Since the law in many European and non- European countries did not provide any principles on risk reporting, professional bodies such as the German Institute of Chartered Accountants (IDW) in Germany, The Securities Exchange Commission (SEC) in the USA and The Canadian Securities Administrators (CSA) in Canada issued specific standards on risk reporting that became effective over time. Professional bodies have considered the issue of risk disclosure very important and provided related discussion papers and risk reporting guidelines (Linsley et al, 2006). Nevertheless, the main question in concern is: ''Do risk disclosures meet professional bodies' regulations?'' and the sub-question is: ''Are risk disclosures useful to the reader of an annual report? ''. This paper attempts to review and compare risk reporting disclosures across a range of top European and non-European companies and then there will evaluate whether their risk disclosures meet relevant legislations.
Furthermore, there will be a critical evaluation whether risk disclosures are useful to the reader of an annual report. The dissertation begins by addressing major problems from insufficient risk disclosures across a number of European and non-European companies. The recent global financial downturn along with prominent corporate failures and bankruptcies is a strong example indicating insufficient risk information by a number of companies.
Theoretical basis
The approach of the mandatory risk reporting as a part of companies' annual report first adopted by the German Accounting Standard Board (GASB) before introduced to all EU member states (Dobler, 2005). The European Commission made a recommendation on 30 May 2001 on the recognition, measurement and disclosure of environmental risks and uncertainties in the annual reports of companies (European Commission, 2001). Although the recommendation had to do with corporate social responsibility, it is useful to recognize specific environmental risks by requiring companies to include them into the accounts as soon as they occur from transactions and facts that have an effect on the financial position and results of the reporting entity. Apart from legal obligations that aim to reduce or repair environmental damage, the EU recommendation takes also into consideration constructive obligations.
The idea of compulsory risk reporting further adopted by the EU in the 2003 Accounts Modernization Directive (2003/51/EC) and the 2004 Transparency Directive (2004/109/EC) (Europa, 2008). The first directive imposes a description of the principal risks and uncertainties that company faces while the second extents the risk disclosure requirement for quoted companies to include half yearly financial reports. Since then, companies in the EU are obliged to include "description of the principal risks and uncertainties" in their annual report. Moreover, companies are required to describe "the principal risks and uncertainties for the remaining six months of the financial year" in their interim management report (Europa, 2003).
Kajüter (2001) found limited risk information and a lack of coherence in companies' disclosures after he examined risk disclosures of 82 German companies. On the other hand, Woods & Reber (2003) having examined annual report risk disclosures of 6 German and 6 UK companies pre- and post- German Accounting Standard (GAS) 5 implementation found a positive effect between the GAS 5 and the quantity of risk disclosures of the 6 German companies. However, there was limited reporting of forward-looking risk information. Beretta & Bozzolan (2004) developed a framework to analyze firm risk communication. More specifically, they explored annual report risk disclosures of 85 Italian non-financial companies and found that companies were reluctant to disclose forward-looking risk information and with regards to future risks there were reluctant to indicate the impact of future disclosures on the company.
Kajüter (2006) conducted a longitudinal study examining annual report risk disclosures of 80 German listed companies between 1999 and 2003. He noted a significant upward trend in risk disclosures over the five-year period. However, firms' report included more external than internal risks. Moreover, apart from the fact that risk reports remain vague, research shows that there is a positive association between the sizes of companies the total quantity of risk disclosures.
In the UK The Companies Act 2006 recommends that a director's report must describe a ''fair view of the company'' and a "description of principal risks and uncertainties facing the company" (section 417(3) (a, b)) (Companies Act 2006). In Canada, the CSA published the Staff Notice 51-330 providing forward-looking information requirements in parts A4 and 4B of National Instruments 51-102-Continues Disclosure Obligations (NI 51-102) (Saskatchewan Financial Services Commission, 2007) that came into effect on December 31, 2007. In the United States, according to the U.S Securities and Exchange Commission (SEC) the disclosure of risk factors through an item 1A of 10-K in companies' annual report is mandatory. The 10-K includes information such as equity, subsidiaries, and audited financial statements, among other information (Sec, 2009).
Using content analysis in Canadian Annual Reports Lajili & Zéghal (2005) examined annual report risk disclosures of the Toronto's Stock Exchange (TSE) 300 largest companies. More specifically, they focused on reporting upon financial risks, commodity risks and market risks. However, they emphasized on reporting negative aspects of risk rather than the opportunities it might present. Furthermore, risk quantification is hardly discussed in their paper as they emphasized more in risk qualitative characteristics.
