Walden University

COLLEGE OF MANAGEMENT AND TECHNOLOGY

This is to certify that the doctoral dissertation by

Guy W. Lin

has been found to be complete and satisfactory in all respects,

and that any and all revisions required by
the review committee have been made.
Review Committee
Dr. Robert T. Aubey, Committee Chairperson,
Applied Management and Decision Sciences Faculty
Dr. William H. Brent, Committee Member,
Applied Management and Decision Sciences Faculty
Dr. Ruth Maurer, Committee Member,
Applied Management and Decision Sciences Faculty

Chief Academic Officer

Denise DeZolt, Ph.D.

Walden University
2008

ABSTRACT

Financial Derivatives: New Instruments for Earnings Management

by
Guy Wan Jia Lin

M.B.A., Lincoln University, 2001

B.S. Pacific University, 2000

Dissertation Submitted in Partial Fulfillment

of the Requirements for the Degree of

Doctor of Philosophy
Department of Applied Management and Decision Science

Walden University
June 2008

ABSTRACT
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.

Financial Derivatives: New Instruments for Earnings Management

By

Guy Wan Jia Lin

M.B.A., Lincoln University, 2001

B.S., Pacific W University, 2000

Dissertation Submitted in Partial Fulfillment

of the Requirements for the Degree of

Doctor of Philosophy
Department of Applied Management and Decision Science

Walden University
June 2008

3320688

2008

3320688

ACKNOWLEDGMENTS
I wish to thank my dissertation committee chair Dr. Robert Aubey, and members,
Dr. William Brent and Dr. Maurer. Dr. Aubey has been a great mentor who has been
teaching me how to perform scientific research and a lot more. I could not have completed
this dissertation without his continuous mentoring. I also wish to thank Dr. William Brent,
who has been teaching me a lot about research methodology. Thanks also go to Dr. Maurer,
who helped me to stay on the right track since my dissertation process began.

ii

TABLE OF CONTENTS

LIST OF TABLES............................................................................................................ vii

LIST OF FIGURES ......................................................................................................... viii
CHAPTER 1: INTRODUCTION TO THE STUDY...........................................................1
Introduction....................................................................................................... 1
Problem statement............................................................................................. 2
Significance of the study................................................................................... 4
Purpose of study................................................................................................ 3
Method of study ................................................................................................ 5
Definition of terms............................................................................................ 6
Limitations and delimitations ........................................................................... 7
CHAPTER 2: LITERATURE REVIEW .............................................................................9
Research design in earnings management ...........................................................................9
Earnings management incentives.......................................................................................12
Earnings management through GAAP discretions ............................................................14
Earnings management through cash flow ..........................................................................15
Derivatives and earnings management ..............................................................................16
Derivatives and hedging ....................................................................................................18
iii

Derivatives and FAS 133 accounting discretion................................................................19

CHAPTER 3: RESEARCH METHODOLOGY ...............................................................22
Research design .................................................................................................................22
Hypothesis development....................................................................................................23
Sample and Variables ........................................................................................................26
Population and sample .......................................................................................................26
Grouping Criteria ...............................................................................................................27
Data Collection ..................................................................................................................28
Variable specification ........................................................................................................28
Earnings smoothness..........................................................................................................28
Reclassified derivative gains (losses) ................................................................................29
Method of inquiry ..............................................................................................................29
Descriptive statistics ..........................................................................................................30
t-test

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Simple regression...............................................................................................................31
Multi-variate regression .....................................................................................................31
iv

Control variables: Multi-variate regression .......................................................................32

CHAPTER 4: RESEARCH RESULTS .............................................................................36
Sample statistics.................................................................................................................32
t-test Earnings volatility comparison ..............................................................................32
F-test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Simple regression...............................................................................................................32
Multivariate regression ......................................................................................................32
Control variables................................................................................................................62
CHAPTER 5: SUMMARY, CONCLUSION, AND RECOMMENDATIONS ...............49
Interpretation of findings ...................................................................................................49
Hypothesis 1.......................................................................................................................49
t-test . .. . ...........................................................................................................................49
Operating earnings volatility..............................................................................................49
The power of derivatives Transfer of volatility ............................................................497
Hypothesis 2.......................................................................................................................82
FAS 133 Accounting for Derivatives ................................................................................86
v

Control variables................................................................................................................91
Conclusion .........................................................................................................................92
REFERENCES ..................................................................................................................73
APPENDIX........................................................................................................................73
CURRICULUM VITAE....................................................................................................80

vi

LIST OF TABLES
Table 1. Descriptive Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Error!
Bookmark not defined.49
Table 2. t-test General Linear Model: EV versus DU . . . . . . . . . . . . . . . . . . . . . . . . . 51
Table 3. One-way ANOVA: EV ReGroup versus DU-ReGroup . . . . . . . . . . . . . . . . 53
Table 4. t-test of operating earnings volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Table 5. Regression Analysis: Earnings versus ReClass . . . . . . . . . . . . . . . . . . . . . . . 58
Table 6. Regression: Earnings versus Reclass, Operating Earnings, PME . . . . . . . . . .60
Table 7. Regression: PME versus ReClass . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Table 8. Regression Analysis: ES vs OCF, TA, DeriUse . . . . . . . . . . . . . . . . . . . . . . 62

vii

LIST OF FIGURES
Figure 1. Boxplot of EV by DU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Figure 2. Histogram of Earnings Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . 41
Figure 3. Histogram of Earnings Volatility Regrouped . . . . . . . . . . . . . . . . . . . . . . . 43
Figure 4. Histogram of Operating Earnings Volatility . . . . . . . . . . . . . . . . . . . . . . . .45

viii

CHAPTER 1:
INTRODUCTION TO THE STUDY
Introduction
Financial Accounting Standards Board (FASB) (1978) defined financial reporting
as a principal means of communicating financial information to those outside an entity.
According to Jonas and Blanchet (2000), good financial reporting standards ensure that
financial statements clearly reflect the real economic condition and performance of the
entity; thereby reducing information asymmetry between managers and external users who
rely on the financial statements to make investment decisions.
Generally Accepted Accounting Principles (GAAP) permit firms to exercise
discretion in financial reporting to convey managers information about performance.
GAAP discretions include whether to disclose, when to disclose, and how to disclose
information (McKee, 2005). Accounting standards for financial derivatives are still in the
early stage, which cannot cover all aspects of the complex financial derivatives
(International Monetary Fund Country report No 05/216). FAS 133 Accounting for
Financial Derivatives and Hedging Activities(FAS 133) requires all financial derivatives
be reported at their fair value. The changes in fair value will be recognized as earnings or
deferred to future periods to offset the changes in the value of items being hedged. The
FAS 133 standards provide discretions for earnings management (Singh, 2004). The
determination of the fair value of most derivative instruments are subject to assumptions,
especially if the derivatives are not actively traded in the market. Most derivative
instruments are simply contracts between a derivative dealer and the user firm, such as

2
interest rate swaps (Dubofsky, 2003). They are not actively traded in the market. So the fair
value of such instrument has no market reference. When the financial derivatives are used
for hedging future losses, the gains or losses realized on such derivatives must be deferred
to future periods in which the items being hedged affect earnigns. The deferred derivative
gains to be reclassified into current earnings are also subject to firms discretion. It is up to
the firm to determine how much losses are being realized from the items being hedged.
However, under FAS 133 the losses of the items being hedged do not need to be reported
separately. Investors have no way to verify firms discretion.
Problem statement
According to Wallison & Hassett (2004), earnings management is possible for two
main reasons. First, the GAAP does not address all possible situations. Thus, the
accounting standards must have some flexibility to allow the standards to keep up with
changes in business practices. Second, even in areas where GAAP provides a framework of
accounting rules, managers may still have some choices over how GAAP is applied.
The growth of the financial derivatives market has increased from $98 trillion in
2000 to $270 trillion in 2005. Public firms are primary users of financial derivatives
because derivatives can be used to hedge risks and reduce expenses, thus improving
earnings (GAO Report, 1996, p. 14). Most firms in the S & P 500 index have reported
smoothed earnings since 1997. The problem is that little empirical research has been
conducted on the impact of such derivatives on earnings volatility. Since financial
derivative instruments can transfer the volatility of earnings from one firm to another,
investors may ask if the reported earnings representing the real economic earnings of these

3
firms. Do firms that use financial derivatives in their daily operations result in smoother
earnings patterns? How do firms manage their earnings with financial derivatives, both
through real transactions and discretions available under current accounting standards?
Congress and accounting standards setters remain uneasy about the misuse of derivative
instruments and the potential consequences that might flow from the default by a major
dealer, and improper accounting treatment of such derivatives (Financial Economists
Roundtable, 1994).
Purpose of study
The purpose of this study is to examine whether or not firms manage earnings
through real financial derivative transactions and/or discretions in the accounting treatment
of derivatives under the Financial Accounting Standard Board Statement 133, Accounting
for Financial Derivatives and Hedging Activities. Firms can use derivatives to reduce the
volatilities of earnings and cash flows arising from changes in interest rates, foreign
exchange rates, commodity prices, and credit risks.
This study will include a test of earnings management practice by misclassification
of derivative gains (or losses) under FAS 133. This issue has important policy implication
in light of Securities and Exchange Commission's (SEC) expressed concern about earnings
management (Levitt, 1998). If the outcome of this study can provide evidence that firms
tend to misclassify derivative gains (or losses), accounting standards setters can improve
the reporting requirements under FAS 133.

4
Significance of the Study
Prior research relied on accounting accruals to detect earnings management (Jones,
1991; DeGeorge, Patel, & Zeckhauser, 1999; and Barton, 2001). After the Sarbanes-Oxley
Act of 2002 (SOX), accrual tests found virtually no evidence in support of earnings
management (Kothari et al., 2005; Lobo & Zhu, 2006, Nissim & Penman, 2003). A survey
by the National Investor Relations Institute found that more and more public firms have not
published earnings forecast guidance since 2005. According to Cohen, Dey, & Lys (2004),
the earnings management incentives of meeting analyst forecasts have no ground.
For earnings management, this study differed from prior research in two ways.
First, this study viewed earnings management as part of a firms ongoing operating
activities, while prior studies considered firms engaging in earnings management on
special events. For example, a violation of debt covenants (DeChow & Skinner, 2000), a
change in tax laws (Mills & Newberry, 2001), or management bonus incentive. Second,
this research studied earnings management without considering accounting accruals, while
prior studies focused on accounting accruals. This study ignored accounting accruals for
two reasons. According to Nissim and Penman (2003), after SOX, the accruals model
cannot detect earnings management. Cohen et al. (2004) also concluded that firms tend to
use real financial transactions instead of accounting accruals in smoothing earnings.
This research improved upon previous research by studying earnings management
with respect to real financial transactions, rather than accounting accruals. No studies have
been done on earnings smoothing by real financial transactions. The hypothesis of this
study is that firms are managing earnings by using derivatives real transactions, and

5
discretions under FAS 133. The hypothesis posits that firms with derivative use will have
smoother earnings patterns relative to firms without derivative use. This study will
investigate this hypothesis by studying the relationship between derivative use
(independent variable) and the smoothness of earnings (dependent variable). Earnings
smoothness will be measured by the standard deviation of the changes in past earnings, as
described in chapter 3.
Although FAS 133 provided a framework for disclosure and reporting of financial
derivative transactions, FAS 133 does not cover all aspects of the growing complexity of
financial derivative transactions. With the mandatory adoption of FAS 133, research has
yet to present the impact of FAS 133 on earnings management activity of firms. Therefore,
this study will extend prior research in the earnings smoothing through derivative
instruments and present new evidence on the discretion available under FAS 133 for
earnings smoothing. If there is evidence of the magnitudes, frequencies, and directions of
earnings management, regulators and accounting standard setters could exercise
appropriate measures or actions to assure more transparent financial reporting.
Method of study
This study used a quantitative causal-comparative approach to assess whether
observed derivatives are consistent with the smoothness of earnings. The
causal-comparative analysis is based on identifying firms in the position to engage in
various forms of financial derivatives and examining the earnings smoothness of such
firms versus that of the firms without derivative use. Because the data used in this study are
from the published financial statements of the sample firms, experiment and manipulation

