An investigation into corporate annual reports of Pakistani firms

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The objective of this thesis is to examine the relationship between the transparency, or disclosures quality of derivative information and firms characteristics. This thesis also investigates the importance of derivatives in a particular hedge information, net fair value information and risk information. Derivatives are financial instruments whose values are derived from the value of underlying assets, liability, interest rate or hedge. Most or these instruments, such as interest rate swaps and option contracts requires no initial cash out lay or only a small initial expend.

Firms use derivatives financial instruments to hedge foreign exchange risk, interest rate and commodity changes prices. However due to the nature of the derivatives they are not recognized as assets and liabilities in the balance sheet nor the unrealized gain or loss recorded in the income statement. But information about them as voluntary and mandatory is disclosed in the notes to the financial statements in order to enhance financial statement user understanding of the implication of derivatives financial instruments and the related risks. To examine the recognized and unrecognized financial information in decision making it is need to examine the quality of information. The quality of financial statement based on three criteria Transparency, Comparability and full disclosure.

Several studies investigate the quality of accounting information based on the impact of corporate annual report disclosures practice and usefulness of the information in decision making. The quality of disclosure based on the perception on the users such as financial analyst, shareholder, creditors, researchers, on the accounting numbers and the association of accounting information with share prices.

There are five categories of information required for presentation and disclosures of financial instruments. These are disclosure of accounting policy, hedge of anticipated transaction, risk information, net fair value information and commodity contracts which are regarded as financial instruments.

Problem Statement

Among many other things that the current global financial crisis has highlighted governance issues in areas of financial statement disclosures transparency, implementation of risk management, remuneration process and the exercise of shareholder rights and where failures in corporate governance occurred. This financial crisis has also highlighted the importance strong risk management which is not limited to financial institutions. Furthermore it is the fact that accounting standards and regulatory requirements have to be sufficiently enforced.

One such critical area relating to accounting standards concerns is the information quality and transparent disclosure of derivatives trading activities of the firms. The use of financial instruments by different companies with different valuations for the same financial instrument contributes to reduced market integrity. Now firms are reporting according to the FASB classification on how the financial instruments have been valued. The IASB is strengthening its standards to achieve better disclosures about valuations of the financial instruments. The International Auditing and Assurance Standards Board (IAASB) is also considering the lessons learned from the market meltdown and where necessary it will enhance the guidance for audits of valuations of complex or illiquid financial products and related disclosures.

High quality accounting and disclosure is an absolute essential for maintaining market integrity. It also provides the much needed comparability that helps investors, big and small, to make well informed capital allocation decisions. Each company should prepare its financial statements on a consistent basis so that investors can analyze performance across time periods. Also the reporting by different companies should be comparable. In this regard I am proud of the fact that the Best Corporate Report Awards organized by the Institute of chartered accountants of Pakistan (ICAP) for the last eight years and it have come a long way in improving the quality of annual reports of listed entities.

A very important condition is that the professional standards which provide the benchmark for comparability and transparency must be of high quality and must provide for full disclosure of financial and non financial activities in corporate annual reports of the firms. The disclosure must also provide for fair, transparent, timely and cost effective access to the users of financial statements. Transparency requires that companies must report compliance with IAS, IFRS, local related laws and regulation, code of corporate governance and, where needed, give reasons for variation. On the other hand evidence of good and transparent disclosure of financial statements leads to increased shareholder value and integrity of the market. It is now evident that global capital markets will insist upon clear and relevant financial information. In a highly competitive volatile global market it is need unwavering commitment to high standards, constant improvement, and fast adaptation to an ever changing business environment. The only way forward is that it is to must begin to look at disclosure as more than just a compliance task and at governance as more than just a hindrance.

