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

Abstract

Cash flow hedge derivatives are an example of an economic transaction that is not fully portrayed in the financial statements and thus distorts financial statement ratio analysis. There are two reasons why the accounting for these transactions does not reflect their economic substance, and as such can create difficulty for investors’ assessments of firm risk. First, while the fair value of the derivative is recorded at each balance sheet date, 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 ratio. Second, the gains/losses associated with these derivatives provide an inverse signal about the persistence of firm profitability; that is, hedge gains signal unfavorable economic changes for the firm. We document a method by which financial statement users can at least 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 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 in a timely manner.

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