Financial reporting quality and corporate hedging policy: preliminary evidence

Purpose
This study evaluates whether firms carry out hedging activities on interest rates and foreign exchange to mitigate the effect of financial constraints caused by the informational disadvantage.

Design/methodology/approach
In this study, the financial reporting quality is measured with conventional approaches following Dechow, Sloan and Sweeney (1995) and Dechow and Dichev (2002), while the magnitude of hedging activities is measured with textual analysis. In particular, we construct the hedging intensity proxy by counting the relevant keywords on hedging on interest rate derivatives and foreign exchange derivatives (IR/FX). We then compute a standardized ratio of the number of hedging keywords counted relative to its peers in the same industry and use this standardized ratio to proxy for hedging activities taken by the firm. Our baseline analysis will test the relationship between firms’ financial reporting quality and hedging activities. We will further test whether this relationship varies across the subsamples partitioned by the hedging need. Our last analysis will test how the hedging activities moderate the underinvestment in firms with low financial reporting quality.

Findings
We find that firms with low financial reporting quality have more hedging activities, as measured by our keyword count proxy. Furthermore, we find the low financial reporting quality firms that are more financially constrained, located in competitive industries, and have better corporate governance provisions undertake more hedging activities. Lastly, we find that firms that undertake hedging activities invest more.

Originality/value
This study is related to the literature that examines the real effects of financial reporting quality. When most studies on financial reporting quality examine its effects on investment, financing and liquidity management, few studies have investigated corporate hedging policies. Given that risk management through financial hedging has become increasingly important and widely used in many large corporations, it is important to extend the studies on the real effect of financial reporting to the hedging activities. In addition, this study is also related to the finance literature that examines the economic determinants and consequences of firms’ hedging policies.