A CONCEPTUAL FRAMEWORK FOR CORPORATE RISK DISCLOSURE EMERGING FROM THE AGENDA FOR CORPORATE GOVERNANCE REFORM

A CONCEPTUAL FRAMEWORK FOR CORPORATE RISK DISCLOSURE EMERGING FROM THE AGENDA FOR CORPORATE GOVERNANCE REFORM

British Accounting Review (2000) 32, 447–478 doi:10.1006/bare.2000.0145, available online at http://www.idealibrary.com on A CONCEPTUAL FRAMEWORK FOR...

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British Accounting Review (2000) 32, 447–478 doi:10.1006/bare.2000.0145, available online at http://www.idealibrary.com on

A CONCEPTUAL FRAMEWORK FOR CORPORATE RISK DISCLOSURE EMERGING FROM THE AGENDA FOR CORPORATE GOVERNANCE REFORM JILL F. SOLOMON, ARIS SOLOMON AND SIMON D. NORTON Cardiff University

NATHAN L. JOSEPH University of Manchester During the last decade an implicit conceptual framework for internal control and corporate risk management has arisen from risk management practice and policy within UK companies. An explicit conceptual framework for risk management is now emerging and is expressed in the Turnbull Report. In this paper, we develop a diagrammatic representation for the conceptual framework for internal control, risk management and risk disclosure. We consider the recent practical and policy developments in the disclosure of risk-related information in order to establish the current state of the art of corporate risk disclosure. Thus, we focus only on the disclosure aspect of the conceptual framework for internal control. We use a questionnaire survey to canvas the attitudes of UK institutional investors towards risk disclosure in relation to their portfolio investment decisions. Our empirical findings indicate that institutional investors do not generally favour a regulated environment for corporate risk disclosure or a general statement of business risk. The respondents agree that increased risk disclosure would help them in their portfolio investment decisions. However, for other aspects of the risk disclosure issue they are more neutral in attitude. Further, we found that the variation in the attitudes of institutional investors appears to be associated with the characteristics of the funds they manage as well as with their investment horizons. Further, we find that institutional investors’ perceptions of corporate governance are related to their investment horizons, among other factors.  2000 Academic Press We would like to express our thanks to Michelle Gleadall and Kenneth MacDonald for their help in the administration of this research project. We also thank the anonymous respondents to the questionnaire survey without whose participation the research would not have been successful. Thanks also to the following for their valuable comments at all stages of this research: Rebecca Boden, Dan Hemmings, Michael Jones, Josephine Maltby, Nell Minow, Andrew Tylecote, John Rogers, and Geoffrey Whittington. We would also like to thank the two anonymous referees and the editor of the special issue for their valuable comments and suggestions. We are also extremely grateful to The Nuffield Foundation for the financial support that made this research possible. Please address all correspondence to: Dr. Jill Frances Solomon, Lecturer in Finance, Cardiff Business School, Cardiff University, Aberconway Building, Colum Drive, Cardiff, CF10 3EU, UK, email: [email protected] Received April 1999; revised May and November 2000; accepted November 2000. 0890–8389/00/040447+32 $35.00/0

 2000 Academic Press

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INTRODUCTION Recent years have witnessed a growing interest in the disclosure of risk information by UK companies. Prominent corporate failures have alerted investors to the importance of certain sources of risk and uncertainty and company directors, as a result, have been required to report on their internal control mechanisms. Inaccurate, or poor interpretation of reported contingent liabilities, for example, has led to several notorious company downfalls (Smith, 1996a). Risk management is essential for the maximization of shareholders’ wealth as it aims to maximize profitability while at the same time reducing the probability of financial failure. The Cadbury Report (1992) and its successors, focused attention on the disclosure of risk information by UK companies, as part of the agenda for reforming corporate governance (CG). Some evidence suggests that UK institutional investors have generally welcomed the reforms recommended by the Cadbury, Greenbury and Hampel Committees. Indeed, a recent survey of institutional investors indicated that ‘. . .the overwhelming majority are of the view that their attention to corporate governance will enhance portfolio returns, by reducing risk and enhancing performance’ (Pensions Investment Research Consultants Limited’s (PIRC) Response, 1997). Improvements in the disclosure of risk-related information represent an important part of these CG reforms. However, until recently, corporate risk disclosure remained at the discretion of individual company management, with little attempt to provide an explicit framework for such disclosures. The Turnbull Report (1999) aims to provide such a conceptual framework for companies to disclose risk. However, there has to date been little attempt by the academic community to summarize developments in risk disclosure,1 or to test the conceptual framework for risk disclosure with empirical evidence. There are a number of aspects of the emerging corporate risk disclosure conceptual framework which beg clarification through academic research. One approach is to survey the attitudes of institutional investors as a primary user group, and to assess whether they consider the current level of risk that is disclosed to be adequate. Further, if more risk disclosure is required, what form should it take? What is the most appropriate vehicle for reporting riskrelated information? Should increased disclosure remain within a voluntary framework, as suggested by professional bodies, or should there be legislation and regulation to establish minimum disclosure requirements? These are the issues addressed in this paper. Here, we document institutional investors’ attitudes towards the current state of risk disclosure and shed some light on the demand for corporate risk disclosure. We also consider the relationship between institutional investors’ perceptions of CG and their investment horizons. We survey UK institutional investors, as this group of shareholders holds more than 60% of UK company shares (see Gaved, 1997). The paper is structured as follows. The following section discusses the evolving conceptual framework for corporate risk disclosure and current

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attempts to interpret this framework in practice. Within this discussion, we establish the current state of the art of UK corporate risk disclosure. We also develop a framework for corporate risk disclosure, detailing a variety of possibilities for an ‘ideal’ risk disclosure framework. The section entitled ‘Research Design and Sample’ presents a discussion of our research design while our hypotheses are formulated in the section entitled ‘Hypothesis Formulation’. The empirical results are presented in ‘Empirical Evidence’ while our conclusions and tentative policy recommendations are presented in the final section. A CONCEPTUAL FRAMEWORK FOR INTERNAL CONTROL, RISK MANAGEMENT AND RISK DISCLOSURE We use the term ‘risk’ in its broadest sense to refer to all types of risk faced by UK companies.2 Risk may be defined as the uncertainty associated with both a potential gain or loss. Every company is faced with different risks and the prioritisation of those risks is an essential part of the risk management process (ICAEW, 1998). The stated objectives of the Turnbull Report suggest a conceptual framework that attempts to make the existing implicit corporate risk disclosure framework explicit. The framework should ‘. . .reflect sound business practice whereby internal control is embedded in the business process. . .’ (Turnbull Report, 1999, para. 8). Here, we consider the CG considerations that are associated with both the implicit and explicit conceptual frameworks for internal control,3 risk management and risk disclosure. In this way, we seek to relate the disclosure considerations that are associated with those frameworks with the attitudes of institutional investors towards the disclosure of risk-related information. We begin by providing some background to the development of CG and proceed to address the emerging conceptual framework for internal control and corporate risk disclosure. Background The Combined Code (1998) states that company directors should conduct a review of the effectiveness of their internal control systems and should report this information to shareholders (Provisions D.2.1 and D.2.2). The Turnbull Report (1999) responds directly to the Combined Code by addressing the whole system of internal control. However, emphasis on the reporting stage of the internal control system is essential both for corporate accountability and for the future success of the business. Indeed, the USA and Canada have recognized the need to improve corporate risk disclosure in recent years (see Boritz, 1990; Courtis, 1993; and the Treadway Commission, 1987) and this need has also been acknowledged, if a little later, by interested parties in the UK (e.g. Arthur Andersen,

