A Content Analysis of Risk Management Disclosures in Canadian Annual Reports

A Content Analysis of Risk i\/lanagementDisclosures in Canadian Annual ReportsKaouthar LajiliDaniel ZeghalUniversity of Ottawa

AbstractThis research paper examines risk information disclo-sures in Canadian annual reports to provide insights intothe current risk disclosure environment, its characteris-tics, and the analytical usefulness of the information dis-closed to the firm's stakeholders. Following a contentanalysis, the authors describe and then analyze ingreater detail the subject matter of risk disclosures ofTSE 300 Canadian companies by summarizing and clas-sifying disclosed risk-related information. Results showa high degree of risk disclosure intensity reflecting bothmandatory and voluntary risk management disclosures.However, the analytical power of such disclosures, ascaptured by the risk assessment analysis, appears to lackuniformity, clarity, and quantification, thus potentiallylimiting their usefulness. The authors conclude that moreformalized and comprehensive risk disclosures might bedesirable in the future to effectively reduce informationasymmetries between management and stakeholders.

JEL Classification: M410, G300, D210, D890

Keywords: Risk disclosure; cotitetit atialysis; riskmanagement.

ResumeLa presente etude analyse les divulgations d'informa-tions sur le risque dans les rapports annuels canadiens.Elle se propose de jeter une tumiere sur Venvironnementactuel de divulgation des risques, ses caracteristiques, etI 'utltite anatytique des informations divulguees pour lesacteurs de I'industrie canadienne. Grace a la methodede l'analyse du contenu, tes auteurs decrivent puisanatysent de fagon plus detaillee le contenu actuel desdivulgations d'informations sur le risque des entreprisesdu TSE 300. Ils y parviennent en synthetisant et en cate-gorisant les informations divulguees. Les resultats mon-trent que les divulgations se font a une frequence assezelevee, consecutive aux divulgations obligatoires et volon-taires de gestion des risques. Cependant, vu la manieredont l'analyse d'evaluation des risques divulgue cesinformations, leur pouvoir analytique semble manquerd'homogeneite, de clarte, et de quantification, ce quilimite potentieliement leur utilite. Les auteurs concluentqu'a I'avenir, les divulgations de risques gagneraient aetre plus formalisees et plus completes. Ceci permettraitde reduire I'asymetrie des informations entre les ges-tionnaires des risques et les investisseurs.

Mots cles : Divulgation du risque; analyse de contenu;gestion du risque

Risk management strategies have long been exam-ined within the boundaries of the firm (i.e., internally)as important managerial decisions since risk is presentin almost every aspect of business operations. Recently,

The authors thank Iraj Fooladi (Co-Editor), Heather Wier (Area Edi-tor), two anonymous reviewers, and Daniel Thornton for helpful com-ments and suggestions. Support from the Social Sciences and Human-ities Research Council of Canada, and the CGA Accounting ResearchCentre at the School of Management at the University of Ottawa, aregratefully acknowledged.Address correspondence to Kaouthar Lajili, School of Management,University of Ottawa, 136 Jean-Jacques Lussier, Ottawa, ON, CanadaKIN 6N5. E-mail: [email protected]

ASAC 2005 125

increasing research attention has been directed to riskmanagement and control from an external viewpoint,and more specifically from the stakeholders' view-points. Driven by increased complexities in the businessworld, and an objective to promote transparency andimprove disclosure quality by reducing informationasymmetries, risk and risk management disclosures arepotentially useful to analysts, investors, and other firmstakeholders. These disclosures provide guidance inevaluating management's effectiveness in dealing withincreased market volatility and business uncertainty andtheir impact on firm-level economic value and growth,as well as trading volume sensitivity to different risks(e.g., Carlin & Mayer, 2003; Clarkson, Kao, & Richard-

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CONTENT ANALYSIS OF RISK MANAGEMENT DISCLOSURES IN CANADIAN ANNUAL REPORTS LAJILI & ZfiGHAL

son, 1999; Linsmeir, Thornton, Venkatachalam, &Welker, 2002; Rajan & Zingales, 1998; Venkatachalam,1996). As part of good corporate governance, risk man-agement information is expected to be increasinglysought by the firm's stakeholders and information usersin general, to elicit potentially relevant information(namely risk exposure and control strategies) that mightbe intentionally withheld by management for strategicpurposes. This would help identify potential managerialproblems (and opportunities) and assess management'seffectiveness in dealing with business uncertainties andopportunities.

The increased attention on effective risk manage-ment is also driven by the increasing importance ofsome types of risks and uncertainties, particularly inthe new knowledge-based economy. In addition to themore commonly analyzed financial risk and businessand operational risks (e.g.. Lev, 1974; Linsmeir et al.,2002; Thornton, 1983), such risks also include strategicrisks, technology risks, regulatory risks, and politicalrisks. For instance, a sudden resignation of the CEO ofa company could be considered a strategic risk andmight potentially affect the company's operating per-formance and economic value in the capital markets, atleast in the short run. Another example concerns therapid change of technology such as the electronic infor-mation technology revolution of the late 1990s and itsimpact on managerial decisions in changing the pro-duction input mix, which will directly affect the oper-ating leverage and risk (i.e., the ratio of fixed to vari-able operating costs) as examined in Lev (1974). Whilethe reporting of most financial risk types (such as cur-rency, credit, and financial instrument use risks) inCanada has been significantly improved since the mid-nineties' and continues to be debated in the accountingstandard setting circles, other types of risk, which thispaper will examine more closely, are only voluntarilydisclosed by companies. We do not focus on the eco-nomic incentives for these voluntary disclosures, whichcould reduce information asymmetries between man-agement and stakeholders. Rather, our objective here isto survey the way management reports these types ofrisks, and which firms and industries are reporting cer-tain categories of risks and associated risk managementstrategies.

Risk has both downside and upside components (oropportunities). Therefore, in addition to controlling riskexposure and minimizing the effects of downside risks,firms should be able to take advantage of the upside riskpotential at any point in time and place, and investorsshould be able to identify those firms that have done so.In examining Canadian risk disclosures and focusing onthe voluntarily disclosed risk categories as explained inthe subsequent sections of this research paper, we seek

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evidence (if any) of the existence of upside risk disclo-sures in addition to downside risk disclosures that aremost commonly reported in the firms' annual reports(see Thornton, 1983, for a detailed description andexamples of reporting practices on contingencies andrisks in Canada).

Despite recent increased risk research attention onthe international scene, there are few Canadianresearch studies that specifically address risk and riskmanagement disclosure and the reporting environmentin Canada (e.g., Clarkson et al., 1999; Linsmeir et al.,2002; Thornton, 1983). This paper examines all typesof risk disclosure and risk management information inthe annual reports in corporate Canada in 1999. Morespecifically, we identify and then analyze alternativeways followed by Canadian firms to communicate riskmanagement information to interested outside parties,namely investors and stakeholders in general. Follow-ing a content analysis methodology, this researchpaper aims at giving a snapshot picture of the state ofrisk disclosures in corporate Canada. Although weencompass all types of risk categories disclosed,our emphasis is on non-financial risk types such asbusiness and operational risk, regulatory risk, andenvironmental risks, as more valuable informationabout a firm's total risk exposure could be inferredfrom the non-financial side of operations, as discussedlater.