6
of data are not possible. Hence, a causal-comparative approach may be the best method of
study. The research questions are as follows: (1) are public firms using derivatives to
smooth earnings? (2) are public firms manipulating accounting standards for derivatives?
Hypotheses 1 and 2 are as follows:
H1: Firms use financial derivatives to smooth earnings. In other words, firms with
derivative use have smoother earnings (lower earnings volatility) than firms
without derivative use.
H01: There is no difference in earnings volatility whether firms use derivatives or
not.
H11: Firms that use financial derivatives have lower earnings volatility (smoother
earnings).
H2: Firms use reclassification of deferred derivative gains (losses) as a means to
smooth earnings.
Definition of Terms
Accounting accrual: This is defined as the difference between operating earnings
and operating cash flow, which represents the element of earnings subject to management
discretion under the generally accounting principles (GAAP). (Barton, 2001).
Derivative: A financial contract whose value is derived from the price of another
asset, the underlying asset. (Dubofsky, 2003).
Earnings: Reported earnings before extraordinary items, which represents the
earnings of a firm after all expenses, income taxes, and minority interest, but before

7
preferred dividends, extraordinary items, and discontinued operations (Philbrick and
Ricks, 1991).
Earnings management: According to the Securities and Exchange Commission,
earnings management is an effort to satisfy consensus earnings estimates and project a
smooth earnings path (Levitt, 1998, p. 12). Earnings management is defined in the
accounting literature as distorting the application of generally accepted accounting
principles. (DeChow et al. (2003).
Earnings smoothing: A special case of earnings management, it attempts to make
earnings look less variable through time (DeChow, Richardson, & Tuna, 2003). This is
consistent with SECs definition of earnings management.
Hedging: This involves taking a derivative position that results in a gain (loss) in
the contract and a loss (gain) in the asset or liability. (Dubofsky, 2003).
Operating cash flow: As defined by FASB (Financial Accounting Standards
Board), this is the cash generated by the operation of business. (DeChow et al. (2003).
Operating earnings: The earnings from continuing operations of a business.
(DeChow et al. (2003).
SOX: Sarbanes-Oxley Act of 2002.
Limitations and Delimitations
The limitation of this study was the lack of randomness in sample selection. The
results from sample firms in the S&P 500 index may not generalize to other firms,
especially nonpublic firms.

8
The key points of investigation of this study included: (a) whether financial
derivatives transactions can result in smoother earnings, and (b) whether firms use
discretions provided by FAS 133 to manipulate the deferred derivative gains (losses) to
smooth current earnings. The rest of the proposal is organized into two chapters. Chapter 2
is the literature review. Chapter 3 includes hypothesis development and research
methodology.
Social Change
The growth of financial derivatives has changed the way public firms report
earnings. Current accounting standards for such derivatives could not cover the complexity
of derivatives, especially those exotic derivatives. The way and timing of the inclusion of
derivatives gains and losses in the reported earnings can be a weakness in the current
accounting standards for derivatives. Investors are questioning whether the reported
earnings of public firms have been manipulated by the gains or losses from such financial
derivatives. For example, during the sub-prime mortgage bubble, home owners default
risk was substantially under estimated. The value of derivatives on such mortgages was
significantly overstated, resulting in a series of huge losses reported in 2007 by large firms
holding such derivatives.
In order to regain public confidence in the investment community, accounting
standards must be updated to catch up with the complexity of derivatives to minimize the
possibility of misuse of them and improve the quality of our financial reporting system.

9
CHAPTER 2:
LITERATURE REVIEW
Earnings management means manipulating reported earnings so that they do not
accurately represent economic earnings at every point in time (McKee, 2005). Earnings
smoothing is a special case of earnings management that involves making earnings look
less variable through time (DeChow et al., 2003). Jin (2005) found evidence that earnings
management has always existed.
Earnings smoothing is extensively documented (Bannister & Newman, 1996;
Beidlerman, 1973; Subramanyam, 1996; and Moses, 1987). Collingwood (2001) took an
in-depth look at earnings smoothing, examining the intricacies of the earnings game and
why companies believe they have no choice but to play it. Until more corporate
executives change their practices, the earning game will never lack for players
(Collingwood, 2001, p. 68).
Research design in earnings management
Prior research on earnings management used two research designs: those based on
accounting accruals (aggregate accruals, Jones 1991; or specific accruals, DeGeorge et al.
1999) and those based on the statistical distribution of earnings after management
(Burgstahler & Dichev 1997). The first design, also called the accrual model, is used in
earnings management literature. Jones (1991) carried out a study by establishing the
normal accruals of a company and comparing the actual accruals with the normal accruals.
A difference may therefore be evidence that earnings management is taking place.

10
The advantage of this design was that earnings management can be detected easily.
The disadvantage was that accrual models (aggregate and specific) had no theoretical
background. They can not reliably reflect the exercise of discretion. Nissim and Penman
(2003) and Kothari (2005), also claimed that Joness (1997) model and DeGeorges (1998)
model, also called the modified Jones model, could not detect earnings management after
SOX. Cohen et al. (2004) found evidence of a decrease in accruals after the introduction of
SOX in 2002. Lobo and Zhou (2006) examined changes in discretionary accruals
following SOX. SOX imposed considerably greater potential penalties on chief executive
officers and chief financial officers; therefore, risk-averse managers are likely to be more
conservative in their financial reporting, and report lower discretionary accruals following
SOX because firms with earnings manipulation by excessive accruals could face the risk of
being sued by the SEC.
Empirical findings suggested that accruals models that do not consider long-term
earnings growth are potentially mis-specified and can result in misleading inferences about
earnings management behavior. To date, the accruals literature has taken a black box
approach (undisclosed approach) to the factors that explain accruals. This causes it to be
extremely difficult to be confident that estimates of discretionary accruals capture
discretion by management and poses difficulty in evaluating research design choices for
earnings management research. Collins and Hribar (2000) provided an example of the gap
between empirical procedures and knowledge of the behavior of financial statement
numbers. The measurement error in discretionary accrual estimates can lead the researcher
to conclude that earnings management exists when it does not.

11
The second approach was to examine the statistical properties of earnings to
identify behavior that influences earnings, as developed by Burgstahler and Dichev (1997)
and DeGeorge et al. (1999). These are known as the earnings distribution model. These
studies focused on the behavior of earnings around a specified benchmark, such as zero or
a prior quarter's earnings, to test whether the incidence of amounts above and below the
benchmark are distributed smoothly, or reflect discontinuities due to the exercise of
discretion.
Burgstahler and Dichev (1997) also found discontinuity in the distribution of
reported earnings around zero and around last years earnings. DeGeorge et al. (1999) used
analysts forecasts as a threshold. They both suggested that if firms had greater incentives
to achieve earnings above a benchmark, then the distribution of earnings after management
would have fewer observations than expected for earnings amounts just below the
threshold, and more observations than expected for earnings just above the threshold. Their
empirical evidence bears this out, in that both studies found significantly more
observations than expected in the range above zero earnings, and in the range above the
prior period's earnings.
Gore et al. (2001) used 10,000 observations to study the distribution of earnings.
They found that fewer companies than expected reported earnings just below zero, and
more companies than expected reported earnings just above zero. Similarly, fewer
companies than expected reported earnings just below last years figure, and more
companies than expected reported earnings just above last years figure. Gore et al.

12
concluded that accruals were a significant part of the earnings management mechanisms
used to boost reported earnings so as to just achieve target.
The advantage of this method is that researchers can avoid the estimation of
discretionary accruals. The disadvantage is that researchers cannot tell the form and
magnitude of earnings management. A noteworthy feature of this design is that the power
of this approach comes from the specificity of their predictions regarding which group of
firms will manage earnings, rather than from a better measure of discretion over earnings.
(Barton 2001.)
The earnings distribution model provides a powerful tool to the earnings
management arsenal in that it identifies contexts in which a large number of firms appear to
manage earnings. The approach also provides an indication of the frequency of
manipulation, though this rests on an assumption about the distribution of earnings absent
earnings manipulation. Myers and Skinner (1999), in the spirit of the earnings distribution
model, tested whether the frequency of consecutive quarterly earnings increases was
greater than would be expected by chance, and found that it was. Furthermore, they
examined the correlation between cash flows and accruals for these firms and their use of
special items, to provide evidence on the ways these firms manage earnings.
Earnings management incentives
Economic theory demonstrated that equity value is equal to the present value of
expected risk-adjusted dividends, calculated using the term structure of risk-free interest
rates. Since interest rate risk can be hedged by using derivatives, the most important factor
that affects firm value is the future dividends (earnings). (DeChow et al. 2003).

13
Theoretically, higher and smoother earnings will increase dividends, and thus firm value.
Market imperfections can create an environment in which firms face economic exposure to
price risk (Dubofsky 2003). If earnings volatility is costly to a firm, then the firm has
incentives to reduce its exposures to risks by reducing the volatilities of its earnings.
Barth, Beaver, and Landsman (2001) examined the earnings management
incentives of public and private property and casualty insurance firms. The researchers
found that they both avoid losses. Similarly, Kasznik and McNichols (2002) provided
evidence indicating that firms that meet or beat analysts earnings forecasts consistently
were valued higher than firms that failed to do so. Bruns and Merchant (1990) provided
evidence that in practice, it appears that a majority of managers use at least some methods
to manage short-term earnings.
DeGeorge et al. (1999) hypothesized that firm managers had various incentives to
avoid reporting decline in earnings. In fact the theoretical value of a companys stock is the
present value of its future earnings. Increased earnings represent an increase in shareholder
value. Beatty, Ke, and Petroni (2002) also found that the number of publicly-held firms
reporting continuous increases in earnings per share was unusually high, and the number
was low in privately-held firms. They claimed the reason for this was that public firms
were more concerned about firm value, while private firms were more concerned about
their income taxes. Burgstahler and Eames (2003), DeGeorge et al. (1999), and Dechow et
al. (2003) showed the same empirical regularity of earnings smoothing. However, there is
little empirical evidence available to explain this pattern.

14
Trueman and Titman (1988) pointed out that high perceived earnings volatility
increases the perceived bankruptcy probability of the firm and its borrowing cost, thus
firms with low credit quality are charged by higher interest rate, so earnings smoothing is
cost-minimizing. By comparing the market valuation between firms with smoother
earnings and firms with volatile earnings, Chez and Fuentes (2004) proved that firms with
long-run income smoothing could yield higher stock returns and appear to carry a lower
risk associated with size and book to market factors.
A 2004 survey indicated that a majority of firms were willing to give up economic
value in exchange for smooth earnings. (Graham, Harvey, & Rajgopal, 2004). Hentschel
and Kothari (2003) claimed that earnings management could improve firm value. They
provided evidence that low earnings volatility would result in a lower cost of capital, a
greater demand on the firms shares, and a greater firm value. This is the main force that is
driving earnings management practice of managers. Their wish for stability of earnings
reporting far exceeds their desire for higher reported earnings.
Liu and Yao (2003) claimed that the market value was higher for earnings-stable
stocks than for earnings-volatile stocks. Based on their sample firms, from 1985 to 2000,
earnings-stable stocks significantly outperformed earnings-volatile stocks in returns.
McKee (2005) claimed that firms with lower earnings volatility were being valued higher
than firms with higher earnings volatility. However, given the current market volatility and
consumer uncertainty, Collingwood (2001) proved that there was no financial benefit for
earnings smoothing.
Earnings management through GAAP discretions

15
Tarpley (2003) argued that the GAAP gave discretions for firms to practice
earnings management. Based on a sample of 515 earnings management attempts obtained
from a survey of 253 auditors, Tarpley identified the patterns of earnings management and
the methods used by managers. However, extreme instances of earnings management
identified in SEC Accounting and Auditing Enforcement Releases (AAERs) are seldom
found after SOX. Lobo and Zhou (2006) examined changes in discretionary accruals
following SOX. They found that firms reported lower discretionary accruals after SOX
than in the period preceding SOX.
Earnings smoothing is still a common practice. According to Beresford, Chairman
(1987-97) of the Financial Accounting Standards Board (FASB), there is virtually no
standard that the FASB has ever written that is free from judgment in its application.
(Beresford, New York Times, June 1, 1997). Firms can determine the amount of deferred
derivatives gains or losses to be reclassified into current earnings.
Earnings management through cash flow
Few studies have been done on the manipulation of cash flows through real
financial transactions as a means to manage earnings. Tucker and Zarowin (2006) used a
new approach to decompose earnings into cash flows and accruals. They measured
earnings smoothing by the negative correlation of a firms change in accruals with its
change in pre-managed earnings.
According to Tucker and Zarowin (2006), the volatility of earnings is the
combination of the volatilities of cash flow and accruals. The following relationship is
valid:

16
Var(Earnings) = Var(Cash flows) + Var(Accruals) + 2Covar (Cash flow, Accruals)
(Tucker & Zarowin, 2006.)
Thus, managers can manage the volatility of earnings by either managing the
volatility of accruals or cash flow, or both. Consider a firm whose cash flow and earnings
are exposed to interest rate risk. Unexpected increase (or decrease) in interest rates will
increase (or decrease) the firms interest cost, and decrease (or increase) its earnings and
cash flow as a resulting of paying lower interest. (McKee, 2005).
According to McKee (2005), derivative transactions can alter cash flow of a
business, resulting in a change of earnings. Firms can time the derivative transaction to
alter the current earnings. For example, when additional earnings are needed, firms can
terminate a hedging derivative that carries an unrealized gain. Then, under GAAP, the
unrealized gain will be added to current earnings immediately. When it is necessary to
decrease current earnings, firms can terminate a hedging derivative that carries an
unrealized loss. Terminating a financial derivative can result in a stop of payment streams
under the derivative contract, thus altering cash flow.
Derivatives and earnings management
Financial derivatives use is widespread. It is particularly among large publicly
traded firms (GAO Report, 1996). According to Naor (2006), derivatives are commonly
used as hedging instruments. Derivative transactions, because of their complex and
obscure nature, attract attention from regulators, accounting standard setters and
researchers.