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1996). Further, if the aim of company management is to reduce the cost of capital by raising confidence in the market, then the communication of risk management policies must be a significant factor (The Corporate Governance Handbook, CGHB, 1996). The Cadbury Report (1992) also highlights the relevance of risk disclosure to the CG agenda by suggesting that validating the company as a going concern, and improving the disclosure of internal control should lead to improvements in the communication links between investors and their investee companies. In theory, one means of improving CG is to reduce the conflict of interest among stakeholders (e.g. Schleifer & Vishny, 1997). Furthermore, as company directors are likely to be better informed of the company’s future prospects than their investors, improving information flows between investor and the investee company will reduce information asymmetry and improve investor relations and CG. Modern portfolio theory would suggest that improving risk disclosure would in turn enable investors to deal more effectively with risk diversification. Indeed, institutional investors would also require information on the unsystematic risks faced by their investee companies, so as to build up a comprehensive profile of corporate risk and to form expectations about the company as a going concern. Relationship investing (Monks, 1994) is becoming increasingly important in the UK, with institutional investors preferring to develop long-term relationships with their investee companies (Solomon & Solomon, 1999) and consequently, move away from the shorttermism which has hitherto characterised the UK’s outsider-dominated CG system (Demirag, Tylecote & Morris, 1995). From a legal perspective, there are however restrictions on the manner in which companies should disclose potential risk so as to avoid individuals (connected or otherwise) using (internal) price sensitive information (for share trading) that could be construed as insider dealing (see London Stock Exchange, 1994; Holland & Stoner, 1996). Attempts to arrive at a legal definition of insider dealing, of which the exploitation of price sensitive information is an essential component, have had varying degrees of success. The Financial Services Act 1986 does not require the making of a profit by the user of the information as evidence of an offence4 and the law requires information to be in the public domain before it can be utilized. However, as Besorai (1995) indicates, whilst premature disclosure may lead to speculation and competitive harm, delayed disclosure deprives the market of mature information, which in turn encourages leaks, rumours, and insider transactions. For these reasons, improved risk disclosure by companies can be beneficial. An existing implicit conceptual framework Despite practitioners’ increasing interest in: (1) internal control; (2) corporate risk management; and (3) corporate risk disclosure, the academic literature has made little attempt to conceptualize a system of internal

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control that accommodates the issues associated with CG. Individual companies have developed their own approaches to internal control and risk management. Meyrick-Jones (1999), for example, documents the risk management approach of British Aerospace in terms of CG. The approach provides the main board with information on the risks within the group; facilitates internal control as well as provides the disclosure required for reporting, and safeguarding the group’s assets; and provides a set of rules that the companies within the group can use to assess risk. These, in turn, are expected to safeguard shareholder value (see also, Groves, 1999; Thomas, 1999). Thus, although there may be generic categories for implementing risk control mechanisms, companies appear to have developed their own systems in order to meet their specific needs. The need for formalizing these sets of procedures seems obvious, and the Turnbull Report represents an attempt to create an explicit conceptual framework for companies to refer to, when developing their own internal control strategies (see also, Blackburn, 1999). An emerging explicit conceptual framework for internal control The existing conceptual framework has remained implicit in the UK until the publication of the Turnbull Report (1999). As in the case of Turnbull, a conceptual framework which makes an implicit system explicit is likely to include a review of existing theory and practice and the development of a model. Conceptual frameworks of this type usually result in policy implications and should be dynamic in nature (see Solomon & Solomon, 2000).5 An interpretation of the explicit conceptual framework as depicted by the Turnbull Report is presented in Figure 1. The figure shows that the system for internal control includes several stages. The first stage of the framework is identification which involves both the identification and prioritization of relevant risks. The recommendation from Turnbull corresponding to this stage of the framework is that in determining a company’s internal control policies the board of directors should consider ‘the nature and extent of the risks facing the company’ as well as, ‘the extent and categories of risk which it regards as acceptable for the company to bear’ (The Turnbull Report, para.17). As stated earlier, the specific types of risk that should be identified explicitly are not specified in Turnbull, so it would be up to the company to identify the sources of risk that are relevant to them. The estimation stage of the conceptual framework depicts the assessment of the potential impacts of identifiable sources of risk. This is described explicitly as a consideration of ‘the likelihood of the risks concerned materialising’ (para. 17). At the developmental stage, the company develops its specific risk management strategy which should be tailored to match specific risks. Thus, the board should consider the ‘company’s ability to reduce the incidence and impact on the business of risks that do materialise’ (para. 17). This stage should also involve an evaluation

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Identification Stage Identification and prioritisation of relevant risks External Feedback Stage Feedback from stakeholders (particularly institutional investors)

Interpretative Stage Interpretation of disclosed information by stakeholders

Estimation Stage Estimation of potential impact of these sources of risk

Internal Feedback Stage Feedback from managers to the board and internal audit

Disclosure Stage Disclosure of risk management strategy, its effectiveness and a predictive discussion of company as a going concern

Developmental Stage Development of risk management strategy tailored to specific risks and consideration of costs

Implementation Stage Implementation of chosen risk management strategy Evaluation Stage Evaluation of effectiveness of risk management strategy

The Disclosure stage of this framework is the principal focus of this study

Figure 1.

of ‘costs of operating particular controls relative to the benefit thereby obtained in managing the related risks’ (para. 17). The development of a risk management strategy leads naturally to the next stage of implementation, where the board puts their chosen risk management strategy into operation. Following implementation, the internal control system should involve an evaluation stage where the effectiveness of the implemented strategy is evaluated. This stage involves ‘effective monitoring on a continuous basis’ (para. 27) so as to ensure a dynamic and effective system of internal control. The evaluation stage flows directly into an internal feedback stage as frequent feedback in the form of reports from managers to the board, as well as (in some cases) an internal audit, to link evaluation to internal disclosure.

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Indeed, where companies do not operate an internal audit they should review the need for one at frequent intervals (The Combined Code, D.2.2). The framework for internal control that is presented here is similar in spirit to a framework based on the US internal control process (Mills, 1997) although the framework in Figure 1 seeks to develop and highlight the dynamic nature of internal control systems through feedback stages. An outlet for the company’s risk management strategy involves formal public disclosure to its stakeholders. This disclosure stage involves reporting information relating to the company’s risk management strategy, its effects and success as well as some predictive discussion of the company as a going concern. In this paper, we focus specifically on the disclosure stage of the internal control conceptual framework because of its importance for institutional investors and users of financial reports. Indeed, it is this aspect of the framework that we address empirically. Despite the explicit guidance for an internal control framework, Turnbull provides remarkably little detail concerning the format of disclosure within the system of internal control. However, Turnbull provides detailed guidance concerning what should be discussed in an annual assessment preceding the company’s public statement on internal control (paras. 33 and 34). Indeed, the only explicit guidance on what should be disclosed states that in their narrative statements, companies should ‘. . .as a minimum, disclose that there is an ongoing process for identifying, evaluating and managing the significant risks faced by the company’ (para. 35). There is then the suggestion that the company could choose ‘. . .to provide additional information in the annual report and accounts to assist understanding of the company’s risk management processes and system of internal control’ (para. 36). There should also be some disclosure of the process the company uses to review the effectiveness of its internal control system as well as information relating to the process it has applied to deal with material control aspects of any significant problems disclosed in the annual report and accounts. Of course, this leaves the decision on materiality to company managers and it is this materiality decision which therefore governs the disclosure. Finally, our conceptual framework for internal control includes a stage of interpretation of the disclosed material by stakeholders which facilitates external feedback and control. This feedback should be incorporated into the first identification stage of the framework as a crucial aspect of the company’s overall risk management strategy and system of internal control. The strengthening of communication and decision links between shareholders and investee companies, for example, is one sign that this feedback process is evolving (Solomon & Solomon, 1999). A conceptual framework for corporate risk disclosure As Turnbull provides so little guidance on what information companies should disclose, where it should be disclosed and what form the disclosure

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should take, it is our intention to investigate these aspects of the emerging explicit conceptual framework. Figure 2 represents a conceptual framework for corporate risk disclosure which details various alternatives which could lead to the production of an ‘ideal’ framework. In this study, we ask institutional investors to indicate their preferences among these alternatives in order to create their own ‘ideal’ framework. Clearly, if other groups of stakeholders are approached, different ‘ideal’ frameworks may ensue. However, elements of the framework in Figure 2 relate specifically to investors as they are generally considered to be the primary user group of corporate disclosure. The figure depicts six variable elements that interrelate to create the extant framework for corporate risk disclosure. One important element is whether corporate risk disclosure should remain in a voluntary environment or whether it should be made mandatory. Another element is the appropriate level of risk disclosure. Is the current level of information that is disclosed adequate? Or, would increased corporate risk disclosure facilitate investment decision-making?

