The impact of hedge accounting on a firm market value

Čiperová, Lenka Article The impact of hedge accounting on a firm market value European Financial and Accounting Journal Provided in Cooperation with: Faculty of Finance and Accounting, Prague University of Economics and Business Suggested Citation: Čiperová, Lenka (2024) : The impact of hedge accounting on a firm market value, European Financial and Accounting Journal, ISSN 1805-4846, Prague University of Economics and Business, Faculty of Finance and Accounting, Prague, Vol. 19, Iss. 1, pp. 21-37, https://doi.org/10.18267/j.efaj.284 This Version is available at: https://hdl.handle.net/10419/315554 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ 21 The Impact of Hedge Accounting on a Firm Market Value Lenka Čiperová* Abstract: In 2018, the International Accounting Standards Board (IASB) introduced International Financial Reporting Standard 9 (IFRS 9), which sets out principles for hedge accounting and replaces International Accounting Standard 39 (IAS 39). IFRS 9 aims to provide better information about companies’ risk management policies by simplifying reporting requirements and improving risk disclosures compared to IAS 39. The objective of hedge accounting is to facilitate investors’ understanding of companies’ risk management strategies and provide information on the effectiveness of hedging. In this study, we attempt to determine how hedge accounting fulfils the IASB’s objective and whether better risk management information translates into value attributed by investors. In the empirical part of this study, a firm valuation framework is used to analyse the impact of hedge accounting on the market value of a sample of Polish companies listed on the Warsaw Stock Exchange. The results show the positive effect of using hedge accounting, suggesting that information about risk management strategies can positively affect investors’ valuation of the firm. The results also show that the simplified reporting requirements under IFRS 9 motivated companies that used hedge accounting to switch to the new accounting standard but, contrary to expectations, did not motivate new companies to adopt hedge accounting. Keywords: Firm Market Value; Hedge Accounting; IFRS 9; Risk Management. JEL classification: M41; M48. 1 Introduction In 2001, IASB adopted IAS 39 Financial Instruments: Recognition and Measurement, a standard originally issued in 1999 by the International Accounting Standards Committee (IASC), which includes regulation of hedge accounting. IAS 39 sets out the conditions under which hedge accounting is permitted and the procedures and requirements for hedge accounting. Hedge accounting is an optional accounting policy. When implemented it should better align financial accounting results with the underlying economic strategy of a company and it should increase * Lenka Čiperová; Prague University of Economics and Business, Faculty of Finance and Accounting, Department of Financial Accounting and Auditing, Winston Churchill Square 1938/4, 130 67 Prague, Czech Republic, <[email protected]>, ORCID iD: 0009-0004-1778-0506. The article is processed as an output of a research project The Impact of the Implementation of Hedge Accounting Under IFRS 9 on the Firm Market Value registered by the Internal Grant Agency of Prague University of Economics and Business under the registration number F1/3/2022. Čiperová, L.: The Impact of Hedge Accounting on a Firm Market Value. 22 the transparency of a company’s risk management activities. The record-keeping requirements of IAS 39 for assessing hedging effectiveness, however, were sometimes considered too demanding by companies and discouraged them from applying hedge accounting even if they used financial instruments to mitigate their risk exposures (Glaum and Klöcker, 2011; Walton, 2004). Neither did the disclosures on hedge accounting provide external users of accounting information with sufficient explanation of risk exposures, risk management strategies or the effectiveness of risk management strategies (Frestad and Beisland, 2015). The International Accounting Standards Board (IASB) listened to comments from companies, auditors, and other stakeholders and developed a more principle-based approach to hedge accounting in IFRS 9. It has simplified documentation requirements, increased the eligibility of hedged items, and improved disclosure requirements to better inform external users of accounting information about companies’ risk management activities. If, in line with the IASB’s intention, hedge accounting should provide investors with a better understanding of companies’ risks and enhance comprehension