Edinburgh NaPie~

IVERSIT

The Usefulness of Derivative Disclosures

by Chinese Listed Companies

By Zhen Huang

A thesis submitted in partial fulfilment

of the requirements of Edinburgh
Napier University, for the award of
Doctor of Philosophy

School of Accounting, Financial Services

and Law

March 2012
I am greatly indebted to my Principal Supervisor, Professor Simon Gao,

and my Associate Supervisor, Associate Professor Steven Li, for their

guidance and encouragement throughout the period of my candidature.

I would like to thank the academic staff at the School of Accounting,

Financial Services and Law. Special thanks go to Dr. Jane Zhang to

whom I am indebted for her invaluable guidance and enthusiastic support

throughout the study. My thanks also go to Dr. Abdelsalam Omneya, Dr.

Robert Raeside and Dr. Henschel Thomas for their assistance.

I am grateful to thank my entire family for encouraging me to finish my

studies. Particularly, I would like to acknowledge my grandmother (Wang

Shuying), mother (Li Shaohua), father (Huang Linying), little lovely wife

(Liu Chang), aunties, uncles, sisters and brothers.

Finally, my thanks also go to my friends for their help and support

throughout my study.
While the world has witnessed the growing use of derivative instruments and rapid
expansion of derivatives markets over the past two decades, the extensive use of
derivatives in developed markets, particularly of mortgage-related derivative products
has been blamed for the recent global financial crisis. The supervisory bodies across
the world have increasingly paid attention to the establishment of an effective
governance system including the issuing of financial reporting rules for companies to
disclose their derivative activities. By far derivativ~s research has predominately been
based on western developed economies; little has been known about reporting and
disclosing of derivatives from developing economies. The motivation of this study is
to fill the research gap with the primary aim to assessing the usefulness of derivative
related disclosures in China - the largest developing economy in the world.

The study is divided into two major stages. The first stage mainly intends to reveal the
degree of derivative related disclosures provided by Chinese listed companies. Annual
reports of 53 Chinese listed firms are considered as the sampling unit for observation
and analysis. Using the content analysis approach this study compares the derivative
related information disclosed in companies' annual reports with the developed
disclosure index that is largely based upon IFRS and lAS provisions. The study has
found: First, the level of the compliance with IFRS and lAS derivative regulations by
Chinese quoted companies is generally low. Second, Chinese listed companies are
likely to prefer the use of equity derivative products rather than other types of
derivatives. Third, the corporate size seems not to significantly affect the amount of
derivative related disclosures by Chinese quoted companies. Fourth, the amount of
derivative disclosures about the significance of using derivatives for the company's
financial position and performance is significantly greater than that of information in
relation to potential risks arising from the use of derivative instruments.

The second phase primarily intends to examine the usefulness of derivative

disClosures perceived by equity market participants. The study conducted in-depth
interviews with 21 institutional investors including 10 investment managers and 11
professional analysts. The key findings include: First, the disclosed information about
the use of derivative instruments by quoted firms is perceived to be useful and helpful
in facilitating investment decisions. Second, the information related to the use of
derivatives is generally thought to play a minor role in facilitating investment
decisions. Third, the current provisions of derivative related information by Chinese
quoted entities are generally unsatisfied by most of institutional investors. Fourth, the
current accounting and reporting policies imposed by regulators seem to be very
difficult for Chinese investors to understand.

The study, the first study of its kind, contributes to the understanding of the current
status and usefulness of derivative related disclosures in China. It also provides the
valuable insight to the development of derivative reporting standards by offering
some policy implications particularly to developing economies.

ii
 Contents

Acknowledgements i
Abstract ii

List of Tables vii

List of Charts ix

Chapter I ................................................................................................ 1
1.1 Introduction .................................................................................................. 2
1.2 Background .................................................................................................. 2
1.3 Overall Aims and Objectives ........................................................................ 7
1.4 Research Design ........................................................................................... 7
1.4.1 Stage One ........................................................................................... 8
1.4.2 Stage Two ......................................................................................... 10
1.5 Outline of Findings and Contributions ....................................................... 12
1.6 Chapter Summaries .................................................................................... 14
Literature Revie,'V ................................................................................... 17
2.1 Introduction .................................................................................................... 18
2.2 Background .................................................................................................... 18
2.3 Prior Literature ............................................................................................... 33
2.3.1 Voluntary Disclosure Theories ............................................................ 34
2.3.2 Prior Studies on the Usefulness of Derivative Disclosures ................ 37
2.4 Summary ........................................................................................................ 67
Chapter China's Derivatives Accounting Derivatives ........... 73
3.1 Introduction .................................................................................................... 74
3.2 History of China's Derivatives MarkeL ........................................................ 74
Commodity Futures Market ......................................................................... 74
Financial Derivatives Market ...................................................................... 77
3.3 Factors Affecting the Development of China's Derivatives Market .............. 79
Inappropriate Product Design ..................................................................... 79
Poor Infrastructure ...................................................................................... 83
Weak Corporate Governance and Control .................................................. 84
3.4 New Developments in China's Derivatives Market ....................................... 87
3.4.1 Commodity Futures Market ................................................................ 87
3.4.2 Financial Derivatives Market .............................................................. 89

iii
 3.5 Accounting and Reporting for Derivatives in China...................................... 95
3.5.1 Harmonisation of National Accounting and Reporting Standards and
Its Relevance to Emerging Economies ........................................................ 95
3.5.2 Evolution of Accounting and Reporting for Derivatives in China ..... 96
3.6 Summary ........................................................................................................ 99
Chapter IV Research Methodology and Data CoUection ..................................... l0l
4.1 Introduction .................................................................................................. 102
4.2 Research Methodology ................................................................................ 102
4.2.1 Deductive Methodology .................................................................... 102
4.2.2 Inductive Methodology ..................................................................... 104
4.3 Research Methodology Used in the Study ................................................... 105
4.4 Research Method ......................................................................................... 106
4A.l Quantitative Research Method .......................................................... 107
4A.2 Qualitative Research Method ............................................................ 107
4.5 Research Methods Used in the Study .......................................................... 110
4.6 Content Analysis .......................................................................................... 110
4.6.1 Definition of Content Analysis ......................................................... 111
4.6.2 Core Steps of Content Analysis Method ........................................... 113
4.6.3 Limitations of Content Analysis ....................................................... 123
4.7 Interview ...................................................................................................... 124
4.7.1 Semi-structured Interview ................................................................. 124
4.7.2 Limitations oflnterview ................................................................... 125
4.8 Data Collection and Description .................................................................. 126
4.8.1 Companies Selection for Stage One ................................................. 126
4.8.2 Interviewees Selection for Stage Two ............................................... 141
4.9 Summary ...................................................................................................... 144
Chapter V Content Analysis Results and Discussions .......................................... 146
5.1 Introduction .................................................................................................. 147
5.2 Overall Disclosures LeveL .......................................................................... 147
5.2.1 Overall Scores ................................................................................... 148
5.2.2 Overall Amounts ............................................................................... 153
5.2.3 Disclosed Sections ............................................................................ 156
5.3 Disclosures by Companies in Different Sizes .............................................. 159
5.3.1 Association between Company Size and Disclosure Quality ........... 159
5.3.2 Scores ................................................................................................ 162
5.3.3 Amounts ............................................................................................ 165
5A Information Content of Derivative Disclosures ........................................... 173
5 A.l Nature of Derivative Disclosures ...................................................... 173
5.4.2 Results ............................................................................................... 176
5.5 Disclosures of Different Types of Derivatives ............................................. 181
5.5.1 Classification of Derivative Instruments .......................................... 181
5.5.2 Results ............................................................................................... 185
5.6 Summary ...................................................................................................... 189
Chapter VI Interview Results and Discussions ..................................................... 191

iv
 6.1 Introduction .................................................................................................. 192
6.2 Interviewees' Opinions about Information Contents of Derivative Disclosures
............................................................................................................................ 193
6.2.1 Ql 'To your best knowledge, for a nonfinancial company, what kind
of information about its use of derivatives should be disclosed?' ............. 193
6.2.2 Q5 'For the disclosures related to the use of derivatives, what kind of
information you most concern?' ................................................................ 198
6.2.3 Q3 'How do you get such information about the use of derivatives?
(What is your source to get such information?), ....................................... 201
6.3 Interviewees' Opinions about the Usefulness of Derivative Disclosures .... 206
6.3.1 Q2 'Have you ever used the information related to the use of
derivatives when evaluate a corporate performance or risk profile? (If no,
why?)' ........................................................................................................ 206
6.3.2 Q4 'Do you think the information about the use of derivatives is
useful or not when making investment decisions? Why?' ......................... 208
6.3.3 Q6 'In your view, is it much more useful if a company discloses more
information about its use of derivatives?' .................................................. 215
6.3.4 Q7 'Generally, are you satisfied with current derivative-related
disclosures provided by listed companies? Do you think the information
disclosed by companies is adequate or not? If not, what kind of information
you would like companies to disclose?' .................................................... 219
6.4 Interviewees' Opinions about Accounting and Reporting Policies for
Derivatives ......................................................................................................... 225
6.4.1 Q8 'Do you think the reporting for derivatives should be compulsory
or voluntary? Why?' .................................................................................. 226
6.4.2 Q9 'What is your view on current accounting and reporting
(IFRS-based requirements) for derivatives? Do you think it is easily to be
understood?' ............................................................................................... 230
6.4.3 QI0 'Do you think the reporting for derivatives should continue to
comply with IFRS requirements, or set up relevant requirements based upon
Chinese scenario, or no need to set up any requirements? What is your
suggestion for the future development of reporting for derivatives?' ....... 234
6.5 Summary ...................................................................................................... 238
Chapter VII Summary, Conclusions, and Future Research ................................ 242
7.1 Introduction .................................................................................................. 243
7.2 Summary ...................................................................................................... 243
7.2.1 Motivations ....................................................................................... 243
7.2.2 Prior Studies ...................................................................................... 244
7.2.3 Overall Aims and Objectives ............................................................ 247
7.2.4 Research Design ................................................................................ 247
7.3 Conclusions and Discussions ....................................................................... 251
7.3.1 China's Derivatives Market and Accounting for Derivatives ........... 251
7.3.2 Level and Contents of Information Related to Derivative Disclosures
.................................................................................................................... 252

v
 7.3.3 The Usefulness of Derivative Disclosures Perceived by Equity Market
Participants ................................................................................................. 254
7.4 Contributions ................................................................................................ 256
7.5 Policy Implications ...................................................................................... 259
7.6 Limitations ................................................................................................... 260
7.7 Future Research ........................................................................................... 261
Reference .................................................................................................................. 264
Appendices ................................................................................................................ 304
Appendix I: Financial Derivatives Disclosures Index (FDDI) .......................... 305
Appendix II: Interview Guide ............................................................................ 324

VI
List of Tables

Table21 World'sMi!icrlliivativeRela1ed Scandals 23

Table22 Mi!icr IXriwtiw-RelatedAa:oon1ingRegulatims 26
Table3.1 Cbina'sCorrnmxli~Fl.lture';Ma!kcts 75
Table32 TumoverofCmmcxlityFuturePxchangesandStOO<.Exdmgesfiuml995to2OOl(BillimRMB) 77
Table33 Loog-term GovenmeotBmds' in 1994& 1995 (BillimRMB) 81

Table3.4 StnnureofCJJines;)GovenmeotBmdhold::rs 1991-1995("10) 83

Table3.5 StatisticsofOJina'sCanrrxxli1yFl.lture';Ma!kctsduting1heFJISI: lOMoothsof2OO.l and20l0 88
Table4.l StrengthernandWeakr=ofQuantitativeandQwlitativeReseaidJ.MctI:xxi 100
Table42 0xIing Uni1sFmployedby llicrStulies 116
Table43 Typ:sofReliabilily 121
Table4.4 Key Warnto te SeaI1::h.:d 128
Table4.5 WofSampleCbmjmies 129
Table4.6 SampleCcnJrenies~by Irxli.Nries 131
Table4.7 OJina'sAandB SharesMmketOvcrview 132
Table4.8 Sample C'c8:npmies inPrevioos Stlrlies 140
Table4.9 Intcrviewees'Rofile 142
Table5.l NosofQoofulsinFDDIDWambyCcnJrenies 151
Table52 OvernllScaesofQoofulsinFDDI 152
Table53 OvernllAmounts(Pen:en1ageofAnnualRep:rt)ofQefunsinFDDI 154
Table5.4 AmoomoflliivativeRela1edlnfi:nmtim(Pen:en1ageofAnnualRep:rt)Dis::lama;:I"(N;Sectimsof1heAnnualRep:rt 158
Table5.5 OvernllScaesofDis::1CB.ll"esby iaIgeandMediumSizeCorqmies 163
Table5.6 ~SamplesTetfcrScaesofiaIgeandMediumSizeFIIIllS 163
Table5.7 ComJxni9:nScoresofiaIgeandMediumSizeFIIIllS 163
Table5.8 Amountof.D;:rivativeRe1atedInfa:rmtim(Pen:en1ageofAnnualRep:rt)Dis::lambyiaIgeandMediumSizeCcnJrenies 168
Table 59 ~SamplesTetferlliivativeDW=AmountbyiaIgeandMediumSizeCcnJrenies 170
Table5.l0 ABreakdownofInfa:rmtiooCmtmtoflliivativeDis::1CB.ll"es 175
Table5.l1 Paired Samples Statistics (Pen:en1ageofAnnualRep:rt)ferliIDrrnatimCmtmtofIXrivaliveDis::1CB.ll"es 177
Table5.12 Paired Samples Carelalims fer IrfumaIim Cmtmtof.D;:rivative Dis::1CB.ll"es 178
Table5.13 PairedSamplesTetferIrfumalimCmtmtofIXrivaliveThrlCB.ll"es 178
Table5.l4 Qnegai£I!imofCcnJreniesbyUsingDiffirentTyp:soJ']);rivatiyes 182
Table5.l5 TetofHcm~ofVariancesferGtulpO, 1and2 185
Table5.l6 ANOVATetferGtulpO,land2 186
Table5.l7 Mu1tipleCompni.<unsofMeans.l3ctwemGtulpO, 1and2 186
Table6.l Js<uesinRe1ationtoQl.Ad:.lr=i by Intcrviewees 197
Table62 Js<uesin~ooto~A~byIntcrviewees 201
Table63 Js<uesin~ooto Q3.Ad:.lr=iby Intcrviewees 204
Table6.4 Preterena:oflnfi:mJatim Omnels by Intcrviewees 205
Table6.5 Js<uesinRe1ationto~A~byIntcrviewees 208
Table6.6 Js<uesin~ooto~A~byIntcrviewees 214

vii
Table6.7 R.emnsferBelievingDerivativeDroa:uresas'M!jcrJrfumation' 214
Table6.8 R.emns fer BeJievingDerivativeDB:los.Jresas 'Comp1em:ntaIy Infmnation' 214
Table 6.9 R.emnsferBelievingDerivativeDB:la:uresas'ItIXp;nds' 215
Table6.1 0 BerefitsferDB:la;ingMcre Derivative RelataiInfamatim 218
Table6.11 Intf:rviewe;s'I't:ra:ptimabootWheth:rMakingfuitiveVa1uatimmCcmrmieswithMcreDerivativeDroa:ures 218
Table6.12 R.emnsferNctMakingfuitive Va1uatimmCcmrmieswithMcreDerivativeDB:la:ures 218
Table6.13 SatisfidimabootCurrentDerivativeDB:1os.Jres 222
Table6.14 NnsferUINIIisfied 222
Table6.15 NnsinRelatimtoMcreDerivativeDroa:ures 223
Table6.16 ln1flvi1:WeeS' OpinimsabootRepJrtingfcr Derivatives 7J9
Table6.17 Reas:JnsferOrosingO::mp.iliny:R.atn::rThan Volun1aiy DB:la:ures 7J9
Table 6.18 ln1flviewees'OpinimsabootlFRSandIASBasWRegulatimsfcrDerivatives 233
Table6.19 ln1flviewees'~abootCurrentDerivativeDroa:ures 234
Table620 R.emnsfcrNctEasily~ofCurrentDerivativeDB:la:ures 234
Table621 ln1flvi1:WeeS' Opinims aboot1lx:AdqJtion ofMedxxlsofRepJrtingfcrDerivatives in China 237

viii
Chart 1.1 Framework of the Research 8
Chart2.l Global ETD Market 1991 - 2009 20
Chart 22 Global OTC* Derivatives Market 1991 - 2009 21
Chart 23 Global OTC* Derivatives Market 1998 - 2009 22
Chart3.l Turnover (Billion RMB) and Volume (Million) of China's 76
Commodity Future Exchanges from 1993 to 2009
Chart 32 Turnover (Billion RMB) and Volume (Million) of China's 88
Commodity Future Exchanges in 2010
Chart 33 Proportions of Future Products in Total Turnover during the First 10 89
Months 2010
Chart 3.4 Turnover (Billion RMB) and Volume (Million) of CSI 300 Index 94
Futures in 2010
Chart 3.5 Proportion (%) ofCSI 300 Index Futures in Month's Turnover of 94
Total Derivatives Trading 2010
Chart 4.1 Deductive V.S. Inductive Approach 103

IX
c
1.1

The major objective of this chapter is to provide the context of the study. In the
subsequent sections, the background of the research area is firstly presented, followed
by the overall aims and objectives of the research and a discussion of the research

design. Finally, the structure and summaries of individual chapters are outlined.

1.2 Background

Since the 1990s, the world has witnessed the growing use of derivative instruments
and rapid expansion of derivatives markets. Prior studies have identified price
discovery, risk shifting, hedging, market efficiency and operational advantages as the

basic social and economiC functions of the derivatives market

For example,
a futures market is an important means of achieving investors' expectations of future
cash prices, which can help people make investment decisions more wisely
1 The interest rate and foreign exchange derivatives markets enable those
wishing to reduce their risk to transfer it to those wishing to increase it 1
and provide invaluable hedging tools against the risks. The derivatives market offers

several operational advantages, such as lowering transaction costs and enhancing

market liquidity ). The literature also provides evidence that the use of
derivatives can be value added to firms (e.g.. 1:
Cvcczy, For instance, 1)
reveal a four per cent increase in the value of large firms that hedge their foreign
currency exposures by using derivatives. (1 shows that firm risk is
decreased for new users of derivative instruments.

2
As long as the widespread of trading of derivative instruments, there has been a rising

intensive debate over the benefits and risk associated with the use of derivatives.

Supporters believe derivatives are powerful in managing companies' exposures to

risks. By contrast, critics describe derivative products as a 'double-edged swords' that

are 'extremely useful for risk management but they also create a host of new risks that

expose the entire economy to potential financial market disruptions' 20(3).

Over the past decades many high profile derivative related losses occurred, including,

for example, Barings, Metallgesellschaft, Orange County, Proctor and Gamble, and

lately Societe Generale. Especially, the recent financial crisis worldwide has

commonly been considered as the consequence of the extensive use of derivatives,

particularly mortgage-related derivative products. The great number of hugely

derivative related losses has undoubtedly promoted calls for improved reporting of

information about derivative activities 1

et et

201

In response to rising public concerns about the trading of derivatives and associated
risks, the supervisory bodies all over the world have paid much attention, over past

decades, to the establishment of effective governance systems including the release of

financial reporting standards for companies to disclose their derivative activities.

For instance, the U.S. accounting standards setting body (i.e., Financial Accounting

Standards Board, FASB) began the project on accounting and reporting for derivatives

in 1986 and a series of the Statements of Financial Accounting

Standards, including SFAS Nos. 105, 107, 119 and 133, were enacted in the

subsequent years. The International Accounting Standards Board (lASB), aiming to

set up a single global accounting standard, also attempts to establish standards on

accounting and reporting for financial instruments, including derivatives. In 1989, the

International Accounting Standards Committee (lASC, the predecessor of the IASB)

started a joint project with the Canadian Institute of Chartered Accountants (CICA) to
3
assess the issues related to accounting for financial instruments

which was an explicit beginning of the IASC to develop comprehensive and generally

accepted international accounting standards for the disclosure, presentation,

recognition and measurement of financial instruments including derivatives. Then the

IASC promulgated the international guidance on accounting and reporting treatments

for derivative instruments, International Accounting Standard (lAS) 32 and 39, in

1995 and 1999 respectively. By far the most complex and controversial accounting

standard ever to be issued is lAS 39. lAS 39 which is the first unique and global

international standard treating the financial instruments sets out requirements for

recognising and measuring financial assets, financial liabilities and some contracts to

buy or sell non-financial items. The main contribution of this standard is a wider

application of fair value for financial instruments valuation. The standard has

removed an important degree of flexibility, making it much more difficult for

companies to allocate external derivatives against external assets or liabilities for

hedging purposes. Consequently, lAS 39 has provoked the most critics. One of the

key areas in which the proposals of the IASB provide a significant improvement over

the previous accounting framework regime is the recognition on the balance sheet of

business transactions that were formerly recorded only off-balance sheet, in particular

derivatives transactions.

The usefulness of the compulsory accounting and reporting practice for derivatives

has attracted considerable academic attention since they were issued.

In the accounting literature, the studies in relation to the assessment of derivative

disclosures have developed into two branches. Firstly, some studies (c.g ..

et

Schroeder, 2005: et 2007;

have examined the quality of derivative disclosures by evaluating the response

of listed companies to the mandated disclosure requirements for derivatives. These

researchers intend to find out the answers about whether the mandated derivative
4
disclosure provisions actually achieve the expectation of accounting authorities, by

demanding the listed companies to provide more information regarding derivative

related activities in their annual reports. Generally speaking, these studies indicate

that the quoted companies are able to prepare both qualitative and quantitative

information about the derivative usage and associated market risk in accordance with

the basic accounting and reporting rules in their annual reports. Nevertheless, they are

unwilling to provide sufficient detailed information such as the assumptions of

quantitative techniques and corporate risk management activities. Hence, it can be

argued that although the implementation of the compulsory disclosure requirements

improves the reported information about use of derivatives, the supervisory

authorities still have a task to inspire the reporting companies to disclose more

information with greater details.

Another strand of studies focuses on the effect of information disclosure on the

behaviour of financial market aggregates such as stock price, stock returns and trading

volume. These researches (c.g., 1 et 1996;

1 .1,.

201 attempt to explain

empirically observed phenomena in the association between the derivative related

disclosures and market responses. Overall, the findings of these studies are mixed

even contrary. Some researchers 1 ct

et

et 2005: et provide the

empirical evidence to prove the value relevance of compulsory derivative accounting

and reporting regulations to investors' assessment of the corporate risk profile while

some empirical studies (e.g., et and

5
 demonstrate that there is no relationship between

the disclosed derivative information and the market response. Some

et argue

that the complicated accounting and reporting treatments for derivatives have caused

difficulties for investors in valuating corporate derivative activities, and even a few

studies (e.g., 1997; ) indicate that the

disclosures following the mandated derivative related requirements have been

misunderstood and adversely affected investors' assessments in a company's risk

profile and associated derivative activities. In addition, the restrictive and complex

derivative related standards, such as SFAS 133, have made the reporting entities hard

to understand and caused a series of significant problems in the use of derivatives and

smooth earnings volatility 1:

et 20(5). Such mixed and contrary results are coincident with the

findings achieved by the first stream that the compliance with derivative related

standards is mixed and the standard has not adequately achieved the desired level of

financial transparency on the use of derivative financial instruments as expected

Overall, the prior researches in relation to the impacts of compulsory derivative

related accounting and reporting requirements were mostly based upon the sample

from developed countries with mature financial derivative markets. In particular, most

of the studies on risk management and disclosures have been directed to the U.S.

setting with an emphasis on financial risk disclosures. However, by now, no study has

been conducted so as to specifically address accounting and reporting for derivatives

in China and examine the usefulness of derivative disclosures by Chinese listed

companies. China as the largest developing economy has made remarkable progress

in its economic development as well as its accounting reform over the last three

decades. Especially, the recent convergence of Chinese Accounting Standards (CASs)

with International Financial Reporting Standards (IFRSs) makes China an interesting

case to examine the issues associated with the application of derivatives accounting
6
rules.

Thus, the intention of filling the research gap existed in the literature is the motivation

for the present study. This thesis aims to assess the derivative disclosure practice in

China with a view to particularly examining the usefulness of such disclosures in

helping the facilitation of investment decisions. It is expected to contribute to the
existent literature by enhancing the understanding of the usefulness of derivative

related disclosures not only in developed economies but also developing countries.

1.3 Overall Aims Objectives

The primary aim of the research is to assess the usefulness of derivative related

disclosures by Chinese listed companies.

In order to achieve the overall aim, this study has four specific objectives as follows:

1. To reveal the level of derivative disclosures made by Chinese listed companies;

2. To identify information contents of derivative disclosures provided by Chinese

listed companies;
3. To examine the response of equity market participants (e.g., institutional investors

and professional analysts) to the derivative related disclosures with a view to

assessing the usefulness of derivative disclosures in the case of China, an

emerging market where derivatives are still new phenomena;

4. To suggest the future direction in the development of derivative reporting

standards particularly for emerging economies.

Research Design

As shown in Figure 1.1, the present research is separated into two major stages and

the following sections provide summarIes about the specific purposes, research
7
methods and data selection of each stage. A detailed specification of the research

methodology employed in both stages including the rationale for the selection of the
research methods and sample collection is provided in Chapter IV.

Chart 1.1 Framework of the Research

Stage Oue
8
 Purposes

In the first stage, the study has the primary aim to assess the degree of derivative

related disclosures provided by Chinese listed companies.

1.4.1.2 Research Questions

Two major research questions have been addressed in the first phase:

• What is the level of derivative related disclosures made by Chinese listed

companies?
• What is the information content of derivative related disclosures provided by

Chinese listed companies?

Research Methods

To answer the above two questions, the content analysis approach is mainly adopted

in Stage One owing to the wide use of this method in prior studies l e.g ..

1 ct

et 2007; ) so as

to evaluate the information quality of derivative disclosures reported by listed

compames. The corporate annual report is adopted as the sampling unit for

observation and analysis as it is widely perceived to be the most dominant, reliable

and significant source of information for users. In addition, the number of page is

used as the unit of analysis. For each annual report of sampling company, the amount

of disclosures regarding the use of derivatives will be firstly noted on a specialised

record sheet and then the contents of this record sheet will be transferred to an Excel
spreadsheet. With the consideration of the convergence with the international

regulatory framework enhanced by Chinese regulators, the disclosure checklist -

9
Financial Derivatives Disclosures Index (FDDI) will be developed. FDDI is largely

based upon IFRS and lAS provisions which are different from many indices used in

the existing literature mainly on the basis of U.S. reporting requirements. The

disclosure checklist is served as the benchmark to be compared with the

corresponding disclosures in companies' annual reports. Besides, a pilot sample of

reports were analysed and a number of procedures were followed to ensure the

reliability and validity of the disclosure measurement.

1.4.1.4 Collection

At the beginning, financial institutions are excluded from the sample as the study only

focuses on non-financial entities that use derivatives to manage their risks. Annual

reports in 2006 1 are chosen as the sampling unit for observation and analysis. All
sample companies are selected from the CSI 100 and 200 representing large and

medium firms in Chinese domestic A-share market as evidence ct

show that the large companies are

more likely to use derivative products. The final sample comprises by 53 companies

including 39 large firms and another 14 medium companies.

1.4.2 Stage Two

I)urposes

1 There are two important reasons for the study to focus on the year of 2006: Firstly, most listed companies
finished their shareholding reform in 2006 and according to the statistics, 94 per cent of Chinese listed companies
had completed the ownership conversion process by mid-year 2006 20(6). Since some companies
may issue warrants to pursue the privatisation reform, it is therefore expected to gather more sample companies
using derivatives from their 2006's annual reports. Secondly, the use of derivative instruments is compulsorily
disclosed after 1 January 2007 so the year of 2006 is an important year to analyse whether Chinese listed
companies have sufficient preparations to be adapted with the forthcoming mandated derivative regulations.
10
In the second stage, the study mainly aims to examine the equity market participants'

perceptions, views and opinions towards the usefulness of derivative disclosures

provided by Chinese listed companies.

1.4.2.2 Research Questions

Four major research questions have been addressed in this stage:

• What is the response of equity market participants to derivative related

disclosures?

• Do they treat disclosing more about derivatives' activities as useful information

when making investment decisions?

• Are they satisfied with the current accounting and reporting treatment of

derivative activities?

• What are their opinions on the future development in derivative related reporting

standards?

1.4.2.3 Research Methods

The quantitative research approach (e.g., modelling) which was employed in previous

studies is not applied in the current research due to the lack of large sample. In order

to obtain some insight of market participants concerning derivative disclosures, this

study has adopted semi-structured interview approach which is the most appropriate

research method to gather information on people's perceptions and experience.

1.4.2.4 Data Collection

The study mainly emphasises on two equity market participants groups - institutional

11
investors and professional analysts as they are widely perceived to have a better

understanding of the complex nature of derivatives and associated disclosures. A total

of 21 interviewees including ten investment managers and another eleven professional

analysts from a mutual funds management company as well as a securities firm are
included in the final sample. There are twelve questions available for each interviewee
and every interview lasted about 40 minutes. The details of interviews and interview

questions are provided in Chapters IV and VI.

1.5 Outline of Findings and Contributions

In the first stage, the study has found the following findings concerning the level and
information contents of the derivative disclosures reported by Chinese quoted

companIes:

• The amount of derivative disclosures provided by listed firms is generally low.

• Equity derivative products such as warrants and convertible bonds are of more
use by listed companies.

• The corporate size has little influence on the amount of derivative disclosures
made by Chinese quoted firms which is opposite to a quite number of western
evidence ( 1 1 1 et 1

• Chinese listed compames tend to report more information related to the

importance of using derivatives for their financial status rather than those about

the risks associated with the use of such instruments.

In the second stage, several key findings have been revealed as follows:

12
• The derivative related disclosures reported by listed companies contain useful and

helpful information for investors to make investment decisions which is

consistent with many studies conducted in mature economies (e.g ..

1 1996; 2002:; et al..

et et

). However, they are generally believed to play a mmor and

supplementary role in facilitating investment decisions.

• The current derivative disclosure practices are not satisfied by the majority of

investors.

• Overall, the present regulatory policies of accounting and reporting for derivative

instruments that are largely based upon lFRS and lAS derivative related

provisions are very difficult to understand for Chinese investors.

The thesis makes a number of contributions to the existing theories and literature

which include:

• It provides evidence to challenge whether the voluntary disclosure theories such

as agency theory, signalling theory, political process theory and proprietary costs

can be capable to explain the corporate size has significant influence on

derivative related disclosures reported by Chinese listed companies.

• It fills up the current research gap by offering an assessment of the usefulness of

derivative reporting and accounting practices in China.

• It extends the understanding of the value relevance of derivative disclosures in

the context of emerging economies.

• It provides evidence from Chinese equity market participants to support the

13
 usefulness and helpfulness of derivative related disclosures undertaken by prior

studies in developed countries

1 et

ct 2005: et

• It also contributes to the research methodology in two major ways: first, the

disclosure checklist employed in the research is mainly on the basis of IFRS and

lAS derivative regulations which is totaHy different to those used in the existent

literature which are largely in line with u.S. based accounting and reporting

provisions; second, the introduction of the interview approach is effective to

directly examine the investors' response to derivative related disclosures reported

by listed companies. The qualitative research method (i.e., interview) contributes

to find out why market participants treat derivative disclosures as useful or

otherwise information in facilitating their investment decisions.

1.6 Chapter Summaries

Chapter I provides a brief introduction to this thesis together with an outline of the

key aims of the research.

Chapter II evaluates the pnor studies about the usefulness of derivative related

disclosures. This review provides a basis for the understanding of the impact of

mandated derivative accounting and reporting regulations on listed companies and

market participants. It starts with a discussion about the development of derivatives

markets and relevant regulated standards, followed by a critical and deep review of

existing literature conducted to assess the usefulness of derivative related disclosures

and a summary of previous researches is presented at last.

Chapter III aims to discuss the evolution of China's derivatives market and associated

accounting and reporting practice for derivatives with a view to assessing the current
14
changes in China's derivatives market and accounting and reporting for derivative

instruments. The purpose of this chapter is twofold. Firstly, it provides insights into

the development of derivatives market in China, highlighting major barriers to the

development. The analysis has adopted theory. Secondly, it looks
into the current accounting standards for derivatives disclosure and reporting,
examining the impact of China's new accounting standards on the development of
derivatives and the firms that have engaged with the use of derivatives. It begins with
the review of the history of China's derivatives market. Then it presents an argument
regarding the factors that may have impacts on the development of China's
derivatives market. Next, the new developments in China's derivatives market are
discussed. Further, it provides an evaluation about accounting and reporting practice
for derivatives in China and finally, the main findings and discussions of this chapter
is summarised in the end.

Chapter IV describes the research methods employed in this study. The chapter
outlines the research objectives and research questions. A section devoted to
describing the research methods chosen to carry out this study is followed and it then
presents the sample selection procedures.

Chapter V reports the results and discussions of the content analysis. It primarily aims
to complete the first phase of the research so as to draw a picture related to the degree
and nature of disclosed information about the use of derivatives by Chinese listed

companies. The chapter starts with the discussions about overall disclosure level,
followed by evaluation of disclosures by companies in different sizes, information
content of derivative disclosures, disclosures of different types of derivatives and a
summary of the main findings and arguments is provided in the end.

Chapter VI reports the results and discussions of interviews. The overall objective of
this chapter is to examine the equity market participants' perceptions, attitudes and
opinions towards the usefulness of derivative related disclosures prepared by Chinese
15
quoted firms. It firstly evaluates interviewees' opinions about information contents of
derivative disclosures and then their views on the usefulness of derivative disclosures
are examined. Next, their perceptions about accounting and reporting policies for

derivatives are addressed and the chapter ends up with a summary of key findings and
discussions.

Chapter VII summarIes the research major findings with a discussion on the
contributions to existing literature as well as implications to Chinese policy makers.
Limitations of the study are also described in this chapter along with the potential
extensions of the study and areas for future research.

16
c

17
2.1 Introduction

This chapter mainly discusses the prior studies on the usefulness of derivative-related
disclosures. The review provides a basis for understanding the effect of compulsory
derivative disclosure requirements to listed companies and market participants. The

chapter begins with an introduction of the development of derivatives markets and

related supervisory standards, followed by a deep review of previous researches that
seek to assess the usefulness of derivative related disclosures.

A derivative instrument is 'a contract between two parties that specifies conditions -
in particular, dates and the resulting values of underlying variables - under which
payments, or payoffs, are to be made between the parties' 1 In
the real word, the forward contracts, futures, options and swaps are the most typical
products in the derivatives market. The literature has identified the price discovery,
risk shifting, hedging, market efficiency and operational advantages as the basic

social and economic functions of the derivatives market

1: 1997). For instance, the futures market is an important

means of obtaining investors' expectations of future cash prices, which can help
people make investment decisions more wisely A futures market, where
buyers and sellers meet readily, can also improve overall market efficiency by
reducing search costs ). The interest rate and foreign
exchange derivatives markets enable those wishing to reduce their risk to transfer it to
those wishing to increase it and provide valuable hedging tools to
18
participants against the interest rate or foreign exchange risks. In addition, the

derivatives market offers several operational advantages, such as lowering transaction

costs and enhancing market liquidity BU.'."'-'"'. 1 In a word, the derivatives can

help financial markets become more efficient and provide better opportunities for
managing risks ). The derivative instruments were firstly invented in
the 1970s and worldwide, the use of derivative contracts has grown dramatically since
the 1990s. Generally, the development of derivatives follows two tracks.

Firstly, the standardised equity and commodity products are traded in well-organised
and transparent exchanges, starting in Chicago, London and Tokyo, which is the
so-called exchange-traded derivatives (ETD) market. Chart 2.1 summarises the
notional value2 of global ETD market from the year end of 1991 to 2009. The
international ETD market had been experiencing a remarkable development over the
last two decades. Its notional amount was only $3,519.30 billion dollars in 1991 and

then increased with the annual rate of 21.47 per cent in the subsequent years. The
notional value of global ETD market reached its peak of $79,066.50 billion dollars in
2007. However, the market saw a global retreat in 2008 in the wake of recent financial
crisis. With the expansion of the financial crisis, the global exchange-traded
derivatives market seized up and was contracted at $57,715.30 billion dollars by end
of 2008 which was taking approximately 73 per cent of the previous year's value. As
the global economy steadily recovered in late 2009, the international ETD market
finally turned around in the year end, achieving $73,137.00 billion dollars in notional

value that was 26.72 per cent higher than previous year.

On the second track, highly customised interest rate and foreign exchange products
were developed by leading financial institutions, which created the so-called
over-the-counter (OTC) derivatives market. Charts 2.2 and 2.3 illustrate the notional
value and gross market value of global OTC market from 1991 to 2009. The OTC

2 The nominal or face amount that is used to calculate payments made on swaps and other risk management
products. This amount generally does not change hands and is thus referred to as notional (Investor Dictionary-com,
2(12).
19
derivatives market achieved a rapid expansion worldwide over the past two decades.

Compared with the ETD market, the international OTC derivatives market developed
faster, with an average annual growth rate of35.81 per cent in terms of notional value

since 1991 and achieved $ 595,738 billion dollars by the end of 2007. While the
notional amount of outstanding saw an 8 per cent decline at the end of 2008 compared

with those of 2007 as a result of financial turbulence, it revived in 2009 with the
notional value of $614,674 billion dollars, 12.17 per cent above the end-2008 level.
The gross market value, which measures the cost of replacing all outstanding
contracts, is a better indicator to gauge the market risk than the notional amounts
outstanding (BIS. The change of gross market value of global OTC derivatives
market is slightly different with those of notional value. It reached its highest point
with $ 32,375 billion dollars at the end of 2008 in contrast to the decline in notional

amount outstanding; this was mainly due to the increase of credit default swap
contracts by 58 per cent in the wake of increases in credit and counterparty risk during
the turmoil. Gross market values rose for both single and multi-name contracts
The gross market value of global OTC derivatives market fell by 33.33 per
cent to $21,583 billion dollars in the end of 2009 and the falling of gross credit
exposures3 by 18 per cent from an end-2008 peak is the major factor

Chart 2.1 Global ETD Market 1991- 2009

(Notional amounts outstanding at end-year in billions of US dollars)

3 Gross credit exposure is the difference (taking into account legally enforceable bilateral netting agreements)
between the gross value of contracts that have a positive market value and the gross value of contracts that have a
negative market value (Bl S, 20(9).
20
 90,000 ------------------------------------------------------------------------------

80,000 ------------------------------------------------------------------------------

70,000 --------------------------------------------------------------

60,000 --------------------------------------------------------------

50,000 ----------------------------------------------------------
- I -ETD* I
40,000 ------------------------------------------------------
30,000 ________________________________________________ _

20,000 -----------------------------------------

10,000

o
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Notes: * ETD includes the interest rate futures, interest rate options, currency futures, currency options, stock
market index futures and stock market index options.
Source: BIS 1998. March, Jllne and December 2007. Afarch ::01 {]

Chart 2.2 Global OTC* DeriyatiycsMarkct 1991 - 2009

(Notional amounts outstanding at end-year in billions of US dollars)

700,000 --------------------------------------------------------------

600,000 -----------------------------------------------------------

500,000 ----------------------------------------------------

400,000 -------------------------------------------------
-Notional Value I
300,000 ---------------------------------------------- -

200,000 ---------------------------------------

100,000

o
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Notes: *OTC includes: foreign exchange contracts e.g., forwards and forex swaps, currency swaps and options;
interest rate contracts e.g., forward rate agreements, interest rate swaps and options;
equity-linked contracts e.g., forwards, swaps and options;
commodity contracts e.g., gold and other commodities forwards, swaps and options;
credit default swaps e.g., single-name instruments and multi-name instruments; and,

21
 other unallocated instruments.
SOllh'e; BI5', J998, March. June ond December 20(}7, March 2()J(j

Chart 2.3 Global OTC* Derivatives Market 1998 - 2009

(Gross market value at end-year in billions of US dollars)

35,000

30, 000 ------------------------------------------------- ------

25,000

20,000
-+-Gross Market Value
15,000

10,000

5,000

o
98 99 00 01 02 03 04 05 06 07 08 09

Notes: *OTC includes: foreign exchange contracts e.g., forwards and forex swaps, currency swaps and options;
interest rate contracts e.g., forward rate agreements, interest rate swaps and options;
equity-linked contracts e.g., forwards, swaps and options;
commodity contracts e.g., gold and other commodities forwards, swaps and options;
credit default swaps e.g., single-name instruments and multi-name instruments; and,
other unallocated instruments.

Indeed, there has been an intensive debate concerning the value and risk of using

derivatives along with the widespread of derivatives' trading worldwide. On the one

hand, the derivative instruments are powerful tools for companies in managing their

exposure to risks. The US and UK studies et 1

have found that larger companies are the dominant

users of derivative products, and the foreign exchange and interest rate risk are the
most commonly managed risks. The former U.S. Federal Reserve Board Chairman

Alan Greenspan believes that derivatives have contributed to the development of 'a

far more flexible, efficient and resilient financial system than existed just a

quarter-century ago' l. In contrast, the U.S. billionaire investor Warren

22
Buffett considers derivatives as 'time bombs for both the parties that deal in them and
the economic system' and Randall Dodd, the director of Derivatives Study Center,
describes derivatives as a 'double-edged swords' that are 'extremely useful for risk

management but they also create a host of new risks that expose the entire economy to
potential financial market disruptions' ). As the derivatives usage grows,
there has been a dramatic rise in reported scandals due to the abuse of derivatives.
Some major high profile derivative-related losses around the world are listed in Table
2.1 as follows:

Table 2.1 World's Major Derivative Related Scandals

Barings PLC. $1 billion loss resulted in the company's bankruptcy. The loss resulted
from unauthorised trading in Nikkei index futures.
Metallgesellschaft. $1 billion loss related to the use of energy futures and other
derivatives which were hedges of future fixed price sales commitments.
Orange County. $1.7 billion loss in value of its $7.4 billion investment portfolio due
to rising interest rates.
Piper Jaffrey. $700 million loss in mutual funds from investments in interest rate
derivatives.
Kidder Peabody. $350 million 'phantom' profit related to trading in government
strips.
Proctor and Gamble. $157 million loss on closeout of leveraged interest rate swaps.
Cargill. $90 million loss in value of mortgage backed derivatives.

Investors Equity Life Insurance Company in Hawaii. $90 million loss resulting

from trading in treasury bond futures.

Air Products & Chemical. $60 million loss in value of leveraged interest rate swaps
due to increased interest rates.
Harris Trust & Savings Bank. $51 million loss in investments in collateralized
mortgage obligation derivatives.
Enron goes Bankrupt (2001). The 7th largest company in the US and the world's
largest energy trader made extensive use of energy and credit derivatives but becomes
the biggest firm to go bankrupt in American history after systematically attempting to
conceal huge losses.
AlB loses $750 million (2002). John Rusnak uses fictitious options contracts to cover
loses on spot and forward foreign exchange contracts.

23
Citigroup bear raid (2004). Citigroup traders led by Spiros Skordos made €15
million by suddenly selling €ll billion worth of European bonds and bond
derivatives, and buying many of them back at a lower price.
Amaranth Advisors loses $6 billion (2006). The US-based hedge fund suffered
enormous loses trading in natural gas futures.
Societe Generale loses €4.9 billion in unauthorised futures trading (2008). A
rogue trader is blamed for the world's largest banking fraud up to that date.
A rogue trader causes havoc in the oil market (2009). Steve Perkins, a futures
broker with PVM Oil, was blamed for unauthorised trades that could have cost the
firm £400m if they had not been discovered and closed.

Despite of the derivative-related scandals listed above, a certain type of derivatives

which is called 'credit default swaps', is widely recognised as a key role in the recent

financial crisis (e.g., Andrews. 2008: Goodman, 2008; Moshinsky, 2009; Krugman,

2010; Blinder. 2010; Galbraith, 2010). The unregulated multi-trillion dollar OTC

credit default swaps market is universally treated as the catalyst to foment a mortgage

crisis, then a credit crisis, and finally a systemic financial crisis that has led the world

economy into a devastating depression in 2008. The number of scandals with huge

derivative related losses has undoubtedly promoted calls for improved reporting of

information about derivative activities 1997;

1998; LYV'-HHM et et and the accurate and

complete disclosures expect to more effective market discipline

It is widely recognised that the accounting for financial instruments (which

includes derivatives) is a major challenge to financial accounting practice and

accounting authorities (e.g., 1 , 1 In

response to rising public concerns about the trading of derivatives and associated risks,

the supervisory bodies all over the world have paid much attention to the

establishment of effective governance systems including the release of financial

reporting standards for companies to disclose their derivative activities over past

decades. For instance, the US accounting standards setters (i.e. Financial Accounting

Standards Board, FASB) began the project on accounting and reporting for derivatives

in 1986 ) and a series of the Statements of Financial Accounting

24
Standards, including SFAS Nos. 105, 107 and 119, were enacted in the subsequent

years. Compared to other accounting standards boards, the FASB is considered more
advanced in regulating the accounting treatment for derivative instruments, even

though the approach employed has been piecemeal (Blankley and Scrocder, 2000).
Under the provisions of SFAS 105 firms are required to report the face,
contract or notional principal amount of financial instruments with off-balance-sheet
risk. SFAS 107 ) expands such derivative-related reporting to incorporate
the fair value 4 amounts of all financial instruments, both organised and
off-balance-sheet, in notes to the financial statements. SFAS 119
requires all US companies to provide disaggregated notional value disclosures (e.g.,
asset versus liability positions). The issuance and implementation of these new
accounting requirements symbolise the shift of disclosure of derivatives' usage from a
voluntary to a compulsory base. Apart from the FASB, some other market governing
and standards-setting bodies, like the Securities and Exchange Commission (SEC)
and Governmental Accounting Standards Board (GASB) also set up their own
requirements to regulate activities regarding the use of derivatives. In 1997, the SEC
issued the FRR No. 48 requiring two types information about derivatives and market
risk: qualitative and quantitative information to be mandatorily reported by entities.
The GASB, with the primary aim to establishing and improving standards of the state
and local governmental accounting and reporting, published a final derivative

instruments standards, 53 which rules governments, either the

state or local, to measure most derivative instruments at fair value as assets or

liabilities in their accrual-based government-wide, proprietary fund, and fiduciary

fund financial statements (but not in the governmental fund financial statements).

In the UK, the Accounting Standards Board (ASB) issued a Discussion Paper
'Derivatives and other Financial Instruments' in 1996 as the first step to develop
accounting and reporting for derivatives. A number of issues related to derivatives

4 The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current
transaction between willing parties, other than in a forced or liquidation sale 107, paragraph 5).
25
including measurement, hedging accounting and disclosure were addressed. Then the

Board continued to enhance the development of standards dealing with the use of

derivatives and published an Exposure Draft (ED) FRED 13 in April 1997. The

formal accounting standard FRS 13 'Derivatives and other Financial Instruments:

Disclosures', was finally promulgated in September 1998. All firms within the scope

of the standard were required to comply with the provisions for accounting periods

ending on or after 23 March 1999.

In Australia, the Australian Accounting Standards Board (AASB) issued AASB 1033
'Presentation and Disclosure (~f Financial Instruments' in 1996 and developed based

on ED 65 'Presentation and Disclosure of Financial Instruments '. The predecessor of

ED 65, ED 59 'Financial Instruments', was released in March 1993. However, ED 59,

which attempted to introduce recognition and measurement rules for financial

instruments in addition to disclosure requirements, was withdrawn. Extensive

lobbying against the recognition and measurement of financial instruments caused the
Australian standard setters to defer the recognition and measurement issue until an

equivalent international standard was issued. All publicly listed companies in

Australia, which issue or hold financial instruments, should comply with the

requirements of AASB 1033. The standard focuses only on the presentation and

disclosure of financial instruments. AASB 1033 was subsequently amended in 1999 to

include the requirement of converting financial instruments to achieve greater

harmonisation with the international standard, lAS 32 'Financial Instruments:

Disclosure and Presentation '.

The major derivative related accounting standards and disclosure rules are shown in

Table 2.2.

Table 2.2 Major Derivative-Related Accounting Regulations

Accounting
Issue
Country Standards Accounting Requirements
Year
Setters
26
 SFAS 80 'AccountinJ<for Futures Contracts' 1984
SFAS 105 'Disclosure of Information about Financial
Instruments with Off-Balance sheet Risk and Financial 1990
Financial Accounting Instruments with Concentrations of Credit Risk'
SFAS 107 'Disclosure about Fair Value ofFinancial
Standards Board Instruments'
1991
(FASB) SFAS 119 'Disclosure about Derivative Financial
1994
Instruments and Fair Value ofFinancial Instruments'
SFAS 133 'Accountingfor Derivative Instruments and
1998
HedJ<inJ< Activities'
Financial Reporting Release No.48 'Disclosure of
U.S.A Accounting Policies for Derivative Financial Instruments and
Securities and
Derivative Commodity Instruments and Disclosure of
Exchange Commission Quantitative and Qualitative Information about Market Risk
1997
(SEC) Inherent in Derivative Financial Instruments, Other Financial
Instruments and Derivative Commodity Instruments'
Governmental
Statement No. 53 'Accounting and Financial Reportingfor
Accounting Standards Derivative Instruments'
2008
Board (GASB)
United States Dodd-Frank Wall Street Reform and Consumer
2010
Congress Protection Act
Accounting Standards FRS 13 'Derivatives and Other Financial Instruments -
UK Board (ASB) Disclosures'
1998

Canadian Institute of
CICA Handbook Section 3860 'Financial Instruments:
Canada Chartered Disclosure and Presentation'
1995
Accountants (CICA)
AASB 1033 and AAS 33 'Presentation and Disclosure of
1996
Financial Instruments '
Australian Accounting
AASB 132 'Financial Instruments: Disclosure and
Australia Standards Board Presentation'
2005
(AASB) AASB 139 'Financial Instruments: Recognition and
2005
Measurements'
lAS 32 'Financial Instruments: Disclosure and
1995
Presentation'
International Accounting Standards Board lAS 39 'Financial Instruments: Recognition and
1999
(IASB) Measurement'
IFRS 7 'Financial Instruments: Disclosures' 2005
IFRS 9 'Financial Instruments ' 2009
Basel Committee on Banking Supervision
Basel III 2010
(BCBS)
Notes: * lAS 32 currently is revised as lAS 32 'Financial Instruments: Presentation '. The disclosure provisions
of IFRS 32 are superseded on the adoption of lFRS 7 'Financial Instruments: Disclosures', which is
effective after 1 January 2007.
**The IASB plans that classification and measurement provisions ofIAS 39 will be replaced by lFRS 9
effective 1 January 2013, with earlier application permitted. However, the lASB released a draft of
proposals to adjust the effective date of 1 January 2015 instead of 1 January for lFRS 9 on 4 August
2011.

The International Accounting Standards Board (lASB) aims to set up a single global

accounting standard for every country and it also has the task of establishing
standards on accounting and reporting for financial instruments, including derivatives.

In 1989, the International Accounting Standards Committee (lASC, the predecessor of

the IASB) started a joint project with the Canadian Institute of Charted Accountants

(CICA) to assess the issues related to accounting for financial instruments

The project is an explicit beginning of the IASC to develop comprehensive and

generally accepted international accounting regulations for the disclosure,

27
presentation, recognition and measurement of financial instruments which includes
derivatives. In 1995, the lASe was firstly issued the international guidance on

accounting treatment for financial instruments,

32 'Financial Instruments: Disclosure and Presentation '. Basically, lAS 32

deals with the following issues:

a) classification of financial instruments as liabilities or equity, by the issuers, and

the classification of related interest, dividends and gain or loss,

b) offsetting of financial assets and financial liabilities and,

c) disclosure of information about financial instruments.

