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Accounting for derivative instruments and hedging activities (SFAS No. 133): Implications for profitability measures and stock prices

Claire Eckstein (Department of Economics, Columbia University, New York, New York, USA)
Ariel Markelevich (Long Island University, Brookville, New York, USA)
Alan Reinstein (Department of Accounting, School of Business, Wayne State University, Detroit, Michigan, USA)

Review of Accounting and Finance

ISSN: 1475-7702

Article publication date: 16 May 2008

Abstract

Purpose

The purpose of this paper is to examine the impact of firms using derivatives applying Statement of Financial Accounting Standards (SFAS) No. 133. It aims to measure the magnitude of cumulative effects of changes in accounting principle from the income statement in the year of adoption, market reaction to earnings announcements, and key financial ratios effects.

Design/methodology/approach

Search of the Compustat Industrial database for firms reporting a cumulative effect of a change in accounting principle in their annual income statements for fiscal years ending after 15 June, 2000. We then examine the impact of firms using derivatives applying SFAS No. 133.

Findings

The sampled firms reported an absolute cumulative effect on income of $6.8 billion, 65 per cent of which was negative. Significant negative unexpected returns were observed around earnings announcement dates. Abnormal returns correlated with the cumulative effect, rather than with change in earnings per share from operations, showing that the surprise related to the accounting change. Ratio analyzes and regressions results show sampled firms with material unrealized gains and losses related to hedging with derivative instruments. Earnings‐related ratios, return on assets (ROA), return on equity (ROE) and measures of other comprehensive income decreased significantly from 2000 to 2001 after experiencing prior period significant increases.

Practical implications

The results presented in the paper should lead to further research on the effect on new authoritative standards on the financial reporting process.

Originality/value

Rather than judge SFAS No. 133's relative merits and shortcomings, the Standard's actual (rather than predicted) effects were analyzed. Focus was on the magnitude of the impact of SFAS No. 133 and the effect on key financial ratios. The impact of adopting the Standard was analyzed and it was found that it violated a basic tenet of financial accounting pronouncements: a “value neutral” basis was examined.

Keywords

Citation

Eckstein, C., Markelevich, A. and Reinstein, A. (2008), "Accounting for derivative instruments and hedging activities (SFAS No. 133): Implications for profitability measures and stock prices", Review of Accounting and Finance, Vol. 7 No. 2, pp. 131-149. https://doi.org/10.1108/14757700810874119

Publisher

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Emerald Group Publishing Limited

Copyright © 2008, Emerald Group Publishing Limited