The remainder of this paper is structured as follows.First, we present the relevance of risk management infor-mation and review the related literature. In a subsequentsection, we discuss the disclosure of risk managementinformation in corporate Canada and current risk disclo-sure guidelines and regulations. The remaining sectionsdescribe the research design and methodology and reportthe content analysis results. The paper concludes withsome implications of the results and suggestions forfuture research.

Relevance of Risk Management Informationand Related Research

Risk management strategies and economic perfor-mance are fundamental parts of managerial competencyand decision-making. Managers are constantly underpressure to achieve the central core objective of enhanc-ing their company's value assuming effective incentivemechanisms are in place to minimize agency-relatedcosts and to facilitate good corporate governance. Riskmanagement might be considered an integral part ofinternal control and governance and as such could beused as a performance check on how successful man-agement is in meeting its objectives, given the uncertain-


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CONTENT ANALYSIS OF RISK MANAGEMENT DISCLOSURES IN CANADIAN ANNUAL REPORTS LAJILI & ZEGHAL

ties and risks surrounding the firm's operations and glob-al environment. Thus, careful identification, measure-ment, and assessment of risk types and contingenciesthat a firm faces represents a first step towards develop-ing a risk management strategy. A subsequent stepinvolves formulating the response to risk (both threatsand opportunities) by managing risk. This formulationwould include determining capacity for bearing risk, riskreduction procedures, and other strategies to benefitfrom the upside risk potential, in other words, develop-ing a risk response model. Finally, a third stage in therisk management internal control strategy involves mon-itoring and checking the performance of the riskresponse model developed by management on a regularbasis as the uncertainty unfolds. In the case of financialand market risk, disclosure of risk categories and riskmanagement strategies is required by the standards set-ters institutionsthe Canadian Institute of CharteredAccountants (CICA) in Canada and the FinancialAccounting Standards Board (FASB) in the U.S.andby the exchange regulators for publicly-listed compa-nies. In other cases (e.g., business risk, political risk,environmental risk), disclosure is voluntary or encour-aged, as discussed in the next section.

To date, more research in risk management account-ing and disclosure has been directed to the U.S. settingwith an emphasis on financial risk disclosures (e.g.,Linsmeir et al., 2002; Roulstone, 1999; Venkatachalam,1996). However, some international research studies arebeginning to emerge (e.g., Kajuter, 2001; Linsley &Shrives, 2000) motivated in part by the current interna-tional accounting debate about IAS and U.S. GAAPreporting quality comparisons (e.g.. Ball, Robin, & Wu,1999; Leuz, 2003). In the Canadian context, with theexception of the seminal research work by Thornton(1983) on the theory and practice of contingencyaccounting in Canada, a research gap persists betweenthe theory and practice of risk measurement and disclo-sure.

In examining the U.S. risk disclosure setting, Lins-meir et al. (2002) use a sample of nonfinancial firms toinvestigate the impacts of forward-looking Securitiesand Exchange Commission (SEC) mandated market riskdisclosures. They document a reduced trading volumesensitivity to variations in market rates and prices, name-ly interest rates, foreign currency exchange rates, andcommodity prices, following SEC's mandated marketrisk disclosure. The authors interpret their findings basedon the research hypothesis that mandated risk disclo-sures would decrease investors' uncertainty and diversi-ty of opinion about the effects of market rate/pricechanges on investors' perceptions of firm risk exposureand consequent implications for firm values. They alsoexamine the effectiveness of the three possible reporting

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methods (i.e., tabular, sensitivity, and value-at-risk dis-closures) as outlined by the SEC (1997, FR-48) and findthat tabular disclosures are more effective in decreasingtrading volume sensitivity to interest rate changeswhereas sensitivity and value-at-risk (VAR) disclosuresare more effective in reducing trading volume sensitivityto foreign exchange rate variations. In the current paper,although we focus our attention on non-financial typesof risk disclosure practices in Canada, we neverthelessreport our empirical findings for all types of risks,including financial risks, and we attempt to link risk dis-closure practices to accounting and exchange regulationsas discussed in the following sections.

Within the same risk disclosure literature, Venkat-achalam (1996) presents evidence on the market value-relevance of U.S. banks' off-balance sheet derivativesdisclosures under SFAS 119 "Disclosure about Deriva-tive Financial Instruments and Fair Value of Financialinstruments". He finds that the fair value estimates forbank derivative financial instruments help explain cross-sectional variations in bank share prices and that fair val-ues disclosures have incremental explanatory power withregard to contractual (or notional) amounts of deriva-tives. Interestingly, this study also finds that about half ofthe sample banks may be using derivatives to increasetheir risk exposure rather than reduce it, which is thesubject of ongoing research.

On the international scene, and within the account-ing standards harmonization debate, some research stud-ies have examined risk reporting and the disclosure envi-ronment in a comparative international context (e.g.,IFAC, 1999; Kajuter, 2001; Shrives & Linsley, 2003).Most of these studies highlight the shortcomings andlack of transparency in risk disclosure and reporting duemainly to the absence of standards and uniform mea-sures for different risk components domestically andinternationally. Studies also document that differentcountries in Europe and North America have differentrisk reporting requirements. For example, Kajuter findsthat Germany has, in general, a more detailed domesticregulation of risk disclosure than the UK and U.S. How-ever, the empirical analysis, based on risk reports issuedby German companies, describes an overall poor disclo-sure practice. In a more recent study, Leuz (2003) exam-ines one particular segment of the German trading mar-ket referred to as Germany's New Market, initiated in1997, to investigate any differences between firms usingthe IAS or the U.S. GAAP (since firms trading in thismarket can choose between either accounting standardfor financial reporting purposes) in information asym-metry and market liquidity using proxy variables. Leuzfinds no statistically significant differences in informa-tion asymmetry proxies between firms adopting IAScompared to those choosing U.S. GAAP and concludes

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that both accounting standards seem to be of fairly com-parable informational and disclosure quality.

We attempt to contribute to this emerging risk dis-closure literature first by describing current risk disclo-sure regulations in the Canadian setting, and second bypresenting the Canadian risk disclosure practice findingsand thus complementing other country-specific risk dis-closure studies.

The Disclosure of Risk Management Information:An Overview of Canadian Regulations

for Risk Disclosure

Risk information and management are usually com-municated at three different levels: internal, external, andan intermediate level between the two.

Internal risk reporting to management and employ-ees involves sharing the information about risk identifi-cation, measurement, performance development, andmonitoring. Internal risk reporting is intended to helpmanagement and employees run the firm efficiently tomeet its objectives by providing relevant operational andstrategic information on a regular basis. This type ofinternal disclosure is usually informal and takes the formof internal meetings and updates that are integrated withthe firm's organizational model. Internal risk reportingrepresents the original and most discretionary type ofrisk information and decision-making catalyst (see forexample AICPA/CICA, 1999).

