The FVO and Firms’ Earnings Management Incentives

Abstract

This paper examines the incentives utilized by firms in applying the FVO (SFAS 159) by analyzing firms’ application decisions under different circumstances. I confirm the finding in prior literature that firms apply SFAS 159 to manipulate earnings upward to meet or beat earnings target. Additionally, I find that approximately 42% of firms adopting SFAS 159 recognized unrealized losses, this stratagem employed by firms suggests that they elect the fair value option (FVO) to smooth incomes. Although the FASB and prior literature suggest that hedge accounting users are more likely to apply a more cost-savings SFAS 159 over hedge accounting (SFAS 133), my findings dispute cost-savings as the likely reason, suggesting that a hedge accounting user’s decision to adopt FVO is not driven by cost-savings consideration.