Preserving Amortized Cost within a Fair-Value-Accounting Framework:

Reclassification of Gains and Losses on Available-for-Sale Securities upon Realization

Minyue Dong†

University of Lausanne

Stephen Ryan‡

New YorkUniversity

Xiao-Jun Zhang*

University of California, Berkeley

First draft: December 2008

Current draft: October 2010

(Revision in Process, for ColumbiaBurton Conference Participants Only:

Please Do Not Cite without Permission)

† Universite de Lausanne, Faculty of Business and Economics, Quartier UNIL-Dorigny, Baliment Internef Bureau 595, CH-1015 Lausanne, Switzerland, (41)216923367. ‡Stern School of Business, KaufmanManagement Center,44 West 4th Street, New York, NY 10012. (01)2129980020. * 545 StudentServicesBuilding #1900, Berkeley, CA94720, USA, (01)5106424789. Comments and suggestions from Anne Cristine dArcy, Jonathan Glover, Pierre Liang, Jack Stecher, Danqing Yang and seminar participants at CarnegieMellonUniversity, ChineseUniversity of Hong Kong, and University of Lausanne are gratefully acknowledged. We thank Jialu Shan and Joseph Cadora for research and editorial assistance.

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Preserving Amortized Cost within a Fair-Value-Accounting Framework:

Reclassification of Gains and Losses on Available-for-Sale Securities upon Realization

ABSTRACT: SFAS No. 115 requires firms to record available-for-sale (“AFS”) securities on the balance sheet at fair value,with accumulated unrealized gains and losses (“AUGL”) recorded in accumulated other comprehensive income (“AOCI”), a component of owners’ equity. Firms reclassify AUGL to net incomewhen they realize gains and losses either economically through sale of AFS securities or for accounting purposes through transfer of the securities to trading or other-than-temporaryimpairment write-downs. We refer to the amount of this reclassificationeach period as “RECLASS.”

For a sample of 200 large U.S. commercial banks from 1998-2006, we examine the incremental valuerelevance of RECLASS beyond AUGL and other components of book value of equity and comprehensive income. We find that the market value of equity is significantly positively associated with RECLASS, with the coefficient on RECLASS being closer to the coefficient onthe relatively permanent net income before extraordinary items and discontinued operations than to the much lower coefficients on the remaining more transitory components of comprehensive income. We also find that the coefficient on RECLASS is much higher than the coefficients on AUGL and other components of book value. This result obtains despite also finding that the coefficient on AUGL is significantly positive in a pure balance-sheet model and higher than the coefficient on the remainder of book value in a combined balance-sheet/comprehensive-income model, consistent with investors placing at least a normal amount of credence in AUGL.

We conduct three analyses investigating possible explanations forthe incremental value relevance of RECLASS. First, we consider the possibilitythat unrealized gains and losses are unreliable, as opponents of fair value accounting often allege.Contradicting this possibility,we find that the coefficient on RECLASS is higher and more significant for banks that hold more liquid securities. Second, we consider the possibility that RECLASS interacts with or is an indicator of future bank growth. Consistent with this possibility, we find that the incremental value relevance of RECLASS is greater for higher growth banks. Third, and further supporting this possibility, we find that RECLASS is significantly positively associated with one-year-ahead comprehensive income, controlling for other components of current book value and comprehensive income, more so for banks holding liquid securities and growing faster.

Overall, our findingssuggest that the value relevance of RECLASSis primarily attributable to the importance of the realization of realized gains and losses as an indicator of bank growth rather than to the limitations of fair value accounting for AFS securities. At a minimum, these findings suggestthat the FASB should continue to require information about realized gains and losses, an amortized costaccounting construct, within the fair value accounting framework for AFS securities.

Key words: Available-for-sale securities; Reclassification; Fair value accounting; Realization principle.

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  1. INTRODUCTION

In this paper, we examine the incremental value-relevance of realized gains and losses beyond unrealized gains and losses and other components of book value and comprehensive income for commercial banks’ available for sale (“AFS”) securities. We focus on AFS securities because they are reported at fair value on the balance sheet, but amortized cost information about realized gains and losses is preserved and reported on the income statement through the use of “dirty surplus”accountingdescribed below. The financial reporting for AFS securities contrastswith the typicalaccounting for financial instruments under current U.S. GAAP,in which one of fair value and amortized cost information is reported only in footnote disclosures or not at all. Prior research generally shows that investors react more strongly to recognized than disclosed information, either because they do not have the ability or inclination to evaluate the many disclosures in financial reports or because they deem recognized amounts more reliable (Schipper 2007). Hence, AFS securities constitute a relatively unambiguous setting in which to test for the incremental value relevance of information about the fair values and amortized costs of financial instruments.

