acfi12001

Derivatives use and financial instrument disclosure in theextractives industry

Jacqueline Birt, Michaela Rankin, Chen L. Song

Department of Accounting and Finance, Monash University, Caulfield, VIC, Australia

Abstract

This article documents the use and disclosure of derivatives in the Australian ex-tractives industry. We find that derivatives are used by 23 per cent of our sample,with mitigation of commodity risk and foreign exchange risk being the mostcommon purposes for which derivatives are used. The most common types ofderivatives used in the sector for hedging purposes are forward rate agreementsand options. Results indicate that derivative use is positively associated withfinancial risk and firm size. We also examine the relation between firm character-istics and the extent of financial instrument disclosure, using a disclosure indexbased on the additional requirements in IFRS 7 Financial Instruments: Disclo-sures. Empirical results reveal that large firms with higher leverage, which usederivatives, and are audited by a Big 4 auditor provide more extensive disclosureof financial instruments.

Key words: Derivatives; Financial instruments; Hedging; Extractive industry;IFRS 7

JEL classification: G32, M41, M48

doi: 10.1111/acfi.12001

1. Introduction

Recent large losses from derivatives (Simmons and Keehner, 2008; West, 2008;Izumi, 2009) highlight concerns about the use and adequate disclosure of finan-cial instruments, and particularly derivatives by Australian firms (ASIC, 2008).Derivatives can be used for both trading and hedging purposes. Derivatives fortrading purposes are used to acquire risk whereby individuals or firms speculateon the value of an underlying asset. Firms also use derivatives to hedge theirown exposure to risks resulting from interest rate, commodity price and foreignexchange rate fluctuations, and more recently ‘weather’ risk.

Received 30 April 2011; accepted 23 August 2011 by Robert Faff (Editor).

� 2012 The AuthorsAccounting and Finance � 2012 AFAANZ

Accounting and Finance 53 (2013) 55–83

Risks associated with the use and trading of derivatives is a burgeoningissue. In 2010, the total notional amount of outstanding over-the-counter(OTC) market derivatives stood at $601 trillion US (Bank for InternationalSettlements, 2011). While, historically significant losses have been associatedwith derivative financial instrument trading,1 derivative use for hedging pur-poses has also contributed to corporate collapse. A contributing factor to thecollapse of both Sons of Gwalia Ltd and Croesus Mining Ltd was the non-disclosure associated with the use of gold hedge books and hedging activities.Cases such as these, and other high profile examples such as Enron, have ledto an increased demand from investors to have transparent reporting offinancial risk management practices (Hassan et al., 2006a). Hodder et al.(2001) argue that inadequate quantitative disclosure of risks from derivativefinancial instruments may lead investors to assign inappropriate risk levels intheir investment decisions. Thus, firms are likely to be mispriced by the mar-ket (Hodder et al., 2001).The risks associated with the use of derivatives in the Australian extractives

industry are of particular importance to the Australian corporate environment.This industry makes a significant contribution to the Australian economy, gener-ating 5 per cent in real term GDP in 2008 (Business Monitor International Ltd,2009). Specifically, coal and iron ore are the top two exports for the Australianextractives industry, and Australia is the world’s largest and third largest expor-ter of coal and iron ore, respectively (Business Monitor International, 2011). Inthe last decade, the growth in these two exports has been nearly sixfold from$12 billion in 1999 to $69.4 billion in 2009 (DFAT, 2011). Indeed, the sector isimportant globally. It is estimated that over 20 per cent of the European Union’sgross domestic product is dependent upon the extractives sector (Brodkom,2001), and many extractives companies are richer and more powerful than thecountries that regulate them (Leaver and Cavanaugh, 2010). Eight of the world’stop 20 companies are from the extractives sector – Royal Dutch Shell, Exxon-Mobil, BP, Sinopec, Chinese National Petroleum, Chevron, Total and Conoco-Phillips (Fortune Magazine, 2010).The sector is subject to potentially high exploration and production risks (Has-

san et al., 2006b; Taylor et al., 2010), which lead to firms’ employing derivativefinancial instruments to mitigate both existing and potential risks. In addition,the volatility resulting from the requirement to measure commodity prices andforeign currency receivables and payables at fair value increases the financial risk

1 In December 1993, Metallgescellschaft AG revealed that its ‘Energy Group’ was respon-sible for losses of approximately $1.5 billion due mainly to cash-flow problems resultingfrom large oil forward contracts (Digenan et al., 2004). Barings Bank was declared bank-rupt (lost $1.4 billion) after trading options on the Japanese stock index (Stock MarketCrash, 2008). These constitute just two examples where losses from derivatives tradinghave contributed to corporate collapse.

56 J. Birt et al./Accounting and Finance 53 (2013) 55–83


to extractives firms.2 Extractive firms commonly utilise derivatives to hedge com-modity prices, foreign exchange risk and interest rate risk (Chalmers and God-frey, 2004; Taylor et al., 2008). As previously indicated, corporate collapses donot result purely from speculation or trading of derivatives. Financial risks asso-ciated with hedge arrangements contributed to the collapse of several extractivescompanies, including both Sons of Gwalia Ltd and Croesus Mining Ltd (Tayloret al., 2010). Taylor et al. (2010) contend that, leading up to these corporate fail-ures, information about risks from hedge restructuring, credit limits and cashflows may not have been fully disclosed.In an attempt to improve disclosure of the risk associated with financial instru-

ments, and in particular derivatives use, the International Accounting StandardsBoard (IASB) issued IFRS 7 Financial Instruments: Disclosures (IASB, 2005) foradoption on 1 January 2007 (AASB, 2005). The application of IFRS7 requires sub-stantially greater disclosure than its precursor IAS 32Financial Instruments:Disclo-sure and Presentation and has introduced significant challenges to many entities(Grant Thornton, 2008).Most of these challenges arise from the increased focus onboth quantitative and qualitative disclosure of financial instruments and the largeamount of disclosure, required to be presented from amanagement perspective, ofhow they monitor and control the risks arising from employing financial instru-ments (Grant Thornton, 2008). The majority of the expanded disclosure require-ments relate to the use ofmore complex financial instruments such as derivatives.In this article, we seek to expand our understanding of derivative financial

instrument use and disclosure in the Australian extractives industry. We initiallydocument the extent to which extractive firms use derivatives to mitigate thefinancial risk associated with their financing and operations and examine therelationship between derivative use and a range of firm characteristics such asleverage, size and firm performance. In addition, we investigate the extent ofdetail sample firms disclose about all types of financial instruments includingderivatives. In doing so, we develop a disclosure index based on the additionalrequirements in IFRS 7, beyond those that were mandatory under the previousIAS 132/AASB 132 requirements. Further, we explore the relation between theextent of financial instrument disclosure and a range of firm characteristics,including derivative use.Our research makes a number of contributions to the extant literature. First,

little is known about the use of derivatives by firms specifically in the extractivessector, in the current market. All publicly listed entities use some form offinancial instruments;3 however, Berkman et al. (2002) noted the substantial

2 While fair value issues affect the measurement of financial instruments and the financialrisk faced by firms in the extractives sector, financial instrument measurement is beyondthe scope of the current study and is acknowledged as an area for future research.

