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Market Reactions to the Disclosures on Currency Risk under IFRS 7

2012; Allied Academies; Volume: 16; Issue: 3 Linguagem: Inglês

1096-3685

Pietro Bonetti, Marco Maria Mattei, Fabrizio Palmucci,

Auditing, Earnings Management, Governance

INTRODUCTION (1) In August 2005, International Accounting Standard Board (IASB) issued IFRS 7 Financial Instruments: Disclosures, which replaced IAS 30 and amended IAS 32. The IASB has enhanced disclosure requirements on financial instruments for all companies, believing that of financial statements need information about an entity's exposure to and how those are managed [...] to make more informed judgements about risk and return (IFRS 7, [section] IN2). IFRS 7, inter alia, requires entities to disclose backward-looking analysis for each type of market risk to which entity is exposed at reporting date, showing how profit or loss and equity would have been affected by changes in relevant risk variable that were reasonably possible at that date (IFRS 7, [section] 40a). For instance, with respect to currency risk, a firm compliant with IFRS has to disclose how its earnings would have been affected, if exchange rate of currency to which it is exposed had been higher and lower than it was at reporting date. The quantitative disclosures on market risk mandated by IFRS 7 represent a new requirement for many IFRS-adopters firms (2), but they are not a novelty per se. In 1997, after several U.S. publicly traded companies reported unexpected losses from derivative financial instruments, Security and Exchange Commission (SEC) issued Financial Reporting Release No. 48 (FRR No. 48) on derivative and market risk disclosures. FRR No. 48 requires companies to disclose annually firm-specific quantitative and forward-looking information about market risk exposures inherent in derivative and non-derivative financial instruments. Several papers have investigated adoption of this new Financial Reporting Release, showing that quantitative disclosures on market risk provided in accordance with FRR No. 48 were useful to investors. However, FRR No. 48 was enacted before adoption of SFAS 133 Accounting for derivative instruments and hedging activities, when U.S. accounting rules for derivatives were fragmentary and incomplete. Thus, it is possible that lack of comprehensive rules for financial instruments increased relevance of FRR No. 48 disclosures. On contrary, IFRS 7 is adopted under IAS 39 regime, which provides high quality accounting rules for all financial instruments and derivatives. Moreover, IFRS 7 differs from FRR No. 48 in some relevant technical issues. This study aims to add to literature on market risk disclosures outlining whether backward-looking quantitative disclosure on currency risk mandated by IFRS 7 is relevant to investors, as expected by IASB. Specifically, using Italian data, we investigate informativeness of currency risk sensitivity analysis from two complementary perspectives. Firstly, we test whether there is a relationship between sensitivity of stock returns to foreign exchange rate changes and sensitivity analysis mandated by IFRS 7. In fact, more precise a new piece of information, more affected stock returns (Verrecchia, 2001). Secondly, we investigate how IFRS 7 disclosure affects trading volume sensitivity to exchange rate changes. According to Kim and Verrechia's (1994) framework, in fact, trading volume sensitivity proxies for investor uncertainty and diversity of opinion about firms' exposure to currency risk. Our results provide evidence that sensitivity analysis mandated by IFRS 7 is useful to investors from both investigated perspectives. The remainder of paper is organized as follows. The next section provides motivations for study and illustrates hypotheses. The sample selection and research design are presented in third section. The forth section discusses empirical results and last section provides some concluding remarks. MOTIVATION AND HYPOTHESES The objective of IFRS 7 is to require companies to provide disclosures that enable users to evaluate not only significance of financial instruments for company's financial position and performance, but also the nature and extent of arising from financial instruments to which entity is exposed during period and at end of reporting period, and how entity manages those risks (IFRS 7, [section]1). …