Hedge accounting and investors’ view of FX risk

• DOI: https://doi.org/10.1108/IJAIM-10-2017-0121
• Date: 05 August 2019
• Published date: 05 August 2019
• Pages: 407-424
• Author: Li Wang,Stephen Makar
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Hedge accounting and investors’

view of FX risk

Li Wang

School of Accountancy, College of Business Administration,

The University of Akron, Akron, Ohio, USA, and

Stephen Makar

Department of Accounting, University of Wisconsin Oshkosh College of Business,

Oshkosh, Wisconsin, USA

Abstract

Purpose –This paper aimsto examine the foreign exchange (FX) risk effects of cash f‌lowhedge accounting

(HA). To the extent the HA qualif‌ication criteria and detailed documentation give investors conf‌idence that

FX derivatives effectivelyhedge risk, market-assigned FX risk premiums will be lower for f‌irms using cash

f‌low HA.

Design/methodology/approach –Probit analyses rely on the HA designation to examinethe decision

to use cash f‌low HA. Primary analyses testthe hypothesized relationship between the magnitude of FX risk

premiums and such HA use. Additionalanalyses allow for the interaction between cash f‌low HA use and the

extent of FX derivativesuse.

Findings –Hypothesis tests indicate that themagnitude of the FX risk premium is, on average, lower for

f‌irms designated as effective cash f‌low hedgers. In additional tests, the evidence suggests that the market

assigns a lowerFX risk premium to f‌irms using a higher level of FX derivatives as effective cash f‌low hedges.

Practical implications –The f‌indings suggest that cash f‌low HA providesrisk-relevant information to

investors. Such positive effects of HA on investors’understanding of risk management may guide US

accounting regulators in their efforts to improve HA. Corporate treasurers also may benef‌it from these

insightsinto evaluating the use of HA.

Originality/value –Responding to the call for research on the riskrelevance of cash f‌low HA, this paper

merges the HA literaturewith the FX risk management literature to directly examine the relationshipbetween

HA use and FX risk premiums for manufacturingf‌irms. The authors take an innovative approach usingFX

rates to which each f‌irm is most exposed and provide evidence consistent with the argument that this

approach is helpful in understandingboth the decision to use cash f‌low HA and the effect of such HA use on

market-assignedFX risk premiums.

Keywords FX derivatives, FX risk, Hedge accounting

Paper type Research paper

1. Introduction

Firms subject to the uncertainties of changing foreign exchange (FX) rates can reduce or

hedge the associated risks by using FX derivatives (FXDs). If such FXD use is “highly

effective”in reducingFX risks, f‌irms may use special accounting treatmentunder Statement

of Financial Accounting Standard No. 133 (SFAS 133), known as hedge accounting

(Financial Accounting Standards Board, 1998). In hedge accounting, the earnings volatility

from FX rate changes is reduced, as the mark-to-market (MTM) adjustments on the FX

derivatives hedge generally are not reported in earnings until the corresponding MTM

adjustments on the underlying hedged FX transaction are also reported. Hedge accounting

is intended to help investors better understand a f‌irm’s derivatives exposure and risk

Investors’view

of FX risk

407

Received13 October 2017

Revised26 December 2017

13March 2018

Accepted7 May 2018

InternationalJournal of

Accounting& Information

Management

Vol.27 No. 3, 2019

pp. 407-424

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-10-2017-0121

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

management practices.Prior studies, however, f‌ind that SFAS 133 may result in unintended

consequences. Panaretou et al. (2013) summarize the potential positive and negative

information effects of hedge accounting (HA), where the net effect (either positive or

negative) is ultimatelyan empirical question.

Motivated by this empirical question, we respond to the call for research that examines

the risk relevance of cash f‌low HA (Black, 2016).In cash f‌low HA, the MTM adjustments on

effective derivative hedges are reported initially in other comprehensive income (a

component of equity), whilethe corresponding MTM adjustments on the underlying hedged

item are not recognized until the future hedgedtransaction is recorded. As a result, investors

may lack information on the net effect of the cash f‌low hedge. Recent studies provide

evidence consistent with such unintended consequences of cash f‌low HA for investors’

understanding of a f‌irm’s FX risk management practices (Makar et al.,2013;Campbell,

2015). In this study, we investigate the effects of cash f‌low HA on the market-assigned FX

risk premiums for USmultinationals. Our focus on FX risk is motivated by thepuzzling lack

of strong evidence to support the theoretical relationship between f‌irm value and FX rate

changes (Bartram and Bodnar,2012).

In light of the heterogeneousnature of FX risk and FXD use, we rely on the cash f‌low HA

designation to distinguish derivatives hedging that investors are likely to view as being

effective in reducing FX risk. We arguethat the stringent criteria for cash f‌low HA use and

the detailed HA documentation increase investors’conf‌idence that FXDs effectively hedge

FX risks. Accordingly,we predict that the level of FX risk premiums for f‌irms designated as

using cash f‌low hedges will be lower, compared to f‌irms not using cash f‌low HA. This

predicted relationshipbetween market-assigned FX risk premiums and the use of cashf‌low

HA is examined using a sample of US multinationalsoperating in the manufacturing sector

(SIC code range 2000-3999) over the 2001-2010sample period. Following recent studies in the

FX risk management and HA literatures, we use hand-gathered data on the bilateral FX

rates to which each sample f‌irm is most exposed (Makar and Huffman, 2013) and

distinguish the types of SFAS 133 HA techniques (i.e. effective and non-effective cash f‌low

hedges) being used by the f‌irm (Kanodia and Sapra,2016). To the best of our knowledge, we

are the f‌irst study to use such f‌irm-specif‌ic bilateral FX rate data to investigate the use of

cash f‌low HA and the effect of such HA use on the FX risk premiums of f‌irms operating in

the manufacturingsector.

Using this innovative approach, we f‌ind evidence that the use of cash f‌low HA is

explained by variations in the bilateral FX rates to which each f‌irm is most exposed.

Building on such probit analyses of HA use, we f‌ind that the magnitudes of the market-

assigned FX risk premiums are, on average, lowerfor f‌irms designated as effectively using

cash f‌low hedges. Our results are consistentwith our expectations and the notion that cash

f‌low HA use increases investors’conf‌idencethat FXDs are effective in hedging FX risk. We

extend this primary analysis by allowing for the interaction between cash f‌low HA use and

the extent of FXDs use. This additional analysis provides evidence suggesting that

investors assign a lower FX risk premium to f‌irms usinga higher level of FXDs designated

as effective cash f‌low hedges. Finally,we demonstrate that our primary results are robustto

a variety of controlsand sensitivity tests.

To summarize, our study makes a number of contributions. First, we merge the HA

literature with the FX risk management literature to directly examine the relationship

between cash f‌low HA use and market-assigned FX risk premiums. Working at the

intersection of these two literatures, we contribute to the HA debate and shed light on the

puzzling lack of conclusiveFX risk evidence. Second,we take an innovative approach using

the bilateral FX rates to which each f‌irm is most exposed, and provide evidence consistent

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