Derivatives disclosure in corporate annual reports: bank analysts' perceptions of usefulness

Abstract

Responding to mixed evidence on the decision-usefulness of annual report disclosures for derivative financial instruments to capital market participants, and concerns identified by practice, this paper examines usefulness in a direct study of user perceptions. Interviews with analysts from Australia's four major banks reveal essential usefulness, limited by the disclosures' failure to reflect companies' actual use of derivatives throughout the period, and inability of users to understand companies' off-balance sheet risk and risk management practices from information considered generic and boilerplate. The research complements and extends existing archival and survey research and provides new evidence suggesting low-cost ways for increasing usefulness. It supports the International Accounting Standards Board's disclosure recommendations in its recent Discussion Paper: A Review of the Conceptual Framework for Financial Reporting, but, at the same time, highlights that for these proposed measures to be successful in relation to IFRS 7, they may need to address other issues. The research increases knowledge of the informational requirements of lenders, an important class of financial information user, and supports calls from practice for companies to improve their disclosure of material economic risks.

Keywords:

• derivatives
• IFRS 7
• risk
• disclosure
• lenders
• users

Acknowledgements

We thank Neil Fargher for his helpful comments and suggestions. We are also grateful to Lee Parker, Sue Newberry, Carolyn Cordery, Jonathan Bader, and Tracy Artiach. We thank the guest editor, Mary Barth, and two anonymous reviewers.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. In May 2011, the Board relocated the disclosures about fair value measurements from IFRS 7 to IFRS 13 Fair Value Measurement (IASB 2011, paras. 91–99). References in this section are to disclosure requirements now in IFRS 13.

2. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability (IASB 2011, paras. 72–90).

3. Companies engage in selective hedging and, in doing so, they are effectively taking a view on whether market changes will benefit or disadvantage them (Bodnar and Gebhardt 1999, Géczy et al. 2007). An example of this is the Australian mining company, Sons of Gwalia Ltd. Prior to its collapse in 2002, none of its directors or management or the highly sophisticated institutional investors who held major positions in the company seemed to be aware that its hedging strategy was, in fact, highly speculative (Bartholomeusz 2004).

4. There are differing points of view as to what would improve the disclosure of derivatives. Johansen and Plenborg (2013), for example, recommended a reduction in the complexity of the notes required under IFRS 7. Others, in contrast, believed that complex transactions require more rigorous disclosure, not less (e.g. Ryan 2012). Preparers are expected to prefer disclosures that do not have high data processing costs (Elbannan and McKinley 2006). High-cost disclosures include quantitative information that is complex, makes use of estimates, and/or requires new information to be gathered and analysed.

5. Armstrong et al. (2010) estimated that nearly 95% of all capital raised by companies in 2006 was in the form of debt.

6. The Australian banking sector is dominated by four banks that also comprise four of Australia's top five listed companies by market capitalisation: Commonwealth Bank of Australia (A$145 billion), Westpac Banking Corporation (A$111 billion), Australia and New Zealand Banking Group (A$95 billion), and National Australia Bank (A$89 billion) (ASX 2015).

7. Yin (2009) recommended the creation of a case database and the clear provision of a chain of evidence, which others sometimes refer to as an audit trail (Shenton 2004). The chain of evidence provides assurance that the evidence originally collected connects with what is in the final report. In the opposite direction, it provides assurance that no original evidence has been lost through carelessness or bias. We follow Yin's (2009) recommendation.

8. Another alternative sometimes suggested is for companies to report average positions during the period, however, not all companies currently revalue their positions regularly (Matolcsy and Petty 2001) or update their hedge accounting, which might increase the cost of this approach.