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    The Impact of SFAS 133 on Income Smoothing by Banks through...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.03 Impact of New Accounting Pronouncements 
    The Impact of SFAS 133 on Income Smoothing by Banks through Loan Loss Provisions.
    Practical Implications:

    This study provides evidence on how SFAS 133 affected reporting behavior. While it is not possible to directly assess the extent to which banks might have used LLP to offset hedge ineffectiveness prior to SFAS 133, a variety of tests in this study collectively indicate that bank managers increase their reliance on discretionary LLP to counteract the undesirable effects of SFAS 133’s recognition requirements. The effects of SFAS 133 go beyond derivatives; SFAS 133 also altered the information content of a non-derivative financial statement component (i.e., LLP) and the pricing of that component in equity markets. The findings are particularly timely given the recent exposure draft on accounting for financial instruments.


    Kilic, E., G. J. Lobo, T. Ranasinghe, and K. Sivaramakrishnan. 2013. The Impact of SFAS 133 on Income Smoothing by Banks through Loan Loss Provisions. Accounting Review 88 (1): 233-260.

    derivatives, hedging, income smoothing, loan loss provisions, SFAS 133
    Purpose of the Study:

    This study examines the impact of SFAS 133, Accounting for Derivative Instruments and Hedging Activities, on the reporting behavior of commercial banks and the informativeness of their financial statements. SFAS 133 changed accounting for derivatives substantially by forcing recognition of (1) all hedging derivatives at their fair values, and (2) any hedge ineffectiveness in income as it occurs. As a result, the hedging derivative gains/losses recognized in income by derivative user banks almost quadrupled following the adoption of SFAS 133, with as much as 20 percent of those gains/losses arising from ineffective hedging. Clearly, hedge ineffectiveness increases income volatility because gains and losses from hedges and hedged items are not offsetting.

    SFAS 133 would arguably inhibit the use of derivatives in smoothing income. This possibility raises at least two interesting research questions regarding the impact of SFAS 133 on the reporting behavior of managers, and the consequent impact on the informativeness of financial statements. In particular:

    1. Did firms using derivative instruments for hedging significantly alter their reporting behavior post-SFAS 133?
    2. Notwithstanding any changes in reporting behavior, by enacting SFAS 133, did the FASB achieve its intended purpose of making financial statements more transparent to users?
    Design/Method/ Approach:

    The authors obtain bank holding company financial data and derivative data from 10-K filings and FR Y-9C filings, and share price data from the CRSP data files. They restrict the pre-SFAS 133 sample period to fiscal years 1998, 1999, and 2000, and the post-SFAS 133 sample period to fiscal years 2001, 2002, and 2003. The authors use a final sample of 105 derivative-user banks. The sample of non-user banks includes 139 publicly traded banks that do not use hedging derivatives during the sample period.

    • Banks likely to be more affected by SFAS 133 achieved a greater degree of income smoothing from offsetting LLP following its adoption.
    • The positive association between discretionary LLP and market returns is significantly lower in the post-SFAS 133 period compared to the pre-SFAS 133 period for affected banks than for unaffected banks and for non-user banks.
    • The informativeness of LLP deteriorated for these banks subsequent to SFAS 133 (i.e., the association of LLP with future loan defaults and contemporaneous stock returns became weaker).
    • The authors do not find evidence that SFAS 133 altered the informativeness of hedging derivative gains/losses for bank holding companies. 
    • This study reinforces the notion that the efficacy of a given regulation cannot be assessed on a standalone basis without giving due consideration to its unintended consequences.
    Standard Setting
    Impact of New Accounting Pronouncements