The Simultaneous Relation between Accounting Conservatism and Risk Reporting and Their Joint Effect on Analysts’ Forecast Accuracy

SCHEME: CORE

CALL: 2014

DOMAIN: IS - Development and Performance of the Financial Systems

FIRST NAME: Anke

LAST NAME: Müßig

INDUSTRY PARTNERSHIP / PPP: No

INDUSTRY / PPP PARTNER:

HOST INSTITUTION: University of Luxembourg

KEYWORDS: risk reporting, management commentary, accounting conservatism, risk assessment, risk disclosure, analysts’ forecast accuracy, disclosure models, information signals

START: 2016-07-01

END: 2019-06-30

WEBSITE: https://www.uni.lu

Submitted Abstract

The present research project is the first to examine the relation between accounting conservatism in primary financial statements and risk reporting in the management commentary. It investigates (1) the independent or joint effect of accounting conservatism and risk reporting on analysts’ forecast accuracy and (2) the substitutive or complementary relation between accounting conservatism and risk reporting.The financial crisis and collapse of various companies have highlighted the importance of companies making provisions for the downside risks to which they are exposed. If companies fail to make provisions and risks materialise, investors may face financial and deadweight losses. If upside risks, i.e. opportunities, are not exploited, investors forego potential profits and an improvement in deadweight loss does not occur to the extent that would be possible.Companies have two typical options for provisioning vis-à-vis capital market participants: on the one hand, they can use conservative accounting, which means that potential future losses are anticipated in the primary financial statements, i.e. they are immediately recognised, whereas potential future profits are not anticipated. On the other hand, there is information-based risk provisioning, which means that downside risks as well as upside risks are reported on in the management commentary.Conservative accounting provides certain advantages. However, it withholds information in the financial statements, in particular about potential future profits. Hence, analysts’ forecast accuracy is affected if analysts only consider information conveyed in the financial statements. For investors, information that reflects an undistorted picture of the company’s future financial development is important in terms of enabling them to make buy-hold-sell decisions.Against this backdrop, it is necessary to see risk provisions reported in the financial statements (accounting conservatism) and off-financial statements risk reporting as a whole. The present research project contributes to this need and analyses the relation between accounting conservatism and risk reporting. It is assumed that managers use accounting conservatism and risk reporting in combination to provide financial analysts with information. When used in combination, it is not clear a priori whether the two complement each other or are substitutive.One might argue that information deficits, which may arise as a result of conservative accounting, could be remedied by risk reporting, i.e. by symmetrical and detailed reporting on downside risks and upside risks in the management commentary. Moxter’s (1986, 1987, 1995) separation theorem develops this line of thought.

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