17
Large firms are the frequent user of derivatives. Mian (1996) proved that firm size
was positively related to derivative use. A survey by Bodnar, Gregory, Hayt, and Richard
(1996) indicated that over two-thirds of large U.S. firms used derivatives, and that almost
half of the respondents considered their most important hedging goal to be the smoothing
of cash flow volatility, followed closely by the smoothing of earnings volatility.
According to McKee (2005), earnings smoothing does not need to eliminate
earnings volatility, just reduce it. Derivatives can reduce risk, thus may result in more
stable earnings. For example, a firm has a variable-rate loan, and managers think that
interest rate will go up. To hedge the floating rate exposures, firms can enter into a
pay-fixed receive-variable interest rate swap.
Hentschel and Kothari (1999) suggested that measures of firm risk did not differ
statistically between users and nonusers of derivatives. Bodnar, Hayt, and Marston (1998),
reported that 66% of the firms in their sample timed their interest rate hedges based on their
view of what the interest rates would fluctuate in the future period. In other words, firms
engaged in selective hedging.
Although some researchers provided evidence suggesting that derivatives use is
consistent with incentives to hedge (e.g., Gczy, Minton, & Schrand, 1996), they did not
directly test whether the use of derivatives reduces earnings volatilities. According to
McKee (2005), derivatives offer many opportunities to manage earnings. Firms are free to
select the time at which a derivative contract is executed or terminated. The timing option
provides an opportunity to manage earnings. Barton (2001) claimed that firms with
derivative use were more likely to engage in earnings management. Karaoglu (2002)

18
proved that banks used gains from securitization of loans to smooth earnings. Shakespeare
(2002) also provided evidence that banks tended to smooth earnings by gains and losses
from securitization of loans.
Derivatives and hedging
Hedging involves taking a derivative position that results in a gain (or loss) to offset
a loss (or gain) in the asset or liability being hedged. According to Stulz (2003), by trading
off potential gains against potential losses, hedging will reduce the volatility of a firm's
earnings. Hence, derivatives provide a flexible and effective means to reduce the volatility
of cash flows and earnings.
Hedging is a common practice among public firms. According to Dubofsky and
Miller (2003), firms managers, stockholders and other stakeholders are risk-averse. It
would seem to make sense that taking steps to reduce risk would be an act desired by all
concerned parties. A survey by the International Swaps and Derivatives Association
(ISDA) showed eighty one percent of the respondents strongly agreed that managing
financial risk more effectively is a way for companies to build shareholder value
(Collingwood, 2001). Eighty four percent agreed that derivative is the most effective tool.
(A survey of finance processors views on derivatives, ISDA, March 2004). Loomis (1999)
also claimed that the number one job of management of public firms is to smooth earnings.
Hedging will certainly reduce risk, thus may result in more stable earnings.
Firms holding assets would hedge against the decline in the fair value of such
assets. Firms holding liabilities would hedge against the increase in the value of liabilities.
Firms having future cash flows would hedge against the decline in value of the net cash

19
flow due to increase in cost such as interest rate. These risks can all be hedged by financial
derivatives. Hedging the fair value of assets and liabilities is simple and straight forward.
However, all models used to determine the fair value of the derivative and the item being
hedged contain many assumptions, such as perfect market, stable volatility, prices follow
normal distribution, investors are wealth maximizers, etc. According to Dubofsky and
Miller (2003), the value generated by these pricing models is a theoretical value.
Hedging cash flows is more difficult to accomplish because the cash flow and the
hedging derivatives are not changing at the same rate. Thus the hedge is always not
effective. Derivative can not hedge both cash flow risk and fair value risk. For instance, a
firm may use derivative to hedge its loan portfolio against a rise in interest rates. Rising
(falling) rates will depress (strengthen) the fair value of the hedged portfolio.
Derivatives and innovative financial transactions serve legitimate business and
investment purposes. The ability to shift, substitute, or transfer risks through the use of
financial derivatives is an essential tool for modern business. In addition to their critical
role in risk management, derivatives also present a number of serious challenges for
financial reporting system. Derivatives are new, complex and not widely understood.
According to McKee (2005), earnings management through the manipulation of
derivatives is difficult to detect.
Derivatives and FAS 133 accounting discretion
Barton (2001) used the correlation between the notional amount and the hedge
ratios to show that derivative use captured basic attributes of hedging. Barton also showed

20
that derivative users tended to have less volatile operating cash flows and total accruals
than nonusers.
Pincus and Rajgopal (2002) concluded that managers of oil and gas producing
firms first determined the extent to which they would use derivatives to hedge oil price risk
and then managed earnings volatility by trading off discretionary accruals and hedging to
smooth earnings. While their results showed no evidence that the extent of hedging was a
significant determinant of hedging, they found the extent of hedging was a significant
determinant of the extent of smoothing. Nissim and Penman (2003) proved that firm value
was positively related with earnings and negatively related with interest rate. According to
Stulz (1996), derivative is the most powerful tool in reducing interest cost. Stulz pointed
out that hedging increased firm value only if managers believed they had informational
advantages.
Nissim (2003) provided evidence that banks tended to overstate the fair value of
their assets in an attempt to favorably affect the market assessment of their risk and
performance. FAS 133 is a major source of accounting discretions. Ciesielski (2006),
member of FASBs Emerging Issues Task Force, says: this is awfully counter-intuitive
for firms to show rising earnings when its debt-payment capacity is declining (Ciesielski,
CFO Magazine, September 1, 2006).
Theoretical underpinnings
Prior studies on earnings management focused on accounting accruals (Burgstahler
and Dichev, 1997 and DeGeorge et al. , 1999). But since the collapse of Enron and a series
of accounting scandals, SEC has imposed severe penalty on public firms misapplication of

21
accounting accruals. In fact, after the Sarbanes-Oxley Act of 2002, accounting accruals are
no longer used by public firms (Kothari et al., 2005; Lobo & Zhu, 2006, Nissim & Penman,
2003).) However, according to Mian (1996), public firms are major users of financial
derivative. McKee (2005) concluded that derivative transactions can alter cash flow of a
business, resulting in a change of earnings from one firm to another. So far, little research
has been done on earnings management via real financial transactions. The research
questions of this study focused on whether reported earnings represented real economic
earnings of public firms, whether such earnings have been smoothed by derivatives
transactions, and whether accounting standards adequately report gains and losses from
such derivatives. If Mckees (2005) theory is true, firms with derivative use should have
lower earnings volatility, because significant portion of earnings volatility can be
transferred to another firm (a financial derivative dealer or another firm) via derivative
contracts. This study used a regression-based causal comparative study of earnings
volatility patterns of two types of firms, one with derivative use and the other without. The
results were consistent to Bartons (2001) theory that financial derivatives can be a
substitute to accruals in terms of earnings management. This study added to the accounting
literature by examining the earnings smoothing activities of public firms through the use of
real transactions in financial derivatives.

CHAPTER 3:
RESEARCH METHODOLOGY
Research methodology utilized for detection of earnings management depends on
the question being asked. In this study, the main question is whether the improper use of
derivative instruments can help public firms render managed financial reports to investors
by using gains or losses from derivative instruments as a means for smoothing real
business earnings. The objective of the research focused on understanding whether
earnings are being managed in a given context, how they are managed, and the incentives.
As such, the researcher aimed to identify contexts where the incentives to manage earnings
are of interest and reliable, because one of the key factors in determining firm value is the
smoothness of earnings. Most firm value models are based on the volatility of a firms
earnings: the more volatile the earnings, the smaller the value of a firms stock. According
to Loomis (1999), the number one job of management of public firms is to smooth
earnings.
Further progress in earnings management research depends on ones ability to
understand the set of actions managers take to manage earnings. The practical relevance of
such an understanding is important both to regulators and investors.
Research design
This study used causal comparative design in analyzing the relationship between
derivative use and earnings smoothness of public firms. The basic causal-comparative
approach is to begin with a noted difference between two groups and then to look for

23
possible causes for, or consequences of, this difference. The causal-comparative study can
begin with subjects that differ on an independent variable and study how they differ on
dependent variables, or begin with subjects which differ on a dependent variable and study
how they differ on various independent variables. This study began with sample firms
which differ on the independent variable (derivative use) by separating the sample firms
into two groups: Group A with derivative use, and Group B without, and study how they
differ on the dependent variable (earnings smoothness).
This study was largely quantitative because earnings volatility was a quantitative
variable, and qualitative research may not be able to measure precisely the earnings
volatility and analyze how earnings volatilities differ between two groups. Given the
nature of earnings volatility between two groups of firms, a qualitative method might be
speculative. Other research methods, such as experiment may not be appropriate because
this study was essentially looking at the earnings published by public firms. The earnings
numbers can not be experimented.
Hypothesis development
The use of derivatives should result in smoother earnings. Therefore, to determine
if financial derivatives have any effect on earnings smoothing, this study proposes the
following hypotheses:
H01 : There is no difference in earnings volatility whether firms use derivatives or
not.
H11: Firms that use financial derivatives have lower earnings volatility (smoother
earnings).

24
H11 posits that firms with derivative use will have smoother earnings relative to
firms without derivative use. There are two ways of measuring earnings smoothness.
McKee (2005) used the standard deviation of past annual earnings. Damodaran (2004)
used the standard deviation of past earnings volatilities, that is, earnings volatility of a
given period is equal to the changes in earnings divided by the earnings in the previous
period.
According to Pincus and Rajgopal (2002), another way of measuring earnings
volatility is using the earnings-smoothing ratio (EMR) which is measured as the standard
deviation of operating cash flows divided by the standard deviation of operating earnings.
This study followed Damodaran (2004) and used the standard deviation of past
earnings volatilities as a measure of earnings smoothness (ES) because it tests the
smoothness of earnings, rather than directional predictions of earnings management.
Earnings smoothness measures how widely earnings are dispersed from the average.
This study measured earnings smoothness by the standard deviation of past
earnings volatilities for three reasons. First, previous earnings figure is considered a
threshold that firms use to manage current earnings. The earnings volatility captures a
firms effort in managing current earnings. This measure assumes that managers use
derivatives to smooth current earnings using previous earnings as a threshold. Second,
transactions in financial derivatives can be directly influenced by management; thus, the
ability to smooth earnings exists. Third, standard deviation can provide accurate measure
when the number of periods is 10 or more. This study used earnings data of 10 years to
measure earnings volatility for all sample firms.

