The effects of the fair value option under IAS 39 on the volatility of bank earnings

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.