Accounting practices for financial instruments. How far are Portuguese companies from IFRS, PT Lopes, LL Rodrigues

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Content: P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 ACCOUNTING PRACTICES FOR FINANCIAL INSTRUMENTS. HOW FAR ARE PORTUGUESE COMPANIES FROM IFRS? Patrнcia Teixeira Lopes* and Lъcia Lima Rodrigues** Contact Details (Corresponding Author) Patrнcia Teixeira Lopes University of Porto, Faculty of Economics Rua Dr. Roberto Frias, 4200-464 Porto, Portugal Phone: 351 22 5571100; Fax: 351 22 5505050; e-mail: [email protected] Abstract The purpose of this study is to analyze the current accounting practices for financial instruments by Portuguese companies and compare them with the measurement, recognition and disclosure requirements stipulated in IAS 32 and IAS 39. In order to attain our objective, we draw up a list of 120 categories of inquiry and 370 possible responses that we are interested in analyzing. We apply content analysis technique to listed companies' 2001 Annual Reports. Our results show that applying IAS 32 and IAS 39 will have its greatest impact on the categories of financial instruments for which the adoption of fair value is required and on hedging accounting practices. These findings throw light on the challenges of adopting IAS 32 and IAS 39, particularly with respect to fair value measurement. * Faculty of Economics, University of Porto ** School of Management and Economics, University of Minho Key Words: Financial instruments accounting, Fair Value, International Accounting, IAS/IFRS, Portugal Acknowledgement: The authors would like to express their gratitude to the discussants in the EIASM Workshop on Implementing IFRS (Brussels, 2003), to Professor Stefano Zambon at the Doctoral Colloquium of the IPA Conference 2003 (Madrid), to the participants of the EAA 2004 Conference (Prague) and to two anonymous referees for their helpful comments on early versions of this paper. The financial support from Faculdade de Economia do Porto (Portugal) and PRODEP is also acknowledged with thanks. 1
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 I. Introduction Standard setters around the world have been coming to recognize the need for change in the conventional accounting model, setting fair value accounting for financial instruments in several standards1. For example, in the first phase the International Accounting Standards Board (IASB) and the financial accounting Standards Board (FASB) issued standards which required fair value at disclosure level: IAS 32 Financial Instruments: Disclosure and Presentation (IASB (1995)); FAS 105 Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk (FASB (1990)); and FAS 107 Disclosures about Fair Value of Financial Instruments (FASB (1991)). Nowadays, these bodies are at a more advanced phase in terms of fair value accounting after the publication of standards which require fair value at measurement and recognition level: IAS 39 Financial Instruments: Recognition and Measurement (IASB (1999)); and FAS 133 Accounting for Derivative Instruments and Hedging Activities (FASB (1998)), amended by FAS 149 Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FASB (2003)) and by FAS 138 Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement 133 (FASB (2000)). In 2002, the European Parliament and the Council adopted the proposal of regulation (Regulation 1606/2002)2 of the European Commission regarding the use and adoption of International Financial Reporting Standards (IFRS3) within the European Community. This regulation states that, for each financial year commencing on or after the 1st January 2005, companies whose securities are traded on a regulated market shall prepare their consolidated accounts in accordance with IFRS adopted by the Commission. Each Member State may permit or require listed companies to prepare their annual accounts and other companies to prepare their consolidated or annual accounts in conformity with those IFRS. 1 Fair value accounting has also been required for other types of assets. This is the case of investment property and agriculture assets for which the IASB sets fair value as the reference measurement criterion (in IAS 40 and IAS 41, respectively). 2 Refer Official Journal of hte European Communitites, L243/1-4, 11/9/2002. 3 The abbreviation IFRS stands for all standards of the IASB, that is, the former International Accounting Standards (IAS), the current International Financial Reporting Standards and related Interpretations (SIC-IFRIC interpretations) issued or adopted by the IASB. 2
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 The adoption of the IFRS means, among other things, a change in the principle stated in the Fourth Council Directive (78/660/EEC) by which the items shown in the annual accounts should be valued on the basis of the principle of purchase price or production cost. So, in September 2001, the Parliament and the Council adopted the 2001/65/EC Directive which amended Directives 78/660/EEC, 83/349/EEC, and 86/635/EEC in regards to the valuation rules for the annual and consolidated accounts of certain types of companies as well as of banks and other financial institutions, allowing fair value valuation for certain types of assets and liabilities. The 2001/65/EC Directive and Regulation 1606/2002 are effective signs of the irreversibility of the accounting harmonization process within Europe, meaning that Portuguese companies will have to adopt IFRS very soon. Regarding financial instrument recognition and measurement, there are several differences between Portuguese accounting standards and IAS 39. In Portugal, financial assets and liabilities are not valued at fair value (except the trading securities of financial institutions) and hedge accounting rules are much less restricted. The purposes of this paper are twofold. First, we want to analyze current accounting practices for financial instruments by Portuguese companies and address the following questions: - How are Portuguese companies accounting for financial instruments (including derivatives) costs, gains and losses? - How are Portuguese companies calculating and disclosing the fair value of financial instruments? - How are Portuguese companies disclosing the risks of their financial instrument positions? - Is the disclosed information understandable and comparable? Then, we want to compare these practices with the measurement, recognition and disclosure requirements of IAS 32 and IAS 39 in order to ascertain how far the Portuguese companies are from their requirements. This paper has important contributions. We provide the first complete and exhaustive template for analyzing the accounting for all types of financial instruments based on companies' annual reports. The research then describes the practices of accounting for 3
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 financial instruments of Portuguese listed companies. We show the areas in which these companies are further away from complying with the requirements of IAS that relate to financial instruments. These results are very useful to companies as they shed light on the areas in which companies will encounter more difficulties in implementing IAS 32 and IAS 39, which are seen as the most complex accounting standards (BDO et al. (2003); Jermakowicz (2004); Sucher and Jindrichovska (2004); Larson and Street (2004); Street and Larson (2004)). Besides, our findings are also very useful to national standard setters, including Portuguese standard setters and to the IASB, as they point out which areas will require more work in order to achieve a smooth transition to IFRS and high degrees of compliance with the new accounting standards on an issue that has been generating much controversy among the several agents of the accounting scene and that is far from being closed (Pacter (2005); Whittington (2005); Walton (2004); Gйlard (2004); Hague (2004)). The remainder of the paper is organized as follows: Section II reviews prior literature. Section III contains the regulatory background related to financial instruments accounting comparing Portuguese standards and IAS 32 and IAS 39. The data and research method are detailed in Section IV. Section V presents empirical results while Section VI discusses the results and outlines future research. II. Prior literature Several studies have studied accounting for financial instruments by companies. There is one type of study that is dedicated to the analysis of compliance with the accounting standards (Chalmers (2001); Chalmers and Godfrey (2000); Blankley et al. (2000); Roulstone (1999); Mahoney and Kawamura (1995)). There is another type of study that does not specifically aim at quantifying the degree of compliance but tries to assess the increase in quality/understanding of the disclosures as a consequence of a new standard on financial instruments (Edwards Jr. and Eller (1995); Edwards Jr. and Eller (1996); Roulstone (1999); Woods and Marginson (2004); Dunne et al. (2004); Hamlen and Largay (2005)). 4
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 Chalmers (2001) and Chalmers and Godfrey (2000) study the degree of compliance with Australian financial instruments accounting standards, namely AASB 10334, among Australian companies. These studies show high levels of non-compliance among sample companies and problems of understanding, comparability and consistency with derivative disclosures. Chalmers and Godfrey (2000) conclude that firms are not disclosing details about derivative accounting policies, making the information neither useful nor comparable. They also find diversity in terms of the clarity, detail and consistency of firms' disclosures about accounting policies. Regarding accounting for hedges, firms generally state that they use the same accounting method as the underlying instrument but do not describe the method in particular. They also find low levels of disclosure regarding special items of hedges of forecasted transactions. Regarding fair value disclosures, they find that firms disclose the fair value but show reluctance to disclose the calculation method. The authors conclude by making a call aimed at standard setters for more specific disclosure requirements. Both Blankley et al. (2000) and Roulstone (1999) measure compliance with FRR 485 based on the 10-K filings of a sample of US firms. Blankley et al. (2000) find mixed results; compliance with qualitative disclosure requirements concerning firm's risk and its management is high, but detailed disclosures for the quantitative items are incomplete or lacking. Roulstone (1999) finds that disclosures are not presented in accordance with SEC requirements: lack of contextual information regarding quantitative market risk exposure and low details about risk management procedures and accounting policies. Mahoney and Kawamura (1995) is a study published by the FASB with the objective of analyzing compliance with FAS 1196. Based on the 1994 annual reports of a sample selected on a random basis from the Fortune 1000 entities, the authors analyze the existence and the content of FAS 119 required disclosures. They quantify the number of companies that disclose or do not disclose the several items of inquiry and 4 AASB 1033: Presentation and Disclosure of Financial Instruments, issued by the Australian Accounting Standards Board (AASB), 1996. 5 FRR 48: Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments, issued by the US Securities Exchange Commission, 1997. 5
