Evaluating and interpreting the effectiveness of end-user interest rate derivative disclosures.

Over the last decade derivative financial instruments have become a key component in firms' capital structures and financial management decisions. However, the huge derivatives losses experienced by Proctor and Gamble, Gibson Greetings, the Orange County Investment Pool, and Barings PLC have generated concerns about how best to measure, evaluate, and disclose the risks associated with these instruments. As a result, managers, creditors, shareholders, and regulators have become increasingly interested in obtaining information about the nature of firms' derivatives portfolios (Bishop, 1996; Loomis, 1995), and the first place they look for this information is in the financial statements and the accompanying notes.

In response to these requests for more detailed and comprehensive information about derivatives, the Financial Accounting Standards Board (FASB) has developed a set of disclosure rules which require firms using these instruments to disclose information about the risks associated with their derivatives activities in the footnotes to the financial statements. Footnote disclosures provide supplemental information about items that have already been recognized in the accounts, or about assets, liabilities, and transactions that have not yet been recognized because of uncertainty about their ultimate financial statement effects. The footnote disclosures for derivatives require firms to present information about these instrument's notional principal, a measure of derivatives activity, and estimated fair value, a measure related to market risk.

Derivatives are "off-balance sheet" financial instruments in that although these instruments are not recorded on the balance sheet, they do generate gains and losses that affect net income. Three types of financial instruments dominate the derivatives market: foreign exchange derivatives, interest rate derivatives, and commodity derivatives. While a vast number of foreign exchange, interest rate, and commodity instruments meet the definition of a "derivative," the factors underlying their use and the financial reporting issues surrounding them vary greatly. This study examines the effectiveness of footnote disclosure requirements for one type of derivative, end-user interest rate derivatives. Before the effectiveness of a specific disclosure can be considered, however, a framework must be developed for evaluating financial statement disclosures in general. As such, after reviewing the basic types of interest rate derivatives and the disclosure requirements for these instruments, this article outlines a general framework for evaluating financial statement disclosures. Once this framework is established, it is then used to evaluate interest rate derivative disclosure requirements for nonfinancial or "end-user" firms. This is followed by a review of the framework and the results of the analysis for interest rate derivatives.