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Synopsis

The research problem

This study examines the association between hedge-based derivatives usage and stock price crash risk, as well as the moderating effect of International Financial Reporting Standard 9 — Financial Instruments (IFRS 9) hedge accounting requirements on the association between derivatives usage and stock price crash risk in China.

Motivation

A growing number of companies worldwide are using financial derivatives to hedge risks; however, evidence is mixed on whether hedge-based derivatives usage increases or decreases firm transparency. While prior studies have demonstrated that financial reporting complexity can affect the informational effect of derivatives, evidence is limited on whether and how the recent changes in hedge accounting requirements in IFRS 9 affect the capital market outcomes of derivatives. Using data from China, one of the largest emerging markets, we tested the informational effects of hedge-based derivatives usage and IFRS 9 requirements to provide incremental evidence on the market outcomes of firm use of financial derivatives. The findings have implications for international investors and facilitate the International Accounting Standards Board’s (IASB) postimplementation review of the IFRS 9 hedge accounting requirements.

The test hypotheses

Our first hypothesis is that no association exists between hedging and stock price crash risk in China. Our second hypothesis is that the implementation of IFRS 9 requirements does not influence the association between hedging and stock price crash risk in China.

Target population

This study is of interest to accounting and finance researchers, firm managers, accounting practitioners, international accounting standard setters, regulatory authorities, and investors.

Adopted methodology

Ordinary least squares (OLS) regressions, difference-in-differences (DiD) research design, propensity score matching (PSM), and entropy balancing (EB) are used in this research.

Analyses

We manually collected derivatives-related information (including purposes of derivatives usage, measurement basis of the derivatives, and hedge accounting treatment) from the annual reports of firms listed on the mainboard of the Shanghai and Shenzhen stock exchanges from 2016 to 2021. We adopted OLS and a DiD research design to test our hypotheses, and used the PSM and EB methods to address endogeneity concerns.

Findings

We find a positive association between hedging and stock price crash risk among the listed Chinese companies. Furthermore, after the implementation of IFRS 9, stock price crash risk decreases more among the hedgers than among firms without financial derivatives. Our channel tests show that IFRS 9 increases the quality of hedge accounting information, thus reducing stock price crash risk. The cross-sectional tests further support the capability of IFRS 9 to reduce noise contained in hedge accounting information, therefore improving firm-level transparency.

Four possible hedge accounting treatments for a foreign currency forward contract used to hedge a purchase of equipment are illustrated. In addition to journal entries illustrating the accounting, the pros and cons of the alternative treatments are discussed.

According to IAS 39 or FAS 133 an a posteriori test for hedge effectiveness has to be implemented when using hedge accounting. Both standards do not regulate which numerical method has to be used.

A number of hedge effectiveness tests have been published recently. Such tests are of different quality; for example, not all of them can deal with the problem of small numbers. This means a test might determine an effective hedge to be ineffective, a scenario which would increase the volatility in earnings. Therefore, it seems useful to have criteria at hand to discriminate and assess hedge effectiveness tests.

In this paper, we introduce such objective criteria, which we develop according to our understanding of miminum economic requirements. They are applicable to tests based on market values of two points in time as well as tests based on time series of market values.

According to our criteria we compare common tests like the dollar offset ratio, regression analysis or volatility reduction, showing strengths and weaknesses. Finally, we develop a new Adjusted Hedge Interval test based on our previous one (Hailer, AC and SM Rump (2003). Zeitschrift für das gesamte kreditwesen, 56(11), 599–603). Our test does not show weaknesses of other effectiveness tests.