Derivative Disclosures Research Articles

On the determinants of derivatives disclosure – an emerging markets perspective

Purpose To ascertain how JSE-listed companies use derivatives to hedge. Aim Determine whether JSE-listed companies apply established rationales for corporate hedging practices. Design/Methodology/Approach This empirical study uses data from the Johannesburg Stock Exchange (JSE), South Africa, as a proxy for emerging markets. Main findings Binomial logistic regression, applied to the 200 largest non-financial firms (by market capitalization) on the JSE from 2005 to 2017, indicates that larger firms, higher leveraged firms, ones with better growth prospects, and less information asymmetry between directors and management are more likely to use derivatives to hedge. Practical implications The findings suggest that some traditional determinants for corporate hedging practices apply in an emerging market context, but local conditions still remain an important consideration. Novelty/Contribution By confirming the applicability of traditional hedging theories in an emerging market context, the study extends the theoretical understanding of corporate risk management. It supports the notion that established hedging rationales, such as reducing financial distress costs and addressing information asymmetry, are relevant across different economic contexts.

Derivative disclosures and managerial opportunism

AbstractDerivatives are increasingly used by managers not only to hedge risks but also to pursue nonhedging activities for fulfilling opportunistic incentives. The Statement of Financial Accounting Standards No. 161 (SFAS 161) requires firms to disclose their objectives and strategies for using derivatives. Using the adoption of this standard, we examine whether and how derivative disclosures influence managerial opportunistic behavior. We employ insider trades and stock price crash risk to capture managerial opportunism. Applying a difference‐in‐differences research design with hand‐collected data on derivative designations, we find that, after the implementation of SFAS 161, derivative users that comply with SFAS 161 experience a significantly greater decrease in both insider trades and stock price crash risk, compared with a matched control sample of nonderivative‐users. We further provide evidence to suggest that SFAS 161 curbs managerial opportunism via reducing information asymmetry between corporate insiders and outside investors and enhancing the effectiveness of derivative hedging.

The derivatives debate: do derivatives disclosures add value during difficult times?

PurposeThis study investigates whether the disclosure of derivatives is value relevant in emerging markets and evaluates the effects of the 2008/2009 global financial crisis on the value relevance of derivative disclosures.Design/methodology/approachPanel regression models using sub-samples and a crisis interaction term were applied to a sample of the 200 largest non-financial firms by market capitalization listed on the Johannesburg Stock Exchange (JSE) from 2005 to 2017 to assess the consequences of the financial crisis.FindingsThe results suggest that the disclosure of derivatives is value relevant in the hitherto understudied context of emerging markets. The 2008/2009 financial crisis had a significant impact on derivatives use and the value relevance of derivatives disclosure by JSE-listed companies.Practical implicationsCompanies should reconsider both how they employ derivatives as part of their risk management practices and how they communicate derivatives use to stakeholders in the financial statements. The findings facilitate a comparative analysis across various market contexts by researchers and assist investors in better decision-making. The findings can influence regulatory practices and can help standard setters to review disclosure requirements.Originality/valueThe benefits of corporate hedging were studied from an emerging market perspective, using an original dataset and approach to investigate the effects of international financial volatility on emerging markets. The authors tested whether companies are valued differently, based on their disclosure of the use of derivatives in the financial statements, and the effect of the financial crisis on the value relevance derivatives disclosures.

Early evidence of the effect of ASU 2017‐12 on derivative disclosure compliance

AbstractThe growth in the use of financial derivatives for a variety of purposes has caused increased complexity in derivative reporting standards. As such, financial statement users have asked the Financial Accounting Standards Board to update guidance to increase transparency while preparers seek clearer guidance on the application of standards and a broadened scope of hedge accounting. The most recent derivative accounting guidance update, ASU 2017‐12 (Topic 815), broadens instruments that qualify for hedge accounting, expands allowable hedge accounting techniques, and reduces reporting requirements by omitting the reporting of hedge ineffectiveness. While these changes might simplify reporting requirements, there is the risk that the omitted disclosure would have been relevant to investors’ decision‐making. In this paper, we examine how derivative disclosure practices changed following the implementation of ASU 2017‐12. Using a hand‐collected sample of twenty S&P 500 firms, we calculate a derivative disclosure compliance (DDC) score and find that, on average, DDC scores decreased following firm adoption of ASU 2017‐12. This decline was realized for firms regardless of the notional amounts of derivative instruments held. However, the decline was not significant for early adopting firms suggesting a motivation for completeness by select firms. Our initial findings indicate that the update on derivative disclosures is not being uniformly applied potentially lessening its value to users. As a result, further updates may be necessary.

