Making Derivative Transactions Transparent
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In an efficient market, it shouldn’t matter where in an annual report a company shows its financial derivatives. Texas A&M accounting researcher Anwer Ahmed notes that investors and analysts in an efficient market would have the time and attention spans needed to pore through information recognized in the balance sheets and disclosed in footnotes.
But if the stock market was as efficient as it is thought to be, someone might have paid more attention earlier on to the alarming activities of Enron’s numerous special purpose entities — which were disclosed in just a few sentences in the footnotes.
“Firms would rather disclose than recognize the effects of derivatives, because they don’t want the volatility of their financial derivatives to affect their reported income or earnings,” says Ahmed, an associate professor of accounting at Mays. “Financial analysts, though, would rather see these effects reported in the financials.”
How investors view derivatives differs, Ahmed finds in recent research, depending on whether the value of such financial derivatives is recognized (or reported) on the balance sheets or found in the footnote disclosures. In other words, recognition and disclosure are not substitutes, his co-authored research indicates.
He points to several theories that might help explain why investors attach more value to information they find in the company’s balance sheets. Investors might have a limited attention span that affects their perusal of footnotes, Ahmed says. The cost of information processing might be prohibitive. Or investors may simply perceive the balance sheets to be more reliable than footnotes in a financial report.
Ahmed and Emre Kilic and Gerald Lobo — both of the University of Houston — also examine differences in investor valuation of derivatives before and after implementation of the controversial standard of accounting for derivatives, Statement of Financial Accounting Standards (SFAS) No. 133. That requires all financial derivatives to be reported on the balance sheet as assets or liabilities and marked-to-market. They find that derivatives were not significantly valued when they were disclosed in footnotes before SFAS 133 but were significantly valued by investors after they were recognized, in accordance with SFAS 133.
Ahmed’s research, in The Accounting Review in May 2006, has implications for both academics as well as accounting standard setters. It supports the presumption underlying SFAS No. 133 that recognizing derivatives on the balance sheet is critical to making derivative transactions transparent to investors.
An earlier version of the study has already been downloaded more than 270 times from the Social Science Research Network. It was also cited by Katherine Schipper, a member of the Financial Accounting Standards Board, in a presentation at the American Accounting Association annual meeting in 2005.
Search for the paper, entitled “Does Recognition versus Disclosure Matter? Evidence from Value-Relevance of Banks’ Recognized and Disclosed Derivative Financial Instruments,” at http://papers.ssrn.com.
—Sommer Hamilton
