The Effect of Fair Value Accounting on the Performance Evaluation Role of Earnings

Abstract

Contracting theory asserts that the income statement's primary role is to provide useful information for management performance evaluation. We study the effect of fair value accounting on this role by examining the change in earnings pay-performance sensitivity (PPS) following the 2005 worldwide adoption of IFRS. We find that while IFRS's non-fair-value provisions improve earnings PPS, its fair value provisions offset this improvement. Overall, we contribute to the literature on the contracting usefulness of fair value accounting by presenting evidence that fair value accounting impairs the usefulness of earnings in evaluating management performance.

Keywords: accounting earnings; executive compensation; fair value accounting; historical cost accounting; contracting; pay performance sensitivity