Why do managers disclose risks accurately? Textual analysis, disclosures, and risk exposures

Abstract

I provide an economic model that justifies using bag-of-words, topic modeling, and machine learning techniques to measure firms’ risk exposures using the percentage they allocate to each risk in their financial statements. The model provides a theoretical set of sufficient conditions under minimal assumptions that make managers optimally disclose risk accurately and give more space to the most critical risks. I document that the SEC Regulation satisfies this set of sufficient theoretical conditions and induces rational managers to disclose risks truthfully.