Environment Voluntary or Mandatory? Level of Risk Disclosure Is the current state of risk disclosure adequate? Would increased disclosure help investment decision making?

Investors’ Attitudes Do attitudes towards risk disclosure depend on their investment horizons, the type of investor, inter alia?

‘Ideal’ framework for corporate risk disclosure

Form of Risk Disclosure Should risks be reported separately or should they be grouped in a general statement?

Location Should the information be in the OFR? Risk Disclosure Preference Should all types of risk be reported with equal importance or do users have a preference?

Figure 2.

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The most desirable location for risk disclosure within the annual report is also an important element of the risk disclosure framework. Is the OFR, for example, the most appropriate vehicle for risk disclosure? The review of modern company law currently underway is certainly pushing for this sort of information to be contained within an augmented OFR (see Modern Company Law, 2000). The framework also presents different possibilities for investors’ risk disclosure preferences and the form of disclosure that certain risks should take. Should all types of risk be reported with equal importance? Should every risk be reported individually or should all risk information be grouped in a general statement for external reporting purposes? Is there a distinct preference for some types of risk information? Whether future developments in the risk disclosure framework will involve explicit guidance on specific risks remains to be seen. At present, it is unclear whether users of financial reports have strong preferences for the disclosure of particular types of risk. So this issue requires clarification to inform future policy recommendations.6 Lastly, we are interested in whether investors’ attitudes are influenced by specific factors. For example, are institutional investors’ attitudes towards corporate risk disclosure influenced by their general attitudes towards CG? Are their perceptions of CG related to their requirements for risk information? Indeed, it is likely that there is a strong link between these issues since internal control has recently become a central aspect of the UK agenda for CG reform. Further, do investors’ attitudes vary according to their type (unit, trust, pension fund, for example) or according to their investment horizons? All these elements require consideration in the development of an appropriate framework for corporate risk disclosure. Such a framework is likely to generate useful information for external users of corporate reports. Indeed, recent US evidence indicates that there is a demand for internal control reporting and that this type of information is considered useful to external decision-makers (Hermanson, 2000). We turn now to our research design, hypothesis formulation, and empirical results from the perspective of both conceptual frameworks.

RESARCH DESIGN AND SAMPLE To conduct the questionnaire survey, a sample of 552 institutional investors was drawn randomly from four sources. The sample comprised the four main types of investment institution: pension funds; investment trusts; unit trusts; and insurance companies.7 The questionnaire was distributed between January and April 1999.8 Most of the questions required the respondents to record a score from 1 (strongly disagree) to 7 (strongly

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TABLE 1 Main activity of respondents Type of Institutional Investor

Frequency

Percentage

Pension Fund Management Insurance Fund Management Investment Trust Management Unit Trust Management Mixed Fund Management

41 24 14 10 6

43Ð2 25Ð3 14Ð7 10Ð5 6Ð3

Total

95

100Ð0

agree) in order to indicate the extent to which they agree with certain assertions (see below). Other questions were more specific and required respondents to tick one of several boxes that contained specific detail. Of the responses received, 97 (17Ð6%) were satisfactorily completed. There was no evidence of late response bias.9 Table 1 indicates the main areas of fund management in which the respondents operate. The table shows that the majority of respondents were from pension and insurance fund institutions. The high response rate (43Ð2%) from pension fund institutions may suggest that they have more interest in CG issues, perhaps because of active encouragement by the National Association of Pension Funds (see NAPF, 1995, for example). The respondents’ funds were invested predominantly in the financial and banking sectors. Other industries that featured significantly included utilities, services, support services, and pharmaceuticals. Table 2 indicates the positions held by the respondents within their organizations. Almost half of them held senior positions, as directors of their organizations, chief investment officers or fund managers. It is interesting TABLE 2 Positions held by Respondents Position Held

Frequency

Percentage

Director Fund Manager Chief Investment Officer Company Secretary Head of Corporate Governance or Corporate Governance Executive Chief Executive Head of Research Analyst Unspecified

19 13 12 6 4

19Ð6 13Ð4 12Ð4 6Ð2 4Ð1

2 2 2 37

2Ð1 2Ð1 2Ð1 38Ð0

Total

97

100Ð0

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TABLE 3 Institutional investors’ investment horizons Portfolio investment Horizon

Frequency

Percentage

Under 2 months Between 2 months and 6 months Between 6 months and 12 months Between 1 year and 2 years Between 2 years and 5 years Between 5 years and 10 years Over 10 year

1 1 4 14 48 12 6

1Ð2 1Ð2 4Ð6 16Ð3 55Ð8 13Ð9 7Ð0

Total

86

100Ð0

to note that the ‘Head of Corporate Governance’ is a relatively new position that seems to be emerging gradually as awareness of CG issues grows. Other background details indicated that about a quarter of the respondents have been involved in fund management for between 10 and 15 years. A further 48Ð9% of them have been involved in fund management for more than 15 years. On average, the institutions managed 7 funds. Table 3 shows that 56% of institutional investors tend to hold shares in their investee companies for between 2 and 5 years; a further 21% held shares for over 5 years. This would suggest that institutional investors are not necessarily behaving in a short-term manner, on average, but are instead displaying some evidence of ‘long-termism’. It must be stressed however that this evidence would not capture the short-term trading that would arise when institutional investors rebalance their portfolios over the period encompassed by the near ‘permanent’ holding of shares. Further, risk disclosure is likely to be more important to long-term holders of stock particularly if they do not actively arbitrage when managing their portfolios. There is some variation in the responses that were received according to the type of fund that is managed but we consider this issue together with our main results.10

HYPOTHESIS FORMULATION In this section, we formulate our hypotheses in terms of the conceptual frameworks for internal control and corporate risk disclosure. Due to the diverse nature of our investigation, the hypotheses that are formulated in this section are in broad terms only. Other specific hypotheses are dealt with as appropriate. Throughout, we rely mostly on the chi-square c2 statistic to test the hypotheses. In all cases, our null hypothesis is that the predicted

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relationship does not exist and so we focus on the alternative hypothesis (suggesting evidence of a relationship) as shown below. Institutional investors’ perceptions of corporate governance Some empirical evidence shows that experience in a specific decision domain can give rise to the sophisticated organization of knowledge such that the decision processes of experienced and inexperienced decision makers would vary (see Ho, 1994; Hershey, Walsh, Read and Chulef, 1990). Since our descriptive statistics suggest that both organizational and individual learning in the institutional investors’ environment would vary, we predict that respondents’ attitudes towards CG would be associated with their personal and organizational backgrounds, thus: H.1: The strength of the respondents’ views regarding the CG definitions would reflect: (i) the amount of practical experience the respondents have; (ii) the type of fund they manage; and (iii) the length of their investment horizons. We also expect the respondents with stronger views to have longer investment horizons and more practical experience. It should be emphasized that fund managers are professional individuals who operate within structured organizational settings and therefore would have specific views on the process of CG and the problems it entails. Both the respondents and the organizations in our sample have had many years of experience in fund management, so we predict: H.2: The more experienced the organizations are in fund management, the more importance their respondents will place on the CG frameworks. Risk disclosure and investment decisions One of the primary functions of financial reports is to provide information to external users on the operational activities and performance of companies. As such, the attitudes of institutional investors towards the current state of risk disclosure would depend on the relevance of the risk that is disclosed for investment decision-making. Since the agenda for CG reform prioritises the disclosure of risk information, it seems likely that institutional shareholders would welcome any process that encourages the disclosure of additional risk information. Thus we predict: H.3: Respondents’ need for any form of increased risk disclosure will reflect their view on the importance of such information for investment decisions. However, because of the impact of organizational and individual learning, the extent of the need for risk risk-related information might reflect organizational characteristics, such that more experienced managers and institutions are likely to have stronger views on the importance of such information.