25
This research tested whether the differences in earnings smoothness are due to
derivative use by dividing sample firms into two groups: Group A, including those with
derivative use, Group B, including those without derivative use. In the sample, it is
expected that earnings smoothness is higher (lower standard deviation in Group A than
Group B) in Group A as compared to Group B. If, during the sample years, firms in group
A are found to have higher earnings smoothness, then hypothesis 1 will be accepted.
If hypothesis 1 is true, then earnings management through derivative transactions
exists. This result may contrast the findings of Brown et al. (2003) that firms are not
successful in hedging risk with derivatives.
H02: Reclassified deferred derivative gains (losses) are not correlated with
reported earnings.
H12: Reclassified deferred derivative gains (losses) are negatively
correlated with reported earnings. Firms use reclassification of deferred derivative
gains (losses) to smooth earnings.
Theoretically, reclassified derivative gains should be offset by the same amount of
losses from the items being hedged. But, if firms manipulate the reclassification, the
reclassified amount should be positively associated with current earnings (reclassified
derivative gains can contribute to current earnings). To test this hypothesis, this study will
further divide Group A into two subgroups, A-1, firms with reclassified gains (losses), and
A-2, firms without reclassification. A simple regression analysis will be performed on
current earnings and reclassified derivative gains on subgroup A-1.

26
Following Beaver et al. (2000), this research performed multivariate regression
analysis on subgroup A-1 regressing reclassified derivative gains (losses) on earnings
difference (current earnings minus prior year earnings minus reclassified derivative gains)
and current operating earnings. The general model is as follows:
RDG = + 1 OE + 2 ED +

(1)

where RDG = reclassified derivative gains; OE = operating earnings; ED =

Earnings Difference.
In this regression model, the predictor variables were operating earnings and
earnings difference, the reclassified derivative gains as the response variable. The purpose
of this analysis is to show that firms use earnings difference and current operating earnings
as thresholds in determining the amount of deferred derivative gains (losses) to be
reclassified into current earnings. If the general least squares model shows adjusted R2 of
85% or higher, and p value of the reclassified derivative gains is less than 0.05, we can
conclude, with 95% confidence, that reclassified derivative gains are related to earnings
volatility.
Sample and Variables
Population and Sample
The lack of randomization is the weakness of causal-comparative studies. In
selecting the samples, researchers must base the selection on certain characteristics. Also
the samples are not randomly placed in groups; the groups can differ on other variables that
may have an effect on the dependent variable. Earnings smoothing practice of public firms

27
is the characteristic of the sample firms in this study. Sample firms which have reported
consecutive smoothed earnings pattern will be selected.

According to Tully (2007),

most firms in the S&P 500 index reported consecutive earnings growth for the period from
2002 to 2006. This study will select the S & P 500 firms, because they have the
characteristic of reporting smoothed earnings. In Standard & Poors annual report of 2006,
the S&P 500 securities represent approximately 80% of the total market value of all US
stocks.
Since firms have reported smoothed earnings since 1997, this study drew upon this
population the firms that had been in the S & P 500 from 1997 to 2006. Firms that were not
in the S & P 500 from 1997 to 2006 were not included. The sample size was 404 due to
changes in the component firms of the S&P 500 in the selected time frame.
Grouping Criteria
The annual reports of public firms were studied to detect their transactions in
financial derivatives. If the firm reported activities in financial derivatives, it was classified
as Group A, otherwise it was classified as Group B. Before 2000, derivative activities
should be reported in the footnotes of the annual report. After 2000, the gains and losses
from such derivatives must be reported as a separate item in the financial statements. The
footnotes and the derivative gains (losses) were used as criteria for grouping sample firms.
Sample size
Although the sample firms in this study represent approximately 80% of the total
market value of all US public companies, justification of the sample size is necessary.
According to SEC, about 6,000 public companies are in the United States as of 2006. We

28
select 500 from total population of 6000. Based on Rosners (1990) minimum sample size
formula, 8.33% resulted in a very narrow confidence interval of 0.076 to 0.09 and a very
small standard deviation of 0.04. So the sample size of S&P 500 public firms was justified.
Data Collection
The reported earnings and other data of the sample firms, including operating cash
flow, total assets, reclassified derivative gains, or losses, were collected from the
Morningstar database at http://www.morningstar.com. The annual reports were obtained
from the Edgar database of the Securites and Exchange Commission at
http://www.sec.gov.
Variable specification
Earnings smoothness
The earnings smoothness was determined by calculating the standard deviation of
the earnings changes for each sample firm over the 10 years from 1997 to 2006. The
calculation of earnings smoothness involves six steps.
Step 1: Calculate the earnings change in two periods. The formula is: ECt = (Et Et-1)/ Et-1, where ECt is the earnings change in period t, Et is the earnings of period t, Et-1 is
the earnings of the period preceding period t. The data of ten years earnings will result in
nine observations of earnings-changes for each firm. For example, the formula for
calculating 2004 earnings change is equal to [(2004 earnings 2003 earnings) / 2003
earnings].
Step 2: Calculate the mean earnings change (ECm). The formula is: ECm = ECt/n,
where n is the number of periods.

29
Step 3: Calculate the deviation of each earnings change from the mean. The
formula is: ECt ECm.
Step 4: Calculate the square of the deviation of each earnings change from the mean.
The formula is: [ECt ECm]2.
Step 5: Sum the results in Step 4 and divide it by n 1. The formula is: [ECt
ECm]2 / (n 1).
Step 6: Calculate the standard deviation, which is equal to the square root of the
result in Step 5.
In summary, the formula for calculating earnings volatility (EV) is as follows:
EV = [ECt ECm]2 / (n 1)
There was one EV for each sample firm.
Reclassified derivative gains (losses)
Under FAS 133, the gains (losses) from derivatives designated as hedging are
determined in the current period, and deferred to future period to offset the losses (gains)
arising from the items being hedged. When the items being hedged affect earnings, firms
have discretion in determining the amount of gains (losses) to be reclassified into current
earnings to offset the losses (gains) arising from the items being hedged.
Since the changes in the fair value or cash flow of the item being hedged are not
required to be reported separately, there are no ways of measuring if firms reclassify the
correct amount of derivative gains (losses), although the reclassified gains (losses) must be
reported separately under FAS 133.
Method of inquiry

30
Descriptive statistics
The basic computation of descriptive statistics in causal-comparative research is
the mean and standard deviation of the variables. This study computed the mean and
standard deviation of the earnings-volatility statistics of both Group A and Group B firms,
and compared the results by displaying the standard deviations of earnings-volatility of
both Group A and Group B in a histogram.
t-test
This study investigated the earnings volatility (EV) using a simple t-test with the
earnings volatility conditioned on the derivative use decision. The mean value for EV in
firms without derivative use was compared with the mean value of EV in firms with
derivative use. The variability of EV in Group B firms should be larger than the variability
exhibited by firms in group A. Thus the sample of user firms (Group A) has a smoother
pattern of earnings relative to the sample of non-user firms (Group B).
If the difference in means of EV between two groups of the sample firms was not
statistically significant (p > 0.05), earnings volatility is the same for both groups of firms
(null hypothesis). Then earnings smoothness is not due to derivative use.
The result of t-test could determine if the difference between the two sample means
is greater than what is expected by chance. This study used a significance (alpha) level of
0.05, meaning that if the difference between two sample means has a probability of
occurring of less than 5%, then the difference is considered statistically significant, and
thus, unlikely to have occurred by chance.
To conduct an independent samples t-test, the following assumptions were made:

31
1. Independence of errors - The error observations on the dependent variables of the
two groups did not co-vary.
2. Normality - The scores on the dependent variable are normally distributed. This
may be violated if the distribution of the dependent variable is skewed or if it is not
measured on an interval or ratio level.
Simple regression
This study included a regression analysis to test hypothesis 2. Subgroup A-1
included firms that engage in hedging derivative transactions, which, under FAS 133,
must defer derivative gains (losses) in Other Comprehensive Income (OCI) and
re-classify such gains (losses) from OCI into current earnings when the items being
hedged affect current earnings. Theoretically, the reclassification of such gains (losses)
should have no effect on earnings, because they should be offset by the recognition of
losses (gains) from the items being hedged.
Hypothesis 2 posits that firms tend to reclassify more gains (less losses) when the
firms current earnings are low, and reclassify less gains (more losses) when the current
earnings are high. In order to test hypothesis 2, this study performed a regression of
reported earnings on the reclassified derivative gains (losses). Since the reported earnings
include the effect of reclassified derivative gains (losses), it is reasonable to expect that
regression will show a significant simple linear relationship between earnings and
reclassified derivative gains (losses).
Multivariate regression

32
Multivariate regression was used to evaluate the statistical relationship between a
dependent variable and two or more independent variables. This study included a
multivariate regression to analyze the relationship between reported earnings (dependent
variable) and reclassified derivative gains (losses), earnings difference (current year
earnings minus previous year earnings), and current operating earnings (predictor
variables). The reason to analyze the relationship between the above variables is that firms
tend to use reclassified derivative gains as a means of smoothing earnings (Barton, 2001).
This study hypothesized that when current operating earnings is low, or when current year
earnings is lower than previous years earnings, firms tend to reclassify more derivative
gains to increase current earnings.
The general model (2) will be used.
E = + 1 OE + 2 ED + 3 RC +

(2)

where E = reported earnings;

OE = operating earnings;
ED = earnings difference;
RC = reclassified derivative gains (losses)
The adjusted R2 of this model should be higher than 85% because 15% of the
reported earnings can be from non-operating earnings and extraordinary items. If the result
is within expectation, the finding confirms with Bartons (2001) suggestion that firms use
derivatives as a substitute for accounting accruals in earnings management.
Control variables: Multivariate regression

33
Because the threat to internal validity in causal-comparative study is the lack of
randomization, extraneous variables should be controlled properly. For example, Barton
(2001) was concerned about the impact of total assets (firm size) on earnings volatility, and
OHanlon (1996) suggested that both operating cash flow (cash flow volatility) and total
assets might have impact on the time series properties of earnings volatility.
To assure better results, this study used strong control procedures to control
extraneous variables. Smoother earnings patterns could result from factors other than
derivative use. Barton (2001) was concerned about firm-specific factors that could affect
the volatility of earnings. Following Barton, this study used multivariate regression to
control extraneous variables, such as total assets changes and operating cash flow changes,
to assess the statistical significance of the findings, and to exclude other possible impacts
of total assets changes to control firm size impact on earnings volatility or operating cash
flow changes to control operating cash flow volatility impact on earnings volatility on the
difference in earnings volatility between two groups.
This study used the following model to control extraneous variables:
EV = + OCF + TA + DeriUse +
where:
= the intercept;
EV = earnings volatility (standard deviation of earnings);
OCF = operating cash flow changes (standard deviation of operating cash flows changes);
TA = total assets changes (standard deviation of total asset changes);
DeriUse = 1 if firm with derivative use, 0 otherwise; and

34
= the error term.
The expectation for each independent variable follows:
EV should be negatively related to OCF, and not significant (p > 0.05), suggesting
that OCF is a reasonable control for firm-specific factors affecting earnings volatility.
Larger firms will be more stable in terms of ES and/or that larger firms will be more
likely to smooth earnings (Watts & Zimmerman 1986). Therefore, the coefficient on TA
will be positive and statistically significant (p < 0.05).
Hypothesis 1 predicts that firms with derivative use will have smoother earnings
patterns relative to firms that do not have derivative use. Therefore, the coefficient on
DeriUse should be negative and significant (p < 0.05), suggesting that earnings are
smoother in firms with derivative use.
If the above model shows significant coefficients, it is reasonable to largely rule out
the possibility that the results were driven by fundamental differences (total assets and
operating cash flow) between the types of firms that use derivatives vs. the types of firms
that do not use derivatives as Barton (2001) was concerned about. Operating cash flow and
total assets are readily available data from www.morningstar.com
The analysis began by looking at the basic statistics of the earnings volatilities
between two groups, followed by an analysis of the equality of means and variation. Then a
t-test was performed to see the difference in means between the earnings volatilities of the
two groups. The regression analysis was performed to study the relationship between
reclassified derivative gains and the current reported earnings. The results were presented
in the next chapter.