Risk information reported to the firm's board ofdirectors is an intermediate stage between the internalinformation channel and the external public disclosurelevel. It is intended to reassure the board of directorsabout management control measures and success in han-dling risk-related issues in the firm. This form of riskreporting might be formal or informal depending on theorganizational model followed and the corporate cultureinside the firm.

External reporting (or public disclosure) of risk-related information is mainly required from firms andorganizations using external financing and is often man-dated by regulatory agencies, creditors (bankers andbondholders), and investors. Risk reporting in this caseusually involves principal regulatory requirements in theform of prospectus uses and annual reports. Prospectususes cover a full range of relevant risk types and consid-erations for prospective or potential investors, whileannual reports provide qualitative and quantitative riskinformation in the financial statements (mainly in thefootnotes) or in the exchange regulator requirement sec-tions, namely the management discussion and analysis(MD&A) sections. Since our sample comprises all TSE300 firms that may be cross-listed with other major for-

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eign exchanges, namely, the U.S. securities exchanges, itis useful to briefly review the current regulatory climatein both countries with regard to risk disclosure.

Financial accounting standards bodies and securityexchange commissions in Canada and the U.S. requirebusiness entities to provide information to financialstatement users regarding their exposure to risk. Finan-cial and market risk disclosures (such as currency, inter-est rate, and credit risks) are the most regulated cate-gories of risk in terms of GAAP and CICA rules forfinancial reporting. In particular, in Canada, the CICAHandbook^ (Section 3860) requires that firms discloseany information that assists users of financial statementsin assessing the extent of risk related to both recognizedand unrecognized financial instruments such as theextent and nature of the financial instruments includingthe terms and conditions. The risks listed in paragraph 44of this section include price risk (currency risk, interestrate risk, and market risk), credit risk, liquidity risk, andcash flow risk. The section outlines the accounting poli-cies and conditions under which specific types of trans-actions and balances for financial instruments should bedisclosed such as measurement methods (i.e., cost or fairvalue methods) and depending on the potential signifi-cance of market risk exposure.

In addition to these disclosure requirements forfinancial instruments, the CICA Handbook (section3860, paragraph 43) states: "entities are encouraged toprovide a discussion of the extent to which financialinstruments are used, the associated risks and the busi-ness purposes served". Other related sections of theCICA Handbook deal with more specific elements ofrisk disclosures, such as section 1650 covering foreigncurrency translation and changes in foreign operations,section 1701 on segment disclosure, and section 1508 onconditions for measurement uncertainty disclosures.Thus, mandatory risk disclosures concern primarilyfinancial instruments use and risk exposure to financialand market risk usually reported in the footnotes to thefinancial statements. Any qualitative or quantitative dis-cussion of the risks associated with the use of financialinstruments and management's policies to manage thoserisks is currently voluntary to a great extent. While theCanadian regulations appear to deal more broadly withdifferent types of financial instruments' use and expo-sure disclosures, the U.S. GAAP regulations containmore specific, detailed, and usually more complex riskdisclosure requirements. For instance, two FASB docu-ments"Disclosure about fair value of financial instru-ments" (FASB, 1991) and "Accounting for derivativeinstruments and hedging activities" (FASB, 1998)establish accounting and reporting standards for finan-cial instruments and derivative instruments respectively.In particular, the latter requires that an entity recognize

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all derivatives as either assets or liabilities in the state-ment of financial position and measure those instrumentsat fair value. Derivatives used for hedging, and thus riskcontrol purposes, are classified under three categoriesdepending on the source of risk exposure: (a) changes infair value of recognized firm asset or liability or anunrecognized firm commitment, (b) changes in cashflows of a forecast transaction, and (c) changes in for-eign currency positions.

In addition to the financial reporting statements forrisk disclosure summarized above, securities exchangeregulators both in Canada and in the U.S. require thatregistrant firms disclose certain information (includingrisk) mainly in the MD&A section of the lOK-reports(e.g., Clarkson et al., 1999). For instance, the OntarioSecurities Commission (OSC) stresses materiality of theinformation to be disclosed in the MD&A,^ which maynot be fully addressed in the financial statements andrequires corporations to provide information regarding,for example, financial instruments and other instrumentsthrough rule 51-102.'' The requirements of this ruleinclude a discussion of the nature and extent of the com-pany's use of financial and other instruments and thebusiness purpose they serve, a description and analysisof the risk associated with the instruments as well asmanagement strategies to control risk including anyhedging activities, and a discussion of significantassumptions made in determining the fair value of finan-cial instruments and their classification.

As Clarkson et al. (1999) document, MD&A disclo-sures provide new, supplementary, and useful informa-tion particularly to investors and financial analysts, andas such represent a part of a firm's overall disclosure pol-icy or package. The OSC (Policy Statement No. 5.10)establishes the MD&A as an information tool designedto "give the investor the ability to look at the Issuerthrough the eyes of management by providing both a his-torical and prospective analysis of the Issuer." Althoughthis policy describes the OSC requirements in terms ofdisclosure content of the MD&A (namely the five spe-cific subcomponents to be discussed, i.e. operations,financial condition, liquidity, forward-looking informa-tion, and risk and uncertainty), the general scope andfiexibility in reporting in some of these areas, includingrisk, further suggest that the MD&A disclosures formanother corporate disclosure channel. The Clarkson et al.(1999) study supports this argument and presents evi-dence on the variability of the MD&A disclosure quali-ty across firms and within disclosure subcomponents,particularly for forward-looking information.

Forward-looking information is presently onlyencouraged in Canada, in contrast with the U.S.exchange rules in which the SEC requires companies toprovide both quantitative and qualitative disclosures

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about market risk including forward-looking information(e.g., SEC, 1997). Specifically, it requires that withinboth the "trading" and "other than trading" portfolios,separate quantitative information should be presented, tothe extent material, for each market risk exposure cate-gory (i.e., interest rate risk, foreign currency exchangerate risk, commodity price risk, and other relevant mar-ket risks, such as equity risk) following three differentdisclosure format alternatives: tabular presentation, sen-sitivity analysis, and VAR-type disclosures as discussedin Linsmeir et al. (2002).'

In summary, most mandatory rules for risk disclo-sure in both Canada and the U.S. concern primarilyfinancial types of risks and commodity or market risks.Nonfinancial types of risk are currently disclosed on avoluntary basis, to a large extent, and mostly in theMD&A sections under the condition of "materiality" and"significant risk exposure," which might give manage-ment a chance to exercise their discretion in choosing topublicly disclose potentially relevant risk information.

