2.5.1
Derivatives and discretionary accruals as earning smoothing substitutes
As discussed above, both hedging derivatives and discretionary accruals have capacity to smooth earnings. The literature review related to derivatives for financial hedging and earnings management shows that they are in part influenced by the same set of managerial incentives. It is on this basis that different authors (Barton, 2001; Rajgopal and Pincus 2002; Singh, 2004 and Zhang et al, 2009) conducted empirical studies to establish whether either of these two choices available to managers seeking to smooth earnings, are in fact substitutes26. The assumption being that as discussed in sections 2.3.1 and 2.4.3, derivatives used for hedging and earnings management through discretionary accruals can enhance shareholder value. This is by making earnings informative and reducing the:
perceived riskiness, cost of capital and expected cost of financial distress;
information disadvantages between informed and uninformed investors;
reducing underinvestment; and
expected future tax liabilities.
Hence, these two choices also can assuage managerial concerns regarding the volatility of their stock holdings in the employer firms.
Empirical evidence on substitution
In contrast to the relatively established strands of literature (see sections 2.3 and 2.4) that separately study derivatives based risk management and earnings management, empirical evidence on their joint use has only begun to emerge. Using 304 firms over the 1994-1996 periods, Barton (2001) finds that there is a substitution relationship between discretionary accruals and derivatives. Using a simultaneous equation model, he finds that increased derivatives use is associated with reduced discretionary accruals and vice versa. He finds that firms with larger derivatives portfolios tend to have lower levels of discretionary accruals and they also show that non-users of derivatives are more likely to violate GAAP by aggressively managing accruals. Barton (2001) recognises that there is a research gap for a similar study data based on post-SFAS 133 data.
Rajgopal and Pincus (2001), focusing on the interaction of discretionary accrual choices in managing earnings volatility in oil and gas producing firms that also face oil exploration risk, also find that derivatives and discretionary accruals are used as substitutes. Zhang, Huang,
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The effective use of derivatives as hedging instruments lowers earnings volatility and, at an aggregate level, reduces the need to manage earnings using discretionary accruals and this yields the substitution relationship.
Deis and Moffit (2009), studying the relationship between discretionary accruals, hedging and firm value, find significant evidence of a substitution relationship between discretionary accruals and the use of derivatives.
See Table 2.3 (for detailed review of studies)
However, Huang, Zhang, Deis and Moffit (2009) find that discretionary accruals have lower impact on firm value relative to the use of derivatives and hence managers will prefer derivatives when seeking to smooth income for long term shareholder benefit. Huang et al (2009), show that accruals are preferred to derivatives use when managers are being opportunistic and seeking privative benefit. The assertion of opportunistic use of accruals is consistent with the evidence of Sloan (1996) showing that managerial self interest, manifest in pursuit of short term oriented, transitory stock price inflation, leads to the higher use of discretionary accruals. Huang et al’s (2009) study suggests that accruals are not really substitutes, as they principally are used in firms with weak corporate governance and with opportunistic intent. However, these claims are inconsistent with a significant body of literature that suggests that accruals also have informational purposes and positively impact long term shareholder value (Subramayan, 1996 and Jiraporn et al, 2008). In fact, Jiraporn et al (2008) find that there are lower levels of accruals in firms with high agency costs (e.g. through weak prevailing corporate governance structures). The findings of Jiraporn et al (2008) contradict the conclusions of Huang et al (2009).
Post-SFAS 133 studies on substitution
Singh’s (2004) investigation of the effects of SFAS 133 on earnings management, earnings volatility and derivatives use, was a necessary extension of the work of Barton (2001) that relied on pre-SFAS 133 data (i.e. 1994-1996). Unlike Barton (2001), Singh (2004) finds evidence of a partial substitution relationship where derivatives use is associated with earnings management, but finds no evidence that earnings management similarly influences the use of derivatives. The few post-SFAS 133 studies reveal an opportunity for studies that are based on post-year 2000 data.
2.5.2
Factors that could offset substitution relationship
Despite the assumption of substitution relationship between hedging derivatives and discretionary accruals, there are several factors that could restrict the substitution relationship including:
Objective of managing cash flow rather than earnings volatility;
Directional earnings management;
Costs and stringent implement requirements of derivatives use; and
Complementary relationship
Objective of managing cash flow rather than earnings volatility:Derivatives affect both cash flow and earnings volatilities. But discretionary accruals only affect earnings volatility but not cash flow volatility. In situations where the manager’s intention is to primarily manage cash- flow volatility, derivatives and discretionary accruals cease to be substitutes. Discretionary accruals only influence earnings and not cash flow. If seeking to cash flow volatility, companies are likely to use derivatives rather than discretionary accruals.
Directional earnings management: As discussed in section 2.4.4, discretionary accruals can be used to meet earnings targets as opposed to smoothing income. For example to avoid violation of debt covenants, maintain dividends, meet bonus targets or analyst forecasts. However, directional earnings management does not occur for derivatives. Hence when the goal is directional earnings management, discretionary accruals should be more likely to be used.
Costs of derivatives use:As Rajgopal and Pincus (2002) and Lin, Servaes and Tamayo (2007) point out, another constraint to the interchangeable use of derivatives and earnings management, is that it is more costly to implement the use of derivatives. The use of derivatives imposes direct and indirect costs. For example, there are significant direct costs of running an effective treasury or risk management function. To use derivatives effectively, organizations have to establish and source personnel with expertise in derivatives use for risk management purposes as well as to establish supporting technological platforms and processes to enable the selection, pricing and accounting of derivatives instruments. The high profile derivatives failures, such as Procter and Gamble and Orange County, were in part a consequence of the shortfall of risk management skills that resulted in ineffective hedges. In addition, there is basis risk (i.e. the economic cost of ineffective hedges) associated specifically with derivatives use (Singh, 2004).
Complementary relationship: Rather than being substitutes, it is plausible that accruals could complement derivatives use. This could, for example, occur when firms use derivatives for speculative purposes. This could lead to increased earnings volatility and a corresponding need to use accruals to offset the increased earnings volatility.
2.5.3
Summary of Income Smoothing choices
The above conceptual analysis of the purpose and determinants of derivatives use and discretionary accruals shows that there is an overlap in how they influence shareholder value and managerial risk incentives. It also shows that there are situations where these two choices cannot be substitutes. This is consistent with Singh (2004) who assumes that they are partial substitutes.
With an understanding of income smoothing choices, it is appropriate at this stage to develop the linkage to derivatives accounting policy, SFAS 133. Dechow and Schrand (2004) asserted that earnings management requires both incentive and opportunity. The earlier sections have analysed the incentives for income smoothing. The focus of the subsequent sections of the theoretical framework is on how SFAS 133 provides both incentive and opportunities for income smoothing choices. This includes a description of the key features of SFAS 133 and shows how these could incentivise income smoothing.