The Effects of The Fair Value Option Under IAS 39 On The Volatility of Bank Earnings

JOURNAL OF INTERNATIONAL ACCOUNTING RESEARCH American Accounting Association
Vol. 10, No. 1 DOI: 10.2308/jiar.2011.10.1.85

2011
pp. 85–108
The Effects of the Fair Value Option under

IAS 39 on the Volatility of Bank Earnings
Peter Fiechter
ABSTRACT: Using an international sample of 222 banks from 41 countries, this study
examines whether the fair value option 共FVO兲 affects earnings volatility. Prior empirical
studies associate higher levels of earnings volatility with fair value accounting 共Barth et
al. 1995; Hodder et al. 2006兲. In contrast, I find evidence that banks applying the FVO
to reduce accounting mismatches exhibit lower earnings volatility than other banks. I
assign this alternative outcome to the optional characteristic of the FVO. Banks can use
the flexibility in accounting to reduce artificial earnings volatility. The cross-sectional
results are robust against outliers and several model alterations, including controls for
endogeneity bias. Furthermore, I predict and find that banks from countries with high
regulatory quality are more likely to apply the FVO to reduce accounting mismatches.
Overall, the findings confirm the IASB’s initial intention on introducing the FVO. Hence,
the study contributes to the current debate on the use of fair values in financial report-
ing.
Keywords: fair value option; FVO; earnings volatility; fair value accounting; financial
instruments; IAS 39; banks.
Data Availability: All data are available from public sources.
I. INTRODUCTION
F
air value accounting has become a crucial measurement principle in international account-
ing. The International Accounting Standards Board 共IASB兲 and the Financial Accounting
Standards Board 共FASB兲 further promote fair value accounting as the future basis for
measurement 共FASB 2007; IASB 2008兲. However, fair value accounting remains controversial,
primarily due to the trade-off between the relevance and the reliability of reported fair values
共Ryan 2008兲. From a theoretical point of view, fair value is believed to be more relevant than the
historical cost approach, since fair values should reflect investors’ risk-adjusted expected future
cash flows more precisely than do other approaches 共e.g., Hitz 2007; Allen and Carletti 2008兲.
There are, however, some practical problems concerning fair value accounting. On the one hand,
the measurement of fair values can be very complex. In the absence of quoted market prices in
active markets, fair value measurement is based on subjective assumptions and, hence, may be
Peter Fiechter is an Assistant Professor at the University of Zurich.
I thank workshop participants at the University of Bern and American Accounting Association 2009 Northeast Regional
Meeting for their helpful comments, and especially Conrad Meyer, Dieter Pfaff, Martin Wallmeier, Zoltan Novotny-Farkas,
Kenneth Ferris 共editor兲, and two anonymous reviewers.
Published Online: February 2011
85
86 Fiechter
subject to manipulation 共Dechow et al. 2010兲. On the other hand, fair value accounting may
increase earnings volatility. Earnings volatility is an important issue, since higher levels of earn-
ings volatility are associated with lower market values 共Easton and Zmijewski 1989; Barnes 2001;
Hodder et al. 2006兲, are perceived as riskier 共Graham et al. 2005兲, and increase the likelihood of
bankruptcy 共Kim et al. 2001兲. In addition, comment letters on new or revised accounting standards
for financial instruments often address concerns about the effects of fair value accounting on
earnings volatility. Song 共2008兲 finds that 47 percent of the comments on SFAS 133 express these
concerns. Also, during the standard-setting process of IAS 39, possible effects on earnings vola-
tility is one of the top issues raised by the comment letters received 共Fiechter 2009, 29–41兲.
Therefore, this paper focuses on the effect of fair value accounting on earnings volatility.
First, it is necessary to distinguish between artificial earnings volatility 共e.g., due to account-
ing rules兲 and real economic earnings volatility. If the financial statements overstate earnings
volatility due to accounting rules, investors may charge a risk premium that is higher than justified
by the economic situation of the entity 共Barth 2004兲. Under the mixed measurement model of IAS
39 共i.e., some financial instruments are measured at fair value through profit or loss, whereas other
financial instruments are measured at amortized cost兲, economically hedged positions may be
measured differently. This so-called accounting mismatch induces artificial earnings volatility. The
IASB introduced the fair value option 共FVO兲 due to this shortcoming among other reasons 共IASB
2007, para. BC74A兲. However, the FVO has been the subject of intense debate. In particular, the
European Central Bank, the Basel Committee on Banking Supervision, and even some members
of the IASB argued that the FVO might increase, rather than decrease, earnings volatility 共ECB
2004; Landsman 2006; IASB 2003, para. DO4兲. These concerns are supported by extant empirical
research that documents an increase in earnings volatility due to fair value accounting 共Barth et al.
1995; Hodder et al. 2006兲. In contrast, the results from a simulation analysis of Gebhardt et al.
共2004兲 indicate a negative association between fair value accounting and earnings volatility. Also,
recent U.S.-based research finds that the FVO under SFAS 159 was eventually used as intended by
the FASB 共Chang et al. 2009兲. However, there is only little empirical evidence on the effects of
optional fair value measurement on earnings volatility to date. Hence, the purpose of this paper is
to provide further insights regarding 共1兲 the determinants of the decision to apply the FVO under
IAS 39, and 共2兲 the effects of optional fair value accounting on the volatility of bank earnings
around the world.
I construct an international sample of 222 banks from 41 countries. Next, I hand-collect data
regarding the application intention of the FVO from the disclosure section in the 2007 annual
reports. I then test whether banks that apply the FVO primarily to reduce accounting mismatches
exhibit lower earnings volatility during the time period from January 2006 until December 2007.1
In contrast to previous empirical literature on fair value accounting, my proxy for earnings
volatility is based on reported earnings figures. Hence, the research design accounts for possible
hedging relationships. However, the research designs of prior literature on fair value accounting
have the advantage that the sample bank can be used as its own control, isolating the effect of fair
value accounting. The current design could, therefore, be influenced by unobservable and endog-
enous determinants of earnings volatility that are difficult to control for. Although I attempt to
address endogeneity concerns by using a treatment effects model as well as propensity score
matching, there remain some concerns regarding the causality of the effect of the FVO on earnings
volatility. In addition, my proxy for earnings volatility may be affected by earnings smoothing
1
The effects of the FVO applied due to other reasons 共see Section II兲 are unclear, since the IASB also intended to
simplify the accounting for financial instruments. Moreover, the IASB issued on November 12, 2009, the new standard
IFRS 9, Financial Instruments: Classification and Measurement, which suggests that the fair value option may be
applied solely to reduce accounting mismatches. Hence, this study focuses on this particular application intention.
Journal of International Accounting Research Volume 10, No. 1, 2011

American Accounting Association
The Effects of the Fair Value Option under IAS 39 on the Volatility of Bank Earnings 87
behavior of banks 共e.g., through discretionary loan loss provisions兲. As I do not explicitly control
for earnings smoothing, my findings should be interpreted with caution.
Nevertheless, my results indicate that banks applying the FVO with the intention to reduce
accounting mismatches report lower levels of earnings volatility than the control group. Further-
more, I provide 共weak兲 univariate evidence that the earnings volatility of these banks is signifi-
cantly lower in the post-introduction period of the FVO than in the pre-introduction period,
controlling for changes in the economic environment over time. Throughout all tests, the reduction
in earnings volatility equals approximately the median earnings volatility of the sample, which is
considered to be of economic relevance. I also find that the application of the FVO is a more
effective tool to reduce earnings volatility than hedge accounting in accordance with IAS 39. It is,
therefore, not surprising that banks from countries with high regulatory quality are more likely to
apply the FVO to reduce accounting mismatches.
The study contributes to the literature in several ways. First, the results support the IASB’s
original intention as well as its current steps in respect to the accounting for financial instruments
共i.e., replacement of IAS 39兲. Second, this study contributes to the ongoing debate on fair value
accounting by presenting alternative conclusions to those in prior empirical research.2 In light of
the substantial critique toward fair value accounting during the financial crisis, this study is “in
defense of fair value,” showing that optional fair value accounting can lead to desired economic
outcomes. Finally, this is the first study on the FVO for a global IFRS bank sample, allowing for
cross-country differences in the application behavior.
The paper is organized as follows. The next section briefly reviews previous research and
develops the hypotheses of the study. Section III explains the research design. Section IV de-
scribes the sample and data. The results are presented in Section V, followed by additional analy-
ses in Section VI. Section VII concludes.
II. BACKGROUND AND HYPOTHESES

Fair Value Option under IAS 39 and SFAS 159
In 2003, the IASB issued the amended standard IAS 39, Financial Instruments: Recognition
and Measurement, including an option to designate irrevocably any financial instrument at fair
value through profit or loss 共FVO兲. The IASB’s intention when introducing the FVO was to
simplify accounting for financial instruments as well as to provide an opportunity to reduce
accounting mismatches 共IASB 2003, para. BC74A兲. Accounting mismatches result from the mixed
measurement model under IAS 39. Depending on the initial classification of a financial instru-
ment, the subsequent measurement is either at fair value through profit or loss 共e.g., financial
instruments held for trading兲 or at amortized cost 共e.g., loans and receivables兲. Hedge accounting
can be applied to reduce accounting mismatches 共IASB 2003, para. 85兲. However, in situations
where hedge accounting cannot be applied 共e.g., due to lack of hedge effectiveness兲, the FVO
works as a sound alternative to hedge accounting 共IASB 2003, para. 75B兲. Hence, the application
of the FVO on the economically hedged position may reduce earnings volatility, avoiding different
impacts on the income statement. However, prudential supervisors such as the European Central
Bank or the Basel Committee on Banking Supervision were concerned that the FVO might be
used inappropriately. These institutions believed that 共1兲 the valuation of some financial instru-
ments designated at fair value through profit or loss might be made on a subjective basis; 共2兲 the
application of the FVO to financial liabilities might result in profits or losses being recognized as
2
Extant literature typically associates higher levels of earnings volatility with fair value accounting 共Barth et al. 1995;
Hodder et al. 2006兲. Moreover, prudential supervisors of banks have expressed major concerns against the FVO 共IASB
2003, para. BC11C兲.