Derivative Instruments on Emission Allowances: factors Influencing Disclosure in Portuguese Companies

Purpose: This article aims to analyze the degree of disclosure of information on Derivative instruments on Emission Allowances, analyzing the degree of compliance with the underlying accounting regulations, and their determinants factors. Theoretical framework: With the evolution of the European Union Emission Trading System (EU ETS), which foresees that the emission licenses will no longer be allocated free of charge and will be negotiated at auction, it is expected that there will be an increase in the trading of derivative instruments on licenses, to cover any risks of future price fluctuations, and therefore an increase in disclosure in this area. Design/methodology/approach: The methodology used in this study was the content analysis of the Reports and Accounts of the sample entities over a 12-year period, based on the creation of disclosure indexes for the topics under analysis. This is a longitudinal study that seeks to address possible changes in the behavior of companies' reporting practices in the periods 2008-2102 and 2013-2020 (corresponding to the 2nd and 3rd phases of the EU ETS). Findings: The results of the derivative disclosure index, in general, is higher (average IDGD is 0.81), although it is still very low when it specifically refers to derivative instruments for risk hedging related to emission licenses (IDL_LE = 0.11). Contrary to expectations, not only companies do not use this type of instrument to cover the risk of fluctuations in the price of licenses, nor is the change in the behavior of companies between the 2nd and 3rd EU ETS periods significant. Regarding the explanatory factors studied, there is only a statistically positive correlation between the disclosure index and profitability. Research, Practical & Social implications: The study will focus on a sample of companies operating in Portugal, which are part of the National Emission Licensing Plan (PNALE) I and II. The literature is silent on previous studies related to disclosure on emission allowances derivatives, so our study represents a contribution to the advancement of literature in this area. Originality/value: As far as we know, previous studies related to the disclosure of derivative instruments for gas emission licenses are non-existent, so our study represents a contribution to the advancement of the literature in this area.

Regulatory interventions in response to noncompliance with mandatory derivatives disclosure rules

We investigate regulatory actions in response to violations of mandatory derivatives disclosure rules (SFAS 161) and the outcomes of these regulatory interventions using a hand-collected sample of derivatives disclosures. Derivatives are used by nearly two-thirds of U.S. nonfinancial firms, and they are one of the most complex types of financial contracts. Consequently, inadequate derivatives disclosures could pose significant challenges to financial statement users in assessing the risk and financial health of enterprises. First, we document that firms with high proprietary and agency costs are less likely to comply with SFAS 161. Next, by examining derivatives-related SEC comment letters, we further show that this noncompliance significantly increases the likelihood of receiving a comment letter. We also find that comment letter resolution is longer for firms with strong proprietary motivations than for those with strong agency incentives. Finally, we find that compliance with regard to derivatives disclosures following comment letter resolution improves for firms with high agency costs but not for firms with high proprietary costs. Collectively, our results imply that, when derivatives-related proprietary costs are high, benefits of noncompliance likely outweigh the costs. Moreover, the SEC’s review effectiveness depends crucially on whether firms’ initial motivation for noncompliance is proprietary versus agency.

Do enhanced derivative disclosures work? An informational perspective

AbstractFirms use derivatives both for hedging and nonhedging purposes. The Statement of Financial Accounting Standards No. 161 (SFAS 161) requires firms to disclose the purposes of their derivatives usage, thereby helping investors to evaluate the effects of derivatives usage on firm performance. Using a hand‐collected sample of US listed firms and a difference‐in‐differences research design, we find that, compared with nonderivative‐users, derivative‐users compliant with SFAS 161 experience a significantly greater reduction in stock illiquidity and the probability of informed trading in the post‐SFAS 161 period, and such impact is evident only for firms with a high degree of investor attention.

