Corporate Governance, Risk Disclosure Practices, and Market Liquidity: Comparative Evidence from the UK and Italy

• Date: 01 July 2015
• Author: Tamer Elshandidy,Lorenzo Neri
• DOI: http://doi.org/10.1111/corg.12095
• Published date: 01 July 2015

Corporate Governance, Risk Disclosure

Practices, and Market Liquidity:

Comparative Evidence from the UK and Italy

Tamer Elshandidy* and Lorenzo Neri

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paperexamines the inf‌luence of corporate governance on risk disclosure practices in the UK

and Italy and also studies the impact of those practices on market liquidity.

Research Findings/Insights: We f‌ind that governance factors principally inf‌luence the decisions of UK (Italian) f‌irms over

whether to exhibit risk information voluntarily (mandatorily) in their annual report narratives. When we distinguish

between f‌irms with strong and weak governance (in terms of board eff‌iciency) in each country, we f‌ind that the factors that

affect mandatory and voluntary risk disclosure appear to be driven more by strongly governed f‌irms in both countries.

Furthermore, strongly governed f‌irms in the UK tend to provide more meaningful risk information to their investors than

weakly governed f‌irms. In Italy, however, we f‌ind that strongly rather than weakly governed f‌irms exhibiting risk infor-

mation voluntarily rather than mandatorily improves market liquidity signif‌icantly.

Theoretical/Academic Implications: This paper emphasizes the importance of distinguishing between mandatory and

voluntary risk disclosure when studying the impact of corporate governance. Our f‌indings differ acrossstrongly and weakly

governed f‌irms, in terms of both the factors that inf‌luence risk disclosure practices and the exact informativeness of those

practices.

Practitioner/Policy Implications: The results support the current regulatory trend in risk reporting within the UK that

emphasizes the importance of directors and encourages rather than mandates risk disclosure. However, the results gener-

ally signal a need for further improvements in the Italian context. Our evidence also supports the value of the conf‌idence in

the UK governance system, compared to that in Italy, which motivates British f‌irms to provide highly informative risk

information more often than Italian f‌irms.

Keywords: Corporate Governance, Automated Textual Content Analysis, Mandatory and Voluntary Risk Disclosure,

Usefulness of Risk Disclosure

INTRODUCTION

Asignif‌icant body of literature demonstrates that the

monitoring function of corporate governance signif‌i-

cantly inf‌luences the propensity for better disclosure

(Bushman & Smith, 2001; Kanagaretnam, Lobo, & Whalen,

2007; Lim, Matolcsy, & Chow, 2007; Patelli & Prencipe, 2007;

Sloan, 2001). However, little work has either examined the

relationship between risk reporting and corporate gover-

nance or studied how risk information inf‌luences market

liquidity. Studying how corporate governance inf‌luences a

f‌irm’s decision over whether to provide risk information is

becoming increasingly important since this information

might be useful for investors seeking to reduce information

uncertainty by enabling them to estimate an appropriate

discount rate to use in their valuation models (e.g.,

Miihkinen, 2013). Investors might incorporate risk informa-

tion into their price decisions and thus improve the market

liquidity by reducing information asymmetry (e.g.,

Campbell, Chen, Dhaliwal,Lu, & Steele, 2014). Furthermore,

Jorgensen and Kirschenheiter (2003) theorize that, if a f‌irm

chooses not to disclose risk information, it will have a higher

risk premium than f‌irms providing such information, and

that premium is likely to be higher in the presence of man-

datory risk disclosure than voluntary risk disclosure.

*Address for correspondence: Tamer Elshandidy, School of Economics, Finance and

Management, University of Bristol, The Priory Road Complex, Priory Road, Clifton

BS8 1TU, UK. Tel: +44(0) 117 39 41483; E-mail: Tamer.Elshandidy@bristol.ac.uk.

Corporate Governance: An International Review,

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12095

2015, 23(4): 331–356

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While the relevant UK literature focuses on investigating

the impact of either f‌irm characteristics (e.g., Linsley &

Shrives, 2006) or ownership and board characteristics (e.g.,

Abraham & Cox, 2007) on aggregate risk disclosure, the

relevant Italian literature (e.g., Beretta & Bozzolan, 2004)

studies the impact of certain f‌irm characteristics (i.e., f‌irm

size and industry type) on the quantity and quality of aggre-

gate risk disclosure. Rather than relying principally on

aggregate risk disclosure, our paper distinguishes between

mandatory and voluntary risk disclosure since there is a

large body of accounting literature that has emerged from

Dye (1986, 1990), such as Bagnoli and Watts (2007), Butler,

Kraft, and Weiss (2007), Einhorn (2005), and Gigler and

Hemmer (1998), showing that increasing attention is being

given to the importance of distinguishing between the two

forms of disclosure as each has different underlying incen-

tives. Similarly, Jorgensen and Kirschenheiter (2003, 2012)

theorize as to how mandatory and voluntary risk disclosure

impact differently on the market indicators (e.g., market

liquidity). The most recent research on the usefulness of risk

disclosure suggests that investors incorporate risk informa-

tion in a way that either affects their perceived risk (Kravet

& Muslu, 2013) or inf‌luences decisions on stock prices

by improving market liquidity (Campbell et al., 2014;

Miihkinen, 2013).

