In the world of corporate finance, what appears in a company’s balance sheet is often accepted as truth. Yet beneath the surface of those neat columns of numbers may lie assumptions and judgments that shape how stable, profitable, or even ethical a business appears. A new study by Lawrence Haar and colleagues from the University of Brighton offers a market-based way to test those assumptions, revealing how international accounting rules might allow companies to overstate or understate their financial resilience.
Published in the Journal of Financial Reporting and Accounting, the article titled “Marking-to-market IAS 37 provisions using options: an empirical demonstration” examines how firms apply the International Accounting Standard 37 (IAS 37), which governs how companies recognise and measure potential liabilities such as legal claims, warranty recalls, or environmental clean-ups.
The study proposes that financial option theory, a concept usually reserved for derivatives markets, can objectively calibrate these provisions using real market data. By comparing a firm’s recorded reserves with the cost of hedging the same risk through traded options, the researchers demonstrate a method to “mark-to-market” the credibility of corporate provisions.
The rules behind corporate rainy-day funds
IAS 37 was designed to make financial reporting more transparent by ensuring that potential liabilities are recognised if they are more likely than not to occur. When the probability of a future outflow exceeds 50 per cent, firms are required to record a provision in their financial statements. If the probability is lower, the risk must at least be disclosed in the accompanying notes.
These rules are intended to protect investors by making corporate exposures visible. Yet, as Haar and his co-authors, Ali Elharidy and Andros Gregoriou, explain, IAS 37’s criteria are open to interpretation. What one management team considers “probable” may look far less certain to another. This discretion can be used, consciously or not, to influence how a company’s performance appears to outsiders.
Financial analysts have long suspected that provisions may be employed as tools of earnings management, allowing firms to smooth profits or create buffers for future losses. Previous empirical studies across Europe and North America have found that discretionary provisions are often linked to attempts to stabilise reported income. The Brighton team set out to test this idea using market-based evidence rather than subjective judgment.
When prudence turns into manipulation
In theory, provisions should make financial statements clearer. In practice, they can blur the picture. If a company “over-provisions” by setting aside more than necessary, it reduces current profits, creating a reserve that can later be released to inflate earnings when business slows. Conversely, under-provisioning can make today’s results look stronger at the cost of future credibility.
Haar argues that such behaviour can erode trust in financial markets and distort the allocation of capital. Investors may assume that firms are conservative when, in fact, they are managing perceptions. “Through mis-estimating potential obligations and their probability, managers can create the illusion of stability,” the paper notes.
To address this, the researchers propose an external benchmark drawn from the logic of financial options, where market participants price risk with mathematical precision. Unlike managerial assumptions, option prices reflect collective expectations about volatility and future uncertainty.
Applying option theory to accounting provisions
In financial markets, options give the holder the right but not the obligation to buy or sell an asset at a fixed price. Their value depends on market volatility, interest rates and time to maturity. Because these parameters are derived from real trading data, options provide an objective measure of perceived risk.
Haar and colleagues reasoned that if a company could hedge a potential liability using an equivalent option, the option price would represent the market’s view of that risk. Comparing this price with the firm’s recorded provision could reveal whether management’s assumptions were realistic.
Using data from 69 companies in the FTSE 100 index, the team replicated corporate provisions with a long-short put strategy, essentially buying and selling options at different strike prices to mimic the pay-off structure of a financial reserve. They then compared the cost of this option-based hedge with the opportunity cost of capital tied up in the provision itself.
On average, the ratio of option-hedging cost to funding cost was 1.11, suggesting that the two approaches were roughly equivalent. Yet some firms were significantly over- or under-provisioned. About half of the sample appeared to assign probabilities that were either too high or too low relative to market expectations.
Linking provisions to market volatility
The Brighton researchers went further, testing whether over-provisioning was linked to share price behaviour. Using ordinary least-squares and panel regressions, they related each company’s recognised reserves to its implied volatility and beta metrics, which capture market risk.
The results revealed a strong statistical relationship: firms with more volatile share prices or higher systematic risk tended to hold larger reserves. This supports the theory that provisions may serve as a tool for earnings smoothing, a way to offset the appearance of instability during turbulent markets.
In statistical terms, the average adjusted R-squared for firm-level regressions was 0.61, indicating that volatility explained a significant portion of the variation in provisions. Panel regressions using robust estimation confirmed the finding, with significance levels well below 1%.
Why the findings matter
For investors and regulators, the implications are far-reaching. Accounting standards, such as IAS 37, were created to enhance transparency; however, their flexibility may inadvertently undermine it. If companies use provisions to smooth their results, financial statements become less informative, and markets become less efficient.
By demonstrating a method to benchmark provisions against real market data, Haar’s research provides auditors and analysts with a new tool to test whether recorded reserves are reasonable. This approach aligns accounting with financial economics, grounding subjective assumptions in observable prices.
In practical terms, the study suggests that analysts can look to option-implied volatility as a signal of whether a company’s provisions are proportionate to its market risk. Excessive reserves relative to volatility could indicate hidden income management, while insufficient reserves might signal underestimation of future liabilities.
Towards a market-aligned accounting future
The Brighton study demonstrates that option-based benchmarking can convert the opaque art of provisioning into a transparent, testable science. By “marking-to-market” corporate reserves, financial reporting can become more consistent with the principles of modern risk management.
As global capital markets demand ever greater accountability, aligning accounting provisions with market realities may be a logical next step. It could help rebuild trust in corporate reporting and ensure that balance sheets reflect not just managerial judgement but measurable economic truth.
Ultimately, the research highlights a simple yet powerful insight: financial statements are not merely factual records, but narratives shaped by choice. IAS 37 was intended to bring clarity to those choices, yet without objective calibration, it may instead create new ambiguities.
Reference
Haar, L., Elharidy, A., & Gregoriou, A. (2025). Marking-to-market IAS 37 provisions using options: An empirical demonstration. Journal of Financial Reporting and Accounting, 23(1), 387–403. https://doi.org/10.1108/JFRA-08-2022-0280
