UNDISCLOSED HAZARDS
Yet another complication in the quest for true equity involves disclosure. Despite the pitfalls previously discussed, analysts can feel comfortable in relying on market capitalization for certain applications, provided they believe that all material information affecting companies’ equity values is available for investors to assess.
In practice, though, companies’ equity values can be significantly altered by items that are either undisclosed or disclosed only in a limited fashion.Early in 1994, analysts were largely caught off guard by problems involving financial derivatives. (The collective term for these instruments reflects that their valuations derive from the values of other assets, e.g., commodities, indexes of securities.) For years, corporations had used derivatives such as swaps and structured financings to hedge against swings in interest rates, currency exchange rates, and other cost factors.
As time went on, some corporate treasurers sought to capitalize further on expertise gained through hedging. Instead of merely trying to control risk, they hoped to profit by correctly predicting the direction of interest rates or the future relationship among various commodity prices. If their predictions proved wrong, trading losses would result.
Provided the companies understood and limited the risks incurred in these transactions, they did not act irresponsibly. Often, the trading was profitable, producing a welcome supplement to earnings generated in more traditional activities.
As a comparatively new phenomenon, though, derivatives trading did not generate highly detailed mandatory disclosure. Typically, corporations divulged the scale, but not the terms or riskiness of the transactions.
Some types of derivative were merely aggregated with the general cash accounts.Just as accounting rule makers were urging companies to expand their derivatives disclosure, while also considering new mandatory reporting on the subject, a sudden burst of interest rate volatility socked several major corporations with huge trading losses. Procter & Gamble took a one-time charge of $102 million on two interest rate swaps it had entered into in the United States and Germany. Air Products & Chemicals charged off $60 million on five swap contracts, acknowledging that with hindsight, its risk analysis had been faulty. Dell Computer sustained a $26.3 million loss on derivatives and other investments related to interest rates. (All figures are on an aftertax basis.)
The shock of these announcements probably moved companies toward greater conservatism in their use of derivatives. Additionally, the surprise losses strengthened the hand of those calling for fuller disclosure. SFAS 133 (“Accounting for Derivative and Similar Instruments and Hedging Activities”) now requires all derivatives to be recorded as either assets or liabilities at fair value. As the values change, the resulting gains or losses may be recognized immediately or deferred, depending on whether the derivative qualifies for classification as a hedge.
At the same time, the incidents underscored the misfortunes that can befall even meticulous and thoughtful analysts. Users of financial statements can process only the information they have, and they do not always have the information they need.
While FASB was able to bring about fuller disclosure of derivatives, the accounting rule makers did not and could not resolve the larger issue for all time. Innovation in the financial markets is unlikely to abate, meaning that it will remain a challenge for accounting rule makers to keep pace. To recognize possible undisclosed hazards, therefore, analysts must stay abreast of new types of transactions. Where feasible, users of financial statements should also solicit as much detail as management will disclose regarding risks not spelled out in the balance sheet or footnotes.