Fair Value Accounting, Earnings Volatility, and Stock Price Volatility

• In Event: Fair Value Accounting

Abstract

This paper examines the effect of fair value accounting and issues with its implementation on the volatility of stock prices. The extant literature shows that investors use earnings volatility in their risk assessments, and that earnings volatility and stock price volatility are strongly correlated. Fair value accounting is argued to facilitate investors’ risk assessment through transparent reporting of underlying economic income. However, regulators are concerned that fair value accounting can make firms appear more volatile than they actually are. This paper uses the U.K. investment trust setting to derive a theoretical relationship between stock price volatility and the volatility of fair value earnings components. It then examines whether the effect of fair value earnings components on stock price volatility is consistent with theoretical predictions. I find that stock price volatility is higher than the volatility of fair value earnings, and that this effect is due to an unrealized (fair value) earnings component. This finding appears to be driven (in part) by the lack of accuracy of some fair value estimates and the artificial earnings volatility due to a mismatch between assets measured at fair value and liabilities measured at historical cost. I corroborate this result by showing that fair value earnings lead to greater stock price volatility when investment trust shares are traded by unsophisticated investors and are followed by fewer analysts.

Author

• Igor Goncharov, Lancaster University