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Corporate governance, risk disclosure and demand for information One important implication of Cadbury and the associated guidance to directors (Rutteman, 1994) is that risk disclosure should lead to good CG. If a link exists between risk disclosure and CG, then the process of CG is likely to provide a useful framework for facilitating the investment decisions of institutional investors. It is therefore likely that institutional investors’ perceptions of corporate risk disclosure would depend on their perceptions of the CG framework within which the companies operate. Thus, respondents’ understanding of certain definitions of CG would reflect their assessment of the benefits that will arise from CG itself. In this case, we predict: H.4: Respondents’ perceptions of the structure that entails existing frameworks of CG would influence their views of the benefits that would arise from using such frameworks. Furthermore, it is possible that the respondents do not consider financial reports to be a primary source of information on corporate risk and that risk disclosure in financial reports is not sufficiently timely for day-today portfolio investment decisions. Indeed, UK companies disclose private information to institutional shareholders on a frequent and quite formal basis (Holland, 1998). Barker (1998) also indicates that institutional investors utilize the processed information of analysts for investment decisions although such information is not considered to be as important as the raw data that flows directly from companies. Thus normative theory would suggest that institutional investors’ perceptions regarding the capacity of a formalised framework of CG to generate risk-related information would in turn reflect their demands for risk-related information.11 As we would expect their demand for risk related information to reflect their understanding of the capability of the CG framework, we predict: H.5: Respondents who show strong agreement with certain CG definitions will also reveal a strong demand for the disclosure of that risk information. Form and location of risk disclosure As indicated earlier, the provisions in Turnbull do not give much guidance on what information companies should disclose where it should be disclosed, and what form the disclosure should take. From a research design perspective, this makes it difficult to address in a coherent manner the specific areas of risk disclosure and how to relate them to the experiences of institutional investors. There is, of course, much concern regarding the manner in which certain risks are disclosed as well as the extent of such disclosures. For example, proponents of hedge accounting have suggested that the rules that apply when calculating the profits or losses from a company’s currency transactions, do not sufficiently capture the underlying economic nature of the derivatives that they use. In this case, not only should

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all sources of those risks be disclosed but also the underlying economics of such risks should be adequately captured. Furthermore, investors appear to attribute different weights to disclosed information in terms of their location in the financial reports.12 Those issues would therefore impinge on any conceptual framework of CG. Thus we predict: H.6: Institutional investors’ attitudes towards risk disclosure would depend on the type of risk information that is disclosed as well as its location and general form in the financial reports. EMPIRICAL EVIDENCE Institutional investors’ perceptions of corporate governance To evaluate the institutional investors’ views of CG we presented them with a number of established definitions of CG. These definitions are not intended to discriminate completely between different views, but rather each has been chosen to emphasize slightly different interpretations of the CG function. The selection represents a range of definitions, starting from the narrowest which describes the basic role of CG (The Cadbury Report, 1992) to a solely financial perspective involving only shareholders and company management (Parkinson, 1993), up to a broader definition, which encompasses corporate accountability to a wide range of stakeholders and society at large (Tricker, 1984). We also included a definition which emphasizes the importance of shareholder activism, as this allows us to gauge institutional investors’ views on their own role in CG (CGHB, 1996). Respondents were also presented with definitions which are regulation-centred (Cannon, 1994) or focused on corporate success (Keasey & Wright, 1993). All those assertions required respondents to record a score on a 7-point scale. Table 4 shows that the average responses for each framework of CG varied between slight disagreement and moderate agreement. Indeed, the Wilcoxon signed-rank Z statistic was applied to pair-wise combinations of the items in the table. The Z statistic was not significant in three cases; i.e. items (b) and (c); (c) and (d); and (d) and (f). Thus respondents attributed similar weights to those assertions. Table 4 also shows the highest average response is for the assertion that CG is a process of supervision and control so as to ensure that the company acts in the interests of shareholders (item (a); meanD5Ð6). Here, only 3Ð2% of respondents recorded a score of 1 or 2 and a further 61Ð1% of them recorded a score of 6 or 7. It is interesting to note that CG is not generally considered to be simply a system for directing and controlling companies (item (f); meanD3Ð6). However, since 21Ð3% of respondents recorded a score of 6 or 7 for this assertion, it seems important that policy makers should ensure that the objectives of CG are clearly communicated to institutional investors. Further, almost a third of respondents (31Ð9%)

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TABLE 4 Institutional investors’ perceptions of definitions of corporate governance frameworksŁ Definitions of Corporate Governance as:

N Mean Median

(a) the process of supervision 95 and control intended to ensure that the company’s management acts in accordance with the interests of shareholders (b) the governance role is not 95 concerned with the running of the business of the company, per se, but with giving overall direction to the enterprise, with overseeing and controlling the executive actions of management, and with satisfying legitimate expectations of accountability and regulation by interests beyond the corporate boundaries (c) the governance of an 95 enterprise is the sum of those activities which make up the internal regulation of the business in compliance with the obligations placed on the firm by legislation, ownership and control. It incorporates the trusteeship of assets, their management and their deployment.

Percentage Percentage rating a rating a SD Range 1 or 2 6 or 7

5Ð56

6

1Ð34

6

3Ð2

61Ð1

4Ð75

5

1Ð54

6

9Ð5

40Ð0

4Ð61

5

1Ð48

6

10Ð5

31Ð6

view CG as a set of structures, processes and cultures that engender the successful operation of organizations (item (e)), even though this definition was not rated as highly as most of the others. To test the hypothesis that the backgrounds of respondents are associated with their perception of what CG entails (H:1 and H:2), the chi-square statistic was computed.13 In terms of H:1, the contingency table for the computed statistic indicated that the degree of experience of respondents in fund management is associated with their perception of what CG entails.

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TABLE 4 (Continued) Definitions of Corporate Governance as:

N Mean Median

(d) the relationship between 95 shareholders and their companies and the way in which shareholders act to encourage best practice, for example, by voting at AGMs and by regular meetings with companies’ senior management. Increasingly, this includes shareholder ‘‘activism’’ which involves a campaign by a shareholder or a group of shareholders to achieve change in companies (e) the structures, process, 95 cultures and systems that engender the successful operation of the organisation (f) the system by which 94 companies are directed and controlled

Percentage Percentage rating a rating a SD Range 1 or 2 6 or 7

4Ð32

5

1Ð59

6

17Ð9

24Ð2

4Ð23

4

1Ð57

6

18Ð9

23Ð1

3Ð57

3Ð5

1Ð88

6

31Ð9

21Ð3

Notes: SD is the standard deviation. The descriptive statistics are from the recorded scores of a 7-point scale where 1Dstrongly disagree, and 7Dstrongly agree. Ł The definitions come from the following sources: (a) is from Parkinson (1993); (b) from Tricker (1984); (c) from Cannon (1994); (d) from the CGHB (1996); (e) from Keasey and Wright (1993), and; (f) from The Cadbury Report (1992).