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 identify the location and the length of the disclosure. The items that show the lowest levels of disclosure are: cash requirements of derivative financial instruments held or issued; disclosures about trading derivatives (average fair value, end-of-period fair value and net gains or losses); hedges of anticipated transactions; gap analysis; and value at risk disclosures. Edwards Jr. and Eller (1995) and Edwards Jr. and Eller (1996) analyze the annual reports of the top ten US dealer banks (measured by derivatives usage) after FAS 119 had become effective. They conclude that the depth of both the qualitative and the quantitative disclosures improved between 1994 and 1995. They argue that the experimentation of better approaches to disclosure encouraged by standard setters is evident, namely in increasing transparency, but further efforts should continue to be made. In order to analyze the effect of FRR 48, Roulstone (1999) compares the disclosures about derivatives and market risk before and after FRR 48. The author concludes that the quality of the disclosures improved in the period of analysis but there is still room for improvements namely regarding the detail of quantitative measures of market risk and discussion of risk management activities. Woods and Marginson (2004) and Dunne et al. (2004) analyze the implementation of FRS 137 in UK. The first study uses the 1999 annual reports of a sample of UK banks to analyze the usefulness of derivative disclosures in the context of FRS 13. The authors conclude that, from a user's perspective, the information disclosed lacks usefulness. The reasons for this are the generic nature of qualitative disclosures (in line with the USA study of Roulstone (1999)), lack of detail and comparability of the quantitative disclosures and difficulty of combining qualitative and quantitative disclosures. Dunne et al. (2004) analyze non-financial UK quoted companies and conclude that the implementation of a mandatory standard on derivatives is associated with an increase in disclosures in the annual reports. In a related study, Dunne et al. (2003) find support for the introduction of the standard from preparers, though 6 FAS 119: Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, issued by the Financial Accounting Standards Board (FASB), 1994. 7 FRS 13: Derivatives and other Financial Instruments: Disclosures, issued by the UK Accounting Standards Board, 1998. 6
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 numerical disclosures appear to be less popular than narrative disclosures, because of the time and effort needed to prepare them. Hamlen and Largay (2005) analyze the disclosures about derivatives provided by the 30 high-profile companies tracked in the Dow-Jones Industrial Average under FAS 133. They find that companies increase disclosures after FAS 133 but these disclosures are not informative enough and reflect unobservable assumptions and choices, thereby harming comparability among companies. Having reviewed prior studies on accounting harmonization/comparability and on accounting for financial instruments, we find that the research objectives that we stated for this research are useful and timely. In the context of the convergence to IFRS within European Union and of the actual discussion evolving around the world about new models of accounting, especially devoted to the financial instruments, this research improves our knowledge and understanding of this complex reality, bringing important contributions to these streams of research. III. Regulatory background In this section, we present the regulatory background related to accounting for financial instruments in Portugal. We adopt the definition of financial instrument as stated in IAS 32 (2000, par. 5)8, "any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise"9. Portugal10 Non-financial companies In Portugal, accounting rules applied to non-financial companies are contained in the Accounting Act (POC - Plano Oficial de Contabilidade, Decree-law 410/89) and in 8 In this regulatory background description we are going to follow the 2000 versions of IAS 32 and IAS 39 because they were the versions that were operative for financial statements in 2001 (the year of our empirical study). 9 IAS 32 and IAS 39 apply to all financial instruments except to interest in subsidiaries, associates and joint ventures, leases, employee benefit plans and insurance contracts. Equity instruments issued by the reporting company (options, warrants that are classified as shareholders' equity) are excluded from IAS 39, but are covered by IAS 32. 10 The Decree-Law 88/2004 which is the transposition to Portugal of the 2001/65/EC Directive, was approved in April 2004, allowing, but not requiring, Portuguese companies (financial and nonfinancial) to adopt fair value accounting for financial instruments in their consolidated accounts from 7
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 the Accounting Directives (Directrizes Contabilнsticas) issued by the Portuguese Accounting Standards Board (Comissгo de Normalizaзгo Contabilнstica)11. The Accounting Act establishes the historical cost principle and the prudence principle as the principles to be applied to all assets and liabilities in general. For short-term financial assets and financial investments, the Accounting Act defines the adoption of the lower of acquisition cost or the market price (LOCOM). Besides those provisions of the Accounting Act, there is a standard specifically devoted to exchange-traded futures ­ the Accounting Directive 17 (CNC (1997)). According to this Directive, the measurement criterion applied to future contracts depends on the type of operation. Trading operations are accounted for at market value, with market value changes being immediately recognized in the profit and loss account. In hedging operations, the principle is the matching of the hedged and the hedging positions, meaning that when the hedged position is held at cost, the gains/losses of the derivative are deferred (as deferred assets or liabilities) until the gains and losses of the hedged position are recognized. According to Accounting Directive 18 (CNC (1996)), non-financial companies are obliged to comply with International Accounting Standards in the absence of national accounting rules. Portuguese companies are therefore subject to IAS 32 and IAS 39 relative to most financial instruments, including almost all derivative instruments. Financial companies Regarding credit institutions and financial companies, the accounting rules are established by the Portuguese central bank (Banco de Portugal) through its Instruction no. 4/9612 which establishes the Accounting Act for the Banking System (PCSB - Plano de Contas do Sistema Bancбrio). The Accounting Act for the Banking System adopts the principle of prudence. In financial companies, fair value should be applied to trading securities and to forward rate agreements (FRA), futures, options and swaps when used in trading 1st January 2004 onwards. This regulatory review is based on the mandatory standards operative in 2001, and thus does not include the provisions of Decree-Law 88/2004. 11 The Portuguese Accounting Standards Board is an independent technical body, which functions under the Ministry of Financial Affairs. According to Decree-Law 367/99, its main objective is to issue standards and establish accounting procedures, harmonized with European and international standards of the same nature, in order to achieve higher quality financial information. One of its powers is to issue Accounting Directives, which are compulsory and approved by the Finance Minister. 8
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 operations. Changes in the fair value should be registered in profits and losses for the period in which they occur. Regarding operations that qualify for hedge accounting, the profits and losses of the hedging instruments and the hedged instruments are registered simultaneously, with the measurement criterion of the hedged position prevailing. Table 1 summarises the differences between Portuguese accounting rules and IAS 32 and IAS 39. 12 http://www.bportugal.pt/ 9
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Table 1: Comparison of IAS 32 and IAS 39 and the Portuguese standards
International Accounting Standards
Portuguese Standards
Non- financial companies
Financial companies
Scope Definition of derivative Recognition
IAS 32/ IAS 39
Accounting Act/ Acc Directive 17
Accounting Act for the Banking System
All companies/all financial instruments
Non-financial companies/only primary financial
instruments and exchange traded futures
Financial instrument whose value changes in response to Financial instrument whose fair value changes reflect fair
the change in a specified interest rate, security price, value changes of the underlying; allows the transference
commodity price, foreign exchange rate, index of prices of the risk of an underlying financial instruments; there is
or rates, no initial net investment, settled at a future date no reference to no initial investment
All financial assets and financial liabilities are
Only primary financial instruments are recognized on the
recognized on the balance sheet, including all derivatives balance sheet
Financial companies/all financial instruments Financial instrument whose value is related to the price of the underlying asset, exchange rate or index; there is no reference to no initial investment Only primary financial instruments are recognized on the balance sheet; off-balance sheet accounts should be used for derivatives reporting
Derecognition Initial Measurement Subsequent Measurement
Lost of control of the contractual rights (by expiration, Not available in applicable Portuguese accounting
realization or surrender) of the asset; extinguishing of the standards
obligation specified in the liability (by discharging,
(N. A., hereon)
expiration or cancellation)
Measured at the fair value of what was received or paid; Acquisition cost (includes transaction costs)
Transaction costs are included in the initial measurement
Allows derecognition if most of the risks and benefits are transferred and the value of the retained risks and benefits may be reliably measured Acquisition cost or nominal value (discounted securities), not including transaction costs
Financial Assets
Held for trading
Fair value
Lower of cost or market (LOCOM)
Same as IAS
Available for sale
Fair value
LOCOM
Acquisition cost or nominal value
Derivatives
Fair value
Futures for trading: Same as IAS Other derivatives: N. A.