of the effectiveness of the hedging instruments used, it could have an impact on the market-assigned risk premium (Wang and Makar, 2019). The empirical hedge accounting research was primarily focused on US companies regulated under Statement of Financial Accounting Standard no. 133 (SFAS 133) or Financial Accounting Standard no. 161 (FAS 161) issued by the Financial Accounting Standard Board (FASB) (Pierce, 2020; Ranasinghe et al., 2022; Wang and Makar, 2019). This study seeks to extend the existing literature on hedge accounting by empirically examining the impact of IASB regulations. Moreover, it is one of the first empirical studies to focus on the effects of hedge accounting under the new standard IFRS 9. The remainder of the article is organised as follows: first, major hedging theories are reviewed and hedge accounting policies under IFRS and their intended impact on the presentation of risk management policies in the financial statements are outlined in Section 2. Next, the source of data, sample formation, variables identification, and model specifications are provided in Section 3. Finally, the results of the tests are presented and discussed in Section 4. Section 5 concludes. 2 Literature review 2.1 Hedging theories and research The influence of hedging strategies on a firm value has been extensively examined since 1985 when Smith and Stulz (1985) developed their positive theory of valuemaximising hedging policies in imperfect capital market conditions. Their approach to corporate risk management builds on the classical theory of irrelevance of European Financial and Accounting Journal, 2024, vol. 19, no. 1, pp. 21–37. 23 financing to firm value in perfect capital market conditions (Modigliani and Miller, 1958). The value maximization approach, also referred to as the financial economic theory (Klimczak, 2008) identifies reasons for hedging that include higher debt capacity, lower bankruptcy costs, lower information asymmetry (DeMarzo and Duffie, 1995) and securing internal financing (Froot et al., 1993), which should increase firm value. Empirical tests of the impact of hedging were conducted to provide evidence for the theory of value maximization. The conclusions of studies on the impact of risk management strategies on enterprise value yield mixed results. Graham and Rogers (2002), Bartram et al. (2011), and Gilje and Taillard (2017) show a positive relation between hedging and the firm leverage and firm value respectively. Allayannis and Weston (2001) found a positive relation between hedging and firm value, the hedging premium was statistically and economically significant for firms with exposure to exchange rates. Judge (2006) found evidence linking the expected costs of bankruptcy and the decision to hedge. Bodnar et al. (1995) surveyed 530 nonfinancial firms in the United States and concluded that in most cases minimising cash flow fluctuations was the predominant reason for using derivatives as opposed to using derivatives for management of accounting earnings. Similarly, Guay (1999) and Guay and Kothari (2003) found only a limited impact of hedging on a company’s earnings. Agency theory brings into the risk management research a managerial perspective on the motivations for hedging (Klimczak, 2008). Any misalignment of risk management objectives between managers and shareholders is limited by the presence of established hedging policies. In the empirical research, we find only limited support for the agency theory (e.g., Tufano, 1996). The determinants of hedging were tested in a more recent study (Klimczak, 2008) and no support was identified for the argument that firms hedge to decrease shareholders’ risk. This study aims to extend the existing risk management literature by examining the effect of hedge accounting on firm value. As already mentioned, the evaluation of the main theories of corporate hedging (value maximization theory and agency theory) shows mixed empirical validation. We intend to test the validity of valuemaximising hedging theory in the case of hedge accounting. The IASB is currently examining the effectiveness of IFRS 9 and hedge accounting. It invites companies and users of financial information to comment on whether the standard has met its objective of providing users with better information about companies’ risk management activities. In our study, we examine the impact of hedge accounting for the period from 2016 to 2019, two years before and after the introduction of IFRS 9, to test whether the more flexible requirements of IFRS 9 compared to IAS 39 had any effect on the value attributed by investors. Čiperová, L.: The Impact of Hedge Accounting on a Firm Market Value. 