The effects of SFAS 133 on foreign currency exposure of US-based multinational corporations

This study examines the change in foreign currency exposure of US-based multinational corporations (MNCs) upon implementation of SFAS 133—Disclosure of Derivative Instruments. We attempt to answer the question of whether this accounting requirement, which seeks to eliminate earnings surprises associated with derivatives, actually impacts earnings volatility and hedging strategies of exporting firms. Our results indicate that firms who were hedged prior to SFAS 133, i.e., those which managed their exposure using operational hedges, derivatives, or both, were able to decrease exposure to exchange rates following SFAS 133. However, those that were hedged prior to SFAS 133 and remained hedged following SFAS 133 did so without significantly changing their imbalances, i.e., without using operational hedges. These firms also experienced an increase in earnings volatility and a decrease in earnings predictability, as predicted by critics of the regulation. However, market value does not change following SFAS 133, implying that investors do not equate accounting regulation changes and EPS volatility with changes in cash flow.     

How fair-value accounting can influence firm hedging

The potential influence of accounting regulations on hedging strategies and the use of financial derivatives is a research topic that has attracted little attention in both the finance and the accounting literature. However, recent surveys suggest that company hedging can be substantially influenced by the accounting for financial instruments. In this study, we illustrate not only why but also how the accounting regulations may affect hedging behavior. We find that under mark-to-market accounting, most firms concerned with earnings smoothness adopt myopic hedging strategies relative to the benchmark, cash flow hedging. The specific influence of the accounting regulations depends on market and firm-specific characteristics, but, in general, the firms dramatically reduce the extent of hedging addressing price risk in future accounting periods. We illustrate that the change in hedging behavior significantly dampens the increase in earnings volatility stemming from fair value accounting of derivatives. However, the adjusted hedging strategies may substantially increase the firms’ cash flow volatility.     

The impact of IAS 39 on the risk-relevance of earnings volatility: Evidence from foreign banks cross-listed in the USA

We examine the impact of adopting International Accounting Standard 39 – Financial Instruments: Recognition and Measurement (IAS 39) by non-US commercial banks cross-listed in the US on earnings volatility and its risk relevance. As IAS 39 requires the recognition of unrealized fair-value gains and losses for a larger set of financial and derivative-financial instruments, and the impairment charges for loans and receivables, we expect and find that IAS 39 adoption increased earnings volatility in IFRS-adopting firms from 2005 onwards. Furthermore, both hedge accounting and the fair value option under IAS 39 are designed to reduce mixed-measurement volatility and to improve the sensitivity of firm risk measures to earnings volatility. We also find that the relationship between credit ratings (proxy for risk) and earnings volatility increases for IFRS-adopting firms after 2005. The evidence is consistent with the argument that IAS 39 increases the credit relevance of earnings volatility.     

Hedge Accounting and its Consequences on Portfolio Earnings – A Simulation Study

Abstract

In this paper, I analyze the consequences of cash flow hedge accounting on portfolio earnings of firms focusing on main changes between IFRS 9 and IAS 39. For this purpose, I develop a simulation study which illustrates the quantitative effects on the accounting entries according to the currently applicable hedge accounting methods. It is especially addressed what accounting differences arise and how these distinctions may affect a firm’s earnings. Furthermore, I examine to which firms early switching becomes especially desirable or burdensome. This information is particularly useful to managers and investors. The paper shows that portfolio earnings are affected differently. In the model, IAS 39 may lead to higher or lower earnings for increasing deviations between foreign and domestic interest rates. Additionally, sensitivity to volatility changes varies among the methods. Moreover, a partly ineffective hedging relationship does not necessarily decrease earnings compared to its fully effective counterpart.     

Effect of derivative accounting rules on corporate risk-management behavior

I examine the effect of the accounting standard for derivative instruments (SFAS No. 133) on corporate risk-management behavior. I classify a derivative user as an “effective hedger” (EH firm) if its risk exposures decreased after the initiation of the derivatives program, and as an “ineffective hedger/speculator” (IS firm) otherwise. I find that volatility of cash flows and risk exposures related to interest rate, foreign exchange rate, and commodity price decrease significantly for IS firms but not for EH firms, suggesting that IS firms engaged in more prudent risk-management activities after the adoption of SFAS No. 133.     

