Investors and investment analysts have low confidence in the reliability of financial-instrument risk disclosures under International Financial Reporting Standards, finding them difficult to understand and lacking consistency and comparability, according to a study released Monday by the CFA Institute.
The study, “User Perspective on Financial Instrument Risk Disclosures Under IFRS, Volume 1,” addresses credit, liquidity, market and hedging risk disclosures under IFRS Statement No. 7 on financial instruments disclosures.
The study found that while risk disclosures are both widely used and regarded as important by investors and analysts, these financial-statement users “have low level of satisfaction” with the disclosures, it states.
Investors and analysts also blame the “incomplete nature and often fragmentary presentation” of risk disclosure, complaining that the market-risk category is too broad and qualitative disclosures are uninformative, the 65-page Volume 1 states.
“(L)imited transparency regarding these risk exposures contributes to the mispricing of risk and misallocation of capital, and abates investors’ ability to provide market discipline on a timely basis,” the study states. “This limited transparency also contributes to the disorderly capital market correction in the valuation of companies during crisis periods.
In the study, the authors — Vincent T. Papa, director, financial reporting policy, and Sandra J. Peters, head, financial reporting policy, both of the CFA Institute — recommend overall disclosure “focus on communication and not mere compliance.”
“IFRS 7 disclosure requirements illustrate that a principles-based definition of disclosure is not the antidote to fears about boilerplate and uninformative disclosures,” the study states. “In fact, broad and vague definitions that are then described as principles are a significant contributory factor to uninformative disclosures. The review of these financial risk disclosures shows that there remains a need for financial statement preparers to shift away from “tick-box mere compliance” with disclosure requirements. Preparers should adopt a meaningful communication mindset aiming to convey risk exposures and risk-management policy effectiveness, as well as to foster a dialogue with investors.”
Based on the shortcomings noted by 133 respondents providing feedback in a survey consisting of 83 CFA Institute members and 50 external sell-side analysts who were not CFA Institute members, the study recommended that companies provide an executive summary of risk disclosures, outlining details of entitywide risk exposure and effectiveness of risk-management mechanisms across different risk types; and differentiate components of market risk into more specific categories, such as interest rate, foreign currency and commodity.
In late December, the CFA Institute plans to release Volume 2, focusing on investor and analyst perspectives on disclosures of hedging activities risk under IFRS No. 7.
The current sovereign-debt crisis and the 2007 to 2009 market crisis accentuated the importance of financial-instrument disclosures to help investors and analysts to understand the risks associated with on- and off-balance-sheet items and the interconnectedness of the state of the economy and credit, liquidity, market and other key financial risk exposures, the study notes.
The full study can be downloaded at the CFA Institute website.