Does mandatory recognition of derivatives and hedging activities influence investors’ uncertainty and diversity of opinion? The moderating role of product market competition

ABSTRACT

The International Accounting Standard No. 39 and the Statement of Financial Accounting Standard No. 133 were issued to address investors’ concerns regarding the reporting requirements for derivatives and hedging activities. I examine the influence of derivatives recognition, as required by SFAS 133, on investors’ uncertainty and diversity of opinion about the cash flow implications of underlying market rate changes. Using a sample of firms included in the S&P 500 Index, I find a decline in investors’ uncertainty and diversity of opinion after the adoption of SFAS 133 for users of derivatives. Furthermore, I find that investors’ uncertainty and diversity of opinion after the adoption of SFAS 133 is higher for users of derivatives operating in highly competitive industries compared to in less competitive industries. Overall, the study highlights the importance of considering a firm’s competitive environment when implementing recognition practices related to derivatives and hedging activities.

Keywords:

• European regulators
• derivatives recognition and disclosure
• competition
• SFAS 133/SFAS 161/IAS 39

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The shortcut method allows an entity to assume no ineffectiveness in a hedge of interest rate risk using an interest rate swap as the hedging instrument.

2 Critics argue that the standard would cause firms to reveal competitively sensitive private information. For example, General Motors described its concerns as follows: If GM recognized the volume of its derivative contacts and their anticipated cash flows, a competitor could calculate the purchase price of GM’ s components (Derivative Disclosure and Accounting, 1997).

3 I excluded the fiscal years ending from 15 June 1999 to 15 June 2000 from the analysis to avoid any temporary changes caused by early SFAS 133 adopters.

4 Like prior studies (Guay, 1999; Zhang, 2009), I hand-collected information about the use of derivatives using the keyword search for all years from 1998 to 2002. I used the following keywords in their annual financial reports: (i) forward contract(s), (ii) currency exchange contract(s), (iii) foreign exchange contract(s), (iv) future(s) contract(s), (v) option(s) contract(s), (vi) swap(s), (vii) hedge instrument(s), and (viii) derivative(s) instrument(s).

5 I obtain market shares by dividing the segment sales figure for the primary industry segment of a firm by the sum of the segment sales of all firms that have this primary industry as their primary sales.