Does Fair Value Reporting Affect Risk Management? International Survey Evidence
Lins, Karl V., Servaes, Henri, Tamayo, Ane, Financial Management
We survey CFOs from 36 countries to examine whether and how firms altered their risk management policies when fair value reporting standards for derivatives were introduced. A substantial fraction of firms (42%) state that their risk management policies have been materially affected by fair value reporting. Firms are more likely to be affected if they seek to use risk management to reduce the volatility of earnings relative to cash flows and if they operate in countries where accounting numbers are more likely to be used in contracting. We document a substantial decrease in foreign exchange hedging and in the use of nonlinear hedging instruments. Finally, firms that take active positions are more likely to be affected by fair value reporting. Taken together, our evidence indicates that requirements to report derivatives at fair values have had a material impact on derivative use; while speculative activities have been reduced, sound hedging strategies have been compromised as well.
There is an extensive literature on the benefits of risk management. Risk management reduces the costs of financial distress (Smith and Stulz, 1985), allows firms to better plan and fund profitable investment projects (Froot, Scharfstein, and Stein, 1993), increases the tax benefits of debt financing (Stulz, 1990; Graham and Rogers, 2002), and lowers tax payments of firms facing progressive income tax rates (Graham and Smith, 1999). Hedging also reduces information asymmetries between the firm and its stakeholders (Brown, 2001), facilitating contracting. For example, DeMarzo and Duffie (1991) demonstrate that managing risk can reduce noise, thus helping outside investors to better identify skilled managers. All these arguments imply that risk management can enhance firm value. (1)
Risk management choices may also be influenced by managerial preferences instead of shareholder wealth maximization (Tufano, 1996). In addition, managers may use derivatives for speculative purposes given that they can often reap large rewards for successful bets but bear relatively few costs for failed ones.
In light of the costs and benefits of risk management, it is important to understand the factors behind firms' decisions to use derivatives and, in particular, whether a factor is likely to impact risk management in ways that are beneficial or harmful to shareholders. In this paper, we study one potentially important factor, derivative reporting regulation, that has received little attention in the literature.
Specifically, we examine whether and how firms changed their risk management policies following the introduction of fair value reporting requirements for derivative securities. Under the previous requirements, many derivatives were not recorded in the financial statements nor were their prices adjusted to fair values. The current standards require firms to report derivatives at fair values in the financial statements with any changes in value recorded in either the income statement or an equity account. As a result, these requirements have the potential to increase the volatility of both earnings and stockholders' equity. While fair values make it easier for investors to observe speculative activities involving derivatives, it is also possible that managers who want to avoid earnings and equity volatility will choose to curtail valuable hedging activities as a result of these rules. Anecdotal evidence suggests that the way in which derivatives are reported is a major driving force of firms' risk management choices, but academic evidence in this area is scarce. (2)
To examine whether firms' hedging policies have been affected by changes in the financial reporting of derivatives, we employ data from a comprehensive global survey of chief financial officers (CFOs) encompassing a broad range of both public and private companies from 36 countries. Using a survey to assess the factors that affect corporate risk management in an international setting has many benefits. …