FRA, Swaps, Futures and Options (exchange traded or OTC) for trading : Same as IAS
Loans and receivables originated At cost/amortized cost + impairment test
by the company
Held to maturity
At cost/amortized cost + impairment test
Assets whose fair value cannot be reliably measured Strict test for held-to-maturity
At cost/amortized cost + impairment test Ability to hold to maturity
Cost LOCOM Not applicable Not applicable
Cost Acquisition cost or nominal value (discounted securities) Not applicable Same as IAS
Tainting of held-to-maturity by Exists; expires after 2 years early sale Financial Liabilities
Not applicable
Does not exist
Financial liabilities other than categories listed below: Held for trading
Amortized cost Fair value
Same as IAS Not possible
Cost Same as IAS
Derivatives
Fair value
Futures for trading: Same as IAS Other derivatives: N. A.
FRA, Swaps, Futures and Options (exchange traded or OTC) for trading : Same as IAS
10
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Fair value changes
Held-for trading (including derivatives): Available -for-sale Hedging
Net profit or loss for the period in which it arises
Futures: Same; Other derivatives: N. A.
Either in the net profit or loss for the period or in equity until the financial asset is sold or determined to be impaired, at which time the cumulative gain or loss should be included in net profit or loss. Three types of hedging relationships: fair value hedge; cash-flow hedge; hedge of a net investment
Not applicable Does not exist
Hedge accounting Qualification for hedge accounting
The hedging and the hedged items are measured at fair Futures: Match of measurement criteria: the hedged
value (even if the hedged item would not be measured at position determines the measurement criterion for the
fair value individually)
hedging position - Always deferral hedge accounting;
Other derivatives: N. A.
Expected to be highly effective (80-125%)
Does not exist
Highly probable forecasted transaction
Does not exist
Effectiveness can be reliably measured
Does not exist
Disclosure
Fair value
Fair value calculation methods and significant assumptions
Not required
Fair value changes in Available- Amount recognized/removed in/from equity for-sale financial assets
Not applicable
Inability of reliability in measurement
Financial assets description /their carrying amount/ explanation of the reason/range of estimates
Not required
Information about securitization Accounting policy/ Nature and extent /Collateral/
and repurchase agreements
Whether the financial assets have been derecognized
Not required
Information about the key assumptions used in
Not required
calculating the fair value of new and retained interests
Derivatives Interest rate risk
Fair values/The period in which forecasted transactions Not required
are expected to occur and to enter in income/The amount
recognized in equity in cash-flow hedging /The amount
removed from equity and recognized in income /The
amount removed from equity and added to initial
measurement of the acquisition cost
Future changes in interest rates
Not required
Maturity dates
Not required
Credit risk
Counterparties identification/Max amount of credit risk Not required exposure/Significant concentration of credit risk
Same as IAS Not applicable Does not exist Match of measurement criteria: the hedged position determines the measurement criterion for the hedging position Same as IAS, but not quantified Same as IAS, plus expected time less than a year Does not exist Not required Not applicable Not required Same as IAS Not required Not required Not required Same as IAS Not required
11
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 Analyzing Table 1, we conclude that the two standards are not as alike as one might initially think. One of the most obvious differences is the lack of derivative accounting standards for non-financial companies in Portugal. This deficiency is remedied by Accounting Directive 18 which establishes compliance with IFRS whenever Portuguese standards are not available. So, it can be expected that Portuguese companies are already making use of IAS 32 and IAS 39 in their derivative accounting. Further evidence is the difference in hedge accounting rules. In fact, Portuguese rules indicate that the measurement criteria of the hedged position define the measurement criteria of the hedging derivatives. This means that, since historical cost is the basis of measurement in almost all financial instruments, hedge accounting is based on the deferral of gains and losses. There is only one exception to this ­ the hedging of the trading securities of financial institutions that are already marked to the market. With respect to non-derivative financial instruments, there are some quite striking differences, particularly in non-financial companies: the general measurement criterion of the lower of cost or market value (LOCOM) and fair value has not yet been introduced. Accounting rules for financial companies are closest to IFRS since fair value is accepted for trading financial instruments. IV. Research Method and Data Research Method With the aim of identifying accounting practices for financial instruments, we applied content analysis technique to listed companies' annual reports. Holsti (1969), p. 14, says that content analysis is "any technique for making inferences by objectively and systematically identifying specified characteristics of messages". Content analysis has been widely used in accounting research, applied to annual reports in order to analyze several issues, such as social, environmental, research and development disclosures13. Specifically concerning financial instruments, we refer to some recently published studies that examine information published on the companies' annual reports in order to identify accounting practices. They are summarized in the Table 2. 13 Please refer to Jones and Shoemaker (1994) for a review of a large number of studies that use content analysis within accounting research. 12
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Table 2: Selected content analysis studies on accounting practices for financial instruments
Woods and Marginson (2004) and Dunne et al. (2004) Chalmers and Godfrey (2000) and Chalmers (2001) Blankley et al. (2000) and Roulstone (1999) Edwards Jr. and Eller (1995), Edwards Jr. and Eller (1996) and Mahoney and Kawamura (1995)
Instrument/Standard Derivatives/FRS1314 Derivatives/AASB 103315 Derivatives/FRR 4816 Derivatives/FAS 11917
Country United Kingdom Australia United States of America United States of America
All studies are specifically concerned with derivative accounting and disclosure practices. We extend our analysis to all financial instruments. In order to develop the content analysis of the annual reports, we drew up a list of the categories of inquiry and possible responses that we were interested in analyzing. These categories and responses covered the items that would assist our attempt to identify the impact of the adoption of IAS 39 measurement and recognition rules and the existence and content of disclosures required by IAS 32 and IAS 3918. The analysis of the annual reports was structured into two levels: 1 ­ Analysis of the balance sheet and income statement to obtain numerical information about some generic accounting amounts and financial instruments specific amounts such as: total assets; total liabilities; total sales/total turnover19; financial investments, excluding parts of capital in group and associated companies, loans to group and associated companies and prepayments; short-term marketable
14 FRS 13: Derivatives and other Financial Instruments: Disclosures, issued by the UK Accounting Standards Board, 1998. 15 AASB 1033: Presentation and Disclosure of Financial Instruments, issued by the Australian Accounting Standards Board (AASB), 1996. 16 FRR 48: Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments, issued by the US Securities Exchange Commission, 1997. 17 FAS 119: Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, issued by the Financial Accounting Standards Board (FASB), 1994. 18 Before developing the content analysis for the entire sample, we conducted an exploratory analysis on three selected annual reports to test the adequacy of the categories/variables identified. This exploratory analysis resulted in few adjustments to the first list of categories related to the amounts of gains and losses realized/non-realized for financial instruments, commissions due to financial instrument operations and amounts of collateral of derivative instruments, which were removed from the list because they were not reported by the companies. 19 In financial companies this amount corresponds to total revenue. 13
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 securities; and loans (which included long and short term bond issues, loans and debts to credit institutions)20. 2 ­ Analysis of the notes to the accounts and other parts of the annual report, namely letter to shareholders, management report and corporate governance report, in order to codify the quantitative and qualitative information into the pre-defined categories and responses. As derivative instruments have very specific accounting rules compared with other non-derivative instruments, we divided this part of the analysis into three parts. The first relates to non-derivative financial instruments; the second to derivative instruments; and the third to information related to all financial instruments. For each category of information, we qualified the type of Information Reported as either quantitative (numerical/monetary) or qualitative (narrative/descriptive) and registered the location in the annual report (letter to shareholders, management report, notes to accounts, other, including corporate governance report and certain parts). In all, 120 categories and 370 possible responses were drawn up. Appendix I shows the list of categories21. Sample Design and data collection In order to study Portuguese companies we decided to study all listed companies at Euronext Lisbon on 31st December 2001. We chose the year 2001 because it was the year that IAS 39 became effective and it was the most recent year that there were published annual reports when we started the research. At the end of 2001, there were 56 quoted companies in Portugal. Appendix 2 contains a list of these companies and their respective economic sectors. The annual reports were obtained by three methods. First, we looked for them in the web site of each company. When this procedure did not yield results, we wrote or e-mailed the company requesting a copy of its 2001 annual report. Finally, the remaining annual reports were obtained through the library of Euronext Lisbon consulting the supplements of the quotation bulletin (Boletim de Cotaзхes) of the Euronext Lisbon. These procedures allowed us to obtain all annual reports of the listed companies, except one from PT Multimйdia.com that did not publish an individual annual report and accounts. Hence, the final sample includes 55 20 This item is not applicable to financial institutions and so it is not obtained for this type of company. 21 A complete list with all the 370 possible responses is available from the authors upon request. 14
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
companies, of which 29% are from the industrial sector and 20% from the financial
sector.
