Value relevance of financial risk disclosures

da Costa Neto, Arlindo Menezes; de Oliveira, Atelmo Ferreira; da Silva, Aline Moura Costa; Barbosa, Alexandro Article Value relevance of financial risk disclosures Journal of Capital Markets Studies (JCMS) Provided in Cooperation with: Turkish Capital Markets Association Suggested Citation: da Costa Neto, Arlindo Menezes; de Oliveira, Atelmo Ferreira; da Silva, Aline Moura Costa; Barbosa, Alexandro (2023) : Value relevance of financial risk disclosures, Journal of Capital Markets Studies (JCMS), ISSN 2514-4774, Emerald, Bingley, Vol. 7, Iss. 1, pp. 22-37, https://doi.org/10.1108/JCMS-06-2022-0024 This Version is available at: https://hdl.handle.net/10419/313305 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Value relevance of financial risk disclosures Arlindo Menezes da Costa Neto PPGCC, Universidade Federal de Pernambuco, Recife, Brazil Atelmo Ferreira de Oliveira PPGCCon, Universidade Federal do Rio Grande do Norte, Natal, Brazil Aline Moura Costa da Silva DCC, Universidade Federal Fluminense, Niter oi, Brazil, and Alexandro Barbosa PPGCCon, Universidade Federal do Rio Grande do Norte, Natal, Brazil Abstract Purpose –The objective of the present study is to examine the value relevance of accounting information presented by Brazilian banks. Design/methodology/approach –The studied sample derived from Brazil’s Stock Exchange, B3, under the banking segment, resulting in a group of 24 publicly listed companies, whose data ranged from 2017 to 2019. The study was conducted using the disclosure index, made with the intent of evaluating the disclosure adherence of a company to the reporting standard. In this case, Comit^ e de Pronunciamentos Cont abeis (CPC) 40, financial instruments: recognition, evaluation and disclosure, Instrumentos Financeiros: Evidenciaç~ ao, Brazil’s interpretation of the International Financial Reporting Standards (IFRS) 7. Findings –The results show that for the sample and period, the disclosure index cannot be used as an explanatory variable for the market evaluation of financial institutions. Originality/value –While other studies have presented a similar approach to the value-relevance theme, the present work is original as it develops the methodology on financial institutions, and even more so on the financial institutions of a developing country. Keywords Financial instruments, IFRS 7, Value relevance, Risk disclosure Paper type Research paper 1. Introduction Financial instruments have rapidly gained prominence as leading tools for hedging risks (Radoi and Olteanu, 2017). This perceived risk-proof strategy has led many companies to use derivatives as a financial instrument option and risk-mitigation device (Aretz and Bartram, 2010). The benefits of using financial instruments, such as derivatives, include the mitigation of revenue reduction risks by preventing the increase in the cost of producing goods or numerous expenses (Chang et al.,2016). In addition to those possibilities, financial instruments may lead to a significant decrease in financial risk exposure, leading to a lower likelihood of financial distress (Bohn, 1990;Huang et al.,2017). Nevertheless, financial instrument usage can result in something other than those benefits, leading to considerable losses in a short period when the strategy is poorly executed, timed, or both. JCMS 7,1 22 © Arlindo Menezes da Costa Neto, Atelmo Ferreira de Oliveira, Aline Moura Costa da Silva and Alexandro Barbosa. Published in Journal of Capital Markets Studies. Published by Emerald Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) license. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this license may be seen at http://creativecommons.org/licences/by/4.0/legalcode The current issue and full text archive of this journal is available on Emerald Insight at: https://www.emerald.com/insight/2514-4774.htm Received 30 June 2022 Revised 14 November 2022 4 February 2023 Accepted 16 March 2023 Journal of Capital Markets Studies Vol. 7 No. 1, 2023 pp. 22-37 Emerald Publishing Limited 2514-4774 DOI 10.1108/JCMS-06-2022-0024 The results of the financial instrument used, whether profitable or not, are intrinsically connected with accounting and its disclosure function (Ohlson, 1995). Accounting is a method capable of providing information regarding financial instrument outcomes to those in the market. This creates responsibility, as perceived in the guilt deposited in accounting practices as one of the culprits of the subprime crisis, specifically, the suggested poorly developed role of accounting in the report of financial instruments used (Laux and Leuz, 2010). As the crisis reached its peak, both depositors and investors pushed for bank transparency, as they realized the lack of information about risk exposure. This was the result of financial institutions’deliberate use of accounting interpretation to keep said exposure away from financial reports (Ackermann, 2008). This maneuver may be regarded as an example of the potential malicious use of accounting, showing firms deliberately