Accounting for complexity

By Sim Shuzhen

SMU Office of Research & Tech Transfer – Financial derivatives can be a double-edged sword. As the 2008 global financial crisis demonstrated, reckless speculation and the unregulated proliferation of derivatives speculation can have catastrophic consequences for the economy. On the other hand, if used appropriately, derivatives can have a stabilising effect; indeed, many corporations use forwards, futures options, swaps and other forms of derivatives to hedge against financial risks and reduce uncertainty.

But given the often byzantine nature of these financial instruments, it is unclear if financial analysts who follow derivatives users actually fully understand the earnings implications of derivatives, says Assistant Professor Hye Sun Chang of the Singapore Management University (SMU) School of Accountancy.

“Financial analysts are known as sophisticated investors, and their significant impact on capital markets has been widely investigated. If analysts are sophisticated enough, does this mean that they would have no difficulty in understanding complex financial instruments such as derivatives?” she asks.

This important question has bearing on the relationship between companies that use derivatives and their investors, and particularly on how investors and other stakeholders should assess financial statements from these companies, adds Professor Chang, whose research focuses on capital markets, the reliability of financial reporting and how investors use accounting information.

Do analysts understand derivatives?

Although derivatives allow companies to manage risk, they are extremely complex financial instruments in two major respects, says Professor Chang. First, they are economically complex, as their value can be linked to virtually any underlying asset or liability, as well as to other derivatives. Second, because of this economic complexity, financial reporting for derivatives is also remarkably complicated, she adds. This is especially the case for hedge accounting, an alternative method of corporate reporting for derivatives that is used to reduce the volatility of earnings and cash flows.  

All this can make it more difficult for financial analysts to forecast earnings, says Professor Chang. “To understand the impact of derivatives on earnings, financial statement users need to be able to understand both the economic and reporting complexities of derivatives,” she explains.

To gauge how well analysts grasp these complexities, Professor Chang and her co-authors looked at firms that had recently initiated a derivatives programme, and assessed the impact of this on the accuracy and dispersion (that is, how varied they are) of analysts’ earnings forecasts.

Compared to a control group of companies that did not use derivatives, analysts for new derivatives users made less accurate and more dispersed earnings forecasts, the researchers concluded. “We also found that these results do not appear to be driven by the economic complexity of derivatives, but rather by the financial reporting side,” elaborates Professor Chang.

Professor Chang and her co-authors published their findings in a 2016 study in the Journal of Accounting and Economics, titled ‘Do analysts understand the economic and reporting complexities of derivatives?’ “One important takeaway is even sophisticated investors are struggling with derivatives information,” says Professor Chang.

Dealing with complexity

A unique feature of the study is that it was designed to disentangle the economic complexity of derivatives from reporting complexity, says Professor Chang, adding that this was a big challenge for her team. “To our knowledge, there has been very limited research on the complexity of accounting information, and no prior studies have attempted to distinguish between the two different types of complexity,” she explains.  

Professor Chang’s findings have several important implications for investors, companies and policy makers. First, they imply that investors should be extremely careful when interpreting and evaluating the financial statements of companies that use derivatives, due to their inherent complexity.

Second, to reduce information asymmetry, companies that use derivatives may need to find better means of communicating with their investors. This can take the form of voluntary disclosure mechanisms, which would provide financial information to investors beyond what is required by the accounting standards, says Professor Chang.

Finally, the study provides evidence that complex accounting standards do indeed hinder analysts’ forecasting decisions – a point that policy makers and regulators should take note of. “Accounting standard setters need to keep in mind that accounting standards should help investors understand the impacts of business transactions on financial statements,” says Professor Chang.  

Learning the language of business

Through her work, Professor Chang hopes to generate useful insights into capital market investment decisions, accounting standard setting and corporate financial disclosure decisions. She says she became fascinated with accounting in college, after realising that the subject is not just about recording business transactions, but instead about how these numbers are put to use.

“When I learned accounting for the first time in college, I felt like I was learning a new language. Accounting is indeed the language of business that helps us to understand how business transactions impact financial statements, and gives us an idea of how we utilise financial statement information for decision making,” says Professor Chang, adding that this concept of accounting as a language is the first thing she now teaches her students at SMU.

One of Professor Chang’s ongoing research projects investigates whether firms disclose mandatory derivatives information as required by the accounting standards. Because there is large variation in the extent to which firms disclose this information, she is keen to understand the driving forces behind non-compliance, as well as the consequences of this behaviour.

Building on her study of financial analysts and their understanding of derivatives, Professor Chang is also investigating the impact of derivatives on firms’ voluntary disclosure decisions. “The fact that sophisticated investors are struggling with derivatives information makes us wonder whether and how firms provide additional voluntary information to investors when there is a high demand for additional information,” she says.

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