Does the Accounting Hedge Ineffectiveness Measure under SFAS 133 Capture the Economic Ineffectiveness of a Firm’s Hedging Activities?

A key criterion for applying hedge accounting under SFAS 133 is the demonstration of hedge effectiveness. Retrospective assessment of hedge effectiveness may reveal hedge ineffectiveness – the extent to which a gain (loss) on the hedging derivative is not offset by a corresponding loss (gain) on the hedged item. SFAS 133 requires that this accounting measure of hedge ineffectiveness be reported in current period earnings. This paper examines whether the SFAS 133-mandated accounting measure of hedge ineffectiveness captures the economic ineffectiveness of a firm’s hedging activities. We find that, among hedge accounting users, firms reporting large hedge ineffectiveness gains/losses have (1) greater risk exposure to changes in interest rates and commodity prices, (2) higher forward-looking, market-implied default risk, and (3) higher implied cost of equity capital than those reporting small hedge ineffectiveness gains/losses. Our findings suggest that the accounting hedge ineffectiveness measure mandated by SFAS 133 is informative about the effectiveness of a firm’s risk management activities and thus is useful to financial statement users for assessing the firm’s underlying risk and the effectiveness of its risk management activities. Our findings also imply that standard setters should continue to require the disclosure of hedge ineffectiveness gains/losses.