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The possibility that the documents a company files with the Securities and Exchange Commission, or the SEC, contain false information is financial reporting risk. The higher this risk is, the more it lowers the price of the assets that depend on a company’s financial health. The company must thus pay more to get funding for its projects. The concept of reporting risk illustrates the importance of integrity and reputation in business.
Errors in financial reporting can arise from lying or mistakes in accounting, and they can affect earnings in either direction. If the errors are caused by incompetence, they should be equally likely to misrepresent earnings as too high and too low. In the long term, average earnings should be close to the correct amount because the errors cancel each other out. Despite this, financial reporting risk lowers a company’s stock prices.
The adverse affect is due to the risk perception that investors have. While purely mathematical theories of risk treat losses and gains equally when calculating measures of volatility, the two are different in the perceptions of investors. People attach more importance to losses than they do to gains of equal magnitude. Behavioral theories recognize the increased importance of losses, which explains the decrease in prices caused by financial reporting risk.
The price of the shares of any stock depends on the performance of the company that issues it. Thus, the accuracy of a company’s financial reports is vital to investors trying to decide whether or not to buy stock shares. The greater weight of losses relative to gains means that if there is an equal risk of both, investors will evaluate the stock as though there were a decrease in the expected returns, and they will be willing to pay less for the stock.
Bond payments are specified in the bond contract. Even though the payment stream is not directly tied to the company’s earnings, the prices of a company’s bonds drop as a result of financial reporting risk. This is because investors do not trust the managers of a company with a high reporting risk, so they are uncertain that the company will be able to pay its debts.
These decreases in the prices of bonds that are issued by companies have the effect of increasing the price that companies must pay to receive funding. Companies use the sale of bonds to raise money to fund their activities. If investors are willing to pay less to receive the same future payment stream, then, in effect, the company is paying a higher interest rate. In this way, financial reporting risk is similar to consumer credit scores in that it determines the rate of interest the company must agree to pay to receive a loan.