Do Investors Adjust for Balance Sheet Risk that Should be “Off Balance Sheet”? Evidence from Cash Flow Hedges

• In Event: DSFI: Part II

Abstract

We identify an item recognized on the balance sheet that distorts the assessment of default risk.
Firms enter into derivatives to protect themselves from price fluctuations on a future purchase or
sale commitment denominated in a commodity, foreign currency, or interest rate. There are two
reasons why the accounting for these transactions creates difficulty in default risk assessments.
First, while the fair value of the derivative is recorded at each balance sheet date, the value of the
forecasted purchase or sale commitment is not recorded. Therefore, the balance sheet only tells
half of the economic story. Second, the gains/losses associated with these derivatives provide a
signal about future firm profitability, which is a determinant of default risk. We examine the extent
to which debt investors, credit analysts, and equity investors understand the implications of these
transactions for a firm’s default risk. Our results suggest that all three of these groups remove
derivative amounts from firms’ balance sheet ratios when assessing default risk. However, only
debt investors correctly price the implications of future profitability on default risk. Overall, our
results suggest that the accounting for cash flow hedges distorts a firm’s leverage and profitability
ratios, that not all investors adjust for this, and that capital market participants might benefit from
more transparent hedging disclosures, particularly related to profitability.

Author

• Jenna Feagin, University of Georgia