USER PERSPECTIVES ON FINANCIAL INSTRUMENT RISK DISCLOSURES UNDER INTERNATIONAL FINANCIAL REPORTING STANDARDS Derivatives and Hedging Activities Disclosures (Volume 2) January 2013 User Perspectives on Derivatives and Hedging Activities Disclosures Under IFRS Foreword CFA Institute1 has undertaken a study to examine the quality of existing financial instruments risk disclosures. The overall study evaluated credit, liquidity, and market risk disclosures and disclosures for derivatives and hedging activities under International Financial Reporting Standards (IFRS). The study specifically focuses on IFRS Statement No. 7 (IFRS 7), Financial Instruments: Disclosures. This report, Volume 2, provides a user perspective on the disclosures of derivatives and hedging activities. It is an extension to Volume 1, which provided a user perspective on financial instrument credit, liquidity and market risk disclosures. Acknowledgements This report was developed with significant contribution from Gerry White, Tony Cope, the Advocacy and Outreach Team of the Standards and Financial Market Integrity (SFMI) division, Publications team, and several other colleagues who reviewed the report, and Catherine Kleszczewski who provided administrative support during the report-writing phase. We also acknowledge the participation and input of the CFA Institute members and non-member sell-side analysts who contributed their time and valuable insights. Authors Vincent T. Papa, PhD, CFA Director, Financial Reporting Policy CFA Institute Sandra J. Peters, CFA, CPA Head, Financial Reporting Policy CFA Institute 1 CFA Institute is the global association for investment professionals. It administers the CFA and CIPM curriculum and exam programs worldwide; publishes research; conducts professional development programs; and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute has more than 115,000 members, who include the world’s 109,000 CFA charterholders, in 135 countries and territories, as well as 137 affiliated professional societies in 59 countries and territories. More information may be found at www.cfainstitute.org. 1 User Perspectives on Derivatives and Hedging Activities Disclosures Under IFRS TABLE OF CONTENTS 1 Overview .............................................................................................................................................................. 3 1.1 Executive Summary....................................................................................................................................................... 3 1.2 Objective and Significance of Study ............................................................................................................................. 9 1.3 Background Information on Derivatives and Hedge Accounting and Disclosures ...................................................... 13 1.4 Scope ........................................................................................................................................................................... 14 1.5 Methodology ............................................................................................................................................................... 15 1.6 Organisation of Document........................................................................................................................................... 17 2 Analytical Framework and Review of Related Studies ...................................................................................... 18 2.1 Analytical Framework ― Useful Derivatives and Hedging Activities Financial Reporting Information ................... 18 2.2 Review of Related Studies ― Verifying the Usefulness of Derivatives and Hedge Accounting Disclosures ............. 22 2.3 Conclusion ................................................................................................................................................................... 27 3 User Feedback on and Application of Derivatives and Hedge Accounting Disclosures ................................... 28 3.1 User Feedback on Derivatives and Hedge Accounting Disclosures ............................................................................ 28 3.2 Potential User Application of Derivatives and Hedging Disclosures .......................................................................... 32 3.3 Conclusion ................................................................................................................................................................... 40 4 Review of Annual Reports’ Derivatives and Hedging Activities Disclosures .................................................... 41 4.1 Construction of the Disclosure Quality Index (DQI) ................................................................................................... 41 4.2 Key Findings ............................................................................................................................................................... 43 4.3 Conclusion ................................................................................................................................................................... 62 5 Recommendations .............................................................................................................................................. 63 5.1 Summary of Recommendations ................................................................................................................................... 63 5.2 Review of Proposed Additional IFRS Disclosures ...................................................................................................... 70 5.3 Overall Report Conclusion .......................................................................................................................................... 72 6 Appendix ― Case Study, Survey Design and Hedge Accounting Requirements ................................................. I 6.1 Case Study ― Usefulness of Airline Company Derivatives and Hedging Disclosures .................................................. I 6.2 Survey Design and Study Limitations ....................................................................................................................... XV 6.3 Current and Proposed Hedge Accounting Requirements ......................................................................................... XVII 2 User Perspectives on Derivatives and Hedging Activities Disclosures Under IFRS 1 Overview This overview section of the report discusses the following: Executive Summary (Section 1.1); Objective and Significance of Study (Section 1.2); Background Information on Derivatives and Hedge Accounting and Disclosures (Section 1.3); Scope (Section 1.4); Methodology (Section 1.5); and Organisation of Document (Section 1.6). 1.1 Executive Summary CFA Institute has undertaken a study to examine the quality of existing financial instruments risk disclosures. This report, Volume 2, provides a user perspective on the disclosures of derivatives and hedging activities. It is an extension to Volume 1 which provided a user perspective on financial instrument credit, liquidity and market risk disclosures. In its approach, the study: Reviews relevant literature on derivatives and hedging activities disclosures; Obtains user feedback through user surveys and interviews; and Reviews the quality of disclosures made in 2011 and 2010 annual reports of 30 IFRS-reporting companies (including a detailed case study review of the disclosures of Lufthansa Airlines). The company review contextualises the user feedback obtained. As a result of reviewing company annual reports, some examples of both useful and less useful disclosures are highlighted. As discussed in Section 1.5, the study triangulates these sources of information in order to recommend derivatives and hedging disclosures which are more useful for users of financial statements. Key Findings ― User Feedback and Existing Literature Reveal That Existing Hedging Disclosures Do Not Fully Inform on Risk Management The user feedback in Section 3.1 shows that hedge accounting disclosures are seen as moderately important when compared with the importance assigned to credit, liquidity and market risk disclosures.2 In addition, there was low user satisfaction with all risk disclosures and with hedge accounting disclosures. Respondents indicated that hedge accounting and disclosure requirements are complex and confusing for users and they do not readily communicate key economic information (e.g. nature of hedging strategies, hedged versus unhedged exposures and hedge effectiveness). The highly complex and arcane nature of hedge accounting rules, along with the partial information regarding hedging activities addressed by hedge accounting disclosures, does not help users to discern the entirety of risk management practices of reporting companies. This explains the ratings of moderate importance of, and low satisfaction with, hedge accounting disclosures. 2 Hedge accounting disclosures cover derivatives that qualify for hedge accounting, while disclosures associated with derivatives instruments are included in users’ ratings of credit, liquidity and market risk disclosures, which cover all financial instruments. 3 User Perspectives on Derivatives and Hedging Activities Disclosures Under IFRS That said, as discussed in Section 3.2, user comments show that high-quality derivatives and hedging activity