With regards to UK and Canadian risk disclosure legislations, Linsley & Shrives (2006a) examined risk disclosures in the annual report of 9 UK and 9 Canadian banks. What they found was limited reporting of forward-looking risk information and limited quantification of risks. Linsley & Shrives (2006b) also examined risk disclosures in the annual reports of 79 UK non-financial companies and found that companies appeared willing to disclose forward-looking risk information. In addition, companies found more likely to disclose good risk than bad risk news. Nevertheless, they argued that since there is no association between the company's general risk level and the number of risk disclosures companies do not fully comply with risk disclosure regulations. Moreover, companies provide risk disclosures that are not useful to the reader of the annual report.
Research methodology
In order to evaluate whether European and non-European companies comply with relevant risk disclosure regulations, annual report risk disclosures of 5 US, 5 UK, 5 Canadian and 5 Spanish non-financial companies are examined. The selection of the companies to be used in the particular study was based upon the top 5 companies of the construction and material industry, food and beverages industry, oil and gas as well as electronic and electrical equipment industry listed in the relevant stock markets. The annual reports selected for analysis were those with a year-end date 30 Dec 2009. Although the overall sample size is relatively small, having selected companies across different countries it is possible to conduct cross-country comparisons. Additionally, this study is exploratory and is attempting to establish a base for further future risk disclosure studies.
The method to be used in analyzing risk disclosures within the annual reports is content analysis. According to Linsley and Shrives (2006a) this method is preferred for measurement and categorization of risk information. Nevertheless, criticisms using this method imply some limitations for this study (ibid). The gap between risk regulations and risk disclosures as well as the usefulness of risk discloses to the readers can be evaluated through the development of five hypotheses.
Linsley and Shrives (2006b) examined the relationship between company size and risk disclosures related to both financial and non-financial risks. Based on Linsley and Shrivas hypothesis framework the first hypothesis examines the relationship between company size and the number of risk disclosures. The first hypothesis is presented in a form of three hypotheses as follows:
Hypothesis 1(a). Company size is positively associated with the total number of risk disclosures.
Hypothesis 1(b). Company size is positively associated with the total number of financial risk disclosures.
Hypothesis 1(c). Company size is positively associated with the total number of non-financial risk disclosures.
The second hypothesis examines the association between company risk level and the number of risk disclosures and is tested as follows:
Hypothesis 2(a). The level of risk within a company is not associated with the total number of risk disclosures.
Hypothesis 2(b). The level of risk within a company is not associated with the total number of financial risk disclosures.
Hypothesis 2(c). The level of risk within a company not associated with the total number of non-financial risk disclosures.
The third hypothesis examines the relationship between monetary risk disclosures and non-monetary risk disclosures. Risk disclosures are expected to be described with infrequent disclosure of risk information that has a monetary value attached (ibid)
Hypothesis 3. The number of non-monetary risk disclosures will be significantly greater than the number of monetary risk disclosures.
The fourth hypothesis analyzes the relationship between past and future risk disclosures and is based on the fact that future information is more useful to interest groups for decision-making than past information. However, directors will be as reluctant to disclose future risk information. Therefore, the fourth hypothesis is:
Hypothesis 4. The number of past risk disclosures will be significantly greater than the number of future risk disclosures.
The amounts of good or bad risk news disclosed will be variable and it is not possible to pre-determine the disclosure patterns of good and bad news (Linsley & Shrivas, 2006b). Therefore, the fifth hypothesis is:
Hypothesis 5. The number of good and bad risk disclosures will not be significantly different from one another.
A number of measures such as gearing ratio, asset cover, beta factor, ratio of book value of equity to market value of equity, quiscore, Business in the Community Index of Corporate Environmental Engagement (BiE Index) and Innovest EcoValue'21TM Rating Model will be used for this study. Although the first two measures are widely used to assess risk within companies, beta factors are based upon the capital asset pricing model and therefore are subject to the limitations of that model. Nevertheless, to overcome the problem, ratio of book to market value of equity figures will be calculated at the company's year end. The EcoValue 21TM Rating Model will be used to measure the number of risk disclosures and level of environmental risk. The model consists of over 40 data points and performance metrics to compile a risk score for any given company. This information is drawn from an extensive range of data sources including annual reports, website data, environmental and industry reports, government records.
The quiscore is used to measure the likelihood of company failure and is based upon the analysis of a number of financial and non-financial factors for individual companies. The BiE Index provides a measure of environmental risk, and because companies and their stakeholders are focused upon environmental risks (Linsley & Shrives, 2006b) this may impact upon numbers of risk disclosures. Pearson correlation coefficients will be calculated to test the first and the second set of hypotheses. To test Hypotheses 3-5 the Wilcoxon signed ranks test will be utilised.
Research plan
