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Review of Accounting Studies

Erschienen in:

01.03.2014

Preserving amortized costs within a fair-value-accounting framework: reclassification of gains and losses on available-for-sale securities upon realization

verfasst von: Minyue Dong, Stephen Ryan, Xiao-Jun Zhang

Erschienen in: Review of Accounting Studies | Ausgabe 1/2014

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Abstract

SFAS No. 115 requires firms to recognize available-for-sale (AFS) securities at fair value with accumulated unrealized gains and losses (AUGL) recorded in accumulated other comprehensive income. Firms reclassify AUGL to net income when they realize gains and losses. We refer to the amount reclassified each period by “RECLASS.” As of 1998, SFAS No. 130 requires firms to present RECLASS prominently in their financial statements. We investigate the incremental explanatory power of RECLASS for banks’ market values and market-adjusted returns. In the market value analysis, we control for AUGL, other components of book value of equity, net income before extraordinary items and RECLASS (NIBEX^other), and other components of comprehensive income. In the returns analysis, we control for ΔAUGL, ΔNIBEX^other, and extraordinary items. We find high positive coefficients on RECLASS in both analyses, consistent with investors pricing RECLASS as a relatively permanent component of net income. Exploring possible explanations for these pricing implications, we find no evidence that they are attributable to RECLASS remedying unreliable fair value measurement of AUGL. We provide three distinct analyses indicating that RECLASS’s pricing implications are explained in significant part by it helping investors predict banks’ future performance. Our results illustrate that an important type of amortized cost accounting information, realized gains and losses, remains highly useful to investors despite the overall fair-value-accounting framework for AFS securities.

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Schultz and Hollister (2003) and Johnson and Swieringa (1996) describe the political process and resulting compromises involved in gaining general acceptance for SFAS No. 115. Interestingly, these compromises occurred despite considerable support for fair value accounting for all investment securities from SEC Chairman Richard Breeden (see his September 14, 1990, speech, “The Proper Role of Financial Reporting: Market Based Accounting,” at Smith Barney's Fourth Annual Financial Services Conference in Washington, DC, available on the SEC website) and many bank regulators because the thrift crisis had recently revealed the limitations of amortized cost accounting. Notably, however, Federal Reserve Board Chairman Alan Greenspan strongly opposed this change in accounting (see his November 1, 1990, letter to Richard Breeden, available http://economyblog.ncpa.org/wp-content/plugins/uploads/Greenspan%20letter%20to%20SEC%20November%201990.pdf).

See the “What are the Main Aspects of the Proposed Guidance?” section on pp. 3–5 and paragraphs BC57, BC58, and BC79 of the May 2010 exposure draft. In its redeliberations of the exposure draft to date, the FASB proposes to require parenthetical presentation on the balance sheet of fair values for most financial instruments measured at amortized cost and of amortized costs for financial liabilities (but not financial assets) measured on fair value. See Financial Accounting Standards Board, Accounting for Financial Instruments: Summary of Decisions Reached to Date during Redeliberations as of June 20, 2012, available on the FASB website.

Trevor Harris points out that securities typically viewed as highly liquid may experience significant price pressures due to financial institutions’ concentrated and correlated trading behavior at certain times. This behavior may occur at the end of accounting periods due to performance evaluation of employees, end-of-period financial statement window dressing, or other reasons.

See Scholes et al. (1990), Beatty et al. (1995), Collins et al. (1995), Beatty et al. (2002), Cornett et al. (2009), and Chang et al. (2011).

Realization of gains and losses on AFS securities is only one of banks’ primary mechanisms for income management, along with the provision for loan losses, realization of gains and losses on other assets and liabilities, and Level 2 and 3 fair value estimates for trading and other positions for which unrealized gains and losses are recorded in net income. As discussed in Sect. 4, we find that RECLASS offsets a significant but relatively small portion of the variation in net income.

From 1993 to 1997, users of financial reports generally could have, with some effort, determined RECLASS from SFAS No. 115-required AFS securities footnote disclosures of AUGL, realized gains and losses, transfers of securities between the standard’s three categories (trading, AFS, and held-to-maturity), and OTT impairment write-downs.

Consistent with evidence of functional fixation on earnings and other forms of mispricing in the literature (e.g., Lakonishok et al. 1994; Sloan 1996; Teohe et al. 1998; and Penman and Zhang 2002), we also considered the possibility that investors undervalue periodic unrealized gains and losses (UGL). We regressed returns for the 12 months beginning five months after fiscal year-end on UGL, Fama and French’s (1992, 1993) three factors, and stock return momentum (Jegadeesh and Titman 1993). We found statistically weak (at the 10 % level) evidence that banks with higher unrealized gains and losses experience economically modest higher future excess returns (0.5 % higher for the highest versus lowest deciles of UGL). Including the year-ahead change in RECLASS in the regression model weakened the drift and rendered it statistically insignificant, consistent with investors mispricing unrealized gains and losses in part because they do not fully incorporate their association with future RECLASS. Given the statistically weak and economically modest return drift, we concluded that investor mispricing explains at most a small portion of the high pricing implications of RECLASS.

