Better Disclosure Needed of Derivatives and Hedging

Investors need greater disclosure of derivatives used for hedging activities at the companies in which they invest if they are to understand the corporations’ risk exposure, according to a new study.

The study, by the CFA Institute, examined the widespread use of derivatives for hedging activities among both financial and non-financial institutions along with the transparency of financial reporting for these activities.

The report argues that improving disclosures is crucial in allowing investors to make more informed decisions, and to ensure that company financial reports communicate key information regarding risk exposures and risk management more clearly.

The new report, User Perspectives of Financial Instrument Risk Disclosures under IFRS Volume II- Derivatives and Hedging Activities Disclosures, aims to inform the process of standard-setter reform of derivatives disclosures by highlighting the user perspective and to encourage companies to disclose useful information that may not be mandated. The use of derivatives for hedging activities is widespread among financial and non-financial institutions, the report noted, and recent high profile losses show how claims of hedging can be misleading.

After reviewing 30 annual reports of IFRS reporting companies and obtaining user feedback on these disclosures, the CFA Institute study recommends the following improvements:

• Improved presentation: Derivatives and hedging disclosures should be provided in an easily identifiable format, and integrated with other types of risk disclosures.

• More comprehensive quantitative risk disclosures: More detailed risk disclosures are needed to assist users in understanding hedged and un-hedged exposures.

• Improved communication of derivatives use and hedging strategies: Companies should adequately explain the nature and purpose of derivatives instruments used, making a clear distinction between derivatives used as accounting hedges, or economic hedges or trading activities.

• Improved communication of financial statement effects of hedging activities: Disclosures related to the impact of both fair value and cash flow hedges on the financial statements need to be improved so as to better illustrate the impacts of hedging activities on the balance sheet, income statement and cash flow statement.

• Disclosures should cover economic hedges: Reports should go beyond disclosing accounting hedges and disclose information about all economic hedges.

“Given the widespread use of derivatives, the broad point made from our analysis is that these instruments are prone to leaving investors with a lack of understanding of associated risks and unable to anticipate potential losses if they are not disclosed properly,” said Vincent Papa, CFA, one of the authors of the report and director of financial reporting policy at CFA Institute. “The quality of financial reporting for derivatives and hedging activities is important as it impacts investor understanding of risk exposure and risk management activities undertaken by companies. Poor disclosures can result in investors underestimating risk. Therefore, it behooves companies to make a concerted effort to improve disclosures. What we find in our study is that any notion that there are either excess or sufficient disclosures related to derivatives and hedging activities is not correct. On the contrary, what is needed is clearer and comprehensive disclosure around different types of derivatives and whether or not they are used as hedges.”

If adopted, the report’s recommendations could contribute to addressing a concern raised by global members of CFA Institute in its Global Market Sentiment Survey 2013, which highlighted that the disclosure/use of derivatives was one of the greatest issues of concern for CFA Institute members globally.