A Study of Income Smoothing on the Fair Value Option in the Banking Industry
Author
Abstract
The Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, was issued in 2007 to allow firms to voluntarily adopt the fair value option for financial instruments with changes in fair value (FVOGL) recognized in net income. This Statement provides a tool for income smoothing to banks which previously used discretionary loan loss provisions (DLLP) to achieve earnings targets. This study collects data for 86 bank holding companies and 2,997 bank/quarter observations over the period from the first quarter of 2008 to the third quarter of 2017 to examine related hypotheses. The empirical results of DLLP regression models present as follows: First, banks use FVOGL to achieve the intent of this Statement to mitigate accounting mismatches and reduce earnings volatility, thereby using less DLLP. Second, banks are inclined to use FVOGLA (for assets) to engage in income smoothing and rely less on DLLP due to there being more categories of financial assets to which the fair value option can apply. Third, by dividing FVOGL into FVOGLC (for credit risk) and FVOGLO (other factors), this study obtains evidence that both FVOGLO and FVOGLO are negatively associated with DLLP.
Key Words
fair value option, discretionary loan loss provisions, income smoothing, accounting mismatches, earnings volatility
