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.