Accounting for derivatives and risk management activities

Abstract

Purpose – The lessons and merits of changes in the recognition and disclosure of derivative instruments and hedging activities are still debated and are a major policy issue. Prior studies provide mixed evidences on the economic consequences of mandatory derivative instruments ' recognition and disclosure. This paper aims to provide empirical evidence on the impact of mandatory derivative instruments ' recognition and disclosure on managers’ risk-management behavior. More importantly, this paper aims to investigate the role of product market competition on the impact of mandatory derivative instruments ' recognition and disclosure on managers’ risk-management behavior. Design/methodology/approach – This paper tests the author ' s hypotheses using the fixed-effects estimation technique, where it includes firm dummies in all the regressions. This approach enables to control for unobserved firm effects (fixed effects) on firms’ risk-management behavior that are assumed to be constant through time but vary across firms. Findings – The author finds that mandatory recognition and disclosure of derivative instruments and hedging activities, on average, decreases firms’ market rate risk exposure. This finding suggests that after the implementation of the recognition and disclosure of derivative instruments and hedging activities required by Statement of Financial Accounting Standards No. 133 (SFAS 133), firms engage in more prudent risk-management activities to mitigate the potential cost of earnings volatility imposed by the standard. However, the decrease in market rate risk exposure is lower when the level of product market competition is higher. This finding is consistent with the idea that the recognition and disclosure of derivative instruments and hedging activities required by SFAS 133 unintentionally forces firms in competitive industries to engage in significant risk-taking. The result suggests that more disclosure in risk management may change risk-management incentives in undesirable ways if firms face the threat of entry in their product markets. Practical/implications – The results provide a new understanding on the role of product market competition on the effectiveness of mandatory derivative instruments ' recognition and disclosure. The findings imply that standard setters should take product market competition into consideration before making derivative instruments and hedging activities ' recognition and disclosure mandatory for all firms. Originality/value – The paper contributes to the accounting literature by providing a new insight into the moderating role of product market competition in the accounting recognition and disclosure regulation and firms’ reporting behavior relation. Moreover, the paper extends the current literature on the effects of SFAS 133 on risk-management activities and sheds light on the impact of accounting regulations on firms’ real economic behavior.

Do Derivative Instruments Increase Firm Risk for Indonesia Non-Financial Companies?

“…It is supported by the fact that there are still not many companies in Indonesia that have derivatives with the aim of hedging in the long term to be able to correct mistakes in the imposition of share prices in a non-instant process. In line with this, compulsory recognition and disclosure of derivative instruments for hedging purposes can reduce the company's total risk exposure (Tessema, 2016).…”

“…Under PSAK 55 (IAI, 2018) and PSAK 60 (IAI, 2018), derivative arrangements for companies in Indonesia are only carried out for hedging purposes. Recognition and disclosure that is mandatory for ownership of derivatives with the aim of hedging can reduce the company's risk exposure (Tessema, 2016). After implementing the recognition and disclosure of derivative instruments and hedging activities required by financial accounting standards, there is an incentive for companies to reduce policies that result in increased idiosyncratic volatility.…”

“…After implementing the recognition and disclosure of derivative instruments and hedging activities required by financial accounting standards, there is an incentive for companies to reduce policies that result in increased idiosyncratic volatility. The existence of standards that regulate the recognition and disclosure of derivative instruments intending to hedge deliberately forcing companies that enter the competitive industry to be more careful in taking significant risks (Tessema, 2016).…”

“…Meanwhile, Bartram et al (2011) concluded that the use of financial derivatives reduces both total risk and systematic risk. Tessema (2016) found evidence that the recognition and disclosure required by financial accounting standards for the ownership of derivative instruments for hedging purposes has a negative effect on the total risk of the company.…”

Effects of the exchange rate on the adoption of hedge accounting: evidence from Brasil

“…Accounting reporting for hedge operations, known as "hedge accounting", influences directly the disclosure of firm's outstanding financial exposure to risk and the timeliness of earnings or losses recognition, so lessons and merits of changes in the disclosure of derivative instruments and hedging activities are still debated and represent a major policy issue -prior studies have provided mixed evidences on the economic consequences of derivative instruments' recognition and disclosure (TESSEMA, 2016).…”