Commercial banks and value relevance of derivative disclosures after SFAS 133: Evidence from the USA

In the last decade there has been a significant increase in the use of derivatives as a vehicle to manage financial risk. The sudden spurt of derivatives has resulted in the Financial Accounting Standards Board (FASB) being forced to develop new standards for quantification and disclosure. The financial standard of interest to this study is Statement of Financial Accounting Standards (SFAS 133). SFAS 133 requires all derivatives, without exception and regardless of the accounting treatment for the underlying asset, liability, or transaction, to be recognized in the balance sheet as either liabilities or assets. SFAS 133 entitled Accounting for derivative activities and hedging (and SFAS 137, which postponed the implementation of SFAS 133 until June 2000) is different from prior standards in that it requires recognition as opposed to mere disclosure in the notes. The justification given for implementing SFAS 133 was to increase transparency to investors. In this study we empirically investigate this issue with particular focus on whether SFAS 133 provides incremental information above that provided by reported earnings, book value, and proxies for omitted variables. We study commercial banks since they are among the most frequent users of large-scale derivative contracts and their use has increased significantly over the last two decades, and in particular over the last five years. Our findings indicate that information regarding total derivative contracts, when disclosed in the financial statements as required by SFAS 133/137, is value relevant to investors. However, investors view this information negatively, perhaps attributing this to higher risk. Losses on holding derivatives are viewed positively and gains are viewed negatively.