Table 3: Sample sectorial distribution
Economic sector
N
Basic materials
7
Consumer, cyclical
9
Consumer, non-cyclical
4
Financial
11
Industrial
16
Technology
4
Telecommunications
3
Utilities
1
Total 55
12.7% 16.4% 7.3% 20.0% 29.1% 7.3% 5.5% 1.8% 100.0%
The main descriptive statistics are in Table 4. In terms of listing type, the large
majority of companies (90%) are quoted on the Portuguese Stock Exchange
exclusively. Additionally, there are five companies that are cross-listed in the USA.
Regarding the auditor company, the majority (76%) are audited by a big-five firm.
The source for companies' listings and audit firm data is the companies' annual
reports complemented by the companies' websites.
Table 4: Descriptive statistics
Panel A: continuous variables
N Min Max
Total assets (10^6 euros)
55
22.05 358,137.51
Liabilities/Asset (%)
55
37.91
96.33
Liabilities/Equity (D/E) (%)
55
61.07 2,628.39
Sales (10^6 euros)
55
5.80 34,885.49
Sales to foreign countries/Sales (%) 55
.00
93.46
Market value/Assets (%)
55
3.36
219.49
Financial liabilities/Assets (%)
45(a)
.04
63.60
Mean 10,833.29 72.55 492.92 1,720.26 24.55 37.12 35.25
Std. Dev. 48,944.85 15.06 550.53 4,890.21 29.64 39.95 15.21
(a) Financial liabilities/Assets ratio is calculated for all non-financial companies plus Mundicenter, SGPS. Although Mundicenter is classified in the financial sector according to the Dow Jones STOXX Global Sector Classification (real estate sub-sector), for accounting issues and according to Portuguese Central Bank regulation, it is considered a non-financial company.
Variable Listing status Auditor status
Panel B: categorical variables Attributes Listed, origin country stock exchange Listed, (one) foreign stock exchange Multi listing, including USA Multi listing, not-including USA Big five Not Big five
N% 50 90.91% 0 0.00% 5 9.09% 0 0.00% 42 76.36% 13 23.64%
We began by developing a standard form to be used to collect the responses to each of the categories of inquiry. All data were then collected by hand from the companies'
15
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 2001 annual reports. A separate form was completed for each company. Finally, we entered the responses from the completed forms in a database from which the data could be analyzed using SPSS software. V. Empirical results In this section, we present the main results of the content analysis of the annual reports of the Portuguese stock exchange listed companies. In accordance with previous empirical studies whose objectives are the same as those of this paper (Tay and Parker (1990); Evans and Taylor (1982); Nobes (1990); Street and Gray (1999); Street et al. (1999); Chalmers (2001); Chalmers and Godfrey (2000)), we are going to present an analysis of the collected information based on descriptive statistics. Before presenting the results, a note must be made relating to non-disclosure. We were very careful when classifying an item as not-disclosed. Before classifying an item as non-disclosed, we analyze the applicability of the item within the company. In this procedure we take into account the complete annual report and if there is no reference to a specific situation in the entire document, the item is considered nonapplicable to the company and not non-disclosed. Consequently, an item is considered non-disclosed only if it is applicable to the company. In the opposite case, it is considered non-applicable and the company excluded from the analysis of that specific item. Financial Instruments, excluding derivatives Measurement Regarding measurement criteria, Portuguese companies use historical cost accounting combined with the prudence principle. All categories of financial assets are measured at cost or amortized cost by the majority of the companies (between 73% and 98%, according to the financial asset category). Twenty percent of the companies measure held-for-trading financial assets at market value or fair value. When we analyze the sectorial distribution of these companies, we conclude that almost all of them belong to the financial sector (eight among nine companies). This result was expected since the Accounting Act for the banking 16
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
system had already required held-for-trading financial assets to be measured at market value.
IAS 39 requires that available-for-sale financial assets are measured at fair value.
Regarding this category of assets, the scenario is very far removed from that defined
by IAS 39, given that only two companies adopt that criterion.
Table 5: Accounting Policies
Non
Cost or Fair value or
disclosing amortized cost market value
Held-for-trading financial assets
3 (6.7%) 33 (73.3%) 9 (20.0%)
Held-to-maturity financial assets
1 (2.0%) 48 (98.0%)
0
Loans and Receivables Originated by the company 1 (1.8%) 54 (98.2%)
0
Available-for-sale financial assets
1 (1.9%) 50 (94.30%) 2 (3.8%)
Held-for-trading Liabilities
1 (33.3%)
2 (66.7%)
Other financial liabilities
1 (1.8%) 54 (98.2%)
0
Notes:
(1) Number of companies that adopt each method; the weight for the number of companies that have
the class of financial assets/liabilities in the analysis is shown in parentheses.
Fair value disclosures According to IAS 32 and IAS 39, companies are required to disclose the fair value determination method and the significant assumptions adopted. Forty-five companies do not disclose the first item22. The market price is reported by seven companies. One company reports the adoption of the discounted cash-flows method and two companies use more than one calculation method (including the market price). None of them discloses the significant assumptions. Financial companies have higher disclosure levels compared with the non-financial ones. Our results show a non-disclosing percentage of 27% companies in the financial sector against 95.5% companies in non-financial sectors. When the assumption that fair value can be reliably measured is not satisfied, IAS 39 requires additional disclosures, namely the description of the financial assets, their carrying amount, the reason for it and the range of estimates within which fair value is likely to lie. Eight companies report the existence of this type of situation but the disclosure level is insufficient. Only one company (from the financial sector) describes the financial assets and explains why fair value cannot be reliably measured;
22Due to the prudence principle of Portuguese GAAP, companies must account for adjustments to the value of assets when there are unrealized losses, calculated using market values. Consequently, this item (disclosure of fair value/market value calculation method) is applicable to all sample companies to the extent that any of their financial assets have incurred unrealized losses. 17
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 none of the companies discloses the carrying amount of the assets or the range of estimates within which fair value is likely to lie. Available-for-sale assets IAS 39 requires companies to disclose if the gain or loss in available-for-sale financial assets is recognized directly in net profit or loss or in equity. Among the companies that adopt fair value in available-for-sale assets, only one discloses that it includes the fair value changes in equity. This company also discloses, as required by IAS 39, the amount recognized and the amount removed from equity during the period. The other companies were silent regarding this issue. Lastly, regarding the location of the disclosures about financial instruments accounting policies and about fair values in the annual report, all companies report this information in the notes to the accounts. Summing up, this analysis suggests that the accounting practices for financial instruments by companies listed on the Portuguese stock exchange are very far from the requirements of IAS 32 and IAS 39. This is especially observed in the measurement and recognition criteria applied to the categories of financial instruments for which the adoption of fair value is required, that is, held-for-trading and available-for-sale financial assets. There is one exception: financial companies that have already been using fair value for held-for­trading assets. However, as far as the available-for-sale assets are concerned, there is almost complete divergence between current practice and IAS 39 requirements. Additionally, the quality of disclosures is less than satisfactory. The main weaknesses are found in the disclosure about the fair value determination. Derivatives Before analyzing the accounting practices for derivatives, we will characterize the sample regarding the user type, instrument type, risk categories and purposes stated for the use of derivatives (Table 6) 18
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Table 6: Derivatives
Panel A: User type
N
Non- Financial
financial
User
18 (32.7%)
10
8
User but not at year end
1 (1.8%)
0
1
Implicit non-user (a)
36 (65.5%)
34
2
Explicit non-user (b)
0
0
0
Total
55 (100.0%) 44
11
Notes:
(a) Companies with no reference to derivatives in their annual reports were considered to be implicit
non-users. This group was excluded from the subsequent analysis relating to derivative accounting.