Regulatory Interventions in Response to Non-Compliance with Mandatory Derivatives Disclosure Rules

Regulatory Interventions in Response to Non-Compliance with Mandatory Derivatives Disclosure Rules

Barriers to Derivative Accounting Disclosure: The Case of Vietnamese Firms

This paper explores the barriers to derivative accounting disclosures in Vietnamese companies and ranks their relative importance for effective and efficient remedies. The Delphi technique was applied to get agreement of panel of experts on the measurement of factors hindering disclosure. Unstructured questionnaires were first sent to twelve experts who had both practical experience and academic knowledge in the field to get ideas on the obstructions to derivatives disclosure. The structured questionnaire was designed to get their agreement on barriers to derivative accounting disclosures. The data analysis with mean, median, mode, standard deviation, and quartile has been implemented to ensure the unanimity. Market-related factors, legislation, accountants' attributes, managers' attributes, information technology and communication, and on-site training were the six major obstacles agreed upon by the experts during their in-depth interviews. Then, these factors were ranked by applying the analytical hierarchy process (AHP). The findings confirmed the priority of information technology and communication, which held the greatest weight. Legislation ranked second, followed by market-related factors and on-site training, which explained the impediments to derivatives disclosure. Managers' and accountants' attributes had the least contribution to the barriers to derivative disclosures. The results have important implications for actions to enhance corporate derivative disclosures in Vietnam.

Information Externalities of SFAS 161: Evidence from Supply Chains

ABSTRACTEffective in 2009, SFAS 161 requires enhanced disclosures about derivative use and hedging activities. We test for changes to the information environment of firms whose disclosure policy is unaffected by this standard directly. Using a sample of non-users of derivatives, we find an increase in stock liquidity after their critical customers expand derivative disclosures under SFAS 161. The effect persists for one year and becomes insignificant in subsequent years as the firms dial back their voluntary disclosure. The effect is also more salient for firms that have stronger economic links with their customers and for firms whose customers exhibit more significant improvements in derivative disclosures. The findings suggest that the mandatory derivative disclosures due to SFAS 161 lead to short-term positive information externalities along supply chains.Data Availability: Data are available from the public sources cited in the text.JEL Classifications: G32; M41; M48.

Analysis of the Effect of Business Diversification and Derivative Disclosures on Tax Avoidance in Manufacturing Companies Listed on IDX

One of the obstacles to accelerating national development is the existence of tax evasion activities or what is commonly referred to as tax avoidance. It is estimated that there are 110 trillion rupees each year, the figure for tax evasion. Most are business entities, around 80%, the rest are individual taxpayers. This study aims to examine the effect of diversification of activities and disclosure of derivative transactions on tax evasion activities. The research was conducted on manufacturing companies listed on the Indonesia Stock Exchange from 2014 to 2018, with a sample of 92 companies. The data analysis method for this study used multiple linear regression. The results prove that corporate diversification as measured by the hirschman-herfindhl index has no effect on tax avoidance activity. Meanwhile, the derivative transaction disclosure variable as measured by the disclosure score has an effect on tax avoidance activities.

The Effect of Mandatory Disclosure on Market Inefficiencies: Evidence from FASB Statement No. 161

ABSTRACTPrior research finds that unrealized gains/losses on cash flow hedges are negatively associated with future earnings, and that investors and analysts fail to anticipate this association. These studies speculate that this mispricing is due to either poor derivatives disclosures or the accounting model for cash flow hedges. We examine whether enhanced mandatory derivatives disclosures set forth in FAS 161 improve users' understanding of firms' hedging activities and offer three main findings. First, we find that this mispricing does not persist after FAS 161. Second, we find that the correction of mispricing is greatest when disclosure might help investors most. Finally, we find that analyst forecast accuracy improves after FAS 161. Overall, our results suggest that the enhanced mandatory derivative disclosures required by FAS 161 improved users' understanding of the effects of derivative and hedging activities on future firm performance and firm value—and consequently mitigated investor mispricing.

