Are Risk Disclosures in Financial Reports Informative? A Text Mining Analysis

The Securities and Exchange Commission (SEC) has been requiring listed companies to delve into the factors that make them speculative or risky in the risk factor section of their annual Form 10-K reports since 2005. While other corporate disclosures provide quantitative financial data, these risk factors offer investors a qualitative summary of potential adverse events in the form of text. These textual disclosures are crucial for shareholders and investors to understand a company’s business environment and potential risks.

There has been ongoing debate about whether the risk factors disclosed in Form 10-K reports are truly informative. Critics have long argued that these risk factors are often generic, boilerplate, and lack substantial information. Two main theories contribute to this criticism. On one hand, the “litigation shield” hypothesis suggests that by warning investors about risks in advance, companies may protect themselves against legal action. On the other hand, the “disclosure overload” theory posits that companies may include so much information that investors struggle to extract meaningful insights.

To explore the informativeness of these risk disclosures, a recent study employed text mining methods to analyze the risk factors reported in 14,089 Form 10-K statements from 1,685 financial firms between 2006 and 2022. The study specifically focused on the subprime crisis as a real-risk event to test the validity of these disclosures. The results revealed that during the subprime crisis, firms tended to disclose risks in more specific and negative terms, reducing the use of generic language. Additionally, the language used in risk disclosures aligned with the actual risk profile before, during, and after the crisis.

Interestingly, the study found that institutions that failed during the subprime crisis disclosed more risks related to the event in a more negative tone compared to institutions that survived. These findings offer valuable evidence that the risk factors disclosed in Form 10-K reports are indeed informative and not mere boilerplate text. This research sheds light on the importance of qualitative risk disclosures in financial reports for investors and stakeholders to make informed decisions.