Earnings Management and Derivative Hedging with Fair Valuation: Evidence from the Effects of FAS 133

Jongmoo Jay Choi · Connie X. Mao · Arun Upadhyay

73 citations0/0 files storedThe Accounting Review

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Auditing, Earnings Management, Governance Accounting Theory and Financial Reporting Risk Management in Financial Firms

Abstract

ABSTRACT Barton (2001) and Pincus and Rajgopal (2002) show that earnings management through discretionary accruals and derivative hedging are partial substitutes in smoothing earnings before 1999. In this study, we investigate whether Financial Accounting Standard (FAS) 133 regarding hedge accounting in 2000 has influenced the relative merit of the two earnings-smoothing methods. Based on a sample of S&P 500 nonfinancial firms during 1996–2006, we find that the substitution relation between derivative hedging and discretionary accrual is significantly attenuated after FAS 133 implementation. We also document a significant increase in earnings volatility associated with derivative hedging post-FAS 133. These results are robust to the use of various model and method specifications, as well as controlling for contemporaneous macroeconomic and regulatory shocks. Overall, our results suggest that a material change in an accounting rule regarding derivatives can influence the level and volatility of reported earnings, as well as the method of income smoothing. JEL Classifications: G32; M41; M48

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References

1978Specification Tests in Econometrics 1991Earnings Management During Import Relief Investigations 2005The economic implications of corporate financial reporting 1980Financial Ratios and the Probabilistic Prediction of Bankruptcy 2003Earnings Management through Real Activities Manipulation 1985The Determinants of Firms' Hedging Policies 2008Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods 1998Earnings Management and the Long‐Run Market Performance of Initial Public Offerings

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