Do Investors Adjust Balance Sheet Ratios for Accounting-Based Timing Distortions? Evidence from Cash Flow Hedges

Abstract

We identify an item recognized on the balance sheet that distorts balance sheet and income statement ratios. Firms enter into derivative contracts to protect themselves from price fluctuations on a future purchase or sale commitment denominated in a commodity, foreign currency, or interest rate. There are two reasons why the accounting for these transactions creates difficulty in investors’ assessments of firm risk. First, while the fair value of the derivative is recorded at each balance sheet date, the changes in the value of the underlying purchase or sale commitment are not recorded until that transaction occurs. Therefore, until the purchase or sale occurs, the balance sheet only portrays half of the economic transaction, resulting in a distorted leverage position for a firm. Second, the gains/losses associated with these derivatives provide a signal about the persistence of current firm profitability, which is also a determinant of firm risk. Our evidence suggests that debt investors adjust their financial statement ratios for the implications of cash flow hedge accounting and thus more appropriately assess firm risk. However, contrary to their claims, our evidence suggests that credit analysts do not fully adjust for these timing distortions. Furthermore, our results suggest equity investors do not adjust for the timing distortions at all. Overall, our results suggest that the accounting for cash flow hedges distorts a firm’s leverage and profitability ratios, not all investors fully adjust for this, and capital market participants might benefit from more transparent hedging disclosures.