Badertscher et al. (2012) examine the pricing implications of banks’ OTT impairments, which may but need not involve reclassifications of AOCI, depending on the extent to which the deteriorations of value captured in these impairments develop prior to the reporting quarter. We discuss this extent in Sect. 2.

Barth (1994) hand collected the fair values of marketable securities for a sample of banks from 1970 to 1990 that appear to have disclosed the fair values of marketable securities in financial reports under industry GAAP or practice. Ahmed and Takeda (1995) obtained similar data from commercial bank holding companies’ regulatory Y-9C filings from the second quarter of 1986 to the fourth quarter of 1991.

Ahmed and Takeda (1995) also examine the effects of income, capital, and tax management on the pricing implications of unrealized and realized gains and losses.

Equation (7) in Ohlson (1995) differs in four primary respects from our Eq. (5). First, Ohlson’s comprehensive income term is a capitalization of comprehensive income reduced by dividends. Second, the weights on the book value and income terms are inversely related. Third, he allows for non-accounting information. Fourth, his equation does not include an intercept.

If dividend payout is not constant, then dividends should be incorporated in Ohlson’s (1995) capitalized comprehensive income term. However, prior research by Hand and Landsman (1998) finds that including dividends in the Ohlson model empirically appears to capture dividends signaling future income rather than dividend payout.

RECLASS also affects AUGL and, depending on the type of realization of gains and losses, one of COST or BV^other in Eq. (6) [This issue does not arise in Eq. (7)]. For example, for economic realizations of gains, RECLASS also appears as an increase in BV^other (its effect on cash) and a decrease in AUGL (its effect on AFS securities). However, unlike RECLASS’s direct and indirect effects discussed in the text, these two additional effects would exist in a clean surplus fair value accounting system that does not report RECLASS or otherwise preserve amortized cost information about realized gains and losses. We conduct our tests using the total coefficient β₄-β₇ because it better corresponds to our focus. However, we have also conducted all tests using the alternative total coefficient (β₃ + β₄) − (β₂ + β₇), which yields the same conclusions as for our tests using β₄ − β₇, albeit with slightly lower significance levels (e.g., 5 % instead of 1 % in our primary tests reported in column III of Table 3, Panel A).

We do not consider the effect of taxes on the total coefficient on RECLASS (an aftertax variable). Warfield and Linsmeier (1992) examine the effect of cross-sectional differences in taxes on the coefficient on realized gains and losses. They argue and provide evidence that realized losses for tax-paying firms and realized gains for nontax-paying firms convey good news, at least for the first three quarters of the fiscal year. In principle, these differences could affect the coefficients on RECLASS in our empirical models. Due to the almost universal good health of the banking industry during our sample period—far better than the 1980–1985 period examined by Warfield and Linsmeier—our sample banks invariably paid taxes.

We do not investigate whether realization of gains and losses smooths net income in a fashion deemed credible by investors. We note, however, that costs that might yield such credibility include regulatory costs associated with realization of losses, tax costs associated with realization of gains, and reputational consequences for managers who manage income along an ex post unsmooth path.

Possibly this low frequency reflects nondisclosure by banks of immaterial realizations for accounting purposes only, given that SFAS No. 115’s provisions need not be applied to immaterial items. Partly for this reason, we do not remove these 11 observations from the sample. Our results are not noticeably affected by the removal of these observations from the sample.

Alternatively, summing the coefficients across the relevant book value and comprehensive income terms involving AUGL in the full market value model Eq. (6) yields a total coefficient on AUGL of β₂ + β₇ = 0.72 + 0.56 = 1.28. This coefficient remains fairly close to the expected coefficient of one for transitory gains and losses and is insignificant. We do not use this alternative approach in the text because, in our observation, researchers generally do not sum coefficients across overlapping book value and comprehensive income terms in Ohlson’s market value models this fashion. See footnote 13 for related discussion.

Our measures of liquidity and growth are essentially uncorrelated, so that the analyses reported in Table 4 and 5 capture different phenomena. In untabulated analyses, we estimated Eqs. (6) and (7) for the four subsamples formed by the intersections of the two liquidity and two growth subsamples. We find that the coefficients on RECLASS are highest and significant in the high liquidity and high growth subsample, about half the size but still significant at the 10 % level or better for both the high liquidity and low growth subsample and the low liquidity and high growth subsample, and approximately zero and insignificant in the low liquidity and low growth subsamples.

Because RECLASS may be associated with many future years’ CI, to maximize the power of the test, the dependent variable ideally would be future CI summed over more than one year in these analyses. We do not do this to avoid losing observations due to the limited number of years of data available.

We partition by beginning, not ending, AUGL so that the partitioning variables are not tautologically related.

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Titel: Preserving amortized costs within a fair-value-accounting framework: reclassification of gains and losses on available-for-sale securities upon realization
verfasst von: Minyue Dong
Stephen Ryan
Xiao-Jun Zhang
Publikationsdatum: 01.03.2014
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 1/2014
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-013-9246-7

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