Search

We identify an item recognized on the balance sheet that distorts the assessment of default risk. Firms enter into derivatives to protect themselves from price fluctuations on a future purchase or sale commitment denominated in a commodity, foreign currency, or interest rate. There are two reasons why the accounting for these transactions creates difficulty in default risk assessments. First, while the fair value of the derivative is recorded at each balance sheet date, the value of the forecasted purchase or sale commitment is not recorded. Therefore, the balance sheet only tells half of the economic story. Second, the gains/losses associated with these derivatives provide a signal about future firm profitability, which is a determinant of default risk. We examine the extent to which debt investors, credit analysts, and equity investors understand the implications of these transactions for a firm’s default risk. Our results suggest that all three of these groups remove derivative amounts from firms’ balance sheet ratios when assessing default risk. However, only debt investors correctly price the implications of future profitability on default risk. Overall, our results suggest that the accounting for cash flow hedges distorts a firm’s leverage and profitability ratios, that not all investors adjust for this, and that capital market participants might benefit from more transparent hedging disclosures, particularly related to profitability.

Firms are not required to disclose immaterial information (i.e., information that fails to influence a current or prospective stakeholder). Nevertheless, regulators have recently called attention to high levels of immaterial disclosure in firms’ annual reports, and express concern that such disclosure makes it difficult for investors to identify and respond to information that is relevant for their decision-making. I examine the determinants of disclosure materiality for quantitative disclosures in annual reports (i.e., the magnitude of quantitative disclosure relative to firm assets). I find that the disclosure of lower materiality information is positively associated with macroeconomic uncertainty, firm-level litigation risk, and manager-level risk-aversion, but not with a manager’s incentive to obfuscate. Finally, I find some evidence that lower materiality disclosure is associated with negative capital market consequences. Overall, these results imply that regulators might be able to improve the materiality of quantitative disclosure by (1) reducing ‘one-size-fits-all’ disclosure regulations, and (2) providing more legal (i.e., safe harbor) protection for firms and managers as they make decisions about disclosure materiality.

Risk is the primary driver of value for any business. In order for a business to be profitable and create value, it must generate returns; and returns are compensation for the risks a business takes. This chapter discusses the economic motivations for hedging with derivatives. It also discusses the accounting for derivatives and hedging. The chapter explains the financial statement analysis challenges that arise when firms hedge with derivatives. In a fair value hedge, the hedged item has a measurement basis other than fair value, creating a mismatch with the hedging instrument that is reported at fair value. Techniques managers can employ to help users of the financial statements better map the accounting for derivatives into firm performance and value. Specifically, firms record derivatives at fair value at each balance sheet date, and record changes in fair value either as part of net income or part of shareholders' equity.