Cash Flow Hedges in Other Comprehensive Income
Prior literature is mixed as to whether gains and losses of cash flow hedges reported in other comprehensive income (OCI) convey information about future firm performance and suggests that market participants are unable to understand these information signals (if any). We re-examine this open question in the literature taking into account the unique nature and characteristics of hedge accounting. Hedging gains and losses provide opposite signals with respect to unhedged versus hedged positions of the underlying item. Further, while OCI hedging gains and losses include both the fair value changes of outstanding hedges and reclassification adjustments of settled hedges, it is only the outstanding hedges that impact future performance. Examining OCI reporting of cash flow hedges by U.S. oil and gas exploration and production firms and directly accounting for the above factors, we find that these disclosures contain relevant information about the subsequent year’s earnings and operating cash flows. Moreover, we find that analysts and investors understand the information signals provided by the fair value changes of outstanding hedges regarding both unhedged and hedged positions of future oil and gas production. We further find the introduction of SFAS 161 and the issuance of management earnings forecasts to improve this understanding. Overall, our findings suggest that disclosures provided under current hedge accounting standards provide value relevant information to capital market participants.