Do Debt Investors Adjust Financial Statement Ratios when Financial Statements Fail to Reflect Economic Substance? Evidence from Cash Flow Hedges

Posted: 13 Jan 2017 Last revised: 8 Sep 2021

See all articles by John L. Campbell

John L. Campbell

University of Georgia - J.M. Tull School of Accounting

Jenna D'Adduzio

University of British Columbia - Sauder School of Business

Jimmy Downes

University of Nebraska at Lincoln

Steven Utke

University of Connecticut - Department of Accounting

Multiple version iconThere are 2 versions of this paper

Date Written: September 7, 2020

Abstract

Cash flow hedge derivatives are an example of an economic transaction that is not fully portrayed in the financial statements in two key ways. First, while changes in the fair value of the derivative are recorded at each reporting date, changes in the value of the underlying purchase or sale commitment are not recorded or disclosed until that transaction occurs. Therefore, until the purchase or sale occurs, the financial statements only portray half of the economic transaction. Second, the gains/losses associated with these derivatives provide an inverse signal about the persistence of firm profitability. We document a method by which financial statement users can partially adjust for these distortions and find evidence that debt investors incorporate information conveyed by cash flow hedge gains/losses into their pricing of new debt issuances. We also find evidence that credit analysts incorporate these adjustments into their firm-level credit ratings but are unable to find consistent evidence of similar adjustments to credit ratings on new debt issuances. Overall, our results suggest that a subset of sophisticated investors (i.e., those in public debt markets) appear to incorporate information from cash flow hedge accounting into their assessments of firm risk, and that users may benefit from enhanced disclosure about the amount and timing of a firm’s future transactions that are exposed to foreign currency, interest rate, or commodity price risk as well as the amount and timing of derivatives that protect the firm from those risks.

Keywords: Financial statement analysis; Ratio analysis; Derivatives and hedging; Cash flow hedges; Cost of capital

Suggested Citation

Campbell, John L. and D'Adduzio, Jenna and Downes, Jimmy and Utke, Steven, Do Debt Investors Adjust Financial Statement Ratios when Financial Statements Fail to Reflect Economic Substance? Evidence from Cash Flow Hedges (September 7, 2020). Contemporary Accounting Research, Vol. 38, No. 3, Fall 2021, Available at: https://doi.org/10.1111/1911-3846.12656, Available at SSRN: https://ssrn.com/abstract=2898184 or http://dx.doi.org/10.2139/ssrn.2898184

John L. Campbell (Contact Author)

University of Georgia - J.M. Tull School of Accounting ( email )

Athens, GA 30602
United States
706.542.3595 (Phone)
706.542.3630 (Fax)

Jenna D'Adduzio

University of British Columbia - Sauder School of Business ( email )

2053 Main Hall
Vancouver, British Columbia V6T 1Z2
Canada

Jimmy Downes

University of Nebraska at Lincoln ( email )

1400 R St
Lincoln, NE 68588
United States

Steven Utke

University of Connecticut - Department of Accounting ( email )

School of Business
Storrs, CT 06269-2041
United States

HOME PAGE: http://www.steveutkedata.com/

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