Narrow Results

In the last decade there has been a significant increase in the use of derivatives as a vehicle to manage financial risk. The sudden spurt of derivatives has resulted in the Financial Accounting Standards Board (FASB) being forced to develop new standards for quantification and disclosure. The financial standard of interest to this study is Statement of Financial Accounting Standards (SFAS 133). SFAS 133 requires all derivatives, without exception and regardless of the accounting treatment for the underlying asset, liability, or transaction, to be recognized in the balance sheet as either liabilities or assets. SFAS 133 entitled Accounting for derivative activities and hedging (and SFAS 137, which postponed the implementation of SFAS 133 until June 2000) is different from prior standards in that it requires recognition as opposed to mere disclosure in the notes. The justification given for implementing SFAS 133 was to increase transparency to investors. In this study we empirically investigate this issue with particular focus on whether SFAS 133 provides incremental information above that provided by reported earnings, book value, and proxies for omitted variables. We study commercial banks since they are among the most frequent users of large-scale derivative contracts and their use has increased significantly over the last two decades, and in particular over the last five years. Our findings indicate that information regarding total derivative contracts, when disclosed in the financial statements as required by SFAS 133/137, is value relevant to investors. However, investors view this information negatively, perhaps attributing this to higher risk. Losses on holding derivatives are viewed positively and gains are viewed negatively.

The comparability of hedge accounting disclosures between companies increases the informational value of financial statements. In order to eliminate inconsistency in the reporting of hedging activities, the FASB issued SFAS No. 133, which was intended to provide comprehensive guidance for all derivatives reporting and disclosure. The fact that SFAS No. 133 allows some hedging transactions to be designated as either a fair value hedge or a cash flow hedge might suggest a lack of comparability for similar transactions. This paper identified several of these transactions and provides the comparative accounting. Even though fair value and cash flow hedges are accounted for differently, there was little difference in their net effect on reported earnings while other comprehensive income did fluctuate somewhat for cash flow hedges.

This paper investigates the effects of SFAS 133 on earnings volatility, earnings predictability, and equity volatility in bank holding companies (BHCs). In contrast to large BHCs' assertion prior to the adoption of SFAS 133, the three income-affecting portions (i.e. hedge ineffectiveness gains/losses, gains/losses excluded in the assessment of effectiveness, and effects from canceled forecasted transactions once designated as cash flow hedge) did not increase earnings volatility in the top 30 BHCs for the first 12 quarters after adoption. Also, the three income-affecting portions did not deteriorate analysts' forecast performance. In addition, there is no evidence that volatility of stockholders' equity significantly increases due to SFAS 133. Further investigation of notes to financial statements reveals that some BHCs adjusted their usage of derivatives prior to SFAS 133 to mitigate the impact of SFAS 133 on earnings volatility.

This paper evaluates the disclosures about derivative financial instruments provided by the 30 high-profile companies tracked in the Dow-Jones Industrial Average (DJIA-30). We discuss investors' needs for information on financial risk, document how the DJIA-30 implemented the requirements of FASB Statement No. 133, "Accounting for Derivatives and Hedging Activities" (SFAS 133), analyze the usefulness of SFAS 133 requirements, and comment on recent controversies over derivatives reporting. We also examine how the DJIA-30 complied with the SEC requirements for qualitative and quantitative information about the market risks attributed to their derivatives positions, and the impact of SFAS 133 adoption on these disclosures.

We find the DJIA-30 generally increased their derivatives' disclosures after adopting SFAS 133, consistent with its requirements. However, the disclosures are not as informative as one might expect, given SFAS 133's detailed requirements. Many companies now omit the previously required table of notional amounts, making it more difficult to assess their exposure to financial risk. Moreover, SEC requirements allow three formats for reporting quantitative information, only one of which is the tabular approach that helps users understand exposure. Because few companies use the tabular approach, disappearance of notional amounts is more serious. Generally small in recognized financial effects, derivatives and hedging activities are combined with other items in the financial statements, thereby complicating analyses of their impact. Footnote disclosures isolating derivatives performance tend to be incomplete and disconnected. Finally, we find that required 12-month forecasts of unrealized derivatives gains and losses reclassified from accumulated other comprehensive income to earnings miss the mark by a wide margin, rendering them unreliable in forecasting future earnings effects.