88 Fiechter
the result of changes in an entity’s own creditworthiness; and 共3兲 in contrast to the IASB’s original
intention, the use of the FVO might increase, rather than decrease, earnings volatility 共IASB 2003,
para. BC11C兲. In response to these concerns, the IASB acted step-by-step to restrict the FVO to
the following three eligibility criteria 共IASB 2003, para. 9 in conjunction with para. 11A兲:
共1兲 It eliminates or significantly reduces inconsistencies in measurement or recognition 共ac-
counting mismatches兲; or
共2兲 A group of financial instruments is managed and its performance is evaluated on a fair
value basis; or
共3兲 A financial instrument contains one or more substantive embedded derivatives.
For annual periods beginning on or after January 1, 2006, the revised FVO may be applied if any
of the three eligibility criteria is satisfied.
In 2007, the Financial Accounting Standards Board 共FASB兲 published SFAS 159, The Fair
Value Option for Financial Assets and Liabilities, which is effective for annual periods on or after
November 15, 2007, while earlier application is possible under certain circumstances 共FASB 2007,
para. 30兲. The FVO under SFAS 159 is similar to the FVO under IAS 39. However, there exist
some differences. First, the FVO under SFAS 159 may also be applied to non-financial items—for
example, firm commitments, insurance contracts, and warranties. On the other hand, deposit
liabilities are not within the scope of the standard 共FASB 2007, paras. 7 and 8兲. Most importantly,
the FVO under SFAS 159 does not incorporate eligibility requirements that are similar to the three
eligibility criteria in IAS 39, since the FASB believes that the incorporation of eligibility criteria
would basically increase the complexity of the standard 共FASB 2007, paras. A20 and A21兲.
Fair Value Accounting and Earnings Volatility

To date, there is hardly any literature regarding the FVO under IAS 39 and its effects on
earnings volatility. There is, however, research that investigates the effects of mandatory fair value
accounting on earnings volatility, as well as studies on the FVO under SFAS 159.
Barth et al. 共1995兲 provide empirical evidence for an increase in the volatility of bank earn-
ings by applying fair value accounting. According to their research design, reported net income is
adjusted retrospectively by unrealized fair value profits or losses on debt and equity securities
disclosed in the notes to the financial statements of the bank. However, their earnings volatility
proxy does not account for any hedge relationships and, hence, the results may be overstated
共Barth et al. 1995, 581兲. The research design of Hodder et al. 共2006兲 and their conclusions are
similar.
Gebhardt et al. 共2004兲 run a simulation of a bank’s balance sheet split into a trading and a
banking book, assuming that the balance sheet is only affected by interest rate changes. Under the
mixed model of IAS 39, Gebhardt et al. 共2004兲 show that a bank reports earnings volatility even
though its balance sheet is economically hedged. Hedge accounting in accordance with IAS 39
also fails to provide a satisfactory solution due to its restrictions. Only a full fair value measured
balance sheet reflects the underlying economic risks and leads to increased comparability between
different banks.
The European Central Bank 共2004兲 enhances the study of Gebhardt et al. 共2004兲 by simulating
credit and market risks along with interest rate risks. Consistent with the findings of Gebhardt et
al. 共2004兲, the European Central Bank shows that applying fair value accounting results in im-
proved reporting of the true economic consequences of financial transactions as well as the im-
proved timeliness of financial statements.3
3
Note that, however, fair value accounting may induce pro-cyclical effects and even endanger the stability of financial
markets if unrealized fair value gains are distributed 共ECB 2004, 24兲.

Recent studies focus on the FVO under SFAS 159. Song 共2008兲 examines whether earnings
volatility is reduced by the FVO under SFAS 159. He finds that the standard deviation in quarterly
earnings, before and after recognition of unrealized gains and losses due to the FVO, does not
differ significantly. Hence, there is no empirical evidence that the FVO decreases earnings vola-
tility. The result, however, represents the volatility of a sample 共i.e., FVO appliers兲 rather than the
entity-specific earnings volatility, since earnings volatility is calculated for one quarter 共i.e., Q1
2008兲. Therefore, no conclusions can be drawn regarding the effects associated with the applica-
tion of SFAS 159 on the entity-specific earnings volatility. Chang et al. 共2009兲 find empirical
evidence that the regular adoption of the FVO under SFAS 159 is explained by variables related
to accounting mismatches, which is consistent with the standard’s intention. The ex ante earnings
volatility of a bank is one of these variables and is expected to be positively associated with
accounting mismatches. However, as the coefficients of this proxy are not statistically significant
throughout all models 共Chang et al. 2009, 54–58兲, the ex ante earnings volatility does not explain
the decision to adopt SFAS 159.
In contrast to the FVO under SFAS 159, banks may apply the FVO under IAS 39 if, and only
if, one eligibility criteria is satisfied. Since IFRS 7 requires disclosure of the eligibility criterion
relating to the application of the FVO, the rationale behind the application of the FVO becomes
observable 共IASB 2007, para. B5兲. Hence, the question whether banks applied the FVO as in-
tended 共see e.g., Chang et al. 2009兲 can be answered by looking at the disclosures of the FVO.
However, whether the application of the FVO actually achieves the desired effects 共i.e., mitigating
the artificial earnings volatility兲 remains to be investigated.
Hypotheses
So far, the optional characteristic and the eligibility criteria of the FVO under IAS 39 are not
fully addressed by existing fair value accounting research. Therefore, I evaluate the effects of the
FVO under IAS 39 on the earnings volatility in the context of the application intention.
The changes in fair value of economically connected positions tend to offset each other. If one
position is measured at fair value through profit or loss, but the other is measured at amortized
cost, the income statement does not properly reflect the opposite changes in fair values. The
application of the FVO on the financial instrument previously measured at amortized cost leads to
a consistent measurement of the economically connected positions. The opposite effects on the
income statement cancel out and, hence, there is no artificial earnings volatility.4 The basic idea is
similar to the principles of hedge accounting, but the criteria to apply the FVO are less restrictive
than the requirements of hedge accounting under IAS 39 共e.g., testing of hedge effectiveness;
IASB 2003, para. 88兲. During the standard-setting process of the FVO, 29 percent of the comment
letters mention that the FVO provides entities with the opportunity to reduce artificial earnings
volatility. Furthermore, 35 percent of the comment letters consider the FVO to be a convenient
alternative to classic hedge accounting under IAS 39 共Fiechter 2009, 32兲. Although disclosure of
the respective application criterion is required, the exact amounts designated under each criterion
are not disclosed. Therefore, it is not possible to investigate the effects on earnings volatility as a
function of the designated amounts. However, if a bank states in the notes to the financial state-
4
For example, a bank enters into a credit default swap 共CDS兲 to protect an originated loan. While the CDS is mandatorily
measured at fair value through profit or loss, the loan is measured at amortized cost 共IASB 2003, para. 9 in combination
with para. 46兲. Although economically connected 共i.e., if the credit rating of the loan decreases, the value of the CDS
increases兲, the only value changes recognized in the income statement are those from the CDS. By applying the FVO to
the loan, value changes of the loan are equally reflected in the income statement. Note that classic hedge accounting
would be difficult or almost impossible to apply in this situation due to lack of hedge effectiveness 共IASB 2003, para.
88兲.

