Earnings Management and Derivative Hedging with Fair Valuation: Evidence from the Effects of FAS 133

Earnings Management and Derivative Hedging with Fair Valuation: Evidence from the Effects of FAS 133

Jongmoo Jay Choi Temple University – Department of Finance; Temple University; Temple University – International Business

Connie X. Mao Temple University – Fox School of Business and Management; Temple University – Department of Finance

Arun Upadhyay University of Nevada, Reno

October 21, 2014
The Accounting Review (Forthcoming)
Fox School of Business Research Paper No. 15-043

Abstract: 
Barton (2001) and Pincus and Rajgopal (2002) show that earnings management through discretionary accruals and derivative hedging are partial substitutes in smoothing earnings before 1999. In this study, we investigate whether FAS 133 regarding hedge accounting in 2000 has influenced the relative merit of the two earnings smoothing methods. Based on a sample of S&P 500 non-financial firms during 1996-2006, we find that the substitution relation between derivative hedging and discretionary accrual is significantly attenuated after FAS 133 implementation. We also document a significant increase in earnings volatility associated with derivative hedging post-FAS 133. These results are robust to the use of various model and method specifications, as well as controlling for contemporaneous macroeconomic and regulatory shocks. Overall, our results suggest that a material change in an accounting rule regarding derivatives can influence the level and volatility of reported earnings, as well as the method of income smoothing.

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