Financial derivatives: New instruments for earnings management

The Securities and Exchange Commission has criticized earnings management---an effort among public firms to use financial derivatives to smooth earnings paths, transferring risk and volatility from one party to another. The problem is that little empirical research has been conducted on the impact of such derivatives on earnings volatility. The purpose of this study was to examine whether firms smooth earnings through financial derivative transactions and/or discretions in the accounting treatment of derivatives. Public firms have been reporting steady earnings growth since 1997. The research questions focused on whether these reported earnings represented real economic earnings, whether earnings have been smoothed by derivatives transactions, and whether accounting standards adequately report gains and losses from such derivatives. A regression-based causal comparative study of earnings volatility patterns with and without derivative use over the past ten years showed that firms with derivative use have lower earnings volatility (n = 500). This study also revealed the weakness in current accounting standards that allowed firms to transfer earnings volatility from one accounting period to another, resulting in smoother earnings pattern over time. These results could make a positive social contribution by providing new information that could be used to establish appropriate accounting standards to improve the quality of our financial reporting system.