90 Fiechter
ments that application of the FVO is primarily to reduce accounting mismatches, I expect that its
earnings volatility is lower than the earnings volatility of a bank, which does not reduce its
accounting mismatches, other things being equal.
Since application of the FVO is irrevocable, it is possible that a designated financial instru-
ment is still measured at fair value through profit or loss, although the original economic match no
longer exists 共e.g., due to the disposal of an economically connected financial instrument held for
trading兲. In this case, the earnings volatility may increase rather than decrease 共IASB 2003, para.
DO4兲. Nevertheless, I expect the negative effect on earnings volatility to be predominant and state
the following main hypothesis:
H1: Banks applying the FVO primarily to reduce accounting mismatches 共eligibility criterion
1兲 report lower levels of earnings volatility than the control group, other things being
equal.
The control group comprises all but those banks that do apply the FVO primarily to reduce
accounting mismatches. For sensitivity reasons, I allow for changes in the composition of the
control group 共see Section VI兲.
Related research on the FVO under SFAS 159 finds that early adopters use the transition
guidance for earnings management purposes 共Song 2008; Henry 2008; Guthrie et al. 2009兲. How-
ever, banks reporting in accordance with IFRS may have applied the FVO for annual periods
beginning on or after January 1, 2005, with early application permitted as of January 1, 2004.
After the transition period, banks are unable to “cherry pick,” as the FVO is applied irrevocably
共IASB 2003, para. BC73兲. Therefore, I do not investigate whether the FVO is used to manage
earnings.
International accounting research finds that accounting properties, as well as the implemen-
tation of accounting standards, vary widely across countries 共e.g., Ball et al. 2000; Leuz et al.
2003; Hail and Leuz 2006; Barth et al. 2008兲. Thus, the regulatory environment may affect the
decision to apply the FVO. I expect that banks facing a strong regulatory environment must
comply in full with the rules of hedge accounting under IAS 39.5 In lax regulation regimes,
however, the guidance of IAS 39 may be interpreted with more degrees of freedom. Hence, I
hypothesize that the less restrictive FVO is particularly welcomed in a strong regulatory environ-
ment:
H2: Banks from countries with high regulatory quality are more likely to apply the FVO
under criterion 1 than banks in lax regulatory regimes, other things being equal.
III. RESEARCH DESIGN

OLS Regression Model
To test H1, I conduct a cross-sectional analysis based on the following ordinary least squares
共OLS兲 regression:
␴EBTi = ␤0 + ␤1FVO1i + ␤2TRADEi + ␤3RWAi + ␤4HEDGEi + ␤5LEVERAGEi

+ ␤6REGIONALi + ␤7S&Li + ␤8␴STOCKSi + ␤9␴FXi + ␤10–51COUNTRY i + ␧i 共1兲
where:
5
For instance, a large number of firms were forced by the SEC to restate their financial reports because of errors in
applying hedge accounting 共Henry et al. 2007兲. According to a survey of the World Bank, the SEC is considered to be
a strong regulator, ranking in the top ten regulators around the world 共Kaufmann et al. 2009兲.

␴EBT ⫽ standard deviation of quarterly earnings before tax scaled by total assets,
beginning with the first quarter 2006 and ending with the fourth quarter 2007;
FVO1 ⫽ binary variable that takes the value of 1 if the FVO is primarily applied under
eligibility criterion 1 共accounting mismatch兲;
TRADE ⫽ average excess of trading assets 共liabilities兲 over trading liabilities 共assets兲, scaled
by total assets for the years 2006 and 2007;
RWA ⫽ average risk-weighted assets, scaled by total assets for the years 2006 and 2007;
HEDGE ⫽ binary variable that takes the value of 1 if the bank applies hedge accounting in
accordance with IAS 39;
LEVERAGE⫽ average debt-to-assets ratio for the years 2006 and 2007;
REGIONAL ⫽ binary variable that takes the value of 1 if the bank operates regionally;
S&L ⫽ binary variable that takes the value of 1 if the bank’s main activity is lending;
␴STOCKS ⫽ annualized standard deviation of daily local stock market index changes during
the time period from January 1, 2006, until December 31, 2007;
␴FX ⫽ annualized standard deviation of daily changes in the local currency rate in
relation to the U.S. dollars 共hereafter, USD兲 in the period from January 1, 2006,
until December 31, 2007;
COUNTRY ⫽ country dummy for each country within the sample; and
␧i ⫽ error term.
To capture the hedging effect of the FVO, I use earnings before tax 共EBT兲 as the relevant
measure of earnings. Following Hodder et al. 共2006兲, EBT is scaled by total assets of the respec-
tive period to avoid size problems within the sample.6 Earnings volatility 共␴EBT兲 is then calcu-
lated as the standard deviation of quarterly scaled EBT, beginning with the first quarter 2006 and
ending with the fourth quarter 2007.7 Waymire 共1985兲, Kim et al. 共2001兲, and Abdel-Khalik
共2007兲 use similar proxies for earnings volatility in their empirical studies.
To proxy for the application of the FVO, I create a binary variable FVO1 that takes the value
of 1 if a bank applies the FVO primarily under eligibility criterion 1 共accounting mismatch兲,
otherwise 0. In this context, the term “primarily” is interpreted as follows. A bank applies the FVO
solely due to criterion 1 共accounting mismatch兲 or the bank explicitly states that it applies the FVO
primarily to reduce accounting mismatches. Since banks do not disclose the balance sheet posi-
tions that are economically related to those under the FVO, the use of a binary variable is
necessary to proxy for the application of the FVO under eligibility criterion 1.
The control variables proxy for the specific structure of the balance sheet, the bank’s opera-
tional characteristics, and country-specific differences. The variables TRADE, RWA, LEVERAGE,
and HEDGE proxy for the bank’s balance sheet structure. The variable TRADE is defined as the
average excess of trading assets 共liabilities兲 over trading liabilities 共assets兲, scaled by total assets.
Earnings volatility is expected to increase with higher levels of TRADE, since this type of balance
sheet structure reacts more sensitively to market fluctuations. RWA is specified as the average
6
The results of the study remain constant, using lagged or average total assets for scaling purposes. Book value of equity
is not used for scaling, since any gains or losses associated with the application of the FVO may affect equity
substantially; whereas, the effects on total assets should be little. However, by including LEVERAGE as an explanatory
variable, I control for different financing structures.
7
The first quarter of 2006 is the earliest possible sample period, since the revised FVO, including the eligibility criteria,
came into effect on January 1, 2006, for all IFRS appliers around the world. Thus, no country-specific endorsement
differences regarding the FVO occur.
Due to market deteriorations in the second half of the year 2007 in conjunction with the U.S. subprime crisis, I create
an additional earnings volatility proxy to ensure that possible subprime effects on earnings volatility do not bias my
results. The results 共not reported兲 do not change considerably by excluding the quarters Q307 and Q407 from the
calculation of earnings volatility.

92 Fiechter
risk-weighted assets, as defined by the Bank for International Settlements 共BIS兲, scaled by total
assets. A positive correlation of RWA with ␴EBT is expected, since risky assets induce higher
volatility. I define HEDGE as a binary variable that takes the value of 1 if the bank applies hedge
accounting in accordance with IAS 39, otherwise 0. Since the primary goal of hedge accounting is
the reduction of earnings volatility 共Fok et al. 1997兲, a negative association between the variable
HEDGE and ␴EBT is expected. Using the debt-to-asset ratio as a proxy for the bank’s financial
leverage 共LEVERAGE兲, I control for different financing structures. Since a high financial leverage
is generally associated with higher risk appetite, earnings volatility is expected to increase. How-
ever, since equity is the primary position to absorb losses, banks with high levels of earnings
volatility may hold larger positions in equity to avoid financial distress. Taken together, I do not
predict the sign of the coefficient LEVERAGE.
The operational characteristics of a bank are represented by the two variables REGIONAL and
S&L. I use controls for the operational characteristics in lieu of size controls 共e.g., total assets or
market capitalization兲, as they represent a bank’s nature and activities. Hence, they are considered
to capture the effects on earnings volatility more precisely than size controls.8 REGIONAL is
defined as a binary variable that takes the value of 1 if the bank operates regionally, otherwise 0.
I expect a negative correlation between REGIONAL and ␴EBT.9 The earnings of a bank whose
main activity is lending 共i.e., a savings and loans bank兲 are expected to be less volatile than the
earnings of a bank with a broader spectrum of products and activities. To control for this charac-
teristic, I create the binary variable S&L that takes the value of 1 if the bank’s main activity is
lending, otherwise 0. A negative correlation between S&L and ␴EBT is expected.
The international scope of this study requires the inclusion of macroeconomic variables to
account for country-specific differences. Stock market volatility 共␴STOCKS兲 is the annualized
standard deviation of daily local stock market index changes during the time period from January
1, 2006, until December 31, 2007. Since volatile stock markets may influence a bank’s earnings,
particularly if the bank holds large non-hedged local stock positions, a positive correlation be-
tween ␴STOCKS and ␴EBT is expected. Foreign exchange volatility 共␴FX兲 is calculated as the
annualized standard deviation of daily changes in the local currency rate in relation to the USD in
the period from January 1, 2006, until December 31, 2007. As foreign exchange gains or losses on
monetary items and on financial instruments at fair value through profit or loss are recognized in
the income statement, I expect a positive correlation between ␴FX and ␴EBT. To control for
different regulation systems and institutional factors across countries 共e.g., Ball et al. 2000; Fran-
cis et al. 2005兲, I further include country dummies.
Treatment Effects Model

The fact that the application of the FVO is a specific decision of a bank raises concerns about
endogeneity bias 共Heckman 1979兲. Following Leuz and Verrecchia 共2000兲, as well as Rogers
共2008兲, I address this concern using a two-equation treatment effects model, in which the appli-
cation of the FVO appears as an endogenous variable.10 In the first stage, I model the decision to
apply the FVO due to criterion 1 共accounting mismatch兲 using a probit regression. At this stage, I
also include a proxy for regulatory quality as independent variable to test H2:
8
DeYoung and Roland 共2001兲 show that a bank’s product mix has a significant impact on the earnings volatility.
9
Since a regional bank has a better overview of its operations, it can control its risks more effectively than a bank that
operates globally. In addition, regional banks enjoy stronger customer loyalty, leading to more stable earnings. These
negative effects on earnings volatility are expected to prevail against the effects of the more limited diversification
possibilities available to regional banks.
10
I use a treatment effects model instead of a two-stage least squares 共2SLS兲 analysis, since it is hard to find instrumental
variables that are uncorrelated with earnings volatility, which is a crucial assumption for 2SLS 共Greene 2000兲. Treatment
effects models, however, assume joint normal distributions of the error terms 共Rubin and Thomas 2000兲.

