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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.

We examine whether the social media reaction to an important firm disclosure provides a signal of the quality of that disclosure and whether capital market participants’ reactions to the disclosure are consistent with the social media reaction. Specifically, we examine the sentiment of posts on StockTwits immediately following management forecasts and offer three main findings. First, the relation between StockTwits sentiment and forecast news is stronger when the forecast is later revealed to be more accurate and less biased, suggesting that StockTwits provides an early signal of forecast quality. Second, we find a positive association between the extent to which social media sentiment agrees with the forecast news and stock price reaction to the management forecast. This suggests that when social media sentiment agrees with management forecast news, investors do too. Finally, we find a positive association between the extent to which social media sentiment agrees with the forecast news and subsequent analyst forecast revisions, particularly when forecast news is positive. This suggests that when social media sentiment agrees with positive management forecast news, analysts do too. Intraday analysis provides preliminary evidence that investors appear to respond to sentiment, but long-run tests suggest that investors appear to underreact to the signal provided by social media sentiment, while analysts appear to overreact to the signal. Overall, our results suggest that the social media reaction to management forecasts provides a timely and accurate reflection of not only the forecast’s quality, but also of how the forecast will be received by important capital market participants.

Prior research finds evidence suggesting a long-term trend of declining accruals quality in the U.S. Using the Dechow and Dichev (2002) accruals quality measure, we provide new evidence that this decline began to reverse around 2000, with accruals quality generally improving through 2016. We find that this pattern is primarily attributable to trends in the volatility of underlying firm performance over time, suggesting that “low” accruals quality is not necessarily a product of a poorly functioning accounting system or management discretion, but rather reflects the economic (cash flow) uncertainty of the firm’s operating environment. We corroborate these results in a battery of additional tests, which explore alternative explanations. We also find that the inverse relation between the intertemporal patterns of accruals quality and cash flow volatility is robust across different regions of the world and different business environments. Overall, our evidence suggests that concerns about a systemic decline in earnings and accruals quality are overstated.

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.