

ASML Technology

BAM Group Industrials

Boskalis Industrials

DSM Basic Materials

Fugro Oil and Gas

Heineken Consumer Goods

KPN Telecommunications

Philips Consumer Goods

Randstad Industrials

Reed Elsevier Consumer Services

SBM Offshore Oil and Gas

Shell Oil and Gas

TNT Industrials

Tomtom Technology

Unilever Consumer Goods

Wolters Kluwer Consumer Services

Source: www.euronext.com and ICB

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http://www.euronext.com/


Appendix III Decision rules for risk disclosures

The following decision rules are based on the decision rules as described by Linsley and Shrives

(2006a):

1. In order to identify risk disclosures a broad definition of risk has to be adopted as explained

below. This indicates that the word ‘risk’ does not have to be included in the sentence.

2. Sentences are to be coded as risk disclosures, if the reader is informed of any opportunity or

prospect, or of any hazard, danger, harm or exposure, that has already impacted upon the

company or may impact upon the company in the future or of the management of any such

opportunity, prospect, hazard, harm, threat or exposure.

3. The risk definition just stated shall be interpreted such that ‘good’ and ‘bad’ ‘risks’ and

‘uncertainties’ will be deemed to be contained within the definition.

4. Although the definition of risk is broad, disclosures must be specially stated; they cannot be

implied, they have to be mentioned explicitly.

5. The risk disclosures shall be classified according to the risk categories as mention in Appendix

V.

6. If a sentence has more than one possible classification, the information will be classified into

the category that is most emphasized within the sentence.

7. Tables that provide risk information should be interpreted as one line equals one sentence and

classified accordingly.

8. Risk-related items in the financial statements will not be examined. This is done from a

practical point of view; the limited time available for this study.

9. Any disclosure that is repeated shall be recorded as a risk disclosure sentence each time it is

discussed.

10. If a disclosure is too vague in its reference to risk, then it shall not be recorded as a risk

disclosure.

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Appendix IV Risk disclosure categories

Financial Risk Interest rateExchange rateCommodityLiquidityCredit

Operations risk Customer satisfactionProduct developmentEfficiency and performanceSourcingStock obsolescence and shrinkageProduct and service failureEnvironmentHealth and safetyBrand name erosion

Empowerment risk Leadership and managementOutsourcingPerformance incentivesChange readinessCommunications

Information processing and technology risk IntegrityAccessAvailabilityInfrastructure

Integrity risk Management and employee fraudIllegal actsReputation

Strategic risk Environmental scanIndustryBusiness portfolioCompetitorsPricingValuationPlanningLife cyclePerformance measurementRegulatorySovereign and political

Source: Linsley and Shrives (2006a)

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Appendix V Risk disclosure index

Company: Ahold

Year: 2006

Risk mentioned: Control mentioned: Total Score:Risk Categories: (yes=1, no=0) (yes=1, no=0)

Financial risks Credit risk 1 0 1 Price risk 1 0 1 Liquidity risk 1 0 1 Interest risk 1 1 2 Currency risk 1 1 2Non-financial risks Operational risk 1 0 1 Empowerment risk 1 0 1

Information processing and technology risk 1 0 1

Integrity risk 0 0 0 Strategic risk 1 0 1

Total Score: 9 2 11

Index = Actual score / Total possible score = 11/ 20 = 0.55

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Appendix VI Risk disclosure scores

Company Year2006 2007 2008 2009

Ahold 0.55 0.55 0.5 0.5Akzo Nobel 0.65 0.75 0.8 0.8ASML 0.4 0.4 0.4 0.4Bam Group 0.55 0.55 0.5 0.5Boskalis 0.55 0.55 0.55 0.55DSM 0.35 0.35 0.35 0.65Fugro 0.5 0.5 0.5 0.5Heineken 0.55 0.55 0.55 0.6KPN 0.4 0.55 0.75 0.75Philips 0.85 0.85 0.85 0.85Randstad 0.8 0.8 0.7 0.7Reed Elsevier 0.25 0.3 0.4 0.5SBM Offshore 0.8 0.85 0.85 0.85Shell 0.4 0.4 0.5 0.5TNT 0.6 0.65 0.65 0.65Tomtom 0.65 0.75 0.75 0.75Unilever 0.6 0.65 0.7 0.7Wolters Kluwer 0.8 0.8 0.8 0.8

