The Fair Value Option as an Accounting Policy on Income Smoothing: Evidence from Risk-Related Incentives in Executive Compensation

Because risk-related incentives urge managers to make riskier investment decisions, leading to unexpected earnings volatility, managers tend to smooth income by avoiding unanticipated economic consequences. Statement of Financial Accounting Standards (SFAS) No. 159 allows firms to measure financial instruments at fair value and effectively reduces earnings volatility. This study provides evidence that the risk-related incentive motivates bank managers to elect the fair value option as an income-smoothing accounting policy even though managers do consider characteristics of financial instruments when selecting specific instruments. Empirical findings imply that banks conform to SFAS 159’s intention when they choose an accounting policy.</p