Do Mandatory Risk Factor Disclosures Predict Future Cash Flows and Stock Returns? Evidence from Tax Risk Factor Disclosures

• In Event: DSFI no. 1

Abstract

Prior research finds that mandatory risk factor disclosures are informative to investors in that they increase their assessments of firm risk (Kravet and Muslu 2013; Campbell, Chen, Dhaliwal, Lu, and Steele 2014). However, the literature is silent as to whether these disclosures provide information about future cash flows and, ultimately, their effect on firm value. We address this gap in the literature by examining the association between Form 10-K risk factor disclosures and future cash flows and stock returns. We focus on the setting of taxes because we can identify the specific income statement and cash flow statement line items to which these risks relate. We offer two main results. First, we find that tax risk factor disclosures are positively associated with future cash flows. This finding suggests that, on average, managers are taking healthy levels of risk as risky tax positions are rewarded with future tax savings. Second, we find that investors do not fully incorporate this relation into stock prices at the time of the risk factor disclosure. Instead, investors do not fully price this information until the implications of risk factor disclosures on future cash flows are more saliently disclosed at the end of the following year. Overall, our results suggest that risk factor disclosures not only provide information about the risk of the firm, but also provide information about future cash flows of the firm. On average, the outcomes from these risks taken by managers are value increasing, and investors do not fully incorporate this into stock prices.

Author

• Anne Ehinger, University of Georgia