Statement of Financial Accounting Standards (“SFAS”) No. 115,Accounting for Certain Investments in Debt and Equity Securities, requires a hybrid fair-value-on-the-balance-sheet/amortized-cost-on-the-income-statement approach to accounting for AFS securities. Specifically, firms record AFS securities on the balance sheet at fair value, with accumulated unrealized gains and losses (“AUGL”) recorded in accumulated other comprehensive income (“AOCI”), a component of owners’ equity distinct from retained earnings. This is dirty surplus accounting because changes in owners’ equity occur without corresponding changes on net income. Subsequently, firms reclassify AUGL to net income when gains and losses are realized economically through sale of AFS securities or for accounting purposes through transfer of the securities to trading or other-than-temporary (“OTT”) impairment write-downs. We refer to the amount of this reclassification each period as “RECLASS.”

Advocates of fair value accounting often criticize thisaccounting for AFS securities as politically motivated and convoluted, particularly for liquid securities for which fair value is the most relevant, comprehensive, and timely measure of the value of the securities.[1] However, this accounting has the desirable feature of preserving certain aspects of amortizedcost accounting for AFS securities—particularly the realization of gains and losses reported on the income statement via RECLASS—within a primarily fair value accounting framework. Even if fair values are well measured, amortized costs may be incrementally value relevant beyond fair values for various reasons. The FASB recognizes this fact in its May 2010 Exposure Draft, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (“the ED”), in which it observes that amortized costs may have incremental value relevance due to their verifiability, association with contractual cash flows, or correspondence with the firm’s business strategy. Consistent with this observation, in the ED the FASB proposes dual presentation on the balance sheet of the amortized costs and fair values of many financial instruments.

The FASB’s proposal is consistent with at least two positions expressed by opponents of fair value accounting. First, most of these opponents question the reliability of fair values (e.g., Wallison 2008, Forbes 2009). In our view, reliability is a minor concern for most of banks’ AFS securities, which are dominated by federal governmental, government-sponsored agency (e.g., Fannie Mae), and other liquidsecurities, although it is a significant concern for someof these (e.g., structured asset-backed) securities. More interestingly, some opponents of fair value accounting point out that realization of gains and losses is important for various purposes, such as contractingand stewardship assessment (Watts 1993 and Holthausen and Watts 2001), capital regulation (Moyer 1990 and Ahmed and Takeda 1995), other aspects of firms’ business strategies (Nissim and Penman 2008), and managerial signaling of their private information (Abdel-Khalik 2008 and Ronen 2008).

In this study, we provide evidence regarding the benefit of preserving amortized cost information within a fair value accounting framework in the specific context of the value relevance of RECLASS. RECLASS constitutes a somewhat more limited and less visible preservation of amortized costs in a fair value accounting framework than the FASB’s proposal in the ED to require dual presentation on the balance sheet of the amortized costs and fair values of many financial instruments. However, our examination of the value relevance of RECLASS is meaningful because this variable embodies the realization principle that is central to amortized cost accounting.

We hand collected RECLASS for the 200 largest publicly traded U.S. commercial banks (based on total assets in 1998) for the period 1998-2006. We limit our sample to banks because total (realized) gains and losses on AFS securities often constitute significant portions of their owners’ equity (net income). Our sample period necessarily begins in fiscal year 1998, when FAS No. 130, Reporting Comprehensive Income, first required firms to disclose RECLASS in a visible fashion.[2]

Our primary findings are as follows. First, we find that banks’ market values are significantly positively associated with AUGLin a pure balance sheet model and higher than the coefficient on the remainder of book value in a combined balance-sheet/comprehensive-income model, consistent with investors placing at least a normal amount of credence in AUGL. This suggests that the incremental value relevance of RECLASS that we document in this paper is not solely attributable to RECLASS remedyingthe unreliability of the fair value accounting-based AUGL.

Second, we find that investors ascribe considerable incremental value relevance to RECLASS, controlling for the other components of book value and comprehensive income. Specifically, we find that the market value of equity is significantly positively associated with RECLASS, with the coefficient on RECLASS being closer to the coefficient on the relatively permanent net income before extraordinary items and discontinued operations (NIBEX) than to the much lower coefficients on the more transitory components of comprehensive income. The coefficient on RECLASS is also much higher than the coefficients on AUGL and other components of book value. These findings imply thatstock investors ascribe considerable significance to the realization of gains and losses recorded in RECLASS. These findings obtain even though RECLASS effectively just reclassifiesone component of owners’ equity, AOCI, to another, retained earnings. Our remaining primary findings pertain to analyses that we conduct to investigate possible explanations for the significance of the realization of gains and losses recorded in RECLASS.

