In a forthcoming issue of the Journal of Accounting Research, I co-author a study (titled “Fair Value Accounting and Managers’ Hedging Decisions”) that investigates how fair value accounting affects managers’ real economic decisions.

The controversial impact of fair value accounting has been long debated, and the recent financial crisis further accentuates opponents’ concerns on its role in inducing volatility and market turmoil. However, there has been little empirical evidence on whether managers’ real economic decisions are actually adversely affected by fair value accounting. Using a context of risk management, we investigate whether fair value measurement of derivatives adversely influences managers’ hedging decisions. Our primary findings are that fair value accounting measurement causes managers to consider more accounting factors relative to economic factors, which in turn result in suboptimal hedging decisions. This effect is more likely when the price volatility is higher than when it is lower. We also propose two remedies to this effect.

In our study, we conduct two experiments using experienced accountants as participants. They were asked to make hedging decisions after reading a case material on hedging. In the first experiment, some participants were shown only the economic impact of hedging, while others were shown both the economic and accounting impact of hedging. The economic impact was positive, but the accounting impact indicated increased earnings volatility arising from the hedging decision. At the same time, we also varied the price volatility of the hedged asset—the price volatility was low in one instance, but high in another. In addition, we included a control condition where participants were provided with information on both the economic and historical cost accounting impact when price volatility was high and further told to assume that the company applied historical cost accounting to recognize derivatives. We found that participants were more likely to forgo economically sound hedging opportunities when both the economic and fair value accounting impact information was presented than when only the economic impact information was presented, or when both the economic and historical cost accounting impact information was presented. This adverse effect of fair value accounting was more likely when the price volatility of the hedged asset was higher—paradoxically, this was a situation where hedging was more beneficial. We also found that the effect was mediated by participants’ relative considerations of economic factors versus accounting factors (e.g., earnings volatility).

We conducted a second experiment to investigate the effectiveness of two simple debiasing mechanisms — altering the salience of accounting versus economic impact, and separately presenting net income not from fair value remeasurements — to mitigate any adverse impact of fair value accounting on managers’ decisions. In the experiment, we held constant the price volatility as high and provided the information on both the economic and accounting impact before asking for participants’ hedging decisions. We manipulated two presentation formats: 1) whether the economic impact information was presented first followed by accounting impact information, or the reverse order; and 2) whether the net income not from fair value remeasurements was reported in a separate column. The findings of the second experiment showed that notwithstanding managers’ concerns about the accounting impact of hedging, their propensity to hedge was increased by making them attend to the economic impact of hedging prior to their decisions, or by separately presenting net income not arising from fair value remeasurements.

The results of this study should be of interest to standard setters in their debate on the efficacy of fair value accounting. The study provides empirical evidence that, despite substantial economic benefits, managers actually abstain from hedging the risk because of their concerns over the fair value accounting impact (e.g., increased earnings volatility) and this effect of fair value accounting is magnified when price volatility of the hedged asset is higher. Our findings about the potential remedies to the negative effect of fair value accounting on managers’ hedging decisions should also be informative to managers and regulators.