Accounting for derivative instruments and hedging activities (SFAS No. 133): Implications for profitability measures and stock prices

Purpose – The purpose of this paper is to examine the impact of firms using derivatives applying Statement of Financial Accounting Standards (SFAS) No. 133. It aims to measure the magnitude of cumulative effects of changes in accounting principle from the income statement in the year of adoption, market reaction to earnings announcements, and key financial ratios effects. Design/methodology/approach – Search of the Compustat Industrial database for firms reporting a cumulative effect of a change in accounting principle in their annual income statements for fiscal years ending after 15 June, 2000. We then examine the impact of firms using derivatives applying SFAS No. 133. Findings – The sampled firms reported an absolute cumulative effect on income of $6.8 billion, 65 per cent of which was negative. Significant negative unexpected returns were observed around earnings announcement dates. Abnormal returns correlated with the cumulative effect, rather than with change in earnings per share from operations, showing that the surprise related to the accounting change. Ratio analyzes and regressions results show sampled firms with material unrealized gains and losses related to hedging with derivative instruments. Earnings-related ratios, return on assets (ROA), return on equity (ROE) and measures of other comprehensive income decreased significantly from 2000 to 2001 after experiencing prior period significant increases. Practical implications – The results presented in the paper should lead to further research on the effect on new authoritative standards on the financial reporting process. Originality/value – Rather than judge SFAS No. 133's relative merits and shortcomings, the Standard's actual (rather than predicted) effects were analyzed. Focus was on the magnitude of the impact of SFAS No. 133 and the effect on key financial ratios. The impact of adopting the Standard was analyzed and it was found that it violated a basic tenet of financial accounting pronouncements: a “value neutral” basis was examined.Accounting standards, Financial reporting, Hedging, United States of America

Earnings Quality Following Corporate Acquisitions

We use the corporate acquisition setting to examine earnings quality during the post-acquisition period. We define earnings quality as an earnings stream more closely associated with future cash flows from operations. We use the stock market’s reaction at the acquisition announcement to infer merger motives and hypothesize that synergy-motivated acquisitions will produce higher quality earnings than agency-motivated acquisitions. Our findings are consistent with this prediction and support the view that managers who pursue synergy or agency-motivated acquisitions do not face the same economic environment and incentive schemes. Our results are also consistent with the notion that incentives for earnings management are greater following agency-motivated acquisitions when compared to those of synergy-motivated acquisitions. We conjecture that these differences originate from those accounting-based contracts that are likely impacted by reported post-acquisition balance sheet and income statement amounts

Did the Accounting for Goodwill Create a Bubble?

This article investigates the accounting standards changes related to business acquisitions and the impact of those changes on the reported goodwill in the past 50 years. We observe that the amount of goodwill on companies’ balance sheets steadily increased before 2001 but has risen to new levels with the adoption of SFAS 141. Goodwill is now equal to about 30 percent of companies’ net assets compared to only about 7 percent in the 1980s. We examine whether the increased levels of goodwill could have resulted from changes in accounting standards.  Specifically, we investigate the impacts of accounting regulations on goodwill reporting under three different regimes: APB 16 and 17, SFAS 141 and 142, and SFAS 141(R). We find that the increase in the reported value of goodwill is not a result of an increase in public companies’ acquisitions, as those have actually decreased over time. Further, the increase overlaps with the changes to the accounting for goodwill and the switch from goodwill amortization to impairment. Our findings are timely and important because the Financial Accounting Standards Board (FASB) has a concurrent project revisiting Identifiable Intangible Assets and Subsequent Accounting for Goodwill (FASB 2020). Our evidence urges caution in the reintroduction of goodwill amortization proposed by FASB, as the level of goodwill has increased dramatically despite FASB’s intentions to improve the quality of goodwill accounting and curtail management’s goodwill manipulation