Empirical Analysis and Methodology

Our analysis in this paper is predominantly a con-tent analysis, which has been widely used in the account-ing research literature, particularly for examining socialand environmental disclosures (e.g., Guthrie & Parker,1990; Milne & Adler, 1999; Zdghal & Ahmed, 1990).We adopt this methodology in the current paper mainlybecause risk disclosures, particularly non-financialtypes, are largely disclosed qualitatively and contentanalysis may capture the extent and volume of such dis-closures. A first step in analyzing risk disclosure byCanadian companies is to examine the intensity andnature of risk-related information, as well as the volumeand location of such information. Our goal, at this stage,is to know in greater detail which industries and compa-nies disclose such information, how much, and wherethey choose to report this information.

This research paper is based on the disclosure of riskmanagement information by the TSE 300 companies asof December 1999, and uses the annual reports down-loaded from the electronic Data Bank SEDAR.^ Weexamined any information related to risk management inthe annual reports and synthesized it using the contentanalysis framework. Following previous content analysisresearch literature (e.g., Milne & Adler, 1999; Zeghal &Ahmed, 1990), a graduate student familiar with contentanalysis procedures was instructed to code the risk infor-mation in the annual reports and identify the categoriesreported by marking on the worksheet the number ofwords in each risk-related sentence and for each risk cat-egory. The number of words and the number of sen-

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CONTENT ANALYSIS OF RISK MANAGEMENT DISCLOSURES IN CANADIAN ANNUAL REPORTS

Table 1Sample Distribution by Industry and Risk Disclosure Intensity

Industries

Auto & PartsBanks & TrustsBiotechnology / PharmacyBreweries & BeveragesBroadcastingBuilding MaterialsBusiness ServicesCable & EntertainmentChemical & FertilizersConglomeratesDepartments StoresFabricating & EngineeringFinancial ManagementFood ProcessingFood storesGas & Electrical UtilitiesGold & Precious MineralHospitalityHouseholds GoodsIndustrial ContractorsInsuranceIntegrated MinesIntegrated Oil

Total

44827763831

161

123

1518261496

Investments companies & Trusts 8MiningMining ExplorationOil & Gas ServicesOil & Gas ProducersPaper & Forest ProductsPipelinesPublishing & printingReal Estate & ConstructionSpecialty IndustriesSpecialty StoresSteel ProducersTechnology SoftwareTechnology HardwareTelephone UtilitiesTobaccoTransport EquipmentsTransportation ServicesWholesale Distributors

Total

416

321825

162

10698814

113

300

Non-Disclosing

Firms

124232113203030550102105001450121212121120

72

Number of Firms

TotalDisclosing

Firms

32404552511

13193

10132512863415

281324

141857760393

228

130

MandatoryDisclosures

Only

311012100002030231100430001221121203140041

53

VoluntaryDisclosures

Only

000020010002002320010020001410040200120011

32

LAHLI & ZfiGHAL

Both Mandatoryand VoluntaryDisclosures

013013415119161581402413413

2210

1380454500341

143

Percentageof

disclosure

75.00%50.00%50.00%

0.00%57.14%71.43%83.33%66.67%62.50%33.33%

100.00%81.25%

100.00%75.00%

100.00%66.67%72.22%

100.00%83.33%

100.00%50.00%88.89%

100.00%37.50%

100.00%100.00%83.33%87.50%72.22%

100.00%80.00%87.50%50.00%80.00%83.33%77.78%87.50%75.00%

0.00%75.00%81.82%

100.00%

76.00%

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Table 2Descriptive Statistics and Mean Comparison Tests between t\Aandatory and Voluntary Risk Disclosure^

Firms with mandatoryonly disclosures

Mean (Std. Deviation)

Firms with mandatoryand voluntary disclosures

Mean (Std. Deviation)

t-test forEquality of Means'*

t-value sig. (2-tailed)

Total Assets

Sales

Profits

Beta

Debt/ Equity

Debt/ Total assets

8319313(34707274)

N = 532772856

(4476413)N = 53130876

(382420)N = 53

0.50(0.51)N = 36

0.91(1.24)N = 50

0.48(0.72)N = 52

3645454(17925814)

N = 1752336281

(11487837)N = 17582753

(460521)N=175

0.51(0.34)

N = 96'=0.85

(0.81)N=167

0.56(3.95)

N=159

1.302

0.270

0.692

-0.149

0.464

-0.424

0.194

0.787

0.490

0.882

0.643

0.672

Notes: The above mean comparison tests are run between firms disclosing only mandatory risk information and firms disclosing both voluntary and manda-tory risk as well as voluntary only risk information.I" Non-parametric tests (e.g., Mann-Whitney tests) were also run and results were fully consistent with the above shown. Mean comparison tests werealso run between risk disclosing firms and non-disclosing firms and similar results obtained.^ The total number of observations for beta, debt/equity, and debt/assets ratios do not add up to the total number of disclosing firms (228 in the sample)in the above tests because some companies have missing observations on these variables in the database used (Stock Guide).

tences were then added together to compute the disclo-sure scores for firms and industries in the sample. Con-sistent with Milne and Adler, and to increase the relia-bility of such content analysis, two more knowledgeablecoders (authors of the current paper) verified the gradu-ate student's scoring worksheet, in addition to using twoscoring and measurement options (number of words andnumber of sentences).

Sample Characteristics

The descriptive results and sample distribution ofdisclosing and non-disclosing firms by industry for thestudy sample appear in Table 1 where 228 companiesand 42 industries have been identified with risk manage-ment information in the annual reports reflecting a dis-

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closure rate of 76%, while 72 companies (or 24%) haveno disclosure of risk management information. Whilethis disclosure rate appears relatively high, one mightquestion the degree of relevance and potential analyticalusefulness of the information disclosed. This particularconcern will be addressed later in the current paper.Table 1 also shows the distribution of disclosing compa-nies by distinguishing between firms disclosing "manda-tory only" risk categories (23% of the disclosing firms inthe sample), those disclosing "voluntary only" risk infor-mation (14% of the disclosing firms), and those disclos-ing both mandatory and voluntary risk categories, whichrepresent the majority of disclosing firms with 63% ofthe total disclosing group in the sample. In terms ofintensity of disclosure by industry group. Table 1 showsthe following characteristics:

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Table 3Voiume of Risk DisclosureLocation in the Annual Report

MD&ANumber of firmsMeanMedianStd. DeviationMinimumMaximum

Notes to the Financial StatementsNumber of firmsMeanMedianStd. DeviationMinimumMaximum

Words

194216.07

185.5159.38

3955

188204|05

159.5167.9

41128

Sentences

19410.1

87.23

142

18810.07

810.01

194

1. Ten industries in the sample have 100% of their firmsreporting risk. These industries are usually highly con-centrated with six firms or less in the industry. Itincludes, for example, the "food stores," "mining," and"wholesale distributors" industries.2. The remaining 30 industries have a combination ofdisclosing and non-disclosing firms with disclosureintensity varying between 33% and 87%.3. There are two industries with zero disclosure ("brew-eries and beverages" and "tobacco").4. The "oil and gas producers" industry has the highestnumber of disclosing firms (28) and an industry dis-closure intensity of 87.5%, whereas the lowest industrydisclosure is displayed by "conglomerates" with33.33%.