The standard requires firms to disclose:

a) risk management policies, including the policy for hedging each major type of
forecasted transactions (lAS 32, paragraph 43A),
b) terms, conditions and accounting policies for each class of financial asset,
financial liabilities and equity instruments, both recognised and umecognised

(paragraph 47),
c) interest rate risk exposure (paragraph 56),
d) credit risk exposure (paragraph 66),
e) fair value of each class of financial assets and liabilities, recognised and

umecognised (paragraph 77) and

f) financial assets carried at an amount in excess of fair value (paragraph 88).

It can be seen that the accounting standards setters, both national and international,

apply themselves to regulate the use of derivatives by requiring companies to disclose

much more information. In the recent years, the accounting standards setters
continuously make their efforts to improve the requirements on accounting and
reporting for derivatives and some new accounting regulations, such as
'Accounting for Derivative Instruments and Hedging Activities' (FASB, 1998) and
28
 'Financial Instruments: Recognition and Measurement' (lASC, 1999) have
been promulgated and implemented. The significant change of the two requirements

is the adoption of the full-fair-value measurement that all entities must recognise all
financial instruments, including derivatives, as assets or liabilities on the
balance-sheet and measure those instruments at fair value, and changes in the
derivatives fair value are to be recognised in the current earnings unless specific
hedge accounting criteria are met. In a corporate annual report, the derivative
instruments are treated as balance-sheet items instead of off-balance-sheet
instruments.

Since 2008, the world has faced the most severe financial crisis post
. The financial crisis, starting with the collapse of the American housing
industry then rapidly spreading across the world, forces most of nations be struggling
with bankruptcy of financial institutions, unemployment, failing business, falling
home prices, and declining savings. Governments and central banks all over the world
have to implement unprecedented fiscal stimulus, monetary policy expansion, and
institutional bailouts to stabilise and revive the economy. The causes of the current
financial crisis all trace back to a certain type of derivatives - credit default swaps
(CDS), which is widely recognised as a key role in the recent financial crisis (e.g.,
Andrews, 2008; Goodman, 2008; Moshinsky, 2009; Krugman. 2010: Blinder, 2010:
Galbraith. 2010). The CDS contracts are sort of financial instruments giving insurance
against a credit event that destroys value in an entity's (usually a corporation's) debt.
The insurer of the credit event is paid a premium (usually quarterly) over a fixed time

period to provide the insurance. And, the insured gets reimbursed for any losses in the
value of the entity's debt, if a credit event occurs over the contract's life. CDS are
customisable, OTC products and can be written to trigger in the event of bankruptcy,
default, failure to pay, restructuring, or any other credit event of the reference entity.
CDS can be physically settled or cash settled. If a physically-settled CDS is triggered,

5 The Great Depression was an economic slump in North America, Europe, and other industrialized areas of the
world that began in 1929 and lasted until about 1939. It was the longest and most severe depression ever
experienced by the industrialized Western world
29
the protection seller pays the face value of the debt (or another pre-specified amount)
to the protection buyer in exchange for the debt itself, which would be worth less than
face value given the recent credit event. Triggering a cash-settled CDS would require

the protection seller to make a payment to the protection buyer of the difference
between the original value of the debt (typically the face value) and the current value

of the debt based on a specified valuation method. Unlike hedging with less risky
bonds which requires a cash outlay upfront, CDS do not subject the buyer to interest
rate risk or funding risk. CDS allow hedgers or speculators to take an unfunded
position solely on credit risk In October 2008, the
notional value of the umegulated OTC market was estimated to be in excess of $ 600
trillion including the estimated amount of CDS markets between
$35-65 trillion ( The CDS contracts are described by Richard Christopher
Whalen, senior vice president and managing director at Institutional Risk Analytics,

as 'high-beta risk, that is, highly correlated with the broad financial markets. Unlike
natural disasters and other low-beta risks, where the frequency of events is relatively
low and uncorrelated to the financial markets, in CDS the high degree of market
correlation ensures that most or all of a portfolio of single-name CDS contracts will
deteriorate when economic conditions turn negative' ( The umegulated
multi-trillion dollar OTC credit default swaps market is universally treated as the
catalyst to foment a mortgage crisis, then a credit crisis, and finally a systemic

financial crisis that has led the world economy into a devastating depression in 2008.
The SEC Chairman Christopher Cox describes the credit default swaps market as a
'regulatory blackhole' and it is in need of 'immediate legislative action'
Former SEC Chairman Arthur Levitt and former Fed Chair Alan
Greenspan, both of whom used to support the removal of OTC derivatives trading

from the federal and state enforcement, have acknowledged that the deregulation of
the credit default swaps derivatives market contributed to the fall 2008 economic

receSSIOn criticise that the current

regulatory system on credit derivatives markets which is mainly based upon

self-regulatory initiatives, is insufficient to ensure the market participants to use credit
30
derivatives prudently and responsibly. They argue that well-structured regulatory

system should be combined self-regulatory initiatives together with mandatorily

supervisory actions as to prevent market participants from misusing credit derivatives,

therefore eliminating the dangers posed by such instruments to the stability of the
financial system. The Commodity Futures Trading Commission Chairman Gary
Gensler recommends that any firm intends to get involved in the swaps trading should
be allowed to process such business in the clearinghouses for swaps transactions

Recently, in response to the increasing calling for strong and effective oversight of the
derivatives market, particularly the OTC trades, governments around the world have

taken actions to overhaul the current derivative regulatory regime. In September 2008,
the FASB issued the FASB Staff Position No. 133-01 and FIN 45-4, aiming at
improving disclosures of credit derivatives, which amends No. 133, that requires
greater disclosure of information about the potential adverse effects of changes in
credit risk in the financial position, financial performance and cash flows of the sellers

of credit derivatives. The u.S. Senate Agriculture Committee approved legislation to

tighten regulation of derivatives trading sponsored by Senator Blanche Lincoln on 21 st

April 2010. The bill allows the limited exemption of derivatives for corporate hedgers

from its proposed exchange trading. It will also force banks to split off their swaps
business and push financial institutions into the stiff regulations On
21 st July 2010, the U.S.
was signed into law by President Barack

Obama. The key of Act is to provide robust supervision and regulation to financial
firms and establish comprehensive regulation framework for financial markets. The
Act stresses the necessity to create comprehensive regulation of OTC particularly
CDS derivatives trading and requires that all OTC derivatives markets, including CDS
markets should be subject to the comprehensive regulation system that symbolises the
governing of OTC derivatives trades shifting from non-regulatory to mandatory

superVISIOn.
31
In the wake of the Greek debt crisis over the lack of disclosure to regulators of credit
market activity, the European Commission is proposing a new regulation on the OTC

derivatives market. The

was

released on 15 th September 2010 and expected to be enacted by the end of 2011. It

requires the trading of OTC derivatives in the EU to be reported to central data

centres (trade repositories) accessible to regulators. A new European Securities and

Markets Authority would be responsible for registering and monitoring trade

repositories, while standard OTC derivatives would have to be cleared through central

counterparties.

The world banking superVISOry institution - Basel Committee on Banking

Supervision (BCBS), also updated their guidelines for capital and banking regulations,

which is so-called the . on 20th September 2010. Regarding to eliminating

risks arising from the trading of credit related derivatives, the regulations require

banks to,

firstly, strengthen the capital requirements for counterparty credit exposures arising

from banks' derivatives, repo and securities financing transactions;

secondly, raise the capital buffers to back these credit exposures;

thirdly, reduce procyclicality6;

fourthly, set up additional incentives to move OTC derivative contracts to central

counterparties like clearing houses so as to strengthen the restriction and supervision

of derivatives trade;
fifthly, provide incentives to strengthen the risk management of counterparty credit

exposures.

6 It refers to any aspect of economic policy that could magnify economic or financial fluctuations }.
32
In summary, the evolvement of accounting and reporting for the use of derivatives

switches from the original voluntary to the current mandated base, shifting from

off-balance-sheet to balance-sheet items, and emphasising from monitoring of ETD to

OTe derivatives. Theoretically, from the views of regulators, these compulsory

disclosure requirements have the benefits for both the listed companies and investors.

Under the compulsory disclosure framework, the listed companies have to disclose

much more information, either good or bad, about their use of derivatives and they

have to improve their internal control system and risk management policy to avoid the
losses from derivative usage. For investors, they can obtain much more useful
information about the risk exposure of a quoted company to facilitate their investment

decisions. however, provides the critical views on the compulsory

derivative disclosure framework. He insists that the greater transparency about

companies' derivative activities is not a panacea for imprudent risk management

strategies and such transparency actually includes firms taking excessive speculative

position in the derivatives market. The author argues that the firm might choose the

prudent risk management strategy in the absence of hedge disclosures but the

implementation of prudent risk management strategy comes to costs and the

company's production policy is distorted in the absence of hedge disclosure. Finally,

he suggests that the regulators should carefully investigate the trade-off between the

risk management distortions and production distortions when evaluating the effect of

compulsory hedge disclosures for all companies. In the literature, the effectiveness of

the mandated derivative-related disclosure requirements has attracted considerable

academic attention.

2.3 Prior Literature

As discussed in the last section, voluntary disclosure about the use of derivative

instruments was dominating at the initial stage. With the enforcement of regulatory

33
bodies in the recent decade, the derivative related information must be mandatorily

disclosed following appropriate regulations by reporting entities. Voluntary disclosure

means, except for compulsory disclosure, reporting companies disclose information

voluntarily to the public. In this section, the study intends to provide a discussion of

theories refer to voluntary information disclosure in general terms, followed by a

review of previous studies specially related to the usefulness of derivative related

disclosure.

2.3.1 Voluntary Disclosure Theories

Corporate voluntary disclosure has been the focus of an increasing amount of

attention in recent years. Such disclosures can be defined as 'disclosures in excess of

requirements, representing free choices on the part of company managements to

provide accounting and other information deemed relevant to the decision needs of

users of their annual reports' Gray, 1 555). Studies in this

area have mainly emphasised on the impact of company characteristics on the extent

of voluntary disclosure. Understanding why firms disclose information voluntarily is

useful t6 both the preparers and users of accounting information as well as to

accounting policymakers ct aI., 1995).

Several theories explain the reasons for companies to reveal voluntary information

(under the assumption that firms perceive benefits from disclosure), including agency

theory, signalling theory and political process theory, among others. Proprietary costs

as well as costs derived from the collection and preparation of information must also

be considered from a theoretical perspective To a lesser extent, other

types of costs have been found as limitations to the disclosure of information, such as

corporate governance and monitoring, capital needs, litigation costs, and audit firm

reputation The theoretical arguments on the determinants

34
of voluntary information disclosure are summarised below.

Agency Theor.v

Agency theory defines an agency relationship as a contract under which one or more

persons (principals) engage another person (agent) to perform some service on their

behalf which involves delegating some decision-making authority to the agent

It is expected that the agent will not always act in the best

interest of the principal. Agency theory claims that conflicts are expected to arise

when there is incomplete and asymmetric information between principal and agent in

a company. Both parties may have different interests and this problem could be

minimised by providing more information. Some determinants of voluntary

information that have been commonly associated to the agency problem are size,

leverage, profitability and listing status.

Firstly, given that larger firms carry out a greater number of contracts which are more

complex than smaller firms, agency costs depend on company size

Larger firms are expected to reveal more voluntary information to reduce these

costs.

Secondly, agency costs are higher when the proportion of debt increases. Agency

theory predicts that a highly leveraged company has more of an obligation to satisfy

the information needs of long-term and short-term creditors, and hence it may provide

more detail to meet those needs than would a less leveraged firm et

Thirdly, higher margin and higher profitability lead to a greater level of disclosure in

order to obtain and justify better contractual conditions. Managers will disclose

35
detailed information to improve their compensation arrangements
Finally, listed companies are expected to provide more information due to the higher

information requirements they face, or due to agency costs 1 Specifically,

international listing status is also expected to influence disclosure. Disclosure serves
to control the agency costs that appear when ownership is more disperse

et

Signal(v Theory

Signalling theory indicates that asymmetric information between a company and the
investors causes adverse selection. To avoid this situation, companies disclose

information voluntarily, providing signals to the market

Size, profitability and growth are factors that influence the decision to disclose

voluntary information to avoid adverse selection.

Information asymmetries will be larger for big companies, which justify more
disclosure for mitigation purposes Moreover, firms with a
high profitability will have a higher tendency to disclose more information to the
markets, to increase investor confidence 1) and prevent
undervaluation of their shares 1997). Finally, growth and disclosure are

expected to be positively related since companies with high

growth rates provide more information to be more attractive in the market.

Process TheOl:V

Political process theory suggests that regulators make decisions based on the

information disclosed by firms Companies disclose

36
voluntary information to minimise these political costs. Size and profitability are

incentives for companies to reveal more information to reduce these costs. Larger

firms are subject to higher political costs, leading to a greater level of disclosure

1986). Higher information disclosure is expected to justify a

firm's large profits and thus avoid legal obligations and

as a justification of the company's profit level ). Political costs and the

competitive environment also influence the level of information disclosed in an

industry Rees.

Proprietmy emits

Proprietary costs are considered as one of the most important limitations to

information disclosure. Competitive disadvantages influence the decision to provide

private information. Smaller firms are sensitive, to a great extent, to the disadvantages

that, in terms of competitive edge, are derived from a higher disclosure level (

Desai, 197 J; 1995). The previous literature has also considered the costs

derived from the collection and preparation of information as an obstacle to revealing

more voluntary information. Company size plays an important role to minimise these

costs, which decrease for larger firms

In summary, under the framework of these theories, the prior research has employed
variables, such as size, leverage, profitability, growth and listing status as

determinants of voluntary information disclosure.

2.3.2 Studies on the Usefulness of Derivative Disclosures

In the accounting literature, the researches in relation to the derivative disclosures

37
have developed into two branches. First, some studies

et 2002:

et 2007: have examined the

quality of derivative disclosures by analysing the response of listed companies to the

compulsory derivative-related disclosure requirements. These researchers seek to

answer the question about whether the mandated derivative disclosure provisions

actually achieve the expectation of accounting authorities, by enhancing the listed

companies to provide more information regarding derivative-related activities in their

annual reports. Another strand of studies focuses on the effect of information

disclosure on the behavior of financial market aggregates such as stock price, stock

returns and trading volume. These researches (e.g. o 1 1

et at,

et et

2005: 2005: 2005:

2006; et al..

attempt to empirically explain observed phenomena III the

association between the derivative-related disclosures and market responses.

2.3.2.1 The Quality Derivative Disclosures

Disclosure Quality: Definitioll

The term of 'quality' has been commonly and interchangeably used with the term of

'transparency' as their definitions are elusive (Kothari, 20(0). Different interpretations

have been adopted to explain the meaning of high quality accounting information.

Ball et al. (2000) interpret the meaning of quality of accounting information as the

38
combination of properties of timeliness and conservatism7. Pownall and Schipper

(1999) define three attributes that are transparency, comparability and full disclosure

as being high quality of financial statements. Transparency means that financial

statements are mandated by standards to 'reveal the events, transactions, judgments

and estimates underlying the statements and their implications' (Pov{nall and Schipper,

1999, p262). Transparent financial reports enable users to see the results and

implications concerning operating, financing and investing decisions, the key

judgments and estimates of preparers. Comparability is interpreted as similar events

and transactions being accounted for in the same way in terms of both

cross-sectionally among firms and over-time consistent for a given firm. Full

disclosure is related to providing all necessary information so as to give reasonable

assurance that investors are not misled.

Although the definition of disclosure quality by Pownall and Schipper (1999) focuses

on the financial statement as a whole, it can also be adapted to individual disclosures

like derivative disclosures within a financial report. Hence, this study defines the

disclosure of being high quality when it possesses the attributes of transparency, full

disclosure and comparability.

The annual report is one of vital channels for firms to report their fmancial

performance. With the aim to improve the quality of financial reports, accounting

standards setters are always endeavoring to produce accounting standards with high

quality by requiring greater detail and more extensive information. Therefore,

companies which produce financial reports complying with the accounting standards

should be expected to provide high quality accounting information.

7 Ball et al. (2000) define the timeliness as the extent to which current-period financials incorporate current-period
economic events, and conservatism as the greater speed with which financials reflect economic bad news than
good news.
39
Disclmrure Quality: Benefits to Inve,')'tors

Investors require fIrms to disclose information with high quality as to making their
economic decisions. Greater disclosure is to minimise the degree of information
asymmetry between managers and investors and therefore, will attract more
investments. Sengupta (1998) argues that fIrms with disclosing high quality

information incur lower costs of debt and equity capital. In addition, high quality
disclosures can reduce the uncertainties faced by investors and creditors (Miller and
Bahnson, 2002) and it helps to increase their confidence in fInancial statements
produced by companies, fInally leading to an increased investment in these fIrms. As
a result fIrms will experience higher share prices. By contrast, if fIrms fail to present
sufficient information, market participants like investors and creditors may take
actions which are disadvantageous to companies such as increasing the cost of capital
or withdrawing their investments. Lack of information disclosures may also force
market participants to seek other investment opportunities which may reduce the
fIrm's shareholders' value. Miller (2001) points out that even though investors could
invest in companies with a low quality disclosure, they are likely to require
comparatively higher rate of return leading to a higher cost of capital and lower share
price. Consequently companies could be difficult to grow and develop.

Disclosure Quality: Prior Studies

In the U.S" (1 conduct a study to analyse the derivative

disclosures by top ten U.S. dealer banks in the year of 1995. They fInd that since the
generally accepted accounting principles for the fIrst time required the separation of
the fair values of derivative contracts in a gain position (assets) from those in a loss

position (liabilities), the detail and clarity of the information about the derivatives'

usage is greatly improved by these ten banks. Compared with the 1994 annual reports,
40
the banks report more quantitative details on value-at-risk and the results of the

trading activities. In particular of those banks whose trading revenues making up a

large share of their income, they tend to disclose more information about the

derivatives and trading. They conclude that the derivative-related disclosure

approaches encouraged by accounting standards setters actually enhance the banks to
present much more information about the derivative activities. However, the authors
also point out that none of the reports could be singled out as the best and most of the
banks adopt a novel approach to disclosing on the use of derivatives that is not used
by the other.

Based upon the sample of 25 Securities and Exchange Commission (SEC) registrants,
(1 compares the disclosures about derivatives and market risk in the
years before 1996 and after the adoption of Financial Reporting Release No. 48 (FRR
No.48, SEC 1997). The author illustrates that although FRR No.48 improves greatly
the market risk disclosures which were encouraged but not required under SFAS 119,
the details and clarity are varied widely within the SEC registrants. Further, certain

required or strongly recommended contextual disclosures are almost completely

absent and the major weaknesses of disclosure are the lack of detailed market's
quantitative measures and the discussion regarding the firm's risk management
activities. Companies appear to prefer the relatively complicated but more discreet
disclosure techniques to simpler but more revealing disclosure formats and they are
reluctant to present the assumptions, limitations and contextual related to those
complicated methods like Value-At-Risk (VAR) and sensitivity analysis formats.

Schroeder examined the disclosures concerning market

risk for the first reporting period following the adoption of FRR No.48 based on the
sample of 45 industrial firms, 45 banks or thrifts and 20 additional Dow 30 industrial

companies and they get similar conclusions as (1 They find that

while the basic reporting requirements of FRR No.48 are met, many of the detailed
disclosures for quantitative and qualitative items are not made. For the sample firms,
41
compliance with the qualitative requirements regarding the pnmary risk and its

management is generally pretty high but the detailed disclosures about the allowable

techniques are often incomplete or lacking. For companies using the sensitivity

analysis and VAR techniques, they do not provide adequate disclosures about the

models and their major assumptions used, nor disclose sufficient information about

the types of instruments and offsetting position included in the analysis. The three

authors demonstrate the same conclusions in based upon the sample

of Dow 30 firms.

By examining the 2001 annual reports of the Dow 30 companies,

Schroeder illustrate that the compliance with the provisions of SFAS 133 is

mixed. The sample companies comply with the qualitative guidelines but

inconsistently meet the quantitative requirements of SFAS 133. They argue that the

users of financial statements are able to assess the company's strategies for using

derivatives but cannot always evaluate the outcomes of these derivative-related

activities. The authors find that the derivative-related disclosures vary widely in terms

of the amount of information disclosed and the format adopted to disclose it. They

argue that the lack of uniformity in disclosing derivative activities under SFAS 133

could result in unnecessary difficulties for the users of financial statements to assess

the impact and potential impact of derivatives' usage on a company's financial

position. In addition, they also find that the disclosure of derivative-related

information is scattered throughout the annual reports of sample companies, difficult

to understand, hard to follow and lacked uniformity. It would make a great effort for

financial statement users to collect and analyse the derivative-related information

from a firm's annual report. Finally, they strongly suggest the development of a more

uniform reporting format for derivative activities.

In the UK, ct al. assess the impact of the Financial Reporting Standard

13 'Derivatives and Other Financial Instruments - Disclosures' (FRS 13) on the

financial statements of UK quoted companies. The sample in this study includes 210
42
non-financial UK companies and they are sorted into large, medium and small groups
following the market value. They adopt the content analysis method and compare the

disclosed information about use of derivatives in the year before and after 1998's
releasing of FRS 13. According to their findings, the implementation of FRS 13 is
associated with a substantial increase in derivative-related information available in
corporate annual reports and the increased disclosures required by FRS 13 could be
viewed as a welcome improvement in the corporate accountability.

In Canada, Zeghal adopt content analysis method to explore and

synthesize the risk-related disclosures in 1999 annual reports of Canadian listed
companies. The sample contains the TSE (Toronto Stock Exchange) 300 index
companIes. They find that the risk information disclosed by Canadian listed
companies is almost exclusively qualitative in nature and located in the notes to the
financial statement and/or in the 'management discussion and analysis' section

following the Canadian risk disclosure regulations (CICA Handbook) and the most
frequently cited risk categories are financial risk, commodity and market risk. In
addition, for the risk sources and risk management techniques, the sample firms
emphasise on down-side risks, but the potential up-side effects and value-creating
opportunities are largely absent. Nevertheless, the risk assessment and analysis
reported by those listed firms are quite limited and they lack valuable quantitative
insights like sensitivity analysis showing the effects of potential changes on financial
statement if one or more categories of risk increase or decrease.

examme the accounting practices following the

requirements of lAS 32 and 39 of European blue chips companies trading on leading
stock exchanges. They compare the STOXX 50 companies' annual reports in 2001
with a checklist according to the provisions ofIAS 32 and 39. Their findings illustrate
that less than a half sample companies use the fair value measurement for the
available-for-sale financial assets as lAS 39 requires. Although most of companies
disclose the determination of fair value technique, the information is still away from
43
being clear and objective. The majority of firms provide low levels of disclosures for
hedging transactions. The authors finally conclude that the largest companies in

Europe have a long way to apply the most sophisticated accounting and reporting

standards for derivatives.

Generally speaking, the prior studies indicate that the quoted companies present both
qualitative and quantitative information as to derivative usage and associated market
risk following the basic accounting requirements and disclosure rules in their annual

reports. However, they are reluctant to disclose sufficient detailed information like
assumptions of quantitative techniques and corporate risk management activities.
Although the implementation of the compulsory disclosure requirements improves the
reported information about the use of derivatives, the supervisory authorities still have
a task to enhance the listed companies to disclose more clear and detailed information
by complying all the accounting and reporting requirements.

2.3.2.2 Derivative Disclosures Value Relevance Studies

While the previous section discusses the prior studies on disclosure quality by listed
firms complying with related accounting and reporting standards, this section assesses
the effect of derivative-related disclosures on market participants, particularly on
investors, known as value relevance studies. This review provides a basis for
understanding the research area on the value relevance of derivative disclosures.

Usefulnes,,>' ofAccounting

According to the recent approved 'Conceptual Framel1JOrk fbr Financial Reporting

201 () (the IFRS Frame'work) , by the IASB, the types of information that are likely to

44
be most useful to users in making decisions are indentified by the qualitative

characteristics of useful financial reporting. 5 of the Framework state that

the relevance and faithful representation are the fundamental qualitative
characteristics of useful financial information.

To be useful, information must be relevant to the decision-making needs of users.

Qualitative Characteristics (QC) paragraphs 6 - lOin the Framework define the
relevant information as follows:

Relevant financial information is capable of making a difference in the

decisions made by users. Financial information is capable of making a
difference in decisions if it has predictive value, confirmatory value, or both.
The predictive value and confirmatory value of fmancial information are
interrelated.

The information must assist users in evaluating the past or present events and help
them to predict futures events that are likely to affect organisations, before making
their decisions. The relevant information also helps decision makers to confirm or

correct their past evaluations.

Ideally, decision makers can use the relevant information about assets or liabilities
disclosed in the financial statements as to measuring future cash flows generated from
each asset or liability. However, due to the uncertain nature of future events, this

qualitative characteristic is not a sufficient condition for usefulness. Therefore, the

relevant information depends on how reliable the information is in terms of its

measurement and sources.

The users of financial statements must depend upon the reliable information when
making decisions. To be reliable, the information must represent faithfully the
economic conditions or events to which it relates. According to QC 'Faithful
45
representation ,S can be interpreted as follows:

General purposes of financial reports represent economic phenomena in words

and numbers. To be useful, financial information must not only be relevant, it

must also represent faithfully the phenomena it purports to represent. This

fundamental characteristic seeks to maximise the underlying characteristics of

completeness, neutrality and freedom from error (QC paragraph l~).

Information must be both relevant and faithfully represented if it is to be

useful (QC paragraph 17). Comparability9, verifiabilitylO, timeliness ll and

understandability12 are qualitative characteristics that enhance the usefulness

of information that is relevant and faithfully represented (QC paragraph 19).

Users are confident in making decisions based on such reliable information as it is

free from error or bias toward particular people.

8 In considering reliability, the IASB observed that there are a variety of views of what the notion means. For
example, some focus on verifiability or free from material error to the virtual exclusion of the faithful
representation aspect of reliability. And to some, reliability apparently refers primarily to precision. Those
considerations led the boards to consider how they could convey better what reliability means. Accordingly, the
boards propose that faithful representation encompasses all ofthe qualities that the previous frameworks included
as aspects of reliability. Faithful representation-the depiction in financial reports of the economic phenomena
they purport to represent-is essential if information is to be decision useful. To represent real world economic
phenomena faithfully, accounting representations must be complete, neutral and free from error (lFRS, 2010).
9 Information about a reporting entity is more useful if it can be compared with similar information about other
entities and with similar information about the same entity for another period or another date. Comparability
enables users to identify and understand similarities in, and differences among, items (QC paragraphs 20 21).
ID Verifiability helps to assure users that information represents faithfully the economic phenomena it purports to
represent. Verifiability means that different knowledgeable and independent observers could reach consensus,
although not necessarily complete agreement, that a particular depiction is a faithful representation (Qe paragraph
26).
11 Timeliness means that information is available to decision-makers in time to be capable of influencing their
decisions (QC paragraph 29).
12 Classifying, characterising and presenting information clearly and concisely make it understandable. While
some phenomena are inherently complex and cannot be made easy to understand, to exclude such information
would make financial reports incomplete and potentially misleading. Financial reports are prepared for users who
have a reasonable knowledge of business and economic activities and who review and analyse the information
with diligence (QC paragraphs 30- 32).
46
Value Relevance

In academic literature, the term of 'value relevance' is not a stated criterion of

accounting standards discussed in the last section. Studies of value relevance are to
assess the relevance and reliability of particular financial information to their users
and they are an empirical operationalisation of the stated criteria of relevance and
reliability (Barth et al., 2001). The financial report is value relevant only if it contains
information relevant to investors in assessing the value of the firm and is measured
reliably enough to be reflected in share prices (Barth et aI., 2001). The value relevant

test commonly includes the joint tests of relevance and reliability because it is
difficult to separately examine the relevance and reliability of the accounting
information (Barth et a1., 2001).

According to the research by Holthausen and Watt 0001), studies related to the value
relevance of accounting information can be sorted to three major categories as

follows:

a) Relative association studies. These researches compare the association between

stock market values (or changes in values) and alternative bottom-line measures.
These studies usually test for differences in the R2 of regressions using different
bottom line accounting numbers. The accounting number with the greater R2 is
described as being more value-relevant. This type of studies also called the

relative association studies.

b) Incremental association studies. These studies investigate whether the accounting

number of interest is helpful in explaining value or returns (over long windows)
given other specified variables. That accounting number is typically deemed to be

value relevant if its estimated regression coefficient is significantly different from

zero. Since differences between the estimated and predicted values are often
47
 interpreted as evidence of measurement error in the accounting number, those

studies are so called measurement studies.

c) Marginal information content studies. These investigate whether a particular

accounting number adds to the information set available to investors. They

typically use event studies (short window return studies) to determine if the
release of an accounting number (conditional on other information released) is
associated with value changes. These researches are commonly called the
information content study.

The majority of value relevance studies (94 per cent) performs the first two types of
studies (relative andlor incremental) (Holthausen and Watt, 2001). Barth et al. (2001)
point out that the value relevance studies provide interesting and fruitful insights for
not only academic research but also accounting and reporting standards setting.

Value (~f Derivative Disclosures: Prior Studies

. issued by the FASB states that the objective of

financial reporting (including disclosure) is to provide 'information that is useful to

present and potential investors and creditors and other users in making rational
investment, credit, and similar decisions' (paragraph 34). The most common-used

method of assessing the usefulness of derivative disclosures is to examine whether the

disclosed information is relevant to investors' decisions - i.e. whether it is reflected in

the change of stock price, equity return, trading volume etc.

In the U.S., (1 provides the evidence that the notional principal

48
amounts of some derivatives (such as futures, forwards, options and interest rate
swaps) required by SFAS 105 are positively related to equity valuation.

Based upon the sample of 146 (133) US banks in 1992 (1993), (1 assesses
the value-relevance of the fair value disclosures under the provisions of SFAS 107 by
examining the association between the market value of banks' common equity and the
fair value estimates under SFAS 107. The findings indicate that only the investment
securities' fair value estimates are marginally informative to book value in valuating
sample banks' common equity, while the fair value estimates of loans, deposits,
long-term debt or off-balance sheet financial instruments do not have incrementally
explanatory power in the valuation of equity. Further, after controlling for variables
related to the banks' future growth opportunities (such as the return on equity and
growth in book value), the fair values of securities has no incremental ability to
explain the market value. Finally, the author adopts the returns specification, which
implicitly control for correlated omitted variables, to confirm the results that there is
no reliable evidence of the fair value disclosures under SFAS 107 having the
significant incrementally explanatory power in the valuation of banks' common

equity.

In contrast to Nelson (1 et provide the evidence that the fairs

value estimates of securities, loans and long-term debt disclosed under SFAS 107 are
value-relevant to the banks' common equity's valuation, but, those for deposits and
off-balance sheet items are not. The sample consists of 136 US largest publicly traded
banks between 1992 and 1993. The primary difference between this study and the

(1 is the finding of incremental explanatory power for loans' fair values

in valuating banks' equity. In addition, the results indicate that the conditioning
variables, including the core deposit intangible asset, nonperforming loans and
interest-sensitive assets and liabilities, are also significantly associated with the banks'
share prices. They argue that since the loans' fair value, nonperforming loans and
interest-sensitive assets and liabilities are simultaneously significant to the banks'
49
share prices, the disclosures of loans' fair value estimates do not fully reflect the loan
default and interest risks. By permitting the coefficient of loans' fair values to vary

according to financial condition of the bank, they find that it is higher for banks with

relatively high regulatory capital ratios, implying that the market participants discount
unrealised gains disclosed by less healthy banks.

conduct a similar study to analyse whether the fair value

disclosures of financial instruments required by SFAS 107 are associated with share
prices of the U.S. banks between 1992 and 1993. They collect data from 296 and 328
banks in 1992 and 1993 respectively, representing the majority of all publicly traded
bank holding companies. By implementing a series of regressions, the authors find
that the difference between fair value and book values of financial instruments is
value relevant to the market-to-book ratios. However, only the fair value estimates for
securities other than net loans, long-term debt and market-related off-balance-sheet
instruments are associated with the variation of share prices across the full sample.
Furthermore, they examine whether the disclosures under SFAS 107 have incremental
value over historical cost variables. The finding suggests that fair value disclosures
only in 1992 are value relevant to market-to-book ratios after taking account of
historical variables. Finally, they argue that the requirements of SFAS 107 have
provided value-related information on banks' financial statements. The information
disclosed under the previous historical cost reporting framework, however, is much
more value relevant compared to the fair value disclosures and therefore, regulators
should carefully evaluate both historical and fair value measurements when choosing

alternative accounting regimes for banks.

By using the sample of 99 bank holding companies, ( point out

that the fair value estimates for derivatives under SFAS 119 help to explain
cross-sectional variation in banks' share prices and the fair value estimates have the

incremental explanatory power over the notional principle amounts of derivatives.

Their findings suggest that the fair value estimates of derivatives are incrementally
50
useful to the notional values of derivatives, while the notional amounts are negatively

related share values.

(1 based upon 57 US public traded savings and loan associations (S&Ls)

during the periods of 1984 - 1988, finds that the greater hedging activities, which are

proxy for off-balance-sheet derivative activities, are associated with the lower
stock-price interest rate sensitivity (measured by a institution's stock price to
unexpected interest rate changes), and the maturity gap (measured by the maturity
mismatch of institutions' assets and liabilities), which is proxy for on-balance-sheet
exposures to interest rate risk, are also value relevant. Specially, the interest rate
sensitivity is significant related to derivative activities for large institutions, while it is
not significant for small institutions. Since the combined measurements of on- and
off-balance-sheet positions are analogous to the derivative-related requirements under
SFAS 119, the author insists that such derivative disclosures will provide

value-relevant information about interest rate risk for S&Ls.

examine the usefulness of derivative disclosures under SFAS

Nos. 105 and 119 based upon the sample of 35 NYSE (New York Stock
Exchange)-traded banks. According to their results, the disclosures related to the
credit exposures and fair value gains and losses on trading and non-trading derivatives
contain new and useful information not incorporated in earnings and market ~ but the

disclosure of notional principle amounts of derivatives is not relevant to the

companies'valuation.

ct al. conduct a study to analyse the value-relevance of banks'

derivative-related disclosures provided by SFAS Nos. 119 and 133 following the
sample of 161 US banks from 1994 to 2002. They emphasize on the notional principal
amounts and demonstrate that the notional values of both trading and non-trading
derivatives are significantly relevant to the banks' valuation, which implies that the
notional amounts can provide the information content beyond earnings and book
51
value.

During 1994 and 1995, the Securities and Exchange Commission (SEC) staff

reviewed approximately 500 registrants' annual reports and they concluded that
although the reporting requirements under SFAS 119 'Disclosure about Derivative
Financial Instruments and Fair Value of Financial Instruments'
improved the quality of disclosures about derivative instruments, there are some

remammg areas that needed amendments SFAS 119 requires

companies to disclose their accounting policies for recognising and measuring

derivatives. The SEC suggests that SFAS 119 'explicitly indicate the type of

information that should be included in the accounting policies footnote to help

investors understand the effects of derivatives on the statements of financial position,

cash flows, and results of operations' SFAS 119 encourages, but
does not require, disclosure of quantitative information about the market risk

exposures that affect the company's derivatives and other financial instruments. In

addition, SFAS 119 only applies to derivative financial instruments held or issued for

purposes other than trading. In order to strengthen the disclosure requirements about

derivatives and market risk under SFAS 119, the SEC promulgated the Financial

Reporting Release No.48 (FRR No. 48) 'Disclosure of Accounting Policies for

Derivative Financial Instruments and Derivative Commodity Instruments and

Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in
Derivative Financial Instruments, Other Financial Instruments and Derivative
Commodity Instruments' in January 1997. FRR No. 48 expands the derivative
disclosure requirements of SFAS 119 to encompass derivative commodity instruments,

other financial instruments, and derivative instruments held for trading purposes. It

requires firms to disclose two types information about derivatives and market risk:

qualitative and quantitative information. Qualitative information includes the

descriptions of a company's primary market risk, the objectives, general strategies and

instruments used to manage the risk. The firm must disclose the changes in market

risk exposures compared to the recent completed fiscal year, and the expected effect
52
in the future reporting periods. To provide the flexibility that will 'accommodate

different types of registrants, different degrees of market risk exposure, and

alternative ways of measuring market risk' p25), the SEC allows

companies to present derivative-related quantitative information using three,

alternative disclosure formats:

a) Tabular presentation: describing the fair values and contract terms of market risk

sensitive instruments (i.e., derivative financial instruments, other financial

instruments, and derivative commodity instruments) sufficient to determine the

future cash flow amounts, categorized by expected maturity dates.

b) Sensitivity analysis: describing the potential loss in future earnings, fair values, or
cash flows of market risk sensitive instruments resulting from one or more

selected hypothetical changes in underlying market rates (e.g., the interest rates

and foreign currency exchange rates) or market prices (e.g., commodity prices and
equity prices) over a selected time period.

c) Value-At-Risk (VAR) format: describing the potential loss in future earnings, fair

values, or cash flows of market risk sensitive instruments over a selected period of

time, with a selected likelihood of occurrence, deriving from changes underlying

market rates/prices.

FRR No. 48 also requires companies to separately report on trading and nontrading
instruments. In general, the SEC hopes the release of FRR No. 48 can 'provide

additional information about market risk sensitive instruments, which investors can

use to better understand and evaluate the market risk exposures of a registrant'

No. However, the critics argue that the reporting requirements under FRR No.

48 are likely to be unreliable and may result in problems for investors in valuating

corporate derivative-related activities. For example, Logan (1

point out that investors are unable to better understand the company's use of
derivatives and associated risk following the requirements ofFRR No. 48, and in fact,

the derivative-related disclosures could be misled. The American Institute of Certified

53
Public Accountants (AICPA) illustrates that the accountants could not certify the
accuracy of the sensitivity analysis disclosures because such disclosures are too
dependent on relevant assumptions and hypotheses 1 (1

argues that allowing firms with three options for quantitative derivative and market
risk reporting may limit investors' ability to compare those disclosures by a company
with another, and consequently, the usefulness of derivative-related disclosures will be
affected. Similarly, et ) conclude that the flexibility of application in
FRR No. 48 will adversely affect users' risk judgments. They suggest that in order to
enable investors to compare market risk disclosures across companies, the SEC
should mandate just one type of disclosure format, alternatively, each market risk
should be quantified by using all three measurement methods, rather than a single one.
argue that the complying with FRR No. 48 is costly and

outweighs the benefits to investors. Increased detailed disclosures will bring extensive
workload to auditors and managers and may not necessarily enhance the
understanding of derivatives by investors. The SEC's new standards seem not to be an
efficient solution for improving the accounting treatment of derivatives.

et carried out a study to examine whether the derivative-related

information disclosed under FRR No. 48 would cause problems for investors' risk
judgments. They used 190 M.B.A students, which are the proxy for reasonably
informed individual investors, to implement a series experiments. According to their
findings, the disclosed information about financial instruments and derivatives under
FRR No. 48 did result in systematic problems in valuating risk by investors. Firstly,
the authors vary the labels which describe financial instrument and derivatives, and
examine whether such label variation affect investors' risk preferences even when
those instruments have the same underlying economic exposures. They find that
participants evaluate different risk judgments for instruments having similar risk
exposures, which the variable-rate debt with a swap are considered as riskier than
other two instruments (i.e., fixed-rate debt and variable-rate debt with a swap

described as a hedge) regardless their similar exposures. Further, they find that even
54
with the supplementary exposure information, investors still evaluate the swap as the

riskiest option. Secondly, FRR No. 48 requires registrants to disclose the potential

negative effects related to certain market rates/prices changes, but does not require
companies to present the disclosure of potential gains. They conduct experiments to
analyse whether those one-sided disclosures cause systematic problems in investors'
risk judgments in companies with different risk-management strategies. Their results
indicate that participants who read the loss-only disclosures make the similar risk
judgments for firms using different strategies to manage risk. Further, they author find
that the two-sided disclosures (i.e., disclose both gain and loss associated with certain
market risk) enable investors to identify the specific derivative strategy which a firm

uses to manage its risk. Finally, they recommend that the regulators should require the
disclosures of both upside (gain) and downside (loss) information as such disclosed
information can improve the usefulness of disclosures about financial instruments and
derivatives.

use 13 US banks to analyse whether the VAR disclosures

are relevant for investors to assess the banks' potential trading loss in the third quarter
of 1998. This study tests the relationship between banks' disclosed VAR and the

magnitude of abnormal returns and abnormal trading volume surrounding the key
LTCM 13 event day. Their findings indicate that there is no association between banks'
VAR disclosures and the magnitude of abnormal returns and trading volume. Thus,

the authors discuss that investors do not use disclosed VAR information by sample
banks to assess the potential loss at the time of LTCM crisis, which implies that such
disclosures are unable to provide useful information to investors at that time. Finally,
they conclude that the VAR disclosures are costly to prepare and difficultly
understood by investors, but these information has no benefits for banks' investors.

13 The hedge fund, long-term capital management (LTCM), co\1apsed in September 1998 mainly due to the
combined adverse impact of the Asian financial crisis, the Russian debt moratorium and the ruble devaluation.
LTCM bet on the spread between low-and high-quality bonds to decrease but due to the joint impact of those
events, the spread between low and high-quality bonds widened and Datal', 20(16).
55
However, inconsistent with critics about FRR No. 48, ct ) argue that
the VAR measurements applied in FRR No. 48 are able to compare the risk among
portfolios and trading strategies, hence, it is likely for institutions to allocate capital in

most efficient manner - i.e., the most profitable business on a risk-adjusted basis.
suggests that the VAR disclosures can improve the governance of
derivative activities as such measurements force companies to develop a systematic
process to manage risk. In addition, some researchers (e.g .. .lorion.

et et provide the
empirical evidence that the derivative-related disclosures following provisions of FRR
No. 48 contain useful information for investors in the company's valuation.

(1 illustrates that the commodity pnce risk disclosures, which are

similar with the requirements of FRR No. 48, are associated with the market's oil and
gas price sensitivity (i.e., oil and gas betas). Based upon the sample of 52 oil and gas
(O&G) companies from 1993 to 1996, the author finds that the proxy for the tabular
format analysis regarding derivatives has a significantly negative association with the
O&G betas. Whereas, the proxy for the tabular analysis with respect to underlying
exposure is significantly positively associated with O&G betas only for the firms
whose disclosures perceived by the market contain less measurement error than those
of the median firms. By using a subsample of 38 O&G firms for the same periods, it
is found that the proxy for the fair value sensitivity disclosures of underlying
exposures are statistically positively associated with O&G betas, while the proxy for
the sensitivity formats of commodity derivatives exhibits a significantly negative
association with O&G betas. This finding is contrary to the claims made by
(l that the sensitivity analysis disclosures are too dependent on relevant
assumption to reliably measuring the firms' market risk exposures. Besides, the author
finds that the proxies for the tabular formats disclosures and sensitivity disclosures
have the incremental power for explaining O&G betas respectively. Hence, the author
concludes that the alternate formats disclosures are not complete substitutes for one
another as each of these formats measure different aspects of O&G market risk
56
 I I

exposures, but this fact may cause difficulties for investors in companng the

outcomes of risk management of companies that use different disclosure formats.

implements a study to investigate whether there is a relationship

between the VAR measurements of banks' trading activities disclosed in their annual
reports and the subsequent variability of corresponding unexpected trading revenues.

The sample includes eight major US commercial banks for the periods of 1994 - 2000.
The results indicate that the publicly available VAR disclosures are significantly
associated with the forthcoming market risk, especially in cross-sections. Specially,
banks with low VAR measurements experience the limited downside risk, and those
with large VAR measurements suffer greater variation in unexpected trading revenues.
Thus, the author argues that the VAR measurement information disclosed in banks'
financial reports can provide useful information for the future unexpected trading
revenues and analysts are able to compare the risk profiles of different banks by using
their publicly available VAR disclosures.

et examined whether the releasing of FRR No. 48 would

reduce the investors uncertainty and diversity about the listed companies' value of
changes in interest rates, foreign currency exchange rates and commodity prices.

According to their findings, after the firms disclose the derivative-related information
following the mandated requirements of FRR No. 48, trading volume sensitivity
changes to the underlying market rates (such as interest rates and foreign currency
exchange rates) and energy prices decline, even after controlling for the factors
affecting the trade volume sensitivity. Further, they found that the simple format like
tabular analysis was more effective in reducing trade volume sensitivity to interest
rate movement, whereas the complicated disclosures like sensitivity and VAR analysis
were more effective in reducing trade volume sensitivity to foreign currency exchange
movement. Finally, they concluded that the market risk disclosures under FRR No. 48

actually provide the useful information to investors.

57
By using a large sample of commercial banks from 1989 to 1997, et

provide indirect supportive evidence on the informativeness of the tabular market risk
disclosures required by the SEC's FRR No. 48 in predicting the interest rate risk of

banks. By testing the relationship between the maturity-gap disclosures made by

sample banks and the future changes in net interest income, the authors achieve three
findings. Firstly, the one-year maturity gap measurements exhibit a significant
relationship with one-year- and three-years-ahead change in net interest income.
Secondly, the fixed and variable-rate instruments disclosures have different
explanatory ability. Thirdly, the one-to-five-year aggregate gap measurements also
exhibit the explanatory power about the three-year-ahead changes in net interest
income. Therefore, the authors conclude that the findings support the disclosure
requirements under FRR No. 48 focusing on disclosed information in indicating
near-term losses, and encourage the FRR No. 48 to separate the disclosures of fixed
and variable instruments.

ct aL conduct a study to assess the usefulness of VAR disclosures required

by FRR No. 48 using a sample of 17 U.S. registered commercial banks from 1997 to

2002. They find that the banks trading VAR disclosures have the predictive power for
trading income variability and this predictive power increases with bank technical
sophistication and over time. In addition, the banks' trading VAR disclosures have the
predictive power for the total risk and return variability, both for the trading portfolio
and the bank as a whole. They also find that the banks' trading VAR disclosures have
the predictive ability for the two-wide measures of priced risk, beta and realised

returns.

carred out a cross-country study on the level and quality

ofVAR disclosures by commercial banks. Their sample consists of 60 U.S., Canadian

and international commercial banks' data between 1996 and 2005. They find that for
the quantity of VAR disclosures, there is an overall upward trend in the disclosed
amount of information by banks where the U.S. banks provide considerably low
58
disclosures than Canada's. In addition, the Historical Simulation is the most

prevailing VAR method in the world with 73 per cent of banks using the Historical

Simulation to report their VAR. The quality of VAR disclosures, however, do not

improve over time and furthermore, the VAR disclosures using the Historical

Simulation method are very little informative to banks' future volatility.

In June 1998, the FASB issued the new derivative-related accounting regulation -

SFAS l33 'Accounting for Derivative Instruments and Hedging Activities '. This

pronouncement is seeking to resolve the problems with previous accounting and

reporting practices for using derivative instruments. FASB believed that the previous

regulatory framework might introduce several vital problems m accounting and

reporting practice for derivatives. For instance, notes that

the impacts of derivatives were nontransparent in the basic financial statements.

Before the issuance of SFAS l33, some derivatives were recognised in financial

statements but others are not, which may cause some realised and unrealised gains

and losses related to derivatives deferring from earnings recognition. This may

introduce some difficulties for users of financial statements to identify the effects of

derivative transaction. Additionally, Nos. 235 report that the

previous accounting guidance for derivative instruments and hedging activities was

incomplete and inconsistent. The prior accounting and reporting practices for

derivatives and hedging activities only addressed a few types of derivative

instruments. For example, 52 'Foreign Currency Translation' provided

accounting treatment for hedging activities in relation to the change in foreign

exchange rates. 'Accounting for Futures Contracts' addressed the use of

futures contracts in other hedging activities. Before the issuance of SFAS l33, the

required accounting treatment also differed on the type of instrument used in a hedge

and the type of risk being hedged. Finally, FASB concludes that 'the lack of a single,

comprehensive approach to accounting for derivatives and hedging made the

accounting guidance difficult to apply' 1 237). Hence, SFAS l33

supersedes SFAS No. 80 'Accounting for Futures Contracts', No. 105 'Disclosure of
59
Information about Financial Instruments with Off-Balance-Sheet Risk and Financial

Instruments with Concentrations of Credit Risk' and No. 119 'Disclosure about

Derivative Financial Instruments and Fair Value of Financial Instruments', and

makes several amendments to SFAS No. 52 'Foreign Currency Translation' and No.
107 'Disclosures about Fair Value of Financial Instruments'. SFAS No. 133 was
originally effective for the fiscal years beginning after 15th June 1999. However, it
suffered from complaints and setback, and the FASB delayed the effective date to
fiscal years beginning after 15 June 2000.

SFAS No. 133 generally addresses the accounting and reporting standards for

derivative instruments, including certain derivatives embedded in other contracts, and

for hedging activities. It requires that all entities must recognise all derivative
instruments as assets or liabilities on the balance-sheet and measure those instruments
at fair value, and changes in the derivatives fair value are to be recognised in the

current earnings unless specific hedge accounting criteria are met (i.e., full-fair-value
measurement). SFAS No. 133 states that if certain conditions are met, a company can
designate a derivative as:
a) a hedge of the exposure to changes in the fair value of a recognised asset or
liabilities or an unrecognised firm commitment (i.e., fair value hedge),
b) a hedge of the exposure to variable cash flows of a forecasted transaction (i.e.,

cash flow hedge),

c) a hedge of the foreign currency exposure of a net investment in a foreign

operation, an unrecognised firm commitment, an available-for-sale securities, or a

foreign-currency-denominated forecasted transaction (i.e., foreign currency

hedge),
d) speculative hedge (i.e., a derivative not designated as a hedging instrument).

The hedging accounting is applied to the gain or loss of derivatives designated and
qualified as fair value hedge, cash flow hedge and foreign currency hedge, while the

change in value of speculative hedge is required to be reported in current earnings.

60
Under this statement, the hedge accounting IS only applied to
'<I. An entity applying hedge accounting must establish the method for

assessing the effectiveness of hedging and measurement approach for determining the

ineffective portion of the hedge. If the hedge is not passed the highly effective
hedging test, the hedging accounting must be terminated. Even though the hedge
meets the highly effective hedge test, some ineffectiveness may occur and the change
in ineffectiveness must be recorded in current earnings. Further, certain detailed
qualitative information, including objective for holding derivatives, associated risk
management policy, and a description of hedged items or transactions, is required to
be disclosed for all derivative instruments which are qualified as hedging instruments.

The FASB believes that the provisions of SFAS 133 can improve the quality of

disclosed derivative information by entities and allow the users of financial statements
to accurately evaluate a company's strategy for using derivative instruments as well as
the effects of derivative transactions to its financial position. The FASB demonstrates
that the statement 'increases the visibility, comparability, and understandability of the

risks associated with derivatives by requiring that all derivatives be reported as assets
or liabilities and measured at fair value' and it also 'reduces the inconsistency,
incompleteness, and difficulty of applying previous accounting guidance and practice
by providing comprehensive guidance for all derivatives and hedging activities'

133. Since SFAS 133 was promulgated, the FASB's

Derivatives Implementation Group (DIG) has issued more than 180 guidelines to help
companies understand and apply this statement. Even all efforts are made to ensure
the implementation of SFAS 133, the problems associated with this standard,
including its complexity, its potential impacts on earnings volatility and the concerns
that the rule will negatively affect managers' behaviour for using derivative
instruments, suffer intense critics from the practitioners and academicians.

