Programa de Pós-Graduação em Controladoria e Contabilidade Comentários ao artigo “Do sophisticated investors use the information provided by the fair value of cash flow hedges?”, John L. Campbell, Jimmy F. Downes e William C. Schwartz Jr., Rev. Account Stud. (2015) Ralph Melles Sticca RCC 5132 FINANÇAS CORPORATIVAS Prof. Dr. Marcelo Augusto Ambrozini

Programa de Pós-Graduação em Controladoria e Contabilidade Abstract An unrealized gain on a cash flow hedge implies that the price of the underlying hedged item (i.e., commodity price, foreign currency exchange rate, or interest rate) moved in a direction that will negatively affect the firm’s profits after the hedge expires; Prior research shows that unrealized gains/losses on cash flow hedges are negatively associated with future earnings and that investors’ expectations, as reflected in stock prices, do not appear to anticipate this association; The authors provide further evidence on this mispricing by examining whether financial analysts understand the future earnings effects of cash flow hedges and find three main results: (1) analysts do not correctly incorporate unrealized cash flow hedging gains and losses into their 2 and 3-year-ahead earnings forecasts; (2) analysts correct their errors after the hedges have largely expired and investors correct their mispricing at this time; and (3) analysts and investors can better process cash-flow hedge information when managers provide forecasts.

Programa de Pós-Graduação em Controladoria e Contabilidade Introduction A cash flow hedge is a derivative financial instrument that hedges a firm’s exposure to variability in expected future cash flows arising from changes in the prices of commodities, foreign currency exchange rates, or interest rates (FASB 1999); Statement of Financial Accounting Standard No. 133 (SFAS 133) Accounting for Derivative Instruments and Hedging Activities establishes the accounting rules for cash flow hedges; Under SFAS 133, firms record the fair value of their cash flow hedges at each reporting date in accumulated other comprehensive income (AOCI), a component of shareholders’ equity on firms’ balance sheets; When the hedge expires and the underlying hedged transaction occurs, firms reclassify the unrealized gains and losses out of AOCI and into net income; Cash flow hedges protect firms from adverse price changes in commodities, foreign currencies or interest rates, and this protection usually expires within 1 year (Bodnar et al. 1998);

Programa de Pós-Graduação em Controladoria e Contabilidade Consequently, an unrealized gain on a cash flow hedge implies that the price of the underlying hedged item moved in a direction that will negatively affect the firm’s profits after the hedge expires; Similarly, a loss implies that prices moved in a direction that will positively affect the firm’s profits after the hedge expires: Introduction

Programa de Pós-Graduação em Controladoria e Contabilidade Prior research provides evidence that unrealized gains/losses on cash flow hedges are negatively associated with future gross profit and cash flows and that investors’ expectations, as reflected in stock prices, do not appear to anticipate this association (Makar et al. 2013; Campbell 2014); A common approach to mitigate this concern is to investigate whether professional investment intermediaries who specialize in interpreting accounting information (i.e., sell-side analysts) fail to incorporate the relevant accounting information into their expectations of future earnings (Bradshaw et al. 2001); Thus the first question the study examines is the extent to which financial analysts correctly incorporate cash flow hedge information into their forecasts of future earnings; The second question the study examines is whether voluntary disclosure by management helps analysts to more correctly incorporate cash flow hedge information into their forecasts; Introduction

Programa de Pós-Graduação em Controladoria e Contabilidade Hutton et al. (2012) find that managers exhibit an information advantage over analysts (i.e., provide more accurate forecasts) when incorporating firm-level information, while analysts exhibit an information advantage over managers when firm performance is more closely related to macroeconomic factors; Cash flow hedges are an interesting setting in which to examine the information dynamics between managers and analysts because these hedges relate to the firm-level effects of macroeconomic price movements in interest rates, commodity prices, and foreign currency exchange rates; Campbell (2014) shows that the accounting requirements under SFAS 133 result in unrealized cash flow hedge gains/losses providing a firm-specific summary measure of the likely aggregate effect of current price changes across all the firm’s underlying hedged items; Given this complexity, managers should be in a unique position to know how current changes in underlying prices will map into their firm’s future profits; Introduction

Programa de Pós-Graduação em Controladoria e Contabilidade Therefore, the study examines whether the association between cash flow hedge information and analysts’ earnings forecast errors is weaker when firms issue management earnings forecasts; Cash flow hedge disclosures are incomplete and costly for users to process because they: (1)are presented in disaggregated and inconsistent forms across several footnotes; (2)fail to specify when the hedges will be reclassified into earnings; and (3)fail to provide fair value changes for the underlying transactions that are hedged (Bloomfield 2002; Hirshleifer and Teoh 2003; Campbell 2014). Both the SEC and the FASB have recently taken positions suggesting that investors may not fully impound the implications of unrealized cash flow hedging gains and losses into firms’ stock price (SEC 2008; FASB 2009, 2011); Introduction

Programa de Pós-Graduação em Controladoria e Contabilidade The authors are the first to examine whether sophisticated users incorporate the information conveyed by unrealized cash flow hedging gains/losses and offer several important results; First, they find that unrealized cash flow hedging gains and losses are negatively related to analyst forecast errors in the subsequent 2 years - this result suggests that sophisticated investors fail to fully incorporate cash flow hedge information into their forecasts of profitability; Second, they find that when managers provide forecasts of earnings, unrealized cash flow hedging gains and losses are no longer associated with analyst forecast errors - this is consistent with the notion that management forecasts improve disclosures to the point where analysts can appropriately reflect cash flow hedging into their forecasts; Finally, for the subset of firms without management forecasts, analysts correct their forecast errors after the cash flow hedges largely expire (i.e., in about 1 year), and that the mispricing corrects itself at that time. Introduction