PR共FVO1 = 1兲i = ␤0 + ␤1REGQUALi + ␤2BIG4i + ␤3ELIGIBLEi + ␤4SIZEi + ␤5MCBi

+ ␤6MIDEASTi + ␤7FVOLi + ␧i 共2兲
where:
FVO1 ⫽ binary variable that takes the value of 1 if the FVO is primarily applied under
eligibility criterion 1 共accounting mismatches兲;
REGQUAL ⫽ average regulatory quality index by Kaufmann et al. 共2009兲 for the years 2006
and 2007;
BIG4 ⫽ binary variable that takes the value of 1 if the bank is audited by a Big 4 audit
company;
ELIGIBLE ⫽ ratio of earning assets plus debt, relative to total assets plus total liabilities in the
year 2005;
SIZE ⫽ natural logarithm of total assets denominated in USD;
MCB ⫽ binary variable that takes the value of 1 if the bank is a money-center bank;
MIDEAST ⫽ binary variable that takes the value of 1 if the bank is from the Middle East
region;
FVOL ⫽ binary variable that takes the value of 1 if the FVO is applied on the liability
side; and
␧i ⫽ error term.
According to H2, banks operating in countries with high regulatory quality are more likely to
apply the FVO to reduce accounting mismatches. To proxy for regulatory quality, I include
REGQUAL, which is an index variable constructed by Kaufmann et al. 共2009兲. REGQUAL cap-
tures survey perceptions regarding the government’s ability to formulate and implement sound
policies and regulations 共Kaufmann et al. 2009, 6兲. The values of REGQUAL range from –2.5 to
2.5, with higher values corresponding to better regulatory quality.
Song 共2008兲, Guthrie et al. 共2009兲, and Chang et al. 共2009兲 examine determinants of the FVO
application in accordance with SFAS 159. However, these studies focus on the first-time applica-
tion, including special transition rules of the FVO; whereas, the banks in my sample may have
already applied the FVO before the investigated time period. Therefore, I do not include a proxy
for the ex ante earnings volatility, although the aforementioned studies expect banks with high ex
ante earnings volatility to be more likely to adopt the FVO under SFAS 159. Furthermore, and
again in contrast to these studies, I focus solely on the application in accordance with criterion 1
共accounting mismatch兲, which induces a different research setting.11 Nevertheless, I include the
variables BIG4, ELIGIBLE, and SIZE. Following Guthrie et al. 共2009兲, I define BIG4 as a binary
variable that takes the value of 1 if the bank is audited by a Big 4 audit company, otherwise 0. I
expect a positive association between BIG4 and FVO1. The variable ELIGIBLE is calculated as
the ratio of earning assets plus debt, relative to total assets plus total liabilities in 2005. I predict
that banks with more eligible items are more likely to apply the FVO under criterion 1. Bank size
共SIZE兲 is measured by the natural logarithm of total assets denominated in USD. I expect large
banks to be more likely to adopt the FVO under criterion 1.12
11
For example, banks with high ex ante earnings volatility may have incentives to apply the FVO to reduce accounting
mismatches and, therefore, lower their earnings volatility. By the same token, banks with already low levels can apply
the FVO to further decrease the volatility of their earnings. Hence, both types of banks have similar incentives to apply
the FVO under eligibility criterion 1.
12
I expect a positive association for two reasons. First, large banks deal with more complexity and, thus, the need for a
FVO increases. Second, the results of Song 共2008兲, Guthrie et al. 共2009兲, and Chang et al. 共2009兲 strongly suggest that
large banks are more likely to adopt the FVO.

94 Fiechter
In addition to the variables used in the aforementioned studies, I include the binary variable
MCB that takes the value of 1 if the bank is a money-center bank, otherwise 0. Money-center
banks provide a variety of services and products, and their accounting has to deal with this
complexity. I include MCB as an additional control along with SIZE, expecting a positive corre-
lation with FVO1. In the Middle East, Islamic Banking is a traditional and widespread banking
activity. The prudence concept associated with Islamic Banking implies the use of historical costs
instead of fair values in the statutory accounts 共Solé 2007兲. Thus, banks from the Middle East
共MIDEAST兲 are expected to be less likely to apply the FVO, although they would be allowed to do
so in their consolidated financial statements in accordance with IFRS.13 Finally, I include the
dummy variable FVOL that takes the value of 1 if a bank applies the FVO on financial liabilities,
otherwise 0. I predict a positive association between FVOL and FVO1, since banks tend to hedge
issued structured products or other financial liabilities 共IASB 2003, para. BC77B兲. In this situa-
tion, the use of the FVO under criterion 1 appears as a convenient alternative to hedge accounting
in accordance with IAS 39.
In the second stage, the so-called Inverse Mills Ratio 共IMR兲 is computed from the first-stage
probit model and included in the earnings volatility equation. Hence, the standard errors are
appropriately adjusted for the selection bias 共Maddala 1983兲:
␴EBTi = ␤0 + ␤1FVO1i + ␤2TRADEi + ␤3RWAi + ␤4HEDGEi + ␤5LEVERAGEi

+ ␤6REGIONALi + ␤7S&Li + ␤8␴STOCKSi + ␤9␴FXi + ␤10–51COUNTRY i
+ IMRi + ␧i . 共3兲
IV. SAMPLE DESCRIPTION

The basic sample consists of all banks around the world that apply IFRS and report quarterly
earnings figures. Since the time period of the study is limited 共i.e., January 1, 2006, until Decem-
ber 31, 2007兲, quarterly reporting increases the data points available for the calculation of the
standard deviation and, therefore, leads to more reliable values of the earnings volatility proxy
共Waymire 1985兲. The study focuses on the banking sector because 共1兲 the FVO under IAS 39 can
be applied to financial instruments only; 共2兲 the balance sheets of banks contain significantly more
financial instruments than do the balance sheets of firms from other branches; and 共3兲 the banking
sector demonstrated a particular interest in the FVO during the standard-setting process.14
As a starting point, the database, Thomson Reuters Knowledge, is used to construct the
sample. After the exclusion of insurers, investment trusts, non-IFRS appliers, and banks that do
not prepare quarterly reports, a research sample 共before data collection兲 of 272 banks results from
a total sample of 8,374 financial services providers. See the Appendix for an overview of the
sample selection.
The variables ␴EBT, LEVERAGE, REGIONAL, S&L, ␴STOCKS, ␴FX, and COUNTRY are
calculated using data from Thomson Reuters Knowledge. Due to missing quarterly earnings data,
7 out of 272 banks are removed from the sample. The variables FVO1, TRADE, RWA, and
HEDGE are based on hand-collected data from the annual reports of 2007. Due to missing
availability of annual reports or missing data in the annual reports, the sample basis for the OLS
regression analysis is further reduced to 222 banks from 41 countries around the world. Table 1,
13
Muller et al. 共2008兲 show that firms are more likely to choose the fair value model for investment property when the
firm’s pre-IFRS domestic standards permitted or required fair values.
14
Dünhaupt 共2007兲 finds that 46 percent of the comment letters regarding the FVO in the year 2004 stemmed from
financial services whereof 80 percent represented banks or banking associations.