24 2.2 Hedge accounting IAS 39 and IFRS 9 classify financial assets and financial liabilities based on their measurement (at fair value or amortised cost) and based on whether the changes to carrying value (gains and losses) are reported in profit or loss (P&L) or the other comprehensive income (OCI). IFRS 9 emphasises the classification and measurement of financial assets at fair value, with changes in fair value recognised in P&L unless strict criteria for classification and measurement of the asset at either amortised cost or fair value through OCI are met. Hedge accounting is an optional accounting policy under both IAS 39 and IFRS 9. The objective of hedge accounting is to reflect the results of hedging activities by recognising the effects of the hedging instruments (derivatives) and the hedged risk in P&L or OCI in the same accounting period. Hedge accounting reduces the volatility in P&L (or OCI) that arises when the two items (hedging and hedged) are accounted for separately, i.e., without the application of hedge accounting. If a hedging instrument is measured at fair value with gains and losses recognised in profit or loss while the hedged item is measured at amortised cost, or if changes in the carrying amount of the hedged item are recognised in OCI, there will be an imbalance in recognition of gains and losses on both items. When hedging and hedged items meet qualifying criteria for hedge accounting their gains and losses can be recognised and offset in P&L (or OCI) in the same accounting period and the volatility in profit or loss from the hedging and hedged items gains or losses will be reduced or eliminated. Both IAS 39 and IFRS 9 define three types of hedging relationships in hedge accounting: fair value hedge (hedging exposure to changes in fair value that could affect profit or loss), cash flow hedge (hedging exposure to volatility of cash flows) and hedge of net investment in foreign operations. In the case of a fair value hedge, the hedged item (asset or liability) is adjusted for changes in fair value that are attributable to the hedged risk and the fair value changes are recognised in profit or loss together with the changes in fair value of the hedging instrument which is measured at fair value. For the cash flow hedge, if the hedge is effective, changes in the fair value of the hedging instrument are initially recognised in equity and they are reclassified to the P&L in the same period when the hedged transaction affects profit or loss (Glaum and Klöcker, 2011). The ineffective portion of the hedge is recognised in profit or loss. Similarly, in the case of hedging of net investment in a foreign operation, the effective part of hedging is recognised in equity and the ineffective part in profit or loss. Gain or loss from revaluation of the hedged item that is accumulated in equity is reclassified to profit or loss on the disposal or partial disposal of the foreign operation. European Financial and Accounting Journal, 2024, vol. 19, no. 1, pp. 21–37. 25 The differences in hedge accounting between IAS 39 and IFRS 9 lie in the qualifying criteria and reporting requirements mainly. IFRS 9 has removed IAS 39’s strict requirements for retrospective testing of hedge effectiveness and focuses on prospective assessment of hedge effectiveness based on more flexible principles and allows more hedging relationships to be included in hedge accounting (Müller, 2020). Firms have a choice to account for financial instruments used for the management of risk exposure as hedging instruments and apply hedge accounting according to IFRS 9 or they can decide to continue to apply hedge accounting in line with IAS 39 or they can apply IAS 39 for a portfolio fair value hedging of the interest rate exposure and IFRS 9 for other hedging instruments. A hedge accounting policy is a voluntary choice of the company’s management. They decide which form of risk management policy will be applied and how it will be presented in the financial statements. According to IFRS 9, “The objective of hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss (or other comprehensive income…)” (IFRS 9.6.1.1). Companies that elect to apply hedge accounting following IFRS 9 must meet the criteria for hedge accounting of the IFRS standard. The criteria are eligibility of hedging and hedged items, formal documentation of the hedging relationship at its inception and the effectiveness of the hedging relationship. If a firm elects not to apply hedge accounting or when its hedging instruments do not qualify for hedge accounting requirements, it will account for financial instruments used for managing risk