3 Receivables, payables and loans are all classified as financial instruments (AASB 132,para 11 AASB, 2004).

J. Birt et al./Accounting and Finance 53 (2013) 55–83 57


proportion of mining firms that specifically utilised derivatives.4 Similarly, Hea-ney and Winata (2005), in their examination of derivatives used by top 500 Aus-tralian firms in 1999, found that approximately 82 per cent of extractive firms intheir sample used derivatives.5 Second, we contribute to our understanding offinancial instrument disclosure practices. While prior research has explored gen-eral disclosure of financial instruments or derivatives in the extractives industry,this work has been restricted to a voluntary setting (Chalmers and Godfrey, 2004)or a period subject to lesser disclosure requirements than the current study.6 Studiessuch as those conducted by Nguyen and Faff (2002, 2003) examined determinantsof derivative use by the largest Australian listed firms in 1999 and 2000. Our studycontributes to the literature by documenting the range of derivatives currently inuse by the Australian extractive sector and the extent of disclosure about howfinancial instruments are used to mitigate the financial risk associated with ongoingoperations. We go beyond the largest firms examined in prior research and drawour sample from across the whole sector, thus contributing to our knowledge aboutderivative use and disclosure activities across all areas of the extractives industry.Third, we provide further insights into IFRS implementation from an Austra-

lian perspective in an industry which is of great importance to the Australiancorporate environment. Recall that Australia’s largest two exports are coal andiron ore, contributing $69.4 billion in 2009. Finally, our results add to priorresearch which investigates the association between the extent of financial instru-ment disclosure and firm characteristics in a setting subject to greater mandatoryreporting requirements that prior research. Lopes and Rodrigues (2007) andHassan et al. (2008) examine determinants of financial instrument disclosure inaccordance with the less comprehensive IAS 32 in Portugal and Malaysia,respectively. In Australia, Wei and Taylor (2009) restrict their study to the extentof fair value disclosures only, while Taylor et al. (2010) document disclosure offinancial risk, both again, in a setting prior to the application of IFRS 7/AASB7. These new accounting regulations require more extensive disclosure of quantita-tive information, market risk, credit risk and liquidity risk – areas that particularlyimpact on firms that use derivatives and on extractives firms due to the nature oftheir activities. Consequently, this article extends prior research to assess the firm

4 Berkman et al. (2002) found 61.5 per cent of mining firms in their sample used at leastone form of derivative financial instrument, when compared to only 52.8 per cent ofindustrial sample firms. This study was based on Australian firms in 1995.

5 Eighty-three per cent of gold explorer/producer firms and 81.8 per cent of minerals/bassmetals producers disclosed derivatives use.

6 While Chalmers and Godfrey (2000) and Hassan et al. (2006b) focus on extractive firms’disclosure practices in accordance with AASB 1033 Presentation and Disclosure of Finan-cial Instruments, Taylor et al. (2008) examine Australian resource firms’ financial instru-ment disclosures pursuant to AASB 132 Financial Instruments: Disclosure andPresentation.



characteristics that determine financial instrument disclosure level under the newIFRS 7/AASB 7 reporting regime for both derivative users and non-users.Our results reveal that derivatives are used by 79 firms (23 per cent) from our

sample. Commodity risk and foreign exchange risk mitigation are the mostcommon purposes for which derivatives are used. Forward rate agreements andoptions are used most frequently in hedging financial risk. Empirical analysisindicates that, consistent with prior research (see, e.g. Berkman et al., 2002;Nguyen and Faff, 2002), derivative use is associated with firm size and financialleverage. Large firms with high leverage, which are audited by a Big 4 auditorand use derivatives are likely to provide more extensive disclosure relating tofinancial instruments.Results also provide feedback to standard setters indicating the extent to which

Australian firms are adequately disclosing financial instruments in accordancewith IFRS 7. In turn, it will inform future amendments to these accounting stan-dards.7

We commence the article with a brief discussion of the regulatory backgroundto IFRS 7, including the risks associated with, and incentives to use, derivatives.An overview of prior research that has examined the use of derivatives and dis-closure of financial instruments follows in section 3. The research method usedto assess the determinants of both derivative use and financial instrument disclo-sure is documented in section 4, in which we also examine the use of derivativefinancial instruments by sample firms. The penultimate section presents results oftests that examine the relation between both derivative use and financial instru-ment disclosure and a range of firm characteristics. We conclude in section 6 byreiterating our findings and outlining limitations and avenues for future research.

2. Regulatory background

2.1. Regulations governing disclosure of financial instruments

Australia issued its first mandatory accounting standard on financial instru-ment disclosures – AASB 1033 Presentation and Disclosure of Financial Instru-ments – in December 1996. Following implementation of the Financial

7 In response to the 2007–2008 credit crisis and following recommendations of the Finan-cial Stability Forum, the IASB published an Exposure Draft 08FR-051 (ED) ImprovingDisclosures about Financial Instruments (proposed amendments to IFRS 7) in October2008 (IASB, 2008). The ED sought to improve disclosure requirements relating to off-bal-ance sheet financial securities and strengthen the standard to ‘achieve better disclosuresabout valuations, methodologies and uncertainties associated with valuations’, with a par-ticular focus on fair value measurement and liquidity risk (Deloitte and Touche, 2009).The changes, which were incorporated into IFRS 7 effective 1 January 2009, were wel-comed by academics and practitioners; however, some issues regarding the complexity ofthe requirements (Group of 100, 2008) and reclassification of financial assets (EuropeanFinancial Reporting Advisory Group, 2008) were noted.



Reporting Council (FRC) decision to adopt IFRS, applicable to reporting peri-ods beginning on or after 1 January 2005, AASB 132 – the Australian equivalentof IAS 32 Financial Instruments: Disclosure and Presentation – replaced AASB1033.

IFRS 7 Financial Instruments: Disclosures was issued by the IASB to replacepart of IAS 32 in order to improve disclosure quality (ICAA, 2008).8 Consistentwith the old IAS 132, the objective of IFRS 7/AASB 7 is to ‘require entities toprovide disclosures in their financial statements that enable users to evaluate (i)the significance of financial instruments for the entity’s financial position andperformance and (ii) the nature and extent of risks arising from financial instru-ments to which the entity is exposed during the period and at the reporting date,and how the entity manages those risks’. (AASB 7 para 1, AASB, 2005). How-ever IFRS 7/AASB 7 introduces additional, more extensive requirements thatare designed to provide an overview of the entity’s use of financial instrumentsand the exposure to risks they create (para 31). The additional requirements inIFRS 7 provide greater transparency regarding risks associated with amount,timing and uncertainty of an entity’s future cash flows, which allows financialreport users to make more informed judgements about risk and return (IASB,2004). Furthermore, it requires broad disclosure of risks relating to financialsecurities, in addition to interest rate risk (which was required by IAS 132) –including liquidity risk and detailed disclosure of credit risk.

2.2. Risks and incentives to use derivative financial instruments

As previously discussed, derivatives are used by firms for both trading andhedging purposes. Derivative use does not only allow companies to hedgeagainst a variety of risks, but can also magnify those risks (Geczy et al., 1997;Hassan et al., 2006a; Al-Shboul and Alison, 2009). Geczy et al. (1997) note thatUS companies’ use of derivatives results in reduced levels of risk. Innovative andcomplex financial instruments are continuously being introduced by financialintermediaries to help firms manage their risk exposures (Hassan et al., 2006a).Accompanying the development of financial instruments, there have been con-cerns that using increasingly complex instruments could undermine the stabilityof financial markets (International Monetary Fund, 2007).Barnes (2002) indicates that maximisation of firm value is not the sole motiva-

tion for managers to hedge – they also seek to maximise their own interests.