using financial disclosure for their convenience by choosing which information is accessible to investors. This discretion also provides a clear example of how accounting plays a significant role as a risk disclosure tool. Although the recent obligatory adoption of the International Financial Reporting Standards (IFRS) is linked to consistent economic benefits (Neel, 2016), one may connect current standards to lessons learned from past misuses. Based on the previous discussion, this study uses a value relevance approach to examine whether a higher financial instrument risk disclosure level is positively associated with higher valuations in an untried setting, the Brazilian banking industry. A modified version of the Disclosure Index developed by Thai and Birt (2019) is employed to assess the risk disclosure of financial instruments, along with hand-collected data from financial notes to identify banks’adherence to Comit^ e de Pronunciamentos Cont abeis (CPC) 40 disclosure requirements (IFRS 7 equivalent), the current standard used by Brazilian banks for financial risk disclosure. The intent to develop a study on financial institutions was twofold. First, as put by Elshandidy et al. (2018), the examples brought by accounting scandals and financial crises can lead to the assumption that financial institutions demand higher regulation to reduce the chances of failure. This assumption is based on the understanding that the use of potentially damaging economic tools may lead to grave damages because financial market failures are considerably more aggressive and long-lasting (Stiglitz, 1993). Second, we discuss the relevance of the sector to Brazil’s economy, as the financial sectors comprise over 30% of the Ibovespa Index: Brazil’s Stock Exchange, Brasil, Bolsa, Balc~ ao, B3 and the main financial index (B3, 2020a). Both reasons also indicate the possible contributions of the present study, given the relevance of the sector and the seldom researched topic. In addition, this study expands the literature on risk disclosure in the Brazilian market, specifically in the financial sector. Further, our work can be valuable to regulators, as it may provide insight into how the market perceives the principles stated by IFRS policy (Hao et al.,2019). Additionally, value-relevant papers such as this also allow market participants to better comprehend how companies adhere to the regulations imposed upon them. Our findings indicate that the Brazilian market does not appear to value financial instruments’risk disclosure information under a value-relevance lens, either positively or negatively. This paper is divided into the following sections. Section 2 discusses the main theoretical cornerstones of the research, value-relevance methodology, risk disclosure literature, signaling and agency theories. Section 3 explains the hypotheses, and Section 4 presents the methodology employed. Section 5 introduces the results and data gathered, followed by section 6, where we discuss the disclosure model findings and lastly, section 7 concludes the paper with the final thoughts on the study. Value relevance of financial risk disclosures 23 2. Literature review and hypothesis development 2.1 Value relevance literature Value relevance has been previously described as a method to study the informational content of accounting data as a tool capable of influencing investors’decision-making (Beaver, 1968), or even as a technique used to evaluate the usefulness of accounting practices, as explained by Ball and Brown (1968). Both descriptions, although not identical, allow the same concept of value relevance, as addressed by Amir (1993), be classified as a group of papers whose motivation, partial or not, is the standard-setting purpose (Holthausen and Watts, 2001). Under the pretenses of value relevance, financial statements and accounting information must provide investors with decision-making data (Badu and Appiah, 2018). However, to evaluate how “useful”an accounting value may be, it must have a predicted association with equity market values, as this is the requirement to be declared relevant (Barth et al., 2001). The concept of value relevance as a methodological approach is presented based on valuation theory, the goal being to estimate the informational value of accounting data for those who use it. The results function as a gauge of the impact of the action of standard setters (Francis and Schipper, 1999). Recently, Barth et al. (2019) developed a literature review whose main finding was the lack of value relevance literature from 1962 to 2014, while also indicating a research gap in determining themes, such as intangible assets and innovative measurement methods. However, value relevance literature has, of late, included studies on the impacts of IFRS adoption on developing countries (Badu and Appiah, 2018), the adoption of integrated reporting (Baboukardos and Rimmel, 2016), the relationship between corporate governance and earnings management (Khalili and Mazraeh, 2016), intangible assets recognition (Kimouche and Rouabhi, 2016), derivatives and financial instruments use (Thai and Birt, 2019) and studies on debt holders (Givoly et al., 2016). This broad range of studies allows for the development of the value relevance discussion while addressing one of the main arguments of criticism on value relevance: its dependence on equity investors (Barth et al., 2001). 