The Effect of Mandatory Disclosure on Market Inefficiencies: Evidence from Statement of Financial Accounting Standard Number 161
55 Pages Posted: 15 Sep 2017 Last revised: 11 Oct 2017
Date Written: September 12, 2017
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 poor derivative disclosures. In this study, we examine whether the enhanced mandatory derivatives disclosures set forth in FAS 161 improve users’ understanding of firms’ hedging activities, and offer two main findings. First, we find no evidence of mispricing after FAS 161, suggesting 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 analysts’ forecasts exhibit less error related to cash flow hedges after FAS 161, suggesting that these enhanced disclosures improve the information environment for sophisticated information intermediaries. In additional analysis, we find that the reduction in mispricing holds regardless of a firm’s institutional ownership level, suggesting that the additional disclosures appear to have benefited all investors regardless of their sophistication. Overall, our results suggest that the enhanced mandatory derivative disclosures required by FAS 161 improved investors’ and analysts’ understanding of the effects of derivative and hedging activities on future firm performance and firm value.
Keywords: Derivatives; Mandatory Disclosure; Market inefficiency; Effectiveness of Regulation
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