Sources of Information about Risk

Examining financial, operating, and other risks is an essential part of an analyst’s job. Here, we discuss sources of information about risk.

Financial Statements

A company’s financial statements provide useful indicators of financial, operating, or other risks. For example, leverage ratios obtained from a company’s financial statement data can be used to determine potential financial risk. Additionally, financial statements contain information about the variability of cash flows and earnings over time. We also saw that quantitative models such as the Altman’s Model usually rely on this accounting information.

Auditor’s Opinion(s)

The content of an auditor’s opinion is not a timely source of information about risk; therefore, its usefulness is limited. However, a discretionary change in auditor is a warning sign that an analyst should scrutinize.

Notes to Financial Statements

A company’s notes usually contain vital information that can guide users of the financial statements in understanding a company’s risk. Additionally, companies are required to make certain disclosures that can provide information about a company’s financial, operating, reporting, or other risks. For example, the management commentary provides management’s assessment of the critical risks faced by the company.

Other disclosures may include capital raising, non-timely filing of financial reports, management changes, or mergers and acquisitions. Analysts should scrutinize these disclosures as they can provide crucial important information in assessing risk.

Management Discussion and Analysis, or MD&A

Under IFRS, financial statements should have an MD&A section. The commentary enables the users of the financial reports to understand the company’s risk exposures, approach to managing risks, and effectiveness of risk management. The management commentary contains information about the nature of the business, objectives and strategies, resources, risks, and relationships, results and prospects, and performance measures and indicators.

Theoretically, companies should include principal risks that are unique to the business as opposed to risks faced by most businesses in their management commentary. However, discussion of generic risks and “boilerplate” language usually makes this information of low usefulness.

SEC in a Form 8-K and NT

Disclosures on specific events such as capital raising, non-timely filing of financial reports, management changes, or mergers and acquisitions contain information relevant to risk assessment.

The SEC form 8-K and ‘NT’ is filed when a firm in the United States is unable to file the required reports on time. These delays could be due to accounting difficulties arising from internal controls, the lack of adequate financial staff, or an accounting fraud that requires further examination. Therefore, such filings typically signal problems with the financial reporting quality.

Financial Press

The initial information about accounting irregularities may come from a news article. Analysts should further investigate this by using definitive sources such as regulatory filings to confirm any accounting and financial disclosures. Further, they should seek supporting information from other sources, where available. This ensures that the information revealed has merit and ascertains the extent and impact of the irregularity.

Question

Which of the following is least likely a source of information about risk?

      A. Management commentary.

      B. Auditor’s report.

      C. Letter from management.

Solution

The correct answer is C.

Sources of information about the risk of business include financial statements, auditor’s reports (auditor’s opinion(s)), notes to financial statements, management commentary or MD&A, and the financial press. Most annual reports have a letter from the management, which contains a summary of company operations. However, this letter is unlikely to provide information about a company’s risk in this context.

Reading 15: Evaluating Quality of Financial Reports 

LOS 15 (m) Describe sources of information about risk.