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When fair value drives volatility

New research verifies the view that fair value accounting can lead to excess stock price volatility and exaggerate the risks taken by some businesses. Dawn Cowie highlights the lessons to be learned

Fair value accounting is supposed to help investors accurately assess risk, but new evidence supports the view that it can make businesses look more risky than they really are. When fair value accounting is selectively applied – for example, to assets but not to liabilities – it can artificially increase earnings volatility and stock price volatility.

An ICAEW-funded project carried out by Igor Goncharov at the Lancaster University Management School used the UK investment trust setting to derive the theoretical relationship between stock price volatility and the volatility of fair value earnings components.