2.2 Financial instruments risk disclosure Accounting disclosure is a research topic of ample academic discussion, with literature arguing about its virtues and problems (Hassan and Marston, 2019). This study avoids the debate on the limitations of some research methods. The foundations of the approach are the history of risk disclosure of financial instruments and the relevant state-of-the-art research on disclosure, aiming to develop a cohesive debate on the current regulation and research production. The timeline of IFRS 7 –financial instruments: Disclosures started as a draft in July 2004, issued in August of the following year (Deloitte, 2012). Since its issuance in 2005, nine amendments were made to the text until its latest version in 2014; many of them due to the events in 2008, where both private and public sectors observed the need to improve areas that, from their perspective, were the priority, such as transparency and risk management (Ackermann, 2008). These improvements resulted from the unregulated use of one of the many financial instruments and derivatives. Derivatives rely on the recognition of an asset derived from an underlying asset, leading to a product with less capital cost and higher economic value added when compared to the usual practice of money lending (Mah-Hui, 2008). Nonetheless, the events of 2008 led to three amendments throughout the year. The first is related to the classification of current and non-current derivatives (IFRS, 2008b). The following amendment, a response to the credit crisis, focused on thereclassification of financial assets, addressing the desire to reduce the JCMS 7,1 24 divergence between United States Generally Accepted Accounting Principles (US GAAP) and IFRS (IFRS, 2008a). The third and final amendment of the year required all entities to provide additional disclosure on all investments in debt instruments not already classified in the fair value category (IFRS, 2008c). All amendments, while not affecting our employed method, still provide us with a background understanding of how regulation has changed as an answer to reducing information asymmetry, following our theoretical framework. Notably, while the methodology is rooted in Brazil’s interpretation of IFRS 7 and CPC 40, the mentions in theory and research design are always in the former because of its main theoretical implications, while the latter presents itself only as a practical application to this research case. 2.2.1 Financial disclosure literature review. Some studies have examined the financial disclosure literature as a research objective (Elshandidy et al., 2018;Khlif and Hussainey, 2014;Ryan, 1997). Thus, the present study addresses only the recent findings regarding the theme of this work. Past research suggests categorization under two main themes: “Incentives for reporting”and “Informativeness of risk reporting”as introduced by Elshandidy et al. (2018). The first theme, incentives for reporting, comprises papers that focus on understanding the leading reasons for a company to provide risk information. This theme includes works such as those by Bufarwa et al. (2020), who focus on the impact of mechanisms employed by corporate governance in financial risk reporting. However, Al-Maghzom et al. (2016) studied demographic characteristics as determining factors for voluntary risk disclosure practices in the banking industry. The second theme, informativeness of risk reporting, presents papers with the main concern of understanding reporting consequences. Research on this theme includes the one developed by Heinle and Smith (2017), where the impact of risk disclosure on pricing was studied to probe the Financial Accounting Standards Board’s understanding of the influence of risk disclosure, archiving said goals by researching the variance of cash flows, and the disclosure of financial risk. On the same theme as measuring cash flow volatility, the work developed by Lobo et al. (2019) aims to measure the risk disclosure quality and its association with cash flow volatility, finding that higher risk disclosure is associated with lower future cash flow volatility. However, cash flow is not the only area where informativeness can be measured; for instance, Linsley et al. (2006) discuss the usefulness of the risk information reported, reporting the finding of a bias toward past information, rather than future information regarding risk; Nahar et al. (2016) investigate risk disclosure, cost of capital and company performance on a company that abides by voluntary disclosure, not mandated. In addition to these previously mentioned works, Thai and Birt (2019) have had a significant impact on the work presented here due to the creation of the disclosure index, which