Does Fair Value Reporting Affect Risk Management? International Survey Evidence

We survey CFOs from 36 countries to examine whether and how firms altered their risk management policies when fair value reporting standards for derivatives were introduced. A substantial fraction of firms (42%) state that their risk management policies have been materially affected by fair value reporting. Firms are more likely to be affected if they seek to use risk management to reduce the volatility of earnings relative to cash flows and if they operate in countries where accounting numbers are more likely to be used in contracting. We document a substantial decrease in foreign exchange hedging and in the use of nonlinear hedging instruments. Finally, firms that take active positions are more likely to be affected by fair value reporting. Taken together, our evidence indicates that requirements to report derivatives at fair values have had a material impact on derivative use; while speculative activities have been reduced, sound hedging strategies have been compromised as well.     

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.     

Does fair value accounting contribute to market price volatility? An experimental approach

This paper contributes to the debate on the impact of accounting measurement rules for financial assets. We examine the association between fair value accounting for financial assets and market price volatility for nonfinancial firms in an experimental setting. One group of participants was provided with financial statements where held‐for‐trading securities were reported at fair market value (FVA). Another group received financial statements with investments reported at historical cost (HCA). Controlling for accounting data, we find no systematic difference between FVA and HCA for three different measures of market price volatility, despite higher earnings volatility and marginally heavier trading under FVA.     

公允价值会计与市场波动

2008年金融危机的爆发,使得公允价值会计倍受关注。一个焦点问题是:公允价值会计是否会加剧市场波动。我们针对2007—2011年中国A股市场的情况对这一问题进行了实证研究,主要结论如下:1)股价能够反应公允价值会计信息,且在市场波动期比平稳期反应更显著;2)公允价值会计信息与波动率之间的正相关关系在市场波动期比在平稳期更加显著;3)波动率与公允价值会计信息的正相关性主要出现在长周期上。     

The Effects of Uncertainty and Disclosure on Auditors' Fair Value Materiality Decisions

Financial accounting standards increasingly require fair value measurements. I experimentally examine how uncertainty affects auditors’ adjustment decisions when evaluating fair values. I manipulate two types of uncertainty, input subjectivity and outcome imprecision, and one reporting choice, supplemental disclosure. I find that auditors are most likely to require adjustments when fair values contain both more input subjectivity and more outcome imprecision, but that this likelihood diminishes when clients supplement recognized fair values with additional disclosure. Thus, consistent with moral licensing, I find that auditors tolerate greater potential misstatement in the financial statements when clients provide disclosure, suggesting that the SEC's preference for supplemental disclosure may have the unintended consequence of affecting fair values recognized in the body of the financial statements. I also provide evidence that auditors determine adjustment size by comparing recorded fair value to the nearest bound, rather than the midpoint, of the auditors’ own range estimate, consistent with strict application of auditing standards.     

Managing earnings risk under SFAS 133/IAS 39: the case of cash flow hedges

Whereas empirical studies suggest that firm hedging is influenced by accounting standards such as SFAS 133 and IAS 39, the nature of earnings risk management remains a puzzle. I develop a model that shows how non-financial firms that prefer predictable earnings jointly optimize their hedging strategy and the choice between fair-value and hedge accounting. I also examine the implications of these decisions for earnings predictability under SFAS 133/IAS 39. In this model, which has two accounting periods, earnings uncertainty arises from economic shocks and accounting mismatches. The specific influence of accounting mismatches is isolated with two benchmarks, one for firm hedging (cash flow hedging) and another for an accounting system that fully complies with the matching principle. In this forward-looking analysis, most firms significantly decrease the hedging of long-term earnings when faced with persistent price dynamics. Under non-persistent price dynamics, the levels of long-term earnings hedging are only slightly reduced. Therefore, the influence of accounting mismatches on firm hedging is highly dependent on the economic environment in which a firm operates, which suggests that the potential influence of accounting on firm hedging may be difficult to identify in archival studies. The analysis also offers a forward-looking perspective on the changing properties of earnings since the late 1970s that supplements the existing body of archival accounting studies. For example, under persistent price dynamics, forward-looking short-term earnings volatility may increase tenfold or more for cash flow hedging under fair-value accounting compared with a perfectly matched accounting system.     