To investigate any statistically significant differ-ences between firms disclosing only mandatory riskinformation and firms disclosing both mandatory andvoluntary risk information, we conducted a one-wayANOVA analysis according to the following firm char-acteristics: total assets, sales, profits, beta, debt/equityratio, and debt to total assets ratio. These variables wereavailable and thus directly collected from the StockGuide database. The mean and standard deviation for theabove accounting variables for each group and the t-testresults are reported in Table 2. Because some observa-tions on the leverage ratios (e.g., debt/equity anddebt/assets) and on the systematic risk (beta) were miss-ing in the Stock Guide database for some sample firms,the total number of observations in Table 2 do not always

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add up to the total number of disclosing firms (228 in thestudy sample).

All the t-tests resulting from the ANOVA analysis^do not seem to indicate any significant differencesbetween strictly mandatory risk disclosures and othermore voluntarily disclosed risk information. Accordingto Table 2, firms disclosing only mandatory risk infor-mation are not statistically distinguishable from firmswith both mandatory and voluntary risk disclosures.This result should be interpreted with caution since theresults compare firms across different industry groups,which potentially introduces variability and "noise"beyond the risk disclosure choice. Nevertheless, theextent to which these firms are disclosing potentiallyrelevant intrinsic risk information about their businessoperations, as will be discussed in detail later in thispaper, would suggest that management considers dis-closing both qualitative and quantitative risk informa-tion to be potentially useful to the firm's various stake-holders and investors in particular. Therefore, a closerlook at what companies report about their intrinsic (orfirm-specific) risk exposure and management strategiesis needed to be able to more accurately assess the poten-tial value gains and current as well as future profitabili-ty and growth prospects.

Location, Volume, and Categories of Risk Disclosurein the Annual Reports

In this section, we examine how and where Canadi-an companies disclose relevant information about theirrisk exposure and risk management strategies and howsuch information could be measured and analyzed.

The two sections of the annual report where theinformation on risk management can be found areMD&A and the notes to the financial statements. Wemeasure the volume of risk disclosure by the number ofwords and sentences used in each firm's disclosure,either in the MD&A or footnote sections, following con-tent analysis as explained above. However, it is only byexamining the actual content of risk disclosure that thequality and potential value of such sensitive informationcould be assessed.

Results of the content analysis are presented inTable 3. This table shows that the mean risk disclosure inthe MD&A is 216 words and 10 sentences, whereas themean disclosure in the notes to the financial statementsis 204 words and 10 sentences. The median is 185 wordsand 8 sentences for the MD&A and 159 words and 8 sen-tences in the notes. However, a relatively high dispersionand variability between the sample firms exist as shownby the standard deviation figures (159 words and 7 sen-tences for the MD&A and 167 words and 10 sentences

Canadian Joumai of Administrative SciencesRevue canadienne des sciences de radministration

22(2), 125-142


Table 4Location ot Risk Disclosure and Frequency Distribution ot Risk Categories

Panel A: Location of Risk Disclosure in the Annual Reports

Section in the annual report Number of Firms Percentage

MD&ANotes to the FSMD&A and Notes to the FS

Total

194188154

228

85.09%82.46%67.55%

Panel B: Frequency Distribution of Risk Categories Disclosure

Number of categoriesreported by firms Number of Firms Percentage Cumulative %

123"4567

1144565334171021

4.82%19.30%24.56%23.25%14.91%7.46%4.39%0.88%0.44%

4.82%24.12%48.68%71.93%86.84%94.30%98.68%99.56%

100.00%

Total 228 100.00%

Notes: The most frequent combination of categories of risk is "Financial", "Commodity", and "Market"

for the notes). Table 4 (panel A) summarizes the locationand relative disclosure intensity of the risk informationin the annual reports. It shows that 85.09% of the com-panies disclosed the information on risk management inthe MD&A only, 82.46% disclosed in the notes to thefinancial statements, and 67.55% disclosed in both sec-tions. We also find that risk information disclosed in thefootnotes is exclusively financial risk information,whereas the MD&A sections cover a wide range of risktypes including financial risks, which seems to be con-sistent with the Canadian risk disclosure and reportingguidelines and regulations outlined earlier in the paper.The analysis by risk category is central and will be cov-ered in more detail in the remaining sections of the paperto look more closely at the different types of risks report-ed and their relative importance and potential effects onfirm operations.

Table 4 (panel B) further describes the volume and

risk disclosure intensity by reporting the frequency ofrisk disclosure and highlighting the most frequently dis-closed combinations of risk categories as reported by thesample firms. In general, some firms disclose only onerisk category, others more than one for a maximum ofnine risk categories. The most frequently disclosed com-bination comprises three risk factors with 56 firms in thesample disclosing three or fewer risk categories, thusrepresenting about 25% of the total sample and a cumu-lative distribution of about 49%. Financial risk with itsfirst four sub-categodes (i.e., currency, interest rate,credit, and financial instruments value) and commodityand market risk categories are the most frequently dis-closed combination. This empirical evidence further sup-ports the predominance of financial, commodity, andmarket risks information in risk disclosure compared tothe other types of risk, consistent with the emphasis thatCanadian disclosure regulations place on these areas.

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Table 5Risk Sources and Management

Risk Sources Risk Management

FinancialCurrencyA significant portion of the revenues & expenses isforeign currency (42)^ (Ma)^Fluctuation of the Canadian $ (46)

Interest rateRising of interest rates (35)

CreditNon-guaranteed accounts receivable, investing andderivative transactions (19) (M"*)Default of the counterparties respecting any commit-ments (35) (M )^

Financial instruments valueFluctuation of the derivative instruments value duringthe time (loss on derivative financial instruments) (45)

Hedging using options contracts (20)^Hedging using forward contracts (25)Hedging using futures contracts (18)Adjusting the selling prices (5)Hedging using swaps contracts (15)Borrowing in a variety of currencies (2)

The mix of fixed and variable loans (3)Hedging using swaps contracts (29)Hedging using forward contracts (25)

Transaction only with pre-authorized counterpartieswhere agreements are in place (8)Establishing credit limits for all parties with whom acredit risk exposure exists (12)Monitoring customers credit on a regular basis (22)Dealing with highly rated counter-parties (15)

The unrealized gains and losses on outstanding contractsare offset against the gains and losses of the hedged itemat the maturity for cash flow hedges; for fair valuehedges, gains and losses on the hedged item go to earn-ings along with losses and gains on the hedginginstrument (4)

Fluctuation of foreign currency exchanges rates (3)

MarketHigh competition (29)Loss of a big customer (8)

The sudden variation in the number of products sold bythe customer (6)Advent of competition in the local service market (10)New alliances and joint ventures (5)Appreciation of the Canadian $^ (I) (M^)

Reduce costs (13)Anticipate and respond promptly to continuous and rapiddevelopments (8)