8 During a similar time frame, FASB issued several statements to amend financial instru-ments regulations: (i) Accounting for Servicing of Financial Assets – an amendment ofFASB Statement No. 140 in March 2006 and (ii) The Fair Value Option for FinancialAssets and Financial Liabilities – including an amendment to FASB Statement No. 115in February 2007. The recent FASB pronouncement relates to Accounting for Transfersof Financial Assets – an amendment of FASB Statement No. 140 in June 2009.



Managers with more stock options are less likely to hedge against stock pricemovement, whereas managers who are remunerated with a larger proportion ofshares are active in managing stock price risk (Tufano, 1996).As previously stated, firms in the extractives industry are subject to high levels

of risks from fluctuations in commodity prices, interest rates and foreignexchange rates (Chalmers and Godfrey, 2004; Taylor et al., 2008) and the result-ing volatility associated with using fair value to measure financial assets andliabilities. Consequently, they have incentives to utilise derivatives to mitigatethese risks.

3. Prior research

Limited research has examined derivative use in Australia, with this work con-ducted prior to 2000 (see e.g. Berkman et al., 2002; Nguyen and Faff, 2002,2003; Heaney and Winata, 2005). Prior literature which has examined the extentof financial instrument disclosure was set either in a voluntary disclosure regime(Chalmers and Godfrey, 2004) or in a setting with less-extensive disclosurerequirements (see e.g. Chalmers and Godfrey, 2000; Lopes and Rodrigues, 2007;Taylor et al., 2008, 2010).Nguyen and Faff (2002) investigated the determinants of derivative use by

large Australian firms in 1999 and 2000. They found that 74.2 per cent of theirsample used derivatives and usage was associated with firm characteristics ofleverage (proxying for financial distress), firm size (proxying for financial distressand set-up costs) and liquidity (proxying for financial constraints). Nguyen andFaff (2003) extended their previous analysis and focused on foreign currency andinterest rate derivatives. They found that the use of foreign currency derivativeswere associated with leverage and firm size. Interest rate derivative use was asso-ciated with leverage, liquidity and payment of dividends.Heaney and Winata (2005) found derivative use prevalent in the largest Austra-

lian firms in 1999. On average, they observed that 65 per cent of firms disclosedderivative use. As previously noted, this was higher for extractives firms (approxi-mately 82 per cent). The authors found derivative use to be associated with econ-omies of scale, financial distress, agency costs, optimal investment, managementcompensation and foreign business exposure. Berkman et al. (2002) showed thatfirm size and leverage (as a proxy for the probability of financial distress) explainderivative use in both industrial and mining firms. A survey of managerial viewsand attitudes on derivative use by Benson and Oliver (2004) revealed that manag-ers focused on the reduction of risk and the volatility of cash flows and earningsin using derivatives. Reducing bankruptcy costs and taxation, which have beenhypothesised in prior research, were not important determinants.Chalmers and Godfrey (2000) investigated the 1998 disclosure of derivative

accounting policy and measurement practices pursuant to the introduction ofAASB 1033 Presentation and Disclosure of Financial Instruments. They found thequality of disclosure to be low, with a lack of clarity around derivatives use and



disclosure (derivative use was sometimes implied rather than explicit). Across asample of 150 firms drawn from the top 500, the authors found that all firms thatused derivatives did so for hedging purposes, with few firms engaging in specula-tive trading. Currency and interest rate derivatives were the most common.As stated earlier, prior studies that examined financial instrument disclosure in

the extractives industry (see e.g. Chalmers and Godfrey, 2000; Hassan et al.,2006b; Taylor et al., 2008, 2010) did so in a regime subject to different manda-tory reporting requirements (either AASB 1033 or IAS 32/AASB 132) or exam-ined a subset of financial instrument disclosure issues such as fair valuemeasurement (Wei and Taylor, 2009) or financial risk management (Tayloret al., 2010).An implication of Modigliani and Miller’s (1958) perfect market world is that

the value of a firm is independent of its hedging policy as individual securityholders can organise their own hedging strategies to rebalance their portfoliosand leave wealth unchanged. However, research has provided an alternative viewthat hedging can be value-enhancing because investors may not be in the posi-tion to undertake the same hedging techniques and strategies themselves (Myers,1977; Smith and Stulz, 1985). These models have produced a range of testablehypotheses relating to derivative use and firm characteristics (Berkman et al.,2002), a number of which will be examined in this study.

3.1. Derivative use, disclosure and firm performance

In the current business environment, financial securities are closely linked tofirm performance (Othman and Ameer, 2009), with many companies undertak-ing extensive derivative trading (Batten and Hettihewa, 2007), either for the pur-poses of hedging risk or for speculation. Derivatives have been found to reducethe probability of a company entering financial distress (Smith and Stulz, 1985;Nguyen and Faff, 2002; Heaney and Winata, 2005). Derivative use is value-enhancing as it alleviates costs (Froot et al., 1993; Nance et al., 1993).Empirical evidence of the relation between performance and disclosure is

mixed however. When firm performance is positively related to the use of finan-cial instruments, Hassan et al. (2006a) find that managers are likely to disclosedetailed information to provide relevant data about their current operations, orto justify the further employment of financial instruments. Wallace et al. (1994)present a contradicting argument however, proposing that a firm which is notperforming well will increase disclosure in order to explain its weak performance.Lang and Lundholm (1993) note disclosure may be related to performance vari-ability and demonstrate that disclosure may increase, remain constant ordecrease in line with firm performance (Lang and Lundholm, 1993; Wallaceet al., 1994). While Wei and Taylor (2009) and Hassan et al. (2006b) find thathigh-performing firms are likely to provide greater levels of information; Wallaceet al. (1994) and Hassan et al. (2008) find no relation. Therefore, the expecteddirection of the association is an empirical question.



3.2. Derivative use, disclosure and financial risk

Utilising derivative financial instruments exposes firms to financial and eco-nomic risks which may arise from changes in the general economic environmentor changes in business conditions of counterparties (Hassan et al., 2006a). Riskexposures could also cause earnings volatility which negatively influences inves-tors’ perceptions of a firm’s performance (Hassan et al., 2006a). Therefore, man-agers have incentives to use financial instruments to minimise or offset theserisks (Hassan et al., 2006a). Nance et al. (1993) indicate that derivative hedgingcan increase a firm’s value and consequently maximise shareholder value. Priorstudies argue agency costs are higher for firms that engage in more externalfinancing, because of the potential wealth transfers amongst management, share-holders and debt holders (Ertugrul and Hegde, 2008; Guay, 2008; Brockmanand Unlu, 2009; Florackis and Ozkan, 2009).The level of financial risk experienced is also likely to relate to firms’ will-

ingness to disclose (Chow and Wong-Boren, 1987; Lang and Lundholm,1993). According to Lang and Lundholm (1993), the level of disclosure islikely to be correlated with financial risk if financial risk is a proxy for infor-mation asymmetry between managers and outside parties. As the variabilityof prior performance is an indicator of unpredictability of future operations,in the presence of adverse selection problems, firms with great variation inprior performance tend to have more severe information asymmetry (Langand Lundholm, 1993).A highly levered firm is likely to provide more detailed disclosure to assure debt

holders that management is not acting opportunistically (Chow and Wong-Bo-ren, 1987; Hossain et al., 1995; Inchausti, 1997; Nguyen and Faff, 2002; Ali et al.,2004). Additionally, the cost of equity and debt can be reduced by an increase inthe level of disclosure (Botosan, 1997; Sengupta, 1998). Jorgensen and Kirs-chenheiter (2003) examine managers’ discretionary disclosure of risk informationand show that ceteris paribus, in a voluntary disclosure regime, firms that discloserisk information have a higher share price than those that do not, leading to theconclusion that it is more beneficial to disclose risk information.Consistent with findings by Berkman et al. (2002), Heaney and Winata (2005)

and Nguyen and Faff (2002), we propose that firms with higher levels of financialrisk, measured by leverage, are more likely to utilise derivatives. In addition, wepropose that firms that incur higher levels of financial risk have greater incentivesto disclose information to indicate how financial instruments are utilised to miti-gate risk exposure.