was adapted and used here. The authors explored mineral and metal sector risk disclosure according to Australia’s internal standard on financial instrument disclosure, the Australian Accounting Standards Board (AASB), 7. The authors introduce a disclosure index as the main contribution to this research, as it allows for the evaluation of both qualitative and quantitative information required by regulations disclosed in companies’financial statements. However, as both countries and markets are distinct, the index was contextually modified with CPC 40. It is important to note that both types of research are part of the second theme of the informativeness of risk disclosure, given the measurement of the relevance of risk disclosure by the market. In addition, neither of the two themes is mutually exclusive, or one paper can focus on the research of both the incentives for reporting and the informativeness of said risk reporting (Elshandidy et al., 2018), allowing for studies with a broader or more specific research focus. Value relevance of financial risk disclosures 25 3. Hypothesis development Value relevance has a deep relationship with information, its disclosure and its resulting value to those who may use such information. Thus, as a valid research route, value relevance is based on the premise that the market is rooted in asymmetric information, leading those inside a company to have more information about its activity than those outside (Levy and Lazarovich-Porat, 1995). To better understand how value relevance studies the exchange of information between stakeholders and executives, the agent–principal problem becomes relevant. Additionally, agency and signaling theories can provide different perspectives on the agent–principal problem (Eisenhardt, 1989). Our theoretical framework explains how accounting information disclosure may be advantageous to investors and regulators. Agency theory has established relevant premises, such as agency costs and increasingly discussed subjects such as moral hazard and adverse selection (Jensen and Meckling, 1976). However, to understand how value relevance may be introduced in this context, one needs to understand the concept of the principal–agent relationship. This relationship is between the agent, one hired or otherwise selected by the principal to execute, in their name, a service or a delegated power (Shapiro, 2005), in which shareholders can be understood as principals, while the chief executive officer of a determined company, can be seen as the agent (Panda and Leepsa, 2017). While the principal–agent relationship may present a conceptual hierarchy of the company’s shareholder relationship, signaling theory may expand on the feasibility of the maintenance of the previously mentioned relationship by focusing on how both parties may prove that they are meeting each other’s expectations. In this regard, disclosure-based actions can be used as tools, providing deeper information sharing among market participants to allow the best execution of capital markets (Ho and Wong, 2001). By studying how this information is shared between market participants, signaling theory expands on the information asymmetry (Connelly et al., 2011;Spence, 1973). This asymmetry is based on the understanding that those involved in the market have different levels of information, which can lead to moral hazard (Al-Sartawi and Reyad, 2018). Those who partake in the market are susceptible to shared risk: the result of their actions and those engaged in the same market (Holmstrom, 1979). As a tool, disclosure may be understood as a regulator’s response, the goal of which is to protect the stakeholders from possible malicious effects caused by information asymmetry (Bamber and McMeeking, 2016), allowing for better signaling of significant information exchange between market participants (Spence, 1973). When well-executed, the push for regulation and disclosure can lead to a decrease in information asymmetry between market participants, as proven by Dignah et al. (2017), while the lack of regulation and questionable accounting choices can lead to greater economic impairment (Laux, 2012). One of the many resulting products of accounting and regulation is the IFRS, which are presented as guidelines for accounting interpretation of certain topics. Although international, in some cases, it requires some sort of country-centered adaptation, as is the case with Brazil’s CPC. While IFRS adoption has been studied (Li et al., 2017;Wieczynska, 2015), IFRS 7 has much to be discussed. Presented as a unification of many of the previous overlapping texts (Grosu and Chelba, 2019), it provides a new slate of text aimed at reducing information asymmetry for the financial instrument used. Brazil’s interpretation of IFRS 7 and CPC 40 will be used in this study as a disclosure standard whose resulting information may impact investors’perceived value of a company, that is, information relevant to firm valuation. Assuming the value-relevance approach to measure the value of accounting information based on its equity market impact and the nature of disclosure, the hypothesis has been developed to measure whether a company price is impacted positively or not by its risk disclosure level, leading to the following hypothesis: JCMS 7,1 26 H1. A company’s share price is positively associated with its disclosure of financial instrument risk. The hypothesis is the result of the premise laid out in value relevance literature: The disclosure of accounting information may impact a financial market participant’s decisionmaking. As previously discussed, the reasoning behind this possible impact lies within the concept of information asymmetry. Practically, the hypothesis is a summary of how value relevant literature can be applied to our reality. 