(b) This category includes the companies that explicitly refer to the fact that they do not use derivative
instruments. In our sample, none of the companies made such a statement.
Panel B: Instrument types
Instrument type
Swaps Options Forwards Futures
Interest rate 12 (66.67%) 5 (27.78%) 5 (27.78%) 6 (33.33%)
Underlying
Exchange rate 9 (50.0%) 5 (27.78%) 9 (50.00%) 2 (11.11%)
Equity
2 (11.11%) 8 (44.44%)
4 (22.22%)
Commodities
4 (22.22%)
Unknown
3 (16.67%)
Notes:
(1) The percentages are calculated based on the number of derivative users with outstanding positions
as of the final year (18).
(2) When identifying the type of instruments used, the absence of a reference to a specific instrument is
interpreted as it not being used.
Panel C: Purposes of holding derivatives
N
Financial
Non-disclosing
2 (10.5%)
1
Hedging only
8 (42.1%)
0
Hedging and no mention to trading
1 (5.3%)
0
Trading
1 (5.3%)
1
Hedging and Trading
7 (36.8%)
7
Total 19 (100.0%) 9
Non-financial 1 8 1 0 0 10
The sample includes 18 companies that are explicitly derivative users with material positions at the end of 2001 and one company that uses derivatives but has no open positions at the balance sheet date. Thirty-six companies were classified as implicit non-users since they made no reference to derivative instruments in their annual reports. The following analysis is based on the 19 users of derivative instruments. Analyzing the sectorial distribution of the derivative users, we conclude that in this category, 42.1% companies belong to the financial sector. So the group of companies that is now going to be analyzed has a significant weight of financial companies, compared with non-financial ones. This situation, which may limit a generalization of the results, signifies the reality of the industry. The financial companies are heavy derivative users and, therefore, comprise the group that should be most affected by IAS 32 and IAS 39. It is also expected that financial companies have more
19
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 sophisticated risk management mechanisms and are thus able to produce higher quality information, providing a benchmark for other sectors (Roulstone (1999)). According to companies' descriptions of the derivative types, the most used instrument is the interest rate swap, followed by the exchange rate swap and forward. According to IAS 32 and IAS 39, companies must disclose the purpose of holding derivatives. We consider four classifications of companies' purposes for holding derivative instruments (besides the category for non-disclosures): hedging only (when the company specifically states that it uses derivatives for hedging and not for speculative strategies); hedging without any mention of speculative strategies; speculation; and, finally, both hedging and speculation. We think that this classification is useful because the specific mention by companies that they do not use derivatives for speculation can be interpreted as an expectation by companies that this disclosure is perceived by the market as a non-risky use of these instruments, normally related to risky positions (see, Koonce et al. (2006)). Many companies (42.1%) state hedging purposes only as the purpose for holding derivatives, explicitly reporting that they do not use derivatives for trading purposes. One company uses derivatives for hedging but makes no statement about trading operations. Trading operations are exclusively held by financial companies. Accounting policies The disclosure of the accounting policies adopted regarding derivative instruments was analyzed by considering four categories of methods of recognition and measurement (lower of cost or market, fair value/market value only, hedge accounting only and both fair value/market value and hedge accounting), besides the category for non-disclosure (Table 7, panel A). Among the sample companies that use derivatives, 47.4% do not disclose any information, revealing a high level of non-disclosure, mainly among non-financial companies. Seven companies disclose the use of fair value/market value combined with hedge accounting in hedging operations. There is one company that uses only fair value measurement. This is the company that uses derivatives for trading only. Through analyzing the hedge accounting methods (Table 7, panel B), we conclude that many companies (44.4%) use deferral accounting with the use of accruals (in the 20
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
asset or in the liability sides of the balance sheet) to account for the change in the value of the hedging item and, if the hedge relates to an existing asset/liability, with maintenance of historical cost in the hedged instrument. This is contrary to IAS 39, which requires immediate gains and losses recognition related to both the hedging and the hedged instruments in profit or loss, even for hedged instruments that, outside the hedging relationship, are measured at cost23. Only two companies recognize gains and losses immediately in hedging operations, one in the profit and loss account and the other in equity. Once again, the results show a big percentage of companies (44.4%, the majority from the non-financial sector) that do not disclose the accounting method for hedging derivatives.
This analysis reveals that companies are not forthcoming with details about accounting policies applied to derivative instruments, considering the large number of non-disclosing companies. The information disclosed by companies about accounting policies is too general and consequently it is not very useful and comparable, making the analysis of accounting figures very difficult.
The information about derivative accounting policies and hedging accounting policies
is located mainly in the notes to the accounts.
Table 7: Accounting policies and methods adopted
Panel A: All types of transactions
N Financial Non-financial
Non-disclosing
9 (47.4%) 2
7
LOCOM
1 (5.3%) 0
1
Fair value/Market value
1 (5.3%) 1
0
Hedge accounting
1 (5.3%) 0
1
Fair value/Market value + hedge accounting 7 (36.8%) 6
1
Total
19
9
10
Panel B: Hedging accounting policies
N
Financial Non-financial
Non disclosing
8 (44.4%)
2
6
Deferral
8 (44.4%)
6
2(a)
Profit and loss account
1 (5.6%)
0
1 (b)
Equity
1 (5.6%)
0
1
Total
18 (100.0%) 8
10
Notes: (a) One of these two is a company that did not disclose the accounting policy, but has on the
balance sheet an accruals account referring to future contracts, making us conclude that the company
adopts the deferral method.
(b) This company corresponds to the one that adopts the LOCOM as a measurement criterion for
derivatives.
23 Even if the hedge does not refer to a recognized asset or liability (the so called cash-flow hedges), IAS 39 prescribes the recognition of the gains and losses of the hedging instrument directly in equity. 21
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Other policy disclosures
Regarding derivative policy disclosures (Table 8, panel A), financial control policy is the least disclosed item. Risk management policies are already being quite well disclosed by companies.
We also analyzed the additional disclosure requirements of IAS 32 and IAS 39 relating to hedging operations (Table 8, panel B). Most companies disclose a description of the financial instruments designated as hedging instruments (72.2% of the companies) and the nature of the risks being hedged (77.8% of the companies). Quite a large percentage of companies (42.1%) do not disclose the description of the hedge. The item that shows the biggest disclosure deficit is the fair value of the financial instruments designated as hedging instruments, which is not disclosed by 77.8% of the companies involved in hedging operations. This fact re-emphasizes the divergence between the companies' accounting practices relating to the fair value calculation and disclosure and the requirements of IAS 32 and IAS 39.
When it comes to the majority of derivative risk disclosures (Table 8, panel C), the
companies are closer to what is required. In fact, most companies separate the
information by risk category and disclose the principal, stated, face, or similar amount
of derivative positions and their maturity. Non-financial companies show quite good
disclosure levels for these items.
Risk management policy Monitoring policy Financial control
Table 8: Other policy disclosures Panel A: Derivative policies disclosures24
Non-disclosing
N
Financial Non-financial
N
8 (40.0%)
3
5
12 (60.0%)
9 (45.0%)
2
7
11 (55.0%)
13 (65.0%)
5
8
7 (35.0%)
Disclosing
Financial Non-financial
6
6
7
4
4
3
24 The total of the companies that disclose and those that do not disclose sums 20 companies because we include both the 19 derivative users and one non-derivative user that reports natural hedge actions. 22
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Hedging description
Financial designated
instruments as hedging
instruments description
Their fair values
Nature of the risks being
hedged
Panel B: Hedging disclosures
Non-disclosing
Disclosing
N
Financial Non-
N
Financial
8 (42.1%)
Financial
5
3
1125 (57.9%)
3
5 (27.8%)
4
1
13 (72.2%)
4
14 (77.8%)
5
4 (22.2%)
4
9
4 (22.2%)
3
0
14 (77.8%)
4
NonFinancial 8 9 1 10
Panel C: Derivative risk disclosures
Non-disclosing
Disclosing
Total Financial Non-
Total Financial
financial
Segregation by risk categories 5 (26.3%)
3
2 14 (73.7%) 6
Extent
5 (26.3%)
3
2 14 (73.7%) 6
Maturity
8 (42.1%)
4
4 11 (57.9%) 5
Effective or weighted interest rate 18 (94.7%) 8
9
1 (5.3%)
0
Nonfinancial 8 8 6 1
The forecasted transactions and the cash-flow hedges imply additional disclosures. We identified eight companies that engaged in hedging of forecasted transactions and 10 in cash-flow hedges. Six companies did not disclose the type of hedge. Relating to the hedging of forecasted transactions, there is a big deficit in disclosure: only one company discloses the period in which the forecasted transactions are expected to occur and when they are expected to appear in the determination of the net profit or loss. With respect to cash-flow hedging, only one company reports the changes of fair value in equity. Analyzing the IAS 39 requirements towards this type of hedge accounting policy (amount recognized in equity, amount removed from equity and reported in net profit or loss, amount removed from equity and added to the initial measurement of the acquisition cost), we register only one disclosure, the amount recognized in equity.