3.3. Derivative use, disclosure and committee governance

As previously indicated, the use of complex financial instruments presentsadditional challenges to firms’ risk management. Audit committees and riskmanagement committees are increasingly being used to manage operational,



economic and financial risks (Fraser and Henry, 2007). Fraser and Henry (2007)document the successful use of audit committees in improving risk managementpractices. The authors found that where audit committees are involved in riskmanagement, they rely on the internal audit function to assure risk managementprocedures and in turn report their findings to the board.Companies are increasingly using risk management committees to deal with

the complex issues surrounding all aspects of firm risk (Fraser and Henry, 2007).Risk management committees generally have a broader range of expertise acrossthe range of issues affecting risk management of the organisation and mayinclude executives with legal, health and safety, operations as well as financeexpertise (Fraser and Henry, 2007). The authors note that a risk managementcommittees with this breadth of expertise is perceived to be a better forum thanthe audit committee to monitor the quality of risk management. It is anticipatedthat boards which institute additional risk management processes through eitherthe audit or risk management committee are likely to have a greater understand-ing of the ability of derivatives to mitigate various risks and are also in a betterposition to disclose more detailed information about how they are managingthese risks.

3.4. Derivative use, disclosure and audit quality

The quality of the external audit process is also considered to be a means ofreducing agency costs between principals and agents (Jensen and Meckling,1976; Watts and Zimmerman, 1983). Firms with substantial agency costs andthe intention to reduce them are more likely to be audited by a Big 4 auditor.Big 4 audit firms have the expertise, including knowledge about appropriatederivatives use and disclosure, to enable the supply of a higher-quality audit.Therefore, firms that have Big 4 auditors are likely to have a higher level of dis-closure and signal the quality of a firm’s disclosure to the market (Craswell et al.,1995; Chalmers and Godfrey, 2004).

3.5. Derivative use, disclosure and firm size

Larger companies are more likely to utilise derivatives than smaller companies(Berkman et al., 2002; Nguyen and Faff, 2002; Heaney and Winata, 2005). Par-ticularly, in a smaller market such as Australia, larger firms are more likely tooperate internationally or have greater access to overseas capital markets thansmaller companies (Heaney and Winata, 2005). Consequently, they have agreater need to use derivatives to mitigate the market risk associated with foreigncurrency fluctuations.Prior studies have consistently found that firm size is associated with the level

of disclosure in corporate annual reports (see Ali et al., 2004; Chalmers andGodfrey, 2004; Hassan et al., 2006b; Lopes and Rodrigues, 2007). Firms of dif-fering sizes are unlikely to have the same reporting incentives. As large firms tend



to have more resources devoted to reducing information asymmetry betweenmanagers and shareholders, they are expected to have more detailed disclosure(Hossain et al., 1995; Laksmana, 2008). Larger firms usually have other existingand potential stakeholders to satisfy with information needs, such as customersand suppliers (Inchausti, 1997).

4. Research method

We investigate the use of derivatives and disclosure of financial instruments intwo stages. The first stage involves initially examining the use of derivatives andhow they relate to the range of firm characteristics documented in the previoussection. The second stage involves analysing the determinants of financial instru-ment disclosure.After discussing the data sources and sample, we document the use of deriva-

tives by sample firms, including the extent and types of derivatives in use in theAustralian extractives sector. Variable measures and models used in both stagesof statistical tests are then outlined in sections 4.3 and 4.4, respectively.

4.1. Data and sample

Sample firms are drawn from the Australian extractives industry. An initialsample of 468 companies was identified from Connect 4. We did not includecompanies which operate across multiple sectors. While prior research thatexamines financial instrument use and disclosure is restricted to larger firmsacross the top 500, we examine companies across the population in this sector.Data regarding derivative financial instrument use and disclosure are drawnfrom financial reports issued in the 2008 calendar year – the first full adoptionyear of the new IFRS 7/AASB 7 requirements. Firms are removed for the fol-lowing reasons: insufficient data to undertake statistical testing (102 firms); a pre-sentation currency other than Australian dollars (10 firms) and firms aresuspended (10 firms) or delisted (five firms) during the sample period. This leavesa final sample of 341 firms. While we examine financial instrument disclosure forthe full sample, we document derivative use for that proportion of the samplethat discloses derivative use.9

Table 1 documents the sample by sector. While many companies operateacross multiple sectors in the industry, we have determined the primary extrac-tives operations of each sample firm. The larger proportions of our sample are

9 It is not always straightforward to determine whether companies use derivatives. Consis-tent with the findings of Chalmers and Godfrey (2000), many companies were identifiedas non-users as a result of no reference to use of derivative instruments in their notes. Useof derivatives was examined by two researchers on the author team, with the results oftheir analysis cross-checked and reconciled prior to compiling a final list of derivativeusers.



involved in gold (36 per cent) or metals and minerals (34 per cent) activities,respectively. Thirteen per cent produce iron ore, while only eight per cent minecoal, oil and gas. When we consider the subsample that uses derivatives (see thediscussion in section 4.2), 39 per cent of these are from the gold sector, and 29per cent are involved in metals and minerals activities. Ten per cent of the samplethat uses derivatives operate in the coal, oil and gas sector, while 12 per centproduce iron ore.Financial statements and accompanying note disclosures were examined to

determine derivative use and to measure disclosure in accordance with a con-structed disclosure index, with information being hand-collected from thosefinancial reports.

4.2. Use of derivative financial instruments

We examined the financial statements and note disclosures in each samplefirm’s annual report for evidence of derivative use. We found that 79 (23 per centof the sample) of our total sample of 341 firms use derivative financial instru-ments. This finding is lower than the 52 per cent industrial and 61 per cent min-ing derivative users reported in the Berkman et al. (2002) study. However, ourstudy is based on the full sample of Australian extractive firms10 while the Berk-man et al. (2002) study was based on a random sample of 158 firms. While 46firms (58 per cent of the sample of 79 derivative users) documented in the notesthat they use derivatives, they did not provide specific information as to the nat-ure of these derivatives, the purpose of their use or separate financial disclosure(refer Table 2). Many of these firms indicated they accounted for derivatives asfinancial assets or financial liabilities at fair value through profit and loss and didnot separately disclose their value.

Table 1

Sample by sector

Sector

Total sample

(n = 341)

Derivative users

(n = 79)

No. of firms % No. of firms %

Gold 124 36 31 39

Metals and minerals 116 34 23 29

Coal, oil and gas 26 8 8 10

Uranium 31 9 8 10

Iron ore 44 13 9 12

10 Few firms removed for reasons of insufficient data to undertake statistical testing (102firms); a presentation currency other than Australian dollars (10 firms); suspended firms(10 firms) and delisted (five firms) during the sample period.



