Does the Use of Financial Derivatives Affect Earnings Management Decisions

I present evidence consistent with managers using derivatives and discretionary accruals as partial substitutes for smoothing earnings. Using 1994–1996 data for a sample of Fortune 500 firms, I estimate a set of simultaneous equations that captures managers' incentives to maintain a desired level of earnings volatility through hedging and accrual management. These incentives include increasing managerial compensation and wealth, reducing corporate income taxes and debt financing costs, avoiding underinvestment and earnings surprises, and mitigating volatility caused by low diversification. After controlling for such incentives, I find a significant negative association between derivatives' notional amounts and proxies for the magnitude of discretionary accruals.

[1]  H. Leland..  Agency Costs, Risk Management, and Capital Structure , 1998 .

[2]  Richard G. Sloan,et al.  Earnings Surprises, Growth Expectations, and Stock Returns or Don't Let an Earnings Torpedo Sink Your Portfolio , 1999 .

[3]  J. Graham,et al.  Is Corporate Hedging Consistent with Value Maximization? An Empirical Analysis , 1999 .

[4]  S. P. Kothari,et al.  A Market-Based Evaluation of Discretionary-Accrual Models , 1996 .

[5]  Mark L. DeFond,et al.  Smoothing income in anticipation of future earnings , 1997 .

[6]  Proxies for the Marginal Tax Rate , 1995 .

[7]  Peter Tufano,et al.  Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry , 1996 .

[8]  Mark L. DeFond,et al.  Debt covenant violation and manipulation of accruals , 1994 .

[9]  Victor L. Bernard,et al.  What motivates managers' choice of discretionary accruals? , 1996 .

[10]  Catherine M. Schrand,et al.  Hedging and Coordinated Risk Management: Evidence from Thrift Conversions , 1998 .

[11]  Susan E. Moyer,et al.  Managing Interacting Accounting Measures to Meet Multiple Objectives: A Study of Lifo Firms , 1996 .

[12]  G. Phillips,et al.  Financing Policy, Basis Risk, and Corporate Hedging: Evidence from Oil and Gas Producers , 2000 .

[13]  D. BeneishMessod,et al.  The Detection of Earnings Manipulation , 1999 .

[14]  Gnanakumar Visvanathan.  Who Uses Interest Rate Swaps? a Cross-Sectional Analysis , 1998 .

[15]  E. Ofek,et al.  Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives , 1997 .

[16]  Christopher C. Geczy,et al.  Why Firms Use Currency Derivatives , 1996 .

[17]  K. Palepu.  Diversification strategy, profit performance and the entropy measure , 1985 .

[18]  Patricia M. Dechow.  Accounting earnings and cash flows as measures of firm performance : The role of accounting accruals , 1994 .

[19]  J. Tukey,et al.  The Fitting of Power Series, Meaning Polynomials, Illustrated on Band-Spectroscopic Data , 1974 .

[20]  Jennifer J. Gaver,et al.  Additional evidence on bonus plans and income management , 1995 .

[21]  M. Petersen,et al.  Risk Measurement and Hedging , 1997 .

[22]  Patricia M. Dechow,et al.  DETECTING EARNINGS MANAGEMENT , 1994 .

[23]  Paul M. Healy,et al.  Discussion of a market-based evaluation of discretionary accrual models , 1996 .

[24]  Peter E. Kennedy,et al.  A Guide to Econometrics , 1980 .

[25]  J. Hausman.  Specification tests in econometrics , 1978 .

[26]  René M. Stulz,et al.  The Determinants of Firms' Hedging Policies , 1985, Journal of Financial and Quantitative Analysis.

[27]  W. W. Muir,et al.  Regression Diagnostics: Identifying Influential Data and Sources of Collinearity , 1980 .

[28]  J. G. Cragg.  Some Statistical Models for Limited Dependent Variables with Application to the Demand for Durable Goods , 1971 .

[29]  W. Guay.  The impact of derivatives on firm risk: An empirical examination of new derivative users 1 I gratefu , 1999 .

[30]  K. R. Subramanyam,et al.  The pricing of discretionary accruals , 1996 .

[31]  D. Collins,et al.  Errors in Estimating Accruals: Implications for Empirical Research , 1999 .

[32]  Anne Beatty,et al.  Interest Rate Risk Management of Bank Holding Companies: An Examination of Trade-offs in the Use of Investment Securities and Interest Rate Swaps , 1997 .

[33]  James A. Ohlson.  FINANCIAL RATIOS AND THE PROBABILISTIC PREDICTION OF BANKRUPTCY , 1980 .

[34]  John R. Graham,et al.  Proxies for the corporate marginal tax rate , 1996 .

[35]  J. Jones.  Earnings Management During Import Relief Investigations , 1991 .

[36]  Gordon M. Bodnar,et al.  1995 Wharton Survey of Derivatives Usage by US Non-Financial Firms , 1995 .

[37]  Douglas J. Skinner,et al.  Earnings Momentum and Earnings Management , 2006 .

[38]  Patricia M. Dechow,et al.  Implications of Nondiscretionary Accruals for Earnings Management and Market-Based Research , 1997 .

[39]  Bernadette A. Minton,et al.  The Impact of Cash Flow Volatility on Discretionary Investment and the Costs of Debt and Equity Financing , 1999 .

[40]  M. McNichols,et al.  Evidence of Earnings Management from the Provision for Bad Debts , 1988 .

[41]  Jennifer J. Gaver,et al.  Managing Insurance Company Financial Statements to Meet Regulatory and Tax Reporting Goals , 1999 .

[42]  Anne Beatty,et al.  MANAGING FINANCIAL REPORTS OF COMMERCIAL-BANKS - THE INFLUENCE OF TAXES, REGULATORY CAPITAL, AND EARNINGS , 1995 .

[43]  John R. Graham,et al.  Tax Incentives to Hedge , 1999 .

[44]  Kenneth A. Froot,et al.  Risk Management: Coordinating Corporate Investment and Financing Policies , 1992 .

[45]  Peter Schmidt,et al.  A Test of the Tobit Specification against an Alternative Suggested by Cragg , 1984 .

[46]  S. Balsam,et al.  Discretionary Accounting Choices and CEO Compensation , 1998 .

[47]  P. J. Huber.  Robust Estimation of a Location Parameter , 1964 .

[48]  Brian W. McCulloch.  Relations Among Components of Accruals Under Earnings Management , 1998 .

[49]  Mary E. Barth,et al.  Market rewards associated with patterns of increasing earnings , 1999 .

[50]  William R. Baber,et al.  Accounting earnings and executive compensation:: The role of earnings persistence , 1998 .

[51]  M. Petersen,et al.  Risk Measurement and Hedging: With and Without Derivatives , 2000 .