The Earnings Smoothing Management Philosophy of BHCs in the SFAS -133 Framework

Abstract

Purpose- The main purpose of this paper is to examine whether or not Bank Holding Companies (BHCs) took advantage of SFAS’s 133 differential treatment of the changes in the fair value of cash flow hedges to smooth earnings.

Design/methodology/approach- The author used a causal-comparative research design featuring an investigation on the Income Smoothing effects of BHCs’ corporate use of derivatives designated as cash flow hedges and discretionary accruals one year after the 2008 amendment of SFAS 133.

Findings- The results of this research showed that SFAS133-Accounting Hedgers had smoother earnings than SFAS133-Compliant Hedgers due to derivative use but did not take advantage of the differential treatment of cash flow hedges to manipulate earnings. This study suggests that hedge accounting rules under SFAS 133 fully determined the hedging behavior of SFAS-Accounting Hedgers. To ascertain the implementation of effective hedges SFAS-Accounting Hedgers captured the benefits of hedge accounting while compromised the economic benefits of hedging in an attempt to manage any associated accounting volatility and smooth earnings.

Research limitations/implications- This study extends prior research on corporate risk management activities of BHCs and impacts social change by presenting new evidence on the effects of SFAS 133 cash-flow hedges on earnings smoothing.

Practical implications- The evidence suggests that corporate governance mechanisms affect earnings management since BHCs withhold discretion with respect to the realization of gains and losses from derivative instruments designated as cash flow hedges. This is an indication that BHCs with an intent to achieve smoother earnings as a leading corporate risk management strategy, have a comparative advantage   compared to non-financial institutions to apply hedge accounting since they regularly use derivatives and are more experienced with the implementation of SFAS 133.

Originality/value- Although prior studies typically considered derivatives and accruals as substitute proxies in managing reported earnings, the paper’s results suggest that the most significant determinant of earnings smoothing is derivative use for SFAS-Accounting Hedgers and information asymmetry for SFAS133- Compliant Hedgers.