Corporate risk management and dividend signaling theory

This article investigates the effect of corporate risk management on dividend policy. We extend the signaling framework of Bhattacharya [1979. Bell Journal of Economics 10, 259–270] by including the possibility of hedging the future cash flow. We find that the higher the hedging level, the lower the incremental dividend. This result is intuitive. It is in line with studies suggesting that cash flows’ predictability decreases the marginal gain from costly signaling through dividends and the assertion that corporate hedging decreases cash flow volatility. It is also in line with the purported positive relation between information asymmetry and dividend policy (e.g., Miller and Rock [1985. The Journal of Finance 40, 1031–1051]) and the assertion that risk management alleviates the information asymmetry problem (e.g., DaDalt et al. [2002. The Journal of Future Markets 22, 261–267]). Our theoretical model has testable implications.     

Adjustment of valuation inputs and its effect on value relevance of fair value measurement

The fair value accounting standards; i.e., FAS 157, FAS 157-3 and FAS 157-4, specify the circumstances where firms need to adjust valuation inputs to fair value measurements in response to changes in market conditions. Such an adjustment inherently involves substantial management judgment and is accompanied with transfers of assets and liabilities among the different levels of the fair value hierarchy. We study the effect of adjusting valuation inputs to reflect market variations on value relevance of fair value measurements by comparing the value relevance of fair value assets between the banks that make transfers of assets and the banks that make no transfers. Overall, we find a significant increase in value relevance of fair value measurements for banks that transferred assets into/out of the Level 3 category. Our study examines a challenging situation in the application of fair value standards; i.e., determining fair value when there is a change in market conditions. Fair value measurement under such a situation involves substantial management judgment and potential estimate errors and manipulation. Our findings provide useful information for researchers, regulators and accounting professionals to assess the market’s perception of the reliability of fair value information when management exercises substantial discretion in adjusting valuation inputs under changing market conditions.     

Fair value accounting for liabilities: The role of disclosures in unraveling the counterintuitive income statement effect from credit risk changes

When liabilities are accounted for at fair value, a deterioration of a company’s credit risk results in the reporting of an income statement gain; an improvement in a company’s credit risk results in a loss. Many argue that these income statement effects are counterintuitive and that financial statement-users are likely to misinterpret fair value gains as positive signals and fair value losses as negative signals. Utilizing an experiment with CPAs as participants, we find that these arguments are indeed valid. Specifically, we find that over 70% of the participants incorrectly assess a company’s credit risk as improving (deteriorating) when a fair value gain (loss) is recognized. We also find that disclosures that explicitly specify the relation between the direction of the credit risk change and the income statement effect significantly reduce participants’ misinterpretations, and are more beneficial when fair value gains versus losses are recognized. These findings provide empirical evidence in the debate over the recognition of company-specific credit risk changes and offer direction for improving disclosures in the area of fair value accounting.     

Volatility spillovers between oil prices and the stock market under structural breaks

This paper employs univariate and bivariate GARCH models to examine the volatility of oil prices and US stock market prices incorporating structural breaks using daily data from July 1, 1996 to June 30, 2013. We endogenously detect structural breaks using an iterated algorithm and incorporate this information in GARCH models to correctly estimate the volatility dynamics. We find no volatility spillover between oil prices and US stock market when structural breaks in variance are ignored in the model. However, after accounting for structural breaks in the model, we find strong volatility spillover between the two markets. We compute optimal portfolio weights and dynamic risk minimizing hedge ratios to highlight the significance of our empirical results which underscores the serious consequences of ignoring these structural breaks. Our findings are consistent with the notion of cross-market hedging and sharing of common information by financial market participants in these markets.     

Hedging derivatives in the banking industry: Evidence of investor confusion

Hedging derivatives are complex instruments that require particular scrutiny by bank regulators to ensure that a bank’s risk profile is consistent with sound banking practices. The Basel II agreement envisions a system of banking oversight that includes market discipline as a key element of the regulatory framework. A necessary condition in achieving market discipline is that market participants must be able to decipher the underlying conditions from reported results. We examine the relationship between investor confusion and the income effects arising from fair value recognition of hedging derivatives in the banking industry. We use abnormal trading volume as a proxy for investor confusion, and we find a positive and significant relationship between fair value accounting incomes and two alternative measures of abnormal trading volume. The findings suggest that accounting requirements alone may be insufficient to communicate the complexities of hedging derivatives to investors in a way that achieves the market discipline prescribed by Basel II. Bank regulators may need to augment extant efforts for transparency to ensure that risks are adequately communicated to the market.     

