Risk Reporting Quality: Implications of Academic Research for Financial Reporting Policy

TLDR: The authors survey empirical research in accounting and finance over the past 15 years (since my prior survey, Ryan 1997) on the relevance of firms' financial report information for the evaluation of their risk and make four primary recommendations for how financial reporting policymakers can improve risk reporting quality.

Abstract: In this paper, I survey empirical research in accounting and finance over the past 15 years (since my prior survey, Ryan 1997) on the relevance of firms’ financial report information for the evaluation of their risk. I assume higher risk-relevance indicates enhanced risk reporting quality. Based on these research findings and assumption, I make four primary recommendations for how financial reporting policymakers can improve risk reporting quality. These recommendations pertain to both summary accounting numbers (which may be recognized bottom-line amounts or analogous amounts calculated from required disclosures) and other financial report disclosures. First, policymakers should require firms to report comprehensive income statements that: (1) measure comprehensive income based on fair value or a similarly information-rich accounting measurement attribute; and (2) present the components of comprehensive income that are primarily driven by variation in cash flows from those that are primarily driven by variation in costs of capital. Such comprehensive income statements would provide users of financial reports with the flexibility to calculate alternative income numbers and thereby to perform different types of risk assessment analyses that research has shown to be useful. This recommendation reflects a central theme of this paper: alternative income numbers play different but fundamental roles in risk assessment. Second, policymakers should attempt to maximize the ties of other financial report disclosures to summary accounting numbers. My primary specific recommendation in this vein is to require firms to conduct and disclose the results of back-tests of prior significant accrual estimates, indicating any identified trends in and drivers of revisions to those estimates, and describing the effects of those revisions on current and if possible future summary accounting numbers. Third, policymakers should encourage and to the extent feasible require firms to aggregate and present risk disclosures in tabular or other well-structured formats that promote the usability of the information. Identifying and propagating the use of existing best disclosure practices and encouraging new best practices is the most natural way to do this. Fourth, for model-dependent risk disclosures, policymakers should encourage and if feasible require firms to disclose the primary historical and forward-looking attributes of the models and their implementation in practice, sensitivity of the model outputs to common variants of those attributes, and benchmarking of the models to standard portfolios of exposures.