Accounting for Derivatives and Corporate Risk Management Policies

Abstract

In this paper, I discuss the issue of how non-financial corporations should report the results of their use of derivative financial instruments. Using the recently issued SFAS 133 as a framework, I introduce three possible accounting regimes (mark to market, mark to market hedge and deferral hedge) and characterize the information provided to users of financial statements under each of the three alternatives. I then present a simple economic model with which to analyze the effect (if any) on corporate risk management policies of the different regimes. My main result is that hedging distortions (defined as deviations from the optimal hedge position in the absence of any accounting considerations) may occur in a mark to market regime but not in a mark to market hedge or deferral hedge regime. Finally, I discuss the policy implications of this result and explain how the ability to make voluntary disclosures may eliminate these distortions - this conclusion is, however, valid only if the underlying risk exposures of firms are ex-post verifiable.

Keywords: Corporate risk management; Hedging; Accounting for derivatives; Fair value accounting

JEL Classification: M41, M44, M45