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ABSTRACT: Using an international sample of 222 banks from 41 countries, this study examines whether the fair value option (FVO) affects earnings volatility. Prior empirical studies associate higher levels of earnings volatility with fair value accounting (Barth et al. 1995; Hodder et al. 2006). In contrast, I find evidence that banks applying the FVO to reduce accounting mismatches exhibit lower earnings volatility than other banks. I assign this alternative outcome to the optional characteristic of the FVO. Banks can use the flexibility in accounting to reduce artificial earnings volatility. The cross-sectional results are robust against outliers and several model alterations, including controls for endogeneity bias. Furthermore, I predict and find that banks from countries with high regulatory quality are more likely to apply the FVO to reduce accounting mismatches. Overall, the findings confirm the IASB's initial intention on introducing the FVO. Hence, the study contributes to the current debate on the use of fair values in financial reporting.
Keywords: fair value option; FVO; earnings volatility; fair value accounting; financial instruments; IAS 39; banks.
Data Availability: All data are available from public sources.
(ProQuest: ... denotes formulae omitted.)
I. INTRODUCTION
Fair value accounting has become a crucial measurement principle in international accounting. The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) further promote fair value accounting as the future basis for measurement (FASB 2007; IASB 2008). However, fair value accounting remains controversial, primarily due to the trade-off between the relevance and the reliability of reported fair values (Ryan 2008). From a theoretical point of view, fair value is believed to be more relevant than the historical cost approach, since fair values should reflect investors' risk-adjusted expected future cash flows more precisely than do other approaches (e.g., Hitz 2007; Allen and Carletti 2008). There are, however, some practical problems concerning fair value accounting. On the one hand, the measurement of fair values can be very complex. In the absence of quoted market prices in active markets, fair value measurement is based on subjective assumptions and, hence, may be subject to manipulation (Dechow et al. 2010). On the other hand, fair value accounting may increase earnings volatility. Earnings volatility is an important issue, since higher levels of earnings volatility are associated with...