Favorable relations with suppliers (7)Provide value-added services to the customers (7)Widening of the major customer base (2)Accurate estimation of the costs of new contracts orprojects (3)Developing custom loyalty (8)Innovation (new products) (8)Developing E-business (1)Entering new markets (6)Market repositioning (6)

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Table 5continued

Risk Sources Risk Management

EnvironmentEnvironmental incidents (20)

Use of environmentally sensitive products (7)Environment activists (1)Environment laws and regulations (30)

Implantation of procedures for managing materialscontaining environmentally sensitive substances (26)Monitoring and training staff (22)Convert the production processes (1)Meet world and/or national environmental standards (20)Inform customers (1)Recycling (1)

Government RegulationAdverse changes of government control and regulationand taxation (26)Many levels of regulations (federal, provincial,municipal) (2)Government's funding cuts (1)High degree of government regulation (1)

Ensure to be at all times in compliance with currentlaws (6)Developing and marketing innovative products andtools (2)Negotiation (1)Adopting a proactive approach to public policyinitiatives (2)Maintaining comprehensive programs and contingencyplans to control health, safety and environmental risks (4)Assesses the risk before making an investment (1)

OperationalTechnical failure (e.g., computer system) (17)Labour disputes (1)

Extreme weather conditions (1)

Natural disasters (e.g., earthquakes) (6)

Changing regulatory requirements (3)Accidents (e.g., blowouts, fires) (10)

Human error (11)

Loss of certain key employees (3)Insufficient resources (5)

Purchase of insurance (16)Hiring and retaining highly trained and experiencedstaff (14)Developing control quality system and equipmentsmaintenance (9)Implementing software which allows better design,drafting, estimation, and manufacturing (2)Diversification of revenue streams (3)Involving engineering, administrative and operatingstaff to identify risks and develop control programs (4)Installing efficient, environmentally sensitive productioninfrastructure (1)Developing an operational emergency response plan (1)Extensive use of new technology (5)

Key suppliers (16) (M')Not secure suppliers (4)

SupplierSeveral sources of supply (8)Developing good relations with the suppliers (6)Owning a supply network (1)Looking for secure suppliers (5)

Natural ResourcesLow quality of reserves (9)Low supply (2)

Insufficient quantities of reserves (10)

Searching for high quality natural resources (7)Developing relationships with strategic vendors tosecure supplies (1)Generation of exploration prospects internally (5)

135


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Table 5continued

Risk Sources ' Risk Management

Legislation restricting exploration in some areas (1) Maintaining a highly motivated, energetic, and talentedstaff (4)Focusing on geographic areas in which the geologicaland engineering considerations are well understood bythe company (2)Maintaining a large inventory of drillable prospects to"high grade" drilling prospects (2)

PoliticalWorking in an international environment (13)Unexpected changes in regulatory requirements (3)

Complex local procurement practices and requirements (1)

Difficulties in enforcing rights in foreign courts (2)The laws of some foreign countries do not protect thecompany's intellectual rights (1)Adverse political developments (5)

Joint venture agreements with local partners (5)Financing for foreign operations with the involvement ofinternational banking syndicates (5)Adopting strategies that are responsive to changingpolitical and economic conditions (2)Acquiring political risk insurance (3)Reviewing closely political and social conditions beforeinvesting (2)Hiring employees who have experience working in theinternational arena (1)

TechnologyRapid technological change (12)Internet (2)

Developing e-commerce (2)Adopting and benefiting from new technologies (3)Hiring highly qualified experienced professionals andtraining of personnel (4)Supporting and developing diversified product offerings (1)

WeatherSevere climatic conditions (7)Unusual (unexpected) weather conditions (2)Unfavourable weather conditions (3)

Investing in all season businesses (3)Geographic diversification (3)Limiting the activities it costs too much and there is riskof incidents) (1)

SeasonalityNatural seasonal patterns (6)

Weather (1)

Sales reporting and merchandise planning using reliableinformation system (1)Investing in four-season businesses (1)Geographic diversification (1)

CyclicalityNatural cyclical trend (6) Geographic diversification (3)

Industry diversification (1)

Notes:* Risk disclosure categories

Financial risk; changes in interest rate, currency, credit and financial instrument valuePolitical risk: conducting business internationallyMarket risk: changes in competition, number of products sold by customer, loss of market shareTechnology risk: rapid technological changeEnvironmental risk: environment incidents, environment laws and regulations

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Table 5continued

NotescontinuedWeather risk: severe, unfavourable climatic cotiditionsGovernment regulation risk: changes in government control, regulation and taxationSeasonality risk: natural seasonal patternsOperational risk: technical failures, accidents, human error, loss of key employeesCyclicality risk: natural cyclical trendSupplier risk: dependence on key suppliers, not secure suppliersNatural resources risk: insufficient quantities of reserves, low quality of reserves

^ The figures represent the number of firms that have chosen a particular source or a particular way of managing.^ "M" refers to mandatory risk disclosures. We classify a risk disclosure item as mandatory if an explicit accounting rule or security exchange require-ment exists and is applicable to the companies in the sample. Therefore, if a risk disclosure item involves management's judgment (or discretion) as tothe materiality and significance of the risk information disclosed, it is classified as voluntary.'' The appreciation of the Canadian dollar could be considered both a currency risk and a market risk because it potentially leads to foregone sales inthe international markets and loss of market share.Relevant Rutes and Regulations for Mandatory Risk Disdosures CICA 1650 Foreign currency translation, and FASB* 133 Establishing hedging accounting and Statement No.l33 Hedging Activities, and SEC* -FRR No.48 Mandatory forward looking market risk disclosure and Item 305 a, b Quantitative & Qualitative information about market risk" CICA 1650.50 Hedging of foreign currency items; 3860.92 Using Financial instrument as a hedge of risks, and FASB 133 Establishing hedgingaccounting and Statement No. 133 Hedging Activities and SEC-FRR 36 Prospective information; FRR No.48; Item 305 a, b^ CICA 3860.57, .58, .63, .64 Interest rate, and FASB 133 Establishing hedging accounting and Statement No. 133 Hedging Activities, and SEC-FRR36 Prospective information; FRR No.48; Item 305 a, b'' CICA 3860.75 Concentration of credit risks; 3860.74 Financial instrument obligation guarantor, and FASB Statement No. 105 Concentration of cred-it risk and SEC-FRR 36 Prospective information; FRR No.48; Item 305 a, b' CICA 3860.75 Concentration of credit risks; 3025 Impaired loans, FASB Statement No. 114 Impairment of a loan' CICA 3860.44, .51 Financial instrument gains & losses net basis disclosure; 3860.45, .59, .61 Financial instrument price risks, and FASB StatementNo. 119 Quantitative Information about Market Risk and FASB 133 Establishing hedging accounting and activities, and SEC-FRR 36 Prospectiveinformation; FRR No.48; Item 305 a, b8 CICA 3860.44, .45, .61 Financial instrument, and FASB 133 Establishing hedging accounting and hedging activities, and SEC-FRR 36 Prospectiveinformation; FRR No.48; Item 305 a, b'' CICA 1650 Foreign currency translation' CICA 1701.42, .43 Major customers; and FASB Statement 14 Major customer*Mandatory risk disclosure from FASB and SEC are applied to companies that are cross-listed on the U.S. and Canadian exchanges.