14 The FASB Statement l33 lmplernentation Issue E7 (200(J) requires that the 'highly effective hedge' is used in
two different ways: prospective and retrospective considerations. Although an effectiveness range is not
specifically defined in SFAS 133, market practice has consistently interpreted 'highly effective hedge' as the
cumulative changes in the hedging derivatives should offset between 80 and 125 per cent of the cumulative
changes in the fair value or cash flows ofthe hedged items and Pat()uha~, 2()() I).
61
 ) points out that SFAS 133 is 'notorious for being the most complex of
any of the FASB's pronouncements' He argues that the complicated
requirements about accounting and reporting for derivatives make the entities hard to
understand and apply it correctly and consistently, and further, may cause difficulties
for investors and analysts in assessing and valuating a company's derivative activities.
Indeed, SFAS No. 133's hedge accounting, in particular, is criticised as being 'so
idiosyncratic and ... esoteric that auditing departments don't have the expertise to
implement this without bringing in specialist expertise'

conducted a study to examine how the market participants (i.e.,

investors and analysts) responded to earnings information after the adoption of
hedging activities by companies. The author chose 107 non-financial firms, which
disclosed information related to the use of derivatives from 1985 to 1995, identified as
derivatives users. Another 64 non-financial firms, which did not disclose the use of
derivatives during the same periods, were selected as non-users to isolate the impacts

of hedging activities. The results indicate that the analysts and investors revise their
attitude to earnings information after the company started the hedging activities. The
magnitude of analysts' forecast errors declines and the unexpected earnings are
incorporated into the subsequent earnings forecasts to a great extent. In addition, there
is an increase in the magnitude of earnings-return relation. The author concluded that
the implementation of hedging activities would be the welcome practice for market
participants to forecast earnings and the participants view subsequently announced
earnings information as providing greater information about future earnings. Finally,

the author argued that even though the companies did not disclose much information

about their use of derivatives following the detailed provisions required by SFAS No.
133, the users of financial statements would be able to detect the impacts of hedging

activities on earnings information.

The full-fair-value measurement about the use of derivatives under SFAS 133 may
introduce a greater degree of volatility in reported results of entities.
62
argues that the sophisticated and restrictive derivative-related treatments under SFAS

133 will result in an increase in earnings volatility and further, make it difficult for
managers to smooth earnings. 1) points out that the implementation of SFAS

133 led to complexity in financial statements. The companies who were hedged prior

to SFAS 133 and continued to hedge risk exposures using derivative instruments

would see an increase in earnings volatility and decrease and/or decrease in ability for

the market to predict their future earnings. 1) demonstrates that the

implementation of SFAS 133 may have impacts on a company's hedging and earnings

management strategies. The author provides the empirical evidence that the managers

choose derivatives and discretionary accruals as substitute tools to control earnings

volatility. He argues that since the adoption of SFAS 133 may potentially increase the

earnings volatility, and subsequently increase costs for using derivative instruments,

managers may adopt discretionary accruals as substitute for smoothing earnings, in

other words, the imposition of SFAS 133 could reduce hedging activities and increase

earnings management. Wang et investigate whether the derivative related

disclosures under SFAS 133 provide incremental information content beyond earnings

and book value. The observed sample consists of 161 banks from June 2000 to

year-end 2002. The findings indicate that the SFAS 133 variables are statistically

insignificant and the authors argue that the fair value data following SFAS 133 may

not be reliable for banks. Based upon a sample of 345 US-based multinational

corporations from 1995 to 2002, "d'-""'- et carry out a study to assess the

impacts of SFAS 133 on foreign currency exposure of US-based multinational

companies. Their results indicate that firms who were hedged prior to SFAS 133, i.e.,

the companies which managed their exposures using operational hedges, derivatives,

or both, are able to decrease their exposures to exchange rates following SFAS 133. In

addition, those firms who were hedged prior to SFAS 133 and remained hedged

exposures using derivatives following SFAS 133 experience an increase in earnings

volatility and decrease in earnings predictability. However, according to their findings,

the market value of those companies does not change following SFAS 133 and this

implies that the investors do not adequately account regulations changes and EPS
63
(earnings per share) volatility into the changes in the expected cash flows. Thus, the

authors suggest that managers should not fear the decreased earnings predictability

which is associated with the complexity of SFAS 133 because the investors could

benefit from the disclosures by SFAS 133 without causing the firm to suffer a

decrease in market value. In contrast to the opponents, some researchers (e.g., et

et provide the evidence that the full-fair-value

measurement required by SFAS 133 contains useful information to the financial

statement users. For example, et (2004) test whether the formats of

fair-value-income measurement influence the bank equity analysts' risk and value

judgments. The authors differ the income measurement: full-fair-value (i.e., all fair

value changes recognised in income) versus piecemeal-fair-value (i.e., some fair value

changes recognised in income, others disclosed in the notes). They also vary the

interest-rate-risk exposure: exposed versus hedged. 56 buy-side equity-security

analysts and portfolio managers participant in the experiment. According to the results,

the bank analysts' risk and valuation judgments do depend on how banks measure

income either by full-fair-value or by piecemeal-fair-value. Particularly, for banks

exposed to interest rate risk, analysts' risk assessments do depend on the formats of

fair-value-income measurement, but for the hedged banks, the measurement formats

do not affect analysts' risk judgments. Additionally, they find that analysts judge

statistically higher risk and lower value for exposed banks than for hedged banks only

under the full-fair-value measurement. Under the piecemeal-fair-value-income

measurements, analysts' risk and value assessments, however, do not distinguish

between exposed and hedged banks. Finally, the authors argue that the

full-fair-value-income measurement enables the professional analysts to clearly

distinguish the fundamental risk and share value characteristics of banks. et

) conduct a study to examine whether the derivative-related information IS

recognised or disclosed is value-relevant to investors' assessments. Using a sample of

58 banks having both recognised and disclosed derivative information in the

pre-SFAS 133 periods (i.e., from 1995 to 2000), the authors find that there is a

strongly positive relationship between investors' valuation and the recognised

64
derivative instruments whereas no linkage exists between investors' valuation and

disclosed derivatives. Further, the authors conduct the test to compare investors'

valuation of derivative instruments before and after the adoption of SFAS 133. The
sample for this test consists of 82 banks which have only disclosed derivative
instruments in the pre-SFAS 133 periods (i.e., from 1995 to 2000) and have
recognised derivative information in the post-SFAS 133 periods (i.e., from 2001 to
2004). The results indicate that while the valuation coefficients on disclosed
derivatives are not significantly different from zero, the valuation coefficients on
recognised derivatives in the post-SFAS 133 periods are significantly positive. Thus,
the authors conclude that investors do not pay an equal amount of attention to the
recognised information relative to the disclosed information and the recognition and
disclosure are not substitutes. Finally, they suggest that SFAS 133 is successful in
increasing the transparency and visibility of financial derivatives.

, conducted a survey to
assess the impacts of SFAS No. 133 on the corporate use of derivatives and associated
risk management practices. The survey focuses on the end users of derivative
instruments and the sample companies are asked detailed questions about the degree
to which they have modified the risk management behaviour in response to SFAS No.
133. It is mailed to the treasury and finance professionals and finally more than 200
companies with a wide cross-section of businesses and revenue size respond. The
survey, in general, shows that the implementation of SFAS No. 133 has caused

significant problems for the use of derivative instruments by respondent companies. A

number of detailed findings are drawn as follows: firstly, two thirds of the respondents
agreed with the view that SFAS No. 133 had imposed an excessive burden on
company's risk management activities. Only 25 per cent believed that SFAS No. 133
fostered a beneficial discipline on risk management activities while 47 per cent
disagreed this view. 25 percent of respondents reported that they would adopt the
regular derivatives accounting, rather than devoting time and expense for special
hedging accounting ruled by SFAS No. 133, to the majority of their derivative
65
instruments because it is able to simplify the accounting treatment for derivatives.

Secondly, although most respondents stated that their hedging activities for interest

rate risks, currency risks and risks related to prices of raw materials would likely

remain the same before and after the implementation of SFAS No. 133, more

respondents reported a decrease in hedging activities than increase. The percentage

that reported a decrease (increase) in hedging activities in relation to interest rate risks,

currency risks and risks related to prices of raw materials was 17 (4), 12 (9) and 8 (2)

per cent respectively. Thirdly, the adoption of SFAS 133 also changes the company's

preference for using derivatives to hedge associated risks. After SFAS No. 133 is

implemented, the use of forward contracts and interest rate swaps holds steady or rises
by three percentage points or less, however, the enhanced preference for forwards and

swaps is accompanied with a decrease in the use of options (e.g., swaps, caps or floors,

option combinations like collars or corridors, and exotic options), futures contracts
and other derivatives. Fourthly, two thirds of respondents that have formal risk
policies and systems before the implementation of SFAS No. 133 stated that they

needed to modify the existing risk management policies to accommodate the new

requirements. Fifthly, the survey shows a reluctant for firms to rely on external

systems expertise. Only 14 percent of respondents reported that they would purchase
or lease a SFAS No. 133 compliant system to satisfy the new standard while over 70

per cent had adapted or planed to adapt existing systems to meet SFAS No. 133

requirements.

provides the indirect evidence on the effect of the adoption of SFAS

133 on corporate risk management behaviour. The total 225 non-financial sampling

companies during the period of 1996 - 1999 are sorted to two groups: EH (effective
hedgers, i.e., firm's risk exposure is successfully decreased after initiating derivative

business) and IS (ineffective hedgers/speculators, i.e., those that fail to reduce their
inherent risk after implementing derivative programs). The results illustrate that the IS

firms have been experiencing a significant decrease in exposures related to the interest

rate, foreign exchange rate and commodity price risk after the adoption of SFAS 133
66
after controlling for potential changes in the underlying business risk. However, there

is no significant change in risk exposures for EH companies following the

implementation of SFAS 133. In addition, the cash flow volatility for IS firms is

significantly declined compared to that for EH companies after the adoption of SFAS

133 while the earnings volatility has no significant change for either EH or IS firms,

implying that the IS firms adjust their derivative business towards more effective

hedging manner following the adoption of SFAS 133. The author finally suggests that

the implementation of SFAS 133 has enhanced IS companies to conduct more prudent

risk management activities.

In the accounting literature, the studies from developed countries particularly the U.S.

dominate the research field of derivative-related disclosures and there are very few

studies conducted in the developing countries. For instance,

investigates the value relevance of disclosed notional amount of derivatives by I

Malaysian listed companies. The sample contains 40 non-financial firms that

consecutively report the use of foreign-exchange and interest-rate derivatives from

2003 to 2007. The results illustrate that firms within the plantation, industrial product,

trading services and consumer products manufacturing sectors are the major users of

foreign-exchange and interest-rate derivatives in Malaysia. The notional amount of

value disclosed by Malaysian listed companies contains incremental information

content beyond earnings and book value.

2.4 Summary

In summary, the impacts of regulations in relation to accounting and reporting for

derivatives have attracted considerable academic attention in the recent decades and

two steams of studies have been conducted by prior researchers. Studies in the first

stream (c.g .. 1 ct

67
 ct

address the information quality of derivative related disclosures

from the view of listed companies. They mainly apply the content analysis technique

to reveal the degree to which quoted companies comply with associated

derivative-related standards. Those researchers usually produce a disclosure index
according to related derivative accounting and reporting requirements and then
compare the quality of information content before and after the implementation of
derivative-related standards. Results of those studies generally indicate that the

mandated derivative-related accounting and reporting regulations have enhanced

listed firms to provide more information about their derivative activities in annual
reports, however, the compliance with relevant requirements is mixed. The basic rules
of corresponding derivative-related standards are met as listed companies are
generally able to present both qualitative and quantitative information related to their
use of derivative instruments, however, many of detailed requirements are not met as
reporting companies do not provide adequately detailed information such as the
assumptions of applied quantitative techniques and the description of corporate

derivative management activities.

The second stream specially exammes the market response to such derivative
disclosures from the view of market participants, particularly investors. The main
purpose of those studies is to examine whether disclosures regarding the use of
derivatives are value relevant to investors when making decisions. By establishing
regression models, they mainly focus on the extent to which these mandated
derivative disclosures are informative to firms' exposure, or sensitive to change of
equity price, or value-relevant to market participants' risk judgments and assessments.
The findings of these studies are mixed even contrary. Some researchers (
1 ct 1 1

LJH'cO,,''''·v'. ct

et ct

et present the empirical evidence that the

68
compulsory accounting and reporting requirements about the use of derivatives are

value-relevant to investors' assessment of corporate risk profile. The disclosed

information following the corresponding standard is significantly relevant to market

response such as the change of equity price, equity return, trading volume etc., which
indicates that the information mandated by derivative-related requirements have
provided the new and useful information to the users of financial statement, especially
to investors. Hence, such information is beneficial for investors to evaluate the
corporate financial performance and effects of associated derivative activities, and
further helps to facilitate their investment decisions. Nevertheless, a number of
researches indicate that the mandated accounting and reporting rules pertaining to the
use of derivatives have caused difficulties on investors' risk assessments and valuation
of corporate financial performance. Some studies (e.g., 1 ct

provide the empirical

evidence that there is no relationship between the disclosed derivative-related
information and the market response. Some (e.g., 1

et aL 1; argue that the complicated

requirements on accounting and reporting treatment for derivatives have caused
difficulties for investors in valuating corporate derivative activities, and even a few
studies (e.g .. 1 ) indicate that the

disclosures following the mandated derivative-related requirements have been

misunderstood and adversely affected investors' assessments in company's risk profile
and associated derivative activities. Besides, the restrictive and complex

derivative-related standards, such as SFAS 133, have made the reporting entities hard
to understand and caused a series of significant problems in the use of derivatives and

smooth earnings volatility ( 1.,

et Such mixed and contrary results are consistent with the

findings achieved by the first stream that the compliance with derivative-related
standards is mixed and the standard's 'desired level of financial transparency on the

use of derivative financial instruments is not being adequately achieved'

69
Overall, the pnor researches in relation to the impacts of compulsory
derivative-related accounting and reporting requirements are mostly based upon the
sample from developed countries with mature financial derivative markets. In
particular, most of studies on risk management reporting and disclosures have been
directed to the U.S. setting with an emphasis on financial risk disclosures. This might
be explained in three ways as follows:

a) The u.S. has the well-structured derivatives market. On the one hand, its market
value is huge. According to the statistics published by the American
ETD market reached notional $36,394.2 billion at the end of 2005, taking around
63 per cent in total global ETD derivatives market. On the other hand, there are
various types of derivatives available on both ETD and OTC market such as
customised forward contracts, futures, options and swaps for market or credit
risks.

b) A series of financial scandals in relation to the abuse of derivatives, especially the

recent collapse of the U.S. submortgage markets causing the most serious
worldwide economy crisis since the Great Depression, make the U.S. an
interesting example to be analysed.

c) The U.S. regulatory bodies always concentrate on establishing effective

accounting and reporting standards to govern the use of derivatives and they have
issued and implemented a large number of derivative-related requirements, which
absorbs so much academic attention to assess the impacts of derivative-related
regulations to the real world.

However, no study has specifically addressed accounting and reporting for derivatives
in China and investigated usefulness of derivative disclosures by Chinese listed

companies. China as the largest developing economy has made remarkable progress
70
in its economic development as well as its accounting reform over the last three

decades. Since China started to transfer its national economy from originally

government- to market-oriented in 1978, it made huge achievements in the

development of economy. The gross domestic product (GDP) have been rapidly

increased with the annual rate over 9.5 per cent and in the second quarter 2010, it
reaches the peak in history of $ 1.335 trillion dollars ranking only behind the U.S.A in

the worldwide (National Bureau of Statistics of China, 2010). In 2008, the amount of
foreign trade total (FTT) including both exports and imports was $ 2.563 trillion

dollars achieving the third place internationally; the foreign direct investment (FDI)

also ranked the third with amount of $ 92.395 billion dollars; referring to the foreign
exchange reserves (FER), it achieved $ 1.946 dollars which is the top 1 in the

worldwide (National Bureau of Statistics of China. 2009). In addition, the recent

convergence of Chinese Accounting Standards (CASs) with International Financial

Reporting Standards (IFRSs) makes China an interesting case to examine the issues
associated with the application of derivatives accounting rules. So far most existing
studies choose the financial institutions as observed sample companies. On the one

hand, such businesses hold significant portion of financial assets (liabilities) in their

total assets (liabilities), thus, compared with other industries, financial institutions are

more sensitive to the financial risks (e.g., interest rate risk, foreign exchange risk,

credit risk etc.), and commonly, they would be active in issuing and using derivative

instruments, such as the forward contracts, futures, options and swaps, to manage the

associated market risks. On the other hand, the listed financial institutions mainly
banks must comply with the regulations not only from accounting and reporting

authorities (e.g., IASB, FASB and SEC) but also from banking supervisory bodies

(e.g., As a result, it is difficult for

researchers to separate the effect of accounting-related and banking-related

requirements on disclosures of the use of derivatives.

Therefore, this study will conduct an exploratory research to reveal the degree of

compliance with accounting and reporting standards as to derivative activities of

71
Chinese listed companies and also examine the response of equity market participants
to the derivative-related disclosures. The research contributes to helping fill the

research gap in the existing literature by providing the assessment of accounting and
reporting practices for derivatives in China. It is expected to enhance the
understanding of the usefulness of derivative-related disclosures not only in
developed economies but also developing countries, and it will provide the valuable

insight to the development of derivative reporting standards by generating more

policy implications particularly to developing economies. The next chapter provides a
discussion of the development of China's domestic derivatives market and accounting

practice for the use of derivatives.

72
c

73
 Ilntroduction

This chapter is to discuss the development of China's derivatives market and

associated accounting and reporting practice for derivatives with a view to assessing
the current changes in China's derivatives market and accounting for derivatives.

3.2 of China's Derivatives Market

Commodity Futures ll-fllrket

Since the late 1970s, China has gradually transformed itself from a centrally planned
economy into a market oriented economy. From 1990, China began to establish its

commodity futures markets with the development of some commodity future products.
Zhengzhou Commodity Exchange (ZCE) founded on 12 October 1990 as the first
experimental futures market approved by China's State Council introduced futures
trading on 28 May 1993 In October 1994, almost 50 local futures

exchanges in China were merged into 15 large ones by the State Council
Further, in 1998 China decided to clear up the whole commodity futures market.
Consequently, the commodity future products were reduced from 35 to 12 and three
Shanghai futures exchanges: Shanghai Metal Exchange, Shanghai Commodity
Exchange and Shanghai Cereals & Oil Exchange, were integrated into one single

exchange: Shanghai Futures Exchange (SHFE) ). Since then, only three

74
commodity futures markets operated in China including Dalian Commodity Exchange

(DCE), Shanghai Futures Exchange (SHFE) and Zhengzhou Commodity Exchange

(ZCE). Nowadays, twenty-one commodity futures products are traded on the three
exchanges as shown in Table 3.1. The metal and industrial materials futures, such as
aluminum, copper and zinc, are mainly traded on SHFE while the agriculture
commodity future products like soybean and wheat, are centrally traded on DCE and
ZCE.

Table 3.1 China's Commodity Futures Mari{ets

Futures Exchange Markets Trading Products

Com, Soybeans, Soybean Meal, Soybean
Dalian Commodity Exchange (DCE)
Oil, LLDPE*, RBD Palm Olein, PVC**
Copper, Aluminum, Zinc, Gold, Steel
Shanghai Futures Exchange (SHFE) Rebar, Steel Wire Rod, Natural Rubber,
Fuel Oil
Wheat, Cotton, Sugar, PTA*** ,Rapeseed
Zhengzhou Commodity Exchange (ZCE)
Oil, Early Long-grain Nonglutinous Rice
Notes: * Linear Low Density Polyethylene
** Polyvinyl Chloride
*** p-Phthalic acid; Terephthalic acid

Chart 3.1 shows the turnover and trading volume of China's commodity future
exchanges from 1993 to 2009. The development of Chinese commodity futures
market can be divided into three stages. From 1993 to 1995, the commodity futures
market achieved a rapid expansion. The turnover of 10,056.53 billion Renminbi
(RMB) and volume of 636.121 million in 1995 was over 18 and 71 times bigger than
the figures of 1993 respectively. From 1995 to 2000, the commodity futures market
was declining at the annual rate of 30.69 per cent as shown in Table 3.2 and its
turnover dropped at the bottom in 2000 with amount of 1608.229 billion RMB. There
also has been a sharp contraction in terms of volume with the annual rate of28.80 per
cent dropping at the historically lowest point at 54.612 million in the end of 2000.
Meanwhile, the other financial markets like the equity market were however
experiencing a flourishing period. The total capitalisation in both Shanghai Stock

75
Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) increased dramatically from

403.647 billion in 1995 to 6082.665 billion RMB in 2000 with the annual growth of

72.04 per cent. Since 2001 the trading of commodity futures has recovered from the

recession. The turnover and trading volume of commodity future exchanges in 2001
was 3014.498 billion RMB and 120.464 million respectively, 87.44 and 120.59 per

cent increase from the respective figures of 2000 figure and the market saw an uprise
in terms of both turnover and volume in following years. Even when the global

exchange-traded market suffered a retreat in 2008 caused by the recent financial crisis

[i.e. the global ETD market was contracted at $57,715.30 billion dollars in the end of

2008 which took approximately 73 per cent ofthe previous year's value 2(10).],

the Chinese commodity futures market was however experiencing a soaring growth.

The turnover of 71,914.194 billion RMB in 2008 was increased by 75.52 per cent
than 2007's while there was an 87.24 per cent rise in trading volume. In the end of

2009, both the turnover and volume reached the historical peak at 130,510.72 billion

RMB and 2,157.43 million respectively.

Chart 3.1 Turnover (Binion RMB) and Volume (Million) of China's Commodity
~"'uture Exchanges from 1993 to 2009

140000 2500

120000
2000

100000
1500
80000 _Turnover
--+-Vo1ume
60000 1000

500

o
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

S\nm;e: Staristics cOilimodity ji!tures' (l9<J3

76
2007 and China F'lItlires Association (CF,./), 2005, 2006, 2007, 2008, 2009, 2010,

Table 3.2 Turnover of Commodity Future Exchanges and Stock Exchanges from
1995 to 2000 (Billion RMB)

Averag
e
1995 1996 1997 1998 1999 2000 Annual
Growt
h(%)
Commodit
10056.5 8411.91 6117.06 3696.72 2234.30 1608.22
Y Future -30.69
3 6 6 4 1 9
Exchanges
II
Stock
2133.21 3072.18 2354.42 6082.66
Exchanges 403.647 3131.96 72.04
* 6 4 5 5
Notes: * Turnover of stock exchanges includes both A and B shares traded on the SHSE and SZSE,
5'ollrce: Slatistics of' (1993 2()O.J). /;JJ}2:/Malo.cllinfb.coli1.cl//~i:::.,/tihb!.Yw(gsc.hfm!.

20{J7.
China S<?curifies lind Flllmt"s Yearhook 20()5

Financial Derivatives lvlarket

In the 1990s, China began to develop some financial derivative products. The SHSE

opened the foreign exchange futures on 28 December 1992. Hainan Stock Exchange

Centre issued the Shenzhen composite stock index future products on 10 March 1993

Other financial derivatives, such as equity warrants, convertible bonds

and government bond futures, were also introduced in China's financial derivatives

market. However, except government bond futures, the scale of other financial

derivative instruments was so small that they were finally stopped due to the low

trading volume as well as a number of abuse operations in the market et al ..

The first government bond future contract was traded on the SHSE in December 1992

77
and then China opened the trading of government bond futures through 50 brokerage

firms to the general public in October 1993 In a short period, the

market expanded considerably; by the end of 1994 the total turnover in government

bond futures market achieved 2.8 trillion RMB that was 10 times bigger than the

figure of 1993 ct However, as the market developed, a series of frauds

occurred and as a result, the supervisory body, China Securities Regulatory

Commission (CSRC), on 17 May 1995, suspended the trading of government bond

futures. The financial derivatives market was then ceased. Since then, only three

commodity futures markets have been operating in China.

China's derivatives market is circuitously developed in its short history. The

evolvement of commodity futures market is fluctuant. It achieved a fast growth in

early years of the 1990s, followed by a five-year depression and rebounded since

2001. Compared with the global derivatives market, the absence of the trading of

financial derivatives impedes the growth of the whole Chinese derivatives market.

According to the statistics by BIS, the global ETD market grew to notional $53

trillion in 2004, of which equity futures and options taking 65 per cent and interest

rate derivatives possessing 26 per cent whereas commodity futures only seizing 9 per

cent (BIS, 2004). The OTC derivative markets reached the notional value ofUS$516

trillion dollars at the end of June 2007, which was dominated by interest rate contracts

(75% of total notional amounts and 60% of total gross market values), followed by

foreign exchange contracts (11 % of overall notional value), credit derivatives (9.88%

78
of total notional amounts), equity derivatives (2.13% of overall notional value) and

commodity derivatives (1.55% oftotal notional amounts outstanding) (BIS, 2007).

3.3 Factors Affecting the Development of China's Derivatives "Market

By companng and analysing the major derivatives markets in the Asia-Pacific

countries, concludes that the successful development of derivatives

must build on three foundations: solid product design, sound market infrastructure and

strong regulation. The cash markets need to be liquid and efficient where the prices
are determined by the markets. The derivatives exchange should be ideally set up

through a single demutualised form and it requires safety cushions like appropriate

capital and a sound margin system. The appropriate regulation which commonly

includes self-regulatory-organisation (SRO) needs to be established. In addition, the

derivative laws and relevant financial reporting policies should be enacted. The author
argues that three vital issues should be carefully considered before the establishment

of derivatives markets, including 'how can liquid cash markets be expanded; how

much regulation is needed in OTC and ETD derivative markets; and what
infrastructure is necessary' 13). Fratzscher's study fills a gap in

the risk management literature, especially from the emerging markets perspective, by

providing a theory on how to set up functioning derivatives markets in emerging

countries. In this section, the study is to provide a critical analysis of the development

of China's derivatives market by adopting Fratzscher's framework.

Inappropriate Product Design

The successful derivatives market should be built upon 'an efficient, liquid, and

79
integrated cash market (either for bonds, equities, other assets, or commodities) that is
broadly market determined rather than driven by administered prices'

The well efficient and liquid cash market is the precondition for design of
derivative products. Otherwise, if the derivatives market is established on a poor
functioning cash market, the prices of derivative products will be misled.
Consequently, the derivative contracts will be traded in a casino-like atmosphere and
highly profiled failures will occur. The 'Contract 327 Affair' is one typical example of
such a failure happened in China's derivatives market.

The 'Contract 327 Affair' was the world's largest exchange that traded 4 million
government bond futures in one day on 23 February 1995 and then collapsed. It is
so-called the 'Chinese Barings Scandal'. China opened the government bond futures
market to the general public in October 1993 and the trading of bond futures was
sharply expanded in a short period. At that time, the government bonds were issued as
zero-coupon bonds with three or five year maturities; some at variable interest rates
which were adjusted by the Ministry of Finance (MOF) with so-called 'inflation
subsidies'. The government bonds were primarily traded in Shanghai, but also in
Beijing, Shenzhen and Wuhan. On 23 February 1995, one small brokerage firm,
named Liaoning Guofa (Group) Limited Company (which was owned by the MOF),
got the news in advance that the MOF would announce the 'inflation subsidies' for
illiquid three-year-maturity bonds issued in 1992 and took long position in these
bonds, which caused the huge losses from the short position at the largest broker,
Shanghai International Securities. To corner the market, Shanghai International
Securities then sold short these futures with amount of $26 billion dollars which
exceeded position limits by 20 times. As a result, the price manipulation caused over
$10 billion dollars losses in just eight minutes! What was worse, the Chinese
government suspended the trading of bond futures three months later on 17 May 1995
and as a result, China's financial derivatives market closed

The most vital lesson learned from this case is that the derivatives design must be
80
based upon a well functioning and liquid cash market. The derivative instruments are

derived from the demand for innovation in cash market and the development of II

derivatives market is restricted by the scale of cash market. However, in early 1990s,

the Chinese government bonds market was so far away from highly efficient and
liquid cash market due to several reasons.

Firstly, the scale of government bonds issuance is small and the variety of bonds is

pretty limited. China reopened the government bonds issuance market in 1981 and
although the circulation of bonds was growing in the following years, the total market

was rather small. The National Bureau of Statistics of China revealed that in 1994, the
government bonds were issued with the amount of 113.755 billion RMB and the

year-end balance was 228.640 billion, where the circulating bonds around 45 billion
only took 19.7 per cent in practice 1 In addition, the
structure of bonds in cash market was quite simplex. At that time, bonds were
dominated by long-term maturities, most of three- or five-year maturity plus a few

with ten year maturities as shown in Table 3.3. In 1994, the long-term bonds took

88.33 per cent in total issuance amount and 94.20 per cent in the year-end balance

while in 1995 the two figures were increased by 92.13 and 96.40 per cent respectively.

Apparently, the small scale and centralised bonds structure could not fulfill the huge

amount of futures' settlement in bond futures market.

Table 3.3 Long-term Government Bonds* in 1994 & 1995 (Billion RMB)

1994 1995
Circulation of long-term
100.485 139.197
government bonds
Total circulation 113.755 151.086
Long-term bonds
88.33% 92.13%
in total circulation (%)
Year-end balance of long-term
215.370 318.141
government bonds
Total year-end balance 228.640 330.030
Long-term bonds
94.20% 96.40%
in total year-end balance
81
 (%)
Notes: * Three, five and ten-year maturity bonds
Source: China Statistical Yearbook 1996 and [997

Secondly, the interest rate is not liberalized. The price of a bond is directly determined
by the interest rate and the fluctuating interest rate in bonds market would drive

investors to use derivatives for the hedging or speculating purpose et

However, in early 1990s, China adopted the fixed interest rate system that the interest
rate was determined by the government instead of the market. At that time, the interest
rate of government bonds was fixed by the MOF when first issued and it was

administrated so strictly that the range of interest rate fluctuation was relatively
narrow. The only exception was 'inflation subsidies' which were adjusted discreetly
by the government to the change of interest rates. However, the 'inflation subsidies'
were calculated by the People's Bank of China (i.e. the central bank) and in fact, it

was still government- not market-oriented. Thus, under that circumstance, the interest
rate could not reflect the real prices of the bonds, which caused the deficiency in
bonds cash market. Consequently, on the one hand, the fixed interest rate reduced the

demand of using bonds futures as hedging tools for interest rate risk. On the other
hand, the 'Contract 327 Affair' reveals that the administrated interest rate would invite
more speculation in derivatives that often lead to overshooting once the policies

constraints are removed Many Chinese practitioners and

academicians ( et point out that the fixed

interest rate system leads the bond futures market to a casino for 'inflation subsidies'

and finally causes its failure.

Thirdly, the liquidity in bonds market is generally low. In early years of the 1990s, the
individual not institutional investors possessed the majority of the government bonds
and as shown in Table 3.4, from 1994 to 1995, 75 per cent of the government bonds
were owned by individuals. Due to this ownership structure, the large proportion of
bonds was not traded in the cash market because the individuals commonly held

bonds for saving rather than trading purpose et

82
 Table 3.4 Structure of Chinese Government Bondholders 1991 - 1995 (%)

Non-bank
State-owned Pension
Year Individuals financial Banks
corporations funds
institutions
1991 - 1993 75% 10% 10% 5% 0
1994 - 1995 75% 5% 10% 5% 5%
Source: et al.. 2000

Poor Infrastructure

The poor infrastructure is another important factor blocking the growth of Chinese
derivatives market. argues that to achieve a successful derivatives
market, the sound infrastructure at exchanges and clearing houses should be
developed and the exchange should set the incentives for market participants to follow
the honour rules of conduct and stabilise the trading system. However, the 'Contract

327 Affair' reveals that in early 1990s, the infrastructure of Chinese government bond

futures exchanges was deficient This is because the margin

system of exchanges is poor. The sound margin system can reduce the counterparty
credit risk to a maximum extent while enhance the efficiency of an exchange
When the 'Contract 327 Affair' happened, a 20,000-yuan government
bond future contract only requires 500 yuan margin which could only cover 2.5 per
cent in its total amount, and the margin for other futures was even less, taking

approximate 1 per cent in the total value et As a result, this low margin

level was deficient in controlling the credit risk and stimulated the speculative

atmosphere in the bond futures market.

Also, the supervision of exchanges is weak. In early 1990s, due to the absence of
supervision from the government and the self-regulatory-organisation (SRO), the
exchanges played the most significant role in supervising derivatives' trading.

83
Although a senes of requirements were promulgated to regulate the derivative
activities, some were ignored in practice ( For instance, in
order to attract more investors, some exchanges loosed the speculative position limits

and lowered the margin which already took so small portion in total contract's value
ct As in the case of the 'Contract 327 Affair', just in one day, Shanghai
International Securities sold short government futures with the amount of $26 billion
dollars which exceeded the position limits by 20 times, which implied that the rules
regarding the trade of futures were ineffective and the supervision of SHSE was
completely deficient. Overall, the poor infrastructure at exchanges, such as inadequate
margin system and weak supervision, reduces its functioning while increases the
systemic risk in the market.

Corporate Gopemance amI Control

The weak corporate governance and control is the third crucial factor for the slow
development and even collapse of derivatives markets in China and the 'China
Aviation Oil (CAO) Incident' is a typical example to illustrate how the weak
regulation from the supervisory body, deficient corporate governance and weak
accounting system can lead to a huge derivative-related loss.

China Aviation Oil (CAO), listed on the Stock Exchange of Singapore since 2001, is
the Singapore subsidiary of China Aviation Oil Holding Company (CAOHC) which is
a state-owned company in Beijing and the monopoly importer of jet fuel. From 2003,
following the anticipation that the oil price would fall in 2004, CAO disregarded
Chinese regulations and engaged in the OTC derivatives trading of oil options, taking
highly speculative short position in the options. However, the rising oil price at the
beginning of2004 caused CAO $5.8 million dollars losses. With a desire not to record
the losses, CAO decided to restructure its option portfolio with several option
counterparties in January, June and September 2004. The restructuring involved the
simultaneous buying of options to closeout existing positions to avoid losses and
84
selling of new options with larger volumes and longer tenure, which finally increased
the short options positions from 2 million tons of crude oil to 52 million tons.
Meanwhile, CAO misrepresented its financial position with accounting gimmicks to
avoid reporting incurred losses. However, as the oil price continuously rose, the losses
sharply climbed and the substantial margin calls depleted CAO's cash reserves.
Finally, CAO sought court protection in November 2004. According to the statistics,
the failure led to losses with over $550 million dollars for CAO which can only
compare to the collapse of Barings ($1 billion dollars losses) in 1995

Before the CAO incident occurred, Chinese regulators had prepared a set of rules,
including China Securities Regulatory Commission (CSRC) regulations of 2001 that
all companies were banned to operate speculative derivatives trading overseas and the

State of Council stipulates that the state-owned companies are strictly forbidden to
engage in the OTC derivatives trading overseas. However, the supervisory body did
not establish the relevant supervision system to monitor the derivative activities
conducted by companies, which caused many practical difficulties for regulators in
governing companies' derivatives trading. In this case, CAO disregarded Chinese
regulations and operated the unauthorised OTC options trading in the overseas

market.

The failure of corporate governance and internal control IS frequently cited as

contributing factor in many derivative-related scandals

1 et

In the case of CAO incident, the company itself had elaborately established
internal systems for governing trading of derivatives. It invested in risk management
systems, created VAR models and built three ways of internal controls which were
senior traders having strict limits, a risk control committee and an internal auditing

department 2006). From 2003, CAO had already engaged in the OTC oil

options but nothing was reported to the parent company until margin calls exploded.
During the two-year period, CAO itself and the parent company did not take any step
85
to deter these highly risky transactions, which implied that the internal control

systems were totally deficient for monitoring trading of derivatives. Thus, this case

indicates that the self-regulation and internal risk control are inadequate for governing
derivative activities.

If the accounting information on trading of derivatives is transparent and adequate,

investors can assess the company's risk exposures and make a better investment
decision. In the case of CAO incident, the inadequate accounting system in both home
and host countries was obvious. At that time, the accounting system regarding
derivative activities was weak in the Stock Exchange of Singapore as the lAS 39
Financial Instruments: Recognition and Measurement was not applied and derivatives

positions were not marked to market. All derivative products were treated as
off-balance sheet instruments and relevant information about derivative activities was
disclosed in notes attached to the financial statement. The situation in China was even
worse that the requirements related to derivative instruments were absent in the
Chinese accounting system and the derivative disclosures were entirely on the
voluntary base. Hence, this lack of timely disclosure together with extreme risks of
these instruments impedes both the investors and regulators' ability to assess all

factors that affect a firm's financial condition and creates an opportunity for CAO to
manipulate its financial reports through accounting gimmicks

To summanse, the inappropriate product design, poor market infrastructure and

inadequate governance and control are three major problematic factors blocking the
development of China's derivatives market. The 'Contract 327 Affair' reveals that the
derivative products design must be established upon a well functioning and liquid

cash market. It also illustrates how a sound infrastructure at exchanges is important

for a successful derivatives market. Finally, the 'China Aviation Oil (CAO) Incident'
underlines the importance of the regulation from the supervisory body, the
effectiveness of the efficient internal control system, and the significance of adequate

accounting disclosure for trading of derivatives.

86
3.4 New Developments in China's Derivatives Market

3.4.1 Commodity Futures Market

During the first ten months of 2010, the Chinese commodity futures market is
fluctuant in terms of trading turnover and volume. As shown in Chart 3.2, the rising of
turnover and trading volume was always followed by the decline of those in the next

month. Both turnover and volume achieved the highest point in August with the
amount of20925.825 billion RMB and 300.209 million respectively.

Until October 2010, the whole Chinese commodity futures market, as shown in Table

3.5, have been growing with 174.59 and 147.20 per cent annual growth in terms of

trading turnover and volume respectively compared with the first ten months 2009.

Among three commodity futures exchanges, SHFE takes the biggest proportion in

total commodity futures' trading (58.61% in total turnover and 43.82% in total

volume), followed by ZCE possessing 24.32 and 31.45 per cent in respective total
turnover and volume. Regarding to the growth, ZCE, however, achieved the highest

rate of growth with 230.05 and 130.82 per cent in terms of total turnover and trading

volume, followed by SHFE and DCE with the least growth rate of 17.07 and -8.27 in

respective turnover and trading volume. For the trading products, as shown in Chart

3.3, the products traded at SHFE take four positions among the top seven of the most

popular commodity futures during the first ten months 2010 which include the natural
rubber (19.94% in total turnover), copper (14.23%), zinc (11.91%) and steel rebar

(9.92%) whereas the sugar (16.24%) and cotton (5.15%) at ZCE, soybean oil (6.23%)

at DCE seize the rest of three among the top seven. At present, the prices of soybean,
wheat and copper future contracts obtain higher attention from both home and abroad.

87
SHFE IS one of three authoritative price-setting centres in global copper market
) and DCE becomes the second largest soybean futures' trading market

in the world

At the same time, the risk management in commodity futures market has been
enhanced. On 2 June 1999 the State Council issued the Administration of Futures'
Trading Tentative Regulations which are the first ruling to regulate activities involved
in futures trading. The 'Three-level Risk Management Regime' has also been
established in the futures market. The three-level regime includes the top level of the
CSRC which is in charge of regulating all activities in the market, the middle level of
the China Futures Association (CFA), a self-regulatory-organisation with the
responsibilities of managing the whole industry, and the lowest level of the exchanges
and brokerage firms which are required to directly govern and manage the risks in the
market.

Chart 3.2 Turnover (Binion RMB) and Volume (Milli.on) of China's Commodity Future
Exchanges in 2010

25000 350

300
20000
250

15000 200 _Turnover

~Vo1ume
150
10000
100
5000
50

0 0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct

Source': CF:·J, 20 JO.

Table 3.5 Statistics of China's Commodity Futures Markets during the First 10
Months of2009 and 2010

88
 Accumulated Accumulated Accumulated Accumulated
Turnover Turnover Annual Turnover % Volume Volume Annual Volume %
(Billion (Billion Growth in Total (Million) (Million) Growth in Total
Exchanges
RMB) until RMB) until Rate Turnover until until Rate Volume
October October (%) 2010 October October (%) 2010
2009 2010 2009 2010
DCE 28954.234 29726.266 2.67 17.07 653.418 599.408 -8.27 24.73
SHFE 57955.958 102061.924 76.10 58.61 662.857 1062.058 60.22 43.82
ZCE 12835.011 42361.729 230.05 24.32 330.224 762.218 130.82 31.45
Total 99745.203 174149.919 174.59 100 1646.499 2423.684 147.20 100
Source: CPA, 2010.

Chart 3.3 Proportions of Future Products in Total Turnover during the First 10
Months 2010

1m Natural Rubber

16.38% liD Sugar

515%~ ~ Copper

lIB Zinc
6.23%~

992%. 11. 91%

6.24% lID Steel Rebar

II Soybean Oil

• Cotton

o Others

Source: Cl~A, 201 fJ.

3.4.2 Financial Derivatives Market

With the rapid development of China's economy, there IS a nsmg calling for the
reestablishment of the financial derivatives market. (2005) claims that the
building of financial derivatives market would improve the capital structure and
profit-making ability of Chinese commercial banks, reinforce the effect of monetary
policies and absorb more international capital, thus accelerating the Chinese
89
economy's future growth. By deliberately rethinking of the bankruptcy of financial

derivatives markets in the early 1990s, the Chinese central government has been very
cautious to reintroduce the financial derivatives market.

In the history, SHSE created the first warrant product - Dafeile stock right offering
warrant, in June 1992 and Shenzhen Bao'an Corporation issued the first long-term put
warrant on 19 October 1992. There were fourteen warrants available in the early
1990s but due to the prevailing of speculation, the warrants market was finally
suspended by the authorised body (Ba ct aI., 2005). The share reform imposed by the
government offered an opportunity for the CSRC to reintroduce financial derivatives
to the market without being rejected by the central government. Before the reform,
most shares of publicly listed companies on Chinese equity market were occupied
directly by the government or indirectly through its agents such as the
government-controlled funds management firms. These shares were forbidden to be

traded in the public market. With the intend to enhance the mobility of the stock
market, the central government in 2005 announced a plan to convert its large
non-tradable share holdings into tradable shares and eventually floated them in the
market. However, this plan was resisted by vast of investors who worried about

suffering large losses due to the depression of stock prices as a result of the dramatic
increase in the numbers of freely tradable shares. In order to convince the public to

accept the share reform plan, the government decided to compensate holders of
floating shares for their potential losses. Under that circumstance, the CSRC allowed
some firms involved in the share reform to issue warrants as part of their

compensation packages to public investors.

A warrant, which is defined as 'an option written by a firm on its own stock' (Chance,

90
1995, p556), is an essentially financial option issued by publicly quoted companies.

There are two basic types of warrants - call and put warrants. A call warrant gives its

holder the right to buy stock from the issuing firm at a predetermined strike price

during a pre-specified exercise period, while a put warrant gives its holder the right to

sell stock back to the issuing firm. Both call and put warrants derive their values from

the underlying stock price: the value of a call warrant increases with the stock price,

while that of a put warrant decreases (Chance, 1995).

Compared with the stock market, the CSRC has provided more trading-favoured

supports for the warrants market which is discussed in the SHSE's regulation -

'Tentative Administration A1easure o.fWarron{s '(1005) as follows:

Firstly, stock trading is subj ect to the so-called 'T+ l' rule, which requires investors to

hold their stocks for at least one day before selling. Warrants trading is subj ect to the

'T+0' rule, which allows investors to sell warrants they purchase earlier - on the same

day. As a result, investors can pursue day-trading strategies in warrants but not in

stocks.

Secondly, investors incur a lower transaction cost when trading warrants. When

trading stocks (either buying or selling), investors pay a stamp tax to the government,

a registration fee to the stock exchange, and a brokerage fee. The stamp tax is a flat

percentage of the total proceeds. The tax rate has changed several times in the past,

ranging from 0.1 to 0.3 percent. The registration fee is 0.1 percent of the total

proceeds. The trading commission is negotiable with brokers and is capped at 0.3

percent of the total proceeds (MOF, 2010). Investors are exempted from paying any

stamp tax and registration fee when trading warrants. They still pay a brokerage fee,

which is also negotiable and is capped at 0.3 percent of the total proceeds. Because of

the large volume in the warrants market, brokers usually charge a lower trading

commission on warrants than on stocks.

91
Thirdly, warrants have a wider daily price change limit. The CSRC imposes a 10

percent limit daily price increase or decrease of any stock traded on the two stock

exchanges in Shanghai and Shenzhen. Once the price of a stock rises or falls by 10

percent relative to the previous day's closing price, the trading of this stock is halted

for the day. The daily permitted price increase (decrease) of a warrant in Chinese

currency unit - Yuan, is equal to the daily permitted price increase (decrease) of the

underlying stock in Yuan, multiplied by 1.25 and the warrant's exercise ratio. An

example is given as below:

Company A put a warrant on 13 November 2010. On the previous trading day,

the warrant's closing price was 1.122 Yuan and the underlying its stock's

closing price was 21.61 Yuan. The warrant had an exercise ratio of 0.5, i.e.,

one share of the warrant gave its holder the right to sell 0.5 share of Company

A stock to the issuing firm. With the 10 per cent daily price change limit, the

price of Company A's stock was allowed to increase or decrease by 2.16 Yuan

on this day. Then, the warrant price was allowed to increase or decrease by

2.16x1.25xO.5=1.35 Yuan, which corresponded to 120 per cent ofthe

warrant's closing price from the previous day.

Since a warrant has a high leverage ratio, its price-change limit is much wider in

percentage terms than the limit on the underlying stocks.

The Chinese law prohibits investors from shorting-sell stocks or warrants in the

market 15 . The severe short-sale constraints make it impossible for investors to

arbitrage any stock or warrant which are over-valuated. Similarly, companies are not

able to easily arbitrage through the overvaluation of their warrants by issuing more as

the quota of the new issuance is restrictively constrained by the central government.

15 The CSRC starts to allow shorting ofa selected set of stocks only in 2010.
92
The SHSE had experimented with a limited shorting mechanism for the traded

warrants by allowing a group of designated brokerage firms to create additional shares

of warrants. When a designated firm wants to create more shares of a warrant, it must

obtain approval from the SHSE 16 . The newly created warrants are traded in the market
undistinguished from original ones and the firm can buy back warrants from the
market to offset its earlier creation17 (SHSE.2010).

Deriwltives Exchange

On 8 September 2006, China Financial Futures Exchange (CFFEX), the first

demutualised exchange focusing on financial derivatives' trading, was inaugurated in
Shanghai with the approval of the State Council and CSRC. This event is a milestone
in the history of Chinese derivatives market as it symbolises the reopening of
financial derivatives market. The CFFEX is a joint venture of the DCE, SHFE, ZCE,
SHSE and SZSE. It constructs a well-structured electronic market, multi-tiered
members' clearing system and risk management policy to improve its competitive
strength. In early 2008, the CFFEX launched the first derivative product - the Chinese
Stock Index (CSI) 300 index futures. After two years' preparation, the trading of the
CSI 300 index futures was finally approved by the State Council and CSRC in the

early of2010 and officially listed in the market on 16 April 2010 (CFFEX, 2010). As
shown in Chart 3.7, the market has been experiencing a rapid expansion in early
months since the CSI 300 index futures were publicly traded and achieved the highest

point at 12,109.055 billion RMB and 15.074 million in terms of trading turnover and
volume respectively in July. But it saw a consecutive two-month decline and
rebounded in October with the amount of9,080.535 billion RMB and 8.945 million in

16 The SHSE does not allow the brokerage firms to issue stock-settled put warrants at a quantity
substantially more than the floating shares of the firm stocks as otherwise the warrant holders won't be
able to exercise their put warrants at expiration.
17 Creations and cancellations are publicly disclosed by the SHSE within the same day.

93
terms of turnover and volume. Similarly, the proportion of the CSI 300 index futures

in total market turnover, as shown in Chart 3.5, was keeping rising from 1.32% in

April to its peak at 5.60% in July. The percentage, however, was consecutively falling

in the next three months. In addition, the CFFEX plans to introduce other financial

derivatives such as other index futures, index options, government bonds futures and

currency futures in the future.

Chart 3.4 Turnover (Billion RMB) and Volume (Million) of CSI 300 Index Futures in 2010

'\/olurnc

14000 16

14
12000
12
10000
10
8000 _Turnover
8
--+-Volume
6000
6
4000 4

2000 2

0 0
Apr May Jun Jul Aug Sep Oct

Source: eFt!. 2010.

Chart 3.5 Proportion ('Yo) ofCSI 300 Index Futures in Month's Turnover of Total
Derivatives 2010

94
 6

o L -______ ~ ______- L_ _ _ _ _ _ ~ _ _ _ _ _ _ _ _L __ _ _ _ _ _J __ _ _ _ _ __ L_ _ _ _ _ _~

Apr May Jun Jul Aug Sep Oct

Source: CPA, 2010.

Clearly, China has accelerated the step to facilitate the derivatives market from 2006,

following the roadmap that firstly developing the commodity futures market then

introducing equity derivative products at the exchange. Some studies (e.g ..

provide the analogical roadmap for emerging countries to

establish a sound derivatives market. suggests the emerging

countries to follow the building blocks which typically start from the commodity to

index futures at demutualised exchanges finally to tailored OTC derivative products.

Similarly, recommends that it is appropriate for emerging countries

to firstly create derivatives related to equities than other types of financial derivative

products.

3.5 Accounting and Reporting for Derivatives in >....-H.H.i.4

3.5.1 'ID<m:i.:satlon of National Accounting and

Relevance to Emerging Economies

95
With the development of the world economy rapidly, globalisation has turned to be
the most obviously characteristic. It presses for a uniform and comparable accounting

standard in the global scopes. The tendency for developed and developing countries to

adopt lFRS and lAS standards has been accelerating in recent years 2).

Advantages to developing nations of harmonising on lFRS and lAS include: the

elimination or reduction of set-up costs in developing national accounting standards;

the potential for rapid national improvement in the perceived quality and status of

financial reports; increases in market efficiency in (inter)national financial markets

through the provision of more understandable, comparable, and reliable financial
statements; and a reduction in the cost to firms of preparing financial statements

2005; 1992; 1

Disadvantages of harmonising on lFRS and lAS for developing nations relate to the

adoption of a set of accounting standards unsuited or irrelevant to national needs

(Tyrrall, 2007). At firm and national levels, this may result in 'standards overload'

& 1 as firms endeavour to comply with lFRS and lAS that

exceed their business requirements in complexity and the ability of

indigenous accounting staff to operate them Increasing harmonisation

and complexity in accounting standards tends to facilitate expansion of large

international accounting firms at the expense of local firms in both developing

1 et 1 and developed

countries.

3.5.2 Evolution of Accounting Reporting for Derivatives

Over the past two decades, China has made an enormous achievement in its economic

96
development and reform. In order to meet the rapid growth in economy, a series of
accounting standards has been promulgated and implemented. Before 2007, the

Chinese Accounting Standards (CASs) consisted of Accounting Standards for

Business Enterprises (called Basic Standards) with 16 other specific accounting
standards and Accounting Systems for Business Enterprises, Financial Institutions and
Small Business Enterprises. Besides, some ad hoc pronouncements (usually titled as
'Caikuai') issued by the MOF have also formed an important part of CASso Since
numerous huge derivative-related losses occurred in the Chinese derivatives market,
the supervisory authorities took some efforts, including issuance of accounting rules
to report on the trading of derivatives. For instance, Caikuai [2000] No. 19
promulgated by the MOF provides a number of pronouncements that standardise the
accounting treatment related to commodity futures. Nevertheless, even though the
Chinese securities supervisory body and accounting standards setters have been aware
of the emergency to regulate the derivatives trading, the requirements for the
disclosure of derivative activities are significantly absent in the Chinese accounting
system.