In particular, respondents who had between 10 and 15 years of experience record high scores for the assertion that the process of CG is aimed at ensuring that companies’ managers act in the interest of shareholders (item (a)), but the recorded scores for those with 15 years or more experience are much higher. In particular, 67Ð5% of the 43 respondents who had 15 years or more experience recorded a score of 6 or 7 for item (a). The chi-square statistic is significant (c28 D13Ð512; p-value D0Ð095) but the relationship is moderate as indicated by Cramer’s V statistic of 0Ð277. Interestingly, respondents with 15 years or more experience are more likely to disagree with the view that the CG process should aim to encourage best practice among companies (item (d), Table 4). Almost a third of those respondents (13 of 43) recorded a score of 1 or 2 for this assertion and a further 43Ð2%

A CONCEPTUAL FRAMEWORK FOR CORPORATE RISK DISCLOSURE

463

recorded a score of 3 or 4. The chi-square test is significant (c28 D15Ð569; p-valueD0Ð049) but the relationship is also moderate (V D0Ð289). Notice that item (d) also relates to aspects of shareholder activism. The finding that UK institutional investors have, on average, a neutral view regarding participating in the internal decisions of companies does contrast with the view put forward by earlier empirical work. But according to Smith (1996b), shareholder activism is likely to be more commonplace when companies’ stock performance is low and institutional investors hold a high proportion of the companies’ shares.14 Yet, it is possible that institutional investors are more likely to participate in decision making to encourage the attainment of desired goals where companies’ performance does not meet expectations. Gaved (1997) suggests this to be the case for UK institutional investors. It is noteworthy that the Hampel Committee pointed out: ‘Institutions are not normally experienced business managers and cannot substitute for them. But we believe that they can take a constructive interest in, and test, strategy and performance over time’ (Committee on Corporate Governance, 1998a, pp. 41). This may explain the reluctance of institutional investors to become more active in the internal decisions of their investee companies. The respondents’ perceptions of CG definitions may also reflect the nature of the type of fund that they manage as well as their investment horizons. We can reject the null hypothesis of no connection (c28 D13Ð708; V D0Ð270; pD0Ð090) between the type of fund institutional investors manage and their attitudes towards item (d). From the contingency table, 22Ð5% of the 40 respondents who are involved in pension fund management recorded a neutral score for that assertion. A further 50% of those respondents also recorded a score of 5 or 6. Similarly, 20Ð8% of the 24 respondents involved in insurance fund management recorded a neutral score for item (d) while a further 50% of them recorded a score of either 5 or 6. The results imply that respondents from both pension and insurance fund institutions appear less keen to participate in a CG system that depicts some form of shareholder activism than other groups of respondents. We seek to explore this finding further below. To evaluate further the respondents’ apparent lack of enthusiasm for participating in investee companies’ decision making, we sought to establish a link with institutional investors’ portfolio investment horizons. One finding is that most pension and insurance fund institutions hold shares in companies for between 2 and 5 years on average while the investment horizons of other institutions were spread over 1 to 5 years.15 This implies that pension and insurance fund institutions have slightly longer investment horizons, and are therefore more likely to take a longer view of the performance of investee companies, thereby favouring the encouragement of best practice. This finding contradicts the current view that pension fund managers tend to exhibit more short-termism than other groups of institutional investors (see Hampel, 1998) due to the influence of trustees. The chi-square statistic indicates that the null hypothesis (of no relationship

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between investment horizon and perceptions of the CG framework) can be rejected (c28 D13Ð700; V D0Ð283; p-valueD0Ð090). Just over half (24 out of 47) of the respondents whose average investment horizons are between 2 and 5 years recorded scores of either 5 or 6 for item (d). It would appear that pension and insurance fund institutions are likely to constitute the majority of the respondents in this group. Overall, our findings suggest that pension fund institutions with longer investment horizons perceive the CG framework as including shareholder activism, whereas pension fund institutions with shorter investment horizons do not. Furthermore, we did not find any evidence to suggest that the degree of experience of the institutional organizations themselves is associated with a particular view of CG framework (H:2). It might be that both organizational learning and experience have not reached the stage where the institutions have formulated internal policies on the particular perspective that they should follow. Risk disclosure and investment decisions Before considering H:3 we briefly discuss the descriptive statistics associated with the attitudes of the respondents towards the current state of risk disclosure and its relevance to their investment decision-making processes. Table 5 indicates that the average scores are typically greater than 4 but do not exceed 5 for most assertions. Thus, it would appear that the respondents’ agreement that there is a need for corporate risk disclosure is moderate. It could be that respondents generally feel that such disclosures are not too important, since they probably obtain more frequent private disclosure through one-to-one meetings. However, almost a third of respondents display a strong need (recorded a score of 6 or 7) for increased corporate risk disclosure that would help to improve portfolio investment decisions (item (a); meanD5). Further, almost 20% of the respondents strongly agreed that the current state of risk disclosure by their UK investee companies is inadequate. Indeed, one respondent of a major pension fund remarked: ‘we understand that companies are feeling the burden of corporate governance compliance but also feel that the level of disclosure from companies can be improved—Hampel did very little to advance the cause’. Whether or not a voluntary or legal framework is more appropriate for corporate risk disclosure has also been extensively debated. The ICAEW (1998), for example, favours a voluntary reporting environment within the existing financial reporting framework although derivatives reporting is mandatory (Accounting Standards Board (ASB), 1996). We find that a significant number of respondents are averse to a legal framework for corporate disclosure (item (l)); 43Ð1% of them recorded a score of either 1 or 2. However, although it is possible under the Companies Act16 to instigate legal proceedings where company directors have abused their access to price sensitive information, shareholders are not necessarily protected within a voluntary framework.17

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TABLE 5 Institutional investors’ attitudes towards corporate risk disclosure

Assertions:

N Mean Median

Percentage Percentage rating a rating a SD Range 1 or 2 6 or 7

(a) I believe that increased corporate risk disclosure would help institutional investors in their portfolio investment decisions (b) I believe that the best way of improving risk disclosure would be to report exposure to, and management of, different types of risk separately (c) I believe that increased risk disclosure would improve the corporate governance of our investee companies (d) I believe that financial risk information is more relevant to institutional investors than other risk information (e.g. product/service, compliance, and environmental risks) (e) I believe that the current state of risk disclosure by our UK investee companies is inadequate (f) I believe that improvements in risk disclosure are essential to a company’s reporting as a going concern (g) I believe that the Operating and Financial Review (OFR) is the most appropriate vehicle for increased risk disclosure (h) I believe that all types of risk affecting an investee company should be reported with equal importance

88

5Ð0

5

1Ð17

6

3Ð4

29Ð5

87

4Ð7

5

1Ð21

6

8Ð0

23Ð0

87

4Ð6

5

1Ð23

6

8Ð0

21Ð8

89

4Ð6

5

1Ð54

6

10Ð1

28Ð1

86

4Ð5

5

1Ð21

6

5Ð8

18Ð6

86

4Ð4

4

1Ð15

6

5Ð9

16Ð3

86

4Ð3

4

1Ð06

6

12Ð8

12Ð8

88

4Ð2

4

1Ð57

6

13Ð7

22Ð7

466

J. F. SOLOMON ET AL.

TABLE 5 (Continued)

Assertions:

N Mean Median

Percentage Percentage rating a rating a SD Range 1 or 2 6 or 7

(i) I believe that the best way for companies to improve risk disclosure would be to publish a general statement of business risk (j) I believe that increased risk disclosure would encourage the development of long-term relationships between institutional investors and their investee companies (k) I believe that corporate risk disclosure should be voluntary (l) I believe that corporate disclosure of risk information should be regulated through Government legislation

88

4Ð2

4

1Ð28

6

12Ð5

11Ð4

88

4Ð1

4

1Ð35

6

13Ð7

17Ð0

88

3Ð8

4

1Ð68

6

26Ð2

16Ð0

86

3Ð0

3

1Ð55

6

43Ð1

4Ð7

Notes: SD is the standard deviation. The descriptive statistics are from the recorded scores of a 7-point scale where 1Dstrongly disagree, and 7Dstrongly agree.