Third, we consider the possibility that unrealized gains and losses are unreliable, as opponents of fair value accounting often allege.This possibility is inconsistent with our aforementioned findings for AUGL and with the high liquidity of most AFS securities. Directly contradicting this possibility, we find that the incremental value relevance of RECLASS is stronger for banks that hold more liquid securities. This implies that this incremental value relevance is not primarily attributable to the lack of verifiability of fair values.

Fourth, we consider the possibility that RECLASS interacts with or is an indicator of future bank growth. Consistent with this possibility, we find this incremental value relevance is larger forhigher growth banks. This suggests RECLASS conveys incremental information about future valuation attributes, which have greater valuation consequences for higher growth firms.

Fifth, consistent with this suggestion, we find that RECLASS is significantly positively associated with year-aheadcomprehensive income, controlling for the other components of book value and comprehensive income. Consistent with the valuation model results, this association is stronger for banks holding more liquid securities and growing faster.

Sixth, we consider the possibility that investors undervalue unrealized gains and losses, saybecause they fixate on reported net income. We conduct regression analyses controlling for Fama and French’s (1992, 1993) three factors and stock return momentum (Jegadeesh and Titman 1993) as well as portfolio analyses grouping banks into terciles each year based on the amount of unrealized gains and losses. Both analyses yield weak statistical evidence that banks with higher unrealized gains and lossesexperience economically modesthigher future excess returns. In the portfolio analysis, we find that the return drift is stronger when excess returns for the tercile observations are value-weighted rather than equally weighted, implying that the market under-reaction is stronger for larger banks. While there are various possible explanations for this finding, we conjecture it may be attributable to the greater difficulty that investors face in evaluating unrealized gains and losses for larger banks, given their more diverse holdings of AFS securities and greater overall complexity. Given the statistically weak and economically modest return drift, investor mispricing appears to explain at most a small portion of the value-relevance of RECLASS.

To our best of our knowledge, our paper is the first to document the value relevance of RECLASS or the reclassification of any other component of AOCI. Our results have implications for the ongoing debate about the relative and incremental usefulness of fair value versus amortized cost accounting for financial instruments. Our findings collectively support the FASB’s view expressed in the ED that it is incrementally value relevant to preserve amortized cost information based on the realization principlewithin a fair value accounting framework.

  1. Prior Research

Our study is primarily related to two areas of prior research: (1) studies on the incremental and relative value relevance of the fair values versus amortized costs of financial instruments and (2) studies on the incremental and relative value relevance of other comprehensive income versus net income. We discuss these two literatures in turn.

Advocates of fair value accounting generally claim that the fair valuesof financial instruments have higher or incremental value relevance compared to the amortized costs of the instruments. Numerous empirical studies have tested this claim, typically using disclosed fair valuesunder SFAS No. 107, Disclosures about Fair Values of Financial Instruments. While generally supportive of this claim, the resultsof these studies vary somewhat depending the type and liquidity of the financial instruments considered, the type of firms involved, as well as aspects of the research design such as the use of levels versus first differences valuation models. These studies often but not always find that market values are significantly incrementallyassociated with fair values controlling for amortized costs, but not vice-versa.

The most related prior study to ours, Barth (1994),examines the value relevance of disclosures about the fair values of banks’ investment securities.[3] Barth estimates levels and first differences modelsin annual cross-sectional regressions and pooled regressions with fixed effects. In her levels model, the market value of equity is regressed on the book value of equity and the fair value and amortized costs of marketable securities. The levels model estimationyields a highly significantly positive coefficient on the fair value of marketable securities and an insignificant or negative significant coefficient on the amortized cost of marketable securities. Barth concludes that the fair values of marketable securities provide significant explanatory power beyond amortized costs, but not vice versa. In her first differences model, returns is regressed on net incomebefore securities gains and losses (alternatively, the change in that net income measure) and realized gains and losses and total gains and losses. The first differences model estimationyields a negative coefficient on realized gains and losses and a positive coefficient on total gains and losses that usually is insignificant except for large and firms holding liquid securities. Barth interprets the weaker result for the income statement variables in the first differences modelas attributable to greater noise in these variables.

Barth’s (1994) results suggest that RECLASS should have little value relevance, partly because it is an amortized cost number and partly because of the aforementioned noise issues. However, our study differs from Barth (1994) on two important dimensions. First, we useamortized costs, fair values, and gains and losses—in particular RECLASS—that are recognized in financial statements rather than simply disclosed. One explanation for Barth’s weak results for gains and losses is investors put less weight on disclosures rather than recognized amounts. Second, our levels valuation models includeconsiderably more extensive breakdowns of book value, net income, and other comprehensive income, consistent with subsequently developed combined balance sheet and income statement valuation models (e.g., Ohlson 1995).