Journal of International Accounting Research
The Effects of the Fair Value Option under IAS 39 on the Volatility of Bank Earnings
TABLE 1
Descriptive Statistics
Panel A: Distributional Statistics of the OLS Variablesa
Percentiles
Variable FVO1 n Mean Min. Q1 Median Q3 Max. Std. Dev.
␴EBT All 222 0.0029 0.0001 0.0007 0.0013 0.0024 0.0490 0.0060
If FVO1 ⫽1 54 0.0010*** 0.0001 0.0004 0.0008*** 0.0013 0.0031 0.0008
If FVO1 ⫽0 168 0.0036 0.0002 0.0009 0.0015 0.0028 0.0490 0.0068
TRADE All 222 0.0419 0.0000 0.0020 0.0161 0.0567 0.6100 0.0683
If FVO1 ⫽1 54 0.0471 0.0000 0.0052 0.0209** 0.0899 0.2201 0.0503
If FVO1 ⫽0 168 0.0403 0.0000 0.0012 0.0149 0.0493 0.6100 0.0732
RWA All 222 0.6785 0.1474 0.5519 0.6781 0.7975 1.4308 0.2227
If FVO1 ⫽1 54 0.5929*** 0.1644 0.4659 0.6195*** 0.6962 0.9625 0.1879
If FVO1 ⫽0 168 0.7062 0.1474 0.5786 0.7002 0.8206 1.4308 0.2270
HEDGE All 222 0.5180 0.0000 0.0000 1.0000 1.0000 1.0000 0.5008
If FVO1 ⫽1 54 0.7037*** 0.0000 0.0000 1.0000*** 1.0000 1.0000 0.4609
If FVO1 ⫽0 168 0.4583 0.0000 0.0000 0.0000 1.0000 1.0000 0.4998
LEVERAGE All 222 0.8843 0.1329 0.8695 0.9112 0.9376 0.9951 0.1058
If FVO1 ⫽1 54 0.9249*** 0.7658 0.9040 0.9373*** 0.9559 0.9951 0.0496
If FVO1 ⫽0 168 0.8712 0.1329 0.8588 0.8991 0.9324 0.9808 0.1155
REGIONAL All 222 0.4910 0.0000 0.0000 0.0000 1.0000 1.0000 0.5010
If FVO1 ⫽1 54 0.4074 0.0000 0.0000 0.0000 1.0000 1.0000 0.4960
If FVO1 ⫽0 168 0.5179 0.0000 0.0000 1.0000 1.0000 1.0000 0.5012
S&L All 222 0.2838 0.0000 0.0000 0.0000 1.0000 1.0000 0.4519
If FVO1 ⫽1 54 0.4074** 0.0000 0.0000 0.0000** 1.0000 1.0000 0.4960
If FVO1 ⫽0 168 0.2440 0.0000 0.0000 0.0000 1.0000 1.0000 0.4308
␴STOCKS All 222 0.1774 0.0864 0.1435 0.1548 0.2032 0.5114 0.0049
Volume 10, No. 1, 2011
If FVO1 ⫽1 54 0.1737 0.1345 0.1497 0.1548 0.2032 0.3192 0.0362

If FVO1 ⫽0 168 0.1786 0.0864 0.1368 0.1542 0.2032 0.5114 0.0779
␴FX All 222 0.0499 0.0015 0.0140 0.0584 0.0584 0.1261 0.0295
If FVO1 ⫽1 54 0.0637*** 0.0121 0.0584 0.0584*** 0.0760 0.0926 0.0123
If FVO1 ⫽0 168 0.0455 0.0015 0.0072 0.0584 0.0584 0.1261 0.0320
95
(continued on next page)
Panel B: Distributional Statistics of the Treatment Variablesb
Percentiles
96
Variable n Mean Min. Q1 Median Q3 Max. Std. Dev.
REGQUAL 209 0.8620 ⫺0.9560 0.5700 0.8280 1.3940 1.8945 0.6237
BIG4 209 0.9282 0.0000 1.0000 1.0000 1.0000 1.0000 0.2587
ELIGIBLE 209 0.1958 0.1379 0.0913 0.1740 0.2457 0.7998 0.1379
SIZE 209 9.6255 5.1806 8.0153 9.4586 10.7030 14.9660 2.1201
MCB 209 0.1292 0.0000 0.0000 0.0000 0.0000 1.0000 0.3362
MIDEAST 209 0.2584 0.0000 0.0000 0.0000 1.0000 1.0000 0.4388
FVOL 209 0.2919 0.0000 0.0000 0.0000 1.0000 1.0000 0.4557
Panel C: Extent of FVO Applicationc

Percentiles
Variable n Mean Min. Q1 Median Q3 Max. Std. Dev.
FVO 06 124
FVO 07 131
FVO Assets 06 118 0.0675 0.0002 0.0074 0.0246 0.0881 0.6611 0.1011
FVO Assets 07 123 0.0609 0.0003 0.0078 0.0272 0.0723 0.6555 0.0945
FVO Liabilities 06 68 0.1003 0.0005 0.0216 0.0502 0.1080 0.8401 0.1501
FVO Liabilities 07 69 0.0931 0.0004 0.0178 0.0488 0.1021 0.6793 0.1350
TOTA 共millions USD兲 222 150638 116 3027 12990 44891 3158325 438581
Panel D: Country Statisticsd

Application of the Fair Value
Option ␴EBT REGQUAL
Country n FVOA FVOL FVO1 Mean Median 2007 2006
Austria 9 8 4 4 0.0091 0.0004 1.6180 1.6070
Bahrain 9 2 0 1 0.0067 0.0019 0.8930 0.7630
Volume 10, No. 1, 2011
Belgium 3 3 3 2 0.0008 0.0007 1.4800 1.4090

Bulgaria 2 0 1 1 0.0010 0.0013 0.6070 0.5330
China 3 2 2 1 0.0015 0.0011 ⫺0.2410 ⫺0.3290
Croatia 4 2 1 2 0.0009 0.0009 0.4210 0.3840
Fiechter
The Effects of the Fair Value Option under IAS 39 on the Volatility of Bank Earnings
Cyprus 2 3 0 0 0.0020 0.0017 1.3050 1.2830
Czech Republic 1 0 0 0 0.0004 0.0004 0.9680 1.0380
Denmark 18 16 7 4 0.0024 0.0021 1.9330 1.8560
France 3 3 2 2 0.0023 0.0017 1.1540 1.1150
Finland 2 2 1 1 0.0007 0.0007 1.6670 1.7560
Germany 14 8 4 5 0.0025 0.0007 1.5040 1.4800
Greece 12 7 2 3 0.0026 0.0009 0.8320 0.7930
Hungary 2 0 1 1 0.0013 0.0013 1.1540 1.1650
Iceland 4 4 3 0 0.0080 0.0028 1.5690 1.6170
Italy 24 13 13 8 0.0068 0.0011 0.8120 0.8540
Jordan 7 1 0 1 0.0014 0.0012 0.3520 0.3910
Kazakhstan 6 0 0 0 0.0030 0.0031 ⫺0.4510 ⫺0.4890
Kenya 3 0 1 1 0.0018 0.0010 ⫺0.2740 ⫺0.3130
Kuwait 9 6 0 0 0.0025 0.0024 0.2940 0.4300
Latvia 2 1 0 0 0.0009 0.0009 1.0580 1.0700
Lebanon 1 1 0 0 0.0004 0.0004 ⫺0.2110 ⫺0.1990
Lithuania 3 1 0 0 0.0038 0.0019 1.1170 1.0450
Malaysia 1 0 0 0 0.0003 0.0003 0.5330 0.5080
Nigeria 1 0 0 0 0.0018 0.0018 ⫺0.9260 ⫺0.9860
Norway 11 1 6 5 0.0008 0.0007 1.4400 1.3480
Oman 3 0 0 0 0.0015 0.0019 0.6340 0.7370
Palestine 1 0 0 0 0.0047 0.0047 ⫺0.5583 ⫺0.4436

Poland 14 8 3 4 0.0023 0.0015 0.7180 0.6840
Portugal 2 1 2 0 0.0008 0.0008 1.0490 1.0450
Qatar 4 0 0 0 0.0016 0.0014 0.5510 0.3830
Volume 10, No. 1, 2011
Russia 3 3 0 0 0.0016 0.0018 ⫺0.4380 ⫺0.5690