As indicated under H:3, respondents’ attitudes towards corporate risk disclosure may well reflect their investment and organizational strategic goals, and we seek to explore these issues below. The general attitude of respondents towards the assertions in Table 5 is surprising given that institutional investors are a major user group of financial reports. The chi-square statistic rejects the null hypothesis of no connection between respondents’ views regarding the importance of risk disclosure for investment decisions (item (a); Table 5) and the number of years the institutions have been operating in fund management (c28 D 8Ð457; V D0Ð213; p-valueD0Ð076). Interestingly, just over half of the respondents for those institutions (35 out of 69) with 15 years or more dealings in fund management recorded a score of 5 for item (a), and a further 15Ð9% (11 out of 69) recorded a score of 4. This finding is unexpected since we had predicted a stronger view for more experienced institutions. The chisquare statistic also rejected the null hypothesis of no connection between a preference for disclosing different types of risks (item (i); Table 5) and the length of time the institutions have been operating in fund management (c28 D7Ð905; V D0Ð207; p-valueD0Ð095). From the contingency table, 41%

A CONCEPTUAL FRAMEWORK FOR CORPORATE RISK DISCLOSURE

467

of the respondents (29 out of 70) for institutions with 15 years or more experience recorded a score of 4 for this assertion while a further 31% recorded a 5. Thus the institutions with more experience appear less enthusiastic about both assertions. These findings appear pronounced for other assertions.18 It is useful to note that the degree of experience of respondents is not associated with those assertions in Table 5. For example, respondents with 15 years or more experience appear to favour the separate disclosure of the different types of risks (item (a); Table 5) but the chisquare statistic is not significant (c28 D8Ð479; V D0Ð222; p-valueD0Ð385). The finding that the organizational characteristic is linked to the assertions rather than the degree of experience of respondents may reflect the dominant role of organizational policy, here. The findings evoke important issues associated with individual versus organizational learning (see e.g. Huysman, 2000). However, if both organizational learning and experience are taken from a cultural perspective, we can suggest that organizational experience, for the purpose of our study, is able to capture shared values, beliefs and practices (see also Pentland, 1995). Alternatively, it can be argued that the stock selection procedures that are instituted by fund managers facilitated a greater focus on portfolio wide decisions. Thus it is possible that the larger the number of stocks that are constituted in the stock portfolios the less experienced fund managers would rely on the information revealed by risk disclosure procedures. We also found a significant connection between the type of fund that is managed and respondents’ perceptions regarding the importance of risk disclosure for portfolio investment decisions (item (a) of Table 5) (c28 D14Ð377; V D0Ð280; p-valueD0Ð072). The respondents of both pension and insurance funds tended to record scores of 5 or 6 for item (a) of Table 5. That is, 72% of pension fund respondents (26 out of 40) recorded those scores while 65% of insurance fund respondents (15 out of 23) recorded similar scores. Similarly, the chi-square statistic (c28 D18Ð926; V D0Ð321; p-valueD0Ð015) rejected the null hypothesis of no connection between the type of fund that is managed and respondents’ perceptions of the importance of a general statement on business risk (item (i); Table 5). Almost threequarters (29 out of 39) of the respondents of pension fund institutions recorded a score of 4 or 5 for that assertion. A further 10 out of 23 of the respondents of insurance institutions recorded similar scores. Additional evidence (c28 D 14Ð242; V D 0Ð279; p-value D 0Ð076) also suggests a link between the type of fund that is managed and the importance of increased disclosure to encourage long-term relationships (item (j) of Table 5), but the recorded scores are generally moderate. In brief, the respondents of both pension and insurance funds appear to hold a dominant view that the disclosure in financial reports of a general statement on business risk and the development of long-term relationships are important but only moderately so. The difference between the views of both pension and insurance fund

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respondents relative to those of other respondents might well reflect the longer-term nature of the former portfolio investment strategies. Corporate governance, risk disclosure and demand for information We hypothesized that respondents’ knowledge of the ability of the existing conceptual framework to facilitate their needs would in turn reflect their views on the benefits that would arise from using the system (H:4). To test this hypothesis, we seek to establish a link between some of the assertions in Tables 4 and 5. The chi-square statistic indicates that the null hypothesis of no connection between the responses to item (a) in Table 4 and item (a) in Table 5 can easily be rejected (c29 D18Ð554; V D0Ð258; p-valueD0Ð029). Thirty-six of the 58 respondents (62Ð1%) who recorded a score of 6 or 7 for item (a) also recorded a score of 4 or 5 for item (a) of Table 5. This finding suggests that the corporate risk disclosure process represents a means of controlling the notorious agency problem. We also found that respondents (28 out of 44) who recorded scores of either 5 or 6 for the extent to which CG can engender the successful operations of companies (item (e); Table 4) recorded similar scores for the inadequacy of the current level of risk disclosure (item (e); Table 5). The overall chi-square statistic is significant (c24 D 12Ð428; V D 0Ð261; p-valueD0Ð014). This finding again validates the link between disclosure of risk information and the agenda for CG reform, as it implies that investors who see CG as a way of improving corporate performance also require greater disclosure, and that this may be provided through improved CG. Finally, respondents who recorded scores of either 4 or 5 for item (e) of Table 4 disagree that legislation is needed to bring about compliance with CG issues (item (l); Table 5). Although respondents are somewhat unsure regarding the extent to which CG can engender success within companies, they are more certain that legislation is inappropriate for implementing CG. The chi-square statistic is however not significant (p-valueD0Ð681) but respondents who appeared more willing to support overall directions on accountability (item (b) of Table 4) also appear less willing to encourage the use of legislation to ensure corporate disclosure (item (l); Table 5). In this case, the overall chi-square statistic is significant (c24 D11Ð883; V D0Ð256; p-valueD0Ð018). The chi-square statistic (c24 D19Ð018; V D0Ð323; p-value D0Ð001) also rejected the null hypothesis of no connection between a CG process that seeks to foster relationships between institutional investors and investee companies (item (d), Table 4) and importance of risk disclosure for financial reporting (item (f), Table 5). Twenty-one of the 44 respondents (47Ð7%) who recorded scores of either 5 or 6 for item (d) of Table 4 recorded similar scores for item (f) of Table 5. If certain respondents view the CG process as a means of developing relationships between shareholders and their investee companies (item (d), Table 4), they should also have a similar view regarding