4. Research design 4.1 Sample and data We chose one industry sector (Botosan, 1997), allowing us to maintain a constant disclosure policy (Adam-Muller and Erkens, 2020): banking companies. The sample was selected directly from B3’s sector classification, companies listed under “finance sector of operation,” specifically those in the sub-sector of “financial intermediaries”under the banking segment (B3, 2020b). This selection process resulted in the inclusion of 24 publicly traded companies in the study. Regarding the timeframe, we designed the research to collect a better possible interval. We chose the most comprehensible span for the sample, three years, from 2017 to 2019. The period limitation was mainly because this period amounted to the largest possible span to maximize the number of listed companies. If we weretoincreasethe timeframe, we would have a considerably smaller number of companies listed, severely unbalancing our data. Previous literature may use only one period to maintain regulatory stability (Brown et al., 2018). However, we chose to use a larger timeframe to allow for more observations, thereby increasing the validity of the findings. This design is conducive to a longitudinal study, given the inherent introduction of time, instead of the cross-sectional model usually chosen by the existing literature (Badu and Appiah, 2018;Bowerman and Sharma, 2016;Kargin, 2013). Finally, for data collection, we manually collected information from each company’s financial statements available on B3’s website, allowing us to have reasonable comparability. 4.2 Measuring a financial risk disclosure The reasoning and usage of a disclosure index are not novel (Elshandidy et al., 2018), with Marston and Shrives (1991) being one of the early uses of this method. The literature indicates that an index must be designed with the best possible fit to maximize desired information (Marshall and Weetman, 2007). The disclosure index employed in this research is the model of Thai and Birt (2019) because of its similar rationale, while also allowing for data from financial statements and granting a more in-depth analysis. The model measures a company’s disclosure adherence regarding three types of financial instruments risk: credit risk, liquidity risk and market risk. The weighted disclosure score of a firm is obtained using the following Equation (1): DScorei¼1 JX 3 j¼1 Scoreij max ðScoreijÞ(1) Assuming i is a given firm, its score of j risk would be the result of the sum of the disclosure marks divided by the highest possible value, in this case, 25, resulting in the relative adherence of a company’s financial statements to the base standard. As required by the methodology employed, we use the information disclosed in the annual financial statements, while the evaluation topics are provided by the CPC 40. It should be noted that the disclosure Value relevance of financial risk disclosures 27 index may be presented in two ways as robustness tests. The model in Equation (2) presents an unweighted disclosure score. RawDScorei¼P 3 j¼1 Scoreij Pmax ðScoreijÞ(2) The third model, presented in Equation (3), captures the isolated score of the qualitative and quantitative dimensions of the disclosure index. DScoreQuant=Qual ¼QuantQualScoreij max Quant QualScore(3) All the models here presented will evaluate the disclosure of a company against an index made with CPC 40 as its underlying metric, said index is composed of 25 topics to be evaluated, ranging from credit risk to liquidity risk and market risk, the scoreboard of the index is presented in Table 1. As shown, each one of the CPC 40 points (33 (a), 33(b) and so on) represents one possible point to be measured additionally; the disclosure type indicates whether the point is either quantitative or qualitative; thus, for the 25 topics, results in 25 points, 5 for credit risk, 5 for liquidity risk and 15 for market risk and its subtypes. As stated, the index introduced by Thai and Birt (2019) has been modified to fit our context, and we would like to clarify how and why we believe it is a valuable metric in our research case. First, the index presents itself as a method to quantify the adherence of information presented in the financial statements to regulation (in our case, CPC 40), which provides a clear contribution to value relevance, as