Saudi Arabia 6 2 1 0 0.0052 0.0026 ⫺0.0960 ⫺0.1780
Slovakia 1 0 0 0 0.0008 0.0008 0.9770 1.0970
South Africa 1 1 1 0 0.0016 0.0016 0.4150 0.5540
Spain 6 5 3 2 0.0007 0.0006 1.1460 1.1120
97
98
Sweden 5 5 4 5 0.0008 0.0003 1.6410 1.5330
Switzerland 2 1 1 0 0.0196 0.0196 1.5620 1.4380
Thailand 1 0 0 0 0.0016 0.0016 0.1130 0.2310
Turkey 2 0 0 0 0.0047 0.0047 0.2340 0.1980
United Arab Emirates 15 5 2 1 0.0019 0.0014 0.7020 0.7060
Total 共Average兲 222 115 68 54 0.0029 0.0013 0.7136 0.6989
*, **, *** Indicate that the means 共medians兲 are significantly different at the 10 percent, 5 percent, and 1 percent levels, respectively, using a two-tailed t-test 共Mann-Whitney-
Wilcoxon test兲.
a
Panel A reports descriptive statistics of the OLS regression variables. Earnings volatility 共␴EBT兲 is calculated by taking the standard deviation of the scaled quarterly earnings
before tax, beginning with the first quarter 2006, and ending with the fourth quarter 2007. FVO1 is a binary variable that takes the value of 1 if the FVO is primarily applied under
eligibility criterion 1 共accounting mismatch兲. TRADE is defined as the average excess of trading assets 共liabilities兲 over trading liabilities 共assets兲, scaled by total assets for the
years 2006 and 2007. RWA is calculated as the average risk-weighted assets, scaled by total assets for the years 2006 and 2007. HEDGE is a binary variable that takes the value
of 1 if hedge accounting is applied in accordance with IAS 39. LEVERAGE is calculated as the average debt-to-asset ratio for the years 2006 and 2007. REGIONAL is a binary
variable that takes the value of 1 if the bank operates regionally. S&L is a binary variable that takes the value of 1 if the bank’s main activity is lending. The local stock market
volatility 共␴STOCKS兲 is calculated as the annualized standard deviation of daily local stock market index changes during the time period from January 1, 2006, until December
31, 2007. The foreign exchange volatility 共␴FX兲 is calculated as the annualized standard deviation of daily changes in the local currency rate in relation to the USD in the period
from January 1, 2006, until December 31, 2007.
b
Panel B reports descriptive statistics of the treatment variables. The average regulatory quality 共REGQUAL兲 is a regulatory quality index ranging from ⫺2.5 to 2.5 for the years
2006 and 2007. BIG4 is a binary variable that takes the value of 1 if the bank is audited by a Big 4 audit company. ELIGIBLE is calculated as the ratio of earning assets plus debt,
relative to total assets plus total liabilities in the year 2005. SIZE calculated as the natural logarithm of total assets denominated in USD. MCB is a binary variable that takes the
value of one if the bank is a money-center bank. MIDEAST is a binary variable that takes the value of 1 if the bank is from the Middle East. FVOL is a binary variable that takes
the value of 1 if the FVO is applied on the liability side.
c
In Panel C, FVO 06 is the number of banks that apply the fair value option 共any eligibility criteria兲 in the year 2006. FVO Assets 06 is the ratio of designated assets to total assets
in the year 2006. FVO Liabilities 06 is the ratio of designated liabilities to total assets in the year 2006. TOTA is defined as the total assets of all sample banks in millions USD
as of December 31, 2007.
Volume 10, No. 1, 2011
d
Panel D reports descriptive statistics for each country within the sample. The earnings volatility 共␴EBT兲 is calculated by taking the standard deviation of the scaled quarterly
earnings before tax, beginning with the first quarter 2006, and ending with the fourth quarter 2007. REGQUAL is a regulatory quality index ranging from ⫺2.5 to 2.5. FVOA is
the number of banks that apply the fair value option to financial assets in both years 2006 and 2007. FVOL is the number of banks that apply the fair value option to financial
liabilities in both years 2006 and 2007. FVO1 is the number of banks that apply the fair value option primarily to reduce accounting mismatches in both years 2006 and 2007.
Fiechter
Panel A, presents summary statistics for the OLS regression variables of banks applying the FVO
to reduce accounting mismatches, and the control group.
The sample mean of the earnings volatility proxy ␴EBT exceeds the third quartile, indicating
a skewed distribution. Fifty-four out of 222 banks 共24.3 percent兲 apply the FVO primarily to
reduce accounting mismatches 共eligibility criterion 1兲. The univariate tests show that banks ap-
plying the FVO in accordance with eligibility criterion 1 report significant lower levels of earnings
volatility than the control group. FVO1 appliers also appear to hold less risk-weighted assets,
being more likely to apply hedge accounting, being more leveraged, and stemming from countries
with more foreign exchange volatility. The decision to apply the FVO to reduce accounting
mismatches may be driven by these differences and, hence, controlling for endogeneity bias is
crucial to the results of this study.
The distributional statistics regarding the treatment variables are set out in Table 1, Panel B.
Due to missing data on earning assets 共ELIGIBLE兲, the sample is further reduced to 209 banks.
The mean and median of REGQUAL do not differ substantially. The first quartile of the distribu-
tion is above zero 共0.57兲. Hence, the regulatory quality of a vast majority of the sample countries
is rated as “good.”15 However, some countries in the sample exhibit a negative regulatory quality
共see also Table 1, Panel D兲. Table 1, Panel C, shows additional descriptive statistics to provide
information about the extent of the application of the FVO. In the year 2006, 124 out of 222 banks
共55.8 percent兲 apply the FVO in any form. While fewer banks apply the FVO to liabilities 共68 out
of 222 in the year 2006兲, the mean 共median兲 amount of liabilities designated at fair value is
considerably higher than the amount of designated assets. Table 1, Panel D, presents country
statistics concerning the application of the FVO, the country-specific earnings volatility, and the
regulatory quality. Since quarterly reporting is conditional to be included in the sample, countries
such as Australia or the United Kingdom drop out.
Table 2 presents Pearson correlation coefficients for the OLS regression variables as well as
for the treatment variables. The maximum absolute value of the correlations is 0.621 between
REGIONAL and S&L. The correlations between the main variable 共FVO1兲 and the other control
variables do not exceed an absolute value of 0.275. Hence, multicollinearity is not considered to
be a substantial issue.16
The significant positive correlation 共0.210兲 between FVO1 and HEDGE suggests that the
FVO under criterion 1 is a complement to, rather than a substitution for, hedge accounting in
accordance with IAS 39.
V. EMPIRICAL RESULTS
OLS Regression Results
Table 3 reports the results of the OLS regression analyses. The adjusted R2 values vary from
31.9 to 59.6 percent. These values are comparable with other empirical studies that use earnings
volatility as the dependent variable.17 The mean variance inflation factors 共VIFs兲 range from 1.36
to 2.79. In addition, the largest VIF does not exceed the threshold value of ten, irrespective of the
model specification. Hence, the VIFs suggest absence of multicollinearity 共Chatterjee and Hadi
2006兲.
Throughout different model specifications 共i.e., including country dummies and possible out-
liers兲, the control variables have the expected sign except for ␴STOCKS. However, the coefficients
15
Note that by design, the mean regulatory quality of all countries worldwide equals zero.
16
If the absolute value of the correlation coefficient exceeds 0.8, multicollinearity is expected to be a substantive issue
共Kennedy 2008兲. The results 共not reported兲 do not change considerably when using Spearman correlation coefficients.
17
The adjusted R2 of the basic model in the study of Kim et al. 共2001兲 amounts to 14.7 percent. In the study of
Abdel-khalik 共2007兲, adjusted R2 between 49.0 and 77.0 percent result.

100
TABLE 2
Pearson Correlation Coefficients
Panel A: Correlation Coefficients of the OLS Regression Variables
FVO1 TRADE RWA HEDGE LEVERAGE REGIONAL S&L ␴STOCKS ␴FX
FVO1 1
TRADE 0.048 1
RWA ⫺0.217*** 0.185*** 1
HEDGE 0.210*** ⫺0.016 ⫺0.213*** 1
LEVERAGE 0.203*** 0.066 ⫺0.126* 0.301*** 1
REGIONAL ⫺0.086* ⫺0.138** 0.159*** ⫺0.030 0.104 1
S&L 0.144** 0.022 ⫺0.007 0.077 0.200*** ⫺0.621*** 1
␴STOCKS ⫺0.039 0.062 0.037 ⫺0.102* 0.070 0.069 ⫺0.040 1
␴FX 0.275*** 0.183*** ⫺0.257*** 0.173*** 0.142** ⫺0.146** 0.303*** 0.077 1
Panel B: Correlation Coefficients of the Treatment Variables