The content analysis followed in this research paperresulted in the identification of different risk categoriesas reported by sample firms to distinguish between vari-ous risk sources and types that a company faces depend-ing on the nature of its business and global environment.All types of risks (e.g., financial and non-financial),whether mandatory or voluntary, are included in the con-tent analysis. The analysis by category of risk reported,as found in the Canadian annual reports of the TSE 300companies in this study, reveals that the highest volumeof disclosure is associated with the financial risk catego-ry with 29.28% intensity relative to the other risk cate-gories. This finding is consistent with CICA Handbookrules for risk disclosure presented earlier in the paperand also the TSX exchange requirements. The relativelyhigh degree of disclosure for the financial risk categoriescan also be explained on the basis that some Canadiancompanies are cross-listed on the Canadian and U.S.exchanges and so would provide more market risk dis-closures as required by the SEC. Other most frequentlydisclosed risk categories include market risks, govem-

137

ment regulation, and environmental risks, which will bediscussed in more detail in Table 5. The analysis of thevolume and intensity of disclosure by risk category canbe used to classify firms and industries in terms of inten-sity of disclosure by risk category for the purpose of ana-lyzing in more depth the risk disclosure behaviour andinformation value by groups of firms facing similar riskenvironments. Such a process can facilitate analyticalcomparisons and the design of performance-orientedmeasures of the effects of disclosure on the value of thefirm in the capital markets as well as investors' percep-tions. To that end, we classify the risk categories underthree major classes depending on the extent of intensity(or volume) of risk disclosure: Cl where risk disclosureintensity is high and exceeds 20% (financial risk belongsto this class); C2 where risk disclosure is low and is lessthan 5% (e.g., supplier, natural resources, political, andtechnology risk categories); and C3 where risk disclo-sure is medium (higher than 5% and lower than 20%). Inthis class, we find commodity, market, environment,government regulation, and operations risk categories.


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Analysis of Risk Exposure and Risk Management

The objective of this analysis is to capture theessence of risk information disclosure by examining ingreater detail the sources of risks for each risk categoryand the risk management strategies employed to mitigateor manage the identified risks. Table 5 shows, on oneside, the sources of risks for each risk category, and onthe other, firms' responses to those risks in terms of dskmanagement strategies with the specification of thenumber of firms in the sample disclosing such informa-tion. It outlines the actions taken by management to mit-igate or eliminate those risks. It is worth noting at thispoint the clear emphasis by Canadian companies on thedown-side aspect of risk and the absence of the up-siderisk potential or opportunity-seeking strategies in riskmanagement to create economic value in the current riskdisclosure environment. This fact has also been docu-mented in similar risk-reporting studies in other coun-tries such as the United Kingdom (see for example Lins-ley & Shrives, 2000).

Table 5 summarizes risk disclosures in the annualreports by identifying the sources of risk and the riskmanagement strategies followed by management to con-trol such risks. It also documents whether the risk infor-mation and items disclosed are part of mandatory disclo-sure rules and regulations based on the regulatoryframework outlined previously in this paper. We classifya risk disclosure item as mandatory if an explicitaccounting rule or security exchange requirement existsand is applicable to the sample firms. Therefore, if a riskdisclosure item involves management's judgment (ordiscretion) as to the materiality and significance of therisk information disclosed, it is classified as voluntary ordiscretionary. Consistent with the content analysis pre-sented above, financial risk (with its sub-categories),which is the most frequently disclosed risk type, is close-ly associated with firms having a significant portion oftheir operations (revenues and expenses) in foreign cur-rency, which are affected by fluctuations in the Canadi-an dollar (currency risk). The risk management tool mostfrequently cited by companies to control for currencyrisk is hedging using forward options, futures, and swapscontracts (i.e., financial instrument use). Similarly, inter-est rate risk refers to a possible increase in interest rates.Note that the one-way change in interest rates (i.e.,increase but not decrease) provides further evidence onthe down-side dsk emphasis, which is also apparent inthe financial instrument value dsk source (loss in valuerather than gain, or both). Again, hedging seems to be theanswer to managing this dsk. Overall, the dsk disclo-sures concerning financial dsk, as reported by the TSE300 study sample, are generally consistent with theCanadian regulations for dsk disclosure presented earli-

138

er in the paper. However, even if such information mightbe useful to stakeholders, it is not clear to what extentfinancial instrument use and hedging are effective incontrolling for such dsks and the related costs involved(overhead and other). Also, it is not clear from the inven-tory of dsk disclosures found in the current studywhether derivatives are used to reduce or increase dskexposure (see for example Venkatachalam, 1996).

Another important component of financial dsk thatis frequently disclosed is credit dsk. It is interesting tonote that some agency/contractual costs (see, for exam-ple, Jensen & Meckling, 1976) appear to be reportedhere. For instance, defaults by counterparties to honourcommitments set forth in the contract represent an inte-gral part of credit dsk, and monitodng (an agency cost)seems to be the most frequently cited dsk managementstrategy adopted by firms facing this type of dsk. Again,the information is purely qualitative and no indication ofthe monetary values involved is found.

The second most commonly disclosed dsk types,market and commodity dsks, are usually defined by thehigh degree of competition (i.e., market structure) whichmay result in the loss of a big customer to a dval and/orthe advent of new entrants in the local service market.The variation of the product mix and quantity sold by thecustomer is also part of market dsk. The commonresponses to this type of dsk include cost reduction andcontrol, developing customer loyalty and product inno-vation, and developing skills to manage change.

Commodity dsk usually refers to the vadation in thepdce of a commodity (input) used by companies in theirproduction process (i.e., price risk). Commodity andmarket dsks could be lumped together to refer to busi-ness dsk. Some ways to manage commodity price dsk,as disclosed by sample companies, include hedgingusing futures or forward contracts. Further, we note thatfinancial and market dsk definitions sometimes overlap.For instance, the SEC defines market dsk as the dskassociated with adverse changes in market rates or pdces(e.g., SEC, 1997).

Finally, other dsk information disclosed includesenvironmental dsks and ways to manage them such asdefining procedures to manage matedals containingenvironmentally sensitive substances and monitodngstaff. Similarly, government regulations may poseincreasing dsks to businesses in the form of adversechanges in government control; laws and regulations,and taxation, which companies will have to deal withand manage on a continuous basis. One interesting find-ing in this analysis is the small amount of dsk informa-tion concerning technology. One might expect such dsksto be increasing in importance, especially with theadvent of e-business and e-commerce, but apparently thephenomenon is relatively new and it will take more time


22(2), 125-142


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22(2), 125-142


and experimenting with the new technology before wesee a good assessment of the involved risks and benefits.