Comparing Alternative Hedge Accounting Standards: Shareholders' Perspective

We study the economic consequences of alternative hedge accounting rules in terms of managerial hedging decisions and wealth effects for shareholders. The rules we consider include the fair-value and cash-flow hedge accounting methods prescribed by the recent SFAS No. 133. We illustrate that the accounting method used influences the manager's hedge decision. We show that under no-hedge accounting, the hedge choice is different from the optimal economic hedge the firm would make under symmetric and public information. However, under a certain definition of fair-value hedge accounting, the hedging decision preserves the optimal economic hedge. We then demonstrate that long-term and future shareholders prefer a certain definition of fair-value hedge accounting to no-hedge accounting, while short-term shareholders prefer either approach depending on risk preferences and the level of uncertainty. We speculate about circumstances in which a manager would choose not to adopt fair-value hedge accounting when he has the option not to do so.     

The effect of SFAS 131 on the stock market’s ability to predict industry‐wide and firm‐specific components of future earnings

This study examines the impact of SFAS 131 on the extent to which stock prices incorporate industry‐wide and firm‐specific components of future earnings. By decomposing earnings into industry‐wide and firm‐specific components, this paper finds that the firms that aggregated segments under the old rule experience significant acceleration in the incorporation of future earnings into current stock prices upon adoption of SFAS 131. However, the acceleration of future earnings is mostly driven by the improved incorporation of industry‐wide components of future earnings, which indicates the market’s ability to predict firm‐specific components is not significantly changed. Supplemental analysis suggests that the reduced geographic earnings information is one possible reason for lack of improvement in incorporating firm‐specific earnings into price.     

The mixed attribute model in SFAS 133 cash flow hedge accounting: implications for market pricing

In this study, we examine the pricing of cash flow hedge adjustments reported in other comprehensive income (OCICF), under the mixed attribute model in SFAS 133 Accounting for Derivative Instruments and Hedging Activities. Our OCICF pricing investigation integrates empirical research on the derivatives use that gives rise to such mark-to-market adjustments with the accounting information pricing literature. Based on this integration, we generalize mispricing theory for the SFAS 133 mixed attribute model and predict both the direction and magnitude of OCICF pricing. Screening on U.S. multinationals with ex ante exposure to currency risk, we provide evidence of OCICF mispricing in the expected direction, consistent with the notion that SFAS 133 cash flow hedge accounting results in a mixed attribute problem (Gigler et al. in J Account Res 45:257–287, 2007). Moreover, we find that both OCICF gains and losses are inversely related to future cash flows and of the expected magnitude, consistent with our predictions based on valuation theory (for example, Ohlson in Rev Account Stud 4:145–162, 1999). Our results support the Financial Accounting Standards Board’s concern that the SFAS 133 mixed attribute model does not provide the information necessary for investors to understand the net economic effects of derivatives use (FASB in Accounting for financial instruments and revisions to the accounting for derivative instruments and hedging activities. FASB, Norwalk, 2010).     

Do earnings reported under IFRS tell us more about future earnings and cash flows?

We contribute to the debate about the relative benefits and costs of International Financial Reporting Standards (IFRS) adoption by examining whether earnings persistence and the association between current accounting earnings and future cash flows differ for firms reporting under IFRS versus firms reporting under United States Generally Accepted Accounting Principles (U.S. GAAP) and firms reporting under non-U.S. domestic accounting standards (DAS). Using samples comprised of 58,832 firm-year observations drawn from 33 countries from 2002 through 2008, we find that positive earnings reported under IFRS are no more or less persistent than earnings reported under U.S. GAAP but losses reported under IFRS are less persistent than losses reported under U.S. GAAP. Moreover, we find that earnings reported under IFRS are no more or less persistent and are no more or less associated with future cash flows than earnings reported under non-U.S. DAS. However, we find that earnings reported under U.S. GAAP are more closely associated with future cash flows than earnings reported under IFRS. This is important if a key role of reported earnings is to help investors form expectations about future cash flows. These results should be of interest to academics and standard-setters as they debate the merits of transitioning to IFRS, and to parties who use reported earnings to form expectations about future earnings and cash flows.     