it allows for a metric on how a company is adhering to a required disclosure policy, proving the concept useful in our case. Second, we performed minor adaptations on the index to allow its use in our context, with our adaptations regarding the substitution of some “evaluation topics”required in the original implementation to those queried by ours. That is, we changed some metrics required by AASB 7 to metrics required by Brazil’s interpretation, CPC 40, allowing the metric to maintain its intended concept and now allowing for a different regulation. As one may see, each line in the “Disclosure Instruction”column represents a possible point. Therefore, the highest points are 25; yet, within those 25, there are three large groups, these being the types of risk: credit, liquidity and market; within each of these types, there are two sub topics: qualitative topics and quantitative topics. The score method chosen, as presented in Equation (1), is given by the total number of marks scored each year by each risk type, divided by the maximum possible and applicable score; thus, the method implies the weight of each risk type. However, in models 2 and 3, there is no weight applied to the risk type; for instance, in the former model, the score is given by the total number of marks divided by the maximum possible and applicable score, while the latter is obtained by the total qualitative or quantitative marks scored by year divided by the total possible quantitative or qualitative score. As previously stated, the work presented here focused on the DScore model, 1, with the Raw DScore, 2 and Quant/Quali market, 3, used as robustness tests. To measure this index, we manually collected information from the financial statements of each company involved. That is, each of the 72 financial statements was read to gather information used in each topic of the index. The period selected reflects not only the timeconsuming task of this search but also the fact that this is the further back one may go without unbalancing the dataset. Additionally, the low variability of the index within each company for the timeframe studied may present itself as a low marginal gain of information given the time of work demanded. JCMS 7,1 28 4.3 Value relevance model As previously stated, the value relevance methodology is based on the resulting impact after the standard-setter’s action (Francis and Schipper, 1999). This can lead to the assumption that to measure such an impact, an econometric model is needed. To that end, Ohlson (1995) presented a model with reasonable reliability. However, to use the disclosure index of Thai and Birt (2019), a modified model with a different set of variables was chosen, with another modification to reduce the possibility of endogeneity. The resulting model is shown in Equation (4). Priceij ¼β0þβ1DScoreit þβ2BVit þLev þProfit þDAH þeit (4) Risk type Disclosure type CPC 40 Disclosure instruction Credit Risk Qualitative 33 (a) Exposure to risk and how it occurs 33 (b) Methods, policies, and process to mitigate risks and methods to measure said risk 38 (b) Policy to sell or use assets used as collateral Quantitative 36 (a) Maximum exposure to credit risk at the end of the period, without collaterals 36 (b) Description and financial effects of securities held Liquidity risk Qualitative 33 (a) Exposure to risk and how it occurs 33 (b) Methods, policies, and process to mitigate risks and methods to measure said risk 39 (c) Description of how the institution manages liquidity risk described in topics 39 (a) and (b) Quantitative 39 (a) A Time-analysis of the non-derivatives liabilities 39 (b) A Time-analysis of the derivatives liabilities Market Risk - Currency Qualitative 33 (a) Exposure to risk and how it occurs 33 (b) Methods, policies, and process to mitigate risks and methods to measure said risk 40 (b) The methods and assumptions used in the sensibility analysis Quantitative 40 (a) A sensibility analysis for each market risk the company has exposure to in the period 40 (c) Changes in the methods or assumptions used from the last period, and the reason behind said changes Market Risk - Interest Qualitative 33 (a) Exposure to risk and how it occurs 33 (b) Methods, policies, and process to mitigate risks and methods to measure said risk 40 (b) The methods and assumptions used in the sensibility analysis Quantitative 40 (a) A sensibility analysis for each market risk the company has exposure to in the period 40 (c) Changes in the methods or assumptions used from the last period, and the reason behind said changes Market Risk - Others Qualitative 33 (a) Exposure to risk and how it occurs 33 (b) Methods, policies, and process to mitigate risks and methods to measure said risk 40 (b) The methods and assumptions used in the sensibility analysis Quantitative 40 (a) A sensibility analysis for each market risk the company has exposure to in the period 40 (c) Changes in the methods or assumptions used from the last period, and the reason behind said changes Table 1. 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