Fair value disclosures Table 9 shows that most companies (73.7%) do not disclose the derivative fair value calculation method. This result is not surprising, considering the results obtained in fair value information in other financial instruments. Once again, non-financial companies show a total lack of disclosure of this information.
25 The sum of the companies that disclose and those that do not disclose the description of the hedge is 19. This number includes the companies that are supposed to provide hedging descriptions, that is, 16 that entered into hedging operations and two that do not say anything about the objective of holding derivatives) plus the company that reports natural hedges. 23
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Table 9: Derivative fair value calculation method
N Financial Non-Financial
Non-disclosing
14(73.7%) 4
10
Market price
1(5.3%)
1
0
Similar instrument market price
0
0
0
Independent appraisal
0
0
0
Discounted cash-flow analysis
0
0
0
Option valuation model
0
0
0
Several
4 (21.1%) 4
0
Total
19 (100.0%) 9
10
Regarding additional fair value disclosures required by IAS 32 and IAS 39 (Table 10),
they are almost totally absent, except the amount of derivative fair value, which is
disclosed by eight companies, six of them financial. This means that some companies
are already prepared to calculate the fair value of financial instruments, though they
are reluctant to disclose the calculation method and assumptions. These factors
complicate the understandability, the comparability, and the consistency of the
information. We question the usefulness of the information about the amount of fair
value, without the other disclosures.
Table 10: Fair value disclosures
Non-disclosing
Disclosing
N Financial Non-financial N Financial Non-financial
Fair value amount
11
3
8
8
6
2
Significant assumptions
19
9
10
0
0
0
Average fair value in the period 19
9
10
0
0
0
To sum up, we find that the fair value measurement criterion is being adopted by a large number of derivative users. However, with respect to hedging transactions (the most frequent operation in our sample companies), the gap between accounting practices and the relevant accounting standards is quite wide. The majority of companies use deferral accounting as the accounting method for hedging operations. Additionally, the level of hedging disclosure is very low. Therefore, the adoption of International Financial Reporting Standards will have its major impact on hedge accounting practices. Since the strategy most commonly adopted with derivatives is hedging, we can conclude that companies will be required to make a big change in their derivative accounting practices as a whole. A big improvement in reporting practices regarding this type of instruments will be needed.
24
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Financial Instruments Risk
We will characterize disclosure practices relating to all financial instruments (derivatives or not), namely, interest rate risk disclosures and credit risk disclosures.
Interest rate risk disclosures
Regarding interest rate risk, the level of disclosure (Table 11, panel A) is low when compared with that required by IAS 32 and IAS 39. Only a small number of companies include the exposure to future changes in the interest rates. Most companies disclose the contractual repricing or maturity dates of the assets and liabilities exposed to interest rate risk. IAS 32 suggests several alternative formats for information disclosure including: tabular; narrative descriptions based on maturity time bands; fixed and floating rate exposures; interest rate sensitivity analysis; and through the use of weighted average rates or ranges of rates. Table 11 (panel B) shows that our sample companies choose either narrative descriptions (33.3%) or a tabular format (50.0%). Only a small number of companies discloses sensitivity analysis information (8.3%).
Regarding the location of interest rate risk disclosures, most companies provide the
information in the notes to the accounts. Although small in number, there is a group of
companies (four) that presents the information only in the management report, that is,
in the non-audited part of the annual report. One company discloses the information in
several parts of the annual report.
Effects of future interest rate changes Maturity dates
Table 11: Interest rate risk
Panel A: Disclosures
Non-disclosing
Total Financial Non- Total
financial
51
7
44
4
21
6
15
34
Disclosing
Financial Non-
financial
4
0
5
29
Panel B: Format
N Financial Non-financial
Narrative descriptions
12 (33.3%) 0
12
Tabular format
18 (50.0%) 3
15
Sensitivity analysis
3 (8.3%)
3
0
Combination of several formats 3 (8.3%)
1
2
Total
36 (100.0%) 7
29
25
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Credit risk disclosures
Regarding credit risk (Table 12), we registered an even worse scenario than in the
above item. Only a small number of companies discloses the main counterparties
(7.3%), the maximum amount of credit risk (3.6%) and significant concentration of
credit risk (9.1%).
Table 12: Credit risk disclosures
Non disclosing
Total Financial Non-
financial
Counterparties identification
51 (92.7%) 8
43
Maximum amount of credit risk 53 (96.4%) 9
44
exposure
Significant concentration of credit risk 50 (90.9%) 8
42
Total 4 (7.3%) 2 (3.6%) 5 (9.1%)
Disclosing Financial 3 2 3
Nonfinancial 1 0 2
Analyzing the type of information about credit risk, three of the four companies that make any disclosure about counterparties' identification make quantitative disclosures; yet, regarding the concentration of credit risk, the disclosures are mainly descriptive (four out of the five companies that disclose the concentration of credit risk make qualitative descriptions). Information about credit risk is disclosed mainly in the management report (namely the one related to credit risk concentrations) and in the notes to the accounts (namely the counterparties' identification).