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Appendix VII Relation between number of pages and risk disclosure score

Unilever:

Year # pages Risk disclosure score

2006 1¼ 0.6

2007 1½ 0.65

2008 3½ 0.7

2009 6¼ 0.7

TNT:


2006 6 0.6

2007 7 0.65

2008 8 0.65

2009 10¾ 0.65

Fugro:


2006 5¼ 0.5

2007 5¼ 0.5

2008 6¼ 0.5

2009 7 0.5

Randstad:


2006 4½ 0.8

2007 4½ 0.8

2008 5¾ 0.7

2009 6½ 0.7

Akzo Nobel:


2006 2 0.65

2007 6 0.75

2008 6 0.8

2009 5 0.8

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Appendix VIII Financial risk category

Company Year # sentences Company Year # sentences

Ahold 2006 58 Philips 2006 199

2007 26 2007 204

2008 33 2008 204

2009 25 2009 215

Akzo Nobel 2006 12 Randstad 2006 22

2007 17 + table 2007 22

2008 24 + table 2008 27

2009 22 + table 2009 30

ASML 2006 10 Reed Elsevier 2006 4

2007 10 2007 6

2008 10 2008 6

2009 11 2009 9

BAM Group 2006 2 SBM Offshore 2006 34

2007 2 2007 37

2008 2 2008 43

2009 3 2009 51

Boskalis 2006 21 Shell 2006 21

2007 24 2007 10 (notes)

2008 26 2008 34 (notes)

2009 26 2009 23 (notes)

DSM 2006 2 TNT 2006 38

2007 4 2007 73

2008 4 2008 64

2009 7 2009 70

Fugro 2006 35 Tomtom 2006 17

2007 38 2007 38 + table

2008 36 2008 49 + table

2009 36 2009 40 + table

Heineken 2006 9 Unilever 2006 9

2007 9 2007 9

2008 15 2008 36

2009 15 2009 36

KPN 2006 25 Wolters Kluwer 2006 69

2007 51 2007 27 (notes)

83


2008 20 (notes) 2008 23 (notes)

2009 12 (notes) 2009 32 (notes)

Appendix IX Risk management and internal control system

Company Year Risk man. system In-control Company Year Risk man. system In-control

Ahold 2006 X X Philips 2006 X X

2007 X X 2007 X X

2008 X X 2008 X X

2009 X X 2009 X X

Akzo 2006 X - Randstad 2006 X X

Nobel 2007 X - 2007 X X

2008 X - 2008 X X

2009 X - 2009 X X

ASML 2006 - - Reed 2006 X X

2007 - - Elsevier 2007 X X

2008 - - 2008 X X

2009 - - 2009 X X

BAM 2006 X - SBM 2006 X X

Group 2007 X - Offshore 2007 X X

2008 X - 2008 X X

2009 X - 2009 X X

Boskalis 2006 X X Shell 2006 - -

2007 X X 2007 - -

2008 X X 2008 - -

2009 X X 2009 - -

DSM 2006 X X TNT 2006 X X

2007 X X 2007 X X

2008 X X 2008 X X

2009 X X 2009 X X

Fugro 2006 X X Tomtom 2006 - -

2007 X X 2007 X X

2008 X X 2008 X X

2009 X X 2009 X X

Heineken 2006 X X Unilever 2006 X X

2007 X X 2007 X X

2008 X X 2008 X X

2009 X X 2009 X X

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KPN 2006 X X Wolters 2006 X X

2007 X X Kluwer 2007 X X

2008 X X 2008 X X

2009 X X 2009 X X

Appendix X Dataset statistical analysis

1. Average risk disclosure scores

Company Y2006-Y2007 Y2008-Y2009

Ahold 0.55 0.5Akzo Nobel 0.6 0.8ASML 0.4 0.4Bam Groep 0.55 0.5Boskalis 0.55 0.55DSM 0.35 0.5Fugro 0.5 0.5Heineken 0.55 0.58KPN 0.48 0.75Philips 0.85 0.85Randstad 0.8 0.7Reed Elsevier 0.28 0.45SBM Offshore 0.83 0.85Shell 0.4 0.5TNT 0.63 0.65Tomtom 0.7 0.75Unilever 0.63 0.7Wolters Kluwer 0.8 0.8

