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Incentives for risk reporting a discretionary disclosure and cheap talk approach Presentation at the 30th Annual Conference of the EAA Lisbon, April 26, 2007 Dr. Michael Dobler, MBR Ludwig-Maximilians-University
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Incentives for risk reporting a discretionary disclosure and cheap talk approach Presentation at the 30th Annual Conference of the EAA Lisbon, April 26, 2007 Dr. Michael Dobler, MBR Ludwig-Maximilians-University Munich University of Ottawa Introduction Risk reporting information on the effects risks (and opportunities) may have on an entity's future economic position (risk factors, risk management, risk forecasts) risk-related disclosure that shall help users to assess the distribution of future cash-flows or parameters of it (verifiable, non verifiable) Tradeoff incentives literature: claimed benefits for preparers and users evidence: variation/restrictions in voluntary risk reporting regulation literature: call for (more) regulation evidence: variation/restrictions in mandatory risk reporting Lisbon - April 26nd, 2007 Michael Dobler 2 Introduction Research question risk reporting incentives in their relation to regulation Research approach adoption, review and discussion of discretionary disclosure and cheap talk models Main results incentives limited by on three levels regulation may partly mitigate, but not overcome incentives Main contribution qualifying prior assessments on risk reporting analytically based considerations on risk reporting rules empirically testable hypotheses on risk reporting Lisbon - April 26nd, 2007 Michael Dobler 3 Background Risk uncertainty-based vs. target-based views distributions of future outcomes Risk reporting verifiable vs. non-verifiable risk information risk-related disclosure that shall help users to assess the distribution of future cash-flows or parameters of it Risk management information source for risk reporting risk reporting as a means of risk handing Lisbon - April 26nd, 2007 Michael Dobler 4 Background Regulation piecemeal approach vs. comprehensive approach table 1 (p. 30) managers have room to exercise discretion Empirical evidence large variation/restrictions in voluntary and mandatory risk reporting table 2 (p. 31) managers do exercise discretion Incentives do matter - even in regulated regimes Lisbon - April 26nd, 2007 Michael Dobler 5 Review Basics unraveling principle verifiable vs. non-verifiable disclosure expected values vs. variances Structure verified risk reporting disclosure models on disclosure cost disclosure models on uncertainty of information availability unverified risk reporting single-period cheap talk models multi-period cheap talk models Lisbon - April 26nd, 2007 Michael Dobler 6 Review Disclosure cost (verified risk reporting) amendment: disclosure associated with cost C 0 general results withholding of (unfavorable) information: low cash flows, large variances of cash flows disclosure less likely with increasing cost C Jorgensen & Kirschenheiter (2003) disclosure of variances less likely with increasing risk aversion of outsiders mandating disclosure of variances will (weakly) increase a firm's cost of capital Lisbon - April 26nd, 2007 Michael Dobler 7 Review Uncertainty of information availability (verified risk reporting) amendment: manager only informed with 0 p 1 general results withholding of (unfavorable) information: low cash flows, large variances of cash flows disclosure less likely with decreasing probability p special results information and disclosure precision (e.g. Penno 1996, 1997; Richardson 2001) herd effects (e.g. Dye & Sridhar 1995) Lisbon - April 26nd, 2007 Michael Dobler 8 Review Single-period cheap talk (unverified risk reporting) amendment: disclosure not verified general results credible communication possible, but needs noise favorable forecasts may be disclosed with more precision than unfavorable ones Fischer & Stocken (2001) information and disclosure precision incomplete ranking of equilibria Lisbon - April 26nd, 2007 Michael Dobler 9 Review Multi-period cheap talk (unverified risk reporting) amendments: disclosure not verified, reputation general results diverse (e.g. Sobel 1985; Benabou & Laroque 1992; Kim 1996; Stocken 2000; Morris 2001) Stocken (2000) perfect public equilibrium in review phases, where a manager nearly always reports truthfully if sufficient weight of long term-term incentives sufficiently long review phases / interaction sufficient usefulness of annual reports to assess former forecast disclosure Lisbon - April 26nd, 2007 Michael Dobler 10 Discussion Incentives/restrictions of risk reporting manager may have no/pretend not to have information manager may withhold private information because he cannot disclose credibly/can misreport manager may withhold private information because he fears disadvantages Regulation on risk reporting managerial risk information endowment enforcement of (credible) risk reporting mandatory risk reporting specific risk reporting rules Lisbon - April 26nd, 2007 Michael Dobler 11 Discussion Information endowment Incentives verified risk reporting depends on common knowledge probability of managerial information endowment information vs. disclosure precision unverified risk reporting non-credible or boilerplate disclosure information vs. disclosure precision Regulation minimum probability of managerial information endowment still margins to withhold available risk information information vs. disclosure precision Lisbon - April 26nd, 2007 Michael Dobler 12 Discussion Enforcement Incentives verified risk reporting cost vs. disclosure unverified risk reporting cost vs. credibility cost vs. disclosure Regulation nominal/actual value comparison ex post inadequate audit (ex ante) reduces to test of plausibility tort and strict litigation potentially inadequate Lisbon - April 26nd, 2007 Michael Dobler 13 Discussion Mandatory risk reporting Incentives verified risk reporting various, most likely related to cost unverified risk reporting various, probably related to cost (self-fulfilling prophecy) Regulation certain costs probably demotivate regulation (verified risk reporting) uncertain costs questionable (unverified risk reporting) unsolved/unsolvable issue of credibility of risk forecasts Lisbon - April 26nd, 2007 Michael Dobler 14 Discussion Specific risk reporting rules Incentives verified risk reporting uncertainty of information availability unverified risk reporting credibility Regulation negative reports risk management reports supplementary risk forecast disclosures Lisbon - April 26nd, 2007 Michael Dobler 15 Conclusions Incentives limited at (at least) three levels Regulation may mitigate, but cannot overcome these incentives General assessment of risk reporting adverse incentives do matter even in presence of regulation caution not to overestimate risk reporting in both, an unregulated and a regulated environment Caveats Empirical research Lisbon - April 26nd, 2007 Michael Dobler 16 Contact Michael Dobler Ludwig-Maximilians-University Munich University of Ottawa Lisbon - April 26nd, 2007 Michael Dobler 17
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