35
Reliability
Joppe (2000) defined reliability as: The extent to which results are consistent over
time and an accurate representation of the total population under study is referred to as
reliability and if the results of a study can be reproduced under a similar methodology, then
the research instrument is considered reliable. (p. 1)
This study was based on the earnings numbers reported by public firms. The
formula for calculating earnings volatility from the earnings has been tested and used
widely in the accounting literature. The causal comparative method used in this study
emphasized the measurement and analysis of the causal relationship between two variables:
derivative transaction and earnings volatility.
Validity
Joppe (2000) provided the following explanation of what validity is in quantitative
research: Validity determines whether the research truly measures that which it was
intended to measure or how truthful the research results are. (p. 1)
The causal comparative method used in this study can precisely measure the
difference in earnings volatility between public firms with derivative transactions and
those without.

CHAPTER 4:
RESEARCH RESULTS
Sample Statistics
The final sample was comprised of 404 firms that are in the S&P list. Of the 404
firms, 277 firms have been using financial derivatives, and 127 firms have not been using
financial derivatives. There are 4,040 firm year observations of variables used in this study.
Table 1 provides the descriptive statistics of the earnings volatilities of the two
groups.

Table 1
Descriptive Statistics: Earnings Volatility (EV)
___________________________________________________________________
Variable DU N N* Mean SE Mean StDev Minimum Q1
Median Q3
EV
1 277 0 1.985 0.192 3.190
0.044
0.337
0.981
2.334
2 127 0 3.965 0.813 9.161
0.040
0.323
1.272
3.270
Variable DU Maximum
EV
1 30.387
2
69.662
_______________________________________________________________________
* EV = earnings volatility, which is the standard deviation of earnings changes in
the sample period from 1997 to 2006.
* DU = derivative use. DU = 1 for firms that use derivatives.
It is apparent that the mean earnings volatility (EV 1.985) of Group A (Derivative
use = 1) is lower than the mean earnings volatility (3.965) of Group B. The standard
deviation of the mean earnings volatility of Group B (9.161) is also higher than that of
Group A (3.190). The effect size d (= StDev2 / StDev1 = 9.161 / 3.190) of 2.871 means the

37
mean earnings volatility of Group B is more than two times that of Group A. The boxplot
of earnings volatility versus Derivative Use is shown in Figure 1. From Figure 1 we can see
that Group B has more outliners than Group A.

Boxplot of EV by DU
70
60
50

EV

40
30
20
10
0
1

2
DU

Figure 1. Boxplot of EV by DU.

Earnings Volatility
t-test - Earnings Volatility Comparison
To investigate earnings volatility, this study used t-test to compare the mean
earnings volatility between two groups of public firms with the use of financial derivatives
as the criteria in grouping the firms. The results are presented in Table 2.

Table 2.

38
Two-Sample t-test and Confidence Interval: EV versus Group
__________________________________________________________________
Two-Sample t-test and CI: Earnings Volatility versus Group
___________________________________________________________________
Group N
Mean StDev SE Mean
1
277
1.985 3.19 0.19
2
127 3.965 9.16 0.81

Difference = mu (1) - mu (2)

Estimate for difference: -1.97909
95% CI for difference: (-3.63036, -0.32782)
T-Test of difference = 0 (vs not =): T-Value = -2.37 P-Value = 0.019 DF = 140
________________________________________________________________________
The results of t-test of the difference in mean earnings volatility between two
groups show that the mean earnings volatility (1.985) of Group A , that is, companies that
use financial derivatives in their daily operations, is much less than the earnings volatility
(3.965) of Group B. The result is statistically significant because the T-value is -2.37 and
the p value is less than 0.05 (at 95% confidence level.).
To ensure the t-test results are not biased, the distributions of the earnings
volatilities of two groups are analyzed and the results are presented in the histogram of
Figure 2. Figure 2 shows the earnings volatilities of two groups are normally distributed,
but the earnings volatility of Group A has higher frequency of occurrence around the mean
of 1.985. The standard deviation of Group A is smaller.

39
Histogram of EV
Normal
180

DU
1
2

160

Mean StDev
N
1.985 3.190 277
3.965 9.161 127

140

Frequency

120
100
80
60
40
20
0
-15

15

30
EV

45

60

Figure 2. Histogram of Earnings Volatility.

F-test
In the t-test, the option of unequal variances was selected. In order to test the
equality of variance of earnings volatility between the two groups, an F-test was performed.
The results are presented in Table 3 and Figure 3.

Table 3.
F-test results
____________________________________________________________________
Test for Equal Variances: Earnings Volatility versus Group
____________________________________________________________________
95% Bonferroni confidence intervals for standard deviations
Group N Lower StDev
1
277 3.7859 4.1441
2
127 25.0803 28.6054

Upper
4.5741
33.2309

40
F-Test (normal distribution)
Test statistic = 0.02, p-value = 0.000
Levene's Test (any continuous distribution)
Test statistic = 5.48, p-value = 0.020
____________________________________________________________________

The results of F-test of the equality of variance in earnings volatilities between two
groups show that the variance of earnings volatility of Group A (4.14) is much less than the
mean earnings volatility of Group B (28.6). The results are statistically significant because
the F value is high (5.48) and the p value is less than 0.05 (at 95% confidence level.).
Figure 3 is a graphic presentation of the F-test results. The variances of earnings
volatility between two groups are not equal. Group As variance is below 5, while Group
Bs variance is between 28.6 and 33.23.
Test for Equal Variances for EV
F-Test
Test Statistic
P-Value

0.02
0.000

Group

Levene's Test
Test Statistic
P-Value
2

10
15
20
25
95% Bonferroni Confidence Intervals for StDevs

30

35

300

350

Group

50

100

150

200
EV

250

5.48
0.020

41
Figure 3. Test for Equal Variances for Earnings Volatility

Operating earnings volatility comparison

Operating earnings are the earnings from the normal operations of a business.
Operating earnings reflect the actual earnings from normal operations (DeChow et al.,
2003). Since management can not exercise discretion on operating earnings, there should
be no difference in volatilities of operating earnings between the two groups (DeChow et
al., 2003).
In order to test the difference between earnings volatilities of two groups without
the impact of financial derivative use and management discretion, a comparison of
operating earnings volatilities was also performed. The results are presented in Table 4.

Table 4.
t-test of operating earnings volatility
_______________________________________________________
Panel A : Two-Sample t-test and CI: OEV versus Group
________________________________________________________
Group N
Mean StDev
SE Mean
1
277
3.77 23.13
1.4
2
127
3.62 11.75
1.0
Difference = mu (1) - mu (2)
Estimate for difference: 0.145894
95% CI for difference: (-3.268821, 3.560610)
T-Test of difference = 0 (vs not =): T-Value = 0.08 P-Value = 0.933 DF = 398
_______________________________________________________________________

Panel B: General Linear Model: OEV versus DeriUse

42
_____________________________________________________________________
Factor Type Levels Values
DeriUse
fixed
2 1, 2
Analysis of Variance for STDEV, using Adjusted SS for Tests
Source DF Seq SS Adj SS Adj MS F P
DeriUse 1
1.9
1.9 1.9
0.00 0.946
S = 20.2370 R-Sq = 0.00% R-Sq(adj) = 0.00%
______________________________________________________________________
*OEV = operating earnings volatility.

Panel A of Table 4 shows the mean operating earnings volatility of Group A is 3.77,
and the mean operating earnings volatility of Group B is 3.62. There is no difference in
operating earnings volatility between two groups. The T statistics and p value both show no
difference in the mean volatility of operating earnings between two groups. Panel B of
Table 4 also shows a zero F value and a high p value of 0.946.
The distributions of the volatilities of operating earnings are presented in Figure 4.
Figure 4 shows the distributions of the volatilities of operating earnings of two groups are
similar, meaning there is no apparent difference between the volatilities of operating
earnings of two groups. The results are consistent with Barton (2001) that operating
earnings are free of earnings management and accounting discretions.

43
Histogramof OEV
Normal
100

DeriUse
1
2

Frequency

80

Mean StDev N
3.765 23.13 276
3.619 11.75 128

60

40

20

0
0

60

120

180
OEV

240

300

360

Figure 4. Histogram of operating earnings volatility

Reclassification of deferred gains (losses)

Hypothesis 2 posits that firms that use financial derivatives as hedging tend to use
discretion in reclassification of deferred derivative gains as a means for smoothing
earnings. To investigate earnings smoothing by reclassification, this study tested whether
there was a relationship between public firms current reported earnings and their
derivative gains realized in prior period but reclassified into current period. To optimize
the test, firms in Group A that use derivatives as hedging were selected because only these
firms have deferred derivative gains (losses) to be reclassified into current earnings each
year. A simple regression and multivariate regression were performed.

44
Simple regression
The simple regression of current earnings (Earnings) and the previously deferred
derivative gains reclassified into current period (ReClass) shows reclassified derivative
gains are positively correlated with current earnings.
The results are reported in Table 5 below.
Table 5.
Regression Analysis: Earnings versus ReClass
__________________________________________________________________
The regression equation is
Earnings = 1.6709 + 1.39 ReClass
Predictor
Constant
ReClass

Coef SE Coef
1.66665 132052
1.3883
0.7188

T
12.62
1.93

P
0.000
0.050

S = 3037674451 R-Sq = 0.7% R-Sq(adj) = 0.5%

Analysis of Variance
Source
DF
SS
MS
F
P
Regression
1
3.44209 3.44209
3.73 0.05
________________________________________________________________________
______
Table 5 offers support for earnings smoothing by reclassifying derivative gains.
Reclassified derivative gains are positively correlated with current reported earnings.
Because in the hedging activity of these firms, the losses from the items being hedged are
supposed to be offset by the gains from such derivatives. Without the gains from
derivatives, the earnings of these firms should be lower. However, the p-value is at the
boundary of 95% confidence level, we need multi-variance regression analysis in order to

45
understand the extent to which reclassified derivative gains have on earnings smoothness, a
multivariate regression analysis on the impact of reclassified derivative gains, operating
earnings and pre-managed earnings (earnings change from prior year before reclassified
derivative gains) on reported earnings was also performed.
Multivariate regression
To assess the extent to which the correlation of reclassified derivative gains with
current earnings is unusual, a multivariate regression is performed to include pre-managed
earnings to further analyze the relationship between reclassified derivative gains,
pre-managed earnings, and current operating earnings. Pre-managed earnings equal to
current year earnings minus previous year earnings minus reclassified derivative gains.
The results are presented in Table 6.
Regression Analysis: Earnings vs Operating Earnings, Pre-Managed Earnings,
Reclassified Derivative Gains
The regression model is
E = + 1 OE + 2 PME + 3 RC +

Table 6.
Regression: Earnings versus Reclass, Operating Earnings, Pre-managed Earnings (PME)
_____________________________________________________________________
The regression equation is
Earnings = 2.342478 + 1.21 Reclass + 0.435 Oper Earnings + 0.581 PME
Predictor
Coef
Constant
227226897
Reclass
1.2083
Oper Earnings 0.435502

SE Coef
57645466
0.2823
0.01030

T
4.02
4.27
41.85

P
0.000
0.000
0.000

46
PME

0.58096

0.05599

10.22 0.000

S = 1178648143 R-Sq = 85.1% R-Sq(adj) = 85.0%

Analysis of Variance
Source
DF
SS
MS
F
Regression
3 4.2071521 1.4023821 999.27

P
0.000

Source
DF
Seq SS
Reclass
1 3.4420919
Oper Earnings
1 4.0296921
PME
1 1.4303920
__________________________________________________________
Table 6 showed the regression coefficients of reclassified derivative gains,
operating earnings and pre-managed earnings are all positive and statistically significant at
95% level.
Pre-managed earnings vs reclassified derivative gains
To investigate whether firms reclassified more deferred derivative gains when
pre-managed earnings are low, a simple regression analysis between pre-managed earnings
(earnings before reclassification minus reported earnings of prior year) and reclassified
derivative gains was performed. The results are reported in Table 7.

