Ebook Corporate Risk Management and Hedge Accounting
The use of derivative instruments for corporate risk management has grown dramatically over the past decades and so has the need to regulate the accounting treatment and reporting of these instruments. This paper evaluates the impact of accounting for derivatives on the scope of corporate risk management, measured by the level of asymmetric information regarding firm’s earnings. The results offer empirical evidence on the total effect of hedge accounting.
According to risk management theories, firms optimally hedge if some market imperfections make volatility costly. Through hedging, firms are able to reduce the cost of financial distress (Mayer and Smith (1982), Smith and Stulz (1985)) and the amount of corporate tax paid (Smith and Stulz (1985)). Ross (1997) and Leland (1998) show that through hedging, firms can reduce the probability of financial distress and hence increase their debt capacity and associated tax advantages. When external financing is more costly, hedging can also ensure that the firm has enough cash flow to internally finance attractive investments (Froot et al (1993), Myers and Majluf (1984)). Finally, financial hedging improves the informativeness of corporate earnings as a signal of management ability (DeMarzo and Duffie (1995)). Barth et al (1999) provide evidence that stock markets reward firms with patterns of increasing earnings, giving managers an additional incentive to avoid volatility.
Accounting for derivatives as prescribed by International Financial Reporting Standards (IFRS) stirred important debate regarding its effect on corporate risk management. On the one hand, it is argued that hedge accounting with fair value measurement makes the use of derivatives more transparent, providing a better picture of the firm’s underlying risk exposure. This encourages optimal use of deriva-tives, as in a setting with no asymmetric information (Melumad et al (1999)) and improves the informativeness of corporate earnings as a signal of management ability (DeMarzo and Duffie (1995)). On the other hand, hedging under this new accounting regime can increase earnings volatility if derivative instruments do not qualify for hedge accounting treatment. This reduces the hedging benefits associated with earnings smoothing.
If hedging instruments do not qualify for hedge accounting treatment, firms can either accept the impact on their annual reports and follow what it is considered as an optimal economic hedge, or adjust their hedging behavior to achieve more desirable accounting results. Adjustments in hedging behavior can imply changes in the type of derivative instruments used, the hedging horizon and the extent of hedging. In the extreme, firms may abandon their hedging program. Under any scenario hedging benefits decrease, as the use of derivatives is either associated with higher earnings’ volatility or become suboptimal in terms of risk management.
The above discussion leads to an interesting research question. Which effect of accounting for derivatives under IFRS dominates, the positive; increase in the trans parency of derivative disclosure or the negative; increase in the earnings volatility and/or deviation of hedging policy from the optimal? To investigate this question we look at the effect of derivatives usage on the level of asymmetric information regarding firms’ earnings2 before and after the introduction of IFRS. Higher information quality on derivative instruments reduces the noise contained in earnings and thus decreases information asymmetry. Not qualifying for hedge accounting, all else equal, increases the noise contained in earnings, achieving the opposite result.
The UK provides a unique framework for this analysis for a number of reasons. Firstly, in the UK market we observe extensive hedging activity (Grant and Marshall (1997), Judge (2006)). Therefore, the effects of hedge accounting are expected to be more pronounced, compared to markets with limited hedging activity. Secondly, the quality of UK GAAP does not differ substantially from IFRS (Christensen et al (2007)). Hence, we expect IFRS effects on information asymmetry to be largely driven by the particular standards that introduce substantial changes, including those concerning hedge accounting. Finally, according to UK GAAP, listed firms were required to report derivatives usage from 1999. This enables us to identify hedgers before the introduction of IFRS.
Using analysts’ forecast error and dispersion as proxies for asymmetric information we find that the positive effects of hedge accounting under IFRS dominate. Specifically, derivative usage under IFRS is negatively associated with analysts’ forecast error and dispersion. Whether or not derivative positions qualify fully for hedge accounting treatment does not significantly influence earnings’ forecast accuracy. The results enhance our understanding of the effect of hedge accounting and suggest that potential IFRS benefits include reduced information asymmetry, which has been shown to reduce cost of capital in theoretical research (Easley and O’Hara (2004)).
The paper is organized as follows: Section 2 presents a review of related academic research. Section 3 summarizes the accounting treatment and disclosure of hedging activity in the UK. The sample and data sources are presented in Section 4. Section 5 presents the variables and models used. The main results of the paper are presented in Section 6. Section 7 concludes.
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