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University of Nebraska–Lincoln

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Do Debt Investors Adjust Financial Statement Ratios When Financial Statements Fail to Reflect Economic Substance?

Journal(s): Contemporary Accounting Research
Published: October 13, 2020
Author(s): John L. Campbell, Jenna D'Adduzio, Jimmy F. Downes, Steven Utke
General Description
Although cash flow hedge derivative transactions have become common practice for corporations wanting to mitigate risk, adjusting financial statements to account for them often confuses investors. Dr. Jimmy Downes, associate professor of accountancy, published an article recently to help provide a full picture of financial statement adjustments needed when considering hedge derivatives.

“Companies use cash flow hedges to protect themselves from changes in commodity prices, foreign exchange rates and interest rates. What we look at in my recent paper is how debt investors understand the accounting for cash flow hedges,” said Downes. “The accounting for those transactions is difficult to understand. Prior literature, including one of my own papers, documents that investors and equity analysts don’t understand the accounting for these transactions.”
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Academic Abstract
Cash flow hedge derivatives are an example of an economic transaction that is not fully portrayed in the financial statements in two key ways. First, while changes in the fair value of the derivative are recorded at each reporting date, changes in the value of the underlying purchase or sale commitment are not recorded or disclosed until that transaction occurs. Therefore, until the purchase or sale occurs, the financial statements only portray half of the economic transaction. Second, the gains/losses associated with these derivatives provide an inverse signal about the persistence of firm profitability. We document a method by which financial statement users can 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 credit 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, and that users may benefit from enhanced disclosure about the amount and timing of a firm's future transactions that are exposed to foreign currency, interest rate, or commodity price risk as well as the amount and timing of derivatives that protect the firm from those risks.

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