Accounting & disclosure

Get Ready to BareAll: DisclosingDerivativesBy Robert Herz, Coopers & Lybrand

SUMMARY: Companies should take steps nowto assess their exposure to pending disclosureexpectations. In January, the staff of the SEC

announced that it expects registrants to revealas much about their off-balance sheet activitiesand positions in derivative markets as they nowdisclose about their activities and cash positionson-balance sheet. Care must be taken in posi-tioning derivative activities with analysts andshareholders, both to avoid misperception and

the revealing of competitive secrets.

Corporate treasuries, as documented in theGroup of Thirty Study, Derivatives: Practices andPrinciples, have become more adept andaggressive with their use of derivative financialinstruments. As a result, they are under increas-ing scrutiny from corporate outsiders concernedabout reported practices that cannot be identi-fied in current public financial disclosures. Inthis context, all companies registered with theUS Securities and Exchange Commissionshould note with some seriousness the state-ments made by its staff in January. The SEC staff has indicated that it would like companies todisclose publicly a laundry list of items, includ-ing:

• A description of the nature of the tradingactivities. This description should include thebusiness purpose for these activities, the tolera-ble risk levels for their use in such situations,and the types of instruments traded.

• The amount of trading revenue recognizedin the income statement for each major type of financial instrument.

Companies that use derivatives in asset/liabil-ity management, should consider the ramifica-tions of the following disclosure requirements:

• A description of the each outstanding deriv-ative instrument, including a breakdown of itstype, amount, expected maturity, and fair value.A tabular presentation will also be required,indicating: the items being hedged; and theproducts used to hedge them, including theduration 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 hedge—in other words,to what extent and under what range of expect-ed circumstances would the exposure be affect-ed.

• A discussion of how corporate hedgingactivities are being monitored by managementand specifically, what modeling techniques arebeing used to assess them.

• An accounting of the notional amountsentered into during the reporting period. Thiswould amount to a summary of the change inthese amounts resulting from new, terminated,matured and/or expired contracts.

• Disclosure of any deferred gains or lossesfrom hedging or “risk-adjusting activities” andthe expected amortization of such amounts ona period by period basis.

• And the impact of derivative activities oneither income from continuing operations, ornet interest income if applicable, for the currentreporting period.

Also to provide a realistic view of future cashflow and prevent the abuse of “anticipatoryhedges”— the SEC has expressed concern thatcorporates could use derivatives (allegedly tohedge anticipated transactions) to carry lossesto future periods— the staff has indicated thatcorporates should consider:

• Disclosing the dollar value of anticipatoryhedges and the period in which the anticipatedtransactions are expected to occur.

• Stating the potential effect of closing out thehedge positions should the underlying transac-tions fail to occur.

Efforts to implement this rather exhaustive listof disclosure requirements are clearly meant tospotlight corporate use of derivatives, focusingin on areas where the company may be takingunnecessary risks. This will help prevent corpo-rates from taking significant risks (e.g. speculat-ing) in financial markets without shareholders’knowledge or approval. As reports of derivativetrading losses continue to appear in the finan-cial press, regulators will continue to focus oncompanies’ derivatives activities. Corporateswill do well to prepare for the consequences of this increasing attention.

March 7, 1994

International TreasurerThe Journal of Global Treasury and Financial Risk Management

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With this article International Treasurer begins a series of contri- butions from our affiliat- ed professionals looking 

at the pending tax,accounting and legal ramifications of deriva- tives use.

Recommendations:

Much of this informationshould be availableinternally for manage-ment reporting purposes:make sure that it is com-plete and determinehow it should be filteredfor public disclosure.

For starters:• Coordinate with all

relevant internal func-tions and external audi-tors and advisors.

 Judgment is required todetermine the extent of 

disclosures needed in aparticular situation.Everyone involved withthe public presentationof the company financialposition should be a partof this process. A buy-in

from your auditor maybe particularly impor-tant, but do not forget toget input from theinvestor relations func-tions.

• Educate senior man-

agement.Commentarypresented in theManagement’sDiscussions andAnalysis portion of thefinancial statementsshould reflect the com-pany's true understand-

ing of treasury’s deriva-tives use. Senior man-agement will need to becomfortable withexplaining this activityto outside analysts andshareholders.