Table 7.
Regression: PME versus ReClass
___________________________________________________________________
The regression equation is
PME = 2.93E+08 - 0.641 ReClass
Predictor
Coef
Constant 292915441
ReClass
-0.6413

SE Coef
45379460
0.2456

T
P
6.45 0.000
-2.61 0.009

S = 1037993801 R-Sq = 1.3% R-Sq(adj) = 1.1%

47
Analysis of Variance
Source
DF
SS
MS
F
P
Regression
1 7.3432918 7.3432918
6.82 0.009
___________________________________________________________________
Consistent with hypothesis 2, Table 7 shows the regression coefficient between
pre-managed earnings and reclassified derivative gains is negative (-0.6413) with p- value
of 0.009, meaning the reclassified derivative gains are significantly and negatively
correlated with pre-managed earnings. Table 7 provides strong evidence that if
pre-managed earnings are high, firms tend to reclassify less derivative gains and vice versa.
PME is a good threshold for earnings management.
Control Variables
This study used the following model to control extraneous variables (operating
cash flow change, total assets change and derivative use). The model is as follows:
EV = + OCF + TA + DeriUse +
(Earnings volatility vs operating cash flow changes, total assets changes and
derivative use)
The regression analysis results are listed in Table 8.
Table 8.
Regression Analysis: EV vs OCF, TA, DeriUse
_______________________________________________________________________
EV = 0.361 - 0.339 TA - 0.00026 OCF - 0.218 DeriUse
Predictor
Constant
TA
OCF
DeriUse

Coef
0.3610
-0.3386
-0.000262
-0.2177

SE Coef
0.3627
0.2372
0.005654
0.2592

T
1.00
-1.43
-0.05
-0.84

P
0.320
0.154
0.963
0.401

48
S = 6.73524 R-Sq = 0.1% R-Sq(adj) = 0.0%
Analysis of Variance
Source
Regression

DF
3

SS MS F P
127.42 42.47 0.94 0.422

Source
DF
Seq SS
TA Ch
1
95.25
OCF Ch
1
0.15
DeriUse
1
32.02
________________________________________________________________________
The regression results in Table 8 show low F values and high p values, suggesting
total assets and operating cash flows have less impact on earnings volatility. The
correlation coefficients of changes in total assets (TA) and operating cash flow (OCF) are
statistically insignificant because F-Values are low pvalues are high.
The results showed that firms that used derivatives in their daily operations had less
volatile earnings pattern than firms that did not use derivatives, and reclassified derivative
gains did contribute to the earnings smoothness. Chapter 5 presented a detailed discussion
about the power of financial derivatives and the weakness in the accounting standards for
derivatives.

CHAPTER 5:
SUMMARY, CONCLUSION, AND RECOMMENDATIONS
Interpretation of findings
Hypothesis 1
Hypothesis 1 posits that the use of financial derivatives results in lower earnings
volatility. Basic statistics in Table 1 show that earnings volatility, that is, standard
deviation of changes in earnings for the past 10 years, of Group A (DeriUse = 1) is 1.985,
and the earnings volatility of Group B is 3.965. Earnings volatility of Group B exceeds that
of Group A by more than 50%, meaning there is much more volatility in the earnings
pattern of Group B firms. The results in Table 3 also showed that the earnings pattern of
Group B firms was more volatile than the earnings of Group A firms.
t-test
Table 2 shows the results of t-test of the difference in mean earnings volatility
between two groups. It is clear that the earnings volatility of firms in Group A (companies
that use financial derivatives in their daily operations) is much less than the earnings
volatility of firms in Group B. The result is statistically significant because the p-value is
less than 0.05. It is obvious that the mean volatility of earnings of Group A is much less
than that of Group B at 95% confidence level. As reflected in Table 2 by the p statistics of
0.019, hypothesis 1 was not rejected.
The histogram of the distributions of earnings volatility is presented in Figure 3.
Figure 3 provides evidence that the earnings volatilities of Group A have higher frequency
of occurrence around the mean of 1.944, while the earnings volatilities of Group B are not

50
centered near the mean, suggesting that the variance of the earnings volatilities of Group B
is higher.
Operating earnings volatility
Overall, the results in Table 2 and Table 3 support hypothesis 1. However,
additional insights can be obtained by analyzing difference in volatility of operating
earnings between two groups because operating earnings are the firms real earnings from
its normal operations free of earnings management. To test the difference between mean
operating earnings volatility of two groups, a t-test of operating earnings volatility was also
performed. The results are presented in Table 4. Panel A of Table 4 shows the mean
operating earnings volatility of Group A is 3.77, and the mean operating earnings volatility
of Group B is 3.62. There is no difference in mean volatility of operating earnings between
two groups. Panel B of Table 4 also shows a high p value of 0.946.
The t-test results of the difference in the volatility of operating earnings between
two groups show the difference in operating earnings volatility between two groups is not
statistically significant. In other words, with or without the use of financial derivatives,
there is no difference in the mean volatility of operating earnings between two groups. The
results are consistent with Tucker and Zarowin (2006) that operating earnings represent the
true shape of the earnings of a business before any earnings smoothing efforts.
GAAP require firms to report operating earnings separately before the final
earnings (which include gains from derivatives and other non-operating activities) are
reported (McKee, 2005). The t-test results show there is no difference in the mean
volatility of operating earnings, but significant difference in the mean volatility of final

51
reported earnings. Based on the evidence here, null hypothesis 1 was rejected, and
hypothesis 1 was thus accepted. Firms that use financial derivatives in their daily
operations have lower earnings volatility, smoother earnings patterns.
The results of this study are consistent with Bartons (2001) findings that financial
derivative could be a substitute for accounting accruals in earnings management.
According to Collingwood (2001), the shares of companies with lower earnings volatility
usually have higher market valuation. Lower earnings volatility is a very good motive for
earnings smoothing. Because financial derivative transactions are legal, public firms can
avoid SEC penalty on earnings management based on real transactions on such derivatives.
The power of derivatives - Transfer of volatility
The reason why financial derivatives can result in lower earnings volatility is that
firms can use derivative to transfer volatility in revenue and expenses to another party,
either a derivative dealer or the counterparty in the derivative contract.
According to Tucker and Zarowin (2006), the volatility of earnings is the
combination of the volatilities of cash flow and accruals. Thus, managers can manage the
volatility of earnings by either managing the volatility of accruals or cash flow, or both.
Barton (2001) proved that financial derivatives are a substitute for accruals in earnings
management. For example, consider a firm whose cash flow and earnings are exposed to
interest rate risk. Unexpected increase (decrease) in interest rates will increase (decrease)
the firms interest expense, and decrease (increase) its earnings and cash flow as a resulting
of paying at higher (lower) interest rates.

52
Consider, another firm that borrows money from banks or from the capital market
at floating interest rates can enter into a swap (a typical derivative contract under which one
party exchange floating payments with a return of receiving fixed payments) contract with
the dealer bank (Dubofsky and Miller, 2003). Under this swap contract, the firm makes a
fixed interest payment to the bank, while the bank pays the market floating rate to the
firms original lender (Dubofsky and Miller, 2003). Thus the firm can transfer the risk of
fluctuation in interest expenses to the derivatives dealer bank by a simple derivative
contract.
Timing of gains/losses
Almost all financial derivatives can be terminated any time by paying the
counterparty. When the market moves in the firms favor, there will be accumulated gains
on the derivatives under the current marked-to-market accounting standards (Dubofsky
and Miller, 2003). If the earnings from normal operations are low, firms can terminate such
favorable derivatives to realize such accumulated gains to be added to current earnings
(McKee, 2005). When firms have more earnings from normal operations, they can
terminate those derivative that have losses (market has moved against the firms position in
such derivatives) to harvest the losses to offset excess earnings from normal operations
(McKee, 2005).
Firms and financial derivative dealers often use regression and complex computer
modeling technology to analyze the performance of different types of derivatives with the
firms operating earnings and see if they are correlated. Then firms can use different
derivatives to smooth earnings. This type of derivatives financial engineering is useful to

53
firms with seasonal and volatile earnings pattern. McKee (2005), and Dubofsky and Miller,
(2003) discussed some typical derivative transactions that firms can use to smooth
earnings.
Interest-rate swaps
For example, firm A has a loan that pays 6% fixed interest rate. As market variable
interest rate drops below 6%, A arranges a pay-variable/receive-fixed swap with a bank to
pay variable rate. Then the savings in interest expense will increase As earnings. If A has
a loan that pays floating rate on LIBOR + 1%, and A concerns about the interest rate will
rise, A will arrange a pay-fixed /receive-variable swap with a dealer under which A pays
fixed rate and receives variable rate of LIBOR + 1%, then A can use the variable interest
payments from the dealer bank to make interest payments under the original loan contract,
thus As earnings will become stable (McKee, 2005).
Forward rate agreement (FRA)
Under FRA, the contract in which one party receives a fixed interest rate while
paying a floating rate for one single fixed future period. FRAs are used by firms to lock in
a fixed interest-rate expense on variable rate assets or liabilities, thus resulting in smoothed
earnings. For example, a firm has outstanding variable rate loans that are due to renew in
three months, it could lock in its interest expense in advance by selling an FRA with a
notional amount equal to the outstanding principal on its loans. So the firms interest
expense for the future three months will be fixed, resulting in lower earnings volatility.
(McKee, 2005)
Per-period return swap

54
Per-period return swap is an innovative swap which sets a different rate of return
for different periods. For example, the swap participant can select lower rate of return in
early period and higher return in later period or vice versa. For example, firms whose
project results in high expense (low earnings) in early stage but low expense (high
earnings) in future periods can use this type of swap to smooth earnings in different
periods. (Dubofsky and Miller, 2003).
Spread option
This type of option has two or more underlying assets, such as the spark spread
option in the energy market. Such options have both the power price and the natural gas
price as underlying assets. The valuation of such options is subject to a lot of assumptions
and discretion. Firms holding positions in such options can exercise more discretion in
recognizing gains or losses from such options.
Forward swap
A forward swap is a swap executed today but the payments are to be exchanged in a
distant future date. Firms can enter into such swaps, and select to exchange payments in a
future period only when the payments are favorable (based on the market condition in the
future) when the firm needs gains, or when the payments are unfavorable when the firms
operating earnings in the future period are higher than some target amount.
Interruptible supply contracts
Under such contracts the supplier can exercise the call option whenever the spot
price exceeds the strike price, effectively canceling the forward contract at the time of
delivery, resulting in an immediate realization of gains on such contracts.

55
Swaption
A swaption is an option that gives the holder the right but not the obligation to enter
into a swap in the future. If the interest or exchange rates have changed to the holders
benefit, the holder will execute the option. If the market does not change to the holders
benefit, the holder does not have to exercise the option. Firms can hold such derivatives to
or not to realize gains in any future accounting periods.
Reset swap
A reset swap is a swap the payment rate of which can be changed by the paying
party in the future period. Firms can use this type of derivative to generate payoffs to add to
earnings or to offset excess earnings in the future periods.
Cancelable swap
A cancelable swap is a swap that can be cancelled by the variable rate payer any
time during the contract term. The termination fee is recorded as current expenses. The
holder of such swap can even cancel portion of the swap.
Take a look at Goodrich Corp (GR)s 2006 annual report regarding the firms
discretion in termination of its derivatives. In June, Goodrich terminated a swap on 6.45%
note, and in September Goodrich re-enter into another swap of 6.29% promissory note.

In June 2006, we terminated $7 million of a $50 million fixed-to-floating interest

rate swap on our 6.45% notes due in 2008 in connection with our long-life debt
exchange offers. We paid $0.3 million in cash to terminate this portion of the
interest rate swap, which was recorded as an expense in other income (expense)
net during 2006. This portion of the interest rate swap was terminated so that the
outstanding notional amount of the fixed-to-floating interest rate swap would
match the outstanding principal amount, subsequent to the exchange of the
6.45% notes due in 2008.

56
In September 2006, we entered into a $50 million fixed to floating interest rate
swap on our 6.29% senior notes due in 2016. The settlement and maturity dates on
the swap are the same as those on the referenced notes. In accordance with
SFAS 133, the interest rate swap is being accounted for as a fair value hedge and
the carrying value of the notes has been adjusted to reflect the fair value of the
interest rate swap. (Goodrich Corp 2006 annual report, p. 44)

Duke Energy Group (DUK) also terminated certain derivatives in 2006 resulting in
$45 million favorable increase in earnings. Below are the notes disclosing such termination
found in Dukes 2006 Annual Report.
Other Income and Expenses, net. The increase was driven primarily by an
approximate $45 million favorable variance resulting from the realized and
unrealized mark-to-market impacts associated with certain discontinued cash flow
hedges originally entered into to hedge Field Services commodity price risk which
are recorded in Other income and expenses, net on the Consolidated Statements of
Operations subsequent to the deconsolidation of DEFS, effective July 1, 2005.
(Duke Energy Group, 2006 Annual Report, Page 62.)
Extendable swap
An extendable swap is a swap the terms of which can be extended to a longer period
at the variable-rate payers choice. If the gain on such swap is in the firms favor, firms can
extend the swap contract to continue to hold on to the swap.
Flexible swap
A flexible swap is a swap the terms of which can be re-negotiated after the contract
has started. The variable-rate payer can change the strike price, the reference asset or even
the principal amount.

