By Frank Byrt
Financial analysts say there's not enough detail being provided in reports from companies that use derivatives and hedging activities, which makes analysis of investments that rely significantly on such financial instruments riskier.
The CFA Institute, which represents chartered financial analysts (CFAs), released the results of an in-depth survey of its members that examined the quality of such reporting and what its members thought of current reporting standards and how they can be improved.
The report, User Perspectives on Financial Instrument Risk Disclosures under International Financial Reporting Standards: Derivatives and Hedging Activities Disclosures (Volume 2), released this month, specifically focuses on International Financial Reporting Standards Statement (IFRS) No. 7, Financial Instruments: Disclosures.
The survey asked users to rate the importance of, and their satisfaction with, credit risk, liquidity risk, market risk, and hedge accounting disclosures. Most of the 133 investors and analysts who participated in the survey found the current level of disclosure lacking.
"Effectively, there is a gap between users' view of the importance of derivatives and hedging disclosures and their satisfaction with such disclosures", the report said. "The feedback from users shows that they require multidimensional risk management information that is often not currently available, including disclosure of hedged versus unhedged risk exposures, details of hedging strategies, and the economic effectiveness of the chosen hedging strategies."
Respondents reported that they put particularly high importance on risk disclosures on derivatives, and moderate importance to hedge accounting disclosures. Most likely, the latter is due to the narrower focus of hedge accounting disclosures on derivatives that are hedge accounting designated as well as the potential lack of usefulness of current disclosure requirements. Sixty percent of respondents said they did not consider hedge accounting disclosures to be important, because the current format did not help them assess a company's risk.
The study said that CFAs found hedge accounting and disclosure requirements complex and confusing for users, and that the disclosures do not readily communicate key economic information, such as the nature of hedging strategies and their effectiveness. "The highly complex and arcane nature of hedge accounting rules, along with the partial information regarding hedging activities addressed by hedge accounting disclosures, does not help users to discern the entirety of risk management practices of reporting companies", the report said. "This explains the ratings of moderate importance of, and low satisfaction with, hedge accounting disclosures."
The overall results of a similar but more comprehensive 2007 survey are consistent with this latest study, as they show that about two-thirds of respondents consider derivatives and hedging disclosures as important, but very few, only about 28 percent, consider these disclosures to be of good quality, and 40 percent consider these disclosures to be of poor quality.
"Companies should go beyond providing the bare minimum of mandated disclosures", the study recommended. "As appropriate and where applicable, [companies] should fully comply with mandated disclosures. Companies should also voluntarily disclose all other information necessary for investors to fully comprehend the risk modification arising from the use of derivatives instruments", and the materiality assessment of derivatives should be based on loss potential of derivatives and not on reported fair values.
CFA Institute, the global association for investment professionals, has over 100,000 members who are chartered financial analysts.
Access the full report.