An Evaluation of FAS 159 Fair Value Option: Evidence from the Banking Industry

Abstract

Whether the fair value option (FVO) of FAS 159 should be permitted is a controversial issue. I examine three research questions using a sample from the banking industry. First, I examine what factors are associated with the adoption of the FVO. Second, I examine whether firms use the FVO as intended by the FASB: reducing earnings volatility and simplifying hedge accounting treatments. Finally, I examine the value relevance of unrealized gains and losses recognized due to the FVO. I find that the determinants of using the FVO are associated with opportunistic motivation, such as earnings management and restructuring portfolios. Second, I find that banks (1) exploit the transitional adjustment provision allowed by FAS 159 to remove available-for-sale securities with loss positions without reporting the losses in earnings, and (2) report higher earnings than the target earnings by managing earnings through the FVO. Finally, I find that unrealized losses recognized due to the FVO are priced, whereas unrealized gains are not. Overall, the FVO seems to induce undesirable effects.

Keywords: FAS 159, Fair Values, Fair Value Option, Value Relevance

JEL Classification: M41, M43, M44