International Treasurer

Accounting & disclosure

The Journal of Global Treasury and Financial Risk Management

Get Ready to Bare All: Disclosing Derivatives By Robert Herz, Coopers & Lybrand
SUMMARY: Companies should take steps now to assess their exposure to pending disclosure expectations. In January, the staff of the SEC announced that it expects registrants to reveal as much about their off-balance sheet activities and positions in derivative markets as they now disclose about their activities and cash positions on-balance sheet. Care must be taken in positioning derivative activities with analysts and shareholders, both to avoid misperception and the revealing of competitive secrets.

Corporate treasuries, as documented in the Group of Thirty Study, Derivatives: Practices and Principles, have become more adept and aggressive with their use of derivative financial instruments. As a result, they are under increasing scrutiny from corporate outsiders concerned about reported practices that cannot be identified in current public financial disclosures. In this context, all companies registered with the US Securities and Exchange Commission should note with some seriousness the statements made by its staff in January. The SEC staff has indicated that it would like companies to disclose publicly a laundry list of items, including: A description of the nature of the trading activities. This description should include the business purpose for these activities, the tolerable risk levels for their use in such situations, and the types of instruments traded. The amount of trading revenue recognized in the income statement for each major type of financial instrument. Companies that use derivatives in asset/liability management, should consider the ramifications of the following disclosure requirements: A description of the each outstanding derivative instrument, including a breakdown of its type, amount, expected maturity, and fair value. A tabular presentation will also be required, indicating: the items being hedged; and the products used to hedge them, including the duration of the hedge (or derivative used to

hedge) and the maturity by year. A discussion of each risk being hedged and any limitations on the hedgein other words, to what extent and under what range of expected circumstances would the exposure be affected. A discussion of how corporate hedging activities are being monitored by management and specifically, what modeling techniques are being used to assess them. An accounting of the notional amounts entered into during the reporting period. This would amount to a summary of the change in these amounts resulting from new, terminated, matured and/or expired contracts. Disclosure of any deferred gains or losses from hedging or risk-adjusting activities and the expected amortization of such amounts on a period by period basis. And the impact of derivative activities on either income from continuing operations, or net interest income if applicable, for the current reporting period. Also to provide a realistic view of future cash flow and prevent the abuse of anticipatory hedges the SEC has expressed concern that corporates could use derivatives (allegedly to hedge anticipated transactions) to carry losses to future periods the staff has indicated that corporates should consider: Disclosing the dollar value of anticipatory hedges and the period in which the anticipated transactions are expected to occur. Stating the potential effect of closing out the hedge positions should the underlying transactions fail to occur. Efforts to implement this rather exhaustive list of disclosure requirements are clearly meant to spotlight corporate use of derivatives, focusing in on areas where the company may be taking unnecessary risks. This will help prevent corporates from taking significant risks (e.g. speculating) in financial markets without shareholders knowledge or approval. As reports of derivative trading losses continue to appear in the financial press, regulators will continue to focus on companies derivatives activities. Corporates will do well to prepare for the consequences of this increasing attention.
March 7, 1994

With this article International Treasurer begins a series of contributions from our affiliated professionals looking at the pending tax, accounting and legal ramifications of derivatives use.
Recommendations: Much of this information should be available internally for management reporting purposes: make sure that it is complete and determine how it should be filtered for public disclosure. For starters: Coordinate with all relevant internal functions and external auditors and advisors. Judgment is required to determine the extent of disclosures needed in a particular situation. Everyone involved with the public presentation of the company financial position should be a part of this process. A buy-in from your auditor may be particularly important, but do not forget to get input from the investor relations functions. Educate senior management.Commentary presented in the Managements Discussions and Analysis portion of the financial statements should reflect the company's true understanding of treasurys derivatives use. Senior management will need to be comfortable with explaining this activity to outside analysts and shareholders.

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