Financial risk and the measurement of risk modification
Faculty Advisor: Trevor S. Harris
This dissertation is an inquiry into the reporting of financial risk. The central research questions are: (1) are current public reports sufficient to measure financial risk? and (2) what additional information could assist financial statement users to assess financial risk? The specific risk measured is interest expense defined as 'line item interest' reported in annual income statements. Two information sets are used to explain interest expense: (1) public reports and (2) private reports. The public reports consist of audited annual financial statements and Securities and Exchange Commission (SEC) filings. The private reports consist of survey responses from a sample of SEC registrants. The information sets were used to estimate interest expense. These estimates were not significantly different. The estimates of interest expense were decomposed into fixed rate, variable rate, and derivative components. The fixed rate and variable rate components differed significantly. Contrary to institutional concerns, derivatives were not found to be in wide use. The private reports reflected a higher degree of precision in quantifying the impact of derivatives. Other financing activities were identified in the course of examining public reports and appeared to be firm specific. The standard deviation of the variable interest and derivatives components appeared high. This supports the need for improved disclosure on other activities and these two components. The differences between the estimated interest and line item interest were examined for association with explanatory variables for measurement uncertainty. Estimation improvements could arise from firms supplying detailed information on: (1) effective yields on debt; (2) fixed rate refinancing activity; (3) derivatives; and (4) by adopting a modified form of the Schedule IX report for variable rate borrowings. The information sets were used to predict future interest expense. Forecasting improved with the inclusion of a measure for risk modification activities. For both information sets, forecasting was less successful for firms where interest was 'underestimated.' These findings lead to potential improvements in the report of financial risk and the identification of roles for the auditor in confirming the report.