57
Under FAS 133, all financial derivatives must be marked-to-the-market. The gains
or losses on the derivatives must be recognized at the end of an accounting period. If the
derivatives are for trading purpose (not being used to hedge any risk item), the gains or
losses must be immediately recorded in current earnings. If the derivatives are designated
as hedge against risk items that will be realized in the future, the marked-to-market gains or
losses on derivatives must be recorded but deferred to be reclassified into earnings in the
future.
From the annual report of some sample firms we can see the impact of realized
derivative gains on current reported earnings. When earnings before derivative gains are
low, firms tend to realize more derivative gains. When earnings before derivative gains are
high, firms tend to realize less derivative gains. The derivative gains or losses here are the
gains or losses immediately recognized under the marked-to-market rule, not the derivative
gains or losses reclassified from prior period as discussed under hypothesis 2.

BMC Software Inc (BMC)

2004

2005

2006

Earnings before derivative

-21.6 million

73.1 million

104 million

Derivative gain/loss

5.2 million

2.2 million

-2 million

Earnings after derivative

-26.8 million

75.3 million

102 million

(BMC 2006 Annual Report, page 57).

58
In 2005 BMCs earnings before derivative gains is 73.1 million, its derivative gains
is 2.2 million. In 2006, BMCs earnings before derivative gains is 104 million, its
derivative gains is -2 million. BMC recognizes less derivative gains when its earnings are
high (in 2006), and recognizes more derivative gains when its earnings are low in 2005.
Intel Inc (INTC)
2004

2005

2006

Earnings before derivatives

83.10 million 124.64 million

56.44 million

Derivative gain/loss

-8.0 million

6.0 million

Earnings after derivatives

75.10 million 86.64 million

-38.0 million

50.44 million

(Intel 2006 Annual Report, Page 71).

Intels earnings before derivative gains show a volatile pattern from 2004 to 2006.
Intel recognized derivative gains of -38.0 million when its earnings before derivatives were
124.64 million in 2005, but recognized derivative gains of 6.4 million when its earnings
before derivatives were 56.44 million. After recognizing derivative gains, Intels earnings
pattern became less volatile from 2004 to 2006.
Because financial derivatives are powerful tools in transferring earnings
volatilities, public firms are primary users of such instruments (GAO Report, 1996, p. 14).
The evidence of this study is supporting hypothesis 1 and consistent with Stulzs
conclusion that derivatives provide a flexible and effective means to reduce the volatility of
cash flows and earnings (Stulz, 2003). In other words, firms that use financial derivatives
in their daily operations will have a lower earnings volatility pattern than firms that do not
use derivatives.

59
Accounting for Derivatives
The reason why firms can exercise discretion is that current accounting standards
for hedging derivatives are too narrow to cover the complexity of financial derivatives and
other financial engineering products. This leaves firms with a lot of discretions in deferring
and reclassifying gains from financial derivative transactions. For example, FAS 133
required that firms recognize both derivatives and hedged items at their fair value, even
before the settlement of the derivative contracts (FAS 133). When the increase/decrease in
a derivatives fair value cannot offset the decrease/increase in its hedged items fair value,
the uncovered part is regarded as the ineffective portion of the hedge and is recorded
immediately into current earnings. The 80/120 rule under FAS 133 in determination of
effectiveness is too broad. Under this rule, if the gains on a derivative can not offset 80% of
the loss of the item being hedged, it is considered ineffective, and the derivative gains must
be recognized immediately in current earnings. Todays market volatility is getting higher
and higher, the change in the market price of the underlying asset can be more than 50%,
the fair value determined on the financial statement date can be 50% lower than or higher
in the next accounting period.
Furthermore, evaluating the fair market value of a derivative is often subjective,
especially for such over-the-counter derivatives. Over-the-counter derivatives are
derivatives without active quotation from a regulated stock exchange. Managers can either
estimate the fair value based on the current market price of other derivatives, especially
when the derivative being valued is not actively traded in the market, or invoke
"marked-to-market model" techniques. According to Dubofsky and Miller (2003) financial

60
models often contain errors. With a subjective estimation of the fair value, the estimation
of the ineffective portion is discretionary. For example, Enron, the seventh largest
company in the United States and the largest energy trader in the world, collapsed.
According to Clayton, Scroggins and Westley (2002), investigations revealed that Enron
had made extensive use of energy derivatives to bolster revenues by overstating the fair
market value of such derivatives.
In Ingersoll-Rand Co (IR)s 2006 annual report, we can see the firms discretionary
assumptions in determining its fair value gains or losses:
The Company experiences currency exposures in the normal course of business. To
mitigate the risk from currency exchange rate fluctuations, the Company will
generally enter into forward currency exchange contracts for the purchase or sale of
a currency to hedge this exposure.
The Company evaluates its exposure to changes in currency exchange rates using a
sensitivity analysis. The sensitivity analysis is a measurement of the potential loss
in fair value based on a percentage increase or decrease in exchange rates against
the U.S. dollar. Based on the firmly committed currency derivative instruments in
place at December 31, 2006, a hypothetical change in fair value of those financial
instruments assuming a 10% increase in exchange rates against the U.S. dollar
would result in an unrealized loss of approximately $32.5 million, as compared
with $16.0 million at December 31, 2005.
(Ingersoll-Rand Co, 2006 annual report, page 41.)
Because the spot rate and the forward rate are not always the same, and because
market price is changing rapidly, the rate selection process also provides firms like
Ingersoll-Rand with an opportunity to discretionarily report the fair value of derivative
instruments resulting in discretionary gains or losses realized on such financial derivative
instruments.
Hypothesis 2
Simple regression - Earnings versus reclassified derivative gains

61
Hypothesis 2 posits that firms that use financial derivatives as hedging tend to use
accounting discretion under FAS 133 in reclassification of deferred derivative gains as a
means for smoothing earnings. To investigate earnings smoothing by reclassification, this
study first tested whether there is a relationship between public firms current reported
earnings and their derivative gains realized in prior period but reclassified into current
period. If earnings smoothing does not exist, derivative gains reclassified into current
period should be equal to the risk of loss realized in the current period for the items being
hedged by the derivatives. The correlation coefficient between reclassified derivative gains
and reported earnings should be zero, because reported earnings contains both loss from
items being hedged and the gains reclassified into this period, offsetting such loss. If
managers of these firms use reclassified derivative gains to smooth earnings, the
reclassified derivative gains should be positively correlated with current earnings.
To optimize the test, firms in Group A that use derivatives as hedging were selected
because under FAS 133 these firms have deferred derivative gains (losses) to be
reclassified into current earnings each year.
The results of a simple regression between current earnings and reclassified gains
of Subgroup 1 are presented in Table 5. Table 5 offers modest support for earnings
smoothing by reclassifying derivative gains. Reclassified derivative gains are positively
correlated with current reported earnings. In other words, reported earnings will go up
when large derivative gains are being reclassified into current year. The positive
coefficient of 1.3883 indicates that firms that reclassify more derivative gains tend to
report higher amount of earnings than firms that reclassify less derivative gains.

62
Pre-managed earnings versus reclassified derivative gains
To investigate whether firms reclassified more deferred derivative gains when
current earnings before reclassification are lower than prior years reported earnings, a
simple regression analysis between earnings difference before reclassification and
reclassified derivative gains was also performed. Earnings difference before
reclassification is equal to current reported earnings minus last years reported earnings
minus reclassified derivative gains. Barton (2001) called it pre-managed earnings. This is
the threshold amount for earnings smoothing. If this amount is low, meaning current
earnings before classification is below last years level, earnings smoothing managers will
have to reclassify more deferred derivative gains to smooth the earnings difference. The
regression analysis results are reported in Table 6.
Table 6 shows that pre-managed earnings are negatively correlated with
reclassified derivative gains. The correlation coefficient is negative (-0.6413), and
statistically significant at 95% level (p value = 0.009). This evidence suggests that firms
with earnings lower than prior years reported earnings tend to reclassify more derivative
gains to smooth current earnings or to bring it closer to or a little bit higher than prior years
reported earnings.
Multivariate regression
To assess the extent to which the correlation between reclassified derivative gains
and current earnings is unusual, a multivariate regression was performed to further analyze
the relationship among current reported earnings, reclassified derivative gains,

63
pre-managed earnings, and current operating earnings as predictor variables. The results
are presented in Table 7.
Table 7 shows that pre-managed earnings, reclassified derivative gains, and
operating earnings are all positively correlated with current reported earnings. R-squared
of 85.1% and adjusted R-square of 85% show that the three independent variables account
for over 85% of the current reported earnings. The rest 15% are non-operating items and
extraordinary items. The low p-value of 0.000 showed that the relationship is statistically
significant at 95% confidence level.
Operating earnings are the major component of current earnings. Operating
earnings should contribute to most of the reported earnings of a business. If earnings
smoothing does not exist, the correlation coefficient of operating earnings should be larger
than the coefficient of reclassified derivative gains. However, in this test, the correlation
coefficient of ReClass (1.2083) is much higher than that of operating earnings (0.435502),
suggesting that the impact of reclassified derivative gains on reported earnings is far more
than the earnings from normal operations of such firms.
Based on the evidence here, we can reject the null Hypothesis 2 and accept
Hypothesis 2.
FAS 133 (accounting for derivatives)
The major loophole in accounting standards for derivatives is the treatment of
effective hedge (the derivative gains/losses that are considered to effectively offset the
loss/gains of the items being hedged) for items the impact on earnings of which is in the
future. Under FAS 133 effective hedge treatment, the gains/losses from derivatives are

64
recognized at the end of each accounting period by marked-to-market rule. For example,
when the market value of a derivative increases, and if it is an effective hedge against items
that impact earnings in the future, the increase in market value of such derivative is
immediately realized in the current accounting period, but not to be reported as current
earnings, but to be deferred in the stockholders equity account as other comprehensive
income. Until the losses/gains of the items being hedged are realized in the future period,
the previously deferred derivative gains/losses must be reclassified into this future period
from the stockholders equity account.
The amount of reclassification is subject to managements discretionary projection
of the loss of the items being hedged to be realized in the current period. If management
projects more loss from the items being hedged will be realized in the future period,
management will reclassify more deferred derivative gains into this future period. Since
the losses/gains from items being hedged are not required to be reported separately,
auditors of such firms normally agree with managements determination of the amount of
derivative gains to be reclassified.
In Ingersoll-Rands 2006 annual report, we can see such discretion in the
reclassification of derivative gains (the firm can adjust the amount to be reclassified any
time):
The estimated fair value of currency hedges outstanding at December 31, 2006 and
2005, was a projected loss of $1.6 million and projected gain of $1.6 million,
respectively. The notional amount of the currency hedges was $559.2 million and
$252.1 million at December 31, 2006 and 2005, respectively. At December 31,
2006 and 2005, $1.1 million and $3.4 million, net of tax, respectively, was included
in accumulated other comprehensive income related to the fair value of currency
hedges. The amount expected to be reclassified to earnings over the next twelve

65
months is $1.1 million. The actual amounts that will be reclassified to earnings may
vary from this amount as a result of changes in market conditions.
(Ingersoll-Rand Co, 2006 annual report, page 68.)
Pincus and Rajgopal (2002) concluded that firms would use derivatives to hedge
risk and then managed earnings volatility by trading off discretionary accruals and hedging
to smooth earnings. While their results showed no evidence that the extent of hedging was
a significant determinant of hedging, they found the extent of hedging was a significant
determinant of the extent of earnings smoothing. The reason why Princus and Rajgopal
could not establish significant relationship between earnings volatility and hedging is that
in their sampling period, gains and losses from derivative transactions were not required to
be reported separately. Firms only need to report their use of derivative in the footnotes of
their financial statements, and the gains (losses) from derivative transactions were
embedded in the final reported earnings.
The evidence in this study shows the correlation coefficient between reported
earnings and reclassified derivative gains is statistically significant. The results in Table 7
support Hypothesis 2 that firms tend to reclassify more derivative gains when their
earnings drop below the reported earnings of the prior year. Overall, the evidence here
suggests that the accounting standards for financial derivatives provide firms with a means
of smoothing current earnings by deferring and discretionary reclassification of deferred
derivative gains into current period.

