Use of Derivatives as Hedging Instruments and Application of Hedge Accounting : Effects on Income Volatility

This study examines whether derivatives as hedging instruments and the application of hedge accounting are associated with income volatility. In Korea, the accounting principle for derivatives was described in Korean Interpretations on Accounting Standards No. 53-70. With the adoption of IFRS in 2011, Korean firms comply with K-IFRS No. 1039 for derivatives. Both accounting standards allow companies to apply hedge accounting when certain conditions, the highly effective hedge relationship based on the bright-line test, are satisfied. With hedge accounting, the valuation gains or losses from hedging instruments and hedged items are simultaneously recognized such that the accounting mismatch with the economic substance is minimized on financial statements. Unfortunately, the current standard requires a strict rule-based hedge effectiveness test and has been criticized to fail to faithfully reflect the actual corporate risk management strategy. Moreover, since K-IFRS No. 1039 does not allow critical-terms match and the shortcut method to judge the effectiveness of hedge, it is more difficult for firms to consistently apply hedge accounting from period to period. K-IFRS No. 1109, the new standard on derivatives, no longer relies on the bright-line test but instead requires qualitative judgement. Using 8,382 sample, we found a negative association between the use of derivatives as hedging instruments and income volatility. We also found a negative association between the application of hedge accounting and income volatility, however, the association is no longer significant after the adoption of IFRS. The results provide a justification for the amendment of accounting standards.