Inconsistent measurement and disclosure of non-contingent financial derivatives under IFRS : a behavioral perspective

The accounting principle of decomposing hybrid financial instruments into their derivative and non-derivative components is widely accepted as it results in a consistent treatment of hybrid instruments and economically equivalent combinations of contracts. On the other hand, non-contingent derivatives and their economic equivalents are not treated consistently under the mixed accounting model underlying IAS 39. This calls for a critical assessment. The conventional criticism regarding such inconsistencies refers to the creation of opportunities for earnings management. The aim of this paper is to add another perspective by including the effects of the related disclosure rules on risk perception by analysts and investors. Thereby, we consider both the presentation on the balance sheet and the additional disclosure in the notes according to IFRS 7. From extant literature, we diligently develop the hypothesis that, due to availability effects, entities using non-contingent derivatives are perceived to be riskier than entities using economic equivalents, although in fact the latter are riskier due to their exposure to additional counterparty risk. This bias in the perception of disclosures might thereby alter an entity’s costs of capital in a way not intended by IAS 39. In particular, we expect individuals to valuate entities using non-contingent derivatives lower than identical entities using economically equivalent contracts instead. We expect this difference in valuation to result from a higher cognitive availability of negative associations with derivatives than with non-derivatives. The underlying assumptions are outlined as they build a framework of hypotheses that could be tested in future research, particularly in experimental survey studies.