REGQUAL BIG4 ELIGIBLE SIZE MCB MIDEAST FVOL
REGQUAL 1
BIG4 0.0303 1
ELIGIBLE 0.0504 ⫺0.0285 1
SIZE 0.1074* 0.1747*** 0.0683 1
MCB ⫺0.1211* ⫺0.0187 0.1818*** 0.2367*** 1
MIDEAST ⫺0.3485*** ⫺0.0508 ⫺0.0733 ⫺0.1348** 0.1447** 1
FVOL 0.2884*** 0.0940 0.0508 0.3616*** ⫺0.0011 ⫺0.2844*** 1
*, **, *** Indicate statistical significance at the 10 percent, 5 percent, and 1 percent levels 共two-tailed兲, respectively.
The table reports Pearson correlation coefficients of the independent OLS regression variables and the treatment variables.
Volume 10, No. 1, 2011
See Table 1 for the definition of the respective variables.
Fiechter
TABLE 3
OLS Regression Analysis of Earnings Volatility on Application of the FVO
Predicted
Variable Sign (1) (2) (3) (4)
Intercept 0.0327*** 0.0304*** 0.0078*** 0.0062***
共4.39兲共3.44兲共5.02兲共3.01兲
FVO1 ⫺ ⫺0.0010** ⫺0.0012* ⫺0.0005*** ⫺0.0004***
共⫺2.54兲共⫺1.82兲共⫺3.62兲共⫺2.69兲
TRADE ⫹ 0.1181** 0.0065 0.0013 0.0002
共2.12兲共1.12兲共1.27兲共0.16兲
RWA ⫹ 0.0012 0.0034 0.0011** 0.0009
共0.47兲共0.96兲共2.33兲共1.35兲
HEDGE ⫺ ⫺0.0003 ⫺0.0007 ⫺0.0000 ⫺0.0002
共⫺0.84兲共⫺1.30兲共⫺0.26兲共⫺0.82兲
LEVERAGE ? ⫺0.0345*** ⫺0.0347*** ⫺0.0075*** ⫺0.0069***
共⫺4.63兲共⫺4.50兲共⫺4.54兲共⫺3.44兲
REGIONAL ⫺ ⫺0.0205* ⫺0.0009 ⫺0.0008*** ⫺0.0007**
共⫺1.77兲共⫺0.57兲共⫺3.25兲共⫺2.36兲
S&L ⫺ ⫺0.0027*** ⫺0.0021* ⫺0.0011*** ⫺0.0010***
共⫺2.80兲共⫺1.85兲共⫺3.91兲共⫺3.00兲
␴STOCKS ⫹ ⫺0.0006 ⫺0.0034 0.0020 ⫺0.0005
共⫺0.22兲共⫺1.23兲共1.41兲共⫺0.23兲
␴FX ⫹ 0.0357*** 0.0144 0.0067* 0.0048
共3.65兲共1.08兲共1.80兲共0.84兲
Country dummies Excluded Included Excluded Included
Possible outliers Included Included Excluded Excluded
R2 0.4989 0.5963 0.3188 0.4827
F-statistic 7.10*** NA 9.96*** NA
VIF 共mean兲 1.36 2.78 1.36 2.79
n 222 222 207 207
Dependent Variable ⫽ ␴EBT
The table reports OLS coefficient estimates and, in parentheses, t-statistics based on heteroscedasticity-robust standard
errors.
Country dummies are included in model 共2兲 and 共4兲, but not reported.
See Table 1 for the definition of the relevant variables.
of this variable are not significant in any model. Depending on the model, the coefficients of the
variables TRADE, HEDGE, and RWA are only of weak significance, but have the expected sign.
In line with H1, the coefficient of the variable FVO1 is negative and significant at the 5
percent level in model 共1兲. Thus, applying the FVO in line with eligibility criterion 1 reduces the
earnings volatility by 0.0010, which can be interpreted as a change in the intercept of the model
共Hardy 1995兲. The estimated reduction in relation to the mean 共0.0029兲 and median 共0.0013兲
earnings volatility 共␴EBT兲 of the sample is considered to be substantial and of economic rel-
evance. A bank may, therefore, reduce its earnings volatility by approximately the median vola-
tility of the sample when applying the FVO to reduce accounting mismatches. By including

102 Fiechter
country dummies in model 共2兲, the coefficients of FVO1 are less significant 共10 percent level兲, but
slightly increase in magnitude.
Since the distribution of the earnings volatility proxy 共␴EBT兲 is considered to be skewed, the
results may be influenced by outliers. Applying the method for the detection of outliers by Hadi
共1994兲, 15 banks are excluded from the sample and, thus, a regression sample of 207 banks results.
By doing so, the explanatory power of the model decreases. While the significance levels of FVO1
increase, the magnitude of the respective coefficients is reduced approximately by half 共i.e.,
0.0005兲, compared to the specifications where possible outliers are included. As the median vola-
tility of the sample remains constant, the economic effect of FVO1 seems to be overstated by
outliers. However, the sample’s mean volatility after removing possible outliers is also reduced by
half 共i.e., 0.0016兲. Hence, the economic relevance of the FVO does not change considerably.
Moreover, influential observations may contain important information, since they increase the
variation of the independent variables. Thus, results of OLS estimates should be generally dis-
closed with and without outliers 共Wooldridge 2009兲.
Although the FVO1 proxy is significant and has the expected sign in all models, its effect on
earnings volatility is weaker than the effect of some control variables, particularly LEVERAGE
and S&L. Nevertheless, the above results show that beside any given structures, a bank may
influence the reported earnings volatility by the choice of accounting, i.e., choosing to apply the
FVO or not. In addition, the coefficients of FVO1 are both higher in magnitude and significance
than the coefficients of HEDGE, which suggest that the application of the FVO to reduce account-
ing mismatches is a more effective tool to reduce earnings volatility than the complex and restric-
tive hedge accounting in accordance with IAS 39. This result empirically supports the findings
from the simulation analyses of Gebhardt et al. 共2004兲 as well as the intention of the IASB when
introducing the FVO 共IASB 2003, para. BC74A兲.
Treatment Effects Results

Table 4 reports the result from the two-step treatment effects model. The pseudo R2 of the
first-stage probit analysis is 24.9 percent. All explanatory variables have the expected sign but the
coefficients of BIG4, ELIGIBLE, and MCB are not significant. In line with H2, there is a positive
association between REGQUAL and FVO1. Hence, banks operating in a strong regulatory envi-
ronment are more likely to apply the FVO to reduce accounting mismatches.
The significant positive Inverse Mills Ratio 共IMR兲 confirms the presence of self-selection.
However, the coefficient of the treated variable FVO1 increases both in magnitude and signifi-
cance, compared to the OLS results. Using a two-step treatment effects model, the effect of the
FVO to reduce accounting mismatches is –0.0047, which exceeds the mean volatility of the
sample 共0.0029兲.18 Although there are several caveats regarding treatment effects models, e.g.,
assumption about joint normal distribution of error terms 共Greene 2000兲, this test does not suggest
that my results are driven by endogeneity.
VI. ADDITIONAL ANALYSES

Propensity Score Matching
In addition to the treatment effects model, I perform propensity score matching 共PSM兲. The
advantage of the PSM, compared to the treatment effects model, is that the assumption about the
18
For brevity, I do not report the results for different model specifications 共i.e., excluding country dummies and possible
outliers兲. When excluding possible outliers, the coefficient of IMR is positive but not significant anymore. Hence, there
is less presence of self-selection in the sample without possible outliers. However, the coefficient of FVO1 is negative
and significant at the 5 percent level. Overall, my inferences do not change due to different model specifications of the
treatment effects model.

TABLE 4
Treatment Regression of Earnings Volatility on the Application of the FVO
Panel A: First Stage
Predicted
Variable Sign Coefficient (Z-statistic)
Intercept ⫺2.7975*** 共⫺4.02兲
REGQUAL ⫹ 0.3316* 共1.70兲
BIG4 ⫹ 0.1255 共0.26兲
ELIGIBLE ⫹ 0.0957 共0.12兲
SIZE ⫹ 0.1369** 共2.50兲
MCB ⫹ 0.3992 共1.11兲
MIDEAST ⫺ ⫺0.6114* 共⫺1.69兲
FVOL ⫹ 0.9051*** 共3.92兲
Pseudo R2 0.2490
LR Chi-square 共6兲 57.83***
n 209
Dependent Variable ⫽ FVO1
Panel B: Second Stage

Predicted
Variable Sign Coefficient (Z-statistic)
Intercept 0.0323*** 共6.01兲
FVO1 ⫺ ⫺0.0047** 共⫺2.38兲
TRADE ⫹ 0.0052 共1.11兲
RWA ⫹ 0.0032* 共1.96兲
HEDGE ⫺ ⫺0.0001 共⫺0.19兲
LEVERAGE ? ⫺0.3518*** 共⫺9.86兲
REGIONAL ⫺ ⫺0.0009 共⫺0.93兲
S&L ⫺ ⫺0.0022** 共⫺2.16兲
␴STOCKS ⫹ ⫺0.0033 共⫺0.38兲
␴FX ⫹ 0.0035 共0.14兲
IMR ? 0.0024** 共1.96兲
Wald Chi-square 共48兲 261.29***
n 209
Country dummies Included
Possible outliers Included
Dependent Variable ⫽ ␴EBT
The table reports first-stage results of the FVO1 application using a probit regression analysis. The Inverse Mills Ratio
共IMR兲 is computed from the first-stage probit model and included in the second-stage equation. Hence, standard errors are
adjusted for selection bias 共Maddala 1983兲.
Wald Chi-square statistics are provided instead of F-statistics when testing multiple parameters simultaneously.
See Table 1 for the definition of the relevant variables.
joint distribution of the error terms can be relaxed 共Rubin and Thomas 2000兲. The omitted vari-
able, however, is only addressed indirectly, since no Inverse Mills Ratio is included. Using the
Kernel Matching method and bootstrapped standard errors 共Becker and Ichino 2002兲, the average