Credit derivatives disclosure in banks’ risk reporting: Empirical evidence from four large European banks

This paper aims to analyze the derivatives disclosure in banks’ annual risk reports. In this paper, the author uses content analysis to examine the qualitative and quantitative profiles of the derivatives disclosure at a cross-country level, with particular reference to credit derivatives. The empirical research is conducted on a sample of large European banks. The paper also shows that there is room to improve various aspects of derivatives disclosure, and provides some useful insights for further research. The derivatives disclosure in banks’ annual risk reports has deep managerial, financial, regulatory and accounting implications at a firm and industry levels, and the comprehension of the rational underlying it is critical to maintaining competitive advantages in the banking industry and informational and allocative efficiency in the financial markets. Although the existence of substantial research on credit derivatives and financial statements in the literature, none have directly focused on credit derivatives disclosure at a cross-country level applying the content analysis based on an objective evaluation approach. It leaves a gap that the paper aims to overcome.

Do Large European Banks Differ in their Derivative Disclosure Practices? A Cross‐Country Empirical Study

Risk disclosure has strategic importance for the efficiency of financial markets and overall financial stability. It plays a pivotal role in strengthening market discipline and building trust to improve relationships with stakeholders in banking. Risk reporting has taken a growing importance in banking over the last years. The topic of this article is derivative reporting in banking. The authors employ content analysis to conduct an empirical study on a sample of large European banks. The authors propose a hybrid scoring model for the assessment of derivative disclosure in banking institutions. The methodology employed in this research is able to capture a considerable amount of information because it combines the characteristics of a quantitative and qualitative analysis. This article provides evidences that banks differ in their derivative reporting, although they are subject to similar regulatory requirements and accounting standards. This empirical analysis shows that there is room to improve various aspects of derivatives disclosure in banking and poses some questions that researchers may develop with further empirical analysis. This article also discusses the potential policy implications of the research findings for practitioners, bank regulators, and accounting standard setters. © 2019 Wiley Periodicals, Inc.

Editorial note

This issue of the journal provides contributions to the exploration of subjects related to different areas of research: public and private sectors, capital market, merger and acquisition, corporate governance and risk management. In particular, the issues dealt with concern: external audit in health care organizations, risk reporting and credit derivative disclosure in the banking sector, risk based management control, governance and financial factors in reverse merger, price to earnings ratio and interest rates in the capital market

Earnings smoothing and CEO cash bonus compensation: the role of mandatory derivatives disclosure policy

Motivated by intense controversy over mandatory derivative instruments disclosure required by the Statement of Financial Accounting Standard No. 133 (SFAS 133), this study is to examine whether the sensitivity of CEOs compensation to earnings smoothing changes following the adoption of SFAS 133. Moreover, the study investigates whether the sensitivity of CEOs compensation to earnings smoothing after the implementation of SFAS 133 varies with the level of market volatility. Using the correlation between the changes in discretionary accruals and the changes in pre-discretionary income as a measure of earnings smoothing and dollar value of a bonus earned by the CEOs during the year as a measure of CEOs compensation, the empirical evidence reveals that while earnings smoothing and CEOs compensation are positively related, the positive relation is stronger after the adoption of SFAS 133. The study also finds that the positive association between earnings smoothing and CEOs compensation after the adoption of SFAS 133 is larger when the market volatility is higher. This study provides direct evidence on the impact of the adoption of SFAS 133 on the sensitivity of CEO compensation to earnings smoothing and sheds light on current literature on the effects of accounting regulations, earnings smoothing, and compensation plan. Moreover, this study helps standard setters to better understand the trade-off between transparency and compensation plans.