2. ROA (x 1 million):

Company Y2006 Y2007 Y2008 Y2009Average

Y20062007Average

Y20082009Ahold 7.578 20.841 9.992 8.702 14.209455 9.347155Akzo Nobel 11.424 62.350 -4.164 2.531 36.88705 -0.816195ASML 18.109 18.852 9.640 -2.752 18.48016 3.444065BAM Group 3.233 6.152 2.874 0.905 4.692575 1.889855Boskalis 8.234 11.131 10.844 8.762 9.68264 9.802955DSM 6.358 5.136 6.854 4.668 5.74687 5.760715Fugro 12.609 15.509 16.295 12.316 14.05923 14.305125Heineken 11.236 7.313 3.200 7.574 9.27446 5.387075KPN 9.842 14.916 8.017 13.110 12.37911 10.56341Philips 16.312 12.122 0.177 2.126 14.21664 1.151675Randstad 17.887 14.981 2.587 1.846 16.43372 2.2166Reed Elsevier 30.062 47.159 22.139 27.324 38.61088 24.73116SBM Offshore 9.605 9.360 6.881 6.592 9.4826 6.736555Shell 11.364 12.816 9.439 4.435 12.08995 6.936685TNT NV 10.967 17.201 10.090 5.294 14.08382 7.691935Tomtom 32.682 22.264 -34.412 5.336 27.472945 -14.53784Unilever 13.929 11.782 14.964 10.355 12.85563 12.659615

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Wolters Kluwer 7.516 18.522 7.038 3.804 13.01883 5.42095Source: ThomsonOneBanker

3. Debt/equity ratio (x 1 million):

Company Y2006 Y2007 Y2008 Y2009Average

Y20062007Average

Y20082009Ahold 1,1894632 1,2813648 0,8006843 0,5887868 1,235414 0,69473555Akzo Nobel 0,714527 0,3253263 0,4929653 0,4980064 0,51992665 0,49548585ASML 0,180314 0,3162176 0,325352 0,3736274 0,2482658 0,3494897BAM Group 2,6698282 2,1898956 2,5118327 2,4060793 2,4298619 2,458956Boskalis 0,1154168 0,1133793 0,3710654 0,0628431 0,11439805 0,21695425DSM 0,2647779 0,3340961 0,5020801 0,4513619 0,299437 0,476721Fugro 0,785691 0,7640977 0,6629831 0,5343979 0,77489435 0,5986905Heineken 0,6586145 0,4914878 2,2484903 1,5397122 0,57505115 1,89410125KPN 2,161621 2,6180401 3,2281501 3,4838458 2,38983055 3,35599795Philips 0,1682394 0,164038 0,2559872 0,2923604 0,1661387 0,2741738Randstad 0,1217259 0,51713 1,0981298 0,5525546 0,31942795 0,8253422Reed Elsevier 0 0 0 0 0 0SBM Offshore 0,8332287 0,8664624 1,3721961 0,8798713 0,84984555 1,1260337Shell 0,1491875 0,1460068 0,1828102 0,2567818 0,14759715 0,219796TNT NV 0,7897126 1,0797514 1,2931333 0,9786408 0,934732 1,13588705Tomtom 0 0 2,7310453 0,7797992 0 1,75542225Unilever 0,7715049 0,7689513 1,1138922 0,815085 0,7702281 0,9644886Wolters Kluwer 1,821608 1,6587436 1,8366337 1,8148426 1,7401758 1,82573815Source: ThomsonOneBanker

4. Type of industry:

Company Type of industryAhold 3Akzo Nobel 5ASML 2BAM Group 3Boskalis 3DSM 2Fugro 7Heineken 7KPN 1Philips 4Randstad 6Reed Elsevier 4SBM Offshore 4Shell 5TNT NV 5Tomtom 1

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Unilever 1Wolters Kluwer 3

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Appendix XI Normal Distribution

1. Normal QQ-plots risk disclosure scores

2. Normal QQ-plots ROA

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3. Normal QQ-plots D/E ratio

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