Financial information risk, caused by false information in SEC filings, can lower a company’s share prices and increase the cost of obtaining funds for projects. Errors in financial reporting can affect earnings in either direction, but investors attach more importance to losses than gains. This risk also affects bond prices, increasing the interest rate companies must pay to receive funds.
The possibility that documents a company files with the Securities and Exchange Commission, or SEC, contain false information is a financial information risk. The greater this risk, the lower the price of the assets that depend on the financial health of a company. Therefore, the company must pay more to obtain funds for its projects. The concept of reporting risk illustrates the importance of integrity and reputation in business.
Errors in financial reporting can arise from lies or errors in accounting, and can affect earnings in either direction. If the errors are caused by incompetence, they should be equally prone to misrepresenting earnings as too high and too low. In the long run, average earnings should be close to the correct amount because mistakes cancel each other out. Despite this, financial information risk lowers a company’s share prices.
The adverse effect is due to investors’ perception of risk. While purely mathematical theories of risk treat gains and losses equally when calculating measures of volatility, the two are different in investor perceptions. People attach more importance to losses than to gains of equal magnitude. Behavioral theories recognize the increasing importance of losses, which explains the decline in prices caused by financial information risk.
The share price of any stock depends on the performance of the company issuing it. Therefore, the accuracy of a company’s financial reports is vital to investors trying to decide whether or not to buy 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 if there were a decrease in expected returns, and will be willing to pay less for the stock.
Bonus payments are specified in the bond indenture. Although the payment flow is not directly linked to the company’s earnings, the prices of a company’s bonds fall as a result of financial information risk. This is because investors do not trust the managers of a company with a high reporting risk, so they are not sure that the company can pay its debts.
These decreases in the prices of the bonds issued by the companies have the effect of increasing the price that companies must pay to receive funds. Companies use the sale of bonds to raise money to finance 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 information risk is similar to consumer credit scores in that it determines the interest rate the company must agree to pay to receive a loan.
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