Evidence on the use of unverifiable estimates in required goodwill impairment

SFAS 142 requires managers to estimate the current fair value of goodwill to determine goodwill write-offs. In promulgating the standard, the FASB predicted that managers will, on average, use the fair-value estimates to convey private information on future cash flows. The current fair value of goodwill is unverifiable because it depends in part on management??s future actions (including managers?? conceptualization and implementation of firm strategy). Agency theory predicts managers will, on average, use the unverifiable discretion in SFAS 142 consistent with private incentives. We test these hypotheses in a sample of firms with market indications of goodwill impairment. Our evidence, while consistent with some agency-theory based predictions, does not confirm the private information hypothesis.     

Intra-Industry Effects of Earnings Restatements Due to Accounting Irregularities

Abstract:  This paper investigates the intra-industry effects of earnings restatements due to accounting irregularities. We detect a significant contagion effect for rival firms whose cash flow characteristics are similar to those of the restating firm. The restatement doesn't seem to influence all the firms in the industry or firms that have a high probability of involving the same type of accounting irregularity as the restating firm does. We do not detect any competitive effect; nor do we find a significant change in the implied cost of equity capital of the rival firms, suggesting that the contagion effect is due to the revision in the expected short-run future earnings of the rival firms.     

Analyst cash flow forecasts and pricing of accruals

This paper investigates how analyst cash flow forecasts affect investors' valuation of accounting accruals. We find that the strength of the accrual anomaly documented in Sloan (1996) is weaker for firms with analyst cash flow forecasts, after controlling for idiosyncratic risk, transaction costs and firm characteristics associated with the issuance of cash flow forecasts. We further show that this reduction in mispricing of accounting accruals is at least partially attributed to the improved ability of investors to price earnings manipulations imbedded in accruals. We investigate several non-mutually exclusive alternative explanations for this improvement in investors' ability and demonstrate that the increased investor attention and the improved accuracy of analyst earnings forecasts both contribute to the mitigation of the accrual anomaly.     

An analysis of the value of cash flow statements of New Zealand pension schemes

Superannuation (pension, retirement) schemes (plans) are required to report their earnings on a fair-value basis, reflecting recent shifts toward fair-value reporting in financial reporting. Fair-value earnings of such schemes include realised earnings and unrealised changes in values of assets and liabilities (unrealised earnings). This study examines the relation between components of fair-value earnings (realised and unrealised) and cash flows of 161 New Zealand defined benefit schemes for the financial year 1998. The findings of the study include that realised earnings are negatively associated with unrealised earnings and positively associated with cash flows from operations, but no association is found between unrealised earnings and cash flows from operations. This suggests that fair-value reporting has reduced the informational disparity between realised earnings and operating cash flows and therefore the reporting of cash flows information may not provide users with different information from reported in realised earnings. However, the results suggest that unrealised earnings provide additional information to users.     

Do firms follow GAAP when they record share repurchases?

This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allocation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retirement firms and find that the choice between the two accounting methods is not always consistent with GAAP, but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases.     

Regular Dividend Announcements and Future Unexpected Earnings: An Empirical Analysis

Previous studies have interpreted stock price reaction to dividend announcements as being consistent with the hypothesis that any changes are forecasts of future corporate profits. Recent studies seem to provide evidence to this effect. This study provides additional empirical evidence pertaining to the issue of whether quarterly cash dividend announcements convey useful information about a firm's future profitability, beyond that contained in contemporaneous quarterly earnings announcements. The association between unexpected changes in quarterly dividends and unexpected accounting earnings in subsequent quarters is examined, after controlling for information contained in past and current earnings series. The results, based on a large sample of regular quarterly cash dividend changes, indicate that firms that increased (decreased) their dividends realized, on average, greater (smaller) unexpected accounting earnings in subsequent periods than firms that did not change their dividends.     

