Complete disclosure of various risks that companies face is a key element in encouraging transparency, promoting risk-management culture and thereby enhancing shareholder value and the process of price discovery in equity markets
V Shunmugam & Ruchi Shukla
The base metals industry and the year 2017, both signify price volatility. In 2017, the base metals complex outperformed, with some metals exceeding expectations—LME basket (LMEX) rose by 22%. In contrast, during early 2016, base metals prices had bottomed out after falling for five consecutive years from 2011 to 2015. Policy-makers can talk of varied macroeconomic factors effecting the volatile scenario but business houses have to manoeuvre themselves through this price volatility to effectively accomplish their financial performance.
Until recently, most commodity businesses managed to withstand commodity price movements as the swings were often temporary and cyclical, and they had fairly long-term supply contracts. However, with structural changes such as development of transparent markets supported by the growth of information and communication technology, the broad-based volatility in commodity prices does not only affect short-term profits but also their capacity in terms of long-term planning and investment. In fact, sharp fluctuations on either side can create significant challenges, impacting the raw material cost, finished product pricing and finally the profitability.
Traditionally, corporates dealing in commodities have managed price risks through ‘pass on’ mechanism or ‘contractual agreements with suppliers’. What has worked in the past has become ineffective especially with reduction in information asymmetries and most commodities moving to dynamic markets. In line with these developments, corporates across the globe have evolved and extensively utilise derivative products for hedging the risk of commodity price movements. Besides the evolving commodity risk management practices, over the years there is also an increased realisation and acceptability that with effective commodity price risk management, good financial reporting in terms of risk disclosures is also necessary to create a business environment of trust, transparency and accountability.
According to the International Accounting Standards Board (IASB), the objective of financial reporting is “to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions”. Globally, the academia have also been working to modernise and simplify corporate governance and risk disclosures such that the same are easily and effectively comprehendible by the various stakeholders.
In fact, risk disclosures not only enhance corporate transparency but also positively impact investor confidence by providing a better understanding of a company’s risk exposures and risk-management practices. The regulatory and compliance requirements of reporting risks and risk-control measures also reduce the gaps and loopholes in internal risk management and provide a better perspective to the boards of companies, motivating for effective risk management. To that extent, the Institute of Chartered Accountants in England and Wales (ICAEW), in its position paper on risk disclosure, calls on company directors to disclose more risk and risk management information in prospectuses and annual reports. The institute specifically asserts that such disclosures will reduce cost of capital for companies, along with risk management and corporate governance benefits and increasing the usefulness of company disclosures.
Indian statutory bodies and regulators have also initiated a large number of steps to encourage good corporate governance and transparency while requiring listed companies to fulfil certain standards. One such step has been the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, which requires listed companies to disclose the information related to commodity price risk in their annual reports as one of the mandatory components of Corporate Governance Report (Schedule V, C(9) (n) and C (10) (g)). SEBI also formed a committee on corporate governance in June 2017 with a view to enhancing the standards of corporate governance of listed entities in India.
The committee, while making various recommendations, encourages boards and managements to view disclosure and transparency as a means to build trust with stakeholders and to proactively disclose material information that may impact decision-making variables. Another big step in this direction is India’s commitment towards the convergence of Indian accounting standards with IFRS and the adoption of Indian Accounting Standard (Ind AS) in a phased manner.
To that extent, the Ind AS 107 Financial Instruments: Disclosures requires entities to provide comprehensive quantitative and qualitative disclosures in their financial statements. While the guidelines and regulations are in place in India, it may still be worthwhile to look at the regulations and disclosure practices in developed jurisdictions, with the spirit of continual improvement and bringing about the desired uniformity in disclosure practices in India. Talking of global standards, in the US the market regulator Securities and Exchange Commission (SEC) vide Item 305 of Regulation S-K requires detailed quantitative and qualitative risk disclosures as part of Form 10-K filing. The SEC-CFR Title 17-§229.305 (Item 305) further elaborates the same as:
The quantitative disclosures are intended to provide an investor with a greater ability to assess the entity’s exposure to market risk (e.g., interest rate risk, foreign currency exchange rate risk, commodity price risk, equity price risk) and must be disclosed in one of the three ways:
(1) Comprehensive table (i.e., tabular presentation) that schedules cash flow amounts by maturity dates for all instruments that are sensitive to future changes in interest rates, currency exchange rates, commodity prices, or other market factors;
(2) Sensitivity analysis that quantifies the effect of at least one hypothetical move in market conditions relating to each market risk factor; or
(3) “Value at risk” disclosures that measure the potential exposure to adverse market movements over a specified time period with a selected likelihood of occurrence.
The qualitative disclosures include discussion of a company’s primary risk exposures, its objectives for managing those exposures and actual or expected material changes in the primary market risk exposures. It is fairly understandable that comprehensive information disclosures are critical for effective decision-making not only for firms’ investors but also for other stakeholders such as the government, employees, lenders, suppliers, etc. Thus, the utility arises not only from the perspective of removal of information asymmetry but also from the perspective of improving corporate governance standards and economic policy-making. In spite of all these benefits, it is a global phenomenon that in terms of driving compliance, only mandatory regulations supplemented by detailed guidelines work better.
In light of the above facts, assistance to corporates in the form of prescriptive guidelines, elucidating various operational aspects of disclosing commodity price risk à la SEBI’s LODR Regulations 2015 and Section 134 of Companies Act, 2013, can go a long way in ensuring not only compliance in terms of disclosing the commodity price risk exposure and risk management measures but also eliminate any information asymmetry that may exist between investors and investees in this regard.
Complete disclosure of various risks that companies face is a key element in encouraging transparency, promoting risk-management culture and thereby enhancing shareholder value and the process of price discovery in equity markets. Disclosures about the entity’s exposure to market risk (e.g., interest rate risk, exchange rate risk, commodity price risk, equity price risk) should be detailed and made available to the stakeholders of the market to help price associated securities accordingly. While it will meet the objective of attaining higher disclosure standards in Indian companies, it would also be of immense benefit to the stakeholders of the economy and commodity markets.
Shanmugam is head and Shukla is AVP, Research, Multi Commodity Exchange of India. Views are personal