Incentives for Banks to Adopt the Fair Value Option under SFAS No. 159: Early versus Regular Adoption

Abstract

Aiming to mitigate earnings volatility and reduce hedge accounting complexity, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 159, The Fair value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (now codified as ASC 825). The fair value option (FVO) provides firms with the discretion of measuring financial instruments at fair value each reporting period with changes in those fair values reported in earnings. This paper investigates banks' incentives to adopt the FVO. Specifically, we examine if banks behave in accordance with the standard's objectives, or they wield the discretionary powers to manipulate accounting numbers. Using a sample of U.S. bank holding companies, we discern divergent incentives for different timings of the FVO adoption. Consistent with other FVO studies (Song, 2008; Henry, 2009), we find that early adopters were mostly motivated by manipulation incentives. However: we present positive evidence on regular adoption complying with the standard's objectives, which has not been discovered by recent research. Our findings provide a more balanced perspective on the assessment of SFAS No. 159, and have significant implications for the FASB since they regard the FVO as an interim step toward full fair value accounting for financial instruments. Moreover; as the FVO is also regulated by Taiwan's SFAS NO.34 but to our knowledge no Taiwanese company has so far elected, we wish to attract more interests and attention via enhanced understanding of this issue.