Loss firms’ annual report narratives and share price anticipation of earnings

We extend prior research into the association between disclosure quality and share price anticipation of earnings by discriminating between firms that report profits and firms that report losses. As a measure of disclosure quality we count the number of forward-looking earnings statements in annual report narratives. To measure the extent to which current share price movements anticipate future earnings changes we regress current stock returns on current and future earnings changes. The coefficients on the future earnings change variables are our measure of share price anticipation of earnings.Our regression results show that the association between annual report narratives and share price anticipation of earnings is not the same for profit and loss firms. For loss firms we find that the ability of stock returns to anticipate next period's earnings change is significantly greater when the firm provides a large number of earnings predictions in annual report narratives. We make no such observation for profit firms. In addition, once we control for variations in the intrinsic lead–lag relation between returns and earnings across industries, the observed difference between profit and loss firms becomes statistically significant. Overall, our results are consistent with annual report narratives being a particularly important source of information for loss-making firms.     

The Stock Price Impact of Mandated Accounting Charges on Rate-Regulated Firms

This study seeks to determine ifmore highly leveraged rate-regulated firms are positively affectedby accounting standards that increase recognized expenses. Itfinds a positive relation between leverage and market reactionsto SFAS 106 for rate-regulated firms. Further, results indicatethat this positive relation is an increasing function of thelevel of financial leverage and the extent to which the regulatoryclimate is favorable.The study makes severalcontributions to the accounting literature. It documents thatfor rate-regulated firms, the relation between financial leverageand the market impact of an accounting standard that increasesrecognized expenses is contrary to that documented for the generalpopulation of firms. It identifies factors that affect the strengthof the positive relation between financial leverage and rate-regulatedfirms' price reactions to accounting standards that increaserecognized expenses. It also has potential implications for futureresearch on the incremental informativeness of cash flows becauseit helps to identify settings in which cash flow informationis likely to be particularly important.     

The Relation Between SFAS No. 95 Cash Flows From Operations and Credit Risk

This study examines the relevance of Financial Accounting Standards (SFAS) No. 95 operating cash flow disclosures for assessing a primary component of firm risk, namely credit risk. We find that SFAS No. 95 operating cash flows is an important determinant of credit risk, measured by debt ratings, incremental to other profitability and risk–related information. We also find that operating cash flows have a stronger incremental relation to credit risk for firms with a larger proportion of long–term debt and larger firms with lower operating uncertainty. Interestingly, cash flows appear to have less incremental importance for firms in high tech and regulated industries.     

Conditional conservatism and the limits to earnings management

We examine the impact of conditional conservatism on earnings management. Our findings support the view that conditional conservatism reduces accruals-based earnings management but also triggers a trade-off between accruals and real earnings management. In our main tests we use the passage of SFAS 121 as a plausibly exogenous regulatory change that increased the level of conditional conservatism but did not materially affect earnings management. We find that, after the regulation, treated firms reduce accruals-based earnings management and increase real earnings management, and are less likely to be marginal or habitual beaters of earnings benchmarks. Given the crucial role of earnings for firm valuation and analysis, and that conditionally conservative accounting choices are observable, our results should be of wide interest for investment professionals.     

Economic determinants of price informativeness about future earnings

This study investigates how the value-creation process affects the extent to which stock prices incorporate value-relevant information about future earnings. In contrast to previous studies focusing on the value-reporting process, this paper shows that strong product market power accelerates the incorporation of future earnings into current equity prices due to less uncertainty about future cash flows and that intensive long-term investment deters such incorporation because of greater uncertainty regarding future cash flows. The results suggest that firm fundamentals shaped by product market competition and long-term investment explain the price informativeness about future earnings beyond the impact of management’s reporting discretion.