Thirty-three firms (42 per cent of the sample of 79 derivatives users) use deriva-tives for hedging purposes, while three of these firms also document use of deriv-atives for speculation and/or trading. As would be expected of firms in theextractives sector, the most common use of derivatives is to hedge fluctuations incommodity values, with foreign currency fluctuations being the second most pre-valent use. We note sector-specific differences when we compare our findings toprior research by Chalmers and Godfrey (2000) and Heaney and Winata (2005)who observe a greater use of interest rate derivatives to hedge liquidity risk. Sam-ple firms use a range of instruments for hedging purposes, with forward rateagreements being the most common. While forward rate agreements are usedacross the industry to reduce the risk associated with foreign currency and com-modity price fluctuations, these are more likely to be used by the gold and metalsand mining firms in our sample. Options for both foreign currency and commod-ity hedging are also frequently used. In addition, swaps and caps are used by asmall proportion of firms – used primarily by coal, oil and gas firms.The depth of disclosure surrounding derivative use varies substantially across the

sample. Only 25 per cent of derivative users (20 firms) recognised derivative financialinstruments as separate line items in the body of their financial statements. The extentof detail disclosed to investors on the nature of financial risk and how it is beingman-aged also differs. Some firms present clear detail on the nature of their activities thatlead to financial risk and how they mitigate that risk. JabiruMetals Ltd, in the notesto its 2008AnnualReport, presents the following detail relating to commodity risk:

Table 2

Derivative use by sample firms

Purpose No. of firms† %

Panel A: purpose of derivative use (n = 79)

Hedging 34 42

Speculation/trading 3 3

No use specified 46 58

Panel B: derivative instruments in use (n = 79)

Interest rate derivatives

Swaps 7 9

Caps 1 1

Foreign currency derivatives

Forward rate agreements 19 24

Options 3 4

Commodity derivatives

Forward rate agreements 12 15

Options 10 13

Swaps 2 3

Caps 1 1

†Some sample firms use a range of derivative instruments. The firms that use derivatives for specula-

tion or trading also use them for hedging purposes.



The Company’s sales revenues are generated from the sale of copper, zinc and silver.Accordingly, the Company’s cash flow is significantly exposed to movements in the

price of these metals, particularly copper and zinc.

The company is entitled to 90 per cent of the value of its concentrate upon delivery into

its customer’s storage facility (‘Provisional Payment’). The Provisional Payment isdetermined by applying the average London Metal Exchange price during the monthto the tonnes of payable metal in the concentrate and then deducting agreed treatment

and refining charges. Upon entitlement to the Provisional Payment, the Companybooks 100 per cent of the revenue for that month. The remaining 10 per cent is payableupon final settlement of each shipment. The Company adjusts the receivable for themark-to-market movements arising from metal prices (and exchange rate) each month.

The metal price the Company receives is based on the average quoted price during thequotational period. Accordingly, the Company’s revenue is exposed to price variationsbetween the time of the Provisional Payment and the final settlement of each shipment.

The markets for copper, zinc and silver are freely traded and can be relatively volatile.As a small producer, the Company has no ability to influence commodity prices. The

Company mitigates this risk through derivative instruments, including, but not limitedto, quotational period hedging, forward contracts and the purchase of put options.(Jabiru Metals Ltd, 2008, pp. 46–47)

Some companies disclose how they measure financial risk; however, they do notdiscuss how they manage that risk. They might report the nature of risk and sen-sitivity analysis, as required by the accounting standard, but do not go on toexplicitly discuss how this risk is managed. The 2008 Annual Report of Elemen-tal Minerals Ltd presents a relevant example when discussing foreign exchangerisk:

The company operates internationally and is exposed to foreign exchange risk arising

from various currency exposures, primarily with respect to the US dollar.

Foreign exchange risk arises from future commercial transactions and recognised assets

and liabilities that are denominated in a currency that is not the entity’s functional cur-rency. The Australian dollar is the reporting currency for the Group and the functionalcurrency for the parent company; however, the Group’s African entities use the US

dollar as a functional currency.

At 30 June 2008, had the Australian Dollar weakened/strengthened by 10 per cent

against the US dollar with all other variables held constant, post-tax loss from the yearwould not have been significantly higher or lower, mainly as a result of the limitedactivity of entities in the group with the US dollar as their functional currency. Equity

would have been $315,000 higher/$315,000 lower had the Australian dollar weakened/strengthened by 10 per cent against the US dollar arising mainly as a result of thechange in value of the net equity including intercompany loans of entities in the groupwith the US dollar as their functional currency. (Elemental Minerals Ltd, 2008, p. 43)



Some companies take a purely ‘monitoring’ approach to risk management.Kingsgate Consolidated Ltd believes it is in the interests of shareholders toexpose the company to a range of financial risks:

The Group’s activities expose it to a variety of financial risks: market risk (includingcurrency risk, fair value interest rate risk and other price risk), credit risk and liquidity

risk.

At this point in the commodity price cycle, the Directors believe that it is in the inter-

ests of shareholders to expose the Group to commodity price risk, foreign currency riskor interest risks. The Directors and the management monitor these risks, in particularmarket forecasts of future movements in commodity prices and foreign currency move-

ments and if it is believed to be in the interests of shareholders will implement risk man-agement strategies to minimise potential adverse effects on the financial performance ofthe Group. (Kingsgate Consolidated Ltd, 2008, p. 64)

Most firms rely on either the Board or the management team to develop andmonitor hedging policy. (The use of an audit committee or risk managementcommittee is examined later in the article.) Bass Metals Ltd, however, has takena more formal approach by setting up a ‘Hedge Committee consisting of theManaging Director, the Financial Controller and a Non-executive Director whois involved in financial markets’ (Bass Metals Ltd, 2008, p. 51).

4.3. Variable measurement

4.3.1. Dependent variable measurement

Derivative useThe first stage of the study investigates the relation between derivative use and

firm characteristics. Use of derivative financial instruments (DERIV) is measuredas a dichotomous variable indicating 1, where the sample firm uses derivatives,and 0 otherwise.

Financial instrument disclosure – disclosure indexThe second stage of the study examines the relation between firm characteris-

tics and the extent of financial instrument disclosure. While financial instrumentsincludes both cash instruments (such as loans and deposits) and derivativeinstruments (such as interest rate swaps, forward rate agreements, currencyswaps), the additional requirements in IFRS 7/AASB 7 Financial Instruments:Disclosures, which revolve heavily around discussion of risk, are more pertinentto derivative instrument users. We construct an index based on the additionalrequirements of IFRS 7/AASB 7 compared with the previously applicable IAS32/AASB 132 Financial Instruments: Disclosure and Presentation, paras 51-95.We develop six categories for the index which comprises incremental disclosureof line items in the Statement of Comprehensive Income and Statement of



Financial Position, a firm’s policy on financial instruments in the notes, creditrisks, liquidity risks and market risks arising from utilising financial instruments.Points awarded consider both the existence and extent of disclosure. A total of19 points was achievable.The six major categories, together with the points assigned to them are as

follows:

1 Statement of Comprehensive Income (two points): fee income and expenses aris-ing from financial assets or financial liabilities not at fair value [para 20(c)];net gain or net loss on financial instruments recognised in statement of com-prehensive income [para 20(a)].

2 Statement of Financial Position (two points): included as a line item (para 8) aseither carrying amounts for all six categories of financial assets and financialliabilities11 or if the financial instruments disclosed in the notes are the onlyassets/liabilities that the company has12 and includes an Age analysis of loansand receivables (para 37).

3 Policy note (three points) (paras 16, 20, 24 and 36): Extent of disclosure anddescription of financial instruments as categorised according to the standardsin the policy note (into the six major categories).