Estimating Volatility Persistence in Oil Prices Under Structural Breaks

Policy makers and financial market participants are interested in knowing how shocks affect the volatility of oil prices over time. We accurately compute the volatility persistence by incorporating endogenously determined structural breaks into a GARCH model. Contrary to previous findings, we find that oil shocks dissipate very quickly but have a strong initial impact. Understanding this behavior is not only important for derivative valuation and hedging decisions but for broader financial markets and the overall economy, for which there are significant consequences.     

Failing Faithful Representations of Financial Statements: Issues in Reporting Financial Instruments

Both the International Financial Reporting Standards (IFRS) and the codified accounting standards (ASC) for the US GAAP categorize hedging relationships as falling into several buckets. The two buckets of relevance in this paper are (i) hedging the volatility of fair values, and (ii) hedging the volatility of future cash flow. In this paper, I argue that at least three accounting treatments of derivatives and hedging lead to creating serious distortion of reporting actual transactions, to combining hard and plastic valuations, and to violating adherence to the principle of ‘faithful representation’. The three accounting treatments are as follows: (1) creating the fictional Hypothetical Derivatives Method; (2) allowing for the establishment of purely discretionary valuation adjustments for all over-the-counter derivative assets (Credit Valuation Adjustment) and liabilities (Debt Valuation Adjustment) without any guides or constraints; (3) requiring subjective metaphysical separation of embedded derivatives with the main guide being the management's own perception of the instrument's embodiment of unrelated value and risk generators. To remedy the resulting distortion in financial reporting, significant revisions of certain accounting standards are sorely needed.     

Corporate reputation and hedging activities

This study examines whether corporate reputation affects derivative hedging. We posit that high-reputation firms are more likely to engage in hedging due to greater reputation costs and/or their commitment to lower financial risks. We find that high-reputation firms are more likely to engage in hedging, especially when their hedging efforts or effects are more observable to stakeholders. We also find that high-reputation firms are less likely to disclose the notional values of hedging positions and that interest rate hedging by high-reputation firms is detrimental to firm value. Our results shed light on the impact of reputational concerns on corporate risk management and disclosure policies.     

Understanding accounting discretion in China: An analysis of fair value reporting for investment property

This study sheds light on the discretionary accounting practices in China, the largest emerging market in the world. In particular, we focus on whether Chinese firms use discretion in investment property fair values to manage reported performance. We examine whether firms’ ex ante needs for accounting discretion affect their decisions to adopt fair value reporting for investment property and the ex post performance management by these fair value adopters. Our findings show that the voluntary adoption of fair value reporting for investment property in China remains low. However, the fair value option for investment property is significantly more likely to be chosen by firms with greater needs for accounting discretion. Consistent with the conjecture that firms choose the fair value model to manipulate reported earnings, we show that fair value adopters use the unrealized gains and losses associated with investment properties to smooth earnings and that these firms are also more likely to meet or beat earnings benchmarks after adoption. Overall, our findings indicate that the use of fair value reporting for investment property in the emerging Chinese market is driven by managerial opportunism.     

The impact of the institutional environment on the value relevance of fair values

Most prior studies attribute valuation discounts on certain fair valued assets to measurement error or bias. We argue that institutional differences across countries (e.g., information environment or market sophistication) affect investors’ ability to process and impound fair value information in their valuation. We predict that the impact of the institutional environment on value relevance is particularly pronounced for reported fair values of assets designated at fair value through profit or loss (hereafter, “FVO assets”), for which investor experience is lowest and complexity is highest. Using a global sample of IFRS banks, we find that FVO assets are generally less value relevant than held-for-trading assets (HFT) and available-for-sale assets (AFS). By partitioning countries into market- and bank-based economies to proxy for institutional differences, we find that the valuation discount on FVO assets is more pronounced in bank-based economies. Additional tests suggest that this valuation discount is attenuated by a richer firm-level information environment and the presence of institutional investors with fair value experience.     

