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Study finds 2001 accounting rule on derivatives alters firms' exposure to risk

A new study by a Fisher College of Business accounting professor may put to rest a decade-old debate on the impact of Statement of Financial Accounting Standards rule on reporting derivatives such as options, swaps and futures contracts.

Effective in 2001, Statement of Financial Accounting Standard 133, accounting for derivative instruments and hedging activities required firms to record all derivatives as either assets or liabilities at fair value and recognize unrealized gains or losses in the income statement. Before the rule, derivative financial instruments were mostly recorded at historical costs. So any changes in their value were not reflected in income statements.

Haiwen Zhang, an assistant professor of accounting, examined how this new rule effects risk management behavior of non-financial firms.

Zhang received her bachelor’s and master’s degrees from Tsinghua University in China and a PhD from the University of Minnesota. Her research interests include accounting regulation, corporate risk management behavior and how capital markets use accounting information, and how accounting choices affect firms’ investment and production decisions.

Based on publicly available data, Zhang study 225 firms that established derivative programs between 1996 and 1999 and compared firms’ risk exposures before SFAS 133 went into effect and after.

Zhang’s study—which differentiated firms as effective hedgers and ineffective hedgers/speculators—suggested that the new rule encouraged firms using derivatives instruments in ineffective hedging and speculating activities to modify risk-management strategies.

“For those firms that I find that are ineffectively hedging or speculating, I find a really big reduction in risk exposure after the accounting rule adoption,” she said. “For the other group, the effective hedgers, I didn’t find anything major.”

Zhang gauged the firms’ derivatives instrument risk exposure based on interest rates, foreign currency exchange rates and commodity prices. Zhang wrote in the paper: “I find no significant change in earnings volatility for both groups of firms; however, cash flow volatility for ineffective speculators significantly decreases relative to effective hedge firms after the adoption of SFAS 133.”

“People have been debating the rule for over a decade whether the adoption of this rule will increase earnings volatility,” Zhang said. “There was not much research that addresses that question from a perspective of asking, how does accounting reporting systems change a firm’s operations.”

Zhang’s entire study is available on Fisher College of Business SSRN Working Paper Series at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=926405.