66
In Darden Restaurants Inc (DRI)s 2006 annual report, we also see the
reclassification of derivative gains from deferred earnings to current earnings is subject to
management discretion:
During fiscal 2006 and 2005, we entered into option contracts and commodity
swaps to reduce the risk of natural gas price fluctuations. To the extent these
derivatives are effective in offsetting the variability of the hedged cash flows,
changes in the derivatives' fair value are not included in current earnings but are
reported as accumulated other comprehensive income (loss). These changes in fair
value are subsequently reclassified into earnings when the natural gas is purchased
and used by us in our operations. Net gains (losses) of $4,281 million and ($311
million) related to these derivatives were reclassified to earnings during fiscal 2006
and 2005, respectively, in connection with the settlement of our contracts. The fair
value of these contracts was a net loss of $3,042 at May 28, 2006 and is expected to
be reclassified from accumulated other comprehensive income (loss) into
restaurant expenses during fiscal 2007.
(Darden Restaurants Inc 2006 annual report, page 30).
In Alcoas 2006 annual report, we can reasonably assume that the firm successfully
reclassified gains (losses) to different accounting periods to smooth earnings over time.

Alcoa Inc (NYSE:AA)

2004
Earnings before reclassification
Reclassified derivative gains (losses)
Earnings

2005

2006

1292 million 1045 million 2845 million

18 million
1310 million

188 million

-597 million

1233 million 2248 million

After reclassification of derivatives gains (losses), Alcoas earnings show a strong

growth from $1310 million, to $1233 million and to $2248 million in 2004, 2005 and 2006
respectively. However, earnings before reclassification are quite volatile from 1292
million to 1045 million to 2845 million in 2004, 2005 and 2006 respectively.

67
Here is a list of more examples of smoother earnings pattern after reclassification of
derivative gains.
Ambac (NYSE: ABK)

2004

2005

2006

Earnings before reclassification

709 million

693 million

867 million

Reclassified derivative gains/losses

15 million

58 million

8 million

Earnings

724 million

751 million

875 million

American Express (NYSE:AXP)

2004

2005

2006

Earnings before reclassification

3489 million

3892 million

3409 million

Reclassified derivative gains/losses

-44 million

-158 million

298 million

Earnings

3445 million

3734 million

3707 million

Ambac reclassified much more derivative gains in 2005 than in 2006 because its
earnings in 2005 before reclassification is lower than the reported earnings of 2004, and its
earnings before reclassification in 2006 is higher than the reported earnings of 2005.
Control Variables
To test whether the results may be affected by other factors, following Barton
(2001) and OHanlon (1996) a multivariate regression was also performed to include
changes in total assets and operating cash flows. Table 8 shows that the correlation
coefficients of total assets (TA) and operating cash flow (OCF) are statistically

68
insignificant (with high p values of 0.963). In other words, earnings volatility is not related
to firm size (total assets) and firm specific operations (operating cash flow). The results are
consistent with Bartons (2001) conclusion that firm size and firm specific factors have no
impact on earnings smoothing.
Because under this study, derivative use is considered part of the normal risk
management activity of a public firm, and the fair value of financial derivatives is subject
to market fluctuation (derivatives of all kinds are marked-to-market), firm size should not
have any impact on earnings smoothness in terms of derivative use. For example, if there is
a change in the market price of a derivative, the change can affect all firms in all sizes that
are holding that particular derivative.
Relationship of findings to theoretical framework
The findings of this study are consistent with Bartons (2001) conclusion that financial
derivatives can be a substitute for accounting accruals in earnings management, because
under the new SEC rules and the Sarbanes-Oxley Act, discretionary accounting accruals
are prohibited. The findings also agree with McKees (2005) theory that financial
derivatives can alter the cash flow of a firm, resulting in transferring of earnings volatility
from one firm to another. The findings of this study also revealed a loophole in the current
accounting standards for derivatives which allow firms to transfer its own earnings
volatility from one accounting period to another by the deferral and reclassification of
gains or losses from derivatives for hedging purpose.
Conclusion

69
In light of the SOX, the pervasiveness of earnings management, the quality of
financial reporting, and the effectiveness of accounting standards have become a national
concern. This study provided evidence that firms manage earnings by using financial
derivative transactions to manage cash flow and/or manipulating reclassification of
derivative gains to smooth earnings volatility. The earnings volatilities between firms that
use derivatives and firms that do not use derivatives were significantly different. The
reclassified derivative gains were regressed on earnings smoothing thresholds, the
pre-managed earnings. The results suggest that firms use derivatives as wells as loophole
in accounting for derivatives as earnings smoothing devices. Consistent with earnings
smoothing hypothesis, some firms apparently manage the discretionary component of the
deferred derivative gains upward if current years pre-managed earnings fall below prior
year reported earnings. The results were consistent with Bartons (2001) findings that
financial derivatives could replace accounting accruals in earnings management.
Accounting research on financial derivatives has immense economic significance
because of extreme risks associated with the large volume of derivative instruments. More
and more complex financial derivative instruments are being created today. By providing
insights on public firms manipulation of earnings through innovative derivatives, this
study contributes to the ongoing efforts of law makers and accounting standard setters to
improve regulations and the accounting standards for derivative instruments. In the recent
real estate sub-prime crisis, most large banks recorded huge amount of losses in 2007 from
mortgage contracts and derivatives on such mortgages because the credit risk (buyer

70
default risk) was significantly underestimated before 2007. No one was questioning about
the valuation of such derivatives on sub-prime mortgages before the end of 2006.
Evidence of earnings smoothing by reclassification of derivative gains suggests
that current accounting standards (FAS 133) are not adequate. To close this loophole,
current accounting standards need to be modified to (a) cover more complex financial
derivatives; (b) require firms to report separately the gains or losses from the items being
hedged, so that investors can see if the reclassified derivative gains (losses) are offsetting
the real losses (gains) from the items being hedged.
However, the earnings smoothing evidence reported by this study must be
interpreted with caution. Results from this study were from firms in the S&P 500 list,
neglecting other significant number of derivative users. Thus, the results of this study may
not apply to all public firms. Moreover, generalizing the results to a time frame outside the
sample period may also be inappropriate because the extent of derivative activities might
be different, and the accounting standards might be different.
Also the relationship between reclassified derivative gains and pre-managed
earnings must not be considered strong evidence because the losses from items being
hedged were not reported. The pre-managed earnings included the losses from such items
being hedged. Although the statistics rejected the hull hypothesis 2, the evidence here can
only cast a reasonable doubt that firms tend to classify more derivative gains when
pre-managed earnings are low. Wait until the accounting standards require firms to report
losses from items being hedged separately, and such losses have been added back to

71
pre-managed earnings, the evidence can be strong enough to conclude that firms tend to
classify more derivative gains when pre-managed earnings are low.
Suggestion for Future Studies
The test of hypothesis 1 of this study can be extended further by using quarterly
earnings data. Earnings volatility on a quarterly basis may show different patterns. The use
of quarterly data may also increase the number of observations. Since earnings smoothing
through derivative reclassification is more likely to be done at the end of the last quarter of
a year, quarterly data may provide more evidence to support hypothesis 2.
Impact on Social Change
The tremendous growth in financial derivatives and recent reports of major losses
associated with derivative products have resulted in a great deal of public confusion about
those complex derivative instruments, which have significantly changed the way public
firms manage their daily risk and operations. Investors may wonder if the growth in
derivative instruments can destroy global financial markets. Are firms that use derivative
products irresponsible because they use financial derivatives as part of their overall
risk-management strategy? Are financial derivatives the source of the next U.S. financial
bubble on the verge of exploding?
In May 1994, the General Accounting Office (GAO) released a two-year study,
"Financial Derivatives: Actions Needed to Protect the Financial System
GAO/GGD-94-133, which called for stiffer government regulation of financial derivatives
markets. GAO believed that financial derivatives created risks that are uncontrollable and
not well understood. Financial derivatives can be useful in risk management, but they can

72
also be very dangerous, especially if used without proper safeguards. This study provided
evidence that financial derivatives are powerful tools for earnings smoothing, and current
accounting standards have yet to be changed to eliminate the earnings smoothing loophole.
Hopefully, this study can help in assessing accounting standards and law and regulations
for financial derivatives to better improve the quality of reported earnings of public firms.

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CURRICULUM VITA
Guy Wan Jia Lin, CPA
584 Black Pine Drive, San Leandro, CA 94577, USA; caiinc@yahoo.com
___________________________________________________________

Executive Summary

A high caliber accounting professional with strong IT, mathematics and statistics
skills, thorough knowledge of GAAP, practical experience in accounting, finance, and
taxation, and very strong passion for education.

Profile

1. Successfully educated & worked in China, familiar with Chinese accounting

practice, business practice, and tax code;
2. On-going studies toward PhD degree in Accounting in the United States, with
exposure to some of the best business ideas and financial theories.
3. An active certified public accountant (CPA) in the United States, with strong
grasp of the US Generally Accepted Accounting Principles (GAAP),
experiencing many tough business issues;
4. Broad proficiency in corporate finance, and risk management;
5. Strong IT background; superior computer skills;

81
6. Strong blend of instructional skills combined with practical, hands-on,
technical skills.
7. Excellent mathematics and statistics skills, very good at financial modeling.
8. Familiar with the US Tax Code.
9. Familiar with International Accounting Standards (IAS) and the legal
environment of international business.
10. Familiar with SFAS 133: accounting for derivatives.
11. Very good at application of information technology in accounting and finance.
Strong independent research skills at doctoral level.

Work Experience

2000 present (Weekends, Evenings and Seasonal)

Senior Partner
Guy Lin, CPA
1. Providing accounting, tax and management consulting service to the public.
2. Advisory with a full range of tax-efficient investment strategies. Working very
closely as an advisor to corporate executives providing a very high level of
guidance, management control and direction in conformity with the Generally
Accepted Accounting Principles, and the US Tax Code.
3. Teaching Uniformed Certified Public Accountant Exams preparation courses.
4. Accounting software training.

82
5. Securities, forex and futures automated trading strategies design,
implementation and optimization.

1998 - 2007 (Over 9 Years)

CFO
Super Link Inc.
In charge of the corporate controllership of this $22 million annual sales waste
management and export company. Duties include:
1. Leading an Accounting Manager, an Internal Auditor and an IT Manager;
2. Monitoring and maintaining a robust internal control system;
3. Working with bankers to control interest rate risk and foreign exchange risk;
4. Assuring compliance in all areas, including environment, insurance, e-waste,
federal and state laws, and tax regulations.
5. Working with outside independent CPAs in audit and corporate tax matters.

1994 to 1996 (2 Years)

Controller
Compaq Computer Technology Ltd

General Ledger;

Financial reporting;

Controllership.

83
1988 to 1989 (1 Year)
Controller
GXS Retail Chain
In charge of the accounting and finance of this large retain chain. Duties include:

Maintaining books of 20 branches;

Preparation of consolidated financial statements;

Internal audit of branch operations.

1984 to 1988 (4 Years)

Bookkeeper
GXS Retail Chain
Daily journal entry, ledger posting and keeping; Bank reconciliation; Payroll; A/R, A/P,
and Inventory.

Education

PhD (2008)
Walden University, USA
School of Applied Management and Decision Science
Concentration : Accounting

MBA (1998)

84
Lincoln University, USA

Bachelors degree in computer science (1997)

Pacific University, USA

Graduate Diploma in International Finance (1994)

Guangdong Academy of Social Science, China

Undergraduate Diploma in Accounting (1984)

ShenYang College of Science and Technology, China

Membership

Member of American Institute of Certified Public Accountants (AICPA).

Accomplishments

Successfully worked as controller of a multi-national high tech company in China.

Successfully obtained CPA license in the USA.
Successfully worked as CFO in a multi-national company in the USA.
Successfully founded a public accounting firm in the USA.

85
Successfully installed more than 100 accounting information systems (networks) for
small and medium-size businesses in China.
Successfully published a series of financial dictionaries world-wide.