Real effects of governmental accounting standards: Evidence from GASB statement No. 53 – Accounting and financial reporting for derivative instruments

GASB Statement No. 53, Accounting and Financial Reporting for Derivative Instruments, (GASB 53) significantly altered U.S. governmental sector accounting of derivative instruments by mandating the recognition of hitherto off-balance sheet derivative instruments in the government-wide statement of net assets and requiring that ineffective hedges be clearly identified. These requirements have an unfavorable financial statement impact for municipalities with net negative fair value derivative positions and municipalities holding ineffective hedges. Using a hand-collected, comprehensive dataset of municipal derivatives, we examine whether the level of U.S. municipal derivative holdings changed following the adoption of GASB 53. Consistent with GASB 53 affecting municipal officials’ derivative decisions, we find a significant post-GASB 53 reduction in derivative holdings for municipalities with net negative fair value derivative positions and ineffective hedges. Our findings suggest that governmental accounting regulations could affect real decisions of municipal officials and therefore could potentially have public policy implications beyond the provision of information to stakeholders.     

Pricing of guaranteed minimum withdrawal benefits in variable annuities under stochastic volatility,stochastic interest rates and stochastic mortality via the componentwise splitting method

This paper values guaranteed minimum withdrawal benefit (GMWB) riders embedded in variable annuities assuming that the underlying fund dynamics evolve under the influence of stochastic interest rates, stochastic volatility, stochastic mortality and equity risk. The valuation problem is formulated as a partial differential equation (PDE) which is solved numerically by employing the operator splitting method. Sensitivity analysis of the fair guarantee fee is performed with respect to various model parameters. We find that (i) the fair insurance fee charged by the product provider is an increasing function of the withdrawal rate; (ii) the GMWB price is higher when stochastic interest rates and volatility are incorporated in the model, compared to the case of static interest rates and volatility; (iii) the GMWB price behaves non-monotonically with changing volatility of variance parameter; (iv) the fair fee increases with increasing volatility of interest rates parameter, and increasing correlation between the underlying fund and the interest rates; (v) the fair fee increases when the speed of mean-reversion of stochastic volatility or the average long-term volatility increases; (vi) the GMWB fee decreases when the speed of mean-reversion of stochastic interest rates or the average long-term interest rates increase. We investigate both static and dynamic (optimal) policyholder's withdrawal behaviours; we present the optimal withdrawal schedule as a function of the withdrawal account and the investment account for varying volatility and interest rates. When incorporating stochastic mortality, we find that its impact on the fair guarantee fee is rather small. Our results demonstrate the importance of correct quantification of risks embedded in GMWBs and provide guidance to product providers on optimal hedging of various risks associated with the contract.     

Investor protection and analysts’ cash flow forecasts around the world

We find that analysts are more likely to provide cash flow forecasts in countries with weak investor protection. This finding is consistent with our hypothesis that market participants demand (and analysts supply) cash flow information when weak investor protection results in earnings that are less likely to reflect underlying economic performance. Our results suggest that information intermediaries respond to market-based incentives to attenuate the adverse effects of country-level institutional factors on earnings’ usefulness. These findings contribute to the literature by shedding light on the institutional determinants of analysts’ research activities, and on the nature of the financial information they generate.     

FAS 133: What Is Accounting Truth?

FAS 133, the rule that governs accounting for derivatives, has been controversial since its inception. Besides being expensive to implement and maintain, the rules often cause accounting treatment to diverge markedly from economic reality, making financial statements less transparent and less useful. For example, by marking to market only one side of what are in fact two‐sided (hedged) positions, FAS 133 often introduces artificial volatility into earnings and, in so doing, discourages companies from hedging. How should companies tackle financial disclosure and balance the economic and accounting effects of hedging? This article recommends that companies make economically sensible hedging decisions and then present two sets of earnings numbers to the investment community: (1) the first prepared and audited in strict accordance with GAAP; and (2) a supplemental calculation showing what earnings would have been had the firm qualified for hedge accounting treatment. This kind of supplemental disclosure should be viewed by companies as an opportunity to explain to their investors, creditors, and counterparties how they conceptualize, measure, and manage risk.