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469

the adequacy of the current state of risk disclosure (item (e), Table 5). Thus we would expect a link between both variables. The null hypothesis of no connection between both variables can be rejected (c24 D9Ð779; V D0Ð232; p-valueD0Ð044). Thirty-three of the 44 respondents who recorded a score of either 5 or 6 for item (d) of Table 4, also recorded a score of 4 or 5 for item (e) of Table 5. Furthermore, we have indicated that most institutional investors do not appear keen to participate actively in the decision-making process of their investee companies or to instigate change to the extent that is suggested in the finance literature. Thus despite the weak support for active participation in decision-making within companies, respondents still feel that disclosure levels are inadequate. Finally, we predicted a link between the conceptual framework for CG and the demand for risk-related information (H:5). Specifically, we seek to establish a link between the assertions in Table 4 and items (a) and (d) in Table 5. According to the chi-square statistic (c24 D7Ð829; V D0Ð205; p-valueD0Ð098), we can reject the null hypothesis of no connection between the view that CG is a process that engenders the successful operations of companies (item (e) of Table 4) and the importance of risk-related information for investment decisions (item (a) of Table 5). Most respondents who recorded moderate to high scores for item (e) of Table 4 also recorded low to neutral scores on item (a) of Table 5. Notice that the relationship can be considered to be weak as depicted by the V statistic and we found no connection between the assertions in Table 4 and item (d) of Table 5. Form and location of risk disclosure As indicated in Table 5, few respondents recorded large scores for the assertions concerned with the appropriateness of the OFR as a vehicle for financial reporting (item (g)). It must be emphasized that the CG committees have placed much importance on the OFR since it is considered to ‘. . .provide a suitable conduit for raising confidence that the directors are applying a sound policy of risk management’ (CGHB, 1996, p. 11). Although compliance with such recommendations has not been as anticipated (Accountancy, 1998a), the finding that institutional investors do not put much emphasis on item (g) does not appear to give much credence to their approach. There is the view, however, that narrative disclosures such as those contained in the OFR, attract wide readership from private shareholders (see Bartlett & Chandler, 1997), and the Financial Reporting Standard 13 (in effect March, 1999) has sought to make more information on derivatives use, for example, available to users. However, the weak and perhaps, contradictory results for items (e) and (h) do not provide any obvious indication of the risk information that institutional investors may require. There is also some debate on the form that risk disclosure should take. For example, the ICAEW (1998) proposed a general statement of business

470

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risk,19 but also emphasized the importance of risk prioritization. This view is not supported by our results. Institutional investors generally hold a neutral view regarding the importance of a general statement on business risk (item (i)) despite the finding elsewhere (see Stooke & Stephen, 1996) that companies are providing a form of risk disclosure which relates to specific risk areas and how risks are managed. Under hypothesis H:6, we predicted that institutional investors would have a stronger preference for the disclosure of risk and that this preference would depend on the type of risk that is disclosed, its location and general form in financial reports (items (b), (g), (h) and (i) of Table 5). Table 5 indicates that the institutional investors’ appetite for increased risk disclosure is not strong but this was not expected to apply to all types of risk. To test whether the respondents attributed similar importance to the assertions, the Z statistic was applied to pair-wise combinations of items (b), (g), (h) and (i) in Table 5.20 The Z statistic was significant indicating that the respondents attributed different weights to those items. Institutional investors’ attitudes towards those disclosure considerations appear to relate to certain CG processes. The null hypothesis of no connection between the view that CG is a system by which companies are directed and controlled (item (f) of Table 4) and all risk should be disclosed with equal importance (item (h) of Table 5) is rejected (c24 D7Ð816; V D0Ð206; p-valueD0Ð098). Most respondents who recorded low scores on item (f) of Table 4 tended to record moderate to high scores on item (h) of Table 5. Our inability to statistically reject the null hypothesis for items (b) and (d) in terms of other CG processes suggests that there may be other factors determining respondents’ behaviour. But a p-value of 0Ð115 for a link between item (c) of Table 4 and item (h) of Table 5 is marginally significant. In brief, respondents’ perceptions of the form and location the information on risk disclosure can take are not associated with the CG frameworks. The null hypothesis of no connection between item (e) of Table 4 and item (g) of Table 5 can also be rejected (c24 D7Ð911; V D0Ð208; p-valueD0Ð095). Almost ninety percent (34 out of 39) of the respondents who recorded a score of 4 or 5 for this assertion also recorded the same set of scores for the adequacy of the OFR for risk disclosure (item (g), Table 5). Further, if those respondents agree that a CG process according to item (e) of Table 4 is useful, we could expect a connection between this assertion and the appropriateness of the OFR for risk disclosure (item (g); Table 5). The null hypothesis can easily be rejected (c24 D7Ð945; V D0Ð210; p-valueD0Ð094). However, only 19 out of 39 respondents who recorded a score of either 5 or 6 for item (e) of Table 4 recorded similar scores for item (g) of Table 5, but the tendency towards recording lower scores is strong. As such, those respondents (34 out of 39) who recorded a score of 4 or 5 regarding item (e) of Table 4 also recorded similar scores for item (g) of Table 5. Thus the majority of respondents hold a neutral to moderate view regarding both assertions.

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CONCLUSION AND POLICY RECOMMENDATIONS In this study, we have explored the existing implicit conceptual framework for internal control, risk management, and risk disclosure, as well as the emerging explicit conceptual framework. Our investigation has involved reviewing theory and practice as well as investigating the attitudes of UK institutional investors towards risk disclosure by UK companies. We have focused on the disclosure aspect of an emerging explicit conceptual framework for internal control, which we have developed from Turnbull. From this framework we have developed a conceptual framework for corporate risk disclosure detailing a variety of different elements which interrelate to create an ‘ideal’ risk disclosure framework. The ‘ideal’ framework was used to assess the views of a representative sample of institutional investors. For example, our results indicate that almost a third of the institutional investors agree that increased corporate risk disclosure would help their portfolio investment decision-making. There is also a strong indication from our findings that risk disclosure is an important and relevant issue within the agenda for CG reform, as certain significant links were established between the perceptions of CG and attitudes towards risk disclosure although such links tended to be moderate. Further, the attitudes of institutional shareholders appear to be associated with specific characteristics of the funds that are managed as well as with their investment horizons. For example, pension and insurance fund institutions seem more likely to agree with the view that a CG process should aim to encourage best practice within companies. Since companies privately disclose information to analysts and institutional investors that can affect share prices, it is possible that the information in financial reports is not sufficiently timely to have a strong effect on institutional investors’ day-to-day investment decisions. Furthermore, the literature considers the stock analysts’ role of processing both public and ‘private’ information to be of central importance in determining share prices. The private meetings facilitate a mechanism of feedback and control such that there is some sense of investee companies being held accountable for their performance (see Gaved, 1997; Barker, 1998). Thus, even if CG considerations may not appear too important to some respondents, there is some attempt to ensure that they are not caught out by unusual company performance which in turn would adversely affect portfolio performance. A number of other elements constituting an ‘ideal’ framework which came from our empirical findings lend themselves easily to policy recommendations. For instance, many of the respondents appeared keen to see some increase in the level of risk disclosure which can endorse recent efforts to formalize and encourage better internal control systems, as presented in Turnbull. Secondly, further developments in corporate risk disclosure should be nested within the agenda for CG reform. Our tests suggest that institutional investors perceive a strong link between corporate

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risk disclosure and the wider agenda for CG reform. Therefore, the findings validate the current approach adopted by Turnbull. Thirdly, it seems advisable to pursue individual and detailed reporting of risk information rather than a general statement of business risk, since institutional investors seem to find such reporting inadequate. Note however, that no link was found with those considerations and the CG framework. Perhaps the additional attachment of an executive summary, which is more general in nature, may satisfy those users who require less detailed information. This finding contradicts, to some extent, recommendations made by the ICAEW. Finally, our findings suggest that the current voluntary framework of disclosure should be maintained. This view may reflect the current stage in the evolutionary development of risk disclosure procedures, such that respondents may still regard those considerations to be fluid. Of course, if respondents can deal with certain types of risk on a costless basis, e.g. diversification, then they would have less desire for legislation. This last argument re-enforces the need for future research to explore the specific types of risk that institutional investors consider to be important in risk disclosure procedures. In brief, institutional investors’ attitudes towards CG are not excessively strong and the link between their perceptions of CG considerations and corporate risk disclosure is at best moderate. We believe that our sample is representative and that we can generalize our findings. However, as the standard deviations of the descriptive statistics are large it is clear that certain respondents would have dissenting views. For example, one respondent remarked: ‘. . .these [corporate governance] reforms are generally acceptable, though the most important point to emphasize is the maintenance of self regulation’. Also, when asked about general attitudes towards CG reform, the CG executive of a major pension fund remarked: ‘I support selfregulation as I believe it will have more positive impact . . . than legislation’. It seems that a voluntary framework is preferred for risk disclosure despite the weaker influence shareholders may have within a voluntary environment unless they have substantial investment in their investee companies. Some limitations of our results should be noted. Our results rely on a research methodology that by its nature presents a static picture of the state of emerging issues in CG. More in-depth case study research may indicate more of the dynamic nature of the risk disclosure issue. A case study approach will also provide the opportunity for further and closer investigation into the specific elements of our framework. For example, an examination of the decision-making processes of fund managers when identifying alternative stock investments against a background of the companies’ CG processes would be useful. We will continue to research this area in the future. Overall, we believe that our findings are informative and