4 Credit risk (five points): how companies have mitigated credit risk [para9(b)];13 maximum exposure to credit risk [para 9(a)]; amount of change inloan or receivables attributable to credit risk [para 9(c)]; amount of change infinancial liability attributable to credit risk (para 10) and additional informa-tion about methods used to comply with paragraphs 9 and 10 (para 11).

5 Liquidity risk (two points) (para 39): Requires disclosure of maturity analysisof financial liabilities and additional information about significant liquidityrisk exposure.

11 The financial assets and financial liabilities are (i) financial assets at fair value throughprofit or loss, (ii) held-to-maturity investments, (iii) loans and receivables, (iv) available-for-sale financial assets, (v) financial liabilities at fair value through profit or loss and (vi)financial liabilities measured as amortised cost (para 8, AASB 7).

12 As an example to illustrate, A-Cap Resources Ltd only has carrying amount of invest-ment on the balance sheet, but it shows all the financial instruments in the notes. In sucha case, ‘one’ is awarded. In comparison, Aragon Resources Ltd does not mention any ofthe financial instruments listed in paragraph 8 AASB 7, so ‘zero’ is assigned. Besides thosetwo cases, ‘available-for-sale financial assets’ and ‘investments’ are the only financialinstruments disclosed by Bannerman Resources Ltd. As ‘available-for-sale financialassets’ and ‘investments’ are the only financial assets that Bannerman Resources Ltd has(cross-checked by referring to ‘other’ in BMN notes), ‘one’ is given.

13 As an example, if a company says, ‘the group has adopted the policy of only dealingwith credit worthy counterparties and obtaining sufficient collateral or other securitieswhere appropriate, as a means of mitigating the risk of financial loss from defaults’ (Fer-rowest Ltd financial report, p. 50), this is not a disclosure of adequately mitigating creditrisk.



6 Market risk (five points) (para 40): Four components relate to this category: (i)sensitivity analysis of each subcategory of market risk, for example, interestrate risk, foreign exchange risk and price risk; (ii) methods and assumptions ofpreparing the sensitivity analysis; (iii) changes in methods and assumptionssince 2007 and (iv) additional information about the company’s exposure tomarket risk.

Some firms did not disclose a range of these elements because they did not uti-lise them. For example, sample firms that were engaged in exploration ratherthan commodity production and operate only within Australia had impacted bymarket risk to only a small extent. To take this into account, we calculate disclo-sure for each firm as a percentage, with the maximum scaled to take into accountthe firm’s extent of risk.Firms were required to disclose where financial instruments had been used as

collateral (para 38) or where financial instruments had been reclassified (para12A). We have not included these in our index, as these disclosures would onlyhave been made if firms had these elements. We found very few of our samplecompanies included these (1.4 per cent).We used two steps to ensure reliability when applying the disclosure index.

Initially, all members of the author team applied the index to a sample of 10corporate reports and then compared their results. Any discrepancies were dis-cussed, and a consensus reached on the most appropriate application. Onceone researcher had completed the collection of data, a further sample of 10reports was reviewed by a second team member to ensure the index had beenapplied as initially agreed. Both researchers agreed within one point in thisinstance.The summary statistics for the each disclosure category and for total disclo-

sure across the disclosure index are presented in Table 2. Mean total disclosureis 57.37 per cent, and the median is 57.89 per cent. Firms in the Australianmetals and mining industry disclose, on average, just over half of the itemslisted in our disclosure index which is based on the additional requirements ofAASB 7.14 Not surprisingly, the category with the largest level of disclosure is‘Policy Notes’, where companies disclose, on average, 70.06 per cent (median100 per cent). This finding is a slight improvement over the results found byLopes and Rodrigues (2007) in their analysis of IAS 132 disclosures in Portu-gal.One of the disclosure categories subject to the greatest level of change –

credit risk – has a mean of disclosure of 52 per cent and maximum score of100 per cent. The top 20 per cent of firms disclose 80 per cent (four of five)of items listed in our disclosure index (i.e. how companies have mitigated

14 While our disclosure index is based on the additional requirements of AASB 7, we haveallocated points for level and extent of financial instruments disclosure.



credit risk, their maximum exposure to credit risk, amount of changes in loanor receivables, amount of change in financial liability attributable to credit riskand additional information about methods used to comply with credit riskrequirements). Firms might make the decision not to fully disclose additionaldetailed information, and there is a possibility that such information couldundermine a firm’s competitive advantage (Verrecchia, 1983). Sample firmsmet over half of the liquidity risk disclosure requirements with a mean of 61per cent and a maximum score of 100 per cent. The disclosure level of marketrisk is comparable, with a mean of 59 per cent and maximum score of 100per cent. A large proportion of firms in the extractives industry are subject tohigh levels of market risk from commodity price and foreign exchange fluctua-tions, which we saw earlier is reflected in the range of derivatives used bysample firms, with the top 10 per cent attaining the maximum disclosurescore, and the top 30 per cent achieving a score of at least 80 per cent (fourout of five). At least two out of five was obtained by 80 per cent of thesample firms.

4.3.2. Independent variable measurement

Consistent with prior research (see, e.g. Raffournier, 1995; Inchausti, 1997; Aliet al., 2004; Wei and Taylor, 2009), profitability (PROF) is used as a proxy forfinancial performance in this article. Profitability is measured as net profit aftertax divided by total assets. In addition, a market-based measure of performanceis used in sensitivity tests. We use the Tobin’s Q ratio measured as the total mar-ket value of the firm divided by total asset value. We also use earnings per sharebefore abnormals as a further test of robustness.A firm with high financial risk is expected to use derivatives. The leverage

ratio, defined as either debt-to-assets or debt-to-equity, is commonly used inprior studies to proxy for financial risk (see, e.g. Wallace et al., 1994; Skaradzin-ski et al., 2006). In this article, we utilise debt-to-assets as a measure for financialrisk (LEV). We also use debt-to-equity (Lang and Lundholm, 1993) in robust-ness tests.To examine the impact of committee governance, the existence of an audit

committee (AC) and a risk management committee (RMC) are measured asdichotomous variables. If a company establishes an audit committee (AC) totake on the risk management role (AC), one is assigned, and zero otherwise.If a risk management committee (RMC) is utilised, a value of one is assigned,and zero otherwise.To examine the relation between the derivative use and audit quality, a

dummy variable (AUDIT) is utilised to distinguish between the engagement of aBig 4 auditor and a non-Big 4 auditor. AUDIT takes the value of one if a com-pany is audited by a Big 4 auditor, and zero otherwise. Firm size (SIZE) is alsoanticipated to relate to firms’ disclosure practices. SIZE is measured as the log oftotal assets.



4.4. Models

In our study, we present two models. The initial model measures the propensityfor firms to use derivative financial instruments; hence, a binary choice logit modelis used. The second model, which comprises the index based on the new disclosurerequirements of IFRS 7, previously outlined, represents the determinants of finan-cial instrument disclosure. The initial binary-choice logit model (Model 1) testinga dichotomous measure of DERIV for the full sample of firms is as follows:

DERIV ¼ f a0 þ b1PROF þ b2LEVþ b3ACþ b4RMCþ b5AUDITþ b6SIZEð Þð1Þ

Where:DERIV = 1 if firm uses some form of derivative financial instrument; 0 other-wise.PROF = reported net profit after tax/total assets.LEV = debt/assets.AC = 1 if the audit committee takes on the risk management function; 0 otherwise.RMC = 1 if establishment of a risk management committee; 0 otherwise.AUDIT = 1 if audited by a Big 4 auditor; 0 otherwise.SIZE = Ln (total assets).

