Fitch Ratings is concerned that the complexity of current derivative accounting standards and the low level transparency create challenges for investors and analysts. It calls for far better disclosure concerning derivatives.

The rating agency says in a report published Wednesday that a surge in derivatives product availability coupled with the advent of mark-to-market hedge accounting, means investors should be aware of the often counter-intuitive effects of derivatives on the financial statements. The effect of hedge accounting can often be to shift income statement volatility associated with mark-to-market on derivatives to the balance sheet, potentially skewing important credit ratios, Fitch says.

“Credit ratios need to be looked at with and without hedge accounting to appreciate creditworthiness fully,” said Bridget Gandy, co-author of the report and managing director, Fitch Ratings.

The study’s findings include: the benefits of achieving lower income statement volatility are at the expense of distortions to balance sheet items; changes in interest rates, exchange rates or commodity prices could exacerbate these effects; disclosure is at best inconsistent and often inadequate, raising questions about derivatives usage and its impact on key credit metrics; and, different applications of complex hedge accounting rules have the potential to result in a high level of restatement risk. To date, the companies in the study do not appear to be speculating on market movements via derivatives, it notes.

“Disclosure of derivatives must be improved substantially in order to achieve an acceptable level of transparency on which to base meaningful credit analysis. Without this, analysts and other market participants face a daunting task in understanding the risks associated with derivatives and their effects on financial statements,” says Roger Merritt, managing director at Fitch.

Fitch studied about 60 companies across a variety of sectors in order to understand the current state of corporate financial reporting for derivatives. As part of the study, Fitch surveyed a representative sample of companies, which was reconciled to the companies’ publicly available financial statements. The study was intended to generate representative data only, and is not necessarily reflective of the market as a whole or any sector of the market.

The study’s focus primarily was on derivatives usage and hedge accounting under US GAAP. Almost all of the European companies in the study either report under US GAAP or reconcile to US GAAP for SEC reporting. Fitch will produce a report in early 2005 that looks at how derivatives have been reported by European companies under local GAAP to date and the agency’s expectations of how conversion to IFRS will impact transparency and reporting volatility.

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