Analysts' Responses to Alternative Methods of Reporting Unrealized Gains and Losses on Derivatives

Article excerpt

ABSTRACT

With the publication of two statements on accounting for derivatives (SFAS 133 and SFAS 138), the Financial Accounting Standards Board (FASB) has taken another substantial step on the path toward its goal of requiring the reporting of all financial instruments at market value, generally with unrealized gains and losses included in income. This study investigates whether reporting an unrealized gain or loss in a separate line item on the income statement, as opposed to disclosure only in a footnote, affects how financial analysts use and evaluate information on such gains and losses. The vehicle for this research is unrealized gains or losses on derivatives. The study consisted of short financial analysis cases, presented to financial analysts and executives primarily through mail surveys. Each subject received one of the four different possible combinations of derivative gain or loss and disclosure type. When the unrealized derivative gain/loss was included as a separate line item in the income statement, analysts included the gain/loss significantly more often in their P/E ratios, and were more likely to list the derivative as a factor affecting their investment recommendation, than when the derivative gain/loss was disclosed only in a footnote. Moreover, regardless of disclosure type, analysts included unrealized losses on derivatives in their P/E ratios significantly more often than unrealized gains, and were more likely to list the derivative as a factor affecting their investment recommendation when there was a loss as opposed to a gain. Perhaps more interesting, given the FASB's disclosure rules in Statement 133 (FASB, 1998), was the fact that when the gain/loss was presented as a separate line item in the income statement a substantial minority of analysts (44 percent) chose to exclude the gains from their P/E ratios, whereas only 17 percent chose to exclude losses. Finally, results from a subset of participants who were asked to think aloud while analyzing the case suggest that analysts are less likely to consider information regarding derivatives when it is contained only in a footnote. In addition, the protocols suggest that if participants acquire the information on derivatives, they may give as much as, if not more consideration to that information, and evaluate it more negatively, when it is disclosed in a footnote rather than on the income statement.

This study contributes to knowledge in the area of financial statement disclosure in two primary ways. First, it provides evidence with respect to disclosure alternatives for unrealized derivative gains and losses that is consistent with inferences drawn from prior capital markets studies regarding disclosure issues, and indicates that disclosure format may affect analysts' use of information, contrary to a strict interpretation of the efficient markets hypothesis. Second, it suggests that a substantial minority of analysts seem to prefer to exclude unrealized derivative gains and losses, particularly gains, when evaluating earnings for analysis, especially if the amount of those gains and losses is clearly disclosed and readily available. This further supports the need for full disclosure of unrealized derivative gains and losses included in income.

INTRODUCTION

This paper investigates whether reporting unrealized losses or gains on financial instruments as a separate line item in the income statement, as opposed to disclosure only in a footnote, affects financial analysts' use and evaluation of information about those gains and losses. We use information on derivatives as the specific vehicle for this investigation. Until implementation of SFAS 133 after June, 2000 (FASB, 1998), in order to find detailed information on a company's investments in derivatives, investors have had to sort through voluminous notes to the financial statements (Roulstone, 1999). Although the new Financial Accounting Standards Board (FASB) standard on derivatives is intended to give investors more readily available information on the value of derivatives held by companies and improve the quality of financial reporting, implementation of the complex new standard on derivatives may be costly and difficult (Reinstein & Lander, 2000; FASB, 1999a; MacDonald, 1997), overly complicated (Wilson, 1998), and could lead to increased volatility in companies' reported earnings and equity (Lesak, 1998). …