In recent decade, especially after the accession to the World Trade Organisation
(WTO) in 2001, China has gathered pace integrated itself with the global economy
and the international capital market, which increases strong needs for more accurate
and objective financial reporting with greater quality, transparency and comparability.
In line with the globalisation of the worldwide economy and the international capital

market, the Chinese authorities fully adopt the International Financial Reporting

Standards (IFRSs) for the reporting of the trading of derivatives. In 2004, the MOF
issued the exposure draft which covers accounting treatment of derivatives and hedge
accounting for financial institutions. On 21 September 2005, the MOF promulgated a

set of proposals about accounting for financial instruments including Financial

Instruments: Recognition and Measurement, Financial Assets Transfer, Hedging
Accounting and Financial Instruments: Presentation and Disclosure. Those four
proposals are quite similar to IFRS No. 32 and No. 39. In November 2005, the
97
Chinese Accounting Standards Committee (CAS C) and the International Accounting

Standards Board (IASB) held a convergence meeting on accounting standards in

Beijing and signed a Joint Statement in which both parties expressed their views on

international convergence of accounting standards and agreed that a new set of CASs
would be developed to achieve the convergence with IFRSs.

points out that an adequate legal framework for enforcement and

the adoption of the IFRSs, including lAS No.32 and No.39, are crucial prerequisites
for a sound derivatives market. On 15 February 2006, the MOF issued a series of new
and revised Accounting Standards for Business Enterprises (the 'New Accounting
Standards') which is effective from 1 January 2007 for all listed companies. The
issuance and implementation of the new accounting system have achieved the
substantial convergence of CASs with IFRSs, taking an important step in integrating
China with global economy and international capital market. The New Accounting
Standards introduce many new concepts in financial reporting, such as financial
instruments, investment property and share-based payments. They also introduce
some new accounting principles and measurement requirements; of which the most
significant shift is the requirement of 'fair value' measurement in many areas. The
New Accounting Standards comprise the revised Basic Standard, 22 newly-issued
specific accounting standards and 16 revised specific accounting standards. There are

four newly-issued standards on 'Financial Instruments' including derivatives, ASBE

Nos. 22 Recognition and Measurement of Financial Instruments, 23 Transfer of

Financial Assets, 24 Hedging and 37 Presentation of Financial Instruments, which

fully converge with corresponding IFRS and lAS standards (i.e., IFRS 7, lAS 32 and
39). They provide detailed requirements regarding derivatives recognition,
measurement, presentation, disclosure and application of hedging accounting.

In the New Accounting Standards, the full-fair-value measurement is adopted that all
entities must recognise all financial instruments, including derivatives, as assets or
liabilities on the balance-sheet and measure those instruments at fair value, and
98
changes in the derivatives fair value are to be recognised in the current earnings

unless specific hedge accounting criteria are met. In a corporate annual report, the
derivatives instruments are treated as balance-sheet instead of off-balance-sheet items.

In addition, the comprehensive disclosures on a firm's financial risk exposures are

now required, including the significance of derivative instruments for a company's
financial position and performance as well as qualitative and quantitative information
regarding the nature and extent of risks derived from those instruments to which the
company is exposed to. All requirements of the four standards are fully consistent
with the corresponding parts ofIFRS 7, lAS 32 and 39.

The issuance of the New Accounting Standards is the new era for the alignment with
international accounting practice in China. It fills in a gap in the area of accounting
for derivatives and also symbolises that the regulations for derivative-related activities
is shifting from a voluntary to mandated base. Although it is too early to assess the
economic consequences of China's new accounting standards, the new system would
expect to have a big effect on governing derivative-related activities. Firstly, under the

compulsory disclosure framework, the listed companies have to disclose more

accurate and objective information, either good or bad, about their use of derivatives
and they have to improve their internal control system and risk management policy to
monitor trading of derivatives. Secondly, investors can obtain much more useful
information about the risk exposures of a quoted firm to facilitate their investment
decisions. Particularly, the New Accounting Standards will help overseas investors
and users of financial statements to better understand financial positions of Chinese

listed companies.

3.6 Summary

Despite China's rapid economic growth over the past three decades, its derivatives

99
market is still in development and offer far less investment choices than the markets

in other developed economies. The evolution of Chinese derivatives market is

circuitous in history and there have been only three commodity futures exchanges

operated in China for almost ten years since the central government closed out all
financial derivatives markets in 1995 after a notorious manipulation scandal -
'Contract 327 Affair'. By using the framework, this chapter has

analysedthree vital factors - the inappropriate product design, poor market

infrastructure and inadequate governance and control that have contributed to the
slow and tortuous development of China's derivatives market. China has begun to
progressively develop its derivatives market by re-establishing the financial
derivatives market since 2005. The reintroduce of the warrants trading, especially the
reopen of the CFFEX, is a remarkable progress in the evolution of China's derivatives
market. The central government has been very cautious about new financial products
because of the concern that they might be misused or abused by investors. Hence,
there is just one financial derivative contract - CSI 300 index futures trading at the
CFFEX at present. The accounting and reporting practice for the use of derivatives
has been largely absent in a long period and as a result, the disclosure of derivative
activities is mainly voluntarily provided by companies. The situation has been
gradually improved since 2005 as the Chinese authority has gathered pace in
integrating its accounting and reporting standards with the IFRSs framework. The
release of the 'New Accounting Standards' in 2006 was an era in the development of
derivative-related regulations in China as it was fully converged with the IFRSs
accounting and reporting practice for the use of derivatives which symbolised that the
disclosure of derivative-related activities was shifting from voluntary to mandatory
basis. The next chapter provides the research design regarding how to assess the
usefulness of derivative disclosures by Chinese listed companies and also discusses

the research methodology applied in the study.

100
 gy

101
 Introduction

This chapter describes the research methodology, methods and sample data selection
employed in the study. It is structured as follows: the argument of the research
methodology is firstly presented, followed by the discussion of research methods and

description of data collection. A summary is provided in the end.

4.2 Research

In logic, there are two broad methodological approaches to reasoning which may

result in the acquisition of lmowledge, namely inductive reasoning and deductive

reasomng

4.2.1 Deductive Methodology

Deductive reasoning starts from the 'general' to the 'specific' and is also called a

'top-down' approach It works as shown in Chart 4.1. It begins with

thinking of a theory about the topic. Then it is narrowed down to specific hypothesis

that can be tested. It needs to be narrowed down even further when the observation is

collected as to addressing the hypothesis. This ultimately leads to test the hypothesis
with specific data - a confimlation (or not) of the original theory. The deductive

perspective ' ... emphasises universal laws of cause and effect on an explanatory
framework which assumes a realist ontology; that is that reality consists of a world of

102
objectively defined facts' P 15). In the deductive

methodology, the researcher starts '... with an abstract, logical relationship among

concepts then move( s) towards concrete empirical evidence' 1

Thus in a deductive research, there is a well-established role for existing theory since
it informs the development of hypotheses, the choice of variables, and the resultant

measures which researchers intend to use. Within this paradigm the researcher

formulates a particular theoretical framework and then sets about testing it. Thereby,

deductive approach is defined as a theory testing process, which commences with an

established theory or generalisation, and seeks to examine whether the theory applies
to specific instances In deductive research, general conclusions are
presented based upon the corroboration or falsification of the hypotheses through

empirical tests 1 Deductive research

develops hypotheses before the testing and generalising the results and these

generalisations and discussions III light of prior knowledge constitute the new

knowledge 1 ).

The deductive approach has its own inherent advantages but also limitations. In

deductive studies, researchers are able to make use of previous study work (
1 However, as hypotheses are generated from prior theoretical knowledge

only, the novelty of the knowledge resulting from deduction is disputable

1931). Deductive study is only possible to examine whether or not, or to what extent,

the hypothesised relationships exist. It, therefore, cannot help researchers to identify

what other unanticipated factors such as contingent variables or new constructs may

exist

Chart 4.1 Deductive V.S. Inductive Approach

103
4.2.2 Inductive Methodology

The inductive research process can be described as the mirror image of the deductive

process 1 It works from observations towards generalisations and

theories, which is also called a 'bottom-up' approach As shown in

Chart 4.1, the inductive research commences from specific observations, followed by

looking for patterns, formulating hypotheses and finally ended up with developing

general theories or drawing conclusions. In other words, argumentation in inductive

process moves from a specific empirical case or a collection of observations to

general law, i.e. from facts to theory

following the pattern of case -result-rule

At the begilming of an inductive research, the knowledge of a general frame or

literature is not necessarily needed

Instead, empirical observations about the world lead to emerging hypotheses

and their generalisation through logical argumentation within a theoretical frame

Furthermore, induction aims to develop not test theory

104
 I; Following inductive research process, hypotheses

are developed on the basis of the empirical study instead of prior to observations
A classic inductive research process is how Sir Isaac

Newton reached to 'Law of Gravitation' from 'apple and his head'.

The inductive research methodology is a very easy tool to use as there is no

specialised knowledge, education or training required 2(06). The inductive

research can be assembled in a relatively short period of time without any great effort
or ability on part of the researcher However, the inductive study

is not by its nature intended for reconstructing a specific research targets situation as

the data is generalised from limited population samples and not specifically related to
anyone case. It is a generalised set of representations, averaged from a small group
who may or may not have been appropriately sampled, depending on the knowledge

an ability of the person collecting and assembling data Although

the generalisations in an inductive study can accurately predict some of the
non-distinguishing elements of a research situation, there is not with a great deal of

consistency or reliability

Generally speaking, inductive reasoning, by its very nature, is more open-ended and

exploratory, especially at the begilming. While deductive reasoning is more nalTOW in

nature and is concerned with testing or confirming hypotheses In

practice, both deductive and inductive arguments occur frequently and naturally. Both
forms of reasoning can be equally compelling and persuasive, and neither form is

prefelTed over the other I

4.3 Research l\lethodology Used in the Study

The current study follows the deductive research process, which starts with a strong

105
theoretical footing 1; and alms to test theoretical

knowledge that has been developed prior to empirical research

Critical reviews and analyses drawn from the existing

literature are the starting point of the research. The research literature about the

usefulness of derivative related disclosures (c.g.,

1 et 2002;
et

et 2007: contain numerous

discussions in relation to the association between corporate value and derivative

disclosures. The researcher built on key research questions and hypothesis from these

literatures. Then the quantitative (i.e., content analysis) and qualitative (i.e., interview) 'II

research methods were employed to gather, analyse and interpret data. As the data was

interpreted, research questions and hypothesis were ultimately answered and

examined. The study ends with extending the current research framework by

generating the new understanding of the value relevance of derivative disclosures in

the context of China-the largest emerging economy in the world .

. 4.4 Research Method

Research method is classified into two different types of approaches: quantitative and

qualitative. Much of the debates on the choice of research tend to revolve on the

choice between quantitative and qualitative methods. Qualitative and quantitative

methodologies refer to commitments to different styles of research, different

epistemologies and different forms of representation 1 ).

However, the decision on the choice of either quantitative or qualitative method relies

on three main criteria - (1) the purpose of the study (2) how the variables are

measured (3) how the information is analysed

106
The quantitative research usually concentrates on measurements and numbers. It aims

to study the association between variables in the population. It relates generally to

research that emphasises 'the measurement and analysis of causal relationships

between variables with inquiry ... purported to be within a value-free framework'

Quantitative methods entail 'the use of standardized

measures so that the varying perspectives and experiences of people can be fit into a

limited number of predetermined response categories to which numbers are assigned'

However, with standard quantitative designs 'there is an effort to

limit the role of personal interpretation for that period between the time the research

design is set and the time the data are collected and analysed statistically sometimes

thought of as a 'value free' period' 1 1). Such research strategy

emphasises the quantification in the collection and analysis of data; it therefore

generates numerical data or data which could be converted to figures while the

researchers remain distant and independent.

4.4.2 Qualitative Research l\-lethod

The qualitative method refers broadly to the 'research that produces descriptive data:

people's own written or spoken words and observable behaviour'

It concentrates on words and observations to articulate reality and

endeavours to describe people in nature and in natural situations et

In contrast to the quantitative research it produces non numerical data. It

employs to explore and understand people attitude and behaviour.

state that qualitative researchers 'study things in their natural settings,

attempting to make sense of, or interpret, phenomena in terms of the meanings people

bring to them.' They argue that this kind of research involves the studies that use
107
collection of a diversity of empirical materials such as case study; personal experience;

introspective; life story; interview; artifacts; cultural texts and productions;

observational, historical, interactional, and visual texts which describe routine and

problematic moments and meanings in individuals' lives.

There are much of debates concemmg strengthens and weaknesses of either

quantitative or qualitative research methods and some key views are summarised in
Table 4.1.

Table 4.1 Strengthens and Weaknesses of Quantitative and Qualitative Research

Method

Strengthens Weaknesses
a) It states the research problem in
very specific and set term a) It fails to distinguish people
and and social institutions from the
1992); world of nature;
b) Clearly specify both the b) There is an artificial and
independent and dependent spurious sense of precision
variables and Bell. 2003); and accuracy in the process of
c) It closely follows the research measurements;
goals, achieves more objective c) It blocks the connection
Quantitative conclusions by testing hypotheses between research and
Approach and finally determines the issues of everyday life due to the
causality and 20(3); reliance on instruments and
d) It contributes to eliminating or procedures;
minimising subjectivity of d) The results by examining
judgment and Protheroe. relationships between
1996); variables create a static view
e) It allows for longitudinal analysis of social life which is
of subsequent performance of independent of people's lives.
research subjects and
20(3).
a) Obtaining a more realistic feel of a) Departing from the original
the world that cannot be objectives of the research in
experienced in the numerical data response to the changing
Qualitative
and statistical analysis used in nature of the context
Approach
quantitative research and &
Bell. 20(3); b) Arriving to different
b) Flexible ways to perform data conclusions based on the same
108
 collection, subsequent analysis, information depending on the
and interpretation of collected personal characteristics ofthe
information (Bryman cmd Bell, researcher;
2(03); c) Inability to investigate
c) Provide a holistic view of the causality between different
phenomena under investigation research phenomena;
(Bogdan & 1975; d) Difficulty in explaining the
980); difference in the quality and
d) Ability to interact with the research quantity of information
subjects in their own language and obtained from different
on their own terms & respondents and arriving at
1986); different, non-consistent
e) Descriptive capability based on conclusions;
primary and unstructured data e) Requiring a high level of
and experience from the researcher
to obtain the targeted
information from the
respondent;
f) Lacking consistency and
reliability because the
researcher can employ
different probing techniques
and the respondent can choose
to tell some particular stories
and ignore others.

However, Stake ( 1995) divided the main differences between qualitative and

quantitative method into three areas. The first is related to the distinction between

explanation and understanding as the purpose of the inquiry. Quantitative researchers

are concerned with explanation as the main purpose of the inquiry, while qualitative

research is mainly interested in understanding the complex interrelationships between

different variables. The second area is associated with the distinction between

knowledge discovered and knowledge constructed. Proponents of qualitative

researchers believe that knowledge is constructed rather than discovered, while,

qualitative researchers see this methodology as a useful tool to expose actors'

meanings and interpretations. The third major difference between qualitative and

quantitative methodologies is about the distinction between the personal and

109
impersonal role of the researcher. The influence of researchers on the research setting

is limited in quantitative studies while it is more recognised in qualitative ones.

4.5 Research Methods Used the Study

This study employs more than one type of approaches to achieve its objectives. Both

quantitative (i.e., content analysis) and qualitative (i.e., interview) were utilised in this

study. Content analysis method is mainly employed in the first stage as the technique

is widely adopted by vast of researchers (e.g.,

et

ct to address the

information quality of derivative disclosures reported by quoted firms. Interview

approach is adopted in the second phase so as to gain some insight of market

participants concerning the usefulness of derivative disclosures provided by Chinese

listed companies. Such a combination of methods ensures the validity and reliability

of the research.

4.6 Content Analysis

Content analysis method was employed in this study as the first research approach in

order to collect quantitative data on derivative related disclosures via the annual

reports of Chinese listed companies. The popUlarity of content analysis comes as it is

a powerful tool that has been used in the analysis of documents and texts that seek to

quantify content in terms of predetermined categories and in a systematic and

replicable manner It has been stated that content analysis

is considered particularly helpful in exploratory research, where there may be no set

of theoretical perspective being adopted, or where there is no need to make

110
generalisation 1). According to ), content

analysis can be used to extract data from a wide range of communications media.

(1952, 1985) pointed out many purposes where content

analysis can be used as following:

• Disclose international differences in communication content;

• Compare media or 'levels' of communication;

• Audit communication content against objectives;

• Code open-ended question in surveys;

• Identify the intentions and other characteristics of the communicator;

• Describe attitudinal and behavioural responses to communications;

• Reflect cultural patterns of groups, institutions, or society;

• Describe trends in communication content.

4.6.1 Definition of vu"", ..u Analysis

A number of definitions of content analysis have been propounded. H:{->,''''!(:''; (1952)

state that content analysis can be used to objectively, systematically, and

quantitatively describe the manifest content of communication. (1977,

defines it as 'a scientific, objective, systematic, quantitative, and generalisable of

communication content' . (1 define content analysis as

a 'technique for gathering data that consist of codifying qualitative information in

anecdotal and literary form into categories in order to derive quantitative scales at

varying levels of complexity'. The above definitions highlight a need for quantitative

description of data. However, (1 1) shift the emphasis by defining

content analysis as 'a research technique for making replicable and valid inferences

from data to their context' . (1 define it as 'a methodology that utilizes

a set of procedures to make a valid inferences from text' .

111
define it as 'summarizing, quantitative analysis of messages that relies on the

scientific method (including attention to objectivity-intersubjectivity, a priori design,

reliability, validity, generalizability, replicability, and hypothesis testing) and is not

limited as to the types of variables that may be measured or the context in which the

messages are created or presented'. More recently, K"",'nv~ state that

content analysis is an approach to the analysis of documents and texts (printed or

visual) that seeks to identify content in terms of predetermined categories and in a

systematic and replicable manner.

Having reviewed the definitions mentioned above, it is apparent that there is a

consensus among researchers that an essential purpose of content analysis is to make

inferences from the message (textual or spoken). Content analysis aims to analyse

language or the text by reference to incidence with certain pre selected recording unite.

A number of researchers (e.g.. 1

985; 1: have discussed

the advantages of conducting a content analysis as follows:

• Content analysis is unobtrusive, neither the sender nor the receiver of analysed
messages is aware that the messages will be analysed 1991 );

• Content analysis of various types of documents produced on regular scheduled

basis presents an opportunity to develop longitudinal data bases I 1);

• Content analysis allows the researcher to work directly on a core human and

organisational behaviour-communication 1985);

• Content analysis may facilitate researchers of differing methodological and

theoretical persuasions to work together thus potentially contributing to the

convergence of theoretical and empirical perspectives );

• Content analysis analyse naturally occurring language which has advantages over

numerical analyses for understanding and describing many organisational

phenomena

• Content analysis facilitates linking summary statistics to natural language thus

112
 resulting in research outcomes having face validity and meaning to everyday

actors as well as scientists 1

• Content analysis research method is transparent as the coding theme and the

sampling procedures can be clearly conducted, which enables the feasibility of

replications and follow-up studies 2007);

• Content analysis is highly flexible because it can accept a wide variety of kinds of

unstructured material 1

4.6.2 Core Steps of Content Analysis Method

According to (1985), the researcher initially has to identify the research

question to be investigated. The first research question for the current study is 'What

is the level of derivative related disclosures made by Chinese listed companies? '. In

seeking to answer this question this study compares the practices of derivative

disclosures by non financial institutions listed on Chinese equity market with core

provisions required by mandated disclosure regulations. There are six essential steps

or processes in any content analysis studies . 1985; 1 which include

first, determine the sampling units; second, determine the recording unit; third,

determine the categories to be coded; fourth, determine the coding mode; fifth, test

coding on sample of text; sixth, assess reliability and validity.

4.6.2.1 Sample Units

In this stage of content analysis a decision needs to be decided concerning the source

of document to be analysed (data source) 2000). Deciding which

documents is to be analysed is an essential stage in any content analysis study

). The great majority of the studies in this field of research has

113
employed the annual report as data source and accepted it as an appropriate source of

a company's attitudes towards derivative accounting and reporting as the annual

report is generally considered to be the most reliable source of information about

corporate activities Deegan 1997). In this regard, et

state: 'The annual report is used as the principal focus of reporting.

There is some justification for this. The annual report not only is a statutory document,

produced regularly, but it also represents what is probably the most important

document in term of organisation's construction of its own social imagery' .

In this accounting literature, proponents of the use of the annual report (e.g.,

1 1

2003) argue that it is considered virtually impossible to identify all

corporate communications on social activities conducted by companies over a long

period of time, and it is therefore not sure how complete non annual report data are

state that the annual report is most

effective means of communication and possesses a degree of credibility not associated

with other forms of advertising. However, there is some recognition in the literature

that this focus on the annual report may not give a full picture of companies' reporting

practice 1992; For example, et

state 'disclosure of social information in the annual report represented a small

proportion of the company's total social reporting'.

examine corporate brochures and advertisements along with annual reports and found

that firms did communicate social and environmental information through other

media. However, Naser point out that in developing countries,

other disclosure channels (e.g., Internet; press releases) are oflittle use to most

companies, and it is very likely to see most of information presented in the formal

annual report. Accordingly, this study will focus on the annual report as a source of

text so as to keeping with the majority of the literature in this field of research

114
4.6.2.2 Determine Recording Unit

The coding unit determines how content is measured or defined 1977;

1 2003; and in other words how the data is to be

captured and measured. In the accounting literature, empirical research chooses

between two alternative paths through which content analysis has been used to date,

namely the number of disclosures and the amount of disclosures et 1995b).

The former focuses on 'the attribution of the incidence on an event as indicated by the

mention of the event under question in the literary document.. ... the resulting scale

varying between zero and the number of attributes being investigated'

The latter quantifies the volume of disclosure using either

words, sentences or pages to different themes. The empirical investigation in

derivative disclosures literature has attempted to capture either incidence or amount.

With respect to the measurement of the extent of disclosure in the reports, there have

been two methods used either through the weighted disclosure approach or the

un-weighted disclosure approach. The weighted one

ot " 1 et is based on the perceived

importance of any disclosure item varies from company to company, industry to

industry and time period to time period' In this study, the

disclosure items were not weighted mainly due to the consideration of the potential
score biases and scaling problems of weighting.

Defining the recording units is one of the most fundamental and important decisions
in the process of content analysis (Weber, 1985). A number of different coding units
have been used in previous investigations that have employed content analysis and
some examples are listed on 'fable 4.2.

Table 4.2 Coding Units Employed by Prior Studies

Pages and Numbe High/Low

Word Sentence Frequencie
Studies Proportion r of Disclosur
s s s
s of A Page Lines e

116
 *

*
*

The most common and preferred units of analysis tend to be 'words', 'sentences' and

'pages' etaL 1 Nevertheless, there is no single accepted unit of capturing

data in content analysis and each has its own pros and cons. Although counting
'words' may provide a precise measure, individual words have no meaning to provide

a sound basis for coding disclosures without a sentence or sentences for context.

Therefore, the extra precision that might be gained is unlikely to add to understanding
). Although the measurement in sentences may be carried out

with greater accuracy than measurement in proportions of a page

the former is likely to give less relevant results than the latter

as it seems to 'ignore the possibility that differences in use of grammar might result in
117
two different writers conveying the same message by using a similar number of words

and taking up a similar amount of space but using a different number of sentences'

p675). In addition, words and sentences are smaller and more

numerous as a unit of measurement compared to sentences, thus, using 'words' or

'sentences' is more time consuming and costly, especially when contemplating a large

sample. et (1995) and (l summarised the debate

concerning the most suitable coding unit for content analysis and they concluded that
pages and the proportion of a page devoted to a particular topic was the preferred

coding unit, as this measurement reflected the amount of space given to the issue and,
by inference, the importance of that issue to the preparer of the document { et

995; and 1 This coding unit was, therefore, employed in the

current research.

4.6.2.3 Determine the Categories of Disclosure

A precise classification and definition of disclosure categories is essential for any

content analysis research 1977: 1 1

indicate that the categories defined are a description of

what has happened in the past years, as well as a benchmark to evaluate the changes

and progress in reporting. The development of explicit decision rules relating to each

category is necessary in order to ensure mutually exclusive, exhaustive and

independent categorisation of all derivatives related disclosures

ct The categorisations need to possess 'shared

meanings' ( et 1995, p85) and the data collection and analysis must be capable

of replication, in order to satisfy criterion for reliability. For these

reasons, this study develops a checklist instrument - Financial Derivatives

Disclosures Index (FDDI) (as sho'wn in Appendix I) describing the categories of

derivative related disclosures. It is mainly based upon IFRS and lAS derivative

118
related provisions which are different from many indices used in the existing literature
largely on the basis of U. S. reporting requirements, since Chinese regulators have
enhanced the convergence of its accounting and reporting policies with IFRS and lAS
regulations in recent years.

As shown in Appendix I, the themes in FDDI were expressed by asking questions

where the definitions and classifications utilised with the 7 'Financial
Instruments: Disclosures', 32 'Financial Instruments: Presentation' and
'Financial Instruments: Recognition and Measurement' were employed. 7
classifies the required disclosures into two categorisations. These categories were
chosen as the basic structure for the content analysis, because Chinese listed
companies would be most likely to use this structure for their reporting practice. In
addition, the categories were 'externally determined' by the IASB and should thus
provide an objective basis for the analysis. This selection procedure resulted in two
categories: first, the information about the significance of financial instruments for the
entity's financial position and performance; second, the information about the nature
and extent of risks arising from financial instruments to which the entity is exposed

during the period and at the reporting date, and how the entity manages those risks.
Further breakdown of the items to be included under the two broad category headings
mentioned in the standard was determined by the classifications included within the
standard. As a result, there are total of 24 items/questions within the disclosure
checklist which includes 23 derived from subheadings under the major disclosure
categories required by IFRS 7 and one extra question - Q24 'Does the firm provide
other disclosures related to their use of derivative instruments?' with the aim to
measuring such voluntary derivative disclosures not required by IFRS and lAS

accounting and reporting provisions reported by companies.

119
4.6.2.4 Determine the Code Mode

There are two types of coding mode: first, coding by human; second, coding by

computer. The computer based interpretation has its advantages such as the speed,

minimum error, and formally comparable results 199 However, it is decided

to focus on the human interpretation in this research as the computer can only provide

explicit data due to the complexity for the computer to pick up on implicit or tacit

meanings, or themes 1 1). In addition, given the nature of Chinese words,

computer has some difficulties to recognise the true meanings of Chinese words as a

combination of Chinese words can lead to many different meanings.

4.6.2.5 Test Coding on Sample of (Pilot Test)

Testing a sample of documents as a pilot study prior to conducting the main content

analysis shall give the researcher practical experience that may add to increase the

reliability of content analysis results In addition, this practice will

make the researcher to become more familiar with the process of content analysis.

Random annual reports were chosen and analysed to ensure the usability of the

framework. The researcher then analysed the content of annual reports of five

surveyed companies as a part of pilot work which completed prior to gathering data

for this study. The reports were coded based on the initially selected and defined

content categories. Throughout the pilot work, difficulties concerning, inter alia, the

interpretation of the decision rules were noted and clarified. Solutions were discussed

with the supervision team and other academics whose have previous experience in

using content analysis.

120
4.6.2.6 Assess Reliability and Validity

Reliability and validity refer to a measuring procedure, which provides the same
results on repeated trails 2002). In other word, reliability and validity are

determined to ensure that different researchers will code the text in the same way and

therefore diminish the chance for inaccuracy and biases. describes

reliability as the extent to which a test or procedure produces similar results under
contrasting conditions on all occasions. According to there are
three types of reliability for content analysis which are stability, reproducibility and
accuracy as shown in Table 4.3.

Table 4.3 Types of Reliability

Type of Reliability Relative

Errors Assessed
Reliability Designs Strengths
Stability Test-retest Intra-observer inconsistencies Weakest
Intra-observer inconsistencies and
Reproducibility Test-test
Intra-observer disagreements
Intra-observer inconsistencies; Intra-observer
Accuracy Test-standard disagreements and systematic deviations from Strongest
a norm
Source: Krippend0l1TfI9S{J, pi 31)

Stability refers to the ability of a judge to code data the same way over time and it is

the weakest form of reliability tests Reproducibility refers to

inter-rater reliability ). It reflects on the measurement of the

extent to which coding is the same when using different coders High

reproducibility is the minimum standard for content analysis Accuracy

involves the assessment of coding performance against predetermined standard 18

). ( 985) argue that there are no

identified standards for disclosures and therefore, no correct performance or measure.

Thus, to ensure the strong form of reliability in this study, it was vital to include

reproducibility and stability.

18 The predetermined standards could be employed in prior studies or set by expert researchers.
121
The reliability of the coding decisions on a pilot sample could be shown to have

achieved an acceptable level before the coder is permitted to code the main data set. A
few steps listed as follows were taken to ensure the research's reliability:

Firstly, coding instruments with well instructed decision rules have been well
specified and developed so as to minimise discrepancies and fulfil objectivity19.

Secondly, the researcher, 'main coder', has undergone an extensive period of

educating and training prior starting the process of analysing in order to have a
better understanding of the subject.

Thirdly, five annual reports were examined by different coders 20in a pilot test in

order to ensure reprodUcibility. Ambiguities were discussed with the researcher with

the aim to ensure that all coders used the same coding rules and any points made were
used to develop the framework of the analysis.

Fourthly, each step in the research process must be fulfilled on the basis of explicitly
formulated rules and procedures. Moreover, any definitions used in the data gathering
must be negotiated to realise these 'shared meanings' which recreate 'the same
referents in all the associated investigators' et 1

Fifthly, a few annual reports analysed by the researcher, were those which were
analysed during the pilot test. This procedure was undertaken in order to ascertain if
the initial categories identified and their measurement have been remained stable at
different times (stability). The result was almost stabilised.

19 The requirement of objectivity stipulates that the categories of analysis be defined so precisely that different
analysts might apply them to the same body of content and secure the same results (Berdson, 1952).
20 Two independent researchers who had years of doing research in accounting and reporting (e.g., corporate
social responsibility and environment reporting) and were familiar with the use of content analysis were employed
in this research as multiple coders.
122
 states that apart from being reliable, the data collected must be

valid. In this regard, ) argues that objectivity implies that all decisions are

guided by an explicit set of rules that minimise (but never quite eliminate) the

possibility that the findings reflect the analyst's subjective predispositions rather than

the content of the documents under analysis. To enhance validity, explicitly

formulated rules and procedures were applied. The agreement between the researcher

and other coders on the categorisation of the text, as mentioned earlier, indicates that

the procedure utilised in the categorisation is valid.

4.6.3 LU1lua1mm of Content .Analysis

Like all research techniques, the content analysis suffers from certain limitations,

which, for instance, have been discussed by as follows:

Firstly, a content analysis can only be as good as documents on which the practitioner

works. When a content analysis is being conducted, it is especially important for the

researcher to carefully assess whether or not the documents are authentic, credible and

representative.

Secondly, it is difficult to answer the 'why' questions by using the content analysis.

The method can only be employed to measure the importance of particular issue to the

preparers of documents, but it is impossible to provide the answers to why that issue

is important to documents.

Thirdly, content analytic studies are sometimes accused of being theoretical. The

emphasis in the content analysis on measurement may easily result in being paid more

focus on what is measurable rather than on what is theoretically significant or

123
important.

4.7 Interview

The interview 'is a conversation, usually between two people. But it is conversation

where one person: the interviewer is seeking responses for a particular purpose from

the other person: the interviewee' 35). The interview has been

strongly claimed to be one of the most widely used methods of research

1 ). It is probably the most popular method employed in qualitative research

2003). The aim of the interview is to gain in-depth information that

could be difficult to acquire via other methods As a matter of fact that

the sample of this research is considered to be low, it is, therefore, more likely that

other types of data collection such as questionnaires would not be suitable in this

study. In addition, (2005) argues that interviews provide an opportunity to

understand meaning held in unarticulated way by the subjects interviewed. ct

al. argue that the interview enables researchers to assess questions not suited to

quantitative analysis and can provide some new explanations that have not been

discussed in the prior studies.

4.7.1 Interview

Interview can be structured, semi-structured or unstructured. A structured interview

intends to capture precise data of a codable nature in order to explain the behaviour

within pre-established categories In

contrary, an unstructured interview aims to understand the complex behaviour of

members of society without imposing any prior categorisation that may limit the field

of inquiry A semi -structured interview lies between the structured and

124
unstructured interview. It is a process in which there are no formal questions, and

instead, a series of topics usually introduced from a checklist, and will be discussed in

any order that seemed natural during the interview

1, argues that semi-structured interviews are employed
when informants' responses cannot be predicted in advance, and the interviewer may

to greater extent have to modify the procedure of the interview in response to the

respondent's replies to the initial prepared questions.

Semi-structure interviews are adopted in the second stage of the current research

because they allow space for discussion and encourage the participants or interviewee

to raise and elaborate on important related issues, in their own terms attitude and
experience that are relevant to the research questions In addition,

semi-structured approach appears to be friendlier and less intimidating

Furthermore, to improve data quality this study employed the
face-to-face interview to attain the highest response, establish rapport, and motivate

the respondent to answer fully and accurately et aL 1 1).

4.7.2 Limitations of Interview

It is recognised that the interview has its limitations that researcher should be aware of,

such as poor recall, inaccurate articulation and researcher bias (

et In addition, the interviewee's answer may not be reflection of his

or her own belief or idea but tend to give the answer that would suit the interviewer

expectations or desires et al., I). In this regards,

1) state 'as a form of conversation, interviews are subject to the same fabrications,

deceptions, exaggerations, and distortions that characterise talk between any person.

Although people's verbal accounts may lend insight into how they think about the

world and how they act, there can be a discrepancy between what they say and what

125
they actually do'. However, in order to overcome such limitations in interviews,

) suggests the corroboration of interview data by information from other sources,

which was undertaken in the present research by combining two methods of data

gathering (i.e., interview data and content analysis data).

4.8 Data Collection and Description

This section describes the data selection for both stages of the study. It provides a
discussion about the sample selection procedures which cover descriptions of the

sample selection process, selection of the sample period and justifications for the

selection of the sampled firms and interviewees.

4.8.1 Companies Selection for Stage One

4.8.1.1 Sample Selection Process

Financial institutions are excluded from the analysis as the study only focuses on

derivative activities reported by non-financial entities. Annual reports of Chinese

listed companies in 2006 are considered as the sampling unit for observation and
analysis. Companies' annual reports are obtained from the Internet and in order to

ensure the validity of the data, only those official websites, such as the websites of

SHSE and SZSE, as well as the authorised securities markets' data providers, like the

China Securities Index Company Limited (CSI Co., Ltd) and luchao Information, are

considered as the figures or reports posted on them are deemed much more reliable.

126
All sample companies are selected from the Chinese Securities Index (CSIi l 100 and

200 representing large and medium firms in terms of market capitalization in Chinese

domestic A-share market as evidence (e.g., et 1

shows that the large compames are more likely to use

derivative products. The process of choosing sample companies can be divided into

two stages:

Firstly, I carefully checked annual reports produced by every CIS 100 entity and

found 39 non-financial firms which used derivative instruments in 2006.

Secondly, 100 randomly22 chosen non-financial CSI 200 companies' reports were

scrutinised so as to provide some indication about reporting by medium size

organizations and the total of 14 listed firms disclosed that they got involved in

derivative business in 2006.

In order to identify whether the company used derivative products, I adopt the 'word

search' function of Adobe Reader. The key words to be searched and the reasons for

choosing them are listed in Table 4.4. By using the 'word search' function, all of the

eleven key words in Table 4.4 have been searched for every annual report. If one of

them has been found in the document, I carefully read the paragraphs where the word

located and make a judgment whether the company got involved in derivatives

21 The CSI Co., Ltd, ajoint venture between the SHSE and SZSE, is a professional business entity specialising in
the creation and management of indices and index-related services. The company produces a series of CSI indices
including CSI 100, 200, 300, 500 and 700 as well as other tailor made indices such as CSI Sector Indices, CSI
Style Indices, CSI Thematic Indices, CSI Strategy Indices, CSI Overseas Indices, CSI Fund Indices, CSI Bond
Indices, CSI Customised Indices and CSI Futures Indices. CSI 100 consists of the top 100 stocks with the largest
market value in CSI 300 aiming to comprehensively reflect the price fluctuation and performance of the large and
influential companies in Shanghai and Shenzhen securities market. CSI 200 consists of all 200 stocks that are
non-constituents of CSI 100 in CSI 300 index.CSI 200 aims to comprehensively reflect the price fluctuation and
performance of the mid-cap companies in Shanghai and Shenzhen securities market (CSI Co .• Ltd. 20 to).

22 The process of random sampling is as follows:

1. Number each company listed on the CSI 200 table from 1 to 200.
2. Label every number between 1 and 200 on an individually small paper card. Drop all two hundred cards into
a box and shake it as to make them mixed.
3. Pick up one card at once and mark the chosen number. Total one hundred cards were drawn out.
4. Find out companies on the CSI 200 table corresponding to the selected numbers and finally get 100 sample
firms.
127
business. If the reporting company clearly mentioned the use of derivatives, it will be

selected as a sample firm; otherwise, the company is not chosen into the sample, if

none of the key words have been found or it did not mention the use of derivative
instruments.

Table 4.4 Key Words to be Searched

KeyWords Reasons
Financial Under the lAS framework, the derivative is a type of financial
Instruments instruments
Financial lAS 39 adopts the full-fair-value measurement that all entities must
Assets recognise all financial instruments, including derivatives, as assets or
Financial liabilities on the balance-sheet and measure those instruments at fair
Liabilities value, and changes in the derivatives fair value are to be recognised
in the current earnings unless specific hedge accounting criteria are
Fair Value
met.
Derivatives
Futures
Warrants By scrutinising hundreds of annual reports, I find that commodity
Convertible futures, warrants, convertible bonds and foreign currency swaps are
Bonds the most popular derivative products used by Chinese listed
Foreign compames.
Currency
Swaps
IFRS 7 requires that, for each type of risk arising from financial
instruments, an entity shall disclose:
a) the exposures to risk and how they arise;
Risk
b) its objectives, policies and processes for managing the risk and the
methods used to measure the risk; and
c) any changes in 33(a) or (b) (see above) from the previous period.
Following the provisions ofIFRS 7, an entity shall disclose the
following separately for each type of hedge described in lAS 39 (i.e.
fair value hedges, cash flow hedges, and hedges of net investments in
foreign operations):
Hedging
a) a description of each type of hedge;
b) a description of the financial instruments designated as hedging
instruments and their fair values at the reporting date; and
c) the nature of the risks being hedged.

The process results III a final sample of 53 compames III 2006 which can be

128
categorised by:

Size - 39 from CSI 100 and another 14 from CSI 200 representing large and medium
size firms respectively as shown in Table 4.5.

Table 4.5 List of Sample Companies

CSI 100 Companies CSI 200 Companies

ANHUI JIANGHUAI
AIR CHINA LIMITED
AUTOMOBILE CO.,LTD
NANJING WATER
ANHUI CONCH CEMENT CO., LTD TRANSPORT INDUSTRY
CO.,LTD
BAOSHAN IRON &STEEL CO., LTD QINGDAO HAlER CO., LTD
BEIJING CAPITAL CO.,LTD TBEA CO.,LTD
BEIJING GEHUA TV NETWORK, INC
CHINA SHIPPING DEVELOPMENT
CO., LTD
CHINA SOUTHERN AIRLINES CO.,
LTD
CHINA UNITED
TELECOMMUNICATIONS
CORPORATION LIMITED
CHINA YANGTZE POWER CO., LTD
SHSE GD POWER DEVELOPMENT CO., LTD
GUANGXI GUIGUAN ELECTRIC
POWER CO.,LTD
GUANGZHOU BAIYUN
INTERNATIONAL AIRPORT CO., LTD
HANDAN IRON & STEEL
CO.,LTD
HUADIAN POWER INTERNATIONAL
CORPORATION
HUANENG POWER INTERNATIONAL,
INC
INNER MONGOLIA BAOTOU STEEL
UNION CO.,LTD
JlANGXI GANYUE EXPRESS
CO.,LTD
JlANGXI COPPER CO., LTD
KWEICHOW MOUTAI CO., LTD
129
 MAANSHAN IRON & STEEL CO., LTD
SHANGHAI AUTOMOTIVE CO.,LTD
SHANGHAI ELECTRIC POWER CO.,
LTD
SHANGHAI INTERNATIONAL
AIRPORT CO., LTD
SHANGHAIZHENHUAPORT
MACHINERY CO.,LTD
SINOCHEM INTERNATIONAL
CORPORATION
TSINGTAO BREWERY CO., LTD
WUHAN IRON AND STEEL CO., LTD
YANTAI WANHUA POLYURETHANES
CO.,LTD
ANHUIBBCA
ANGANG STEEL CO., LTD
BIOCHEMICAL CO., LTD
CHINA MERCHANTS
BEIJING YANJING BREWERY
PROPERTY DEVELOPMENT
CO.,LTD
CO., LTD
CHINA INTERNATIONAL MARINE
CSG HOLDING CO.,LTD
SZSE CONTAINERS (GROUP) CO., LTD
HEBEl JINNIU ENERGY
CHINA VANKE CO., LTD
RESOURCES CO., LTD
CHONGQING CHANGAN SHANDONG CHENMING
AUTOMOBILE CO., LTD PAPER HOLDINGS LIMITED
HUNAN VALIN STEEL TUBE & WIRE SHANDONG HAIHUA CO.,
CO., LTD LTD
SHENZHEN ZHONGJIN
PANZHIHUA NEW STEEL &
LINGNAN NONFEMET CO.,
VANADIUM CO., LTD
LTD
QINGHAI SALT LAKE POTASH CO., YUNNAN ALUMINIUM
LTD CO., LTD
SHENZHEN ENERGY INVESTMENT
YUNNAN COPPER CO.,LTD
CO., LTD
TCL CORPORATION YUNNAN TIN CO., LTD
WULIANGYE YIBIN CO.,LTD

Listing exchange - 32 listed on SHSE and the remaining 21 on SZSE as shown in

Table 4.2.

Industries - The sample firms are operated in 14 different industries as shown in

130
'fable 4.6. The Metal & Nonmetal industry with the largest number of 16 companies

takes nearly a third of the total sample, followed by the industries of Transportation &

Warehousing (7), Machinery, Equipment & Meter (6), Electricity, Gas, Water

Producers & Suppliers (6), Food & Beverage (5), Oil, Chemical & Plastic (3), Real

Estate (2), Social Service (2), and the industries of Broadcast & Culture, Electronics,

IT, Mining, Paper Making & Pressing, Wholesale & Retail with the only one

respectively have the least sample firms. It is quite interesting that compared with

other non-financial organisations, the metal enterprises seemed to be more active to

use derivative instruments in 2006. Regardless the incentives of using derivatives, I

think the availability of derivative instruments in China's securities markets is one

possible reason to explain such situation. As discussed in Chapter III, China only had

three commodity futures markets in 2006 and the metal and industrial materials like

aluminum, copper and zinc were centrally traded on SHFE. There were more

derivative products for metal companies to choose and they were therefore more

likely to get involved in derivatives' trading.

Table 4.6 Sample Companies Categorised by Industries

Industries N os of Companies
Broadcast & Culture 1
Electricity, Gas, Water Producers & Suppliers 6
Electronics 1
Food & Beverage 5
IT 1
Machinery, Equipment & Meter 6
Metal & Nonmetal 16
Mining 1
Oil, Chemical & Plastic 3
Paper Making & Pressing 1
Real Estate 2
Social Service 2
Transportation & Warehousing 7
Wholesale & Retail 1

131
4.8.1.2 Factors Considered Companies Selection

1. Why choose companies listed on A not B shares market in the sample?

China's equity shares are listed in terms of A shares (known as domestic shares), B
shares (known as foreign shares) and H shares (referring to the quoted shares of
companies incorporated in mainland China that are traded on the Hong Kong Stock
Exchange). The A and B shares are major types of equities traded on both SHSE and
SZSE. The key distinction is that the A share is denominated in China's local currency
- RMB whereas the B share in foreign currencies (US dollars in SHSE and Hong
Kong dollars in SZSE). For a long period, the A shares market was merely open for

Chinese residents and closed to foreign investors while the B shares market was only
to foreign investors due to the regulatory restriction. However, when it comes to the
21st century, especially after China's accession to the World Trade Organisation
(WTO) in 2001, China's stock market started to relax the restrict capital control and

open its domestic market to the foreign investors. In February 2001, China
implemented plans to allow domestic Chinese residents with authorised
foreign-currency accounts to legally purchase the B shares. In November 2002, China
published the regulations to permit the Qualified Foreign Institutional Investors (QFII)
with authorised local-currency accounts to invest in the domestic equities. Some
companies list their equities on both boards, but their B shares trade at a large
discount to their A-shares, which tend to see much larger trading volumes
Compared with the B shares market, the A shares market is greater huge in terms of
numbers of listed companies and the market size as shown in Table 4.7. In the end of
2006 focused by the research, the number of companies listed in the A shares market
was over ten times larger than those in the B shares market while the market value of
the A shares market was almost twenty folders bigger over that of the B shares market.
Hence, the study chooses companies listed on the domestic A shares market as sample
units so as to provide a picture of the disclosure of using derivatives by firms quoted
132
on the main China's stock market.

Table 4.7 China's A and B Shares Market Overview

Year N os of Listed Companies Market Value (Billion RMB)

A Shares B Shares A Shares B Shares
Market Market Market Market
2002 1113 111 1171.9 76.6
2003 1176 111 1230.6 87.3
2004 1267 110 1099.8 69.0
2005 1272 109 1002.8 60.2
2006 1325 109 2373.1 127.2
2007 1441 109 9052.7 253.8
2008 1516 109 4441.9 79.5

2. Why emphasise on the year of 2006?

China was a centrally planned economy that developed a number of features designed
to maintain the central control by the government. Various share ownership types
have been created in a shareholding enterprise and among them the state shares, legal
person shares and A shares are most dominant. Both the state shares and legal person
shares are state-controlled and they have some commonalities. Firstly, they are
usually owned by the government. The state shares are exclusively owned and
managed by the government asset management bureaus and the legal person shares,
on the other hand, are held by domestic institutions and other non-individual entities,
such as state-private mixed companies and non-bank financial institutions et
Although those entities commonly have mixed ownership structure with both
the state and private stakes, they are usually indirectly controlled by the government

in fact. A dataset created by comprising of Chinese quoted

companies during the periods 1991 - 2001, illustrates that the government-related

organisations owned 81.5 per cent of total legal person shares. Secondly, the state and
legal person shares are not legally tradable which is distinct with the A shares. The
state-owned shares can only be transferred privately to other government agencies,

133
legal entities, and foreign investing firms subject to state approval

Thirdly, the state-controlled shares take the majority of shares III most listed

companies. In a database assembled by et which covers listed firms in

SHSE in the end of 2004, the state and legal person shares averagely took 60 per cent

in a company's total shares. The government-centrally-controlled ownership usually

creates several problems as follows:

Firstly, the government political interference distorts and misleads the entity's goal to

maximise shareholders' wealth as the government may pursue objectives that do not

necessarily aim to maximise the company's value which is to some extent in conflict

with the expectation of holders of the A shares (Gupta, 2002; Jiang et aI., 2008).

Secondly, the state ownership often leads to the lack of managerial discipline and

incentives that may result in low efficiency of state owned enterprises (SOEs)

et 1 1 1996: 2002).

Thirdly, the corporate control would only be in the hand of the government but may

not be converted to other private owned businesses by conducting takeovers as the

majority of total shares are non-tradable (Jiang ct aI., ).

Such problems triggered the Chinese government to conduct a series of shareholding

reform. The state has a goal of achieving greater economic efficiencies by establishing

a 'modem enterprise system' et 20(2) that led to the privatisation of small

and large SOEs since the late 1990s ct 1). The

development of the shareholding reform can be divided into two stages as follows:

a) Reforms before 2005

The shares reform of enterprises in China has begun with small and medium SOEs

since the late 1990s. The privatization of small and medium companies was carried
134
out by the change of state owned to employee owned enterprises, or the sale of large

shares to a small number of parties like managers In December

1999, the government deliberately picked ten companies with stable and high profits,

to start selling off their state owned shares. The sale of shares was mainly for the
23
immediate purpose of covering the gap in the social security system

Two companies -China Jialing Industry Co., Ltd (Group) and Guizhou Tyre Co., Ltd,

were firstly selling their state owned shares. However, only 80 per cent of the shares

were sold because their shares were priced close to market value despite their

excellent performance (Bengtsson, Since the result of the reform did not

achieve the government's expectation, it had to be suspended before the other eight

companies had started selling (CSRC

In June 2001, a new shares reform took off and 16 listed SOEs were selected this time
to sell their state owned shares to the public. The income from the selling of state

owned shares was supposed to cover social security funding as well 2007).

But the equity market shrank 30 per cent as investors seriously concerned about the

possible decrease of the market value as a result of supplying more trading shares and

the reform was abandoned like the 1999's

b) Reforms since 2005

In February 2004, the State Council issued guidelines to facilitate the shareholding
reform of selling state owned shares. CSRC, the State-owned Assets Supervision and

Administration Commission of the State Council (SASAC), and MOF were

responsible for supervising the reform and guiding companies to sell state-owned

shares. CSRC announced the initiation of the shareho1ding reform in April 2005 and

four listed SOEs were chosen as the experimental examples for the privatisation in

23 Since 1997, the government has been working on reforming the social security system in line with selling state
owned shares in state owned enterprises. Back then, the government had just changed the retirement system from
pay as you go to official funding, and needed cash to fill up the gap representing workers that had not participated
in the pay as you go system !B<:nglsson, 20(5).
135
May 2005 In order to protect minority investors, CSRC ruled that two

thirds of the owners of tradable shares must vote in favour of a decision for it to be

accepted. In early June, share prices of the stock market fell to the lowest level in

eight years. In response, the CSRC issued a new regulation on 16 June to urge

companies to buy back their own shares. On 17 June they introduced a lower limit on
ratio of shares to stop the share price from falling even lower and then 42 companies

were chosen for the second part of the reform on 20 June, and this time lessons were
learned from the first part of the reform 20(5). On 26 August 2005,

CSRS announced a draft of ruling all companies listed on the exchanges to be

privatized and companies involved in the reform would receive the preferential

treatment by authorities. On 4 September, the draft became to the formal regulation -

The Administrative Measures of the Shareholding Reform by Listed Companies
('Measures 'thereafter), and 40 companies announced that they would participate in

the reform , 2(07). The Measures state that shareholders owning more than

five percent of former non-tradable stock may sell their shares after a twelve month
lock up period. From the date that the implementation plan is accepted, the

shareholders that are entitled to sell have to wait twelve months, and after that period

is over they may sell a maximum of five percent of the total shares in the listed

company during the first twelve months. During the first twenty four months they

may sell a maximum of ten percent of the total share value in the listed company.

These are minimum regulations, and the companies may very well decide to prolong

the suggested period before the state is allowed to sell their shares 2(05).

