Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133): Implications for Profitability Measures and Stock Prices

Abstract

Statement of Financial Accounting Standards No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities, is one of the Financial Accounting Standards Board's (FASB) most complex and controversial pronouncements. Its complexity stems from the underlying financial derivative instruments (derivatives) themselves. Its controversy arises from the accounting and reporting requirements that it sets for all entities using derivatives. The new requirements prescribe specific accounting treatment for derivatives that differ significantly from previous practice. Our study researches the impact that adopting FAS 133 had on firms that use derivatives. We focus on the magnitude of the impact of FAS 133 as measured by the cumulative effect of a change in accounting principle (cumulative effect) reported on the income statement in the year of adoption, the market reaction to the earnings announcement, and the effect on key financial ratios. We derive two key conclusions. First, the actual dollar amount of the cumulative effect of adopting one of the most publicized and controversial Standards promulgated came as a surprise. For the firms in our sample, footnote disclosures of anticipated non-material effects of adopting the new rules for hedge accounting belie the reported amounts. The firms in our sample reported an absolute cumulative effect on income of $6.8 billion, 65% of which was negative. Significant negative unexpected returns were observed around the Wall Street Journal earnings announcement dates. The abnormal returns were correlated with the cumulative effect, rather than with the change in earnings per share from operations, providing evidence that the surprise was related to the accounting change. Convergence towards International Accounting Standards has resulted in new accounting rules (SFAS 154) that eliminate the reporting of the accounting change on the income statement. Our research results are particularly relevant at this time as they suggest the new rule may reduce the expected information value of financial reports. Second, we find that the adoption of FAS 133 had a significant impact on non-financial firms. The results of the ratio analyses and regressions provide evidence that the firms in our sample had material amounts of recorded unrealized gains and losses related to hedging with derivative instruments. Earnings-related ratios, ROA, ROE and measures of other comprehensive income decreased significantly from 2000-2001, after experiencing significant increases during the prior period.