The current credit critical situation has spread from its origins in the sub prime financial borrowing market to affect investors across the all of financial sectors. The causes of this inaccessible reaching matter are many but some stand out. The quality of disclosure and improperly valued financial derivatives in companies' financial statement and annual reports can mislead investors and it may also cause poor investment decisions. The current consequences of falling financial markets are partially a result of market correction to the appropriate disclosure and valuation levels for the financial instrument or financial derivatives.

The quality of derivative disclosure and fair value measurement also represents a current trend in financial reporting away from traditional historical cost accounting. Recent pronouncements IAS 32, IAS 39 and IFRS 7 such as FAS 133 and FAS 119 are evidence of FASB and IASB active support of this movement. These standards clarify and create more accuracy behind current financial derivative disclosures and fair value techniques.

Research Questions

Do the firms in the industries provide more transparent disclosure in their corporate annual reports?

Do the performance of firms in the industry is a base of more transparent derivatives disclosure in the financial statements and corporate annual reports.

Do the firms in the industry reflect the information of financial instruments that firms hedge their exposure to the risk from anticipated transaction?

Methods of Investigation

I plan to research this topic using studies and articles published in this regard in the past and rules, regulation and standard applied by different accounting bodies such as IAS, IFRS and GAAP. I will use sources available through the Foster Business Library's online catalog, found through such databases as Pro Quest and the Social Sciences Research Network (SSRN). These and other databases I will use may include articles and studies from such industry publications as the Journal of Accountancy body such Management Accountant by ICMAP and Accountant by ICAP, I will refer to accounting guidance such as IAS 32, IAS 39 and IFRS 7 such as FAS 133 and FAS 119 and other related standards on accounting for derivative instruments and hedging Activities in order to review the standards that my research may refer to.

Effects of derivative accounting rules on company risk management policy. Further to examines the effect of IAS and IFRS on Accounting for Derivative Instruments and Hedging Activities on how companies manage their derivative trading activities. The FASB and IASB intent with their standards and regulation was to mandate recognition of derivative and hedging activities, but it is to examine whether the standard had an additional effect on managerial decision making. The structure international accounting standards and international reporting standards provides better accounting treatment for derivative instruments that are effective in hedging a company's exposure to risk that varies with the overall effectiveness of the instrument. It seems that these firms have succeeded in maintaining a steady earnings pattern in the face of a new financial reporting development by changing their investment strategies to counteract the mandated change in their accounting. Thus the IAS and IFRS encouraged firms to manage the risk in their derivative trading activity more prudently. The study of these standards evidence of the effect of fair value measurement and disclosure of derivative trading activities on reporting entities.

The problem of how to allow managers to report their financial instruments at fair value accurately while minimizing their ability to manipulate the representation they must use to determine fair value. The financial institutions that do business internationally may have to reconcile the values of their overseas financial instruments measured under differing fair value criteria.

The unintended effects of fair value accounting for financial derivative instruments commonly associated with fair value measurement cannot always be applied to complex derivative instruments because there is not often an arm's length market where they can be traded smoothly and openly. Therefore methods where values must be calculated using a computer model. For example when a firm must sell off collateral supporting a complex credit backed derivative the sale price it obtains sets the market price for that formerly unpriced asset. If that price is significantly lower than the value the firm had previously assigned to that asset then it follows that all such assets must be written down. This is essentially what has happened in the sub prime credit crisis with firms being required to revalue their holdings at significantly lower values.

To analyze whether investors react differently to derivatives disclosed in the notes than to those recognized on the balance sheet. The passage of IAS and IFRS ( IAS 32, IAS 39 IFRS 7) Accounting for Derivative Instruments and Hedging Activities required studying of several firms that made the transition from footnote disclosure of their derivative instruments to mandatory recognition post IAS and IFRS ( IAS 32, IAS 39 IFRS 7). These studies both support their conclusion that recognition and disclosure are not looked upon equally by investors, and that IAS and IFRS (IAS 32, IAS 39 IFRS 7) has succeeded in increasing financial statement transparency.