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that they contribute to the current debate on the disclosure of corporate risk within UK companies. NOTES 1. Indeed, the Cadbury Committee specified that the guidance for directors should be designed by the accountancy profession in conjunction with representatives of preparers of accounts. The academic community was clearly dismissed at this stage of the proceedings. 2. We use the term risk to include both financial and non-financial risks but do not distinguish between specific types, e.g. interest rate risk, value-at-risk. This is in the spirit of the Turnbull Report which does not discuss risk according to type. Further, a recent survey also suggests that UK firms are adopting a unified framework for dealing with all types of risk (Financial Times Survey, 25th July, 1999) although the disclosure of risk according to type would provide useful information to external users of financial reports (see also note 6). 3. Internal control has been defined as ‘The whole system of controls, financial and otherwise, established in order to provide reasonable assurance of: effective and efficient operations; internal financial control, and; compliance with laws and regulations’ (see Rutteman, 1994, p. 1). 4. The Criminal Justice Act 1993, section (2)(a) defines inside information as having the following four characteristics: (i) it relates to particular securities or to a particular issuer of securities, and not to securities generally or to issuers of securities generally; (ii) it is specific or precise; (iii) it has not been made public, which would cover information provided to institutional investors in one-to-one meetings with the managers of the investee companies, and; (iv) if it were made public it would be likely to have a significant effect on the price of any securities. 5. Solomon & Solomon (2000) develop a ‘conceptual framework of conceptual frameworks’ in which they depict a continuum of conceptual frameworks which includes frameworks which make implicit systems explicit, inter alia. 6. For example, our study does not focus on the disclosure of specific risks, only whether there is a preference between types. This is because our primary aim was to focus on CG and how it set the context for issues such as corporate risk disclosure. We are grateful to an anonymous referee for pointing out that the disclosure of specific information on the different elements that drive company risk would be invaluable to fund managers in their stock selection and portfolio construction. This is an essential area that should be explored in future research. 7. Specifically, the sources were: (i) the National Association of Pension Funds Year Book (NAPF, 1997); (ii) the Investment Trusts and Closed End Funds Manual (1997); (iii) the Association of British Insurers List (1997); and, (iv) the Unit Trust Yearbook (1997). 8. The questionnaire that was distributed included risk disclosure as just one of a number of corporate governance issues. Therefore our research into corporate risk disclosure is couched firmly within the corporate governance debate. 9. The null hypothesis tested is that the samples of early and late responses come from identical populations with the same median. Here, late responses were considered to be those responses that were received over the second half of the time period of the survey. These two categories and the associated responses to all questions formed the basis for applying the Kruskal-Wallis (K-W) statistic. The computed K-W statistics were not significant which implies that the two samples could be aggregated. Throughout, we reject the null hypothesis if the probability (p-) value that is associated with a test statistic is less than 0Ð10.

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10. The test was performed using the five groups of institutional investors in Table 1 and the recorded scores (on the 7-point scale) for all assertions. 11. This can be inferred from the behavioural and accounting information literature concerned with participation and involvement in information systems initiatives. The evidence from this literature shows that a common reason for information systems failure is the poor level of communication between users and information systems’ staff (see Hunton & Price, 1994; Griffiths, 2000, for a review). 12. Davis-Friday et al. (1999) indicate that investors attribute more weight to retiree and other pension liabilities that are explicitly recognized in the body of the financial statements compared to related information that just disclose those liabilities. 13. The chi-square statistic (c2 ) is used to assess the significance of the differences among k groups that are independent. The reported statistics are based on the pooled recorded scores in order to ensure that the expected cell frequencies are not ‘too small’—a term which has been taken to mean that the expected frequencies should be no less than 5. Cochran (1954) suggests that this rule of thumb is too stringent and recommended that in cases where the degrees of freedom exceed one, no cell should have an expected frequency less than one and no more than 20% of the cells should have an expected frequency of less than 5. Slakter (1966) also shows that expected cell frequencies as low as one do not substantially affect the test. The pooling of frequencies can adversely however affect statistical inferences particularly when it is not based on economic grounds and/or was not contemplated at the research design stage (see also Everitt, 1977). This is because polling can adversely affect the randomness of the sample and result in a loss of information, for example. In any case, we pool the recorded scores such that a score of 4 is retained as a ‘neutral’ score and the other scores either side of it formed the other two groups. At a minimum our approach generally complies with Cochran’s suggestion. A further computation of that chi-square statistics for the 7-point (ungrouped) recorded scores suggests that the statistical inferences are not substantially different although the estimated p-values are much larger for the pooled results. Our reporting of the results also focus on the actual recorded scores on the 7-point scale. 14. Smith (1996b) shows that CalpERS targeted US firms when the level of institutional ownership was typically 60% or more. Some UK evidence indicates that one-third of the largest shareholders in the largest 150 UK companies hold single financial shareholdings of 10% or more (Gaved, 1997). Such shareholders may therefore be more proactive compared with those with smaller shareholdings. 15. Although on average the institutions held shares in companies for between 2 to 5 years (see Table 3), there was significant variation in their investment horizons (c28 D15Ð486; V D0Ð300; p-valueD0Ð050). In particular, 51Ð4% of the 35 pension fund institutions held shares in their investee companies for between 2 and 5 years. For investment trust institutions, 42Ð9% (6 out of 14) held shares for between 1 and 2 years and a further 42Ð9% held shares for between 2 and 5 years. Finally, 69Ð6% of insurance fund institutions (16 out of 23) held shares for between 2 to 5 years. 16. Section 459 of the Companies Act 1985 provides that a shareholder may apply to a court if a company’s affairs are being or have been conducted in a manner which is ‘unfairly prejudicial’ to the interests of that shareholder. Riley (1992) has considered the functions of Section 459, and its relationship with the wider tenets of the common law relating to companies. 17. In the case of Re Astec (BSR) plc (1998), it was argued that aggrieved shareholders had a legitimate expectation that the investee company should have complied with provisions of The Cadbury Code (1992) inter alia. The presiding judge rejected shareholders’ contention and suggested that it precluded the imposition of equitable considerations. The ruling ‘. . .seems at odds with expectations that institutional investors can perform a supervisory role in listed companies’. (Copp & Goddard, 1998, p. 278). Such discretion facilitates a potential flaw in voluntary disclosure. Thus although there may be a free

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flow of information when a company’s performance is satisfactory, such openness will be susceptible to reduction in times of underperformance. 18. The test statistics for the length of time the institutions themselves had been involved in fund management and the relevant assertions in Table 5 are as follows: Length of time c24 V p-value Table 5 Item (d) 8Ð458 0Ð213 0Ð076 Item (e) 10Ð584 0Ð242 0Ð032 Item (g) 13Ð119 0Ð270 0Ð010 Item (i) 7Ð905 0Ð207 0Ð095 19. This proposal suggested coverage of the following classes of risk disclosure: environment risk, process risk, and information for decision-making risk. 20. In fact, the Z statistic was applied to all pair-wise combinations of the items in Table 5. All pair-wise comparisons were significantly different except for that of items (d) and (h). Thus the respondents appear to place a similar weight on both items (p-value of 0Ð113), while attributing different weights to other combinations.

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