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
Date Written: July 20, 2018
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
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