The second stage of our study examines the link between the level of disclo-sure, pursuant to the additional requirements of IFRS 7, and the firm character-istics previously discussed. The ordinary least-squares (OLS) linear regressionmodel (Model 2) is constructed as follows:

Disclosurei ¼ a0 þ b1PROFi þ b2LEVi þ b3ACi þ b4RMCi

þ b5AUDITi þ b6SIZEi þ b7DERIVi þ e ð2Þ

Where:Disclosure = total level of compliance with additional AASB 7 requirementsfor firm i.PROF = reported net profit after tax/total assets for firm i.LEV = debt/asset for firm i.AC = 1 if the audit committee takes on the risk management function; 0 other-wise for firm i.RMC = 1 if establishment of a risk management committee; 0 otherwiseAUDIT = 1 if audited by a Big 4 auditor; 0 otherwise for firm i.SIZE = Ln(total assets) for firm i.DERIV = 1 if firm uses some form of derivative financial instrument; 0 other-wise for firm i.



5. Results

5.1. Descriptive statistics – independent variables

Descriptive statistics of the independent variables for the full sample are pre-sented in Table 3. From untabulated results, SIZE, PROF and LEV demon-strate high skewness. As SIZE and LEV have large positive tails, results couldpotentially be biased towards large firms. The average PROFIT for our samplefirms is )0.321, explained by the large number of loss firms (untabulated) – 301from the total 341 sample firms (88.3 per cent).Less than one-third of the companies are audited by Big 4 auditors. The most

frequently engaged auditor is Ernst and Young, which accounts for 36 of thetotal sample (9.5 per cent). Only 7 per cent of firms have a risk managementcommittee, less than that observed by Hassan et al. (2008). Audit committeeswere present in 56 per cent of sample firms. Finally, as previously discussed, 23.2per cent of the sample use DERIV (Table 4).

5.2. Derivative use and firm characteristics

Our first objective is to assess the firm characteristics related to use of financialderivatives. We conduct a binary choice logit regression with a dummy depen-dent variable (DERIV). Results are presented in Table 5.While we do not find any association between our measure of financial perfor-

mance (PROF) and derivative use, we do find that the level of financial risk(LEV) is positively related to derivative use (p < 0.01). Financial leverage hasbeen found in prior research (see, e.g. Smith and Stulz, 1985; Berkman et al.,2002; Nguyen and Faff, 2002; Heaney and Winata, 2005) to equate to the likeli-hood of financial distress, with derivative use reducing the probability of acompany entering financial distress.

Table 3

Descriptive statistics: disclosure index

Categories N

Mean

%

SD

%

Min.

%

Max.

%

Percentiles

10% 20% 30% 40% 50% 60% 70% 80% 90%

Income statement 341 44 35 0 100 0 0 0 50 50 50 50 50 100

Balance sheet 341 65 31 0 100 50 50 50 50 50 50 100 100 100

Policy notes 341 70 36 0 100 0 33 67 67 100 100 100 100 100

Credit risk 341 52 26 0 100 20 20 40 40 60 60 60 80 80

Liquidity risk 341 61 37 0 100 0 50 50 50 50 100 100 100 100

Market risk 341 59 28 0 100 20 40 40 60 60 60 80 80 100

Total 341 57 15 16 100 37 42 47 53 58 58 63 74 79

The table shows the extent of disclosure for each category and the total disclosure score.



Consistent with prior research (Berkman et al., 2002; Nguyen and Faff, 2002,2003; Heaney and Winata, 2005), firm size (SIZE) is also related to the use ofderivatives. Large firms are more likely to operate internationally and thereforebe subject to market risk associated with foreign currency fluctuations. Neitheraudit quality nor committee governance relates to the use of derivatives.

5.3. Financial instrument disclosure and firm characteristics

We identified that heteroscedasticity is not an issue using the White test(White, 1980). Results of the regression analysis, testing the hypothesised associ-ation between the disclosure of financial instruments and a range of firm charac-teristics, are presented in Table 6. Variance Inflation Factor (VIF) statisticsindicate that multicollinearity is not a concern in the model. The hypothesisedfirm characteristics firm performance, financial risk, audit and risk managementcommittees, audit quality and control variables explain 20.9 per cent of variationin the level of financial instruments disclosure.Our proposition that the level of financial instruments disclosure is related to

firm performance receives limited support at p < 0.1, in the negative direction.One factor potentially impacting our sample during the sample period is the glo-bal financial crisis (GFC), which is likely to affect performance of sample firms

Table 4

Descriptive statistics: independent variables

Variable Mean Median SD Min. Max.

Quartiles

25% 50% 75%

Panel A: descriptive statistics on continuous dependent and independent variables (N = 341)

PROF )0.321 )0.156 3.312 )22.628 49.841 )0.409 )0.157 )0.038LEV 0.104 0.056 0.114 0.000 0.540 0.028 0.056 0.123

SIZE 16.481 16.361 1.400 12.178 20.036 15.456 16.354 17.280

Variable Code No. of Firms %

Panel B: descriptive statistics on categorical independent variables (N = 341)

AC 0 150 44.0

1 191 56.0

RMC 0 317 93.0

1 24 7.0

AUDIT 0 250 73.3

1 91 26.7

DERIV 0 262 76.8

1 79 23.2

PROF = reported net profit after tax/ total assets; LEV = total debt outstanding/total assets;

SIZE = Ln (total assets); AC = 1 if audit committee responsible for risk management, 0, otherwise;

RMC = 1 if separate risk management committee, 0 otherwise; AUDIT = 1 if firms are audited by

a big 4 auditor, 0 otherwise; DERIV = 1 if firm uses derivatives, 0 otherwise.



during 2008, leading to this negative relationship. The large proportion of lossfirms previously highlighted is also likely to contribute to this result.The prediction that disclosure of financial instruments is positively related to

financial risk is supported at p < 0.001. The result is consistent with Wei and Tay-lor (2009) and Taylor et al. (2010), who found that the level of fair value andfinancial risk disclosures, respectively, under a mandatory regime pursuant to IAS32, is related to financial risk levels. The extent of disclosure increases with escalat-ing financial risk, where firms with higher leverage increase disclosure to reducepotential agency costs associated with external financing and asset substitution.We find some support for our RMC variable (p < 0.1). Interestingly, we

observe that firms with a risk management committee disclose less than thosewithout. This result should be viewed with caution given the small proportion ofsample firms which have a risk management committee – an emerging gover-nance mechanism in Australia. Risk management through the audit committees(AC) does not relate to disclosure level.However, as predicted, external audit quality (AUDIT) is positively related to

disclosure at p < 0.01, indicating that firms using a higher-quality auditor pro-vide more detailed disclosure. Big 4 auditors are more likely to have ensured

Table 5

Determinants of derivative use

DERIV = f(a0 + b1PROF + b2LEV + b3AC + b4RMC + b5AUDIT + b6SIZE + e)

Model Pred. sign B SE Wald Sign. (p)

Constant +/) )8.470 2.110 16.107 0.000

Firm performance

PROF +/) 0.046 0.046 0.982 0.322

Financial risk

LEV + 3.985 1.139 12.231 0.000***

Corporate governance

AC + )0.477 0.310 2.362 0.124

RMC + 1.237 0.740 2.797 0.094*

Audit quality

AUDIT + )0.211 0.324 0.426 0.514

Firm size

SIZE + 0.824 0.249 10.947 0.001***

Chi-square (sig.) 46.550

Log likelihood 324.182

Cox and Snell R2 0.127

Nagelkerke R2 0.192

Classification table – overall percentage correct 80.8%

***Significant at the 0.01 level, **significant at the 0.05 level, *significant at the 0.1 level.

DERIV = 1 if firm uses some form of derivative financial instruments, 0 otherwise; PROF =

reported net profit after tax/ total assets; LEV = total debt outstanding/total assets; SIZE = Ln

