Does Fair Value Accounting for Derivatives Improve Earnings Quality?*

Abstract:     
This study investigates the income statement effect of SFAS 133, which requires the application of fair value accounting to hedging derivatives, by examining 1) whether SFAS 133 improves the information content of accounting earnings, and 2) whether the differential accounting treatment of different categories of hedging activities under SFAS 133 induces opportunistic earnings management behavior. Using a sample of bank holding companies during the period from 1995 through 2005, I find evidence that SFAS 133 results in more informative earnings. However, this improvement in earnings quality is mitigated by differential accounting treatment of cash flow hedge that defers the recognition of derivative gains/losses, and I find evidence that firms take advantage of this deferral mechanism to avoid earnings decreases.

Keywords: fair value accounting, SFAS 133, earnings quality, earnings management

JEL Classifications: M43, M44

Working Paper Series