exposure as trading financial instruments with fair value changes recognised in profit or loss. Costs of implementation of hedge accounting and maintenance of hedging documentation play an important role when firms decide whether to apply hedge accounting or not. The introduction of IFRS 9 brought a partial simplification in the required hedging documentation which could motivate firms to adopt hedge accounting policy. We therefore expect that firms will adopt the hedge accounting in line with IFRS 9 and formulate the following hypothesis: H1: The introduction of IFRS 9 will motivate companies to adopt hedge accounting. A review of hedging literature provides evidence of both the positive and negative effects of hedge accounting. Wang and Makar (2019) report that SFAS 133 cash flow hedge accounting provides risk-relevant information to investors. Müller (2020) examined the consequences of cash flow hedge accounting on portfolio earnings and concluded that IAS 39 hedge accounting regulation may lead to higher Čiperová, L.: The Impact of Hedge Accounting on a Firm Market Value. 26 volatility of portfolio earnings whereas IFRS 9 hedge accounting leads to less volatility in portfolio earnings. DeMarzo and Duffie (1995) studied the US Generally Accepted Accounting Principles (US GAAP) issued by FASB and argued that while financial hedging improves information about reported corporate earnings, the choice of hedge accounting can also lead to suboptimal hedging strategies if managers’ and shareholders’ views of disclosure requirements differ. Chen et al. (2013) studied the effects of hedge accounting on managerial hedging strategies. They conducted experiments to evaluate how fair value hedge accounting under SFAS 133 affects managerial economic decisions. They found that when the price volatility of the hedged item is higher, fair value hedging leads to suboptimal managerial hedging decisions (e.g., foregoing economically beneficial hedging opportunities). Melumad et al. (1999), also investigated hedge accounting under SFAS 133 and argued that the attitude of long-term and short-term shareholders to risk management strategies differ. Long-term shareholders prefer fair value hedge accounting to no hedge accounting, while the preference of short-term shareholders will depend on their attitude towards risk, so hedge accounting will not necessarily lead to higher market value. They also concluded that the accounting method used will have an impact on managerial hedging decisions and consequently on wealth effects for shareholders. Frestad (2018) developed a model that shows that nonfinancial firms will optimise their hedging strategy and hedge accounting choices to achieve predictable profits under both SFAS 133 and IAS 39 standards. Similar findings were described for IFRS hedge accounting by Panaretou et al. (2013), who found that earnings are more predictable under hedge accounting. Pirchegger (2006) analysed firms’ incentives for hedging and hedge accounting under both US GAAP and IAS/IFRS and concluded that shareholders prefer hedging to no hedging, while hedge accounting is preferred only in periods with increased differences in risk exposures. In summary, previous empirical research has shown only modest effects of hedge accounting, which may be due to the demanding requirements and qualification criteria of hedge accounting. We build on previous research on risk management theory and the value relevance of hedge accounting and examine whether the adoption of hedge accounting has a significant impact on the value attributed by investors. The prior empirical research was mainly conducted in US GAAP. Although not certain, we hypothesise that IAS/IFRS hedge accounting could improve investors’ understanding of risk management activities and we formulate the following hypothesis: H2: The use of hedge accounting increases the value relevance of accounting information for investors. European Financial and Accounting Journal, 2024, vol. 19, no. 1, pp. 21–37. 