The Effect of Mandatory Disclosure on Market Inefficiencies: Evidence from Statement of Financial Accounting Standard Number 161

51 Pages Posted: 15 Sep 2017 Last revised: 30 Jul 2018

John L. Campbell

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

Urooj Khan

Columbia Business School - Accounting, Business Law & Taxation

Spencer Pierce

Florida State University - College of Business

Date Written: July 20, 2018

Abstract

Prior research finds that unrealized gains/losses on cash flow hedges are negatively associated with future earnings. However, equity investors and analysts fail to anticipate this association. These studies speculate that the mispricing is due to either poor derivatives disclosures or the accounting model for cash flow hedges. We examine whether enhanced mandatory derivatives disclosures set forth in FAS 161 improve users’ understanding of firms’ hedging activities, and offer three main findings. First, we document evidence of mispricing prior to the passage of FAS 161, but find that this mispricing does not persist after FAS 161. These findings suggest that enhanced mandatory derivative disclosures helped correct investors’ understanding of the implication of unrealized cash flow hedge gains/losses for future firm performance. Second, we find that the correction of mispricing is greatest when mandatory disclosure might help investors most – i.e., when firms operate in industries that more heavily use derivatives, when firms hedge multiple risk types and items, and when firms failed to voluntarily provide quantitatively disclosure prior to the disclosure mandate. Finally, we find that investors appear to contemporaneously price the information conveyed by cash flow hedge gains/losses without any delay following FAS 161. Overall, our results suggest that the enhanced mandatory derivative disclosures required by FAS 161 improved investors’ understanding of the effects of derivative and hedging activities on future firm performance and firm value – and consequently mitigated investor mispricing.

Keywords: Derivatives; Mandatory Disclosure; Market inefficiency; Effectiveness of Regulation

Suggested Citation

Campbell, John L. and Khan, Urooj and Pierce, Spencer, The Effect of Mandatory Disclosure on Market Inefficiencies: Evidence from Statement of Financial Accounting Standard Number 161 (July 20, 2018). Columbia Business School Research Paper No. 17-94. Available at SSRN: https://ssrn.com/abstract=3035887 or http://dx.doi.org/10.2139/ssrn.3035887

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)

Urooj Khan

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
New York, NY 10027
United States

Spencer Pierce

Florida State University - College of Business ( email )

423 Rovetta Business Building
Tallahassee, FL 32306-1110
United States

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