The shareholding reform was initially resisted by most of investors as they worried

about suffering huge losses as a result of depression stock prices caused by the

dramatic increase in the supply of freely tradable equities ( When

the state owned shares become tradable, holders of the former non-tradable shares

gain money by selling them, by contrast, holders of tradable shares often have to see

the value of their shares decrease, because there is a larger supply of shares on the
market. The government therefore decides to compensate holders of floating equities
136
so as to encourage the privatisation reform. Under that circumstance, CSRC allowed
some firms to complete the shareholding reform by issuing warrants as a way to
compensate their public investors. Take Baoshan Iron & Steel Co., Ltd for instance,

the company's compensation plan to investors holding tradable shares are as follows:

The owners of non tradable shares will give the owners of tradable shares 2.2
shares for every ten shares held and a European call option with a strike price of
RMB 4.5 and 378 days to expiry. The parent Baosteel Group will also guarantee
a price floor; if the price falls below 4.53 RMB they will buy back the shares
outstanding up to a total purchase amount of RMB 2 billion. The plan is for
Baosteel Group to hold 67 per cent of total outstanding shares in three years

There are three important reasons for the study to focus on the year of 2006 as
follows:

Firstly, most listed compames finished their shareholding reform in 2006 and
according to the statistics, 94 per cent of Chinese listed companies had completed the
ownership conversion process by mid-year 2006 Since some
companies may issue warrants to pursue the privatisation reform, it is therefore
expected to gather more sample companies using derivatives from their 2006's annual

reports.

Secondly, literature has identified the price discovery, risk shifting, hedging, market

efficiency and operational advantages as the basic social and economic functions of

the derivatives 1: 1995: 1 ).

However, a certain type of derivate instruments - warrants, can be used as a

compensation tool for listed companies to finish the privatisation reform in emerging
economies such as China and it is an interesting phenomenon existing in Chinese
equity market. Hence, there is a need for researchers to choose the year of 2006 to
l37
investigate why Chinese listed firms adopt warrants to complete their shareholding

reform, how they finish the process, what kind of information they disclosed etc.

Thirdly, as discussed in Chapter III, the use of derivative instruments is compulsorily

disclosed after 1 January 2007 so the year of 2006 is an important year to analyse

whether Chinese listed companies have sufficient preparations to be adapted with the

forthcoming mandated derivative regulations.

3. Why choose non-financial rather than financial institutions 24 as sample

companies?

Previous studies have examined the usefulness of derivative disclosures by both

financial and non financial organisations and most of them choose one type of

institutions rather than mixing them up as shown in Table 4.8. The study only selects

non-financial institutions in the sample and it is based upon following considerations:

Firstly, financial organisations are more likely to get involved in financial derivatives

business as there is a need for them to use derivative instruments to manage risks

arising from the adverse movement of the market factors (e.g., interest rate and

foreign exchange rate) that may cause huge losses to their financial assets. Meanwhile,

they are restrained by different regulations not merely accounting and reporting

standards. For instance, banks are under the supervision of BCBS in the worldwide

and will follow their guidelines for capital and banking regulations, which is so-called

the 'Basel Accords,25. In China, different with a non-financial company, a listed

24 Financial institutions are enterprises that are principally engaged in financial intermediation or in auxiliary

financial activities which are closely related to financial intermediation. There are three major types of financial
enterprises:
a. Deposit-taking institutions that accept and manage deposits and make loans, including banks, building
societies, credit unions, trust companies, and mortgage loan companies
b. Insurance companies and pension funds
c. Brokers, underwriters and investment funds for Economic and
20(1).
25 The first of the Basel Accords (Basel I) was published by BCBS in 1988 and the Basel Capital Accord sets
down the agreement among the G 10 central banks to apply common minimum capital standards to their banking
industries, to be achieved by end-year 1992. The objective was to introduce international convergence of capital
138
financial institution faces multi-folder regulatory framework which is so-called 'One
Bank and Three Committees Regime' meaning that it would be supervised by the
People's Bank of China (i.e. the central bank), as well as CSRS, China Banking

regulatory Commission (CBRC) 26 or China Insurance regulatory Commission

(CIRC)27 . For the information disclosed in annual reports, the listed financial

companies therefore follow not only accounting and reporting standards required by
the Chinese accounting authorities but also specified regulations imposed by the
regulators of financial institutions. Since the research solely focuses on whether
quoted companies disclose their use of derivative products following related
accounting and reporting standards, financial institutions were excluded from the final
sample.

Secondly, there were only eight and one listed fmancial institutions on CSI 100 and

measurement and capital standards. The standards are almost entirely addressed to credit risk, the main risk
incurred by banks. The second of the Basel Accords (Basel II) was initially published in June 2004 aiming to
create an international standard that banking regulators can use when creating regulations about how much capital
banks need to put aside to guard against the types of financial and operational risks banks face. Basel II attempted
to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds
capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices.
BCBS updated their guidelines for capital and banking regulations, which is so-called the 'Basel III' on 20th
September 2010 in a response to the deficiencies in financial regulation revealed by the recent global financial
crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank
liquidity and bank leverage :::0 J 0).
26 CBRC is an agency authorised by the State Council to regulate the banking sector. Its main functions are as
follows:
a. Formulate supervisory rules and regulations governing the banking institutions.
b. Authorise the establishment, changes, termination and business scope of the banking institutions.
c. Conduct on-site examination and off-site surveillance ofthe banking institutions, and take enforcement
actions against rule-breaking behaviors.
d. Conduct fit-and-proper tests on the senior managerial personnel of the banking institutions;
e. Compile and publish statistics and reports of the overall banking industry in accordance with relevant
regulations.
f. Provide proposals on the resolution of problem deposit-taking institutions in consultation with relevant
regulatory authorities.
g. Responsible for the administration of the supervisory boards of the major State-owned banking institutions.
h. Other functions delegated by the State Council 20(6).
27 CIRC is an agency of China authorised by the State Council to regulate the Chinese insurance products and
services market and maintain legal and stable operations of insurance industry. It was founded on 18 November
1998, upgraded from a semi-ministerial to a ministerial institution in 2003, and currently has 31 local offices in
every province. The major functions of CIRC include:
a. Create laws, rules and regulations to supervise the industry.
b. Approve and examine incorporation of insurance entities, merge, split, change or dissolve.
c. Accreditation, regulate the hiring of senior managers in various insurance companies.
d. Regulate premiums, new insurance products and categories.
e. Ensure payment ability, insurance deposit, insurance guarantee fund.
f. Regulate self-insurance and mutual insurance, insurance trade associations.
g. Investigate and punish unfair competition and illegal conduct, non compliance of registration.
h. Regulate overseas operations of domestic insurance firms.
i. Create standards for risk, forecast, profitability and report to the People's Bank of China.
j. Subordinate to State Council directives (eIRe 20(6).
139
200 respectively in the end of 2006 28 indicating that Chinese large and medium size

quoted companies were dominant by non-financial organisations at that time. Hence,

it is beneficial for selecting non-financial companies to the sample to get better

understanding of the overall patterns of derivative related disclosures in Chinese

equity market.

Table 4.8 Sample Companies in Previous Studies

Financial N on-Financial
Institutions Institutions
Ahmed et aI., 2004 *
Ahmed et aI., 2006 *
Ameer, 2009 *
Barth et aI., 1996 *
Bhamornsiri and Schroeder,
2004 * *
Blankley, 2000 and 2002 * *
Chipalkatti and Datar, 2006 *
Dunne et aI., 2007 *
Eccher et aI., 1996 *
Edwards and Eller, 1996 *
Jorion, 2002 *
Lajili and Zeghal, 2005 * *
Linsmeier et aI., 2002 *
Liu et aI., 2004 *
Lopes and Rodrigues, 2008 * *
Nelson, 1996 *
Perignon and Smith, 2010 *
Rajgopal, 1999 *
Reynolds-Moehrle, 2005 *
Richie et aI., 2005 *
Roulstone, 1999 * *
Schrand, 1997 *
Seow and Tam, 2002 *
Venkatachalam, 1996 *
Wang et aI., 2005 *

28 Financial institutions on CSI 100 include: Bank of China Limited, China Merchants Bank Co.,Ltd, China
Minsheng Banking Corp.,Ltd, CITIC Securities Co., Ltd, Hua Xia Bank CO.,Ltd, Industrial and Commercial Bank
of China Limited, Shanghai Pudong Development Bank CO.,Ltd and Shenzhen Development Bank CO.,Ltd.

The financial institution on CSI 200 Includes: Hong Yuan Securities CO.,Ltd.
140
 Zhang, 2009 *

4.8.2 Interviewees Selection for Stage Two

4.8.2.1 Sample Selection and Profile of Interviewees

The study mainly concentrates on two equity market participants groups, institutional

investors and professional analysts, as they are widely perceived with a better

understanding of the complex nature of derivatives and associated disclosures. Table

4.9 summaries the details of the interviewees. There are total 21 interviewees in the

sample where ten investment managers and another eleven professional analysts are

included. Interviewees are selected from two organisations which include ten (i.e.,

five funds managers and five analysts) from a mutual funds management company -

China Southern Fund Co., Ltd. (CSF/ 9 , and the rest eleven (i.e., five investment
managers and six analysts) from a securities company - Qilu Securities Co., Ltd.

(QLS/o. As shown in Table 4.9, all of interviewees are male and relatively young as
19 out of 21 (90.48%) are aged from 21 to 40. Generally, they have much of

experience in the securities business on average, they have worked for seven more

years in the business. Sample interviewees are well educated as the vast majority (i.e.,

20 out of 21) achieved the postgraduate degrees like Masters and PhD. Most of them

which are 16 out of 21 (76.19%) have one qualification, namely Qualifications of

Securities Practitioners (QSP)31 and four interviewees possess one more additional

29 In March 1998, with the approval of CSRC, China Southern Fund Management Company, the first regularised
fund management company, was officially established with a registered capital of 150 million RMB. Headquarter
of CSF is located in Shenzhen. By the end of 20 10, the assets managed by the company including 26 mutual funds
had been approaching to 190 billion RMB which was ranked the top within the industry (CS E 2(11).
30 Qilu Securities Co., Ltd. is a large-scale comprehensive securities company approved by CSRC with registered
capital of 5.2 billion RMB and a staff of over 2000. Headquarter of the company is located in Jinan and it has 117
branches all over Shandong Province as well as large and medium-sized cities in China. QLS is the only national
securities dealer in Shan dong Province 20 J).
31 CSRC stipulates that the professionals, who undertake securities business in the institutions engaging the
securities business, shall pass the qualification examination for the securities practitioner and meet the stipulated
professional conditions.
141
qualification, such as Chartered Financial Analyst (CFA) and Certified Public

Accountant (CPA).

Table 4.9 Interviewees' Profile

Professiona
Age Years of Highest
Interviewe Locatio GmJ I
Grou Job TItle Working Education
e'sCode n er QuaJificatio
p in the Field QuaJification
n
Interview Chief
Sh;nzh Mal 31-4
ee (IV) Investmen 9 Master QSP
en e 0
01 t Manager
Deputy
Sh;nzh Mal 31-4
IV 02 Chief 10 Master QSP
en e 0
Analyst
Sh;nzh Mal 21-3
IV 03 Analyst 2 Master QSP
en e 0
Sh;nzh Mal 21-3
IV 04 Analyst 2.5 PhD QSP
en e 0
Sh;nzh Mal 31-4 CFA,
IV 05 Analyst 2 PhD
en e 0 QSP
Sh;nzh Mal 21-3
IV 06 Analyst 1 Master QSP
en e 0
Sh;nzh Mal 31-4 Funds CPA,
IV 07 9 Master
en e 0 Manager QSP
Sh;nzh Mal 31-4 Funds CPA,
IV 08 16 Master
en e 0 Manager QSP
CFA,
Sh;nzh Mal 21-3 Funds
IV 09 6 Master CPA,
en e 0 Manager
QSP
Assistant
Sh;nzh Mal 21-3
IV 10 Funds 3 Master QSP
en e 0
Manager
Mal
IV 11 Jinan 50+ Analyst 16 PhD None
e
Mal 31-4
IV 12 Jinan Analyst 13 Master QSP
e 0
Mal 31-4
IV 13 Jinan Analyst 10+ Master QSP
e 0
Mal 41-5 Senior
IV 14 Jinan 15 Bachelor QSP
e 0 Analyst
IV 15 Jinan Mal 31-4 Senior 11 Master QSP

142
 e 0 Strategy
Analyst
Mal 31-4
IV 16 Jinan Analyst 1 PhD QSP
e 0
Mal 31-4 Investmen
IV 17 Jinan 11 Master QSP
e 0 tManager
Senior
Mal 31-4
IV 18 Jinan Business 3 PhD QSP
e 0
Manager
Senior
Mal 21-3
IV 19 Jinan Investmen 6 Master QSP
e 0
t Manager
Mal 21-3 Investmen
IV 20 Jinan 3 Master QSP
e 0 t Manager
Mal 31-4 Business
IV21 Jinan 2 Master QSP
e 0 Manager

4.8.2.2 Interview Process

A senes of semi-structured interviews were undertaken in Shenzhen and Jinan

between July and October 2009. All interviews were conducted in the interviewees'
offices. An interview guide (see Appendix n3:2), which contains a cover letter with
descriptions of the general background of the research and a list of questions, was
prepared prior to the interview process. Such guide would help interviewees to focus
on some points and gain the related information in respect to those particular points.
As shown in Appendix II, there are total twelve questions included in the guide and all
questions prepared are open ended, which allow for more dialogue between
interviewees and the researcher. However, the last two questions - Q 11 'In your view,
what is the impact of recent financial crisis to the development of Chinese derivatives
market?' and Q12 'In your view, what is the impact of recent financial crisis to the
accounting and reporting for derivatives in China?' are not taken into account in the
present research as the primary objective of asking these two questions is to collect

32 Appendix II is an English version of the interview guide but in practice, the Chinese version was provided to
each interviewee prior to the interview.
143
qualitative data for other studies in the future, and therefore, the first ten questions

were employed in the study to examine equity market participants' attitudes, opinions

and views towards derivative disclosures reported by Chinese listed companies.

Before conducting interviews, the participants were assured that the whole process
was confidential and their names and personal details would not be disclosed. Thus,
all of 21 participants gave their permission to record the interviews. The researcher
took all possible effort to cover the entire topic, however, phrasing and sequence of

questions varied from one interview to another At the beginning of

each interview, the researcher explained to the participants the aim of the interview

and the research, and then, asked if there was any further explanation needed. It was

explained to the interviewees that the researcher was not looking to the right and
wrong answer but rather seeking their opinions and perceptions on

the matters of discussion. Interviews were carried out in Chinese.

All interviews lasted for approximately 40 minutes. According to

different method could be followed in transcribing the interview data. In this research,

all of 21 interviewees were voice recorded. Then the entire interview has to be writing

down word by word and writing up the transcript was done in the same interview
language. Next, the researcher translated the entire documents to the English and
doubly checked the translation with a Chinese to English translator on the accuracy of

the translation to make sure the translation carry the same meaning emphasised by the

interviewee 2005). No variations were found.

4.9 Summary

This chapter has comprehensively described the research methodology, methods and
data collection adopted in this research. The study has followed the deductive research

144
methodology. It employed both quantitative and qualitative research methods and

with regard to the research approaches, content analysis as well as interview was

applied in either the first or second stage of the study. In conducting content analysis,
six essential steps suggested by (1 (1 ), which include first,
determine the sampling units; second, determine the recording unit; third, determine
the categories to be coded; fourth, determine the coding mode; fifth, test coding on
sample oftext; sixth, assess reliability and validity, were adopted. The semi-structured
interview approach was then employed to elicit the perspectives of equity market
participants on derivative related disclosures provided by Chinese listed companies.
By carefully selecting, the final sample used in the first phase comprises 53 large and
medium non-financial listed companies in 2006 and in the second phase, there are

total 21 interviewees included in the sample.

145
C apter C Analysis·
ISCUSSlons
9 "

146
 Chapter V Content Analvsis Results and Discussions

5.1 Introduction

This chapter is to provide an argument of the first stage of the study with the primary
aim to answer following research questions:

• What is the level of derivative related disclosures made by Chinese listed

companies?
• What is the information content of derivative related disclosures provided by
Chinese listed companies?

It tries to draw a picture to describe the degree and nature of information in relation to

the use of derivative instruments by Chinese quoted firms. The chapter starts with the

discussion of overall disclosures level, followed by reporting on the disclosures made

by companies in different sizes, information content of derivative disclosures,
disclosures of different types of derivatives. A summary of findings will be presented
in the end.

5.2 Disclosures Level

In this section, the degree of derivative disclosures complying with relevant IFRSs
and lASs regulations by Chinese listed companies is presented and discussed from
three major perspectives: the scores, amount of information and disclosed sections.

147
5.2.1 OveraH Scores

Table 5.1 presents the result of the number of questions in Financial Derivatives

Disclosures Index (FDDI) disclosed by individual companies. The quantities of

questions mentioned by each sample company were ranging from 1 to 11 33 and the

mean value was 4.28 indicating that firms, on average, only disclosed around 4
questions out of total 24 in FDDI. In other words, almost 20 questions related to the

use of derivative instruments were absent in the company annual reports.

Table 5.2 summarises the numbers of sample firms that disclosed individual questions
in their annual reports and all of 24 questions presented in FDDI can be categorised
into three groups as follows:

1. Frequently Disclosed Questions. This group contains Questions 2, 4, 9, 10, 17, 19,

22 and 24 that are mentioned by over or nearly a third of sample companies

implying that these questions are most popularly addressed by reporting entities.
Q2 has the biggest score of 40 indicating that the majority of 53 sample
companies revealed the objectives of their using derivative products, followed by

Q24 (33) that provided information not required by IFRSs and lASs. Concerning
Q9, nearly half of the sample companies report derivatives in terms of principal,

stated, face or other value. 23 out of 53 companies stated their compound financial

products containing both derivative and non derivative features (referring to Q22).

For Q19, 20 firms presented the residual market value of derivatives after netting

gains and losses arising from those instruments. While 19 companies mentioned

the date of their derivative instruments to be mature, expire or executed (QI0),

almost one third of the entities reported the fair value of their derivative products
(Q 17) and 17 sample firms provided information about accounting policies for the

33Among total of 53 companies, GUANGZHOU BAIYUN INTERNATIONAL AIRPORT Co., LTD merely
mentioned one question while JIANGXI COPPER Co., LTD disclosed the biggest quantities of 11 questions in its
2006's annual report.
148
 treatment of derivatives (Q4).

2. Less Frequently Disclosed Questions. This group includes questions addressed by

less than 10 sample companies. It consists of Questions 1, 5, 6, 7, 8, 18, 20 and 23.

These questions were infrequently disclosed in a firm's annual report. For

example, for Q 18 and Q23, there are only six reporting entities that presented the
carrying amount of derivatives and separated embedded derivatives from their
compound financial instruments. Five companies addressed Q20 by disclosing
methods to determine the value of derivative products. Q5 and Q6 are equally
discussed by four firms that provided information about corporate hedging
policies and the management of risks arising from the derivatives business. Q7
'Does the firm discuss any changes to the above disclosures from the previous

reporting period?', Q8 'Does the firm segregate information by risk categories

(i.e. credit risk, liquidity risk, and market risk)? 'and Ql 'Does the firm sort its
derivative instruments into appropriate financial instruments' category (held for
trading or hedging instruments)?' were addressed by only three, two and one
entities respectively.

3. Rarely Disclosed Questions. This group refers to the questions that were hardly

mentioned in the annual reports. Eight of total 24 questions were not mentioned
by any company in the sample, including:

• Q3 'Does the firm specify the associated risks provided by derivative

instruments? '

• Q11 'Does the firm disclose the early settlement and conversion options,
including details of their exercise of derivative instruments?'

• Q12 'Does the firm disclose the amount and timing of scheduled future cash flows
related to derivatives' principal amount? '

• Q13 'Does the firm disclose the interest, dividends, or other periodic returns on
principal and their timing related to derivative instruments?'
149
• Q14 'Does the firm disclose the effective interest rates of derivative instruments? '
• Q15 'Does the firm specify to whom they have credit risk exposures?'

• Q16 'Does the firm provide the estimated maximum credit risk exposures at the
reporting date? ' and

• Q21 'Does the firm use the sensitivity analysis to demonstrate the impact of
possible movements in each market risk variable on profit and loss and equity? '

The absence of disclosures in relation to Q15 and Q16 is understandable as unlike

mature economies such as the U.S. and UK, there were no any credit related
derivatives such as CDS available in the Chinese securities market at the time.
Chinese listed companies were not permitted to get involved in the trade of credit
related derivative instruments. However, it is quite interesting that no one mentioned
Q3, suggesting that the information related to the risk arising from the use of
derivatives was not provided by any sample company. As discussed in Chapter II,
derivative instruments are usually described as 'double-edged swords' that are not
only useful for risk management but also create huge risks that expose the entire
corporate to financial distress ). The North American and European
evidence (e.g., 1 et

2005: et a1.,

has demonstrated that companies in mature economies provide

some quantitative information regarding the risk related to the use of derivative
instruments although reporting entities do not provide adequately detailed information
(e.g., the assumptions of applied quantitative techniques). For example, by analysing
the derivative disclosures by top ten U.S. dealer banks in 1995,
find the evidence that the reporting quality of the information related to the use
of derivative instruments is greatly improved by sample banks. The ten banks
provided more detailed quantitative disclosures about the value-at-risk and the results

of trading activities in their 1995 annual reports. However, the authors also suggest
that none of the reports could be singled out as the best because most of the banks
adopt a novel reporting approach on the use of derivatives that is not used by the
150
others. From the evidence reported in this study, it seems that Chinese listed

companies were reluctant to disclose potential risks inherent in the use of derivatives.

Unfortunately, this study cannot find any reporting entity that has explained the

reasons for not reporting on information about the risk arising from the use of

derivative products in their annual reports. There are several possible reasons that

could be used to explain why Chinese listed companies did not disclose information
on risks potentially caused by the use of derivatives as follows:

Firstly, the large absence of derivative-related regulations in CASs could be a factor

contributing to such phenomenon. Although Chinese authorities encouraged listed

companies to comply earlier with the New Accounting Standards which was effective
from 1 January 2007, the accounting and reporting for the use of derivative
instruments was still on a voluntary base in 2006. Therefore, it is possible that most of

the companies adopted non-reporting strategy in terms of risks embedded in the

derivatives business.

Secondly, the agency problem could be another reason reflecting the fact where

managerial disclosure preferences are not aligned with those of shareholders. The risk

associated with derivatives' trading would have adverse impacts on corporate value so
managers may have a tendency to hold such 'bad news' as career concerns can
motivate them to withhold bad news and gamble that subsequent corporate events will

allow them to 'bury' the bad news (N et al ).

Thirdly, there might be another explanation that the risk associated with derivative

instruments was so immaterial to companies' earnings that there was no need to

disclose such information. This can be an interesting issue for further researches in

terms of materiality of derivatives disclosure. There is a need to examine the impact

of the use of derivatives on a company's earnings in a transitional economy.

Table 5.1 Nos of Questions inFDDI Disclosed by Companies

151
 Nos of Minimum Disclosed Maximum Disclosed Std.
Mean
Companies Questions Questions Deviation
53 1 11 4.28 2.042

Table 5.2 Overall Scores of Questions in FDDI

Nos of
Questions Mean
Companies
Q2 Does the firm specifY the objectives for holding or
40 1
issuing derivative instruments?
Q24 Does the firm provide other disclosures related to their
33 1
use of derivative instruments?
Q9 Does the firm disclose the Principal, stated, face, or
25 1
other similar amount of derivative instruments?
Q22 Does the firm specifY the existence of derivative features
23 1
in its compound financial instruments?
Q 19 Does the firm disclose the net market value for
20 1
derivative instruments?
Q 10 Does the firm disclose the date of maturity, expiry, or
19 1
execution of derivative instruments?
Q 17 Does the firm disclose the fair value of derivative
19 1
instruments?
Q4 Does the firm specifY the accounting policies for
17 1
derivative instruments?
Q 18 Does the firm disclose the carrying amount of derivative
6 1
instruments?
Q23 Does the firm separately provide information for
embedded derivatives and liability component of a 6 1
compound financial instrument?
Q20 Does the firm specifY the methods in determining the
5 1
value of derivative instruments?
Q5 Does the firm specifY its hedging policy? 4 1
Q6 Does the firm specifY how they monitor and manage the
4 1
risks associated with derivative instruments?
Q7 Does the firm discuss any changes to the above
3 1
disclosures from the previous reporting period?
Q8 Does the firm segregate information by risk categories
2 1
(i.e. credit risk, liquidity risk, and market risk)?
Q 1 Does the firm sort its derivative instruments into
appropriate financial instruments' category (held for trading 1 1
or hedging instruments)?
Q3 Does the firm specifY the associated risks provided by
0 0
derivative instruments?
152
 Q 11 Does the firm disclose the early settlement and
conversion options, including details of their exercise of 0 0
derivative instruments?
Q 12 Does the firm disclose the amount and timing of
scheduled future cash flows related to derivatives' principal 0 0
amount?
Q 13 Does the firm disclose the interest, dividends, or other
periodic returns on principal and their timing related to 0 0
derivative instruments?
Q 14 Does the firm disclose the effective interest rates of
0 0
derivative instruments?
Q 15 Does the firm specify to whom they have credit risk
0 0
exposures?
Q 16 Does the firm provide the estimated maximum credit
0 0
risk exposures at the reporting date?
Q21 Does the firm use the sensitivity analysis to demonstrate
the impact ofpossible movements in each market risk 0 0
variable on profit and loss and equity?
Total 53 4.283

5.2.2 Overall Amounts

The overall amount of information regarding the use of derivatives disclosed by

sample companies is presented in Table 5.3 and the disclosures are measured at the

percentage of the annual report that relates to the overall size of the annual report.

There are two new variables in Table 5.3: -1) NoFairValue which contains Questions

9, 10, 11, 12, 13 and 14 with respect to the disclosures related to derivatives valued at

alternative methods other than the fair value measurement; and 2) FairValue which

comprises Questions 17, 18, 19 and 20 as to the amount of information regarding to

derivative instruments measured at the fair value method.

The mean value of the total sample is 0.972 per cent that indicates that the disclosures

related to derivative activities take less than 1 per cent in a firm's annual report. The

disclosure amount is relatively smaller compared with the evidence from developed

153
economies. For instance, according to the study conducted by ct m

that compared the derivative related information disclosed by non-financial UK listed

companies in the year before and after 1998's releasing of FRS 13, the mean value of

the pre and post FRS 13 periods was 2.124 and 4.479 per cent respectively, which

were two and four times greater than those disclosed by Chinese listed companies
reported in this study.

Referring to individual questions, for example, Q22 'Does the firm specify the
existence of derivative features in its compound financial instruments?' has the
biggest mean value at 0.278 per cent demonstrating that firms report the largest

amount of information concerning the use of compound financial instruments (e.g.,

convertible bonds 34 ) embedded with derivative instruments in their 2006 annual

reports. This can be explained as the convertible bond viewed as 'delayed equity' is an

important financing tool adopted by a large number of Chinese listed companies

Q24 'Does the firm provide other disclosures related to their

use of derivative instruments' gets the second largest mean value at 0.251 per cent.
The figure implies that companies provide much information about their use of

derivatives not required by lFRSs and lASs and this is likely due to the
voluntary-based reporting framework applied to the disclosure of derivative activities.

Q2 ranks the third place in terms of the mean value at 0.110 per cent, followed by

NoFairValue (0.0996%), FairValue (0.0734%), Q4 (0.0558%), Q8 (0.0541%), Q5

(0.0198%), Q23 (0.0195), Q7 (0.0062%), Q6 (0.0036%) and Ql (0.0003%). Sample

companies do not provide any amount of information related to Questions 3, 15, 16

and 21, which is consistent with the findings reported in the previous section that no

reporting entity mentioned these questions in their annual reports.

Table 5.3 Overall Amounts (Percentage of Annual Report) of Questions in FUUI

34 Convertible bond is a kind of hybrid financial instruments with both fixed-income securities and equity
characteristics. Convertible bonds especially for its hybrid characteristics could provide an additional option with
financer (Chen 3nd Cao" 10(8).
154
 Minimum Maximum Mean
Questions
(%) (%) (%)
Q22 Does the firm specify the existence of
derivative features in its compound financial 0 1.503 0.278
instruments?
Q24 Does the firm provide other disclosures
0 1.373 0.251
related to their use of derivative instruments?
Q2 Does the firm specify the objectives for
0 0.671 0.110
holding or issuing derivative instruments?
NoFairValue * 0 0.593 0.0996
FairValue** 0 0.866 0.0734
Q4 Does the firm specify the accounting
0 1.113 0.0558
policies for derivative instruments?
Q8 Does the firm segregate information by risk
categories (i.e. credit risk, liquidity risk, and 0 1.868 0.0541
market risk)?
Q5 Does the firm specify its hedging policy? 0 0.551 0.0198
Q23 Does the firm separately provide
information for embedded derivatives and
0 0.334 0.0195
liability component of a compound financial
instrument?
Q7 Does the firm discuss any changes to the
above disclosures from the previous reporting 0 0.166 0.0062
period?
Q6 Does the firm specify how they monitor and
manage the risks associated with derivative 0 0.076 0.0036
instruments?
Q 1 Does the firm sort its derivative instruments
into appropriate financial instruments'
0 0.017 0.0003
category (held for trading or hedging
instruments) ?
Q3 Does the firm specify the associated risks
0 0 0
provided by derivative instruments?
Q 15 Does the firm specify to whom they have
0 0 0
credit risk exposures?
Q 16 Does the firm provide the estimated
maximum credit risk exposures at the reporting 0 0 0
date?
Q21 Does the firm use the sensitivity analysis
to demonstrate the impact ofpossible
0 0 0
movements in each market risk variable on
profit and loss and equity?
Total 0.095 3.549 0.972
Notes: * NoFairValue includes Q9 'Does the firm disclose the Principal, stated, face, or other similar amount of
155
derivative instruments?', QI0 'Does the firm disclose the date of maturity, expiry, or execution of derivative
instruments?', Qll 'Does the firm disclose the early settlement and conversion options, including details of their
exercise of derivative instruments?', Q12 'Does the firm disclose the amount and timing of scheduled future cash
flows related to derivatives' principal amount?' principal amount', QJ3 'Does the firm disclose the interest,
dividends, or other periodic returns on principal and their timing related to derivative instruments?' and Q14
'Does the firm disclose the effective interest rates of derivative instruments? '.
** FairValue includes Q17 'Does the firm disclose the fair value of derivative instruments?', Q18 'Does the
firm disclose the carrying amount of derivative instruments?', Q19 'Does the firm disclose the net market value for
derivative instruments?' and Q20 'Does the firm specify the methods in determining the value of derivative
instruments? '.

5.2.3 Disclosed Sections

The derivative related disclosures are dispersedly reported across sixteen sections in
the companies' annual reports as shown in Table 5.4 and the amount of information is
measured at the percentage of the annual report. The section of Notes to the Financial
Statements has the largest mean value at 0.3494 per cent, which indicates that Chinese
listed companies report the most amount of information concerning about their use of
derivatives in the notes pertaining to the financial statements and this finding is
consistent with some North American evidence in relation to the risk information
disclosures. For example, Zeghal find that the risk related
disclosures reported by Canadian listed companies are centralisedly located in the
sections of Notes to the Financial Statements and Management Discussion and
Analysis.

It is interesting that the amount of derivative related information disclosed in the

section of Change of Shares and Shareholders' Information is just behind those in
Notes to the Financial Statements with the second biggest mean value of 0.2730 per
cent, which implies that sample firms provide a large amount of information that

relates to how derivative instruments affect their equity structure. There are various
types of derivative products but not all of them are able to have impacts on the user's

156
structure of shares. Taking an interest rate swap35 for instance, it is likely to influence

the company's future cash flows rather than its shares structure. Commonly, the use of

two types of derivative instruments - warrant and convertible bond might affect an

issuer's equity structure as the holders of those derivatives are likely to purchase, sell

or transfer parts of shares of the issuing company over a period in the future. This

finding suggests that Chinese listed companies seem to prefer to use derivatives such

as warrants and convertible bonds that have potential impacts on the company's

structure of shares in 2006. This phenomenon is understandable as, on the one hand,

most quoted firms finished the shareholding reform in the sample year of 2006

) and the warrant was an important tool to complete such reform

and, on the other hand, the convertible bond was favoured by Chinese listed

companies to refinance 2008).

The board of directors report has the third biggest mean value of 0.1358 per cent,
followed by sections of Important Affairs (0.0833%), Table ofAdjusted Shareholders'

Funds Between Old and New Accounting Standards 36 (0.0572%), Supplementary

35 An interest rate swap is an agreement between two or more parties to exchange of interest payments over a
period in the future (Kolb. 1997).
36 In order to prepare for implementing the New Accounting Standards that would be effective from 1st January
2007, the Chinese authorities require listed companies to provide a table called Table ofAdjusted Shareholders'
Funds Between Old and New Accounting Standards and notes pertaining to this table to briefly summarise
differences of accounting numbers before and after the adoption ofthe New Accounting Standards in their 2006
annual reports and an example quoted from CHONGQING CHANGAN AUTOMOBILE Co., LTD is shown as
follows:

Table of Adjusted Shareholders' Funds Between Old and New Accounting Standards (Yuan RMB)

Items
Items Notes YuanRMB
Nos.
Consolidated Shareholders' Funds on 31 st December 2006 (Current
1 1 7,306,779,344
Accounting Standards)
A<!justments:
Difference of consolidated long-term equity investment under the same
2 2 (20,612,082)
enterprise's control
Adjusted amortisation of the debit balance of other long-term equity
3 investment employed equity method following the New Accounting 3 19,909,725
Standards
4 Financial derivative instruments 4 (16,873,622)
5 Income tax 5 201,319,271
Influence of joint ventures according to the new accounting standards to
6 6 (2,254,835)
retroactively adjusts the book value ofthe long-term equity investment
7 Government subsidies pertinent to assets 7 (79,822,013)
8 Period expenses of organisation costs 8 (301,050,194)
Adjustments of investment return on Jiangling Motors Corporation, Ltd
9 9 7,847,576
according to the New Accounting Standards
157
Documents (0.0258%), Information of Warrants and Convertible Bonds (0.0126%),

Board of Supervisors Report (0.0123%), Brief Summary ofFinancial and Operational

Performance (0.0105%), Information of Directors, Supervisors, Senior Managers and

Employees (0.0033%), Brief Information of Shareholders' Conference (0.0028%),

Corporate Governance (0.00192%), Financial Statements (0.00186%), Evaluation

Report of Board of Directors to Internal Control (0.0014%), Basic Information of the

Company (0.0011 %) and Company Dairy 2006 (0.0002%).

Table 5.4 Amount of Derivative Related Information (Percentage ofAnnual

Report) Disclosed across Sections of the Annual Report

Minimum Maximum Mean

Sections
(%) (%) (%)
Notes to the Financial Statements 0 1.335 0.3494
Change ofShares and Shareholders'
0 1.503 0.2730
Information
Board ofDirectors Report 0 1.868 0.1358
Important Affairs 0 1.183 0.0833
Table ofAdjusted Shareholders' Funds
Between Old and New Accounting 0 0.359 0.0572
Standards
Supplementary Documents 0 0.954 0.0258
Information of Warrants and Convertible
0 0.666 0.0126
Bonds
Board of Supervisors Report 0 0.166 0.0123
Brief Summary ofFinancial and
0 0.128 0.0105
Operational Performance
Information ofDirectors, Supervisors,
0 0.176 0.0033
Senior Managers and Employees
Brief Information ofShareholders'
0 0.149 0.0028
Conference
Corporate Governance 0 0.102 0.00192
Financial Statements 0 0.036 0.00186

Adjustments above mentioned from item No.2 to 9 belonging to equity of

10 10 18,055,293
minor shareholders
Balance of minor shareholders' equity on 31 51 December 2006 under Current
11 Accounting Standards classified to the shareholders' funds under New 1,694,956,851
AccountiIlg Standards.
Consolidated shareholders' funds on 151 January 2007 (New Accounting
8,828,255,314
Standards)

158
Evaluation Report ofBoard ofDirectors on
0 0.076 0.0014
Internal Control
Basic Information of the Company 0 0.041 0.0011
Company Dairy 2006 0 0.013 0.0002
Total 0.095 3.549 0.972

In summary, the compliance with IFRSs and lASs derivative related regulations by

Chinese quoted companies is generally low as sample companies on average only

disclosed approximate four out of twenty-four questions in FDDI and less one per

cent in terms of the amount of derivative related information in its annual report.

Similar with firms in developed economies, Chinese listed companies provided the

most amount of information related to the use of derivatives in the section of Notes to

the Financial Statements, but they tended to use those derivatives (e.g., warrants and

convertible bonds) that may affect the structure of shares as they presented a great

quantity of information about derivative activities in the section of Change of Shares

and Shareholders' Information.

5.3 Disclosures by Companies in Different Sizes

This section is to provide a discussion about the relationship between the level of

derivative disclosures and the size of Chinese listed companies. Although the study

does not intend to find out the determinants of derivative related disclosures by

Chinese quoted firms as it is not the main objective of the research, it still helps to

have a better understanding of derivative related disclosure patterns in a transitional

economy by providing an argument about whether the size of a Chinese company has

an impact on the degree of disclosures related to the use of derivatives.

5.3.1 Association between Company Size Disclosure

159
Investors require companies to provide high quality disclosures in order to make their
economic decisions. Compared with investors, managers are claimed to have more

and better information about the economic performance of their firms and they have
incentives to withhold value-relevant unfavourable information
Greater disclosure, therefore, is to diminish the level of such information asymmetry
between managers and investors and as a result, will attract investors to participate
more aggressively. argues that the costs of capital (i.e., debt and
equity) would be lowered for companies that disclose high quality information.
Moreover, high quality disclosure is able to reduce the uncertainties faced by
investors and creditors and help to level up their
confidence in financial statements produced by reporting firms, finally leading to an
increased investment in these firms. The firms' value will be eventually boosted as a
result of higher share prices. To be contrary, failing to meet the information needs of
investors and creditors is likely to have a huge impact on companies as they may take
actions which are disadvantageous to firms such as increasing the cost of capital or
withdrawing their investments. Lack of information disclosures may also force market
participants to seek other investment opportunities which may reduce the firm's
shareholders'value. ) suggests that even though investors could invest in
companies with a low quality disclosure, they are likely to require comparatively
higher rate of return leading to a higher cost of capital and lower share price and as a
result companies could be difficult to grow and develop.

Although it is perceived that the provision of sufficient and high quality information

is vital for companies, prior studies 1

ct 1

generally suggest that the level and quality of disclosures is related to firms
characteristics such as firm size, listing status, firm auditor, scope of business, risk of

trading and industry type. They find that the firm's size is one of the key determinants
of quality of accounting disclosures and there is a positive relationship between
corporate size and the disclosure quality. There are several arguments that can be used
160
to link the company's size and disclosure quality. For instance,

1971 ) argue that larger firms have larger resources to allocate for the preparation of

high quality information and lesser costs used to generate such information due to the

economies of scale. Similarly, 975) states that the publication of annual

reports would place a financial burden on small companies as the process of gathering,
preparing and disclosing information in the form of annual reports is costly and

therefore, only large firms are more likely to afford such expenditure. In addition, big

companies tend to disclose more detailed information in their annual reports because

compared with small corporate, they are more exposed to scrutiny by financial
analysts and more recognised by the public Based upon the agency
theory proposed by Jensen which suggests that disclosures are
associated with the amount of outside financing, (1 1) assert that
companies with large sizes have incentives to disclose more information in their

public reports as they use more outside capital. Likewise, larger firms have greater
chances to operate in different markets or sectors to obtain funding in different

countries and therefore have to provide more information to the public

(1 points out that the proprietary costs in

relation to competitive disadvantages of additional disclosures are smaller as the

company Size Increases. provide an argument that

political costs are high in larger companies and so bigger firms are more likely to
show high levels of disclosure since it improves confidence and reduces political costs.

Also bigger companies have incentives to disclose more information because the
potential litigation costs and net disclosure-related costs are an increasing function of

company Size ct at, 1 Moreover, smaller companies are more

inclined to disclose far less information than their larger counterparties as the smaller

a firm, the greater chances the disclosure of information puts it in a competitive

disadvantage position 1992; ct 1

1 1

161
5.3.2 Scores

As shown in Table 5.5, the mean value of questions disclosed by 39 large size firms is

4.44, which is bigger than that of 3.86 for 14 medium companies indicating that large

firms on average disclosed more questions than the medium firms in terms of

disclosures related to the use of derivatives. Interestingly, the group of big companies

contains not only the company with the largest score (i.e., JIANGXI COPPER Co.,

LTD scored at eleven) but also the one with the least (i.e., GUANGZHOU BAIYUN
INTERNATIONAL AIRPORT Co., LTD merely scored at one) among the total of 53
sample firms. Table 5.6, which summarises the statistical result by comparing the

mean values of the two types of firms, demonstrates that the p value of 0.368 is larger

than the significance level of 0.05 implying that the mean values of the two groups are

not significantly different and in other word, the quantity of questions disclosed by

large and medium companies is statistically insignificant although the mean value of

big firms is larger than that of the medium firms. Referring to individual questions, as

shown in Table 5.7, the two types of companies have the similar disclosure tendency

with little differences. For instance, Q2 and Q24 were most frequently mentioned

questions by both groups as more than a half of the firms in either group provided

information about those two questions in their 2006 annual reports. The difference is

that opposite to large companies, Q24 was mentioned by most medium firms (10)

followed by Q2 (8). Nearly fifty per cent of companies from either group provided

disclosures related to Q4, Q9, Q17, Q19 and Q22 with one difference that eighteen

big companies (46.15% in their group) mentioned Q10 'Does the firm disclose the

date of maturity, expiry, or execution of derivative instruments?' while disclosed by

only one medium firm (7.14%). Q3, QIl, Q12, Q13, Q14, Q15, Q16 and Q21 were

not discussed by either types of firms while compared with large companies, five

more questions - Q1 'Does the firm sort its derivative instruments into appropriate

financial instruments' category (heldfor trading or hedging instruments)?', Q6 'Does

the firm specifY how they monitor and manage the risks associated with derivative
162
instruments?', Q7 'Does the firm discuss any changes to the above disclosures from

the previous reporting period?', Q8 'Does the firm segregate information by risk

categories (i.e. credit risk, liquidity risk, and market risk)?' and Q18 'Does the firm
disclose the carrying amount of derivative instruments'?, were not mentioned by any
medium company in their annual reports.

Table 5.5 Overall Scores of Disclosures by Large and Medium Size Companies

Size (Large = 1; Medium = Nos. of Std. Std. Error

Mean
0) Companies Deviation Mean
0 14 3.86 1.994 .533
1 39 4.44 2.062 .330

Table 5.6 Indcpendcnt Samples Test for Scores of Large and Medium Size Firms

Levene's
Test for
Equality
t-test for Equality of Means
of
Variance
s
95%
Confidence
Std. Interval of
Sig. Mean
Sig Error the
F t df (2-taile Differen
. d) ce
Differen Difference
ce
Lowe Uppe
r r
Equal
varianc
.19 .66 -.90 -1.85
es 51 .368 -.579 .637 .700
6 0 8 8
assume
d
Equal
variance -.92 23.69 -1.87
.365 -.579 .627 .716
s not 3 7 4
assumed

Table 5.7 Comparison Scores of Large and Medium Size Firms

163
 Nos of Companies
Questions Large Medium
Firms Firms
Q2 Does the firm specify the objectives for holding or issuing
32 8
derivative instruments?
Q24 Does the firm provide other disclosures related to their
23 10
use of derivative instruments?
Q9 Does the firm disclose the Principal, stated, face, or other
19 6
similar amount of derivative instruments?
Q 10 Does the firm disclose the date of maturity, expiry, or
18 1
execution of derivative instruments?
Q22 Does the firm specify the existence of derivative features
16 7
in its compound financial instruments?
Q 19 Does the firm disclose the net market value for
15 5
derivative instruments?
Q 17 Does the firm disclose the fair value of derivative
14 5
instruments?
Q4 Does the firm specify the accounting policies for
11 6
derivative instruments?
Q 18 Does the firm disclose the carrying amount of derivative
6 0
instruments?
Q6 Does the firm specify how they monitor and manage the
4 0
risks associated with derivative instruments?
Q20 Does the firm specify the methods in determining the
4 1
value of derivative instruments?
Q7 Does the firm discuss any changes to the above
3 0
disclosures from the previous reporting period?
Q23 Does the firm separately provide information for
embedded derivatives and liability component of a compound 3 3
financial instrument?
Q5 Does the firm specify its hedging policy? 2 2
Q8 Does the firm segregate information by risk categories
2 0
(i. e. credit risk, liquidity risk, and market risk)?
Q 1 Does the firm sort its derivative instruments into
appropriate financial instruments' category (held for trading 1 0
or hedging instruments)?
Q3 Does the firm specify the associated risks provided by
0 0
derivative instruments?
Q 11 Does the firm disclose the early settlement and
conversion options, including details of their exercise of 0 0
derivative instruments?
Q 12 Does the firm disclose the amount and timing of
scheduled future cash flows related to derivatives' principal 0 0
amount?
164
 Q 13 Does the firm disclose the interest, dividends, or other
periodic returns on principal and their timing related to 0 0
derivative instruments?
Q 14 Does the firm disclose the effective interest rates of
0 0
derivative instruments?
Q 15 Does the firm specifY to whom they have credit risk
0 0
exposures?
Q 16 Does the firm provide the estimated maximum credit risk
0 0
exposures at the reporting date?
Q21 Does the firm use the sensitivity analysis to demonstrate
the impact ofpossible movements in each market risk 0 0
variable on profit and loss and equity?
Total 39 14

5.3.3 Amounts

The mean value of the amount of disclosures by large and medium firms, as shown in

Table 5.8, is 0.9680 and 0.9824 per cent respectively, which implies that medium size

companies disclosed more information than big ones in terms of their use of

derivative instruments but as discussed in the section of 5.1.2, the disclosure amount

by Chinese listed companies is far less than the evidence from mature economies.

Concerning about the individual question, the two categories of firms nearly have the

same disclosure trend. For example, although Q24, Q22, Q2, NoFairValue and

Fairvalue are the top five of most amount of derivative information provided by both

groups, there is one difference existing between the two groups. Compared with large

firms, medium firms have four more questions (i.e., Ql, Q6, Q7 and Q8) with the

mean of zero as these questions were not mentioned by any sample medium

companies. Table 5.9 demonstrates the statistical results by comparing the means of

the amount of information related to the use of derivatives disclosed by big and

medium companies. Although medium firms disclosed more derivative related

information than the large, the difference is not statistically significant as the t-test of

the mean values of total disclosure amount shows that the p value is 0.954 that is

165
bigger than the significance level of 0.05. Furthermore, the t-test of the difference of

means regarding to any individual question indicates that for every derivative related
question, the amount of disclosures provided by large and medium firms is

statistically indifference as the p value is bigger than 0.05 and in other word, the
derivative related disclosures provided by Chinese listed companies are not
significantly affected by the difference of corporate size. This finding is pretty
interesting as it is contrary to the large quantity of evidence from developed countries
as discussed in Section 5.3.1, arguing that the firm's size is a key determinant of
disclosures level and bigger ones generally provide more information than the smaller
but this controversial phenomenon could be explained as follows:

Firstly, there are two external factors that have joint contributions to this phenomenon.

1. The availability of derivative instruments is pretty limited in the Chinese

securities market. As discussed in Chapter III, there were only three maj or types
of derivatives - commodity futures, warrants and convertible bonds available in
the year of 2006 and companies therefore had fewer choices for the use of

derivative products. As a result, firms were likely to adopt the same derivatives
and provided the similar information in their annual reports. Otherwise, if various
derivative instruments are available for companies' needs, different types of
derivative related information could be disclosed. For instance, firms that get
involved in interest swaps business are likely to provide disclosures such as the
aim of using such derivatives, fair value, possible outcomes to future cash flows
and sensitivity to the change of market interests, and to be different, those using
convertible bonds might disclose information about the existence of derivative
features in its compound financial instruments, date of conversion and so on.

2. The regulations for the use of derivatives were largely absent in the Chinese
accounting and reporting system. Under the voluntary reporting framework, the
derivative related information was discretionarily disclosed so listed companies
166
 were probably reluctant to provide more disclosures about their use of derivative

products. Evidence from a large number of western-based studies as discussed in

Chapter II et

2004; ct

2007: suggests that the compulsory accounting and

reporting regulations related to the use of derivative products have promoted

listed firms to disclose more information about their derivative activities although

the compliance with relevant requirements is mixed.

Hence, the limited types of derivative instruments together with the absence of

regulations impeded Chinese quoted companies to provide more quantity and

diversified of information regarding to their use of derivative products.

Secondly, agency theory could help to explain why the level of derivative disclosures

amount by Chinese listed companies is much lower as the trading of derivative

instruments is likely to adversely affect the corporate value so managers may have

incentives to withhold such value-relevant unfavourable information and gamble that

subsequent corporate events will allow them to 'bury' the 'negative' news

1 et This can be an interesting research issue for further study to

examine whether there is a difference between larger and smaller firms in terms of

managers' motivations to disclose derivative related information in a transitional

economy.

Thirdly, the limitations of the study may contribute to this controversial finding.

1. This study only emphasises on the derivative disclosure patterns by large and

medium listed compames as evidence (e.g., et

I shows that the larger firms are more likely to

use derivative products. Due to the small sample size, it is unable to conduct

regression models to analyse the relationship between the company size and
167
 quality of derivative related disclosures in this study and it leaves an interesting

research area for following ups to examine the determinants of derivative

disclosures by Chinese listed companies when the sample is adequate to carry out
statistical regression analysis.

2. In this study, the company SIze IS measured at the year-end market value.
However, corporate size can be represented by many different indicators such as
annual sales, total assets, number of employees, capital employed etc. and prior
studies (c.g.. illustrate that some indicators of corporate size,
for instance, the capital employed and sales, do have little impact on the
disclosure of information. Hence, it is necessary for future researchers to use
different measures of company size to analyse the association between the quality
of derivative disclosures and firm size.

Last but not least, the finding that there is no relationship between corporate size and
derivative disclosures is likely to challenge the adaptability of voluntary disclosure
theories, which include agency theory, signalling theory, political process theory and
proprietary costs, on Chinese equity market. They all insist that company size plays a
vital role for reporting companies to provide more voluntary infornlation and larger
firms tend to disclose more than smaller ones. However, those theories are related to
voluntary information disclosure in general terms, while this concept embodies
several attributes or dimensions. The study provides evidence that the disclosure of a

specific information attribute (e.g., derivative related information) might be different

to the rationale. When the sample is adequate, it is an interesting area for following up
studies to examine the determinants of derivative related disclosures in China and find
out whether there are some unique factors such as ownership structure, culture etc.
can have influence on the derivative disclosure patterns presented by Chinese listed

compames.