Programa de Pós-Graduação em Controladoria e Contabilidade Collectively, these results suggest that investors either rely on analyst forecasts to correctly price the cash flow hedge information, or make the same errors as analysts when predicting firms’ future profitability in the absence of forward- looking disclosures from management; Overall, their results suggest that even sophisticated investors have difficulty processing the information provided by unrealized cash flow hedging gains and losses, and that this problem can be mitigated for both analysts and investors if managers voluntarily provide more transparent, complete, and forward-looking derivatives disclosures; The authors, then, provide evidence that this mispricing is not likely to be explained by an unidentified risk factor or unknown research design flaw by showing that: (1)unrealized cash flow hedge gains/losses are negatively associated with sophisticated investors’ forecast errors; and (2)investors correct the mispricing during the same time periods when analysts correct their forecast errors (Kothari 2001; Bradshaw et al. 2001). Introduction

Programa de Pós-Graduação em Controladoria e Contabilidade The derivative position (i.e., a hedge tied to jet fuel prices) follows a ‘‘fair value’’ model whereby unrealized gains/losses are currently reflected in the financial statements; However, the future transaction that is being hedged (in this case, the future purchase of fuel) follows a historical cost model whereby the transaction is neither recorded nor disclosed until the transaction occurs; In theoretical work, Hirshleifer and Teoh (2003, p. 380) predict that the mixed attribute reporting model for cash flow hedges is likely to make it difficult for investors to understand that current unrealized cash flow hedging gains and losses will be offset by an opposite (and unreported) gain/loss on the underlying hedged transaction; The authors test these theoretical predictions and are the first to provide evidence that a fair value accounting model combined with a lack of transparent and complete disclosure requirements leads to a mispricing of accounting information—even for sophisticated investors; Background and motivation

Programa de Pós-Graduação em Controladoria e Contabilidade Importantly, the authors also show that the mispricing is reduced when managers provide voluntary disclosures; This study provides evidence that regulators could keep the mixed attribute model while mitigating any associated mispricing if they require managers to provide more transparent, complete, and forward-looking disclosures surrounding their cash flow hedges; Specifically, the results imply that mispricing is attenuated when managers provide disclosures about when the firm’s cash flow hedges expire and the proportion and price at which they protect future transactions with the underlying hedged item; They extend this result by finding that, when firms complement mandatory disclosures with voluntary disclosures, investors can anticipate the implications of cash flow hedges; FASB is currently debating the nature of items that firms should include in OCI considering that the investors would benefit from improved presentation and disclosure of the cash flow hedge component of OCI. Background and motivation

Programa de Pós-Graduação em Controladoria e Contabilidade Sample The sample begins in 2001 because that is the year that SFAS 133, which governs the accounting for cash flow hedges, was adopted; The sample period ends in 2008 because the authors require each firm-year to have a corresponding t + 1 (2009), t + 2 (2010), and t + 3 (2011) consensus analyst earnings forecast; The information on unrealized cash flow hedging gains/losses requires firm footnote disclosures, thus they use the first forecasts issued after the filing of the 10-K to ensure analysts have access to the necessary information on cash flow hedges; They also require the sample to have a non missing, nonzero value of cash flow hedge activity reported in AOCI (i.e., with nonzero Compustat Item AOCIDERGL) and total assets; They eliminate firm-year observations that do not have an industry classification, as well as firms in the financial services industries; The final sample size consists of 2281 firm-year observations covering the years 2001–2008.

Programa de Pós-Graduação em Controladoria e Contabilidade Sample

Programa de Pós-Graduação em Controladoria e Contabilidade Sample

Programa de Pós-Graduação em Controladoria e Contabilidade Hypothesis and statistics Hypothesis 1: analyst forecast errors for future earnings are negatively associated with unrealized cash flow hedging gains/losses; Hypothesis 2: the association between analyst forecast errors and unrealized cash flow hedging gains/losses is weaker when management issues a forecast.

Programa de Pós-Graduação em Controladoria e Contabilidade Hypothesis and statistics Before formally test H1 and H2, they must first confirm that an association between unrealized cash flow hedging gains and losses and future earnings holds for the sample of firms, so they model the change in earnings as a function of prior period’s change in earnings and the variable of interest and estimate the following pooled, ordinary-least-squares (OLS) model: The authors include six additional control variables in the model: a control variable for firm size, LMVAL (Fama and French 1995), for whether the firm has a Big 4 auditor, AUDITOR (Behn et al. 2008), for firm growth opportunities, MKBK (Fama and French 1995), for whether the firm reports a loss, LOSS (Hayn 1995), for the change in net income from time t - 1 to time t, SURPRISE (Lang and Lundholm 1996) and for the standard deviation of the prior 12 quarters of earnings, EARNVOL (Kross et al. 1990).

Programa de Pós-Graduação em Controladoria e Contabilidade Hypothesis and statistics

Programa de Pós-Graduação em Controladoria e Contabilidade Conclusion The authors provide evidence that, similar to investors, sophisticated information intermediaries (i.e., financial analysts) have difficulty processing the information provided by unrealized cash flow hedging gains and losses; On the other hand, this problem can be mitigated for both analysts and investors if managers voluntarily provide more transparent, complete, and forward-looking disclosures; These findings are timely given the recently expressed concerns by the SEC and FASB that the accounting model for cash flow hedges may confuse investors across periods; The results also suggest that analysts and investors would benefit from improved disclosures; However, as with any analyst forecast study that requires 3-year-ahead earnings forecasts, the authors are limited to a relatively small sample of firms; Second, although the results imply that analysts and investors would benefit from improved forward-looking disclosures for cash flow hedges, they do not examine whether the costs associated with such disclosures.