VI. Discussion of the results and future research The primary objective of this study is to ascertain how far Portuguese companies are from complying with IFRS concerning accounting for financial instruments. In order to achieve these objectives, we begin by analyzing Portuguese accounting standards related to financial instruments and comparing them with IAS 32 and IAS 39 with specific regard to measurement, recognition and disclosure rules. This provides initial insight into those areas where Portuguese companies are further away from IAS 32 and IAS 39 requirements. Then we analyze current accounting practices for financial instruments by Portuguese companies using as a benchmark the measurement, recognition and disclosure requirements of IAS 32 and IAS 39. This allows us to ascertain how far the Portuguese companies are from IFRS compliance. Our analysis suggests that the accounting practices for financial instruments are very far from meeting the IAS 32 and IAS 39 requirements, especially in the measurement 26
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 and recognition criteria applied to the categories of financial instruments for which the adoption of fair value (that is, held-for-trading and available-for-sale financial assets) is required. The quality of the disclosures is less than satisfactory, particularly with respect to fair value determination. Regarding derivative financial instruments, fair value measurement is being adopted by a large number of derivatives users. However, relative to hedging transactions, the gap between accounting practices and the relevant accounting standards is quite wide. Furthermore, the level of hedging disclosure is very low. The adoption of IAS 32 and IAS 39 will have a major impact on hedge accounting practices. Given that the most commonly adopted strategy with derivatives is hedging, we conclude that companies will have to make a considerable change in their derivative accounting practices as a whole. In addition, IAS 32 and IAS 39 will require enhanced disclosures, in terms of both quantity and specificity. We register generic and qualitative type descriptions of risk management policies and derivative financial controls, making difficult a clear understanding of information by users. Similar studies in other countries (Roulstone (1999) in USA, Woods and Marginson (2004) in UK, Chalmers and Godfrey (2000) in Australia) also find that companies disclose generic information about risk, derivatives adoption and risk management. All studies agree that this situation leads to a lack of usefulness and relevance of disclosed information, impeding users' understanding of risk exposure. Chalmers (2001) presents two arguments for these findings: the lack of quality of information available to managers and the proprietary nature of specific disclosure items. In her opinion, there are two areas, commodity risk and interest rate risk, that may be critical for companies due to their specific commercial sensitivity. Chalmers and Godfrey (2000) argue that the solution lies on more stringent standards with extended disclosure requirements in terms of quantity and specificity. They point out IAS 39 and FAS 133 as examples of standards that require enhanced disclosures. Woods and Marginson (2004) are in line with this last solution. They expect that improvements in the derivative disclosures of UK banks may be forthcoming with new financial instrument standards, namely as a consequence of IAS 32. Our empirical study shows that Portuguese companies have a quite long way to go in terms of accounting and disclosure of financial instrument activity, namely derivatives. This is a new and quite complex (namely in what concerns derivatives) area of companies' activity. In this context, we think that companies are still in the 27
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 process of acknowledgement of products' functioning and respective accounting regulation and designing information systems that produce adequate information for regulatory requirements. We think that the mandatory adoption of more stringent standards such as the IAS 32 and IAS 39 will improve the information disclosed by companies. However, this area is quite critical and sensitive to companies as it deals with exposure to risks and their management. Accordingly, doubt remains: first as to whether the existence of mandatory standards will necessarily mean compliance with them; and second, even if companies comply with IAS 32 and IAS 39, it remains to be seen whether the information disclosed under these standards is more useful for decision-making. This study also shows the importance of looking at de facto harmonization and not just de jure harmonization (Tay and Parker (1990)), namely when enforcement mechanisms are not efficient (and this may be the case of Portugal regarding the adoption of Accounting Directive 18 ­ a good point for new research). It is well documented in the literature that compliance must be enforced (Cairns (1998), Cairns (1999)) and that some companies claim to comply with IFRS but in fact fail to comply with many IFRS requirements (Street et al. (1999), Street and Bryant (2000), Street and Gray (2001)). All this reinforces the need to study practices instead of regulations only, when analysing compliance and harmony. As a next phase of this research, we are going to develop the same analysis for other years, namely after 2005, in order to analyze the evolution of accounting practices and compliance within new accounting frameworks and draw some conclusions on the role of mandatory standards and on the efficiency of enforcement mechanisms. Finally, we would like to mention some limitations of this study. First, regarding the types of derivative users, we adopt the classifications of explicit derivative users, explicit non-users and implicit non-users. The classification as implicit non-user is based only on annual report silence. While care was taken with classifications, it is possible that some sample firms that are classified as non-users of derivatives may in fact be non-disclosers rather than non-users. The effect of this would be that our incidence of non-disclosure may be understated, implying a greater impact of the adoption of IFRS. Second, we are aware that annual reports may not be the best source of information on compliance or, at least, they are certainly not the only one. We should thus accept that our results may not show important aspects of accounting 28
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 practices, and that they are naturally influenced by the source of information used. There is also a limitation inherent to the research method adopted. Whilst the authors took every care when examining the information provided in the annual reports and classifying it into the categories, errors may still have occurred. In spite of these limitations, this research reveals very important results. It sheds light on the areas where Portuguese companies will encounter more difficulties when changing to IFRS. Besides, our findings are also very useful to national standard setters, including Portuguese standard setters, and to the IASB as they point out which areas will require more work in order to achieve convergence to IAS 32 and IAS 39 and high degrees of compliance with these accounting standards. 29
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Appendix I - List of categories for the content analysis
N Category description 1 Financial investments 2 Sort-term marketable securities 3 Loans 1. FINANCIAL INSTRUMENTS, EXCLUDING DERIVATIVES Information about accounting policies 4 Held for trading securities 5 Held-to-maturity securities 6 Loans and receivables originated by the enterprise 7 Available-for-sale financial assets 8 Liabilities held for trading 9 Other financial liabilities 10 Trade date vs Settlement date 11 Location of the information Information about fair values and market values 12 Measurement method 13 Significant assumptions 14 Fair value changes in Available-for-sale financial assets 15 Amount recognized in equity 16 Amount removed from equity 17 Inability of reliability in measurement 18 Financial assets description 19 Their carrying amount 20 Explanation of the reason 21 Range of estimates within which the fair value is likely to lie 22 Location of the information Information about securitization and repurchase agreements 23 Existence of operations 24 Type of information 25 Accounting policy 26 Type of information 27 Nature and extent 28 Type of information 29 Collateral 30 Type of information 31 Information about the key assumptions used in calculating the fair value of new and retained interests 32 Type of information 33 Whether the financial assets have been derecognized 34 Type of information 35 Location of the information 36 Impairment losses 37 Location of the information 38 Total interest income and total interest expense separately 39 Location of the information 40 For AFS assets, realized and unrealized profits/losses 41 Location of the information
Number of answers 3 3 3 3 3 3 2 5 7 2 3 2 2 2 2 2 2 2 5 2 2 2 2 2 2 2 2 2 2 2 2 5 2 5 2 5 2 5
30
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
2. DERIVATIVES
42 Type of user
4
43 Instruments
25
Information about accounting policies
44 Risk management policy, including hedging policy
2
45 Type of information
2
46 Location of the information
5
47 Objectives of holding or issuing derivatives
5
48 Type of information
2
49 Location of the information
5
50 Accounting policies and methods adopted
5
51 Type of information
2
52 Location of the information
5
53 Monitoring and controlling policy
2
54 Type of information
2
55 Location of the information
5
56 Financial controls
2
57 Type of information
2
58 Location of the information
5
Information about risks
59 Segregation by risk categories
2
60 Type of information
2
61 Location of the information
5
62 Principal, stated value, face value, notional value
2
63 Type of information
2
64 Location of the information
5
65 Maturity
2
66 Type of information
2
67 Location of the information
5
68 Weighted average/effective interest rate
2
69 Type of information
2
70 Location of the information
5
Information about hedging transactions
71 Hedging description
2
72 Type of information
2
73 Location of the information
5
74 Accounting method
4
75 Type of information
2
76 Location of the information
5
77 Financial instruments designated as hedging instruments
2
78 Type of information
2
79 Location of the information
5
80 Fair values
2
81 Type of information
2
82 Location of the information
5
83 Nature of the risks being hedged
2
84 Type of information
2
85 Location of the information
5
Future transactions hedging
86
Existence
2
87
