Missed Distress Signals : Evidence from the Fair Value Option for Liabilities

We test for the presence of adverse selection among firms adopting the fair value option for liabilities (FVOL) embedded in SFAS 159. The FVOL is a controversial accounting choice because it allows firms to increase earnings when credit quality deteriorates. We find that firms with higher credit risk, lower profitability, and negative abnormal stock returns are more likely to adopt the FVOL and that these firms exhibit negative abnormal stock returns over one- to three-year horizons after adoption. We conclude that adverse selection occurs among adopters. While a fair value option for financial liabilities can reduce comparability and information transparency, further tests suggest that this accounting choice effectively reveals private information about a firm's financial vulnerability. This supports the argument that accounting choice is a valuable tool in standard setting.This paper has been revised to "An Option for Lemons? The Fair Value Option for Liabilities" Available at SSRN: 'http://ssrn.com/abstract=2418459' http://ssrn.com/abstract=2418459