“Fair value” is a gold standard in valuation, but there is no consensus on its usefulness in other areas, such as evaluating management performance. HKUST’s Mingyi Hung and her colleagues settle this dispute in important new work, contending that fair value accounting may actually be unhelpful when it comes to contracting. This finding is particularly meaningful given the worldwide introduction of the International Financial Reporting Standards (IFRS) in 2005.

Fair value is a widely recognisedvaluation principle that is used to estimate the up-to-date value of an asset. Since the worldwide mandatory IFRS adoption, many firms have adopted fair value accounting. However, “the costs and benefits associated with IFRS’s fair value provisions are hotly debated,” say the researchers. Although fair value accounting is widely praised for its transparency and comparability, some researchers have warned that it might introduce noise and obscure firm performance, thus impeding the ability of net income to reflect risk or economic performance.

To settle this debate, the researchers investigated how the association between net income and manager performance differs according to companies’ adoption of the IFRS’s fair value provisions. They hypothesised that “if these provisions contain noise or bias that makes net income a poor summary measure of management performance,” the association between net income and management compensation will be weaker.

Armed with data spanning 6 years, the authors explored the association between net income and managerial compensation following IFRS adoption. Data on 1,654 unique firms in 22 countries were included in a series of thorough analyses. Importantly, managerial compensation was assessed in terms of executive cash pay.

Strikingly, the association between net income and cash pay was weakest for firms that were most affected by the IFRS’s fair value provisions. This suggests that fair value accounting actually impedes the ability of net income to reflect managerial performance, potentially due to “greater earnings manipulation and noisier earnings,” say the authors. Conversely, this net income–cash pay association was strongest in firms that were least affected by IFRS’s fair value provisions. “This suggests that IFRS's non-fair-value provisions increase the association between net income and cash pay,” claim the authors.

Crucially, this study provides firms across the world with key information on the performance evaluation role of earnings under IFRS provisions. A major contributor to the field, this work also resolves the controversy surrounding the usefulness of the contracting role of IFRS-based accounting. It suggests that mixed findings in the literature may arise from the opposing effects of fair value and non-fair-value IFRS provisions on the evaluation of managerial performance. The authors conclude that their findings “are consistent with the notion that fair value accounting may reduce the usefulness of earnings in executive performance evaluation by reducing the reliability of reported earnings.”