Risk Analysis and Assessment

Risk is usually assessed analytically through a care-ful examination of the likelihood of the event describingthe risk and the consequences or expected outcomes ifthat event actually occurred. Likelihood and conse-quence are essentially contingency-related and thusdenote the uncertainty component in risk management.A "risk map" (e.g., AICPA/CICA, 1999) concept mightbe useful for that purpose; it would simply show the like-lihood of occurrence (e.g., rare, unlikely, possible, like-ly, almost certain) of an event versus its consequences(e.g., high, moderate, and low effects). Despite its sim-plicity, a risk map communicated to outside informationusers might be of little analytical use for assessing firms'exposure to certain risks since it overlooks importantdetails about how the risk probabilities and consequenceassessments have been determined and quantified bymanagement. A more formal framework for linking thelevels of probability to the risk distributions and theirconsequences (e.g., probabilistic measurement) such asthe one outlined in Thornton (1983), or the one present-ly used by SEC-mandated disclosures on market risks,might be desirable in the future.

Our final analysis of the risk disclosure informationin Canadian annual reports focuses on risk assessmentand analysis of different risk categories identified by thedisclosing companies. Table 6 gives the likelihood ofeach risk category identified for all the firms in the sam-ple, based on qualitative information. The likelihood of arisk occurring varies from "almost certain" to "rare".The effects of the likelihood of an identified risk rangefrom "insignificant" to "catastrophic". At this level ofanalysis, one would hope to finally capture some quanti-tative indicators of the magnitude of the risk faced bydisclosing firms. Unfortunately, the disclosure persists inbeing general, scattered, and sometimes ambiguous.This ambiguity might signal that the firm is unwilling topublicly disclose detailed risk information although itmight have it internally for fear of suffering competitivedisadvantages.

Some interesting observations and interpretationscould be drawn from Table 6. Consistent with the previ-ous risk content and volume analysis, financial risk fol-lowed by commodity and market risks appear to be themost likely to affect firms' operations. For instance, 22companies in the sample report that market risk is"almost certain" while 124 companies perceive currencyrisk to be "likely". For all risk categories combined, themost reported qualitative information is "likely" with

140

46.75%, followed by "possible" with 41.44%, and to alesser extent "almost certain" with about 9%.

In terms of consequence or outcome of each riskcategory, and following the likelihood assessment asso-ciated with each risk factor, the most frequently reportedrisk outcome qualification is "moderate" with 75.56% ofthe firms judging the potential effect of all risk cate-gories combined to be only moderate. When taken indi-vidually, the predominance of financial risk, market risk,and commodity risks resurface with the added informa-tion that firms assess the consequence of those risks asmoderate or minor most of the time. This finding is mostlikely due to Ein established and reasonably successfulway to manage those risks, especially if the firm hasgained experience in dealing with such risks.

Concluding Remarks

The current research paper explores and synthesizesrisk information disclosures by Canadian companies asshown on their annual reports in 1999. It thus representsa primary and necessary step towards more comprehen-sive and systematic risk disclosure studies. The purposeof this paper is to examine the state, nature, and volumeof risk and risk management disclosures by Canadiancompanies. Risk exposure assessment and analysis arealso presented based on the disclosed information. Thisanalysis should prove useful to managers, board direc-tors, and various firm stakeholders who focus theirefforts on responding to potential shortcomings of thecurrent disclosure environment especially in the turbu-lent new knowledge-based economy where risk has evengreater dimension and scope.

The main findings of this research paper are:1. Risk information disclosed by Canadian companies isalmost exclusively qualitative in nature and is located inthe notes to the financial statements and/or in the "man-agement discussion and analysis" section followingCanadian risk disclosure regulations;2. Given the qualitative nature of risk disclosure in thisstudy, we performed a content analysis focusing on thevolume and intensity of disclosure using the number ofwords and sentences with reference to different risk cat-egories and sub-categories. The most frequently citedrisk categories were financial risk, commodity and mar-ket risk (business risk);3. A content analysis of risk sources and risk manage-ment techniques as disclosed by the sample of firms inthis study offers interesting insights into the nature ofrisks that firms face and remedial actions taken by man-agement to mitigate the potentially negative effects ofthose risks. An emphasis on down-side risks is noted andpotential up-side effects and value-creating opportunities


22(2), 125-142


are largely absent from the current disclosure; and4. Risk assessment and analysis as reported by disclos-ing companies in this sample is quite limited and lacksvaluable and perhaps quantitative insights such as sensi-tivity or simulation analysis showing the effects ofpotential changes on the financial statements followingan increase of risk in one or more categories. Given thevoluntary nature of most risk disclosures, this is proba-bly intentional since the competitive pressures and pro-prietary information costs associated with such disclo-sure could be substantial.

The controversial question of whether it would bemore beneficial to make risk disclosure for non-financialrisks mandatory by the accounting standards settinginstitution in Canada and elsewhere remains open. Inaddition to the difficulty in measuring and objectivelyassessing risks (such as operational risks) that differfrom firm to firm and industry to industry, auditing suchmandatory risk disclosure may pose challenges. Theeffort could be reinforced by closely coordinating withthe international standards setters in the IAS/GAAPaccounting debates. Future research studies could exam-ine the validity or reliability of current risk disclosures inCanada by possibly linking identifiable risk measures tosubsequent market performance (see Linsmeir et al.,2002). Furthermore, a risk management disclosure indexcould be built (see for example Botosan, 1997) based onthe content analysis presented in the current paper usinga combination of word and sentence coding to measurethe volume of disclosure in each risk category. Anotherrelated avenue of future research could focus on the mar-ket relevance of derivatives and other hedging instru-ments in the Canadian context in comparison to the U.S.setting (e.g., FASB, 1998) in order to investigate whetherthe accounting and exchange rules in the future shouldfollow the level of detail and enforcement prevalent inUnited States standards.

Notes

1. The URL www.riskreports.com/standards.html is a usefulsource of information for an overview of risk managementstandards and guidelines in Canada and in other countries(editor: Felix Kloman).

2. See CICA Handbook, section 3860 (Financial Instru-ments: Disclosure and Presentation) and other related sec-tions such sections 1650, 3280, 1701, and 1508.

3. The information on the TSE requirements for risk disclo-sure can be found on the OSC webpage atwww.osc.gov.ca/en/Regulations/Rulemaking/Rules.

4. "Other instruments" are instruments that may be settledby the delivery of non-financial assets such as a commod-ity futures contract.

141

5. See for example SEC Item 305 "Quantitative and Qualita-tive Disclosures about Market Risk"

6. SEDAR database can be found at www.sedar.com.7. Since we examine the entire TSE 300 sample, problems of

heteroscedasticity might be present in Table 2 and thus themean test comparison results should be interpreted withsome caution.

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Documents

A Content Analysis of Risk Management Disclosures in Canadian Annual Reports