Determinants of Financial Derivative Disclosures in an Emerging Economy: A Stewardship Theory Perspective

The accounting system in India is undergoing a significant change. With the notification of Companies (Indian Accounting Standards) Rules 2015, the Ministry of Corporate Affairs in India converged the Indian Accounting Standards (Ind AS) with International Financial Reporting Standards (IFRS) which was applied in a phased manner from 1 April 2016 beginning with large companies whose net worth was equal to or exceeded INR 5 billion, followed by its implementation for smaller companies with net worth between 2.5 billion to 5 billion thereafter. Among other accounting standards, Financial Instruments Standards Ind AS 32, 109 and 107 that defines, recognises, measures and specifies disclosure norms of financial instruments including financial derivatives were introduced. Warren Buffet very famously called derivatives, “financial weapons of mass destruction,” and giving credence to his views, time and again, financial as well as non-financial firms in India and around the world have sustained losses due to the usage of financial derivatives. Over the years, the capital markets have changed, and business models have become more challenging with complex sources of risk and uncertainty which has transformed risk management into a sophisticated art. This complex and ever-changing business environment has brought to the fore the necessity and importance of developing reliable and relevant disclosure norms to help protect all stakeholders, as derivatives, due to their underlying complex nature, can be a significant source of systematic risk. This is also reiterated, with shareholders and investors stepping up the demand for increased financial disclosure. This empirical study models the factors that determine Financial Derivative Disclosure of Indian non-financial firms The study develops a self-constructed unweighted Financial Derivative Disclosure Index (FDDI) to measure the derivative disclosure. The sample represents companies from Nifty 50, out of which banking and financial services companies were removed. Using multiple regression model, this study modelled the corporate governance factors which determine derivative disclosure. The factors identified were presence of usage of derivatives, size, foreign income, presence of risk management committee, institutional shareholding and binary variable for family business. The results show that the stewardship theory explains the determinants of financial derivative disclosure in Indian context, and promoters act as stewards and guide their firms to improve their financial derivative disclosures.

The Effect of Mandatory Disclosure on Market Inefficiencies: Evidence from Statement of Financial Accounting Standard Number 161

Prior research finds that unrealized gains/losses on cash flow hedges are negatively associated with future earnings, and that investors and analysts fail to anticipate this association. These studies speculate that this mispricing is due to either poor derivatives disclosures or the accounting model for cash flow hedges. We examine whether enhanced mandatory derivatives disclosures set forth in FAS 161 improve users’ understanding of firms’ hedging activities and offer three main findings. First, we find that this mispricing does not persist after FAS 161. Second, we find that the correction of mispricing is greatest when disclosure might help investors most. Finally, we find that analyst forecast accuracy improves after FAS 161. Overall, our results suggest that the enhanced mandatory derivative disclosures required by FAS 161 improved users’ understanding of the effects of derivative and hedging activities on future firm performance and firm value – and consequently mitigated investor mispricing.

Information Externalities of Disclosure Regulation: Evidence from SFAS 161

Effective in 2009, SFAS 161 requires enhanced disclosures about derivative use and hedging activities. We test for changes to the information environment of firms whose disclosure policy is unaffected by this standard directly. Using a sample of non-users of derivatives, we find an increase in stock liquidity after their critical customers expand derivative disclosures under SFAS 161. The effect persists for one year and becomes insignificant in subsequent years as the firms dial back their voluntary disclosure. The effect is also more salient for firms that have stronger economic links with their customers and for firms whose customers exhibit more significant improvements in derivative disclosures. The findings suggest that the mandatory derivative disclosures due to SFAS 161 lead to short-term positive information externalities along supply chains.

Derivatives Usage, Disclosure Standards, and Risk in the U.S. Insurance Sector: An Investor's View

This paper studies the effect of derivatives disclosure and usage by U.S. insurers on their idiosyncratic risk. We find insurers that were less transparent regarding their derivatives activities had a lower Marginal Expected Shortfall, stock return volatility, and default risk before an update in disclosure standards in Q4:2008. Using a difference-in-difference approach, we show that stricter standards concerning the disclosure of derivatives usage in insurance increases uncertainty about stock movements, exposure to extreme market downturns, and default risk of insurers that had already disclosed derivatives usage voluntarily. However, increased transparency regarding the objectives of derivatives usage reduced systemic risk exposure, volatility, and default risk for a subsample of insurers that did not publish information on these objectives before the change in accounting rules.