The period in which forecasted transactions are expected to occur
2
88
The period they are expected to enter in income
2
Cash-flow hedging
89
Existence
2
90
The amount recognized in equity
2
91
The amount removed from equity and recognized in income
2
92
The amount removed from equity and added to initial measurement of 2
the acquisition cost
31
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Information about fair values 93 Fair value 94 Method adopted 95 Significant assumptions 96 Average fair value during the year 97 Location of the information 3. ALL FINANCIAL INSTRUMENTS Information about interest rate risk 98 Future changes in interest rates 99 Type of information 100 Maturity dates 101 Disclosure format 102 Location of the information Information about credit risk 103 Counterparties identification 104 Type of information 105 Location of the information 106 Maximum amount of credit risk exposure 107 Type of information 108 Location of the information 109 Significant concentration of credit risk 110 Type of information 111 Location of the information Others 112 Collateral ­ terms and conditions 113 Type of information 114 Location of the information 115 Collateral - Carrying amount and fair value 116 Type of information 117 Location of the information 118 Negative Information 119 Type of information 120 Location of the information
2 7 2 2 5 2 2 2 4 5 2 2 5 2 2 5 2 2 5 2 2 5 2 2 5 2 2 5 Total answers 370
32
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1
Appendix II ­ Sample companies
company name Barbosa & Almeida BANIF BCA BCP BES BPI BRISA
Economic Sector Industrial Financial Financial Financial Financial Financial Industrial
BSCH Banco Totta & Aзores Corticeira Amorim
Financial Financial Industrial
Companhia de Celulose do Caima CENTRAL - Banco de Investimento CIMPOR CIN CIRES COFINA COMPTA Modelo Continente EDP EFACEC Estoril - Sol F.Ramada FINIBANCO FISIPE Grгo-Parб IBERSOL IMOLEASING IMPRESA INAPA
Industrial Financial Industrial Basic materials Basic materials Basic materials Technology Consumer, non-cyclical Utilities Industrial Consumer, cyclical Basic materials Financial Basic materials Industrial Consumer, cyclical Financial Consumer, cyclical Basic materials
Company Name ITI Jerуnimo Martins LISGRAFICA Mota-Engil Mundicenter NOVABASE Soc. Comercial Orey Antunes Papelaria Fernandes PARAREDE PORTUCEL Produtora de Pasta e Papel PT Multimйdia.Com PT Multimйdia REDITUS Salvador Caetano Soares da Costa SAG GEST SEMAPA SOMAGUE SONAE Indъstria SONAE SGPS SONAE.COM SUMOLIS Teixeira Duarte Portugal Telecom TERTIR Vista Alegre Atlantis Vodafone Telecel
Economic Sector Consumer, cyclical Consumer, non-cyclical Consumer, cyclical Industrial Financial Technology Industrial Consumer, cyclical Technology Basic materials Technology Consumer, cyclical Technology Industrial Industrial Consumer, cyclical Industrial Industrial Industrial Consumer, non-cyclical Telecommunications Consumer, non-cyclical Industrial Telecommunications Industrial Consumer, cyclical Telecommunications
33
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 References BDO, Delloite, Ernst&Young, G. Thornton, KPMG, & PricewaterhouseCoopers. (2003). GAAP Convergence 2002: a survey of national efforts to promote and achieve convergence with International Financial Reporting Standards. Ed.: BDO, Delloite, Ernst&Young, Grant Thornton, KPMG, and PricewaterhouseCoopers. Blankley, A., Lamb, R., & Schroeder, R. (2000). Compliance with SEC Disclosure Requirements about market risk. Journal of Derivatives, 7 (3), 39-51. Cairns, D. (1998). Compliance must be enforced. Accountancy: International Edition, 122, 1261, 64-65. Cairns, D. (1999). Degrees of compliance, Accountancy: International Edition, 124 (1273), 114-118. Chalmers, K. (2001). The progression from voluntary to mandatory derivative instrument disclosures - Look who's talking. Australian Accounting Review, 11 (1), 34-44. Chalmers, K., & Godfrey, J. (2000). Practice versus prescription in the disclosure and recognition of derivatives. Australian Accounting Review, 11 (2), 40-50. CNC. (1996). Accounting Directive No. 18 Objectivos das Demonstraзхes Financeiras e Princнpios Contabilнsticos Geralmente Aceites (Objectives of financial reporting and Generally Accepted Accounting Principles). Only Portuguese version available. CNC. (1997). Accounting Directive No. 17 Contratos de Futuros (Futures Contracts). Only Portuguese version available. CNC. (2003). Projecto de Linhas de Orientaзгo para um Novo Modelo de Normalizaзгo Contabilнstica. Ed.: CNC. Only Portuguese version available. Decree-law 410/89, 21st November 1989 ­ Portuguese Accounting Act. Decree-Law 367/99, 18th September 1999 ­ Portuguese Accounting Standards Board Statutory Rules. Decree-Law Nє 88/2004, 20th April 2004 ­ Transposition to Portugal of Directive 2001/65/EC. Directive 78/660/EEC, 25th July 1978 based on Article 54 (3) (g) of the Treaty on the annual accounts of certain types of companies, Official Journal L 222, 14/08/1978 P. 0011 ­ 0031. Directive 2001/65/EC, 27th September 2001 amending Directives 78/660/EEC, 83/349/EEC and 86/635/EEC as regards the valuation rules for the annual and consolidated accounts of certain types of companies as well as of banks and other financial institutions, Official Journal L 283, 27/10/2001 P. 0028 - 0032. Dunne, T., Helliar, C., Mallin, C., Moir, L., Ow-Yong, K., & Power, D. (2003). The financial reporting of derivatives and other financial instruments: a study of the implementation and disclosures of FRS 13. Ed.: Institute of Chartered Accountants in England & Wales (ICAEW). Dunne, T., Helliar, C., Power, D., Mallin, C., Ow-Yong, K., & Moir, L. (2004). The introduction of derivatives reporting in the UK: A content analysis of FRS 13 disclosures. Journal of Derivatives Accounting, 1 (2), 205-219. Edwards Jr. G., & Eller, G. (1995). Overview of derivatives disclosures by major U.S. banks. Federal Reserve Bulletin, September, 817-831. Edwards Jr., G. & Eller, G. (1996). Derivatives disclosures by major U.S. banks, 1995. Federal Reserve Bulletin, September, 792-801. 34
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 Evans, T. & Taylor, M. (1982). Bottom line compliance with IASC: A comparative analysis. The International Journal of Accounting, 18 (1), 115-128. FASB. (1990). FAS 105 Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk. FASB. (1991). FAS 107 Disclosures about Fair Value of Financial Instruments. FASB. (1994). FAS 119 Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. FASB. (1998). FAS 133 Accounting for Derivative Instruments and Hedging Activities. FASB. (2000). FAS 138 Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement 133. FASB. (2003). FAS 149 Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Gйlard, G. (2004). What can be expected from Accounting Standards? Accounting in Europe, 1, September, 17-20. Hague, I. (2004). IAS 39: Underlying principles. Accounting in Europe, 1, September, 21-26. Hamlen, S. & Largay, J. (2005). Has SFAS 133 made derivatives reporting more transparent? A look at the Dow-Jones 30. Journal of Derivatives Accounting, 2 (2), 215-230. Holsti, O. R. (1969). Content analysis for the social sciences and humanistics (Reading: Addison-Wesley). IASB. (1995). IAS 32 Financial Instruments: Disclosure and Presentation. IASB. (1999). IAS 39 Financial Instruments: Recognition and Measurement. Jermakowicz, E. (2004). Effects of adoption of International Financial Reporting Standards in Belgium: The evidence from BEL-20 companies. Accounting in Europe, 1, September, 51-70. Jones, M. J. & Shoemaker, P. A. (1994). Accounting narratives: A review of empirical studies of content and readability. Journal of Accounting Literature, 13, 142-161. Koonce, L. L., Lipe, M. G., & McAnally, M. L. (2006). Investor reactions to derivative use: Experimental evidence, Working Paper. Larson, R. & Street, D. (2004). Convergence with IFRS in an expanding Europe: progress and obstacles identified by large accounting firms' survey. Journal of International Accounting, Auditing & Taxation, 13 (2), 89-119. Mahoney, J. & Kawamura, Y. (1995). Review of 1994 disclosures about derivative financial instruments and fair value of financial instruments. Financial Accounting Series. Ed.: Financial Accounting Standards Board, 156-A. Nobes, C. (1990). Compliance by US corporations with IASC Standards. The British Accounting Review, 22 (1), 41-49. Pacter, P. (2005). What exactly is convergence. International Journal of Accounting, Auditing and Performance Evaluation, 2 (1/2), 67-83. Roulstone, D. (1999). Effect of SEC Financial Reporting Release nє 48 on derivative and market risk disclosures. Accounting Horizons, December, 13 (4), 343-363. Street, D., and Bryant, S. (2000). Disclosure level and compliance with IASs: A comparison of companies with and without US listings and filings. The International Journal of Accounting, 35 (3), 305-329. 35
P. T. Lopes and L. L. Rodrigues/FRRaG (Financial Reporting Regulation and Governance) 2006, 5:1 Street, D. & Gray, S. (1999). How wide is the gap between IASC and U.S. GAAP? Impact of the IASC comparability project and recent international developments. Journal of International Accounting, Auditing & Taxation, 8 (1), 133-164. Street, D., and Gray, S. (2001). Observance of International Accounting Standards: Factors explaining non-compliance, ACCA Research Report nє 74, L. Certified Accountants Educational Trust. Street, D., Gray, S., & Bryant, S. (1999). Acceptance and observance of International Accounting Standards: An empirical study of companies claiming to comply with IASs. The International Journal of Accounting, 34 (1), 11-48. Street, D. & Larson, R. (2004). Large accounting firms' survey reveals emergence of "two standard" system in the European Union. Advances in International Accounting, 17, 1-29. Sucher, P. & Jindrichovska, I. (2004). Implementing IFRS: A case study of the Czech Republic. Accounting in Europe, 1, September, 109-141. Tay, J. & Parker, R. (1990). Measuring international harmonization and standardization. Abacus, 26 (1), 71-88. Walton, P. (2004). IAS 39: Where different accounting models collide. Accounting in Europe, 1, 5-16. Whittington, G. (2005). The adoption of International Accounting Standards in the European Union. European Accounting Review, 14 (1), 127-153. Woods, M. & Marginson, D. (2004). Accounting for derivatives: An evaluation of reporting practice by UK Banks. European Accounting Review, 13 (2), 373391. 36

PT Lopes, LL Rodrigues

File: accounting-practices-for-financial-instruments-how-far-are-portuguese.pdf
Title: Fair Value Accounting of Financial Instruments
Author: PT Lopes, LL Rodrigues
Published: Wed Sep 13 14:37:39 2006
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