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.

The theoretical relationship between stock price volatility and the fair value earnings components

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.

The research focused on investment trusts, which use a mixed measurement approach in their financial statements – predominantly using fair value accounting for financial investments and historical cost measurements for related liabilities and other assets. As a result, financial statements account only for changes in asset values, resulting in poor matching of gains and corresponding losses. This artificially increases the volatility of reported earnings.

In some periods income will appear too high because it accounts for a fair value gain on an asset but not for an offsetting loss on a related liability. In other periods, income will appear too low. This leads to higher volatility of income, which may be perceived by some investors as evidence of higher investment risk. In this case, stock price volatility will be higher.

The findings were based on analysis of the financial statements of investment trusts that have at least 10 years of consecutive financial statements over the period 1990–2013. The earnings components, reconciliation of fair value balances, and categories of fair value investments were taken from the financial statements of 155 funds.

Other factors: investor experience and institutional ownership

Another key finding of the research is that fair value earnings lead to greater stock price volatility when investment trust shares are traded by unsophisticated investors and followed by fewer analysts.

When the institutional ownership share exceeds 41% or there are about two analysts producing forecasts of fair value earnings, then stock price volatility is normal. However, where funds are predominantly owned by unsophisticated private investors, the result is that excess volatility goes unadjusted and translates into higher volatility of stock prices.

Despite concerns that fair value accounting increases stock price volatility, there was little prior evidence of a link. Now it seems that a combination of measurement issues and misunderstanding of fair value information by some investor groups may undermine some of the benefits of fair value accounting.

Dawn Cawie, financial journalist

Valuation Group, June 2017