Do Investors Adjust Balance Sheet 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. There are two reasons why the accounting for these transactions does not reflect the economic substance, and as such creates difficulty in 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 a signal about the persistence of firm profitability. 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, credit analysts do not appear to fully adjust for these timing distortions. Furthermore, our results suggest that equity investors do not adjust for these 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.

Keywords: Financial statement analysis; Ratio Analysis; Derivatives and hedging; Cash Flow Hedges; Cost of capital