New study from CFA Institute emphasizes need to enhance disclosure of derivatives and hedging activities to bolster investor understanding of risk exposure and risk management
London, United Kingdom, 2013
The widespread use of derivatives for hedging activities among both financial and non-financial institutions is addressed in a new study by CFA Institute, which looks at 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 report, User Perspectives of Financial Instrument Risk Disclosures Under IFRS Volume II – Derivatives and Hedging Activities Disclosures, aims to inform the ongoing 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, and recent high profile losses show how claims of hedging can be misleading.1 As a result of 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: 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; and
- Disclosures should cover economic hedges: reports should go beyond disclosing accounting hedges and disclose information about all economic hedges.
Vincent Papa, CFA, one of authors of the report and director of Financial Reporting Policy at CFA Institute, commented: “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. 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 behoves 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 will 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.