Table 5.8 Amount of Derivative Related Information (Percentage of Annual

168
 Report) Disclosed by Large and Medium Size Companies

Mean (%)
Questions Large Medium
Firms Firms
Q24 Does the firm provide other disclosures related to
0.2528 0.2471
their use of derivative instruments?
Q22 Does the firm specifY the existence ofderivative
0.2312 0.4077
features in its compound financial instruments?
Q2 Does the firm specifY the objectives for holding or
0.1166 0.09292
issuing derivative instruments?
NoFairValue * 0.1087 0.07424
Fair Value ** 0.07875 0.05843
Q8 Does the firm segregate information by risk categories
0.07358 0
(i.e. credit risk, liquidity risk, and market risk)?
Q4 Does the firm specifY the accounting policies for
0.06289 0.03619
derivative instruments?
Q5 Does the firm specifY its hedging policy? 0.01589 0.03064
Q23 Does the firm separately provide information for
embedded derivatives and liability component of a 0.01387 0.03526
compound financial instrument?
Q7 Does the firm discuss any changes to the above
0.008437 0
disclosures from the previous reporting period?
Q6 Does the firm specifY how they monitor and manage
0.004852 0
the risks associated with derivative instruments?
Q 1 Does the firm sort its derivative instruments into
appropriate financial instruments' category (held for 0.0004389 0
trading or hedging instruments)?
Q3 Does the firm specifY the associated risks provided by
0 0
derivative instruments?
Q 15 Does the firm specifY to whom they have credit risk
0 0
exposures?
Q 16 Does the firm provide the estimated maximum credit
0 0
risk exposures at the reporting date?
Q21 Does the firm use the sensitivity analysis to
demonstrate the impact ofpossible movements in each 0 0
market risk variable on profit and loss and equity?
Total 0.9680 0.9824
Notes: * NoFairValue includes Q9 'Does the firm disclose the Principal, stated, face, or other similar amount of
derivative instruments?', Q10 'Does the firm disclose the date of maturity, expiry, or execution of derivative
instruments?', Qll 'Does the firm disclose the early settlement and conversion options, including details of their
exercise of derivative instruments?', Q 12 'Does the firm disclose the amount and timing of scheduled future cash
flows related to derivatives' principal amount?' principal amount', Q13 'Does the firm disclose the interest,
dividends, or other periodic returns on principal and their timing related to derivative instruments?' and Q14
169
 'Does the firm disclose the effective interest rates of derivative instruments? "
** FairValue includes Q17 'Does the firm disclose the fair value of derivative instruments?', Q18 'Does the
firm disclose the carrying amount of derivative instruments?', Q19 'Does the firm disclose the net market value for
derivative instruments?' and Q20 'Does the firm specify the methods in determining the value of derivative
instruments? "

Table 5.9 Independent Samples Test for Derivative Disclosure Amount by Large
and IVIedium Size Companies

Levene's Test for

Equality of t-test for Equality of Means
Variances
Questions 95% Confidence
Sig. Mean Interval of the
F Sig. t df
(2-tailed) Difference Difference
Lower Upper

variances 1 >6 .227 -.595 51 -4.389E-6 -1.919E-5 1.041E-5

assumed
Q1 Equal
vanances
-1.000 38.000 .324 -4.389E-6 -1.327E-5 4.496E-6
not
assumed

Ivananc ~s 1 1 -.539 51 -2.369E-4 -1.119E-3 6.449E-4

lssumed
Q2 Equal
varIances
-.635 32.757 .530 -2.369E-4 -9.963E-4 5.226E-4
not
assumed

Ivariances 1.223 -.515 51 -2.671E-4 -1.308E-3 7.736E-4

assumed
Q4 Equal
variances
-.794 49.502 .431 -2.671E-4 -9.425E-4 4.084E-4
not
assumed

-,
Q5 Ivanances ,783 ~~') .528 5 1.475E-4 -4.133E-4 7.083E-4
assumed

170
 Equal
vanances
.517 22.149 .610 1.475E-4 -4.437E-4 7.387E-4
not
assumed
Equal
variances 5.216 .027 -1.080 51 .285 -4.852E-5 -1.387E-4 4.165E-5
assumed
Q6
Ivanances
-1.814 38.000 -4.852E-5 -1.027E-4 5.614E-6
not
assumed
Equal
vanances 4.026 .050 -.954 51 .345 -8.437E-5 -2.620E-4 9.323E-5
assumed
Q7
Ivanances
1- .602 13 )00 .117 -8.437E-5 -1.910E-4 2.226E-5
not
•assumed

Ivariances "")
L-. )9 -.815 51 -7.358E-4 -2.548E-3 1.076E-3
n ss 1l111f"<1
Q8 Equal
vanances
-1.369 38.000 .179 -7.358E-4 -1.824E-3 3.522E-4
not
assumed

vanances 1.275 -.755 51 -3.446E-4 -1.262E-3 .0005722

lssnmed
NoFairValue * Equal
vanances
-.882 32.211 .384 -3.446E-4 -1.140E-3 .0004510
not
assumed

Iv; Ices .447 .507 51 -2.032E-4 -1.181E-3 7.749E-4

assumed
FairValue ** Equal
vanances
-.479 30.946 .635 -2.032E-4 -1.067E-3 6.611E-4
not
assumed

171
 Equal
vanances 5.308 .025 1.425 51 .160 1.764E-3 -7.208E-4 4.249E-3
assumed
Q22
[varIances
1.222 1 )84 1.764E-3 -1.268E-3 4.796E-3
not
assumed

Ivariances 3 ~8 .075 1 51 2. 139E-4 -1.987E-4 6.265E-4

assumed
Q23 Equal
variances
.813 16.214 .428 2. 139E-4 -3.431E-4 7.709E-4
not
assumed

Ivariances .073 1 51 -5.705E-5 -2.304E-3 2.190E-3

assumed
Q24 Equal
variances
-.053 24.850 .958 -5.705E-5 -2.272E-3 2.158E-3
not
assumed

Ivariances 1 )0 51 1.439E-4 -4.817E-3 5.105E-3

assumed
Total Equal
vanances
.060 24.236 .953 1.439E-4 -4.815E-3 5.102E-3
not
assumed
Notes: * NoFairValue includes Q9 'Does the firm disclose the Principal, stated, face, or other similar amount of
derivative instruments?', Q10 'Does the firm disclose the date of maturity, expiry, or execution of derivative
instruments?', Qll 'Does the firm disclose the early settlement and conversion options, including details of their
exercise of derivative instruments?', Q12 'Does the firm disclose the amount and timing of scheduled future cash
flows related to derivatives' principal amount?' principal amount', Q13 'Does the firm disclose the interest,
dividends, or other periodiC returns on principal and their timing related to derivative instruments?' and Q14
'Does the firm disclose the effective interest rates of derivative instruments? '.
** FairValue includes Q17 'Does the firm disclose the fair value of derivative instruments?', Q18 'Does the
firm disclose the carrying amount of derivative instruments?', Q19 'Does the firm disclose the net market value for
derivative instruments?' and Q20 'Does the firm specify the methods in determining the value of derivative
instruments? '.

In summary, the derivative related disclosures by Chinese listed companies in terms

172
of both scores and amount are not significantly affected by corporate size that is

opposite to a number of we stem evidence (e.g.,

1 et 1 2008;

Both large and medium firms have the similar tendency in terms of the quantity of

disclosed questions and related amount of information about their use of derivatives.

Several factors, such as the limited availability of derivative products, large absence

of derivative related regulations, agency problems and limitations ofthe study, are

possible to explain such abnormal phenomenon in China's equity market.

5.4 Information Content of Derivative Disclosures

This section intends to find out what kind of information provided by Chinese quoted

companies in relation to their use of derivative instruments. The study firstly classifies

derivative disclosures following the requirements of IFRS and lAS and then adopts

the t-test to examine whether there is a statistical significance between different types

of information, and finally some examples with reference to quotations in companies'

annual report will be 'presented.

5.4.1 Nature Derivative Disclosures

In order to gain additional information regarding to how companies communicated to

the users of financial statements about their use of derivatives, a breakdown of the

nature of derivative related disclosures is necessary (Dunne et aI., 2007). In the

accounting literature, a number of U.S. based studies

1 et :2002;

Zeghal, :2005; usually sort the disclosed information

into two categories - qualitative and quantitative following corresponding derivative

173
related rules imposed by the U.S. regulators. The results generally illustrate that the

derivative related regulations have enhanced reporting companies to disclose more

information concerning their use of derivatives. Firms provide both qualitative and

quantitative disclosures following basic requirements of accounting and reporting

standards but many detailed requirements such as the assumptions of applied

quantitative techniques and description of corporate derivative management activities

are often incomplete or lacking in companies' annual reports. Since one of the

research's objectives is to identify the degree and information content of derivative

disclosures by Chinese listed companies complying with relevant regulations

proposed by IASB, this study, however, intends to adopt IFRS and lAS requirements

to classify the nature of derivative related disclosures reported by Chinese quoted

firms. IFRS 7 'Financial Instruments: Disclosures' requires the

reporting entity to provide two main categories of disclosures in its annual report:

1. the information about the significance of financial instruments for the entity's

financial position and performance; and

2. the information about the nature and extent of risks arising from financial

instruments to which the entity is exposed during the period and at the reporting date,

and how the entity manages those risks. The qualitative disclosures describe

management's objectives, policies and processes for managing those risks. The

quantitative disclosures provide information about the extent to which the entity is

exposed to risk, based on information provided internally to the entity's key

management personnel. Together, these disclosures provide an overview of the entity's

use of financial instruments and the exposures to risks they create.

Paragraphs 7 - 29 of IFRS 7 are detailed requirements for companies to report the

first type of information regarding their use of derivative instruments while

paragraphs 33 - 42 are those related to the second type. For questions in FDDI, as

shown in Table 5.10, Questions 1,4,5,17,18,19,20,22 and 23 are related to the first

type of disclosures and incorporated into a new group - VI, whereas Questions 2,3,6,
174
7,8,9, 10, 11, 12, 13, 14, 15, 16 and 21are sorted into the second type of information
and combined to V237.

Table 5.10 A Breakdown of Information Content of Derivative Disclosures

Reference in Categories of
Questions
IFRS 7 Information
Q 1 Does the firm sort its derivative instruments
Paragraphs 8,
into appropriate financial instruments' category
20 and 22
(held for trading or hedging instruments)?
Q4 Does the firm specify the accounting policies
Paragraph 21
for derivative instruments?
Paragraph 22,
Q5 Does the firm specify its hedging policy?
23 and 24
Q 17 Does the firm disclose the fair value of
Paragraph 25
derivative instruments?
Q 18 Does the firm disclose the carrying amount
Paragraph 8
of derivative instruments? VI
Q 19 Does the firm disclose the net market value
Paragraph 20
for derivative instruments?
Q20 Does the firm specify the methods in Paragraph 27,
determining the value of derivative instruments? 28 and 29
Q22 Does the firm specify the existence of
derivative features in its compound financial Paragraph 17
instruments?
Q23 Does the firm separately provide information
for embedded derivatives and liability component Paragraph 17
of a compound financial instrument?
Q2 Does the firm specify the objectives for
Paragraph 33
holding or issuing derivative instruments?
Q3 Does the firm specify the associated risks
Paragraph 33
provided by derivative instruments?
Q6 Does the firm specify how they monitor and
manage the risks associated with derivative Paragraph 33 V2
instruments?
Q7 Does the firm discuss any changes to the
above disclosures from the previous reporting Paragraph 33
period?
Q8 Does the firm segregate information by risk Paragraph 33

37 Q24 'Does the firm prOVide other disclosures related to their use of derivative instruments?' is not included in
the classification as it refers to the derivative related information voluntarily disclosed by reporting companies but
not required by IFRS and lAS.
175
 categories (i. e. credit risk, liquidity risk, and
market risk)?
Q9 Does the firm disclose the Principal, stated,
face, or other similar amount of derivative Paragraph 34
instruments?
Q 10 Does the firm disclose the date of maturity,
Paragraph 34
expiry, or execution of derivative instruments?
Q 11 Does the firm disclose the early settlement
and conversion options, including details of their Paragraph 34
exercise of derivative instruments?
Q12 Does the firm disclose the amount and
timing ofscheduled future cash flows related to Paragraph 34
derivatives' principal amount?
Q 13 Does the firm disclose the interest,
dividends, or other periodic returns on principal
Paragraph 34
and their timing related to derivative
instruments?
Q 14 Does the firm disclose the effective interest
Paragraph 34
rates of derivative instruments?
Q 15 Does the firm specifY to whom they have
Paragraph 36
credit risk exposures?
Q 16 Does the firm provide the estimated
maximum credit risk exposures at the reporting Paragraph 36
date?
Q21 Does the firm use the sensitivity analysis to
demonstrate the impact ofpossible movements in Paragraphs
each market risk variable on profit and loss and 40,41 and 42
equity?

5.4.2 Results

Table 5.11 illustrates that the mean value of VI and V2 is 0.45 and 0.27 per cent

respectively. The difference of 0.173 per cent, as shown in Table 5.13, is statistically

significant as the p value of the t-test is 0.04 less than the significance level of 0.05.

The result indicates that Chinese listed companies report significantly higher amount

of information about the impact of derivative instruments on their financial position

and performance than those related to risks arising from using derivatives with respect

176
to those of disclosures following IASB derivative regulations. It also confirms the

speculation in Section 5.2.1 that Chinese quoted corporations seemed not to be willing

to provide much information in relation to potential risks as a result of using

derivative instruments in their annual reports. Among total 14 questions ofV2, up to

eight questions i.e., all of 'Rarely Disclosed Questions' discussed in Section 5.2.1,

including Q3 'Does the firm specifY the associated risks provided by derivative

instruments?', Qll 'Does the firm disclose the early settlement and conversion

options, including details of their exercise of derivative instruments?', Q12 'Does the

firm disclose the amount and timing ofscheduled future cash flows related to

derivatives' principal amount?', Q13 'Does the firm disclose the interest, dividends,

or other periodic returns on principal and their timing related to derivative

instruments?', Q14 'Does the firm disclose the effective interest rates of derivative

instruments?', Q15 'Does the firm specifY to whom they have credit risk exposures?',

Q16 'Does the firm provide the estimated maximum credit risk exposures at the
reporting date? ' and Q21 'Does the firm use the sensitivity analysis to demonstrate

the impact ofpossible movements in each market risk variable on profit and loss and

equity?', are hardly mentioned by the sample companies. To be contrary, all 11

questions within VI were addressed in firms' annual reports. Consistent with

discussions in Section 5.2, the agency problem, large absence of derivative related

reporting requirements under China's Accounting and Reporting System as well as

unimportance of risks arising from the use of derivative instruments to the company's

financial performance are likely to be major factors contributing to this phenomenon.

Table 5.11 Paired Samples Statistics (Percentage of Annual Report) for

Information Content of Derivative Disclosures

Std.
Mean Std. Error
N Deviation
(%) Mean (%)
(%)
VI .45 53 .464 .064
Pair 1
V2 .27 53 .354 .049

177
 Table 5.12 Paired Samples Correlations for Information Content of Derivative
Disclosures

Correlatio
N Sig.
n
V1&
Pair 1 53 -.043 .761
V2

Table 5.13 Paired Samples Test for Information Content of Derivative

Disclosures

Paired Differences
95% Confidence
Std.
Std. Interval of the Sig.
Mean Error t df
Deviation Difference (2-tailed)
(%) Mean
(%) Lower Upper
(%)
(%) (%)
1
If>: !r
1
- .173 .596 .082 .337 12111 52
-

Among total nine questions of VI, Q22 'Does the firm specify the existence of

derivative features in its compound financial instruments? 'was discussed by a large

number of companies in terms of the score (23) and mean value of disclosed amount

(0.278%) as presented in Section 5.2. The following quotations provide typical

examples of these disclosures.

Approved by CSRS, the company issued 8.80 million convertible bonds to the

public with the nominal value of 100.00 RMB per note and total amount of 880

million RMB on 15 April 2004. Approved by SHSE, the company's convertible

bonds were traded on SHSE with the trading code of' 110418' and abbreviation of

'Jianghuai Zhuan Zhai' on 29 April 2004. The duration periods of these

convertible bonds are five years and the converting periods with the most recent

converting price of3.50 RMB per share will be between 15 October 2004 and 14

April 2009 2007).

178
 The convertible bonds of the firm were issued on 18 July 2003. The issuing

quantities were two million valued at 100.00 RMB per note and two billion RMB

in terms of total issuing amount. These convertible bonds were listed on SHSE on

1 August 2003. The converting periods are five years (valid from the issuing date).
The nominal interest rates are: 1st year-0.8%, 2nd year-I. 1%, 3rd year-I.8%, 4th

year-2.1 % and 5th year-2.5%. The initial converting price was 10.55 RMB per

share. The converting periods will last from 18 January 2004 to 17 July 2008. The

convertible bonds started to be executed on 18 January 2004

2(07).

By contrast, Q 1 'Does the firm sort its derivative instruments into appropriate

financial instruments' category (held for trading or hedging instruments)? 'was

merely disclosed by one company with the least amount of 0.0003 per cent as

discussed in Section 5.2 and these disclosures could be illustrated by reference to the

following quotations from nANGXI COPPER CO., LTD.

Due to the adjustment of fair values of financial derivative instruments, the

shareholder's equity was increased by 19,449,950 RMB on 31 December 2006,

including 38,747,100 RMB earning related to the use of financial derivatives

which is eligible to standards of highly effective hedging while 19,297,150 RMB

loss that is not according with standards of highly effective hedging

).

Referring to questions ofV2, Q2 'Does the firm specifY the objectives for holding or

issuing derivative instruments? 'was mentioned by most of firms in terms of the score

(40) and mean value of disclosed amount (0.110%) following the discussion in

Section 5.2. Some examples of these disclosures are provided as follows with

reference to quotations in companies' annual reports.

179
 The group is mainly engaged in export sales. In order to avoid foreign exchange

risk, the group has got involved in foreign currency forwards business with

several banks. In addition, the group borrowed long-term loans with floating

interest rates from a number of banks. The risk arising from the movement of

interest rates was eliminated by agreeing and signing interest swaps with banks

).

The shareholder's conference discussed and approved the project of firm's

shareholding reform in December 2005. Holders of outstanding shares obtained

six warrants provided by the company as well as 1.9 shares paid by overall

holders of non-tradable shares for every 10 outstanding shares and as a result,

holders of non-tradable shares paid discounted 76,000,000 shares of equity in total.

This shareholding reform finished in December 2005. The total shares of the

company were still 1,000,000,000 but previously non-tradable shares held by

company promoters became restricted tradable ones that were falling from 60 to

52.4 per cent in terms of holding percentage. On 20 December 2006, a part of

restricted tradable shares achieved the deadline required by the shareholding

reform's project that these shares were not allowed to be traded or transferred

within at least 12 months after the project was executed and since these shares

were traded in the market, the percentage of restricted tradable shares held by

company promoters was down from 52.40 to 50.304 per cent

2007).

The funds raised by issuing convertible bonds were used to the payment of

purchasing Wenhou Expressway and liujing Expressway

In summary, the results confirm the hypothesis in Section 5.2 by demonstrating that

Chinese listed companies provided relatively more information about the significance

of using derivative instruments for their financial position and performance than those
180
of disclosures related to potential risks arising from the use of derivatives and the

difference is statistically significant. In line with arguments in Section 5.2, three major

factors which are the agency problem, huge absence of derivative related accounting

and reporting regulations and unimportance of risks as a result of using derivatives to

the entity's financial performance have possible contributions to this phenomenon.

5.5 Disclosures DitIerent Types of Derivatives

This section intends to provide an argument that whether there is a difference in terms

of disclosures related to various types of derivative instruments. It begins with the

categorisation of derivatives employed by Chinese listed companies, followed by a

discussion of statistical results and a summary will be provided in the end.

5.5.1 Classification of Derivative Instruments

Derivative products can be categorised by several ways. For instance, they can be

sorted to forwards, options and swaps by the relationship between the underlying

asset and the derivative; equity derivatives, foreign exchange derivatives, interest rate

derivatives, commodity derivatives or credit derivatives by the type of underlying

asset; and exchange-traded or OTC derivatives by the market in which they trade

'-../1.H,I"V'-. 1 In this section, the study plans to classify derivative instruments used

by sample companies based upon the type of underlying asset because equity

derivatives (e.g., warrants), as discussed in the previous chapter, were widely used by

Chinese listed companies during the transition of the shareholding reform, so this

section is seeking to find out whether there is a difference of disclosures between

derivatives with different types of underlying asset. Three companies, including

ANHUI CONCH CEMENT CO., LTD, HUADIAN POWER INTERNATIONAL

181
CORPORATION and SHANGHAI AUTOMOTIVE CO.,LTD, were not considered

during the analysis as they did not clearly mention what kind of derivative

instruments they used and eventually the final sample of 50 firms, as shown in Table

5.14, can be sorted into three groups in accordance of types of derivatives they

employed. Table 5.14 illustrates that nearly two thirds of companies (32 out of 50)

merely used equity derivatives (e.g., warrants or convertible bonds), followed by

those that adopted derivative instruments rather than equity derivatives (14 out of 50)

and only five employed both types of derivatives. The finding verifies the speculation

discussed in Section 5.2.3 that Chinese listed companies were more likely to use

derivatives that might affect the structure of equities than other types of derivative

instruments in 2006. In GroupO, there are ten entities for merely using convertible

bonds, eleven for warrants and the rest eleven for both derivatives. Six companies of

Groupl employed foreign exchange or interest rate derivatives (e.g., foreign currency

forwards/swaps or interest swaps) while another seven got involved in commodity

derivatives' business (e.g., commodity futures/options/swaps). Group2 is comprised

by five firms which employed derivative instruments mentioned in GroupO and 1

simultaneously.

Table 5.14 Categorisation of Companies by Using Different Types of Derivatives

Group * Companies Derivatives Employed

ANHUI BBCA BIOCHEMICAL CO., LTD Convertible Bonds
ANHUI lIANGHUAI AUTOMOBILE
Convertible Bonds
CO.,LTD
BEIJING GEHUA TV NETWORK, INC Convertible Bonds
BEIJING YANJING BREWERY CO.,LTD Convertible Bonds
GUANGXI GUIGUAN ELECTRIC
Convertible Bonds
POWER CO.,LTD
0
HEBEl lINNIU ENERGY RESOURCES
Convertible Bonds
CO., LTD
NANlING WATER TRANSPORT
Convertible Bonds
INDUSTRY CO.,LTD
SHANDONG CHENMING PAPER
Convertible Bonds
HOLDINGS LIMITED
SHANDONG HAIHUA CO., LTD Convertible Bonds
182
 TCL CORPORATION Convertible Bonds
BEIJING CAPITAL CO.,LTD Warrants
CHINA YANGTZE POWER CO., LTD Warrants
GUANGZHOU BAlYUN
Warrants
INTERNATIONAL AIRPORT CO., LTD
HUANENG POWER INTERNATIONAL,
Warrants
INC
KWEICHOW MOUTAI CO., LTD Warrants
QINGDAO HAlER CO., LTD Warrants
QINGHAI SALT LAKE POTASH CO.,
Warrants
LTD
SHANGHAI INTERNATIONAL
Warrants
AIRPORT CO., LTD
SHENZHEN ENERGY INVESTMENT
Warrants
CO., LTD
WULIANGYE YIBIN CO.,LTD Warrants
YANTAIWANHUAPOLYURETHANES
Warrants
CO.,LTD
Convertible Bonds &
ANGANG STEEL CO., LTD
Warrants
CHINA UNITED
Convertible Bonds &
TELECOMMUNICATIONS
Warrants
CORPORATION LIMITED
Convertible Bonds &
CHINA VANKE CO., LTD
Warrants
Convertible Bonds &
GD POWER DEVELOPMENT CO., LTD
Warrants
HANDAN IRON & STEEL Convertible Bonds &
CO.,LTD Warrants
HUNAN VALIN STEEL TUBE & WIRE Convertible Bonds &
CO., LTD Warrants
INNER MONGOLIA BAOTOU STEEL Convertible Bonds &
UNION CO.,LTD Warrants
llANGXI GANYUE EXPRESS Convertible Bonds &
CO.,LTD Warrants
Convertible Bonds &
MAANSHAN IRON & STEEL CO., LTD
Warrants
PANZHIHUA NEW STEEL & Convertible Bonds &
VANADIUM CO., LTD Warrants
Convertible Bonds &
WUHAN IRON AND STEEL CO., LTD
Warrants
Subtotal of
32
GroupO

183
 CHINA INTERNATIONAL MARINE
Foreign Currency Swaps
CONTAINERS (GROUP) CO., LTD
CHINA SHIPPING DEVELOPMENT CO.,
Foreign Currency Swaps
LTD
CHONGQING CHANGAN Foreign Currency
AUTOMOBILE CO., LTD Forwards
CSG HOLDING CO.,LTD Foreign Currency Swaps
Foreign Currency
SHANGHAIZHENHUAPORT
Forwards & Interest
MACHINERY CO.,LTD
Swaps
1 Foreign Currency
TSINGTAO BREWERY CO., LTD
Forwards
Aviation Oil Options &
AIR CHINA LIMITED
Swaps
JIANGXI COPPER CO., LTD Copper Futures
SHENZHEN ZHONGJIN LINGNAN
Commodity Futures
NONFEMET CO., LTD
TBEA CO.,LTD Commodity Futures
YUNNAN ALUMINIUM CO., LTD Commodity Futures
YUNNAN COPPER CO.,LTD Commodity Futures
YUNNAN TIN CO., LTD Commodity Futures
Subtotal of
13
Group!
Foreign Currency
BAOSHAN IRON &STEEL CO., LTD Forwards, Interest Swaps
& Warrants
Foreign Currency
CHINA MERCHANTS PROPERTY
Forwards & Convertible
DEVELOPMENT CO., LTD
Bonds
2
CHINA SOUTHERN AIRLINES CO., Aviation Oil Futures and
LTD Swaps & Warrants
SHANGHAI ELECTRIC POWER CO., Foreign Currency Swaps
LTD & Convertible Bonds
SINOCHEM INTERNATIONAL Rubber Futures, Warrants
CORPORATION & Convertible Bonds
Subtotal of
5
Group2
Total 50
Notes: * GroupO contains companies that only used equity derivatives (e.g., warrants or convertible bonds);
Groupl includes those which adopted derivative instruments other than equity derivatives (e.g., foreign exchange
derivatives, interest rate derivatives, commodity derivatives or credit derivatives); and Group2 is comprised by
firms that used equity derivatives mentioned in GroupO as well as other types of derivatives mentioned in Groupl.

184
5.5.2 Results

In previous sections, the t-test was mainly employed to analyse whether the means of

two groups were statistically different from each other. However, the study adopts the

analysis of variance (ANOVA) to examine whether the means are statistically equal

between Group 0, 1 and 2 in this section as ANOVA can generalise t-test to more than

two groups and is therefore useful in comparing two, three or more means. The results

by using one-way ANOVA are proven to be reliable under following three

assumptions:

• The values in each of the groups (as a whole) follow the normal curve

• With possibly different population averages

• Equal population standard deviations

The third assumption, that the populations' standard deviations are equal, is

particularly important in principle 2003). The result of testing

homogeneity of variance between three groups as presented in Table 5.15,

demonstrates that the p value of 0.142 is higher than the confidence level of 0.05

which indicates that the standard deviations between group 0, 1 and 2 are equal and

they are therefore eligible for ANOVA test. As shown in Table 5.16, the result of

F-test is 1.790 but the corresponding p value is 0.178 bigger than 0.05 implying that

the variances of any two groups are statistically insignificant and in other words,

disclosures related to different types of derivative instruments are not significantly

different. The findings are supported by further evidence from Table 5.17, which

illustrate that the p value of any two groups is greater than the confidence level of

0.05.

Table 5.15 Test of Homogeneity of Variances for Group 0, 1 and 2

185
 Total
Amount of
Disclosures
Levene
dfl df2 Sig.
Statistic
2.036 2 47 .142

Table 5.16 ANOVA Test for G.roup 0, 1 and 2

Total Amount
of Disclosures
Sum of Mean
df F Sig.
Squares Square
Between
.000 2 .000 1.790 .178
Groups
Within Groups .003 47 .000
Total .003 49

Table 5.17 Multiple Comparisons of Means Bet\'Ileen Group 0, 1 and 2

Dependent Variable: Total

Amount of Disclosures
(I (J Mean Difference Sig 95% Confidence Interval
Std. Error
) ) (I-J) . Lower Bound Upper Bound
.0025559210 .06 -3.06821306438E 9.97687863817E
1 .004835028666
73 5 -4 -3
0
.0037370483 .73 -6.25145350311E 8.78448966561E
2 .001266518081
58 6 -3 -3
-4.835028665865E .0025559210 .06 -9.97687863817E 3.06821306438E
0
LS -3 73 5 -3 -4
1
D -3.568510584615E .0040894737 .38 -1.17954705403E 4.65844937107E
2
-3 17 7 -2 -3
-1.266518081250E .0037370483 .73 -8.78448966561E 6.25145350311E
0
-3 58 6 -3 -3
2
.0040894737 .38 -4.65844937107E 1. 17954705403E
1 .003568510585
17 7 -3 -2

Although no significant differences exist between various categories of derivatives in

186
terms of disclosure quantities, some exist in terms of detailed presentations of

derivative instruments. The following quotations provide typical cases of different

disclosures by companies using equity or other types of derivatives with reference to

Q2 'Does the firm specify the objectives for holding or issuing derivative

instruments? '.

The program of the shareholding reform was discussed and approved in the firm's

shareholders' conference held on 10 April 2006. Meanwhile the group sent nine

European-style put warrants with the executing price of 4.39 RMB and valid

periods of 12 months to outstanding shareholders who were registered on the date

of the implementation of the shareholding reform for every 10 outstanding

equities. The group had sent 607,361,050 put warrants in total. The registration of

shares to be conducted for the firm's shareholding reform (including sending

bonus shares and warrants) was taken place on 15 May 2006 and the resumption

of trading shares and listing of consideration shares were started on 17 May 2006

TCL Group and TCL Multimedia were endeavour to improve the debt structure by

using various measures, including the private equity issue and other financing

ways (e.g., TCL Communication has issued 27 million US dollars convertible

bonds until now with the target of 45 million US dollars in total). TCL Multimedia

was also trying to adopt a number of ways to improve its debt structure. We are

confident to enable the debt structure of the whole group improved in the near

future

In order to ensure the production and management of the factory to be smoothly

operated without the influence of sharp ups and downs in prices, the company had

got involved in the forward trading business as a hedging tool to lock profits since

June 2005. The main variety of commodity futures used in the hedging business

was Tin Ingot (

187
A few questions such as Q23 'Does the firm separately provide information for

embedded derivatives and liability component of a compoundfinancial instrument?'

were mainly addressed by firms that used equity derivatives and others like Q 17

'Does the firm disclose the fair value of derivative instruments? ' were, however,

primarily discussed by those with the use of derivative instruments other than equity

derivatives. Some examples of disclosures regarding these two questions are provided

as follows with reference to quotations in companies' annual reports.

The corporation issued the separation of trading convertible bonds with the total

value of 5.5 billion RMB at SHSE on 13 November 2006 and meanwhile, the

purchasers of these bonds freely obtained warrants with the total quantities of

1.265 billion that were issued by the firm as well. These warrants had been valid

in 24 months since they were issued and the executing price of a warrant was 3.40

RMB. If all holders of warrants executed their warrants, there would be an

increase of 1.265 billion in A shares. Following the New Accounting Standards No.

37 'Presentation of Financial Instruments " these separation of trading convertible

bonds were recognised as embedded compound financial instruments mixed with

liability and equity components ... Accordingly, the equity component of these

separation of trading convertible bonds was recognised as 714,253,399 RMB on

31 December 2006 and there were, therefore, an increase of714,253,399 RMB in

shareholders' equity of the parent company on 1 January 2007

The outstanding principal amount of the foreign currency forwards contracts was

197,074,000 US dollars and the fair value of them was -21,321,497 RMB on 31

December 2006

L 2(07).

In summary, the study finds that the equity derivatives (e.g., warrants or convertible
188
bonds) were adopted by the majority of firms which reconfirms the speculation in

Section 5.2.3 stating that Chinese quoted companies are likely to prefer the use of

derivatives that would have impacts on their structure of shares rather than other types

of derivative products (e.g., foreign currency forwards/swaps, interest swaps or

commodity futures/options/swaps). However, the results of ANOVA test illustrate that

the amount of disclosures between different categories of derivatives is not

significantly different although there are some distinguishments within the detailed

presentations of different derivative instruments.

5.6 Summary

By using the content analysis method to compare the IFRS and lAS based disclosure

index (i.e., FDDI) with relevant information provided by Chinese listed entities,

several findings are reached as follows:

Firstly, the degree of complying with IFRS and lAS derivative related regulations by

Chinese quoted companies was generally low.

Secondly, sample firms preferred to use equity derivative instruments (e.g., warrants

or convertible bonds) that may affect the structure of shares than other categories of

derivatives (e.g., foreign currency forwards/swaps, interest swaps or commodity

futures/options/swaps) as they presented greater amount of information related to the

use of derivatives in the section of Change of Shares and Shareholders' Information.

The difference of disclosures within different types of derivatives is, however, not

statistically significant.

Thirdly, the corporate size does not have significant impacts on the amount of

derivative related disclosures by Chinese quoted companies which is contrary to much

189
western evidence (e,g .. et

201 There is a similar

tendency within both large and medium firms in providing information about their use

of derivative instruments and a number of factors, such as the limited availability of

derivative products, large absence of derivative related regulations, agency problems

and limitations of the study, have possible contributions to such abnormal

phenomenon in China's equity market.

Fourthly, derivative related disclosures in relation to the significance of using

derivatives for corporate financial position and performance are statistically greater

than those of information related to potential risks arising from the use of derivative

instruments and three major factors, including the agency problem, huge absence of

derivative related accounting and reporting regulations and unimportance of risks

resulted from the use of derivatives to the company's financial performance, are likely

to provide explanations to this finding.

190
VI Interview
..
Dis Slons

191
6.1 Introduction

This chapter intends to complete the second phase of the study by answenng

following research questions:

• What is the response of equity market participants to derivative related

disclosures?

• Do they treat disclosing more about derivatives' activities as useful information

when making investment decisions?

• Are they satisfied with the current accounting and reporting treatment of
derivative activities?

• What are their opinions as to the future development III derivative related
reporting standards?

It includes the results of the in-depth interviews conducted with 10 investment

managers and 11 professional analysts from a mutual funds management company as

well as a securities company. The primary objective of this chapter is to examine the

equity market participants' perceptions, attitudes and opinions towards the usefulness

of derivative related disclosures provided by Chinese listed companies.

The chapter is structured as follows: it commences by the discussions related to the

interviewees' opinions about information contents of derivative disclosures, followed

by the assessment of their views about the usefulness of derivative disclosures, the

analysis and arguments in relation to their perceptions about accounting and reporting
policies for derivatives and it ends up with a summary of findings and discussions.

192
 Intervie"H~es' Opinions about Information Contents of Derivative Disclosures

In order to get insight into opinions about what types of derivative disclosures really
needed by market participants, interviewees initially were asked Q 1 'To your best

knowledge, for a nonfinancial company, what kind of information about its use of
derivatives should be disclosed?', then Q5 'For the disclosures related to the use of
derivatives, what kind of information you most concern? ' followed up and Q3 'How
do you get such information about the use of derivatives? (What is your source to get
such information?)' was finally to be asked so as to understand the information
channels for interviewees to obtain the information related to the use of derivatives.

6.2.1 Ql <To your best knowledge, for a "'v.U ........ 'L""' ...." "-,,, ..... "" .. kind of

information about its use of derivatives should be disclosed'?'

Table 6.1 presents a summary of issues addressed by interviewees about Ql 'To your
best knowledge, for a nonfinancial company, what kind of information about its use of
derivatives should be disclosed? '. Among total 24 issues, 'Scale' and 'Purpose' are
the most popular topics mentioned by interviewees. Over three quarters of them,
which are 16 out of 21 (76.19%), indicated that the scale of derivatives' business
should be reported by a nonfinancial entity if it was engaged in and almost half which

are 10 of21 (47.62%) stated that it was necessary for a reporting company to disclose
the purpose of using derivative instruments. In addition, nearly one in five
interviewees pointed out that the users of derivatives had responsibility to provide
information to discuss issues such as 'Qualitative Description of Derivative Products'
(23.81 %), 'Risk' (19.05%), 'Direction' (14.29%), 'Price' (14.29%), 'EamingslLosses'
(14.29%) and 'Terms' (14.29%). There are up to two thirds of total topics (i.e., 16 out
of 24) associated with the disclosures of using derivatives, including 'Confidentiality',

193
'Depend on Views of Investors/Companies', 'Tenure', 'No Idea', 'Supervisory
Bodies' Responsibility' , 'Valuation' , 'Impacts', , Accounting

RecognisationiMeasurement', 'Fair Value', 'Decision-making Mechanism', 'Value

Chain', 'Currencies', 'Deposit', 'Counter Party', 'Qualification' and 'Unnecessary to

Disclose Information', merely mentioned by less than ten per cent of total

interviewees. Referring to the individual interviewees' group, managers and

professional analysts have similar tendency regarding the information contents of

derivative disclosures with a few differences as follows:

Firstly, although 'Purpose' is the second hottest topic addressed by both groups, it is
obvious that managers paid more attention to this issue than analysts as up to 60 per

cent of managers mentioned the need to disclose the purpose of using derivative

instruments which is much higher than that of analysts (36.36%).

Secondly, despite of 'Scale' and 'Purpose' themes like 'Qualitative Description of

Derivative Products' and 'EamingslLosses' discussed by a certain portion of

managers (i.e., 30% and 20% respectively) were not attracted much insight from
analysts' group as its corresponding proportion was only 18.18 and 9.09 per cent

respectively. Instead, nearly 30 per cent of analysts separately emphasised on whether

firms had provided information related to the risk or terms of their derivative

products.

Thirdly, there are nine out of 24 topics which contains 'Tenure', 'Decision-making
Mechanism', 'Value Chain', 'Currencies', 'Deposit', 'Counter Party', 'Qualification'

and 'Unnecessary to Disclose Information', not addressed by managers while six,

including 'No Idea', 'Supervisory Bodies' Responsibility', 'Valuation', 'Impacts',

'Accounting RecognisationiMeasurement' and 'Fair Value' ,were not discussed by

analysts.

With respect to the topic of 'Scale', interviewees insisted that reporting entities ought
194
to disclose information concerning the quantities, positions or proportion of derivative

instruments as showing in the following examples with reference to quotations by

three investment managers.

Major information about the use of derivatives should include for instance ... their
holding quantities ... 1 mainly concerned this kind of information when I was

investigating the hedging business of staple commodities conducted by listed

companies (Interviewee (IV) 17).

From the VIew of our demanding ... then the information about positions of

derivatives held by the firm is useful for us as it surely had greater impacts on the
corporate performance (IV 09).

The company should describe ... the proportion of derivative products in its entire

asset (IV 08).

One of analysts provides an example to illustrate why he believed there was a need

for firms to discuss the purpose of using derivatives as follows:

In the domestic market, financial derivative products mainly refer to commodity

futures. First of all, organisations must report whether they got involved in
derivatives business and rigorously disclose that the use of such instruments was

aiming for either hedging or speculating because many listed companies initially
targeted to hedging but conducted some investment businesses later on and finally

suffered huge derivative-related losses (IV14).

Three managers and two analysts demonstrated that it was necessary for quoted

companies to provide detailed qualitative disclosures about their use of derivatives

and in this regard, one of managers stated:

195
 Some large Chinese companies owned by the central government would take part
in derivatives trading in overseas market. Although the supervisory body -
State-owned Assets Supervision and Administration Commission (SASAC)

stipulated that all state-owned enterprises were only allowed to get involved in the
hedging businesses, previous experience told us that there were still a number of
firms engaged in speculating rather than hedging businesses by using derivative
instruments. From this viewpoint, I think listed companies should prepare some
qualitative disclosures to strictly report the details of their holding derivatives,
such as the investing types, OTC or Exchange based and positions of those
products (IV 18).

It is interesting that one of interviewees from each group addressed the issue of
'Confidentiality' and argued that although as investors they wanted to know
everything about companies' derivative activities, it is impossible for enterprises to
disclose all information particularly those in confidential related to their use of
derivatives to the public. They provided the following arguments:

.. .It is difficult to say that what kind of derivative related information should be
disclosed and it depends. From the view of investors, they certainly hope reporting
enterprises to provide more detailed disclosures. From the view of companies,
however, they are likely to keep some confidential information if they got
involved in forwards or futures businesses. Hence, it is impossible to just consider
one aspect rather than another and I think the supervisory bodies have

responsibility to decide what derivative related information should be reported.

More disclosures are certainly beneficial for investors to make decisions but
probably not good for enterprises' operation (IV 01).

The principle of corporate governance is to ensure the maximum of shareholders

interests. Thus, it is necessary for companies to disclose those of information
which would influence the shareholders particularly minority stockholders'
196
 interests ... Every firm has its own situations. For instance, an industrial enterprise

used its own funds to invest in commercial futures that are highly related to its

major businesses. In principle, the firm should provide more information in

greater depth and details but if the information was associated with its operational

confidentiality such as possible to leak its costs, the company needs to seriously

consider the balance between the principle and confidentiality. All in all, the most

vital principle is to protect investors (IV 16).

Table 6.1 Issues in Relation to Ql Addressed by Interviewees

Percentag Percentag Percentage

Nos. of Nos. of
einTotal einTotal Tom in Total
Issues Manage Analyst
Manager Analysts I Interviewe
rs s
s(%) (%) es(%)
Scale 8 80 8 72.73 16 76.19
Purpose 6 60 4 36.36 10 47.62
Qualitative Description of
3 30 2 18.18 5 23.81
Derivative Products
Risk 1 10 3 27.27 4 19.05
Direction 1 10 2 18.18 3 14.29
Price 1 10 2 18.18 3 14.29
Earnings/Losses 2 20 1 9.09 3 14.29
Terms 0 0 3 27.27 3 14.29
Confidentiality 1 10 1 9.09 2 9.52
Depend on Views of
1 10 1 9.09 2 9.52
Investors/Companies
Tenure 0 0 2 18.18 2 9.52
No Idea 1 10 0 0 1 4.76
Supervisory Bodies'
1 10 0 0 1 4.76
Responsibility
Valuation 1 10 0 0 1 4.76
Impacts 1 10 0 0 1 4.76
Accounting
RecognisationiMeasurem 1 10 0 0 1 4.76
ent
Fair Value 1 10 0 0 1 4.76
Decision-making
0 0 1 9.09 1 4.76
Mechanism
Value Chain 0 0 1 9.09 1 4.76
Currencies 0 0 1 9.09 1 4.76
197
 Deposit 0 0 1 9.09 1 4.76
Counter Party 0 0 1 9.09 1 4.76
Qualification 0 0 1 9.09 1 4.76
Unnecessary to Disclose
0 0 1 9.09 1 4.76
Information

6.2.2 Q5 'For the disclosures related to the use of derivatives, what kind of

information you most concern?'

Table 6.2 summarises issues addressed by interviewees in relation to Q5 'For the

disclosures related to the use of derivatives, what kind of information you most
concern? ' and different with Q 1, Q5 primarily aims to identify what kind of derivative
related information is important for interviewees to make investment decisions. There
are total 16 issues mentioned by interviewees regarding the importance of information
contents of derivative disclosures. Among them, 13 issues, including 'Scale',
'Purpose', 'Price', 'Direction', 'Risk', 'Impacts', 'Terms', 'Qualitative Description of
derivative Products', 'No Idea', 'Earnings/Losses', 'Tenure', 'Currencies' and
'Valuation', were also discussed in Q 1 which indicates that from interviewees'
perspective, these issues should be not only disclosed but also important to company's
derivative disclosures and three new topics - 'Cost', 'Leverage' and 'Trading Place'

which were not addressed in Q 1 are also believed to be of importance to the

understanding of derivative related information provided by nonfinancial entities.
Although many topics were discussed by interviewees in both Ql and Q5, the
frequencies of individual issues in Q5 are inconsistent with those in Q 1 and the

differences are as follows:

Firstly, similar with the results of Q1, 'Scale' and 'Purpose' are still top two topics
addressed in Q5 which implies that the derivative information related to these two
issues are most vital to interviewees. As discussed in Chapter V, the majority of
sample firms (40 out of 53) disclosed the objectives for the use of derivatives in their
198
2006 annual reports and, therefore, it can be argued that most Chinese listed

companies are able to disclose information for equity market participants to

understand the purpose of using derivative products. However, referring to the

frequencies, the proportion of either topic is sharply declined from 76.19 (16
interviewees) and 47.62 (10) per cent in Ql to 47.62 (10) and 33.33 (7) per cent

respectively which indicates that although more interviewees believe that the
reporting company should provide information associated with the scale or purpose of

using derivative instruments, these kinds of information are not necessary to be most

concerned with the evaluation of derivative disclosures.

Secondly, issues of 'Price' and 'Direction' attract more attention III Q5 as the

quantities of interviewees of either topic in Q5 (6 and 5 respectively) are almost twice

as much as those of Ql (3 and 3 respectively) which means that from market
participants' view, the disclosures in relation to the price or movement of derivatives

are likely to be much of significance. By contrast, the numbers of interviewees who

mentioned 'Qualitative Description of Derivative Products' and 'Earnings/Losses' are

dramatically down from five and three in Ql to two and one in Q5 separately which
implies that the information related to these two issues seems not to be important to

interviewees although they believe that firms should report the use of derivatives

regarding these two topics.

Last but not least, it should be noticed that the issue of 'Risk' attracted much of

insights in both Q 1 and Q5 as nearly one out five interviewees addressed this topic in

both questions. However, as discussed in Chapter V, none of sample companies

provided the information related to risks arising from using of derivatives in their
annual reports and, hence, it can be argued that there is a need for Chinese listed firms

to discuss the risks associated with derivative instruments in their public reports so as

to satisfy the information needs of institutional investors.

With respect to the issue of 'Price', some interviewees stressed the importance of
199
derivatives' price to the assessment of derivative products used by companies and this

view is clearly stated as the following quotations by a manager and an analyst:

Currently, the derivative disclosures are commonly referred to warrants embedded

in convertible bonds. For warrants, I mainly concern the converting percentage

and price because these are associated with the space of arbitrage ... (IV 19).

I mainly care about the information related to the quantities and price in short
terms, and purpose, risk control mechanisms etc. in long term (IV 03).

Five interviewees pointed out that the operating direction of the derivatives business
was quite vital to the users' financial performance. In this regard, one manager stated:

... I primarily care about whether the direction of derivative instruments is correct
when companies got involved in OTC businesses as I have doubts with the current
ability of Chinese nonfinancial enterprises to operate OTC derivative

products ... (IV 20).

Another analyst further provided supportive statements as follows:

I mainly concentrate on the operating direction of derivative instruments. Its

operating direction is fundamentally important for me to judge the price trend of
objects under derivative contracts in the near future and the subsequent effects to a

firm's profits (IV 12).

One manager and three analysts emphasised on the impact of risks arising from the
transactions of derivatives when making investment decisions as showing in the

following quotations by one analyst:

For me, I seriously concern the risk exposures of derivative products. How huge is
200
 the potential risk? Is there a cap or bottom? It would have a great effect if you
issue a put warrant (IV 10).

Table 6.2 Issues in Relation to Q5 Addressed by Interviewees

Percentage Percentage Percentage in

Nos. of in Total Nos. of in Total Total
Issues Total
Managers Managers Analysts Analysts Interviewees
(%) (%) (%)
Scale 5 50 5 45.45 10 47.62
Purpose 2 20 5 45.45 7 33.33
Price 2 20 4 36.36 6 28.57
Direction 1 10 4 36.36 5 23.81
Risk 1 10 3 27.27 4 19.05
Impacts 2 20 0 0 2 9.52
Terms 1 10 1 9.09 2 9.52
Qualitative
Description of
1 10 1 9.09 2 9.52
Derivative
Products
No Idea 1 10 0 0 1 4.76
Cost 1 10 0 0 1 4.76
EamingslLosses 1 10 0 0 1 4.76
Tenure 0 0 1 9.09 1 4.76
Currencies 0 0 1 9.09 1 4.76
Leverage 0 0 1 9.09 1 4.76
Trading Place 0 0 1 9.09 1 4.76
Valuation 0 0 1 9.09 1 4.76

6.2.3 Q3 •How you get such information about the use of derivatives'? (\Vhat is

source to get such information?),

In order to find out the channels for investors to obtain the information related to the
use of derivative instruments by listed companies, interviewees were subsequently
asked Q3 'How do you get such information about the use of derivatives? (What is
your source to get such information?)' and 'fable 6.3 provides a summary of

201
information channels addressed by interviewees. As shown, the use of public reports
such as quarterly, semi-annual or annual reports produced by quoted companies is the
most prevalent method to gather derivative related information as almost every

interviewee except one manager mentioned the adoption of public reports as a source
to collect information. There are up to 80.95 per cent of interviewees (17 out of 21)
regarded the way of conducting surveys like communication with listed companies in

private as a major channel for the collection of information. Eight interviewees

including four managers and four analysts as well suggested the employment of other
public information like internet or media. Lastly, only less than ten per cent of
interviewees (2 out of 21) pointed out that they obtained such information associated
with the use of derivatives through the reports produced by professional analysts.

Interviewees were further asked about which way they most preferred to collect
derivative related information and the results are presented in Table 6.4. It is quite

interesting that no more than half of interviewees (47.62%) considered the use of
public reports to be the primary way to gather derivative information whereas it was
mentioned by almost every interviewee in Table 6.3 which indicates that although the
adoption of public reports is a major information source in Chinese equity market,
institutional investors still have other important channels to collect the information
associated with the use of derivatives by listed companies. Some interviewees who
preferred to use public reports demonstrated that the information received from public
reports was relatively reliable which is showing in the following examples with

reference to quotations by an investment manager:

I think the use of public reports is the main information channel as it is not easy to
control the authenticity and reliability of surveys (IV 07).

Other supporters expressed their worries about the effectiveness of other information
source like surveys as firms sometimes might not provide any more information
beyond those in public reports due to the consideration of confidentiality and this
202
view is argued as following statements by two analysts:

.. .I think doing surveys does have much of effect because the companies have to

avoid the risk related to disclosures of information (IV 11).

I believe the use of public reports is more vital because conducting survey has

greater uncertainties as companies sometimes could answer your questions but

sometimes not (IV 13).

As shown in Table 6.4, there are eight (38.10%) interviewees who insisted that they

were more likely to choose other information channels rather than 'Public Reports'
which includes four for 'Other Public Information', three for 'Surveys' and one for

'Analysts' Reports'. Moreover, three of them (14.29%) did not manifest their

preference to different ways of gathering derivative related information. For

interviewees who preferred the adoption of surveys, some argued that the inadequacy
of derivative disclosures by Chinese listed companies was the major reason for not
using public reports and this view is discussed as the following examples with

reference to quotations by one manager and analyst respectively:

I think conducting surveys is the most important information channeL It is an

opportunity to have a deep and straight-out communication with listed companies

as the current information disclosure by domestic companies is incomplete and in

many cases, the information which should be disclosed in public reports seems not

to be reported in practice (IV 17) .

. . .The other method is to directly contact firms to ask whether they have got
involved in derivatives businesses. I think the direct communication with quoted
companies is a little bit more straightforward. The use of public reports produced

by firms is another way to obtain information but public reports contain too much

information not mainly focused on derivative issues. Even if you categorise the
203
 information in reports, it still needs to be verified by contacting reporting entities.
In my opinion, the information provided by many Chinese companies in their

public reports is not adequate and therefore, it would be more effective to directly
communicate with listed firms (IV 04).

