Accounting for Derivatives and Income Smoothing via Discretionary Accruals : The Role of Hedge Effectiveness and Market Volatility

Motivated by the continued debate about the costs and benefits of mandatory recognition and disclosure of derivative instruments and hedging activities as required by Statement of Financial Accounting Standard No. 133 (SFAS 133), we investigate whether SFAS 133 influences firms' income smoothing via discretionary accruals decisions. Moreover, we investigate whether the level of hedge effectiveness and market volatility affects the impact of SFAS 133 on firms' income smoothing via discretionary accruals decisions. Consistent with our predictions, we find a significant increase in income smoothing via discretionary accruals activity after the adoption of SFAS 133. We also find that income smoothing via discretionary accruals after the adoption of SFAS 133 increases with the level of hedge ineffectiveness. Finally, we find that the higher the market volatility, the stronger income smoothing via discretionary accruals after the adoption of SFAS 133. This implies that higher market volatility makes it more difficult for firms to meet hedge accounting requirements, thereby increasing unmanaged earning volatility and income smoothing. Prior studies suggest that regulators are expressing concern about the effect of earnings management on the quality of reported earnings and the function of capital markets (e.g., Barton, 2001). In this regard, our findings imply that accounting standard setters should take into account the tradeoff between transparency and income smoothing