Empirical Analysis of Effects of SFAS No. 133 on Derivative Use and Earnings Smoothing

Abstract

Managers use derivatives to reduce cash flow volatility and achieve earnings smoothing. In 1998, FASB issued SFAS No. 133, under which firms are no longer allowed to simultaneously record all offsetting gains and losses on the items being hedged. Thus, critics argued that this treatment could potentially induce volatility in earnings. The critics also argued that SFAS No.133 would deter the use of derivatives. Consequently, cash flows were expected to become more volatile, which would also lead to increased volatility in earnings. Based on a sample of Fortune 500 firms, the current study documents that: (1) derivative usage did not significantly decline following the implementation of SFAS No. 133, and (2) derivative users' cash flow volatility did not increase. Although derivative users' earnings volatility did increase during the period 1997 to 2002, the evidence suggests that this increase may have been caused by factors other than SFAS No. 133.