The trade-off between risk management and earnings volatility: Evidence from restatements

Date of Completion

January 2009


Business Administration, Accounting




This study examines whether a change in accounting treatment for derivative instruments used to hedge firms' market risk exposures affects corporate risk-management and if so, which factors increase the likelihood that a change in accounting treatment will affect risk-management. I analyze a sample of firms that restated their financial statements due to the misclassification of economic hedges as accounting hedges, both of which are derivative instruments used to reduce firms' market risk exposures and differ only in accounting treatment. Economic hedges are accounted for under fair value accounting whereas accounting hedges receive hedge accounting treatment, the preferred method because it avoids the increase in earnings volatility associated with fair value accounting. ^ I first examine why certain firms use hedge accounting treatment following the restatement and other firms do not. I find that the type of hedging instrument used, the market risk that was being hedged, and the disclosed reason for the restatement affect the likelihood that firms will apply hedge accounting following the restatement. Firms that do not use hedge accounting following the restatement face a trade-off between continuing the economic hedge which increases earnings volatility, and discontinuing the hedge which avoids the increase in earnings volatility but increases market risk exposure. I find that dividends, tax benefits and firms' historic patterns of reporting positive earnings are associated with the likelihood that firms discontinue economic hedges, increasing market risk exposure. I also find that leverage, growth, distress and analyst following are associated with the likelihood that firms continue economic hedges, maintaining market risk exposure but increasing earnings volatility. This study provides an example of how a change in accounting treatment affects firm behavior and results of this study contribute to our understanding of firm characteristics which influence managers to focus on accounting earnings versus market risk exposure. ^