Risk Disclosure, Earnings Smoothing and Firm Perceived Risk

Hend Monjed*, Salma Ibrahim, Bjørn N. Jørgensen

*Corresponding author for this work

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

Purpose
This paper aims to examine the association between perceived firm risk and two reporting mechanisms: risk disclosure and earnings smoothing in the UK context.

Design/methodology/approach
This study juxtaposes three competing views, the “null”, the “divergence” and the “convergence” hypotheses, and empirically investigates whether risk disclosure and earnings smoothing affect firm perceived risk for a sample of large UK firms with rich and poor information environments. This study also uses the global financial crisis as an external shock on overall risk in the economy to investigate when and how managers use these two reporting mechanisms to shape the firm perceived risk.

Findings
This paper documents that risk disclosures have no significant effect on investors’ risk perceptions, consistent with risk disclosures containing boilerplate and generic statements about firm risk. This paper also finds that earnings smoothing reduces investors’ risk perceptions, reflecting investors’ interpretations about future firm performance. Additional tests reveal that earnings smoothing is not associated with perceived firm risk for firms with rich information environments and expanded risk disclosures. Furthermore, reporting smooth earnings decreases perceived firm risk following the global financial crisis. These findings are robust to alternative specifications and measures of earnings smoothing as well as post-filing perceived firm risk.

Research limitations/implications
This study does not distinguish between the garbling role and the informational role of earnings smoothing. The risk disclosure measurement used in this study, developed based on UK annual reports, may limit the generalizability of findings to other countries.

Practical implications
The findings suggest that managers should revise their risk disclosure strategies to provide in-depth details on firm risk. Investors might require information and thorough assessment to evaluate investment risks when firms provide generic risk disclosures and smoothed earnings by consulting sources like financial intermediaries. Regulators should keep an eye on firms reporting boilerplate risk disclosures and on how smoothing earnings impacts the firm perceived risk following economic turmoil, to guide interventions that promote market stability.

Originality/value
The findings provide new insights into when and how managers use their financial reporting discretion to make firms appear less risky and, therefore, influence investors’ risk perceptions.
Original languageEnglish
JournalJournal of Financial Reporting and Accounting
Number of pages25
ISSN1985-2517
DOIs
Publication statusPublished - 17 Sept 2024

Bibliographical note

Epub ahead of print. Published online: 17 September 2024.

Keywords

  • Risk disclosure
  • Textual analysis
  • Earnings smoothing
  • Perceived firm risk

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