Four interviewees considered the employment of other public information like news
on internet or media to be prior over either public reports or surveys and for instance,
one manager and analyst separately provided some arguments for this as follows:

Conducting surveys must be good because you could acquire first hand
information. However, the problem is that at present, a lot of derivative
transactions are treated as off-balance sheet items and therefore, you are unable to
figure out the consequences of such businesses before they are finally settled and
delivered. Hence, the conduction of surveys must be good but has limited effects
on the acquirement of derivative related information. As for my experience, the
most vital channel is the information platform on internet (IV 21).

The major channel is to get information from some financial websites such as sina
(wvV11-:sina.com.cn), eastmoney (ww1v.eastmoney.com) etc. They have specialised

subjects particularly to financial derivatives like futures (IV 12).

Table 6.3 Issues in Relation to Q3 Addressed by Interviewees

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
Public
9 90 11 100 20 95.24
Reports
Surveys 8 80 9 81.82 17 80.95
Other Public
4 40 4 36.36 8 38.10
Information
Analysts'
1 10 1 9.09 2 9.52
Reports
204
 Table 6.4 Preference of Information Channels by Interviewees

Nos. of Percentage in Total

Information Channels
Interviewees Interviewees (%)
Public Reports 10 47.62
Other Public Information 4 19.05
Surveys 3 14.29
Preference Not Clearly
3 14.29 ~

Mentioned
Analysts'Reports 1 4.76

In summary, with regard to the information contents of derivative disclosures, the

information in relation to the scale and purpose of derivative businesses was

perceived to be greatest of importance to the sample institutional investors. In

addition, the disclosures concerning the price and direction of derivative transactions

were also believed to be vital to the understanding of derivative disclosures provided

by Chinese listed companies. Last but not least, the information related to the risk

arising from the use of derivatives which was not reported by any sample companies

as discussed in Chapter V has attracted considerable attentions from interviewees

implying a necessity for the users of derivatives to produce discussions associated

with risks accompanying with employing derivative instruments in their annual

reports so as to meet the expectation of equity market participants.

Referring to the channels of obtaining information, although the use of public reports

provided by reporting entities was the most popular method, it was merely chosen by

less than 50 per cent of interviewees to be the primary way to collect derivative

related information while there were a quite number of interviewees who tend to

mainly employ other ways such as surveys and internet/media to gather information.

In interviewees' opinions, the reliability of disclosures was thought to be the major

reason to be prior to using public reports whereas the inadequacy of derivative

disclosures by Chinese listed companies was mainly contributed to the adoption of

other information channels.

205
6.3 Intervic\'fCeS' Opinions about Usefulness of Derivative Disclosures

This section intends to provide a discussion about the usefulness of derivative related

disclosures perceived by Chinese equity market participants. It begins with the

presentations and arguments of interviewees' responses to Q2 'Have you ever used the

information related to the use of derivatives when evaluate a corporate performance

or risk profile? (If no, why?)', followed by Q4 'Do you think the information about

the use of derivatives is useful or not when making investment decisions? Why?', Q6

'In your view, is it much more useful if a company discloses more information about

its use of derivatives?', Q7 'Generally, are you satisfied with current

derivative-related disclosures provided by listed companies? Do you think the

information disclosed by companies is adequate or not? If not, what kind of

information you would like companies to disclose?' and a summary of findings and

discussions will be provided in the end.

6.3.1 Q2 you ever used information related to the use of derivatives

when evaluate a corporate performance or risk profile'! (If no, why'?)'

Table 6.5 summanses the results associated with Q2 'Have you ever used the

information related to the use of derivatives when evaluate a corporate performance

or risk profile? (If no, why?) '. As shown, the majority which are over three quarters of

interviewees (76.19%) have ever used derivative related disclosures provided by

Chinese listed companies when assessing the value of a firm, however, it should be

noticed that there are still a certain portion of interviewees which are nearly a quarter
(23.81 %) including one manager and four analysts stating that they have never or
hardly employed such disclosures in the process of evaluation. With regard to the
206
reasons for not adopting derivative related information, one manager and two analysts

argued that derivative instruments were seldom employed by their focused companies

within particular industries and this view is illustrated in the following quotations:

Almost not (used derivative disclosures). Generally speaking, the scale of

derivative businesses is relatively small which is mainly concentrated on foreign

exchange products with few futures, and it takes very little in total assets or

liabilities. As a result, the use of derivatives is unlikely to be treated as a

significant risk to corporate performance (IV lO).

I think the assessment of the derivatives trading is one of important aspects to

evaluate a company's risk profile but different industry has different situations. I

emphasise on the petroleum and petrifaction industry and as my experience, the

domestic petroleum and petrifaction firms are usually seldom involved in financial

derivative transactions as based upon previous experience, they know that the

fluctuation of petroleum is greatly huge which is not easy to be controlled or

predicted (IV 04).

My focused enterprises which are mainly within the paper making industry have

never used derivative related instruments because the derivative products

specialised to this industry are currently not available in the domestic market (IV

13).

Another two analysts highlighted the inadequacy and incompletion of derivative

related information reported by quoted companies is the vital reason for not

employing such disclosures and they provided some discussions as follows:

· .. never used derivative related disclosures as the formation related to the use of

derivatives is not fully disclosed by listed firms. Previously, I tried to seek such

information but never found. For instance, the prices of staple commodities such
207
 as non-ferrous metal, crude oil etc. have been heavily fluctuated in recent years,

however, I really cannot understand why companies closely associated with such

commodities like airlines did not use derivative products to hedge their price risk

because in my memory, they never report such derivative activities in public

reports. Finally, I knew that they got involved in derivatives trading and suffered a

huge loss. Hence, it is impossible for me to use such inadequate derivative related

information as the users did not tell you anything about when they conducted such

businesses but the consequences came out at end (IV 14).

I seldom use derivative disclosures in practice. In the real world, such disclosures

are usually not adequately, completely and timely reported by quoted companies. I

think the derivative related information is too little to make a judgment (IV 16).

Table 6.5 Issues in Relation to Q2 Addressed by Interviewees

Percentage Percentage Percentage in

Nos. of in Total Nos. of in Total Total
Issues Total
Managers Managers Analysts Analysts Interviewees
(%) (%) (%)
Ever Used
Derivative 9 90 7 63.64 16 76.19
Disclosures
N everlHardly
Used
1 10 4 19.05 5 23.81
Derivative
Disclosures

6.3.2 Q4 'no you inform.ation about the use of derivatives is or not

when making investment decisions? 'Vhy?'

In this section, the interviewees' opinions about the usefulness of derivative related

disclosures is examined by asking Q4 'Do you think the information about the use of

208
derivatives is useful or not when making investment decisions? Why? '. Different with

previous sections, the study mainly emphasises on interviewees who have employed

the disclosed derivative information by listed companies when making investment

decisions and therefore, the final sample in this section are 16 in total where five

interviewees containing one manager and four analysts are not included. Generally, all

of 16 interviewees reached a consensus that the information provided by quoted

companies about their use of derivative instruments was useful and helpful to make

investment decisions. This finding is consistent with a great many western studies

mainly based on the U.S. and UK's scenarios (c.g., ct

ct ct ~005;

which provided empirical evidence to prove that the derivative related disclosures

following corresponding regulations contain useful information to users of financial

statements, particularly to investors and therefore, they are value relevant to investors'

assessment of the corporate value.

However, they had different VIews III terms of the significance of derivative

disclosures in the process of decision making which is summarised in Table 6.6. Most

of interviewees which are seven out of 16 (43.75%) considered derivative related

disclosures only as the complementary information, followed by five (31.25%) with

the view of the role of such information subject to different situations and only a

quarter of interviewees insisted that the derivative information disclosed by Chinese

listed firms played a major role when making investment decisions. Referring to

individual interviewees groups, managers have different preference with analysts with

regard to the importance of derivative disclosures. The supplementary effect of

derivative disclosures was favoured by over half of managers (55.56%) whereas the

major role was suggested by most of analysts (42.86%). The findings are likely to

provide a possible reason to explain the result found in Chapter V that the degree of

disclosures complying with lFRSs and lASs derivative related regulations is generally
209
low in Chinese equity market as reporting entities are possible to be encouraged to
disclose the information highly concerned by market participants rather than those

considered as supplements in assisting investment decision. This can be an interesting

topic for further studies to analyse the incentives of derivative users to provide
corresponding information to the public.

Interviewees were further asked why they believed derivative related disclosures to be
major, complementary or subject to different cases and the results are presented in
'fables 6.6, 6.7 and 6.8. As shown in Table 6.7, among interviewees who treated the
derivative related information as the major basis to decide investments, three quarters
including one manager and two analysts claimed that they thought such disclosures
were highly related to the valuation of a company and they expressed this view by

stating:

I think it (the derivative disclosure) is the major information for valuation of a

firm. For example, JIANGXI COPPER CO., LTD suffered great losses in terms of
derivative transactions and this kind of losses would directly affect the valuation

of the company. Thus, I feel that the information related to the use of derivative
products is not assistant and supplementary while it is very vital to influence your
judgment about the corporate value (IV 18).

As many expenences, derivative disclosures reported by listed companies are

quite important to make investment decisions as the trade of derivative
instruments on the one hand, may have significant impacts on a enterprise's
profits or earnings; on the other hand, it also reflects the prediction of the firm
regarding the future movement of the market where it is operated (IV 05).

Derivative disclosures are much of importance for me to decide investments

because the prices of derivative products particular staple commodities would
largely affect the prices of products a firm produced and eventually, affect the
210
 share pnces. At present, the share pnces of domestic listed companIes are
particularly highly related to derivatives like staple commodities. As a result,

when the prices of staple commodities go up, the share prices of quoted

companies would be changed simultaneously (IV 12).

In addition, an analyst provided the following arguments to illustrate the significance

of using derivative related information in helping judge the direction of investment

decisions:

I think there would be a huge difference in terms of your decisions whether the
information related to the use of derivatives is available. At least, with such
information, it is able to make the decisions in a right direction although you

cannot get an accurate answer due to the incompletion of such derivative

disclosures (IV 03).

As shown in Table 6.8, the majority of interviewees (71.43%) who considered

derivative related disclosures as complementary information argued that such

disclosures were mainly used to evaluate the corporate risk profiles and comparatively,

the main body disclosures like information related to profits, assets, liabilities etc.
were primarily much of importance to make investment decisions. In this regard,

some examples with reference to quotations by two managers and one analyst are

shown as follows:

The information about the use of derivative instruments is a sort of

complementary information and we mainly look at the information related to an

enterprise's assets, liabilities and profits. To invest a company or not is still based

on its fundamental businesses. The derivative related information is only a

supplementary explanation without decisive effect and it is merely to be employed

to evaluate corporate risks (IV 07).

211
 It (the derivative disclosure) is a kind of complementary information. We look at

derivatives and actually pay attention to whether the use of derivative products
can cause a huge risk to a firm. If its strategy of employing derivatives is to be
complemented with fundamental businesses with the primary aim to fix costs, the

derivative businesses would have large influence on fundamental businesses and

therefore, the risk is easily to be estimated (IV 09).

The information (in relation to the derivative usage) is useful to evaluate market
risks as the evaluation of investment risks is one of aspects to make investment
decisions (IV 02).

The small scale of derivative transactions in total businesses mentioned by 28.57 per
cent of interviewees is the second popular factor contributing to the minor role of
derivative disclosures in the valuation of a company and a manager stated:

In my opinion, it (the derivative disclosure) is the supplementary information

because as far as I know, the quantities of derivative instruments used by domestic
firms would not be very huge and as a result, the derivative transactions are not
likely to have significant impacts on companies' whole businesses (IV 08).

Another manager expressed the similar view as shown in the following paragraphs:

I think the derivative related information is complementary. After all, mainland

listed companies can only employ very few derivative products and the scale of
derivative businesses is quite limited as well. In addition, the use of derivatives is
merely an aspect of a firm's operation and therefore, it cannot be treated as
primary but only as supplementary aspect (IV 21).

An analyst indicated the complementary effect of derivative disclosures on evaluating

corporate governance:
212
 The disclosures in relation to the use of derivatives have a certain complementary

role on the valuation of a company's stock prices. It (the derivative disclosure) is

one of factors with reference to corporate governance. If it (the derivative

disclosure) was disclosed in time, the reporting firm must be trusted and there
would be less uncertain in terms of its stock price (IV 15).

Referring to interviewees who believed derivative related disclosures to be depending

on specific situations as shown in 'fable 6.9, the vast majority (80%) of the

interviewees insisted that the significance of such disclosures should be subject to the
impact of using derivatives on a company's financial status. The following quotations

from one manager and analyst respectively provided typical examples to illustrate this
VIew:

I think the importance of derivative related information should depend on the

quantities of derivative businesses. If they are greatly invested, it would be

possible to cause a large rise and fall in short term earnings and in this case, the

derivative disclosures would be vital for evaluating the firm. Otherwise, the

impact of derivative transactions would be immaterial and therefore, such

disclosures would not be likely to be temporarily considered (IV 19).

It (the significance of derivative disclosures) relies on the scale of derivative

instruments and further, their impacts on the corporate financial performance. If

the scale is too small, derivative disclosures should not be focused. For instance, if

a company with billions RMB of net profits has hundreds of millions RMB of
derivative products, the impact of derivatives would not be hugely affected its

financial status as it only has a percentum effect on corporate profits even though
the company suffers derivative related losses. Otherwise, if derivative transactions

enormously affect the firm's financial performance, such disclosures should be

paid much attention (IV 06).

213
 Table 6.6 Issues in Relation to Q4 Addressed by Interviewees

Percentage Percentage Percentage in

Nos. of in Total Nos. of in Total Total
Issues Total
Managers Managers Analysts Analysts Interviewees
(%) (%) (%)
Complementary
5 55.56 2 28.57 7 43.75
Information
It Depends 3 33.33 2 28.57 5 31.25
Major
1 11.11 3 42.86 4 25
Information

Table 6.7 Reasons for Believing Derivative Disclosures as 'Major Information'

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
Closely
Related to
1 100 2 66.67 3 75
Corporate
Value
Direction of
0 0 1 33.33 1 25
Judgment

Table 6.8 Reasons for Believing Derivative Disclosures as 'Complementary

Information'

Percentage Percentage in
Percentage
Nos. of in Total Nos. of Total
Issues in Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
Focus on
Main Body 4 80 1 50 5 71.43
Disclosures
Small Scale 2 40 0 0 2 28.57
Depending on
Your Own 1 20 0 0 1 14.29
Judgment
Corporate
0 0 1 50 1 14.29
Governance

214
 Table 6.9 Reasons for Believing Derivative Disclosures as 'It Depends'

Percentage Percentage Percentage in

Nos. of in Total Nos. of in Total Total
Issues Total
Managers Managers Analysts Analysts Interviewees
(%) (%) (%)
Impact on
Corporate
2 66.67 2 100 4 80
Financial
Performance
Terms 1 33.33 0 0 1 20

6.3.3 Q6 'In your view, is it much more useful a company discloses more

use of derivatives?'

In order to get insight into the perceptions of investors about disclosing more

derivative information by listed companies, interviewees were asked Q6 'In your view,

is it much more useful if a company discloses more information about its use of
derivatives? '. Overall, all of 21 interviewees agreed that it was more of use and help
to make investment decisions if a quoted firm provided more derivative related

disclosures and they also explained the reasons for welcoming the disclosure of more

derivative information as shown in Table 6.10. The majority of analysts which are

seven out of eleven (63.64%) argued that it was helpful to facilitate their investment

decisions by getting better understanding of the risk profile of a company if it reported

more derivative disclosures and this view is illustrated as following examples with

reference to quotations by two analysts:

It (the more derivative disclosure) must be helpful. By using more derivative

related information, I could make clear awareness about a firm's risk profile at

least. Although I have little knowledge about risks related to the use of financial

derivatives, if the reporting entity provided more detailed disclosures, I can

understand their inherent risks by consulting some specialists (IV 04).

215
 It (the more derivative disclosure) is useful as the more information you obtained,

the more likely to measure risks a company faced and furthermore, the more
comprehensive understanding of risks, the more ability to make accurate valuation
(IV 14).

Different with the analysts, most of the managers (40%) treated the provision of more
derivative disclosures as the improvement of information transparency which can
contribute to make better investment decisions. For instance, two of them provided
some discussions as follows:

... It is possible to gIVe some premiums on listed firms with more derivative

disclosures because they are more transparent and welcomed (IV 09).

It (the more derivative disclosure) is useful. Firstly, disclosing more information at

least indicates the reporting enterprise is more open and transparent in terms of
information disclosures and also shows that it is responsible for shareholders.

Secondly, disclosing more derivative information is beneficial for me to analyse

the details of derivative instruments adopted by the company. I believe the
transparency of a quoted firm to external investors is greatly significant (IV 17).

Nearly a quarter of interviewees (23.81%) did not specifically address the

contributions related to the disclosure of more derivative related information. In
addition, almost one fifth (19.05%) including three managers and one analyst
suggested that other issues like the improved management level were likely to be
perceived accompanied with reporting more derivative information and in this regard,

one manager stated:

It (the more derivative disclosure) must help. It may reflect the management level
of a listed company by disclosing more information in relation to the use of
216
 derivatives ... and therefore, the more, the better (IV 10).

Interviewees were further asked about whether they made favoured valuation on firms

with more derivative disclosures when deciding investments and the responses are

summarised in Table 6.11. Generally speaking, two thirds of interviewees

demonstrated that they were likely to positively valuate companies with more
provision of derivative related information while up to one third insisted that it was

not necessary to make positive valuation for those with more derivative disclosures.

With regard to reasons for not making favoured assessments, as shown in Table 6.12,
almost all of interviewees which are six out of seven (85.71 %) achieved the consensus

that they would not be able to give positive valuation unless companies with more
derivative disclosures provided relevant information to their appraisal of investments

which is showing as following examples with reference to quotations by two analysts:

... However, I think the disclosed derivative information should be relevant. Listed
firms need to prepare more information related to their essential operations such

as why you used those derivatives and what impacts would have on the company's

operation if you employed other products as substitutes rather than those about the
explanation of mathematics and financial theories like how to price by using BS
Model (Black-Scholes Option Pricing ModeI 38). I pay more attention on the

virtual effect of derivative products on an enterprise other than theoretical

background knowledge (IV 02) .

.. .It is useful to decide investments if more information is available. Nevertheless,

these information must be useful for our concerns such as the derivatives' scale,

price and any adjustment for an increase or decrease after the disclosure (IV 03).

38 The Black - Scholes Option Pricing Model is an approach for calculating the value of a stock option. In the
early 1970's, Myron Scholes, Robert Merton, and Fisher Black made an important breakthrough in the pricing of
complex financial instruments by developing what has become known as the Black-Scholes model. In 1997, the
importance of their model was recognised worldwide when Myron Scholes and Robert Merton received the Nobel
Prize for Economics. The Black-Scholes model displayed the importance that mathematics plays in the field of
finance. It also led to the growth and success of the new field of mathematical finance or financial engineering
(i'vlad-:enzk.2003).
217
Besides, a manager provided an argument that the positive assessment should depend

on the consequence of using derivative instruments by stating following paragraphs:

It (making favoured valuation) is not necessary. Even if the company disclosed

more information, it did not well operate its derivative businesses like hedging

and in other words, its risk exposures were otherwise increased by employing

derivatives, and therefore, disclosing more derivative related information is not

necessary for me to make positive investment valuation (IV 21).

Table 6.10 Benefits for Disclosing More Derivative Related Information

Percentage Percentage in
Percentage
Nos. of in Total Nos. of Total
Issues in Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
Risks 1 10 7 63.64 8 38.10
Not Clearly
2 20 3 27.27 5 23.81
Mentioned
Information
4 40 0 0 4 19.05
Transparency
Others 3 30 1 9.09 4 19.05

Table 6.11 Interviewees' Perception about Whether Making Positive Valuation on

Companies with More Derivative Disclosures

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues TotalAnalysts Total
Managers Managers Analysts Interviewees
(%)
(%) (%)
Positive
8 80 6 54.55 14 66.67
Valuation
Not
2 20 5 45.45 7 33.33
Necessary

Table 6.12 Reasons for Not Making Positive Valuation on Companies with lVlore
Derivative Disclosures

Issues Nos. of \ Percentagein \ Nos.of Percentage \ Total \ Percentage in

218
 Managers Total Analysts inTotal Total
Managers Analysts (%) futerviewees
(%) (%)
Relevant
1 50 5 100 6 85.71
Information
Consequence 1 50 0 0 1 14.29

6.3.4 Q7 'Generally, are you satisfied with current derivative-related disclosures

provided by listed companies? Do you think the information disclosed by

companies is adequate or not? not, ...vhat kind of information you would like

companies to disclose?'

The study intends to examme the satisfaction of equity market participants to

derivative related disclosures by asking interviewees about Q7 'Generally, are you
satisfied with current derivative-related disclosures provided by listed companies? Do

you think the information disclosed by companies is adequate or not? If not, what
kind of information you would like companies to disclose? '. At the beginning, they

were asked about whether they were satisfied with current derivative disclosures by
Chinese quoted firms and their opinions are summarised in Table 6.13. Among total

21 interviewees, the great majority (85.71%) including eight managers and ten
analysts claimed that they were not satisfied with the present provisions of derivative
related information by listed organisations whereas only one manager expressed the
satisfaction with those disclosures as following quotations:

The disclosure of information is not decided by individual compames. For

example, CSRC has specialised mechanisms regarding the provision of
information related to firms' tombstone advertisements and raised funds'
instructions. I think the basic information has been fully disclosed and it is pretty

enough (IV 19).

219
In addition, two interviewees had no clear awareness about derivative related
disclosures and this view was explained by an analyst as the absence of using
derivatives by some companies. He stated:

The firms I faced have never been involved in derivative transactions and as a
result, they did not disclose any derivative related information in public reports or
other public documents. Thus, I have no idea about whether I am satisfied with
them (IV 04).

Then 18 out of 21 interviewees who were claimed to be unsatisfied with derivative

disclosures by listed companies were further asked about questions 'Why are you not
satisfied with current provisions of derivative disclosures?' and 'What kind of
information you would like companies to disclose?', and the responses are
demonstrated in Tables 6.14 and 6.15 respectively. As shown in Table 6.14, the issue
of 'Insufficient Disclosures' was perceived by two thirds of interviewees as the
primary factor associated with the dissatisfaction of derivative related disclosures and

in this regard, some examples are provided as following quotations made by a

manager and analyst separately:

It (the derivative disclosure) is not adequate. The key issue is the degree of details
about the disclosed information related to derivative transactions. Some listed
companies usually provided very general disclosures without detailed analyses
(IV 18).

I am not satisfied with the derivative related information in A shares market as the
disclosures are not enough. Generally, the enterprise just disclosed the result of
hedging - how much it earned or lost but did not tell you the quantities of
derivatives and reasons for losses. Consequently, the information was too little to
be used to make judgments or predictions (IV 05).

220
Up to nine interviewees (50%) argued that the lack of timely disclosures about the use
of derivative instruments was much of significance for their dissatisfaction and for
instance, one manager noted this view as follows:

It (the derivative disclosure) must be inadequate. For example, if a company

conducts a hedging business by employing derivative products, no one would
know until it suffered a huge loss and in my opinion, it should provide some
discussions in its quarterly reports at least (IV 21).

A similar discussion was also provided as following quotations with reference to an

analyst:

.. .Information lag. Basically, we all know when a firm suffered derivative related
losses but could not comprehensively understand the information such as when it
bought derivatives (IV 16).

As shown in Table 6.15, disclosures about the scale and purpose of using derivative
instruments are top two popular types of information that interviewees expected listed
companies to greatly disclose and this finding reconfirms the conclusion achieved in
Section 6.2.2 that the information associated with the scale and purpose of a firm's
derivative businesses were most concerned by sample equity market participants. It
should be noticed that nearly two thirds of managers which are five out of eight
(62.5%) suggested that the users of derivative products should timely disclose

derivative related information in periodical as well as temporary reports and this view
is illustrated as following examples with reference to quotations by two managers:

It (the derivative related disclosure) needs to be disclosed and when a grave

change incurs in the market, the relevant information ought to be timely disclosed

(IV 17).

221
 .. .I feel that it is necessary to forward a suggest to supervisory bodies that once a

quoted company gets involved in derivative transactions especially for those

engaged in overseas OTe businesses, it must be required to constantly provide

relevant information in temporary reports (IV 20).

Last but not least, two analysts argued that it was impossible for reporting entities to

fully disclose the derivative related information as they had to carefully balance the

risk of leaking something in confidential and the information needs of the public and

they stated:

... Sometimes it is impossible to get what you want. For instance, if the derivative

information is related to the company's trade secret, it is unnecessary for listed

firms to provide detailed disclosures. Although investors wish it to be reported, it

is not objective and realistic (IV 13).

Investing in financial derivative products may actually refer to key elements of an

enterprise's operation. There might be different goals between enterprises and the

public in terms of disclosing derivative related information. It should be found an

appropriate balance and it is not able to ask listed companies to tell everything in

order to satisfy the public (IV 16).

Table 6.13 Satisfaction about Current Derivative Disclosures

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues TotalAnalysts Total
Managers Managers Analysts Interviewees
(%)
(%) (%)
Unsatisfied 8 80 10 90.91 18 85.71
No Idea 1 10 1 9.09 2 9.52
Satisfied 1 10 0 0 1 4.76

Table 6.14 Issues for Unsatisfied

Issues Nos. of Percentage I Nos. of Percentage I Total I Percentage in I

222
 Managers in Total Analysts in Total Total
Managers Analysts Interviewees
(%) (%) (%)
Insufficient
5 62.5 7 70 12 66.67
Disclosures
Lack of
5 62.5 4 40 9 50
Timeliness
Confidentiality 2 25 0 0 2 11.11
Complexity of
0 0 1 10 1 5.56
Derivatives
Information
0 0 1 10 1 5.56
Cost

Table 6.15 Issues in Relation to More Derivative Disclosures

Percentage Percentage Percentage in

Nos. of in Total Nos. of in Total Total
Issues Total
Managers Managers Analysts Analysts Interviewees
(%) (%) (%)
Scale 3 37.5 4 40 7 38.89
Purpose 3 37.5 3 30 6 33.33
Timely
5 62.5 0 0 5 27.78
Disclosure
Direction 2 25 2 20 4 22.22
Price 1 12.5 1 10 2 11.11
Qualitative
Description of
2 25 0 0 2 11.11
Derivative
Products
Trading Place 1 12.5 1 10 2 11.11
Tenure 1 12.5 1 10 2 11.11
Confidentiality 0 0 2 20 2 11.11
Cost 1 12.5 0 0 1 5.56
Fair Value 1 12.5 0 0 1 5.56
Impacts 0 0 1 10 1 5.56
Currencies 0 0 1 10 1 5.56
Risks 0 0 1 10 1 5.56
Fundamentals 0 0 1 10 1 5.56
Brief Summary
of Financial 0 0 1 10 1 5.56
Statements

In summary, the derivative related disclosures provided by Chinese listed companies

223
have ever been employed by most of institutional investors to facilitate their

investment decisions as 16 out of 21 sample interviewees claimed the use of such

information when evaluating the corporate financial performance. The hardly

involvement of derivative transactions by focused firms and inadequacy of the

provision of derivative related information are major reasons asserted by investors
without using derivative disclosures.

Chinese institutional investors generally treated derivative disclosures as useful and

helpful information when making investment decisions as the usefulness of such

disclosures for deciding investments was affirmed by all of 16 interviewees who ever
employed derivative related information and this finding is coincident with a large

number of empirical studies mainly based on western mature economIes

et 1 ct

et et et

ct aL 2006: Ameer, which prove the usefulness and relevance of

derivative disclosures following respected regulations to be value relevant to the

assessment of companies made by users of financial statements. However, the

investors' perceptions about the significance of derivative related disclosures are no of

consistence. Firstly, the use of derivative related disclosures just played a minor role
in facilitating investment decisions because most of sample equity market participants

(43.75%) claimed to consider such information to be supplementary to the assessment

of the corporate value. The derivative information was believed to be majorly served

as the supplementary information for the investors' judgement of firms' risk profile
whereas the main body disclosures related to the corporate fundamental businesses

such as profits, assets and liabilities were thought to be of priority to make investment

decisions. Secondly, a significant portion of sample investors (31.25%) argued that

the importance of derivative disclosures should rely on the impact of derivative

instruments on the corporate financial status. Thirdly, the derivative related

information was believed to be primarily significant by the majority of professional

224
analysts (42.86%) as it was claimed to be closely related to the valuation of a listed

company.

The provision of more derivative related information by quoted organisations was

deemed to be more useful and helpful in facilitating investment decisions by sample

interviewees. The better understanding of the corporate risk profile as well as the

improvement of information transparency was separately considered by most of

analysts and managers as the major factor for welcoming more derivative disclosures.

Two thirds of interviewees claimed that companies with more derivative disclosures

were more likely to be received positive valuation while the rest argued that they were

unnecessary to be positively assessed unless those disclosures contained the relevant

information to their evaluation of the corporate performance.

Overall, the derivative related disclosures by Chinese quoted firms were not satisfied

by equity market participants as the large majority of sample interviewees (85.71 %)

expressed their dissatisfaction with the current reporting status. Two major factors

including the insufficient information and the lack of timely disclosures were claimed

to be contributed to the dissatisfaction of reporting information related to the use of

derivatives. In addition, disclosures about the scale and purpose of employing

derivative instruments were expected to be greatly discussed and the provision of

timely disclosure was addressed by most of managers as the improvement of the

status quo.

6.4 Interviewees' Opinions about Accounting Policies for

Derivatives

In this section, with the purpose to get equity market participants' Views on the

accounting and reporting policies for derivatives in China, interviewees were firstly

225
asked Q8 'Do you think the reporting for derivatives should be compulsory or
voluntary? Why?', followed by Q9 'What is your view on current accounting and

reporting (IFRS-based requirements) for derivatives? Do you think it is easily to be

understood?' and Q10 'Do you think the reporting for derivatives should whether

continue to comply with IFRS requirements, or set up relevant requirements based

upon Chinese scenario, or no need to set up any requirements? What is your

suggestion for the future development of reporting for derivatives? ' was discussed at
last.

6.4.1 Q8 'Do you reporting for derivatives should compulsory or

voluntary'? Why'?'

The study proposed to gain insight into sample interviewees' preference of patterns of
reporting for derivatives by asking Q8'Do you think the reporting for derivatives
should be compulsory or voluntary? Why?' and Tables 6.16 and 6.17 provided
summaries of interviewees' answers. As illustrated in Table 6.16, the great majority of
interviewees which are 18 out of 21 (85.74%) claimed that the information
concerning the use of derivative instruments ought to be mandatorily disclosed by
listed companies which indicates the strong desire of equity market participants to
improve the previously voluntary reporting framework for derivatives. Nevertheless, a
manager as well as an analyst suggested that the patterns of derivative disclosures
should depend on the scale of derivative transactions in a firm's overall financial
performance and they provided arguments as follows:

The reporting for derivatives should depend on the scale of such products. For
instance, a company buys a standardised option contract and in the worst situation,
it would just suffer a loss no more than an option premium. Thus, it is not
necessary to disclose derivative related information if the premium is so small.

226
 However, if a company involves in an OTe business with huge scale as a tool to

hedge its future transactions, it should mandatorily report its derivative activities

as such businesses are possible to have a big strike on the firm's operations (IV
20).

It (reporting for derivatives) is subject to the scale of derivative instruments. The

derivative transactions which remarkably affect the corporate earnings must be

compulsorily and detailed disclosed. Otherwise, those with little scale and impacts
could be voluntarily reported. It (reporting for derivatives) mainly relies on the

significance of using derivatives on firms' financial performance (IV 05).

Besides, another analyst believed the patterns of reporting for derivatives to be subject

to the risk arising from the use of derivative instruments as showing in the following
statements:

The information is usually reported to the exchanges and supervisory bodies at the

beginning. I think the exchanges need to set up a 'line' and the derivative related

information have to be mandated disclosed when derivative businesses over the

'line'. The 'line' refers to the risk which means the losses generated by the risk
exposures of financial derivative products (IV 16).

Table 6.17 summarises the reasons addressed by 18 interviewees for their preference

of compulsory derivative disclosures. As shown, almost half of interviewees which

are eight out of 18 argued that under the mandated reporting framework, quoted

companies would be less discretional in deciding what kind of derivative related

information should be disclosed and eventually it contributes to reduce the possibility

of hiding certain information deliberated by some reporting entities. Two managers

stated:

· .. The voluntary disclosure grants a very large discretion to reporting enterprises.

227
 As a responsible company, it may disclose sufficient and comprehensive

information. By contrast, an irresponsible firm is likely to viciously modify some

terms so as to violate investors' interests and if investors do not pay much

attention, they could suffer some losses (IV 19) .

. . . Since the accounting and reporting for derivatives such as the valuation of fair
values is too complex and tremendous, under the voluntary disclosure framework,
many listed firms could be unwilling to deal with them. In addition, as off-balance
sheet items, the reporting for derivative instruments is pretty flexible and
consequently, reporters are able to hide much information not or little to be
disclosed (IV 21).

Four managers along with four analysts demonstrated that the derivative related
information must be compulsorily disclosed by quoted companies mainly due to the
consideration of the potentially huge financial losses caused by risks embedded in the
use of derivatives and this view is clearly illustrated in the following examples with

reference to quotations by a manager and an analyst respectively:

... Given the enormous risk possibly associated with employing derivatives, if the
derivative related information is not forced to be reported, it is quite easy for the

management to do something immoral which may result in an increase in moral

costs. In many cases, the management may take away the earnings of derivative
transactions but the shareholders have to afford the losses generated from such

businesses (IV 10) .

.. .Just like a bomb, a derivative product is so dangerous that might be exploded at

any time. When the market is normally fluctuated, derivatives appear to be
unharmful, however, when the price is slumped or sharply raised in the market,

they could have significant impacts on a company's profits even its survival.
Hence, I believe the information related to the use of derivative instruments must
228
 be mandatorily disclosed as in some cases, such information would be crucial to

make investment decisions (IV 03).

Nearly a quarter of interviewees (22.22%) claimed that the compulsory regulations

about accounting and reporting for derivatives were helpful to enhance the quality of

disclosures and eventually lead to an increase in the corporate value and for instance,

one manager stated:

... Actually from the other perspective, the mandated prOVISIOn of derivative

disclosures is also contributed to the promotion of a firm's value as a large number

of empirical studies prove that investors may give additional premiums on the

valuation of companies with higher quality of information disclosure (IV 18).

Table 6.16 Interviewees' Opinions about Reporting for Derivatives

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
Compulsory
9 90 9 81.82 18 85.74
Disclosure
It Depends 1 10 2 18.18 3 14.29

Table 6.17 Reasons for Choosing Compulsory Rather Than Voluntary

Disclosures

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues TotalAnalysts Total
Managers Managers Analysts Interviewees
(%)
(%) (%)
Less
5 55.56 3 33.33 8 44.44
Discretion
Risk 4 44.44 4 44.44 8 44.44
Valuation 2 22.22 2 22.22 4 22.22

229
6.4.2 Q9 'What is your view on current accounting and reporting (U'RS-based

requirements) for derivatives? Do you it is easily to be understood?'

I this section, the investors' opinions about the current derivative related accounting
and reporting treatments largely based upon IFRS and lAS regulations were addressed
by initially asking the question 'What is your view on current accounting and
reporting (IFRS-based requirements) for derivatives?' and interviewees' responses are

summarised in Table 6.18. It is interesting that the majority of interviewees which are

15 out of 21 (71.43%) appeared to have little knowledge on the subject matter as a

manager stated:

I have little understanding about the accounting and reporting standards about
derivatives and did not pay much attention because the derivative related
accounting and reporting regulations were just implemented and therefore, they
are quite new subject for me (IV 09).

The finding is likely to imply the fact that the current derivative related accounting

and reporting regulations imposed by Chinese policy makers are far away from being

comprehensively understood by external investors as it can be argued that if

institutional investors focused in this study who are generally perceived to be better
understanding of accounting and reporting policies were even basically believed to be
unfamiliar with regulations related to the treatment of derivatives, personal investors

are possible to be hardly understood such requirements. In this case, it should be

suggested that as long as the derivative related regulations were implemented, there

was a strong necessity for Chinese policy makers such as MOF and CASC to pay

more attention and spend much time to educate equity market participants,

particularly investors, to be familiar with the new requirements about accounting and

reporting for derivatives.

230
Nearly a quarter of interviewees (23.81 %) including four managers and one analyst

clearly showed their positive attitude towards IFRS and lAS based accounting and

reporting requirements. For instance, a manager supported the adoption of the fair

value measurement in the current derivative related treatments as illustrating in the

following quotation:

The historical cost method is a relatively static measurement after all and it has

little meaning to measure the current value of a derivative. However, the fair value

method is much useful and helpful to measure the derivative's current value (IV

10).

By contrast, a manager expressed his confusion about current derivative related

treatments and advantages of the historical cost method for making investment

decisions as shown in statements as follows:

I really do not like the current accounting and reporting treatments for derivatives.

According to the current treatments, losses or earnings of derivative transactions

must be recognised in current earnings but in practice, the new treatment is more

ambiguous and unclear to investors. For example, a company bought tons of crude

oil this year and got involved in hedging businesses last year. It is supposed that

the price of this year was $60 per barrel and the price would be fixed at the last

year end level, saying about $40 per barrel. If it accrued expense, the firm had a

little loss last year but some earnings this year. If you did not know the

distribution of its settlements, you could not figure out how much the loss was

indeed as there were new transactions available this year. Nevertheless, if it used

the historical costing method, I should be clearer about the realistic situations as I

knew the cost was $60 per barrel if it did nothing and otherwise, it was $40 if it

employed derivatives. Once it disclosed how much it locked, I should make clear

about its financial status. Personally, I feel compared with the fair value, the

historical cost is much more of benefit to us (IV 03).

231
Interviewees were further asked about their feelings about the derivative information
disclosed following the new reporting regulations compared with those under the
previous disclosure framework and the results are illustrated in Table 6.19. As shown,
up to half of interviewees which are 10 out of 21 (47.62%) insisted that they felt that
the information provided by listed companies following the current reporting
standards was not easier to be understood or indifferent compared with those
disclosed previously. As shown in Table 6.20, the inadequacy and vagueness of
information reported by firms is the most primary reason argued by many
interviewees (seven out of eight) attributed to their perceptions about not easily
understanding derivative disclosures under the current regulations and this view is
clearly stated in following examples of quotations from two analysts:

It (derivative related information following current reporting standards) is not

easily understood. Reporting entities are merely able to achieve the written
paragraphs of those standards but do not realise its essence that is to disclose
useful information. The disclosed information is too ambiguous. For instance, if a
company involves in futures transactions, according to the current requirements,
the information about these businesses should disclose in the column of securities
investments. However, the detailed information such as what transactions are
related to futures in securities investments, how much reserved for such

transactions, how much deposit paid and the price of a future contract including
the cost and market price, is not disclosed and therefore, we all are not clear (IV
02).

The currently disclosed information is easily to make simple question to be

complex and vague and there are more of things in specious sometimes like 'have
grave impacts on assets' (IV 11).

Following the above findings, it can be argued that from the perspective of users of
232
financial statements, it has been little effective for the implementation of new IFRS

and lAS based requirements in terms of accounting and reporting for derivatives since
2007 as they still believed the current derivative disclosures to be insufficient, vague

and less detailed. In addition, these findings provide evidence from the view of equity
market participants to reconfirm the results discussed in Chapter V that the provision
of derivative information by Chinese listed companies is generally low compliance
with IFRS and lAS related requirements. Last but not least, these findings also leave a
question for Chinese accounting and reporting policy makers - Does the
implementation of newly compulsory derivative related regulations achieve their

expectation? Theoretically, from the policy makers' perspective, the enhancement of

mandated derivative related reporting standards will force quoted companies to

provide more and useful information and further help investors to make better
investment decisions, however, the findings indicate that in the real world, such
derivative information under new reporting regulations was hardly informative to
investors which is contrary to the policy makers' expectation. Thus, it is strongly
suggested that the policy makers should start to review the effectiveness of current
derivative related reporting framework that to what extent, those requirements
achieved the expectations from policy makers themselves, listed companies and
investors. What is more important, they should try to find out the reasons why listed
companies do not report much more information related to their use of derivatives and
what kind of information really needed by external investors.

Table 6.18 Interviewees' Opinions about IFRS and lAS Based Regulations for
Derivatives

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues TotalAnalysts Total
Managers Managers Analysts Interviewees
(%)
(%) (%)
Unfamiliar 6 60 9 81.82 15 71.43
Welcome 4 40 1 9.09 5 23.81
Dislike 0 0 I 9.09 1 4.76

233
 Table 6.19 Interviewees' Understanding about Current llerivative llisdosures

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues TotalAnalysts Total
Managers Managers Analysts Interviewees
(%)
(%) (%)
Not Easy 2 20 6 54.55 8 38.10
Easy 2 20 3 27.27 5 23.81
No Idea 2 20 2 18.18 4 19.05
Indifferent 2 20 0 0 2 9.52
It
2 20 0 0 2 9.52
Depends

Table 6.20 Reasons for Not Easily Understanding of Current Derivative

llisdosures

Percentage in Percentage in
Percentage
Nos. of Total Nos. of Total
Issues in Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
Insufficient,
Vague 2 100 5 83.33 7 87.5
Disclosures
Complex
Nature of 0 0 1 16.67 1 12.5
Derivatives

6.4.3 QI0 'llo reporting for derivatives should continue to comply

IFRS requirements, or set relevant requirements based Chinese

scenario, or no to set up any requirements? What is your suggestion the

future development of reporting for derivatives'?'

Table 6.21 provides a summary of interviewees' ideas about the adoption of derivative

related reporting regulations in China. Over half of the interviewees which are 11 out

of 21 (52.38%) believed that the Chinese reporting policies should continue to be

converged with IFRS derivative related regulations and in this regard, some examples

234
are shown as following statements with reference to quotations by a manager and
analyst respectively:

... First of all, I think the harmonisation of reporting for derivatives with
international regulations is a general trend. Initially, there were no derivative

products available in China and then they were brought in from overseas markets.

As a result, the provisions and regulations associated with derivatives were setup

according to the international standards and therefore, it should also follow the

international mechanisms when you consider the reporting of derivatives (IV 19).

It (reporting for derivatives) should be integrated with IFRS requirements. At the

beginning, you can make some amendments based upon the Chinese conditions as

an interim but since you are not isolated as you are under the globalised
background, the standards must be fully converged with the IFRS' in the end. In
the short term, China may need a transition but in the long term, it (reporting for

derivatives) still needs to be converged with the IFRS' (IV 15).

Four interviewees (36.36%) including two managers as well as two analysts suggested
that the derivative reporting practice in China should follow the IFRS framework and

meanwhile, it needs to include specialised and detailed requirements particularly

based on Chinese scenarios and this view is separately demonstrated by following

quotations from a manager and an analyst:

.. .I think the treatments related to derivatives' recognisation, how to affect

assets/liabilities and how to affect profits should be unified in the worldwide,

however, referring to the degree of the detailed information, there is a need to set

up more detailed regulations based upon Chinese real situations (IV 07).

Given the short time of the development of derivatives in China, it (reporting for

derivatives) should firstly employ overseas techniques for reference and then
235
 based on our national conditions, it needs to be enhanced in terms of information
disclosures and supervisions. I think the supervision of derivative instruments

should be more detailed and specific than that of stocks, bonds and mutual funds
(IV 12).

The establishment of derivative reporting standards solely in line with Chinese

scenarios is only supported by two interviewees and one analyst argued:

With the development of derivatives market, more and more companies may get
involved in derivative businesses and as a result, there should be a specialised
standard based upon Chinese scenarios. In my opinion, the circumstance of
developing derivatives in China which contains the general perceptions about
derivatives, specific products and so on is totally different with other countries'
and therefore, there is a necessity to make changes for accounting and reporting
practice (IV 02).

Interviewees were further asked 'What is your suggestion for the future development
of reporting for derivatives?' and their answers are various. For instance, a manger
mentioned the reporting policies for derivatives should be depending on the
development of derivatives and he stated:

... Basically, the current derivative products used by Chinese listed companies are
pretty simple. I think when the Chinese derivatives market is developed to a
certain level i.e., we have such products unavailable in overseas markets, there is
likely to a need to set up our own information disclosure regime (IV 10).

Another analyst believed the accounting and reporting for derivatives to be more

rigorous in the future which is illustrated as follows:

.. .In the future, the disclosure of derivatives will be getting more rigorous. It
236
 depends on different phases, it can be a little loosed if the corporate governance is

generally good. Nevertheless, the current corporate governance of domestic listed

firms is usually no good, so it should be better to be more rigorous (IV 06).

Table 6.21 Interviewees' Opinions about the Adoption of Methods of Reporting

for Derivatives in China

Percentage in Percentage in
Percentage in
Nos. of Total Nos. of Total
Issues Total Total
Managers Managers Analysts Interviewees
Analysts (%)
(%) (%)
IFRS 6 60 5 45.45 11 52.38
IFRS
Combined
2 20 2 18.18 4 36.36
with
Chinese
No
1 10 2 18.18 3 14.29
Preference
Chinese 1 10 1 9.09 2 9.52
No Idea 0 0 1 9.09 1 4.76

In summary, the compulsory accounting and reporting framework for derivatives was

welcomed by overwhelming majority of sample institutional investors and under such

mandated regulatory circumstance, listed companies were believed to be imposed
more restraints and as a result, would have less discretion in deciding the types and

quantities of derivative related information to the public. In addition, the worry about
the potential financial losses arising from the use of derivative instruments was
another important factor addressed by interviewees attributed to their preference of
the compulsory reporting framework.

Chinese investors seemed to be unfamiliar with the current derivative related

accounting and reporting policies as most of sample institutional investors (71.43%)

appeared to have little knowledge on the subject matter which implies that Chinese
policy makers such as MOF and CASC should not merely focus on the establishment
and implementation of derivative related regulations and what is more important, they
237
need to pay more attention on the education of equity market participants to be

adapted with the new reporting environment. The derivative information provided
under the current disclosure framework was claimed by many investors to be not

easier to be understood as such information was primarily believed to be insufficient,

ambiguous and less detailed. This finding on the one hand enhances the argument
discussed in Chapter V that derivative disclosures reported by Chinese listed
companies are generally low complying with lFRS and lAS related regulations by
providing evidence from the investors' perspective. On the other hand, it indicates that
from the view of equity market participants, the implementation of new lFRS and lAS
based accounting and reporting standards since 2007 was appeared to have little effect
on derivative reporting practice by Chinese quoted firms. Hence, there is a strong
necessity for policy makers to enhance the communication with reporting entities as
well as market participants to seek reasons why reporters do not disclose more
derivative information and what information really wanted by investors. It is possible
for policy makers to make some amendments about current derivative disclosure
regulations by balanced considering the interests of information providers and users.

Referring to the path associated with the adoption of derivative reporting rules in
China, the convergence with lFRS related provisions which was currently imposed by
supervisory bodies was generally accepted and welcomed by the majority of sample

participants, followed by the employment of lFRS based requirements along with the
inclusion of some specialised and detailed regulations particularly to Chinese
scenarios and the way of the establishment of unique Chinese reporting standards was

the last option favoured by the least of interviewees.

6.5 Summary

The purpose of this chapter is to examine equity market participants' perceptions,

238
attitudes and opinions towards the usefulness of derivative related disclosures

provided by Chinese listed companies and by interviewing 21 institutional investors

which include 10 investment managers and 11 professional analysts, several findings
are achieved as follows:

1. The information related to the use of derivative instruments disclosed by quoted

companies is useful to help investors facilitate their investment decisions and this
finding is consistent with a great number of western studies (e.g .. 1

et 1996; et

et et

This study provides empirical evidence to

prove that the derivative disclosures in line with corresponding accounting and
reporting regulations are informative and useful for investors to make better
investment decisions.

2. The significance of derivative disclosures for making better investment decisions

is inconsistently perceived by investors. The derivative related information is

generally believed to playa minor role in deciding investments. Such derivative

disclosures are only served as the supplementary information contributed to
investors' assessment of a corporate risk profiles while the main body disclosures
concerning a company's fundamental businesses such as profits, assets and

liabilities are deemed to be crucial to make investment decisions. In addition, the

notion that the importance of derivative disclosures should depend on the impact
of derivative products on the corporate financial status is also considered by a
significant portion of investors. Lastly, the primary significance of derivative
disclosures in facilitating investment decisions is admitted by the majority of
analysts who claimed that such information was closely related to their valuation

of a listed firm.

239
3. The provision of more derivative related disclosures is largely welcomed by the

participants as it is believed to be more useful and helpful in understanding the

corporate risk profiles and also a symbol of improved information transparency.

Furthermore, listed firms with more disclosures of derivative activities are more
likely to be positively valuated by most of institutional investors.

4. The current derivative disclosures provided by Chinese quoted entities are not
satisfied by most of sample investors as they are widely regarded as the
insufficiency of information as well as lack of timely disclosures.

5. The disclosures about the scale and purpose of derivative transactions are
considered as the greatest important information for investors while the
information related to the risk arising from the use of derivative instruments

which was largely absent in companies' derivative related disclosures as

discussed in Chapter V has also attracted much of consideration from investors.

6. Although the employment of public reports released by listed companies is the

most prevalent channel for investors to obtain derivative related information,

other ways such as surveys and internet/media are also preferred by a quite
number of investors mainly due to the worry about the inadequate derivative
information available in public reports.

7. The adoption of a compulsory framework for accounting and reporting for

derivatives is praised and accepted by the large majority of sample institutional
investors mainly because the mandated accounting and reporting framework is
claimed to have contributions to regulate and restrain the companies' reporting

behaviours which is likely to reduce the discretion for reporting entities to decide
the contents and quantities of derivative disclosures. In addition, the view
regarding the path of the choice of derivative reporting standards in China is
dominated by the convergence with IFRS related regulations currently enhanced
240
 by supervisory bodies, followed by the combination of lFRS requirements and

specialised provisions based upon Chinese national conditions and the setup of

unique reporting standards in China is least agreed and accepted by investors.

8. The accounting and reporting policies currently imposed by regulators appear to

be little understood by Chinese investors and the disclosed information under the
present reporting environment is believed to be difficult to understand mainly due

to its insufficiency and ambiguity perceived by many sample investors. By

providing the evidence from the view of information users, these findings

reconfirm the discussions in Chapter V that in Chinese equity market, the

compliance with lFRS and lAS related requirements in terms of derivative

disclosures reported by listed companies is generally low. Last but not least, it
should be argued that from the market participants' perspective, the
implementation of the new regulations largely based on lFRS and lAS provisions
since 2007 has been little effective to improve the derivative reporting practice

made by quoted firms. Therefore, there should be a strong necessity for Chinese

policy makers such as MOF and CASC to pay more attention training and

communications with reporting entities and investors in order to implement the

new reporting standards and if necessary, it is possible to make some changes

about current disclosure requirements by the balanced consideration of interests

of information providers as well as its users.

241
c c

242
 Chapter VII Summary, Conclusions, and Future Research

7.1 Introduction

The core aim of this chapter is to bring together and highlight the primary conclusions

related to the research objectives set out in Chapter 1. A summary of the research

motivations, overall aims and objectives, research designs and the approaches adopted

in achieving these aims and objectives are outlined at the beginning. Then the

conclusions and discussions of the main findings of the research are summarised.

Next, the contributions to the literature and policy implications for Chinese regulators

are discussed followed by identifying key limitations of the study. Finally, further

areas that could potentially be explored comprise the section of future research.

7.2 Summary

7.2.1 Motivations

In the recent decade, the world witnessed the growing use of derivative instruments.

