Abstract
The goal of this research was to investigate the controversy surrounding the inability of Statement of Financial Accounting Standard No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities to portray the economics of hedging. This research examined whether or not the possibility of increased volatility evolved from economic hedges that do not qualify for hedge accounting under SFAS 133 prompted Bank Holding Companies (BHCs) to adjust their corporate risk management strategy to one that is more accounting responsive. Based on the results of this research, BHCs' which increased the level of accounting hedges and decreased the level of economic hedges experienced a significant decrease in earnings volatility relative to pre-SFAS 133. The findings suggest that BHCs' ability to reduce earnings volatility and increase earnings smoothing to meet analysts' expectations after the 2008 amendment of SFAS 133 has an adverse impact on BHCs' continual use of economic hedges. Analysts and investors are recommended to evaluate further BHCs' risk strategies to gain a better representation of their risk paradigm with derivatives. This study extends prior research on corporate risk management activities of BHCs and contributes to social change by presenting new affirmation to investors of the influence of SFAS 133 economic hedges on earnings volatility.
Highlights
In 2008, the Financial Accounting Standards Board (FASB), in response to the explosive derivative activities growth fueled by the financial market innovations and the need to actively manage financial risk exposures inherent in the operations of large financial institutions, amended Statement of Financial Accounting Standard No 133 (SFAS 133), Accounting for Derivative Instruments and HedgingActivities with the intention to regulate the accounting for corporate hedging strategies with derivatives and minimize the information asymmetry recognized in the standard before amended
From the entire target population of 167 Bank Holding Companies (BHCs) only 62 banks use derivatives that qualify for hedge accounting from which 38 BHCs are classified as SFAS133-accounting hedgers and 24 BHCs are classified as SFAS133-compliant hedgers
The limited number of derivative users confirms that hedge accounting is very expensive for small banks to implement and maintain since they do not have the enormous resources needed to dedicate to training their personnel in derivatives, hedge accounting, and hedge effectiveness testing according to Pollock[35]
Summary
In 2008, the Financial Accounting Standards Board (FASB), in response to the explosive derivative activities growth fueled by the financial market innovations and the need to actively manage financial risk exposures inherent in the operations of large financial institutions, amended Statement of Financial Accounting Standard No 133 (SFAS 133), Accounting for Derivative Instruments and HedgingActivities with the intention to regulate the accounting for corporate hedging strategies with derivatives and minimize the information asymmetry recognized in the standard before amended. Hedge accounting reduces earnings volatility by minimizing the potential income statement effect of the risk that is being hedged, since it causes the derivative gains or losses to influence revenues in the period corresponding to the gain or loss consequential to the risk being hedged. The alternative to hedge accounting that is applied to economic hedges that do not qualify for hedge accounting is to recognize fluctuations in the recorded fair value of derivative hedging instruments immediately in earnings, causing redundant volatility in earnings. Proponents of the standard presumed that the hedging activities addressed in SFAS 133 mitigated the economic risks hedged with derivatives This view is supported by Guay[20] and Melumad, Weyns, and Ziv[29] who illustrated that the accounting method used influenced the manager’s hedging decision under a certain definition of fair-value hedge accounting preserving the ultimate economic hedge
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