This study examines the accounting treatment of financial liabilities under IFRS 9, with a particular focus on the application and implications of the fair value option (FVO) within European banking institutions. Building on the International Accounting Standards Board’s (IASB) post-implementation review (PIR), the analysis confirms that the existing requirements for financial liabilities are largely considered decision-useful by stakeholders.

Empirically, the study analyses a sample of 77 banks directly supervised by the European Central Bank over the period 2018 – 2024. The findings indicate that the use of the FVO for financial liabilities is widespread but limited in quantitative significance. Although 58% of the sampled banks apply the FVO at least once, the proportion of financial liabilities designated under this option remains relatively low, averaging 3.67% over the observation period. Larger institutions are more likely to apply the FVO, revealing a size-related pattern.

The analysis further demonstrates that fair value changes are predominantly driven by market factors rather than own credit risk (OCR), with OCR-related effects exhibiting a declining trend over time. Three primary designation criteria are allowed by IFRS 9. The criterion to avoid accounting mismatches is empirically shown to be the most relevant in practice. The embedded derivatives criterion (the second way into the FVO) permits designation where a financial liability contains one or more embedded derivatives that would otherwise require separation. Designation is thirdly allowed when financial liabilities are managed and evaluated on a fair value basis in accordance with a documented risk management or investment strategy. In practice, this method appears to be less frequently applied in isolation.

Disclosures regarding designation methods and the underlying financial instruments are often insufficiently detailed, limiting users’ ability to fully assess the economic substance of reported figures. An evaluation of compliance with IFRS 7 disclosure requirements reveals moderate fulfilment levels, with an average disclosure index of approximately 56 – 60%.  Overall, the study contributes to a deeper understanding of the practical relevance of the FVO and its associated disclosure requirements. It underscores the limited quantitative importance of the FVO, despite its widespread use, and highlights ongoing challenges in relation to transparency and comparability.

Read the entire article here: https://ssrn.com/abstract=6504879 or here: https://dx.doi.org/10.2139/ssrn.6504879.