THE INFORMATION QUALITY OF DERIVATIVE DISCLOSURES IN CORPORATE ANNUAL REPORTS OF AUSTRALIAN FIRMS IN THE EXTRACTIVE INDUSTRIES Mohamat Sabri Hassan B.Ac (Hons.) (Universiti Kebangsaan Malaysia), M.Social Science (Southampton) A dissertation submitted for the degree of Doctor of Philosophy within the School of Accountancy at Queensland University of Technology 2004 Keywords: Disclosure quality; transparency; disclosure index; financial instruments; derivative instruments; market value; extractives industries. ii ABSTRACT Recent events in the business world have focused attention on the importance of high quality financial reporting. Of particular interest is where the collapse of prominent companies such as Baring Plc. was due to the company’s involvement with derivative instruments. In Australia, some derivative instruments are not recognised in the balance sheet. However, the Australian accounting standard AASB 1033 Presentation and Disclosure of Financial Instruments requires extensive disclosures to overcome the lack of guidance with regard to the recognition and measurement. Therefore, AASB 1033 may be regarded as a high quality disclosure standard. This thesis investigates the transparency or information quality of derivative disclosures of Australian firms in the extractive industries using 1998 to 2001 financial reports. The extractive industries play a major role in the Australian economy, where they generated exports worth more than A$30billion in 2000 to 2002 (Department of Foreign Affairs and Trade, 2003a and 2003b). Further, firms in the extractive industries extensively use derivative instruments for hedging purposes (Berkman, Bradbury, Hancock and Innes, 1997). The objective of this study is, first, to examine the relationship between the transparency or disclosure quality of derivative information and firm characteristics. Second, this study investigates the value relevance of derivative disclosures in particularly hedge information, net fair value information and risk information. Quality is measured based on a disclosure index developed from AASB 1033 Presentation and Disclosure of Financial Instruments. A finding of concern is that the majority of firms in this study provide less than complete information and therefore enforcement power is required to ensure compliance (Kothari, 2000) Prior studies have related disclosure quality of accounting information with firm characteristics but no attempt has been made to relate those characteristics with the disclosure quality of derivative instruments. The current study contributes to the literature by examining the relationship between firm characteristics and the quality of derivative disclosures. Firm characteristics investigated are size, profitability, price- iii earnings ratio, market-to-book ratio, research and development activity, auditor, debt- to-equity ratio and type of extractive firm. This study finds that the variables, firm size, price-earnings and debt-to-equity ratios are associated with the disclosure quality of derivative information. To a lesser extent, the variables, market-to-book ratio and profitability, are also associated with disclosure quality. High disclosure quality has been argued to lead to a reduction in the cost of debt (Sengupta, 1998) and equity (Botosan, 1997), resulting in higher security prices (Miller and Bahnson, 2002). The results of this study indicate that high quality derivative information, as represented by the disclosure index, is value relevant. Market participants do consider hedge information and risk information components as important for decision-making. However, examining the specific information disclosed in the financial statements indicate that some of the disclosed information such as the unrealised gain or loss on financial assets and liabilities and off-balance sheet derivative financial instruments are not significant. These results contribute to the value relevance literature as this study focuses on the extractive industries which have been neglected in the literature. This study provides important information for standard setters and regulators for future directions in developing accounting standards and is particularly relevant for the impending adoption of International Accounting Standards. iv Table of Contents Page ABSTRACT ......................................................................................................................................... III ACKNOWLEDGEMENTS ...............................................................................................................XII CHAPTER 1 INTRODUCTION .....................................................................................................1 1.1 PURPOSE OF THE STUDY.........................................................................................................1 1.2 PRIOR RESEARCH AND THE MAIN FINDINGS OF THE THESIS...................................................3 1.3 MOTIVATION..........................................................................................................................6 1.4 PLAN OF THESIS .....................................................................................................................9 CHAPTER 2 INSTITUTIONAL BACKGROUND .....................................................................12 2.1 RISK MANAGEMENT.............................................................................................................12 2.1.1 To Hedge or Not to Hedge?............................................................................................14 2.2 INTERNATIONAL ACCOUNTING PRACTICES ..........................................................................16 2.2.1 Financial Accounting Standard Board...........................................................................17 2.2.1.1 SFAS 133 Accounting for Derivative Instruments and Hedging Activities. ............................19 2.2.2 International Accounting Standards Board....................................................................20 2.2.2.1 IAS 32 Financial Instruments: Disclosure and Presentation.....................................................20 2.2.2.2 IAS 39: Financial Instruments: Recognition and Measurement ...............................................22 2.2.3 Accounting for Financial Instruments in Australia ........................................................23 2.2.3.1 AASB 1033 Presentation and Disclosure of Financial Instruments .........................................23 2.3 FAIR VALUE ACCOUNTING...................................................................................................31 2.4 STUDIES OF ACCOUNTING PRACTICES IN AUSTRALIA ..........................................................35 2.5 RISK MANAGEMENT PRACTICES IN THE EXTRACTIVE INDUSTRIES ......................................37 2.6 SUMMARY............................................................................................................................39 CHAPTER 3 LITERATURE REVIEW: DISCLOSURE QUALITY........................................41 3.1 DISCLOSURE QUALITY: THE DEFINITIONS ...........................................................................42 3.2 DISCLOSURE QUALITY: REGULATION, ENFORCEMENT AND COMPLIANCE...........................44 3.3 STUDIES ON DISCLOSURE QUALITY .....................................................................................46 3.3.1 Disclosure Quality of Accounting Standards..................................................................46 3.3.2 Disclosure Quality of Accounting Information and the Impact on Firms.......................48 3.3.2.1 Disclosure Quality and Firms Characteristics ..........................................................................48 3.3.2.2 Disclosure Quality of Specific Information..............................................................................52 3.3.3 Disclosure Quality of Accounting Information and Benefits to the Investors.................54 3.3.4 Disclosure Quality of Derivative Information ................................................................57 3.4 SUMMARY............................................................................................................................59 CHAPTER 4 LITERATURE REVIEW: DERIVATIVE DISCLOSURES AND VALUE RELEVANCE STUDIES.....................................................................................................................60 4.1 DISCLOSURE QUALITY OF ACCOUNTING INFORMATION AND INVESTORS’ DECISIONS .........60 4.2 DISCLOSURE AND CAPITAL MARKETS RESEARCH................................................................62 4.2.1 Capital Markets Research ..............................................................................................62 4.2.2 Relevance and Reliability of Accounting Information and Capital Markets Research...65 4.2.3 Value Relevance Studies.................................................................................................68 4.2.3.1 Other Value Relevance Studies................................................................................................69 4.2.3.2 Research on Value Relevance in Australia...............................................................................70 4.3 VALUE RELEVANCE OF FINANCIAL INSTRUMENTS...............................................................73 4.3.1 Studies on Value Relevance of Fair Value Disclosures..................................................73 4.3.2 Studies on Value Relevance of Derivative Financial Instruments Disclosures ..............76