SEC Market Risk Disclosures: Implications for Judgment and Decision Making

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SYNOPSIS: In this paper, we draw on Judgment and decision-making research to examine the behavioral implications of the SEC's Financial Reporting Release No. 48 on market risk disclosures. While these disclosures have been examined using archival data, no research has investigated how these disclosures might-affect individual users of financial statements. The purpose of our paper is to draw on research in the judgment and decision-making arena to identify and analyze the behavioral implications of the new risk disclosures. We offer three conclusions. First, FRR No. 48 users may have more complex evaluations of risk than perhaps anticipated by the SEC. Second, the flexibility accorded firms in FRR No. 48 will adversely affect users' risk judgments. Third, because the Release does not require disclosure of certain quantitative information that is important to risk assessments, inappropriate risk assessments may result. We believe our insights can help others conduct research in this important area and can help the SEC when they revisit the disclosure requirements in FRR No. 48.

INTRODUCTION

In 1997, the Securities and Exchange Commission (SEC) issued Financial Reporting Release No. 48, Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative In formation about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments (FRR No. 48). FRR No. 48 requires that companies disclose both qualitative and quantitative market risk information for risks of loss arising from adverse changes in interest rates, foreign currency rates, commodity prices, and equity prices. This reporting requirement is one of the few that requires companies to disclose forward-looking information about risk.

Understanding how these risk disclosures are likely to be interpreted by financial statement users is important because risk disclosures are not always interpreted as intended (Slovic 1987). Research in many domains documents the difficulties in communicating risk information (Fischhoff et al. 1998). Because prior research shows that risk perceptions influence behavior (Slovic et al. 1980; Viscusi et al. 1986), unintended interpretations of the FRR No. 48 risk disclosures could adversely affect investor and analyst judgment and decision-making (e.g., valuation judgments; buy/sell/hold decisions).

In this paper, we draw on judgment and decision-making research to examine two related issues. First, we summarize research from other domains that addresses how people perceive risk and conjecture as to how FRR No. 48 users might think about risk. Second, we examine how FRR No. 48's reporting requirements could adversely affect users' perceptions of the riskiness of companies' financial and derivative instruments. While existing research documents incidents of noncompliance with FRR No. 48 (Elmy et al. 1998; Roulstone 1999), we focus primarily on how the design of the FRR No. 48 disclosures (rather than noncompliance with them) causes judgment difficulties. [1] Throughout the paper, we draw on actual disclosures to illustrate our points about FRR No. 48. The purpose is to provide a descriptive understanding of behavioral implications of the new risk disclosures so that other researchers may draw on our insights when conducting research in this area. Our scholarly insights also could be used as input when th e SEC revisits the disclosure requirements. Finally, companies can use our insights to better understand the possible behavioral implications of their risk disclosures.

We draw three conclusions in the paper. First, we conclude FRR No. 48 users may have more complex evaluations of risk than perhaps the SEC anticipated. Psychology research indicates that when judging risk, individuals often consider additional risk factors beyond those in the SEC's risk disclosures. …