Use of derivatives as hedging instruments and market pricing of earnings*

This study examines the market pricing of the association between the use of hedging derivatives and income persistence. This study also investigates whether the market pricing before and after the adoption of International Financial Reporting Standards (IFRS) is different. Examining 1,229 firm-year data hedging with derivatives for the period from 2004 to 2014, we find that market participants misprice the effect of the use of hedging derivatives on accrual persistence. The results are consistent with the concern that economic and financial reporting complexities of derivatives and insufficient disclosures on hedging activities harm understandability of financial information, although the use of hedging derivatives increases income persistence. However, the Korean adoption of IFRS made the accrual anomaly stemmed from the use of hedging derivatives dissipate. The results are attributed to more extensive and transparent disclosure rules of IFRS on derivatives and risk management. This study contributes to the studies on the relationship between accounting and disclosure quality and accrual anomaly. While the functional fixation hypothesis ascribes the mispricing of accruals to the limited attention and judgement error of information users, our results suggest that the supply side of information plays a significant role.