(total assets); AC = 1 if audit committee responsible for risk management, 0 = otherwise;

RMC = 1 if separate risk management committee, 0 otherwise; AUDIT = 1 if firms are audited by

a big 4 auditor, 0 otherwise.



clients address the new, expanded requirements of AASB 7. The finding is againconsistent with prior research by Chalmers and Godfrey (2004) and Lopes andRodrigues (2007).The significant SIZE variable (p < 0.01) indicates that, consistent with prior

research (see, e.g. Taylor et al., 2008), large firms present more extensive disclo-sures of financial instrument information. Results indicate firms which use deriv-atives (DERIV) have more extensive disclosures of financial statementinformation (p < 0.01).

5.4. Sensitivity tests

A number of sensitivity tests are conducted to check robustness of the results.We test two alternative proxies for performance: (i) a market-based measure(Tobin’s Q) and (ii) earnings per share before abnormals (EPS). Additionally,as an alternative proxy for leverage, debt-to-equity is used. We also introduce a

Table 6

Determinants of financial instrument disclosure

Disclosurei = a0 + b1PROFi + b2LEVi + b3ACi + b4RMCi + b5AUDITi + b6SIZEi

+ b7DERIVi + e

Model Pred. sign Coeff. SE t stat VIF

Constant +/) 0.252 0095 2.652

Firm performance

PROF +/) )0.004 0.002 )1.808* 1.040

Financial risk

LEV + 0.281 0.067 4.193*** 1.116

Corporate governance

AC + )0.011 0.016 )0.671 1.173

RMC + )0.056 0.030 )1.822* 1.185

Audit quality

AUDIT + 0.071 0.018 3.944*** 1.213

Firm size

SIZE + 0.037 0.014 2.734*** 1.314

Derivative use

DERIV + 0.062 0.019 3.339*** 1.162

Adjusted R2 0.211

F statistics 14.081

p-Value 0.000

N 341

***Significant at the 0.01 level, **significant at the 0.05 level, *significant at the 0.1 level. Disclo-

sure = disclosure score based on level of financial instruments disclosure for individual companies in

accordance with a defined index; PROF = reported net profit after tax/total asset; LEV = total

debt outstanding/total assets; SIZE = Ln (total assets); AC = 1 if audit committee responsible for

risk management, 0 = otherwise; RMC = 1 if separate risk management committee, 0 otherwise;

AUDIT = 1 if firms are audited by a big 4 auditor, 0 otherwise; DERIV = 1 if firm uses deriva-

tives, 0 otherwise.



dummy variable to the model to recognise loss-making firms. All tests revealedresults consistent with the main tests previously outlined.Given coal and iron ore are the greatest exporters in the industry, and our gold

firms utilise more financial instruments than others, we also include a dichoto-mous control variable – SECTOR to explore its relative influence on derivativeuse and financial instrument disclosure. We do not find any association betweenour SECTOR control and derivative use and between SECTOR and financialinstrument disclosure. SECTOR is a relatively noisy measure, with many firmsproducing resources across the industry, in addition to their main product. Assuch, they are less likely to differ in their use of derivatives based on the natureof their production activities.

6. Conclusions, limitations and avenues for future research

The objective of this article is to examine both the use of derivative financialinstruments and the level of financial instrument disclosure subsequent to theexpanded disclosure regime under IFRS 7/AASB 7 – many of which are relatedto the risks associated with derivative use and associated fair value fluctuations.We examine the relation between derivative use and financial instrument disclo-sure and a range of firm characteristics for firms in the Australian extractivesindustry. While prior research has examined derivative use (see, e.g. Chalmersand Godfrey, 2000; Nguyen and Faff, 2002; Heaney and Winata, 2005) or theassociation between disclosure level of financial instruments and firm characteris-tics (see, e.g. Chalmers and Godfrey, 2004; Hassan et al., 2006b; Taylor et al.,2008, 2010), this work was all conducted in either a voluntary setting or a settingsubject to accounting standards with less-extensive disclosure requirements thanIFRS 7/AASB 7. To examine the association between disclosure and a range offirm characteristics, a disclosure index was developed in accordance with theadditional disclosure requirements in AASB 7 to measure the disclosure level.The results support the following conclusions:

1 Derivatives are used by 79 firms from our sample. While 46 of these firms didnot disclose the purpose of derivative use, 33 firms use derivatives to hedgefinancial risk. Commodity risk and foreign exchange risk mitigation was themost common purpose of derivatives use in our sample of extractives firms.Forward rate agreements and options are used most frequently in hedgingfinancial risk. The extent of detail disclosed varies greatly across sample firms.This is also reflected in our disclosure index. Consistent with prior research,we also find that derivative use is positively associated with financial risk andfirm size.

2 Firms with greater levels of disclosure of financial instruments tend to usederivatives, are larger, less profitable, more highly geared and are audited by aBig 4 firm.



The findings reveal several contributions of this article. First, it adds to ourvery limited knowledge of derivative use in the current environment and determi-nants of the level of financial instrument disclosures. Second, while prior researchexamines the relation between the use of financial instruments and firm charac-teristics in a voluntary setting (see, e.g. Chalmers and Godfrey, 2004; Lopes andRodrigues, 2007), or in a setting prior to the release of IFRS 7 (Taylor et al.,2008; Wei and Taylor, 2009), we add to our understanding of the firm character-istics associated with disclosure of financial instruments in a mandatory environ-ment, that is, IFRS 7/AASB 7.Third, this study contributes to the knowledge base that standard setters can

use to determine the extent to which Australian firms are disclosing derivativesunder IFRS 7/AASB 7 and will assist in future directions in developing financialinstrument accounting standards. The IASB continues to make changes toreporting requirements post the GFC.As with all such research, our study is subject to some limitations. First, this

article examined specifically the relation between derivative use, disclosure levelof financial instruments and firm characteristics in the Australian extractivesindustry. This could potentially limit its generalisability to other industries. Sec-ond, the disclosure score for individual companies as well as information onindependent variables are based on firm’s financial reports. Therefore, the depen-dent and independent variables may not reflect fully all of the business activitiesrelating to use and disclosure of financial instruments information by a firm.Third, the construction of the disclosure index utilised in this article is based onthe difference in disclosure requirements between IAS 132/AASB 132 and IFRS7/AASB 7. Although we are confident of the inter-rater reliability in applyingthe index, the construction of the disclosure index in some cases requires acertain degree of discretion.Additional research could extend the time period to examine pre- and post-

mandatory adoption of AASB 7 to analyse the evolution of the disclosurepractices and firm characteristics. Evidence of whether its adoption providesvalue-relevant or incremental information to stakeholders to enable them toevaluate a firm’s financial instruments activities could also be gathered. Finally,future research could incorporate other accounting standards on financialinstruments, such as AASB 139 Financial Instruments: Recognition and Mea-surement (AASB, 2010) or the recently issued AASB 9 Financial Instruments(AASB, 2009) to the analysis. This would allow a more comprehensive exami-nation of financial instruments–related issues, and most importantly the fairvalue of derivatives.

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