104 Fiechter
treatment effect of the treated 共hereafter, ATT兲 is –0.0020 and significant at the 1 percent level
共t-statistic ⫽ ⫺4.102兲. The ATT may be interpreted as the average difference in earnings volatility
between FVO1 appliers and the matched control group, which is consistent with H1.
Difference-in-Differences Analysis
Although the results from the treatment effects model as well as the PSM support the main
hypothesis, I further use a difference-in-differences design. The earnings volatility of those banks
that apply the FVO in order to reduce accounting mismatches 共criterion 1兲 is compared across
time; i.e., differences in earnings volatility before and after the introduction of the FVO are
examined. By analyzing changes over time, each bank figures as its own control. The original
FVO 共without eligibility criteria兲 was applicable for annual periods beginning January 1, 2005,
where early adoption as of January 1, 2004, was permitted. In order to make sure that no FVO was
applied in the pre-introduction period, earnings volatility ␴EBTQ403 is calculated as the standard
deviation of quarterly scaled EBT beginning with the third quarter 2002 and ending with the
fourth quarter 2003 of banks applying IFRS at this time. Similar to Hail and Leuz 共2009兲, I deduct
the median earnings volatility of the non-appliers to control for changes in the economic environ-
ment over the time.
The empirical results 共not reported兲 indicate that the earnings volatility of banks applying the
FVO to reduce accounting mismatches decreases over time, after controlling for changes in the
economic environment. The mean 共median兲 earnings volatility decreases by 0.0007 共0.0002兲,
which is smaller in magnitude compared to the cross-sectional analysis. However, the reduction is
statistically significant at the 5 percent level against a two-sided alternative. The sample size is
considerably reduced to 29 banks, as only few banks have already applied IFRS in the pre-
introduction period 共i.e., 2002 to 2003兲. In addition, it is not possible to conduct multivariate
difference-in-differences tests due to lack of data availability regarding the control variables in the
pre-introduction period. Hence, the statistical power of the difference-in-differences analysis is
limited.
Model Alterations
So far, the control group comprises all banks that do not apply the FVO to reduce accounting
mismatches. This control group includes banks applying the FVO due to other reasons 共eligibility
criterion 2 and 3兲 as well as banks that do not apply the FVO at all. To reduce heterogeneity in the
control group, I repeat all tests using a control group that consists of banks that do not apply the
FVO. Despite the small sample size of 143 banks, the OLS coefficient of FVO1 共not reported兲 is
negative and significant at the 5 percent level. By including country dummies, the significance
level drops to 10 percent. The pseudo R2 of the first stage in the treatment effects model is 66.5
percent. Hence, there is less noise in estimating the decision to apply the FVO under criterion 1
when excluding banks that apply the FVO under other eligibility criteria. The coefficient of FVO1
in the second stage is –0.0016 and significant at the 10 percent level. Thus, my inferences do not
change when using a different control group.
Next, I test whether the application of the FVO without the main intention to reduce account-
ing mismatches affects earnings volatility. I define the variable FVOX that takes the value of 1 if
a bank applies the FVO in any form, otherwise 0. The OLS coefficients of FVOX 共not reported兲
are negative but not significant. The t-value including country dummies is –1.00 and even lower
without the country dummies. Also, the results for the treatment effects model do not indicate a
significant negative association between FVOX and ␴EBT. Hence, the FVO reduces earnings
volatility only if the main intention of the application is to reduce accounting mismatches. How-
ever, the estimated first-stage probit model shows a strong positive correlation between FVOX and
REGQUAL. The z-value of FVOX is 3.89, suggesting that the FVO 共any eligibility criteria兲 is

predominantly applied in countries with high regulatory quality. In addition, the pseudo R2 of 42.0
percent is higher than the explanatory power of the base model 共i.e., 24.9 percent兲.
VII. CONCLUSION
This study provides empirical evidence that the effects of the FVO on earnings volatility
should be assessed based on the application intention. Banks applying the FVO primarily to
reduce accounting mismatches 共criterion 1兲, report lower levels of earnings volatility than the
control group, although the FVO is irrevocable. Throughout different model specifications, the
reduction equals, on average, the median earnings volatility of the sample. Thus, the effects of the
FVO are considered to be economically relevant. The results also indicate that the application of
the FVO is a more effective tool to reduce earnings volatility than hedge accounting, in accor-
dance with IAS 39. It is, therefore, not surprising that the FVO to reduce accounting mismatches
is predominantly applied in strongly regulated countries, figuring as a complement to the restric-
tive hedge accounting. Taken together, this study confirms previously noted reservations toward
hedge accounting 共e.g., Gebhardt et al. 2004; IASB 2008兲. In addition, I find 共weak兲 univariate
evidence that the adjusted earnings volatility of FVO1 appliers decreases across time. The results
are robust to several modifications of the model, i.e., modifications of the sample composition,
alteration of the time periods, and controlling for self-selection bias.
The main difference between this paper and prior literature on the subject of fair value
accounting is the calculation of an earnings volatility proxy that is based on reported earnings,
instead of retrospectively adjusted fair value income measures or simulation analyses. The design
of my research, therefore, accounts for possible hedging relationships and the structure of a bank’s
balance sheet. However, the research designs of prior literature on fair value accounting have the
advantage that the sample bank can be used as its own control, isolating the effect of fair value
accounting. Thus, some concerns about the “true” effect of the FVO on earnings volatility remain,
despite various sensitivity analyses. Another limitation is that my research design does not account
for any earnings management strategies. For example, previous research finds that banks use
discretionary loan loss provisions to smooth earnings 共e.g., Beaver and Engel 1996; Ahmed et al.
1999; Beatty et al. 2002兲. Since my proxy for earnings volatility is based on reported earnings, it
may be affected by smoothing behavior. At last, fair value measurement issues, which were
excluded from the scope of this research, should also be considered when assessing the FVO.
Nevertheless, this study contributes to the current debate about fair value accounting and, in
particular, presents alternative conclusions to those in prior research, which typically associates
higher levels of earnings volatility with fair value accounting. Overall, the results confirm the
IASB’s initial intention on introducing the FVO, i.e., providing an opportunity to reduce earnings
volatility. Since the U.S. subprime crisis became a global financial crisis in 2008, the effect of the
FVO on the volatility of bank earnings remains a controversial but interesting issue for accounting
research and practice 共e.g., own credit risk adjustments on financial liabilities designated at fair
value兲. Therefore, I encourage future research to investigate the field of the FVO further.
APPENDIX
SAMPLE SELECTION
Thomson Reuters Financials 8374
./. Insurance companies ⫺616
./. Investment trusts ⫺2293
./. Real estate ⫺2023

106 Fiechter
⫽ Global bank sample 3442

./. Non-IFRS banks ⫺2424
./. No quarterly reporting ⫺205
./. American depositary receipts ⫺6
./. Non-banking chart of accounts ⫺535
⫽ Sample before data collection 272
./. Annual report 2007 not available ⫺28
./. Reporting date is not as of December 31 ⫺4
./. Missing quarterly earnings figures ⫺7
./. Missing data in annual reports ⫺11
⫽ Final sample 222
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The Effects of The Fair Value Option Under IAS 39 On The Volatility of Bank Earnings

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JOURNAL OF INTERNATIONAL ACCOUNTING RESEARCH American Accounting Association

Vol. 10, No. 1 DOI: 10.2308/jiar.2011.10.1.85

The Effects of the Fair Value Option under

Data Availability: All data are available from public sources.

Peter Fiechter is an Assistant Professor at the University of Zurich.

Published Online: February 2011

Journal of International Accounting Research Volume 10, No. 1, 2011

II. BACKGROUND AND HYPOTHESES

Journal of International Accounting Research Volume 10, No. 1, 2011

Fair Value Accounting and Earnings Volatility

Journal of International Accounting Research Volume 10, No. 1, 2011

Journal of International Accounting Research Volume 10, No. 1, 2011

III. RESEARCH DESIGN

␴EBTi = ␤0 + ␤1FVO1i + ␤2TRADEi + ␤3RWAi + ␤4HEDGEi + ␤5LEVERAGEi

Journal of International Accounting Research Volume 10, No. 1, 2011

Journal of International Accounting Research Volume 10, No. 1, 2011

Treatment Effects Model

Journal of International Accounting Research Volume 10, No. 1, 2011

PR共FVO1 = 1兲i = ␤0 + ␤1REGQUALi + ␤2BIG4i + ␤3ELIGIBLEi + ␤4SIZEi + ␤5MCBi

Journal of International Accounting Research Volume 10, No. 1, 2011

␴EBTi = ␤0 + ␤1FVO1i + ␤2TRADEi + ␤3RWAi + ␤4HEDGEi + ␤5LEVERAGEi

IV. SAMPLE DESCRIPTION

Journal of International Accounting Research Volume 10, No. 1, 2011

If FVO1 ⫽1 54 0.1737 0.1345 0.1497 0.1548 0.2032 0.3192 0.0362

Panel C: Extent of FVO Applicationc

Panel D: Country Statisticsd

Belgium 3 3 3 2 0.0008 0.0007 1.4800 1.4090

Palestine 1 0 0 0 0.0047 0.0047 ⫺0.5583 ⫺0.4436

Russia 3 3 0 0 0.0016 0.0018 ⫺0.4380 ⫺0.5690

Total 共Average兲 222 115 68 54 0.0029 0.0013 0.7136 0.6989

Journal of International Accounting Research Volume 10, No. 1, 2011

Panel B: Correlation Coefficients of the Treatment Variables

See Table 1 for the definition of the respective variables.

Journal of International Accounting Research Volume 10, No. 1, 2011

Treatment Effects Results

VI. ADDITIONAL ANALYSES

Journal of International Accounting Research Volume 10, No. 1, 2011

Panel B: Second Stage

Journal of International Accounting Research Volume 10, No. 1, 2011

Journal of International Accounting Research Volume 10, No. 1, 2011

(continued on next page)

Journal of International Accounting Research Volume 10, No. 1, 2011

⫽ Global bank sample 3442

Journal of International Accounting Research Volume 10, No. 1, 2011

Journal of International Accounting Research Volume 10, No. 1, 2011

Journal of International Accounting Research Volume 10, No. 1, 2011

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