The aim of this paper is to contribute to the current discussion about fair value accounting (FVA). We discuss the problem surrounding FVA by relying on the role played by prudence, its meaning, and how the treatment of prudence has changed in the accounting framework of standard setters due to its ‘apparent’ inconsistency with neutrality. To highlight the relevance of this issue, we provide (1) a brief analysis of the high impact that Level 2 fair value estimates have on large US and European banks’ financial positions; (2) a ‘case study’ by pricing two common exotic derivatives and comparing the valuation results of two different assumptions of volatility (local vs. stochastic); and (3) a discussion of potential solutions to the problem surrounding FVA. Our findings are consistent with the argument that neutrality is supported by the exercise of prudence in achieving a faithful representation, since a non-conservative use of FVA can lead bank managers towards model misspecification error in the valuation of complex financial instruments. We conclude by arguing that the problem surrounding FVA can be mitigated if prudence is reinstated by standards setters.
Bibliographical noteFunding Information:
This research was supported by the Ministry of Education of the Republic of Korea; National Research Foundation of Korea: [Grant Number: NRF-2015S1A3A2046811] and the Spanish Ministry of Economy and Competitiveness, within the “Programa Estatal de Fomento de la Investigaciün Científica y Técnica de Excelencia. Subprograma Estatal de Generación de Conocimiento”: [Grant Number: ECO2015-66240-P].
© 2016 Asociación Española de Contabilidad y Administración de Empresas (AECA).
All Science Journal Classification (ASJC) codes
- Economics and Econometrics