Literature review

Decision Factors

In order to determine whether the current derivatives disclosure and fair value measurement techniques accurately represent the true economic value of financial instruments, we must first arrive at an unbiased definition of fair value itself. In FASB abstract of its recently issued FAS 157: Fair Value Measurements, it offers the following: "This Statement emphasizes that fair value is a market based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability." The author makes it clear that fair value, although valued by management, is not specific to the firm holding the investment at all, but should reflect a value determined collectively by the market. Therefore, any discussion of whether fair value measurement techniques are accurate must be based around whether the measurement equates to the market's opinion of the underlying item.

Historical Considerations

Valuation techniques used in the past have shaped the present move toward fair value measurement. Historical cost was a simple valuation method that kept assets on the books at the same value over time. However, fair value accounting has been introduced gradually into the traditional cost method of accounting over many decades. Standards dealing with inventory, investments, and financial instruments of all kinds, business combinations and stock options have all been infused with fair value adjustments (Miller & Bahnson, 2007). Additionally, write downs of impaired assets to amounts less than their original cost or book value are variations on fair value accounting.

Financial Services Firms

Financial services firms are affected by two main standards with relation to valuing their derivative instruments. Accounting for derivative instruments and hedging activities first required firms to place all derivative instruments on the balance sheet at fair value, and offered several categories into which to flow the gains and losses related to these instruments, based on the intended purpose of the derivative. Additionally financial services firms indirectly effect of derivative accounting rules on corporate risk management behavior, according to IAS and IFRS (IAS 32, IAS 39 IFRS 7) gives preferential accounting treatment to managers who are able to effectively use derivative instruments to hedge business risk. In order to make their hedges effective, managers of financial institutions are managing risk far more cautiously in order to qualify for the preferred treatment they can only get with effective hedging instruments on their balance sheets.


The public accounting industry should be pleased with recent developments in fair value measurement as it clarifies many issues regarding the acceptability of clients' fair value measurement practices, Thus auditors will likely see fewer differences in opinion with management over derivative disclosure and fair value issues of financial derivatives.

Many in public accounting welcome this framework as a base for uniting standards systems used around the globe. The FASB further defines the Conceptual Framework as one that is essential to fulfilling the Boards' goal of developing standards that are principles-based, internally consistent, and internationally converged" (Bossio, 2008). This principles based framework is appealing to auditors because it allows more flexibility within GAAP to report the underlying economic reality of a firm.

Changes Necessary

Some inherent problems persist within derivative disclosure accounting across its entire application. The managers are given more freedom to manipulate estimates and assumptions to suit their financial reporting goals. Derivative disclosure regulations must seek to minimize this.

In order to more appropriately consolidate operations across national borders, the disclosure and fair value measurement must also be standardized internationally. Especially in an interconnected financial world where one firm may trade simultaneously in such distant locations as London, Tokyo, New York and Lahore, it is important that regulators work to bring the standards for valuing financial products, and all reporting standards for that matter, under one unified framework for ideal effectiveness.

External Users

Financial statement users have already seen the benefits of fair value measurement of derivative instruments, whether they know they have or not. The effects of balance sheet recognition and the associated simple footnote disclosure of derivative instruments on value relevance for investing firms. It is discovered that valuation coefficients on recognized derivatives are significant while valuation coefficients on derivatives that were only disclosed are not, these investment companies place a high level of importance on derivative instruments only when recognized at fair value on the balance sheet. As now requires this balance sheet recognition, investors will benefit from the improved fair value recognition.

Preliminary Expectations

I expect to find that for the most current derivative discloser and fair value measurement techniques as applied to complex financial instruments are effective at reporting the true economic value of the assets and liabilities they describe. I expect that many studies I note that deficiencies still exist in regards to minimizing management manipulation and I hope to find ways currently underway to help prevent these issues. I hope that further research of derivative disclosure and fair value accounting will reveal new dimension of derivatives disclosure fair value measurement of derivative instruments can further be refined.