Despite the importance of this distinction that has been

highlighted by the above-mentioned theoretical research,

empirical research on risk disclosure (e.g., Abraham & Cox,

2007; Campbell et al., 2014; Kravet & Muslu, 2013; Linsley &

Shrives, 2006) neither distinguishes mandatory from volun-

tary risk disclosure in observing the factors that inf‌luence

that disclosure, observes how corporate governance inf‌lu-

ences the observed risk disclosure practices over time, nor

observes the usefulness of each form of risk disclosure.

Additionally and more importantly, prior research does not

examine the extent to which observed usefulness (i.e.,

market liquidity) is conditional on the strength of a f‌irm’s

corporate governance.

Our paper addresses this gap by studying the following

two questions: (1)whether, and if so how, corporate governance

characteristics, including board size, non-executive directors,

independent non-executive directors, duality of chief executive

off‌icer (CEO) and chairman, dividend-yield, concentrated owner-

ship structure, and audit quality, inf‌luence mandatory and vol-

untary corporate risk disclosure in the UK and Italy; (2) the extent

to which risk information – either mandatorily and/or voluntarily

provided – reduces information asymmetry, by improving the

market liquidity between market participants in each country.

In this paper, mandatory risk disclosure is takento mean risk

information that f‌irms exhibit within, or in excess of but still

related to, the risk regulations (under International Financial

Reporting Standards (IFRS), UK Generally Accepted

Accounting Principles (GAAP), and Italian GAAP) that set

the minimum requirements. We def‌ine voluntary risk disclo-

sure as any other information about risk appearing in the

narrative sections of corporate annual reports. Both types of

risk disclosure are measured by the number of sentences

providing risk information, calculated using automated

textual content analysis, which is increasingly being em-

ployed in the accounting and f‌inance literature (Kearney &

Liu, 2014; Li, 2010a, 2010b).

Our paper contributes to the prior literature calling for a

multi-country study of corporate governance characteristics

(e.g., Judge, 2011) as such multi-element measures of corpo-

rate governance are an appropriate means of capturing cor-

porate governance effectiveness (e.g., Donnelly & Mulcahy,

2008). It also contributes to the strand of research calling

for the investigation of risk reporting incentives across

countries (e.g., Dobler, 2008; Linsley & Shrives, 2006). The

prior literature on cross-national comparison (e.g., Gordon,

Greiner, Kohlbeck, Lin, & Skaife, 2013; Moscariello, Skerratt,

& Pizzo, 2014) emphasizes the importance of the underlying

differences in cultural, economic and institutional circum-

stances when investigating factors that inf‌luence accounting

practices. The extant evidence on cross-country risk report-

ing (Dobler, Lajili, & Zéghal, 2011; Elshandidy, Fraser, &

Hussainey, 2014) emphasizes the importance of observing

differences in risk reporting practices and investigating the

specif‌ic factors that explain such variation. Neither Dobler et

al. (2011) nor Elshandidy et al. (2014), however, investigate

how corporate governance inf‌luences risk reporting

practices.

The comparison of the inf‌luence of corporate governance

on risk reporting practices between the UK and Italy is

useful since the two are widely seen as representative of

contrasting models of European culture and economic and

regulatory milieus (Cooke & Wallace, 1990; Nobes, 1998;

Nobes & Parker, 2010). In particular, these two countries

offer unique sets of characteristics and have very different

legal origins, the UK having a strong common-law tradition,

and Italy one of civil law. Further differences in institutional

settings include the large stock market, dispersed corporate

ownership, high level of investor protection and stronglegal

enforcement in the UK compared with a less developed

stock market, concentrated ownership, low level of investor

rights and weak legal enforcement in Italy (La Porta,

Lopez-de-Silanes, Shleifer, & Vishny, 1998). According to

Ball, Kothari, and Ashok (2000), in common-law countries

the shareholders alone elect the members of the governing

board, payouts are less closely linked to current-period

accounting income and disclosure is a more likely solution

to the information asymmetry problem.

Our f‌indings suggest that the inf‌luence of governance

characteristics on risk disclosure practices in UK and Italian

f‌irms varies according to the strength of governance within

each country, and also that the predominant effects are due

to strongly governed f‌irms. Furthermore, our f‌indings

support the idea that risk disclosure in the narrativesections

of annual reports conveys credible information in the UK,

but is less informative and can be characterized more as

boilerplate disclosure in Italy. Our results support the UK’s

current regulatory trend, which emphasizes the importance

of directors for stimulating f‌irms to reveal more risk infor-

mation, and encouraging rather than mandating risk disclo-

sure. However, the results generallysignal a need for further

improvement in the Italian context. Our evidence also sup-

ports the value of the conf‌idence in the UK governance

system, compared to that in Italy, which motivates UK f‌irms

to provide more highly informative risk information than

Italian f‌irms provide.

The following section of the papersets out the background

to our research, synthesizes the prior literature and develops

CORPORATE GOVERNANCE

© 2014 John Wiley & Sons Ltd

Volume 23 Number 4 July 2015

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