The Interaction between Accrual Management and Hedging: Evidence from Oil and Gas Firms

Abstract

This research investigates whether discretionary accrual decisions and use of derivative instruments areindependent of each other. We examine firms primarily engaged in oil exploration and drilling since we can identify two kinds of risks to which these firms are exposed that can cause earnings volatility. These are oil price risk and exploration risk. While firms can hedge oil price risk with derivative instruments, markets do not exist in which firms can hedge the operational risk of unsuccessful drilling. Discretionary accrual choices can be used to reduce variability in earnings induced by the exploration risks and both discretionary accruals and hedging can reduce earnings variability associated with oil price fluctuations. We find that firms in our sample do not hedge all oil price risk they face, but instead appear to want to achieve some benchmark level of earnings volatility. In our primary analysis, we separate the decision to hedge oil price risk from the extent of hedging, and simultaneously consider the extent of hedging and the extent of smoothing with discretionary accruals. The results indicate that firms are more likely to hedge the higher the level of exploration risk they face. Moreover, after controlling for other determinants of hedging and discretionary accrual smoothing, we find that the extent of hedging and the extent of discretionary accrual smoothing are substitutes.