‘Real Effects’ of COVID-19 Risk Factor Disclosures

Item 503(c) of the United States Securities and Exchange Commission’s (SEC’s) Regulation S-K requires companies to disclose the ‘most significant’ factors that affect them in their risk factor disclosures made in Item 1A of their annual or quarterly SEC filings (SEC, 1998, 1999). Item 503(c) states that each risk factor should be set forth under a heading that adequately describes the risk and risks that could simply apply to any company should be avoided. Companies usually engage in a company-specific discussion on only some of the risk factors (hereafter referred to as ‘specific risk factors’) and not on others (hereafter referred to as ‘general risk factors’), thus creating a potential for biases in what investors and other stakeholders can take away from these disclosures about a company’s overall risk profile (Bao and Dutta, 2014; Campbell and others, 2014; SEC, 2016). Companies are also known, at times, to give a lengthy boilerplate explanation of relevant risk factors (Beatty and others, 2019).

Prior to COVID-19 pandemic, companies discussed risk factors such as liquidity, competition, etc. as part of their Item 1A disclosures. The current pandemic has resulted in the COVID-19 risk factor (hereafter referred to as the ‘C19 risk factor’) being widely discussed as part of companies’ Item 1A risk factor disclosures. Specifically, the C-19 risk factor can have an effect of decreasing the perceived likelihood of other significant risks disclosed by a company in its Item 1A disclosures if the company engages in a lengthy company-specific discussion on this risk factor, thus making it more salient compared to the others that are discussed more generally. However, these other risks disclosed were always relevant to the company’s risk profile, and the pandemic may have actually exacerbated them (Hope and others, 2016).

Real effects of C-19 risk factor reporting

In my newly published research paper titled ‘Are Firms Biasing Stakeholder Expectations by Attributing Prior Poor Performance to COVID-19?’, I predict that US publicly traded companies with prior poor performance that were hardest hit by the pandemic had incentives to disclose the C-19 risk factor in a certain company-specific manner that, in turn, affected stakeholder perceptions of other significant risks that were already negatively affecting the performance of these companies. My empirical results are consistent with the aforementioned prediction. Specifically, I find that market reactions to Item 1A risk factor disclosures were significantly more positive for the hardest hit C-19 companies with prior poor performance if they disclosed the C-19 risk factor in a certain company-specific manner compared to those that didn’t. Thus, I conclude that the true risk profile of the former group of companies was obfuscated to some extent, thus preventing their investors from making normative risk assessments.

Using the meta-theoretical framework of the elaboration likelihood model (Petty and Cacioppo, 1986a, 1986b), I also explain how, if the information source (here, risk factor disclosures) quality and credibility is negatively affected by the C-19 risk factor being more representative than other general but significant risk factors, then investors would end up making biased evaluations of a company’s risk profile. Unbiased and high-quality evaluations of a company’s risk profile would need its risk factor reporting to be of quality and credible (Petty and others, 1995; Wegener and others, 1994).

Conclusion

My study provides timely evidence to stakeholders and regulators about how C-19 risk factor disclosures can affect the way a company’s performance and risk profile are judged by the market. My inferences suggest that there are ‘real effects’ of C-19 risk factor reporting as it may affect resource allocation by investors in the economy by leading to (continued) investments in poorly performing companies due to an underestimation of the true risks impacting their businesses. I propose a solution to this issue that involves companies presenting risk matrices accompanying their Item 1A risk factor disclosures so that the relative likelihood and impact of a risk factor can be assessed by stakeholders.

Hrishikesh Desai is an Assistant Professor of Accounting at Arkansas State University.