However, as the derivatives' usage grows, many high profile derivative related losses

happened around the world. There has been rising public concern about the use of

derivatives and associated risks. The supervisory bodies all over the world have

recently paid much attention to the establishment of effective control systems

including the release of financial reporting standards for companies to disclose their

derivative activities. The usefulness of the mandated derivative related disclosure

requirements has attracted considerable attention with a focus on the cases of

243
developed economies. There is a dearth of academic studies conducted in emerging
countries. Currently, no study has specifically addressed accounting and reporting for

derivatives in China and examined the usefulness of derivative disclosures of Chinese

listed companies. China as the largest developing economy has made remarkable
progress in its economic development as wen as its accounting reform over the last
three decades. The recent convergence of CASs with IFRSs makes China an
interesting case to examine the issues associated with the application of derivatives
accounting rules. Hence, this study has conducted an exploratory research to reveal
the degree of the compliance with accounting and reporting requirements as to
derivative activities of Chinese listed companies and also examine the response of
equity market participants to the derivative related disclosures. The motivation of the
present research is to fill the research gap in the existing literature by providing the
assessment of accounting and reporting practices for derivatives in China. It is
expected to enhance the understanding of the usefulness of derivative related
disclosures not only in developed economies but also developing countries, and it
provides the valuable insight to the development of derivative reporting standards by
generating more policy implications particularly to developing economies.

7.2.2 Prior Studies

In order to get better understanding of the research area, the study at the beginning
comprehensively reviews the existing literature in the area of the value relevance of

derivative related disclosures and some findings are summarised as below:

Firstly, the effectiveness of derivative related accounting and reporting policies have
attracted considerable academic attention in the recent decades which is following

two major research steams. Studies in the first stream

1 et

244
 ct assess the
disclosure quality regarding derivative related information from the view of listed

companies. They mainly employ the content analysis to reveal the degree of quoted

companies complying with associated derivative related regulations. Those

researchers usually compare the quality of information contents before and after the

implementation of derivative related standards by producing a disclosure checklist

with reference to corresponding derivative accounting and reporting requirements.

Findings of these studies generally demonstrate that the compulsory derivative

regulations have improved the quality of information by enhancing listed companies

to provide more information about their use of derivatives in annual reports. However,
the compliance with relevant derivative related requirements is mixed. The basic rules

of corresponding derivative standards are met as quoted firms are generally able to
prepare the qualitative as well as quantitative information related to their derivative

activities while many of detailed requirements (e.g., the assumptions of applied

quantitative techniques and the description of corporate derivative management

activities) are not achieved due to the lack of adequate and detailed disclosures.

Secondly, the second types of studies specially examme the market response to
derivative disclosures from the view of market participants, particularly investors.

These studies primarily aim to test whether disclosures about the use of derivatives
are value relevant to investors when making decisions. By using quantitative methods

like the establishment of regression models, they mainly concentrate on the extent to

which mandated derivative disclosures are informative to firms' exposure, or sensitive

to change of equity price, or value relevant to market participants' risk judgments and
assessments. Generally speaking, the findings of these studies are mixed and to some

extent even contrary. Some researchers (c.g" et aL

ct ct al..

provide the empirical evidence to prove that the compulsory accounting and reporting
245
requirements for derivatives are value relevant to investors' assessment of the

corporate risk profiles. The disclosed derivative information following corresponding

standards is significantly relevant to market responses such as the change of equity

price, equity return, trading volume etc., which indicates that the information required

by mandated derivative related provisions have offered the new and useful
information to the users of financial statement, especially to investors. Thus, such

information is contributed for investors to evaluate the corporate financial

performance and impacts of associated derivative activities, and further helps to

facilitate their investment decisions. Nevertheless, a number of researchers propose

that the mandated accounting and reporting rules for derivatives have caused

difficulties for investors to assess risk and to value corporate financial performance.
Some empirical studies 1 et

201 illustrate that there is no relationship between the

disclosed derivative related information and the market response. Some (c.g.,
1 et

argue that the sophisticated requirements as to the accounting and reporting treatment

for derivatives have caused difficulties for investors in valuating corporate derivative

activities, and even a few studies 1 et

point out that the disclosures following the compulsory derivative related

requirements have been misunderstood and negatively affected investors' assessments

in company's risk profiles and associated derivative activities. In addition, the

restrictive and complex derivative related standards, such as SFAS 133, have led to
difficulties for reporting entities to follow and resulted in a series of significant

problems in the use of derivatives and smooth earnings volatility

1: I: et Such mixed and

contrary results underline the findings achieved in the first stream that the compliance

with derivative related standards is mixed and the standard's 'desired level of

financial transparency on the use of derivative financial instruments is not being

adequately achieved' (15l:l.a:nl0rnS1Tl

246
7.2.3 Overall Aims Objectives

The primary aim of the research is to assess the usefulness of derivative related

disclosures by Chinese listed companies.

In order to achieve the overall aim, this study has four specific objectives as follows:

1. To reveal the level of derivative disclosures made by Chinese listed companies;

2. To identify information contents of derivative disclosures provided by Chinese

listed companies;
3. To examine the response of equity market participants (e.g., institutional investors

and professional analysts) to the derivative-related disclosures with a view to

assessing the usefulness of derivative disclosures in the case of China, an

emerging market where derivatives are still new phenomena;

4. To suggest the future direction in the development of derivative reporting

standards particularly for emerging economies.

7.2.4 Research Design

The study is divided into two major stages and the specific purposes, research

questions, research approaches and data collection of each stage are summarised as

follows:

7.2.4.1 Stage One

247
The first stage primarily aims to evaluate the degree of derivative related disclosures
provided by Chinese listed companies.

Research Questions

In this stage, two research questions have been formulated:

• What is the level of derivative related disclosures made by Chinese listed

companies?

• What is the information content of derivative related disclosures provided by

Chinese listed companies?

Research Methods Data Collection

The content analysis method is mainly employed in this stage as the technique is
widely adopted by the vast of researchers (e.g.,
ct aL

et to address the
information quality of derivative disclosures reported by quoted firms. The corporate
annual report is adopted as the sampling unit for observation and analysis because it is
widely perceived as an important vehicle for financial communication between
reporting companies and their stakeholders. In addition, the number of page is used as
the unit of analysis. For each annual report, the amount of disclosures regarding the
use of derivatives was firstly noted on a special record sheet and then the contents of

248
this record sheet were transferred to an Excel spreadsheet. Since Chinese regulators

have enhanced the convergence of its accounting and reporting policies with lFRS

and lAS regulations, a disclosure checklist - FDDl mainly based upon lFRS and lAS

derivative related provisions which is different from many indices used in the existing

literature on the basis of U.S. reporting requirements was developed as a benchmark

to be compared with the relevant disclosures in Chinese quoted firms' annual reports.

A pilot sample of reports were analysed and a number of procedures were followed to
ensure the reliability and validity of the disclosure measurement.

Financial institutions are not included in the sample as the study only emphasises on

derivative disclosures provided by non-financial entities. Annual reports of Chinese

listed companies in 2006 are considered as the sampling unit for observation and

analysis. All sample companies are selected from the CSl 100 and 200 representing

large and medium firms in Chinese domestic A-share market as evidence (e.g ..

L#V"-HHM. et aL 1 1 shows that the large

companies are more likely to use derivative products. The final sample consists of 53

companies including 39 large firms and another 14 medium companies.

7.2.4.2 Stage

The second phase of the study mainly intends to examine the usefulness of derivative

disclosures perceived by equity market participants.

249
Research Questions

Four major research questions have been addressed in this stage:

• What is the response of equity market participants to derivative related

disclosures?

• Do they treat disclosing more about derivatives' activities as useful information

when making investment decisions?

• Are they satisfied with the current accounting and reporting treatment of
derivative activities?

• What are their opinions on the future development in derivative related reporting
standards?

Research ltfethods ami Data Collection

The quantitative research method which was employed by most of prevIOUS

researchers is not applied in the current study mainly due to the absence of large
sample. In order to gain some insight of market participants concerning derivative

disclosures, semi-structured interviews have been adopted as the most appropriate

research technique to gather information in this stage.

The study mainly concentrates on two equity market participants groups - institutional
investors and professional analysts as they are widely perceived to have a better
understanding of the complex nature of derivatives and associated disclosures. The
sample includes 21 interviewees in total which contains ten investment managers and
another eleven professional analysts from a mutual funds management company as
well as a securities firm. There are twelve questions available for each interviewee
and every interview lasted about 40 minutes.
250
7.3 Conclusions Discussions

7.3.1 China's Derivatives and Accounting fo:r De:rivatives

By critically reviewing the development of China's domestic derivatives market and

accounting and reporting practice for derivatives, the study has found:

Firstly, the development of China's derivatives market is fairly falling behind its rapid
economic growth over last three decades. The market can only provide limited

investment options far less than others in matured economies. In history, the Chinese
domestic derivatives market was circuitously evolved and the only availability of
three commodity futures exchanges which are DCE, SHFE and ZCE has been lasted

for around ten years since the closeout of all financial derivatives markets by the

central government in 1995 after a notorious manipulation scandal - 'Contract 327

Affair'.

Secondly, with the employment of the framework, three crucial factors

including the inappropriate product design, poor market infrastructure and inadequate
governance and control, are identified as the main contributes for the slow and

tortuous development in China's derivatives market. China has started to gradually

progress its derivatives market by the rebuilding of the financial derivatives market

since 2005. The reintroduction of the trading of warrants, especially the reopen of
CFFEX, is a remarkable progress in the development of China's derivatives market.

Due to the worries of the abuse of derivative instruments appeared in the history, the

Chinese government has been quite cautious about the introduction of new financial
derivative products and therefore, there is just one financial derivative contract - CSI

251
300 index futures currently being traded at CFFEX.

Thirdly, the disclosure of the use of derivatives was mainly reported voluntarily by

listed companies in the past as the accounting and reporting practice for derivatives

was largely absent in Chinese regulatory framework over a long period. With the

enhancement of integrating China's accounting and reporting standards with IFRS and

lAS regulations since 2005, the situation has been progressively improved. The

release and implementation of the 'New Accounting Standards' in 2007 was an era in

the evolvement of derivative related regulations in China because it was fully

converged with IFRS and lAS accounting and reporting treatments for the use of
derivative instruments which stands for the shift of the derivative disclosure from a
voluntary to mandatory basis.

7.3.2 Level Contents .tol·m~lUcm Related to Derivative Disclosures

By using the content analysis approach to compare the information disclosed in

companies' annual reports regarding their use of derivative instruments with
disclosure index (i.e., FDDI) which is largely based upon IFRS and lAS provisions,

the study, in the first stage, draws following findings about the degree and nature of

derivative related information provided by Chinese listed companies:

Firstly, the level of the compliance with IFRS and lAS derivative regulations by

Chinese quoted companies is generally low and this finding is further supported by

the discussion in Chapter VI that was based on the views of equity market participants.
The derivative related information provided following the current derivative

accounting and reporting policies are insufficient, ambiguous and difficult to

understand.

252
Secondly, Chinese listed companies are likely to prefer the use of equity derivative

products like warrants or convertible bonds that may influence the structure of shares
rather than other types of derivatives such as foreign currency forwards/swaps,

interest swaps or commodity futures/options/swaps as the results show that there is

much information in relation to the use of derivatives disclosed in the section of
Change of Shares and Shareholders' Information. Nevertheless, the variance of
amount of disclosures within different types of derivative instruments is statistically
insignificant.

Thirdly, the corporate size seems not to significantly affect the amount of derivative
related disclosures by Chinese quoted compames which IS contrary to much of
western evidence I ct

201 Both large and

medium firms have a similar tendency in reporting the employment of derivative
instruments and this abnormal phenomenon is possible to be attributed to a number of
factors such as the limited availability of derivative products, large absence of
derivative related regulations, agency problems and limitations of the study.

Fourthly, the amount of derivative disclosures about the significance of using

derivative products for the company's financial position and performance is
significantly greater than that of information in relation to potential risks arising from
the use of derivative instruments and this finding is likely to be explained by three

major factors which include the agency problem, huge absence of derivative related
accounting and reporting regulations and unimportance of risks resulted from the use
of derivatives to the company's financial performance.

253
7.3.3 Usefulness of Derivative Disclosures Perceived by Equity Market

Participants

In the second stage, the study conducted in-depth interviews with 21 institutional

investors which contain 10 investment managers and 11 professional analysts and a

number of findings and discussions have been achieved regarding the market
participants' perceptions, attitudes and opinions towards the usefulness of derivative
related disclosures provided by Chinese listed companies as follows:

Firstly, the disclosed information about the use of derivative instruments by quoted

firms is believed to be useful and helpful in facilitating investment decisions and the

finding is coincident with many empirical studies primarily conducted in developed

countries (e.g., ct ct 1

et

et et which prove that

the derivative disclosures following corresponding accounting and reporting

regulations contain useful and relevant information for investors to make better

investment decisions.

Secondly, the investors' perceptions about the significance of derivative disclosures

for deciding investment decisions are mixed. The information related to the use of

derivatives is generally thought to play a minor role in facilitating investment

decisions and such information is believed to be treated as the complementary

information used to assess the corporate risk profiles whereas the main body
disclosures related to firms' core operations such as profits, assets and liabilities are

deemed to be of most importance to achieve investment decisions. A percentage of the

participants held the idea that the significance of derivative disclosures should rely on

the impact of derivative products on the corporate financial position. Last but not least,
254
the crucial importance of derivative related information in facilitating investment

decisions is agreed and acknowledged by the majority of analysts as such information

is believed to be closely related to their valuation of a quoted company.

Thirdly, the disclosure of more information about using derivative products is largely
welcomed by investors as on the one hand, it is deemed to be more useful and helpful
in understanding the corporate risk profiles and on the other hand, it symbolises the
improvement of information transparency. Furthermore, listed firms with more
disclosures of derivative activities are more likely to obtain positive valuation from
most of institutional investors.

Fourthly, the current provisions of derivative related information by Chinese quoted

entities are generally unsatisfied by most of institutional investors as they are widely
regarded as the inadequacy of information as well as lack of timely disclosures.

Fifthly, the disclosures in relation to the scale and purpose of derivative transactions
are considered as the most vital information for investors while the information
concerning the risk arising from the use of derivative instruments which was largely
absent in companies' derivative disclosures as discussed in Chapter V has also
attracted considerable investors' attentions.

Sixthly, publicly available annual reports provided by listed companies are the most
common channel for investors to obtain derivative related information, however, other
means such as conducting surveys and reading news from the internet/media are also
preferred by a quite number of investors mainly due to the worry about the inadequate
derivative information available in the reports.

Seventhly, the adoption of compulsorily regulatory framework for accounting and

reporting for derivatives is welcomed and accepted by the overwhelming majority of
investors mainly because the mandated accounting and reporting environment is
255
deemed to contribute to regulate and restrain the companies' reporting behaviours,

which is likely to reduce the discretional activities commenced by reporting entities.

Besides, the convergence with lFRS related regulations currently promoted by

supervisory bodies is widely perceived as the major choice of derivative reporting
standards in China, followed by the combination of lFRS based requirements and
specialised provisions based upon Chinese scenarios and the establishment of unique
. Chinese reporting regulations is barely agreed and accepted by sample investors.

Eighthly, the current accounting and reporting policies imposed by regulators seem to
be very difficult to understand for Chinese investors. The derivative related
information provided under the present reporting environment is perceived to be
insufficiency and ambiguity by many interviewed investors. These findings provide
the evidence from the view of information users to reconfirm the arguments in
Chapter V that in Chinese equity market, the compliance with lFRS and lAS related
provisions in terms of derivative disclosures by listed companies is generally low.

Last but not least, it should be argued that from the market participant perspective, the
implementation of the newly lFRS and lAS based regulations since 2007 has little
effect on the improvement of the derivative reporting practice made by quoted firms.
Therefore, it is strongly suggested that Chinese policy makers such as MOF and
CASC should pay more attention to the training and communications with reporting
entities and external investors in order to adapt with the new reporting environment
and it should make some necessary changes about current disclosure regulations by

considering the interests of both information providers and users.

7.4 Contributions

The present thesis contributes to the existing theories and literature in several ways
listed as follows:

256
Firstly, the current study provides evidence to challenge the adaptability of voluntary

disclosure theories in China. The voluntary information disclosure theories, including

agency theory, signalling theory, political process theory and proprietary costs,

believe that the corporate size has vital influence on voluntarily disclosed information.

By contrast, the research found that there was no significant association between

company's size and the amount of derivative related information voluntarily disclosed

by reporting entities. The finding indicates that it might be different to the rationale

when analyse the determinants of a specific information disclosure attribute (i.e.,

derivative related disclosure).

Secondly, since prior studies about the usefulness of derivative related disclosures are

mostly based upon the sample from developed countries with mature financial

derivative markets, the current study fills up the research gap by providing an

evaluation of the accounting and reporting practices for derivatives in China. It

extends the understanding of the value relevance of derivative disclosures in the

context of developing countries.

The study enhances our understanding of the reporting quality for derivatives in

emerging economies by examining the degree and nature of information in relation to

the use of derivative instruments reported by Chinese listed companies.

Thirdly, the findings that the derivative related disclosures are generally perceived by

sample investors to be useful to help facilitate investment decisions are contributed to

confirming the claims about the usefulness and relevance of these types of

information for investors in their investment decision-makings (e.g ..

et al., 1 et 1

ct et 2005: et aL

257
The research enhances our knowledge about the significance of derivative disclosures

in achieving investment decisions from the view of Chinese equity market

participants. It indicates that such disclosures are considered by most of the investors
only as a supplementary role in making investment decisions whereas the main body
disclosures referred to a company's fundamental businesses such as profits, assets and
liabilities are crucial to make investment decisions.

Fourthly, the present study provides a critical assessment of the development of

China's derivatives market. It is the first attempt to analyse the factors attributed to
the circuitous evolution of derivatives market in China by employing
propositions about the foundations of the successful development of derivatives. It
shows the inappropriate product design, poor market infrastructure and inadequate
governance and control are the major factors that block and slow the progress of
developing derivatives in China

Last but not least, the study also makes following contributions to the research
methodology:

First, the disclosure index employed in the content analysis is largely based upon
lFRS and lAS accounting and reporting practices for derivatives which is totally
different from those adopted by other researchers mainly in line with U.S.
requirements with the primary consideration of the enhancement imposed by Chinese

regulators of converging its national accounting and reporting standards with lFRS
and lAS regulatory framework. This index can be widely acknowledged and accepted
as a checklist which is mainly used to identify the derivative related disclosure level
and information contents provided by companies regulated under lFRS and lAS

accounting and reporting framework.

Also, the qualitative research method (i.e., interviews) was applied in the second
258
phase of the study with a view to examining the equity market participants' opinions
about the usefulness of derivative related disclosures. The use of interview method is
more effective in directly examining the investors' attitude, perceptions and opinions

towards derivative related information and as a result, it is more appropriate to

investigate the reasons for considering derivative disclosures as useful or otherwise in
facilitating investment decisions.

In conclusion, the present study has made a positive contribution to expand our
current understanding of accounting and reporting practices for derivatives and
contributed to the growing debate on the usefulness of derivative related disclosures.

7.5 Policy Implications

In this study, the derivative disclosures provided by Chinese listed companies are
generally believed to be useful and helpful in facilitating investment decisions but
such information is mainly claimed to be served as a complementary role in making
investment decisions. The main body disclosures related to the corporate core
operations such as profits, assets and liabilities are deemed to be more significant. In
addition, the derivative related information under the current reporting environment is
claimed to be difficult to be understood as such information is largely insufficient and

vague to many investors. It can be argued that from the view of information users, the
implementation of new accounting and reporting regulatory framework largely based
upon IFRS and lAS provisions since 2007 has little effect on the improvement of
derivative reporting practice made by Chinese listed companies. These findings leave
a question for Chinese accounting and reporting policy makers - Is it necessary to
setup derivative related regulations at present?

If the answer is 'Yes', there is a strong need for policy makers such as MOF and

259
CASC to reVIew whether the current accoUflting and reporting practices for
derivatives are achieved the expectations from regulators themselves, reporting

entities and equity market participants and what is more important, regulators should
try to find out the reasons for reporters' unwillingness to make adequate derivative
disclosures that are really needed by investors. Compared with the rapid convergence
with international regulatory framework, the Chinese policy makers should pay more
attention to educating and training information providers as well as its users to be

accommodated with the new derivative accounting and reporting regulations.

If the answer is 'No', it should be argued that Chinese regulators should focus their
attention in the future to the enhancement of accounting standards related to the

disclosure of core elements in financial statements rather than derivative related

disclosures. However, given the strong expectations of equity market participants for
the adoption of the mandated reporting framework largely based on IFRS and lAS
derivative provisions as discussed in the research, it is possible for policy makers to
progressively impose a mandated accounting and reporting agenda for derivatives.
Meanwhile, the training and education of reporting companies and market participants
are still to be much of significance in the process of establishment of derivative

related reporting framework.

7.6 Limitations

As every piece of research, this study also has its own limitations listed as below

which have to be considered when interpreting the results:

Firstly, since the study only used limited annual reports as sampling Uflits, it is
possible that the findings can be altered if a large sample size was studied.

260
There are only 53 large and medium nonfinancial firms in the sample due to the low

usage of derivatives by Chinese listed companies, so it is impossible to carry out the

meta-quantitative analysis to test the economic effect of derivative related disclosures.

Secondly, this study has focused on the derivatives disclosure, but it did not look into

the level of disclosure itself in comparison with the level of total financial information

disclosed by the sample listed firms. It can be argued that the extent of derivative
disclosure is associated with the level and the quality of overall financial information
disclosure made in a country. The future research can investigate the possible link and

offer an insight into the development of financial information and derivatives

disclosures

Thirdly, the research employs a sample of 21 institutional investors to examine the

usefulness of derivative related disclosures perceived by equity market participants.

However, it should be admitted that the robustness of the findings is likely to be weak
as the results are possibly to be changed if different sample of interviewees were

chosen. Also, it is possible that individual investors held different views from these

interviewees from funds management and securitises firms, which might lead to

different conclusions.

Fourthly, this study has adopted contents analysis as the research method for the first
major research objective. The limitations inhered in this particular research method

remain in this study as well, including the count units, check index, and possible

errors in interpreting the meanings of written information.

7.7 Future Research

Although this study has achieved its research objectives, many issues related to

261
derivatives disclosure remain to be answered. Given the current changes in accounting

and capital markets, many new questions in the topic area will emerge which require

further research.

Firstly, there is a need to conduct further research to analyse the impact of new lFRS

and lAS standards (e.g., fair value measurement) on the derivative disclosures and the

increasing capital market regulations. Particularly, the imposition of corporate

governance and risk controls by authorities across the world would expect to have

impacts on the financial reporting behaviours of corporations, including derivative

disclosures. Further research into the impacts can enhance our understanding of the

derivatives disclosure patterns and behaviours.

Secondly, there is a need to carry out empirical studies to examine the value relevance

and determinants of derivative disclosures in the setting of Chinese capital market

once the derivative instruments are widely used by Chinese listed companies with the

development of Chinese derivatives market. Both value relevance and determinants of

derivative disclosure research was largely carried out in developed markets, it would

be interesting to know whether the findings that were based on western developed
markets apply to the case of China, the largest developing economy.

Thirdly, it is necessary for following up studies to examine whether the voluntary

disclosure theories such as agency theory, signally theory, political process theory and

proprietary costs, can be applicable in the Chinese context. It would be an interesting

area to examine factors that can influence the infornlation voluntarily disclosed by

Chinese list companies. Furthermore, it would be curious to find out whether there are

some distinctive elements in China like the ownership structure, culture etc. can have

impact on the level of voluntary information disclosure.

Fourthly, smce the present research merely exammes the response of users of

financial statements concerning derivative disclosures, the future research would be

262
required to examine the incentives and cost implications to the reporting companies
for the provision of information related to their use of derivative instruments. Such a

research would enhance our understanding of benefits and costs associated with the

disclosures of derivatives related information and particularly the quality of the

disclosures as they are very much related to the characteristics and ability of the

providers.

Last but not least, the comparability of derivative disclosures across countries is
another potential area for future research. Future research could compare the
derivative disclosures provided by companies in China and other economies in line

with the development of intemationalisation of financial reporting.

263
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303
endices

304
 Amount of
Disclosed
Information
Reference in Sections in
(How many
Themes IFRS 7, lAS Score* A Firm's
pages in a
32 and 39 Annual
firm's annual
Report
report)
Significance of
Financial Instruments
for the Entity's
Financial Position and
Performance
Q 1 Does the firm sort its
derivative instruments
IFRS t*, P
into aj7j7roj7riate
(Paragraph) 8,
financial instruments' 1 (0)
20,22; lAS
category (held for
39, P 9,45
trading or hedging
instruments) ?
Q4 Does the firm sj7ecify
the accounting j70licies
IFRS 7, P 21 1 (0)
for derivative
instruments?
Q5 Does the firm sj7ecify IFRS 7, P 22,
1 (0)
its hedging j7olicy? 23,24
Q 17 Does the firm
disclose the fair value of IFRS 7, P 25 1 (0)
derivative instruments?
Q 18 Does the firm
disclose the carrying
IFRS 7, P 8 1 (0)
amount of derivative
instruments?
Q 19 Does the firm
disclose the net market
IFRS 7, P 20 1 (0)
value for derivative
instruments?
Q20 Does the firm
IFRS 7, P 27,
sj7ecify the methods in 1 (0)
28,29
determining the value of
305
derivative instruments?
Q22 Does the firm
specifj; the existence of
IFRS 7, P 17;
derivative features in its 1 (0)
lAS 32, P 94
compound financial
instruments?
Q23 Does the firm
separately provide
information for
lFRS 7, P 17;
embedded derivatives 1 (0)
lAS 32, P 28
and liability component
of a compound financial
instrument?
Nature and Extent of
Risks Arising from
Financial Instruments
Q2 Does the firm specifj;
the objectives for
lFRS 7, P 33 1 (0)
holding or issuing
derivative instruments?
Q3 Does the firm specifj;
the associated risks
lFRS 7, P 33 1 (0)
provided by derivative
instruments?
Q6 Does the firm specifj;
how they monitor and
manage the risks IFRS 7, P 33 1 (0)
associated with
derivative instruments?
Q7 Does the firm discuss
any changes to the above
disclosures from the lFRS 7, P 33 1 (0)
previous reporting
period?
Q8 Does the firm
segregate information by
IFRS 7, P33;
risk categories (i.e. 1 (0)
lAS 32, P 52
credit risk, liquidity risk
and market risk)?
Q9 Does the firm
disclose the Principle, lFRS 7, P 34;
stated, face, or other lAS 32, P 60, 1 (0)
similar amount of 63
derivative instruments?
306
 °
Q 1 Does the firm
disclose the date of IFRS 7, P34;
maturity, expiry, or lAS 32, P 60, 1 (0)
execution of derivative 63
instruments?
Q 11 Does the firm
disclose the early
settlement and IFRS 7, P34;
conversion options, lAS 32, P 60, 1 (0)
including details of their 63
exercise of derivative
instruments?
Q 12 Does the firm
disclose the amount and
IFRS 7, P34;
timing ofscheduled
lAS 32, P 60, 1 (0)
future cash flows related
63
to derivatives' principle
amount?
Q 13 Does the firm
disclose the interest,
dividends, or other IFRS 7, P34;
periodic returns on lAS 32, P 60, 1 (0)
principle and their 63
timing related to
derivative instruments?
Q 14 Does the firm
IFRS 7, P34;
disclose the effective
lAS 32, P 60, 1 (0)
interest rates of
63
derivative instruments?
Q 15 Does the firm
specify to whom they
IFRS 7, P 36 1 (0)
have credit risk
exposures?
Q 16 Does the firm
provide the estimated
maximum credit risk IFRS 7, P 36 1 (0)
exposures at the
reporting date?
Q21 Does the firm use
the sensitivity analysis to
demonstrate the impact IFRS 7, P 40,
1 (0)
ofpossible movements in 41,42
each market risk
variable on profit and
307
 loss and equity?
Voluntary Disclosures
Q24 Does the firm
Voluntary
provide other disclosures
Disclosures by 1 (0)
related to their use of
Companies
derivative instruments?
Total Score 24 (0)
Notes: *Item scored at 1 means that the reporting entity provided information related
to corresponding question in their annual reports. Item scored at °contains
two situations: firstly, the reporting companies did not disclose any
information in relation to corresponding question; secondly, the question (s)
was not applicable in China. Q15 'Does the firm specijj; to whom they have
credit risk exposures?' and Q16 'Does the firm provide the estimated
maximum credit risk exposures at the reporting date?' are applicable in the
second situation as unlike mature economies such as the Us. and UK, there
were no any credit related derivatives such as CDS available in the Chinese
securities market at the time. Chinese listed companies were not permitted to
get involved in the trade of credit related derivative instruments.
**IFRS 7 Financial Instruments: Disclosures requires the reporting entity to
provide two main categories of disclosures in its annual report:
1. the information about the significance of financial instruments for the
entity sfinancial position and performance; and
2. the information about the nature and extent of risks arising from

financial instruments to which the entity is exposed during the period and at the

reporting date, and how the entity manages those risks.

Among total 24 questions, Questions 1,4,5,17, 18, 19, 20, 22 and 23 are related

to the first type of disclosures, whereas q Questions 2, 3, 6, 7, 8, 9, 10, 11, 12, 13,
14, 15, 16 and 21 are sorted into the second type of disclosures.

Disclosure requirements in relation to the FDDI

308
lAS 39 requires financial assets to be classified in one of the following categories:
p

Financial assets at fair value through profit or loss

Available-for-sale financial assets

Loans and receivables
Held-to-maturity investments

Those categories are used to determine how a particular financial asset is recognised

and measured in the financial statements.

Financial assets at fair value through profit or loss. This category has two

subcategories:

Designated. The first includes any financial asset that is designated on initial
recognition as one to be measured at fair value with fair value changes in profit or

loss.
Held for trading. The second category includes financial assets that are held for

trading. All derivatives (except those designated hedging instruments) and

financial assets acquired or held for the purpose of selling in the short term or for

which there is a recent pattern of short-term profit taking are held for trading.
p

Qualitative disclosures
For each type of risk arising from financial instruments, an entity shall disclose:
p

a) the exposures to risk and how they arise;

309
b) its objectives, policies and processes for managing the risk and the methods used to
measure the risk; and

c) any changes in 33(a) or (b) (see above) from the previous period.

Accounting policies

In accordance with paragraph 108 of lAS 1 Presentation of Financial Statements, an

entity discloses, in the summary of significant accounting policies, the measurement

basis (or bases) used in preparing the financial statements and the other accounting

policies used that are relevant to an understanding of the financial statements .

.P

7, B Notes:
Accounting policies that are relevant to the understanding of the financial statements

include:

a) for financial assets or financial liabilities designated at fair value through profit or

loss:
i) the nature of the financial assets or financial liabilities the entity has designated at

fair value through profit or loss;

ii) the criteria for so designating such financial assets or financial liabilities on

initial recognition; and

iii) how the entity has satisfied the criteria in paragraphs 9, llA and 12 of lAS 39

for such designation including, where appropriate, a narrative description of the

circumstances underlying the measurement or recognition inconsistency that

would otherwise arise, or how designation at fair value through profit or loss is

consistent with the entity's documented risk management or investment strategy;

b) the criteria for designating financial assets as available-for-sale;

c) whether regular way purchases and sales of financial assets are accounted for at

trade date or at settlement date;

310
d) when an allowance account is used to reduce the carrying amount of financial
assets impaired by credit losses;

i) the criteria for determining when the carrying amount of impaired financial assets

is reduced directly (or, in the case of a reversal of a write-down, is increased

directly) and when the allowance account is used; and
ii) the criteria for writing off amounts charged to the allowance account against the

carrying amount of impaired financial assets;

e) how net gains or net losses on each category of financial instruments are
determined, for example, whether the net gains or net losses on items at fair value

through profit or loss include interest or dividend income;

f) the criteria the entity uses to determine that there is objective evidence that an

impairment loss has occurred; and

g) when the terms of financial assets that would otherwise be past due or impaired
have been renegotiated, the accounting policy for financial assets that are the

subject of renegotiated terms.

Hedge accounting

An entity shall disclose the following separately for each type of hedge described in
lAS 39 Financial Instruments: Recognition and Measurement (i.e. fair value hedges,

cash flow hedges, and hedges of net investments in foreign operations): p

a) a description of each type of hedge;

b) a description of the financial instruments designated as hedging instruments and

their fair values at the reporting date; and

c) the nature of the risks being hedged.

For cash flow hedges, an entity shall disclose: P

a) the periods when the cash flows are expected to occur and when they are expected
311
 to affect profit or loss;

b) a description of any forecast transaction for which hedge accounting had previously
been used, but which is no longer expected to occur;
c) the amount that was recognised in equity during the period;

d) the amount that was removed from equity and included in profit or loss for the
period, showing the amount included in each line item in the income statement; and
e) the amount that was removed from equity during the period and included in the
initial cost or other carrying amount of a non-financial asset or non-financial
liability whose acquisition or incurrence was a hedged highly probable forecast
transaction.

An entity shall disclose separately: p

a) in fair value hedges, gains or losses:

i) on the hedging instrument; and
ii) on the hedged item attributable to the hedged risk;
b) the ineffectiveness recognised in profit or loss that arises from cash flow hedges;
and
c) the ineffectiveness recognised in profit or loss that arises from hedges of net
investments in foreign operations.

P The detailed disclosures required under lAS 32 (see below) should

provide information to assist users of fmancial statements in assessing the extent of

risk related to financial instruments.

Notes:
Transactions in financial instruments may result in an entity assuming or transferring
to another party one or more of the following financial risks - market risk, credit risk,

liquidity risk and cash flow interest rate risk.

312
a) Market risk includes the following three types of risk:

i) currency risk is the risk that the value of a financial instrument will fluctuate due
to changes in foreign exchange rates;

ii) fair value interest rate risk is the risk that the value of a financial instrument will

fluctuate due to changes in market interest rates; and

iii) price risk is the risk that the value of a financial instrument will fluctuate as a

result of changes in market prices whether those changes are caused by factors

specific to the individual security or its issuer, or factors affecting all securities
traded in the market.

Market risk embodies not only the potential for loss but also the potential for gain.
b) Credit risk is the risk that one party to a financial instrument will fail to discharge

an obligation and cause the other party to incur a financial loss.

c) Liquidity risk (also referred to as funding risk) is the risk that an entity will

encounter difficulty in raising funds to meet commitments associated with financial

instruments. Liquidity risk may result from an inability to sell a financial asset
quickly at close to its fair value.

d) Cash flow interest rate risk is the risk that the future cash flows of a financial
instrument will fluctuate because of changes in market interest rates. In the case of

a floating rate debt instrument, for example, such fluctuations result in a change in

the effective interest rate of the financial instrument, usually without a

corresponding change in its fair value.

I For each type of risk arising from financial instruments, an entity shall
disclose:
(a) summary quantitative data about its exposure to that risk at the end of the
reporting period. This disclosure shall be based on the information provided
internally to key management personnel of the entity (as defined in lAS 24 Related

Party Disclosures), for example the entity's board of directors or chief executive

officer.
(b) the disclosures required by paragraphs 36-42, to the extent not provided III
313
 accordance with (a).

(c) concentrations of risk if not apparent from the disclosures made in accordance

with (a) and (b).

P a) For each class of financial asset, financial liability and equity

instrument, both recognised and unrecognised, an entity shall disclose information
about the extent and nature of the financial instruments, including significant terms

and conditions that may affect the amount, timing and certainty of future cash flows.

P I Notes:
l) When financial instruments held or issued by an entity, either individually or as a

class, create a potentially significant exposure to the risks (i.e. market risk, credit
risk, liquidity risk and cash flow interest rate risk), terms and conditions that
warrant disclosure include:

• the principal, stated, face or other similar amount, which, for some derivative

instruments, such as interest rate swaps, might be the amount (referred to as the

notional amount) on which future payments are based;

• the date of maturity, expiry or execution;

• early settlement options held by either party to the instrument, including the period

in which, or date at which, the options can be exercised and the exercise price or

range of prices;

• options held by either party to the instrument to convert the instrument into, or
exchange it for, another financial instrument or some other asset or liability,
including the period in which, or date at which, the options can be exercised and

the conversion or exchange ratio(s);

• the amount and timing of scheduled future cash receipts or payments of the principal
amount of the instrument, including installment repayments and any sinking fund

or similar requirements;
• stated rate or amount of interest, dividend or other periodic return on principal and
314
 the timing of payments;

• collateral held, in the case of a financial asset, or pledged, in the case of a financial

liability;

• in the case of an instrument for which cash flows are denominated in a currency

other than the entity's functional currency, the currency in which receipts or
payments are required;

• in the case of an instrument that provides for an exchange, similar information for
the instrument to be acquired in the exchange; and

• any condition of the instrument or an associated covenant that, if contravened,

would significantly alter any of the other terms (for example, a maximum
debt-to-equity ratio in a bond covenant that, if contravened, would make the full

principal amount of the bond due and payable immediately).

Credit risk

The entity shall disclose by class of financial instrument: p

a) the amount that best represents its maximum exposure to credit risk at the reporting

date without taking account of any collateral held or other credit enhancements (e.g.
netting agreements that do not qualify for offset in accordance with lAS 32

Financial Instruments: Presentation) (see also lFRS 7, B 9 and B 10);

b) in respect of the amount disclosed in 36(a) (see above), a description of collateral

held as security and other credit enhancements;

c) information about the credit quality of financial assets that are neither past due nor

impaired; and
d) the carrying amount of financial assets that would otherwise be past due or

impaired whose terms have been renegotiated.

B
1) For a financial asset, the entity's maximum exposure to credit risk is typically the
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 gross carrying amount net of any amounts offset in accordance with lAS 32 and
any impairment losses recognised in accordance with lAS 39.

2) Activities that gIVe rIse to credit risk include, inter alia, granting loans and
receivables, placing deposits, granting financial guarantees, making irrevocable

loan commitments and entering into derivative contracts. Further guidance for
determining the maximum credit exposure in each of these instances is included in
IFRS 7.BIO.

Fair value
7, P Except as set out in paragraph 29 oflFRS 7 (see below), for each class
of financial assets and financial liabilities, an entity shall disclose the fair value of that
class of assets and liabilities in a way that permits it to be compared with its carrying

amount.

Balance sheet
Categories of financial assets and financial liabilities
The carrying amounts of each of the following categories, as defined in lAS 39
Financial Instruments: Recognition and Measurement, shall be disclosed either on the

face of the balance sheet or in the notes: p

a) financial assets at fair value through profit or loss, showing separately:

i) those designated as such upon initial recognition; and
ii) those classified as held for trading in accordance with lAS 39;
b) held-to-maturity investments;

c) loans and receivables;

d) available-for-sale financial assets;
e) financial liabilities at fair value through profit or loss, showing separately:
i) those designated as such upon initial recognition; and
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 ii) those classified as held for trading in accordance with lAS 39; and

f) financial liabilities measured at amortised cost.

Items of income, expense, gains or losses

An entity shall disclose the following items of income, expense, gains or losses either

on the face of the financial statements or in the notes: I P

a) net gains or net losses on:
i) financial assets or financial liabilities at fair value through profit or loss, showing

separately those on financial assets or financial liabilities designated as such upon

initial recognition, and those on financial assets or financial liabilities that are

classified as held for trading in accordance with lAS 39 Financial Instruments:

Recognition and Measurement;

ii) available-for-sale financial assets, showing separately the amount of gain or loss
recognised directly in equity during the period and the amount removed from
equity and recognised in profit or loss for the period;

iii) held-to-maturity investments;

iv) loans and receivables; and

v) financial liabilities measured at amortised cost;
b) total interest income and total interest expense (calculated using the effective

interest method) for financial assets or financial liabilities that are not at fair value

through profit or loss;

c) fee income and expense (other than amounts included in determining the effective

interest rate) arising from:

i) financial assets or financial liabilities that are not at fair value through profit or

loss; and
ii) trust and other fiduciary activities that result in the holding or investing of assets

on behalf of individuals, trusts, retirement benefit plans, and other institutions;

d) interest income on impaired financial assets accrued in accordance with paragraph

AG93 of lAS 39 Financial Instruments: Recognition and Measurement; and

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e) the amount of any impairment loss for each class of financial asset.

Fair value
The entity shall disclose: P
a) the methods and, when a valuation technique is used, the assumptions applied in
determining fair values of each class of financial assets or financial liabilities;
Note: For example, if applicable, an entity discloses information about the
assumptions relating to prepayment rates, rates of estimated credit losses, and
interest rates or discount rates.

b) whether fair values are determined, in whole or in part, directly by reference to

published price quotations in an active market or are estimated using a valuation
technique (see paragraphs AG71-AG79 ofIAS 39);
c) whether the fair values recognised or disclosed in the financial statements are

determined in whole or in part using a valuation technique based on assumptions

that are not supported by prices from observable current market transactions in the
same instrument (i.e. without modification or repackaging) and not based on
available observable market data; and
d) if paragraph 27(c) ofIFRS 7 applies (see above), the total amount of the change in
fair value estimated using such a valuation technique that was recognised in profit
or loss during the period.
IFRS 7, P 27(c): In the circumstances described in paragraph 27(c) of IFRS 7 (see
above), for fair values that are recognised in the financial statements, if changing
one or more of those assumptions to reasonably possible alternative assumptions

would change fair value significantly, the entity shall state this fact and disclose the
effect of those changes.
Note: For this purpose, significance shall be judged with respect to profit or loss,
and total assets or total liabilities, or, when changes in fair value are recognised in
equity, total equity.
If a difference exists between the fair value at initial recognition and the amount that
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would be determined at that date using a valuation technique (see note below), the

entity shall disclose, by class of financial instrument:

a) its accounting policy for recognising that difference in profit or loss to reflect a
change in factors (including time) that market participants would consider in setting

a price (see paragraphAG76A ofIAS 39); and

b) the aggregate difference yet to be recognised in profit or loss at the beginning and
end of the period together with a reconciliation of changes in the balance of this
difference.

[IFRS 7, P 28] Notes: If the market for a financial instrument is not active, an entity

establishes its fair value using a valuation technique (see paragraphs AG74-AG79 of

lAS 39). Nevertheless, the best evidence of fair value at initial recognition is the

transaction price (i.e. the fair value of the consideration given or received), unless the
fair value of the instrument concerned is evidenced by comparison with other
observable market transactions in the same instrument or based on a valuation

technique whose variables included other data from observable markets. It follows

that there could be a difference between the fair value at initial recognition and the

amount that would be determined at that date using the valuation technique.

Disclosures of fair value are not required: 7, P

a) when the carrying amount is a reasonable approximation of fair value, for example,

for financial instruments such as short-term trade receivables and payables;

b) for an investment in equity instruments that do not have a quoted market price in an
active market, or derivatives linked to such equity instruments, that is measured at

cost in accordance with lAS 39 Financial Instruments: Recognition and

Measurement because its fair value cannot be measured reliably; or

c) for a contract containing a discretionary participation feature (as described in IFRS

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 4 Insurance Contracts) if the fair value of that feature cannot be measured reliably.

In the cases described in paragraphs 29(b) and (c) of IFRS 7 (see above), an entity

shall disclose information to help users of the financial statements make their own

judgments about the extent of possible differences between the carrying amount of

those financial assets or financial liabilities and their fair value, including: P

a) the fact that fair value information has not been disclosed for these instruments
because their fair value cannot be measured reliably;
b) a description of the financial instruments, their carrymg amount, and an

explanation of why fair value cannot be measured reliably;

c) information about the market for the instruments;

d) information about whether and how the entity intends to dispose of the financial
instruments; and

e) if financial instruments whose fair value previously could not be reliably measured

are derecognised, that fact, their carrying amount at the time of derecognition, and

the amount of gain or loss recognised.

Market risk

Unless an entity complies with paragraph 41 ofIFRS 7 (see below), it shall disclose:

p
a) a sensitivity analysis for each type of market risk to which the entity is exposed at

the reporting date, showing how profit or loss and equity would have been affected

by changes in the relevant risk variable that were reasonably possible at that date;

b) the methods and assumptions used in preparing the sensitivity analysis; and
c) changes from the previous period in the methods and assumptions used, and the

reasons for such changes.

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 P If an entity prepares a sensitivity analysis, such as value-at-risk, that

reflects interdependencies between risk variables (e.g. interest rates and exchange
rates) and uses it to manage financial risks, it may use that sensitivity analysis in place
ofthe analysis specified in paragraph 40 ofIFRS 7 (see above).
The entity shall also disclose:
a) an explanation of the method used in preparing such a sensitivity analysis, and of
the main parameters and assumptions underlying the data provided; and
b) an explanation of the objective of the method used and of limitations that may
result in the information not fully reflecting the fair value of the assets and
liabilities involved.

P When the sensitivity analyses disclosed in accordance with paragraph

40 or 41 of IFRS 7 (see above) are unrepresentative of a risk inherent in a financial
instrument (for example because the year-end exposure does not reflect the exposure
during the year), the entity shall disclose that fact and the reason it believes the
sensitivity analyses are unrepresentative.

Compound financial instruments with multiple embedded derivatives

7,P If an entity has issued an instrument that contains both a liability and
an equity component and the instrument has multiple embedded derivatives whose
values are interdependent (such as a callable convertible debt instrument), it shall

disclose the existence of those features.

P If an entity has issued an instrument that contains both a liability and

an equity component and the instrument has multiple embedded derivative features
whose values are interdependent (such as a callable convertible debt instrument), it
321
shall disclose the existence of those features and the effective interest rate on the

liability component (excluding any embedded derivatives that are accounted for

separately).

Compound financial instruments

32, I) The issuer of a non-derivative financial instrument shall evaluate the

terms of the financial instrument to determine whether it contains both a liability and

an equity component. Such components shall be classified separately as financial

liabilities, financial assets or equity instruments in accordance with paragraph 15 of

lAS 32.

Notes:

P I ) An entity recognises separately the components of a financial

instrument that

(a) creates a financial liability of the entity and (b) grants an option to the holder of

the instrument to convert it into an equity instrument of the entity. For example, a

bond or similar instrument convertible by the holder into a fixed number of

ordinary shares of the entity is a compound financial instrument. From the

perspective of the entity, such an instrument comprises two components: a financial

liability (a contractual arrangement to deliver cash or another financial asset) and

an equity instrument (a call option granting the holder the right, for a specified

period of time, to convert it into a fixed number of ordinary shares of the entity).

The economic effect of issuing such an instrument is substantially the same as

issuing simultaneously a debt instrument with an early settlement provision and

warrants to purchase ordinary shares, or issuing a debt instrument with detachable

share purchase warrants. Accordingly, in all cases, the entity presents the liability

and equity components separately on its balance sheet.

P 2) Classification of the liability and equity components of a

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convertible instrument is not revised as a result of a change in the likelihood that a
conversion option will be exercised, even when exercise of the option may appear to

have become economically advantageous to some holders.

32, P 3) lAS 39 deals with the measurement of financial assets and financial
liabilities.

Equity instruments are instruments that evidence a residual interest in the assets of an
entity after deducting all of its liabilities. Therefore, when the initial carrying amount
of a compound financial instrument is allocated to its equity and liability components,
the equity component is assigned the residual amount after deducting from the fair
value of the instrument as a whole the amount separately determined for the liability

component. The value of any derivative features (such as a call option) embedded in

the compound financial instrument other than the equity component (such as an equity
conversion option) is included in the liability component. The sum of the carrying

amounts assigned to the liability and equity components on initial recognition is

always equal to the fair value that would be ascribed to the instrument as a whole. No

gain or loss arises from initially recognising the components of the instrument
separately.

P 4) Under the approach described in paragraph 31 of lAS 32 (see

above), the issuer of a bond convertible into ordinary shares first determines the

carrying amount of the liability component by measuring the fair value of a similar

liability (including any embedded non-equity derivative features) that does not have

an associated equity component. The carrying amount of the equity instrument

represented by the option to convert the instrument into ordinary shares is then
determined by deducting the fair value of the financial liability from the fair value of

the compound financial instrument as a whole.

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 Appendix II: Interview Guide

Part I Cover IJetter

Dear Madam or Sir,

This is Zhen Huang, the PhD student at the School of Accounting, Economics and
Statistics, Edinburgh Napier University, UK. I currently want to conduct a few
interviews to finish my research titled as 'The Usefulness ofDerivative Disclosures by
Chinese Listed Companies '. I sincerely hope you to be one of the interviewees. The
following is the background of my research.

While the world has witnessed the growing use of derivative instruments and rapid
expansion of derivatives markets over the past two decades, the extensive use of
derivatives in developed markets, particularly of mortgage-related derivative products
has been blamed for the recent credit crisis worldwide. There has been a rising public
concern about derivatives trading and associated risks. By far derivatives research has
predominately been based on western developed economies; little has been known
about reporting and disclosing of derivatives from developing economies. This
research aims to fill this gap by looking at derivative-related disclosures and reporting
in China - the largest developing economy in the world.

The overall aim of the study is to assess the usefulness of derivative-related

disclosures provided by Chinese non-financial listed companies. In my research, a
derivative instrument is defined a contract between two parties that specifies
conditions - in particular, dates and the resulting values of underlying variables -
under which payments, or payoffs, are to be made between the parties, including, for
example, the forward contracts, futures, options, swaps and convertible bonds.

I have completed the first stage of the study which found out the level and
information content of derivative-related disclosures provided by Chinese
non-financial listed companies in their annual reports. Currently, I move to the second
stage with the aim to gain some insight of market participants like institutional
investors and professional analysts to derivative disclosures. I plan to conduct a few
interviews to finish the research.

The interview would take less than one hour and all of your answers are only used to
finfish my study. Your identity would remain anonymous.

Your participation is invaluable to my research and I am looking forward to having a

meeting with you in the future.

Yours sincerely,

ZhenHuang
School of Accounting, Economics and Statistics
Edinburgh Napier University
Craiglockhart Campus, Edinburgh, EH14 IDJ, UK
Email: z.huang(q)napier.ac.uk
324
 Interview Questions

Section 1 - Intervie'wee's Details

Years of
Highest
Interviewee's Age Job Working Professional
Location Gender Education
Code Group TItle in the Qua1ification
Qua1ification
Field

Section 2 - Key Questions

1) To your best knowledge, for a nonfinancial company, what kind of information

about its use of derivatives should be disclosed?

2) Have you ever used the information related to the use of derivatives when
evaluate a corporate performance or risk profile? (If no, why?)

3) How do you get such information about the use of derivatives? (What is your
source to get such information?)

4) Do you think the information about the use of derivatives is useful or not when
making investment decisions? Why?

5) For the disclosures related to the use of derivatives, what kind of information you
most concern?

6) In your view, is it much more useful if a company discloses more information

about its use of derivatives?

7) Generally, are you satisfied with current derivative-related disclosures provided

by listed companies? Do you think the information disclosed by companies is
adequate or not? If not, what kind of information you would like companies to
disclose?

8) Do you think the reporting for derivatives should be compulsory or voluntary?

Why?

9) What is your view on current accounting and reporting (IFRS-based requirements)

for derivatives? Do you think it is easily to be understood?

10) Do you think the reporting for derivatives should continue to comply with IFRS

325
 requirements, or set up relevant requirements based upon Chinese scenario, or no
need to set up any requirements? What is your suggestion for the future
development of reporting for derivatives?

11) In your view, what is the impact of recent financial crisis to the development of
Chinese derivatives market?

12) In your view, what is the impact of recent financial crisis to the accounting and
reporting for derivatives in China?

326