27 3 Data and Methodology The sample consists of data on the TOP 100 (by market capitalization) companies whose shares were publicly traded on the Warsaw Stock Exchange over four years from 2016 to 2019. Market data and data from annual reports were used for the analysis. The Warsaw Stock Exchange has been selected because it is the largest capital market in Central and Eastern Europe. Hedging data were hand-collected from annual reports. Firm-level financial data were sourced from the Amadeus database. In line with the previous literature on hedging (Bartram et al., 2011; Graham and Rogers, 2002; Geczy et al., 1997) financial firms were excluded from the sample. After excluding 14 financial firms and 14 firms for which financial statements were not available, the sample consists of panel data with 284 observations In the empirical tests, the study is inspired by Feltham and Ohlson (1995) and Ohlson (1995) models which incorporate accounting information in the equity valuation. The model of Feltham and Ohlson (1995) includes the market value of equity as the dependent variable and the book value of equity, operating assets, operating earnings and other information as independent variables. In this study hedging information variable is added to the model to identify whether the application of hedge accounting has a significant impact on firm value. Two dummy variables for hedging are included, one for the application of hedge accounting according to IFRS 9 and one for IAS 39. We have also tested the model where a dummy variable for hedge accounting, in general, is added instead of the two hedging variables to eliminate the possible effects of hedgers using the alternative hedging policy from the non-hedging sample. In the value relevance model in Equation (1), the market value of a company is a function of accounting variables and other factors affecting the firm market value. 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒𝑖,𝑡 = 𝑓(𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛, 𝑂𝑡ℎ𝑒𝑟 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑛𝑡𝑠)+ 𝑒𝑖,𝑡 (1) Dependent variable 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 represents the market capitalisation of a company. Independent variables representing 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 are variables presented in financial statements (𝐵𝑉, 𝑂𝐴, 𝑂𝐸) and 𝑂𝑡ℎ𝑒𝑟 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑛𝑡𝑠 are other factors affecting the firm 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒. In our model, we include variables indicating whether the company is using hedge accounting or not (𝐼𝐹𝑅𝑆9, 𝐼𝐴𝑆39, 𝐻𝐴). Due to the possible correlation between book value (𝐵𝑉) and operating assets variable (𝑂𝐴), we first run the regressions without the 𝑂𝐴 variable and then with the variable included. We test each model for multicollinearity using VIF tests. The model in Equation (1) is adapted into four sub-models. The purpose of the submodels is to evaluate the impact of hedge accounting when it is applied in line with IFRS 9 or IAS 39 (Models (1A) and (1C)) and when it is applied in line with any of Čiperová, L.: The Impact of Hedge Accounting on a Firm Market Value. 28 the two standards (Model (1B) and (1D)). The dummy variables for hedge accounting (𝐼𝐹𝑅𝑆9, 𝐼𝐴𝑆39, 𝐻𝐴) are the primary variables of our interest. They indicate whether hedge accounting has any impact on a stock return. A positive coefficient for hedge accounting dummy variables would indicate that hedge accounting information disclosed in the financial statements increases the value relevance of financial statements. 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐸𝑖,𝑡 + 𝛽3𝐼𝐹𝑅𝑆9𝑖,𝑡 + 𝛽4𝐼𝐴𝑆39𝑖,𝑡 + 𝑒𝑖,𝑡 (1A) 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐸𝑖,𝑡 + 𝛽3𝐻𝐴𝑖,𝑡 + 𝑒𝑖,𝑡 (1B) 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐴𝑖,𝑡 + 𝛽3𝑂𝐸𝑖,𝑡 + 𝛽4𝐼𝐹𝑅𝑆9𝑖,𝑡 + 𝛽5𝐼𝐴𝑆39𝑖,𝑡 + 𝑒𝑖,𝑡 (1C) 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐴𝑖,𝑡 + 𝛽3𝑂𝐸𝑖,𝑡 + 𝛽4𝐻𝐴𝑖,𝑡 + 𝑒𝑖,𝑡 (1D) Our sample consists of a broad range of non-financial firms. To eliminate the effects of industry sectors we add an industry variable (𝐼𝑁𝐷) to the original model. In line with the hedging literature (Bartram et al., 2011; Gilje and Taillard, 2017; Graham and Rogers, 2002) we have also included leverage (𝐿𝐸𝑉) in the extended model to control for the effect of leverage on stock returns. The extended models are: 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐸𝑖,𝑡 + 𝛽3𝐼𝐹𝑅𝑆9𝑖,𝑡 + 𝛽4𝐼𝐴𝑆39𝑖,𝑡 + 𝛽4𝐼𝐴𝑆39𝑖,𝑡 + 𝛽5𝐿𝐸𝑉𝑖,𝑡 + 𝛽6𝐼𝑁𝐷𝑖,𝑡 + 𝑒𝑖,𝑡 (2A) 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐸𝑖,𝑡 + 𝛽3𝐻𝐴𝑖,𝑡 + 𝛽4𝐿𝐸𝑉𝑖,𝑡 + 𝛽5𝐼𝑁𝐷𝑖,𝑡 + 𝑒𝑖,𝑡 (2B) 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐴𝑖,𝑡 + 𝛽3𝑂𝐸𝑖,𝑡 + 𝛽4𝐼𝐹𝑅𝑆9𝑖,𝑡 + 𝛽5𝐼𝐴𝑆39𝑖,𝑡 + 𝛽6𝐿𝐸𝑉𝑖,𝑡 + 𝛽7𝐼𝑁𝐷𝑖,𝑡 + 𝑒𝑖,𝑡 (2C) 𝑀𝑉𝑖,𝑡 = 𝛼 + 𝛽1𝐵𝑉𝑖,𝑡 + 𝛽2𝑂𝐴𝑖,𝑡 + 𝛽3𝑂𝐸𝑖,𝑡 + 𝛽4𝐻𝐴𝑖,𝑡 + 𝛽5𝐿𝐸𝑉𝑖,𝑡 + 𝛽6𝐼𝑁𝐷𝑖,𝑡 + 𝑒𝑖,𝑡 (2D) A list of all variables included in the models with definitions is presented in Tab. 1. Operating assets in Feltham and Ohlson (1995) are defined as all assets other than net financial assets. Net financial assets represent the difference between “marketable securities” and debt (“bonds payable”). In the analysis, operating assets are defined as total assets net of cash and cash equivalents and other short-term assets. 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