Fair value accounting and earnings quality (EQ) in banking sector: Evidence from Europe

Abstract

This research investigates the influence of fair value accounting (FVA) on earnings quality (EQ) inEuropean banking sector over the 2007 to 2016 period. As financial reporting system of banks is particularly exposed to FVA, we assume that FVA may produce significant effects on EQ for European banks. It can be expected that financial instruments' prices are not available in illiquid markets, so Fair Values are estimated by applying valuation models. The application of valuation models (that is, market to model) in estimating Fair Value gives managers the opportunity to manipulate values, and thus could bring through lower quality of earnings. This study develops a multidimensional concept of EQ, and measures it using a set of attributes as persistence, predictability, variability, and earnings smoothing. The findings suggest that European banks with large Fair Value reporting in financial statements have higher rank of aggregate EQ.

The effect of decreasing interest rates on European banks’ earnings quality

“…The definitions of these components were discussed earlier and are presented in Table 1. According to the definitions of the four components (with a reference to Paoloni et al, 2017), high values of PERS (better sustainability), and low values of PRED (smaller error in earnings predictions), VAR (low volatility) and SMOOTH (effective smoothing activities) refer to better quality of earnings. After calculating the raw values of the components for each bank, rankings of all 128 banks in the sample were created by each component, by giving the highest rank (that is, 128) for the bank showing the best value from the viewpoint of earnings quality, and giving the lowest rank (that is, 1) for the worst value.…”

“…One of the most recent studies in this field is that of Paoloni et al (2017), who argue that, from the seven factors defined by Francis et al (2004), the three market-based components have lower relevance in measuring earnings quality, as they are derived from market data that change quickly and are often uncertain. Therefore, they only use the four accounting-based components, namely persistence (PERS), predictability (PRED), volatility (VAR) and smoothing (SMOOTH) of earnings for computing EQ.…”

“…High quality of earnings means that it serves as an accurate measure of performance and of returns realized, and helps investors to minimize the risk of their decisions, so the net income presented in the income statement is a key in making decisions (Schipper & Vincent, 2003). The earnings quality (EQ) is usually measured by creating a complex indicator, which considers the persistence, the predictability, the volatility and the smoothing of earnings (Paoloni et al, 2017).…”

Earnings Quality Research: Trend, Recent Evidence and Future Direction

“…On the contrary other studies reported that fair value has increased earnings quality (Takacs et al, 2020;Yao et al, 2018;Paoloni, 2017). The advocates of fair value believe that, since fair value reflects the current price of a security which is the starting point for the forecasting of future price, it is assumed that fair value has greater predictive power as compared to the historical cost model.…”

Fair Value Gains or Lossses and Earnings Quality of Listed Nigerian Deposit Money Banks.

“…This study, which follows earlier empirical researchers (e.g. Francis et al, 2004;Sodan, 2015;Paoloni et al, 2017), adopts earnings quality as a multidimensional concept and investigates the impact of FV gains/losses on the four most popular EQ accounting measures-persistency, predictability, volatility, and smoothing-in an aggregate form.…”