Historical cost or fair value accounting

reviews about fair value and historical cost

Historical-cost or Fair-value Accounting: Analysis of Banks’ Reclassification

of Unrealized Holding Gains and Losses for Marketable Securities

Minyue Dong

University of Lausanne

and

Xiao-Jun Zhang*

University of California, Berkeley

April 2009

Preliminary and incomplete.

Please do not quote.

595, CH-1015 Lausanne, Switzerland, (41) 216923367. * 545 Student Services Building #1900, Berkeley, CA

94720, USA, (001) 5106424789.

Universite de Lausanne, Faculty of Business and Economics, Quartier UNIL-Dorigny, Baliment Internef Bureau

reviews about fair value and historical cost

Historical-cost or Fair-value Accounting: Analysis of Banks’ Reclassification of Unrealized

Holding Gains and Losses for Marketable Securities

ABSTRACT

In this paper we study the reclassification of unrealized holding gains and losses for

available-for-sale securities and cash-flow-hedge. These gains and losses, which have

previously been recognized on a firm’s balance sheets, become part of the net income at the time

of reclassification. We document a positive association between this reclassified amount and

firms’ stock prices. This finding suggests that the fair value accounting method for marketable

securities does not incorporate all relevant information for valuation. We also document that

firms reclassify substantially more gains than losses into the income statement for available-for-

sale securities. In contrast, the reclassified amounts of gains and losses are roughly even for

cash-flow hedge. Analysis of future stock return further indicates that investors may be misled

by the inflated amount of reclassified net gains for available-for-sale securities.

Key words: Available-for-sale; Cash-flow Hedge; Reclassification; Earnings Manipulation;

Stock Return

reviews about fair value and historical cost

1. INTRODUCTION

Since 1998 U.S. firms have been required to use the fair value accounting method to

measure their holdings of marketable securities. The rule also requires firms to disclose a

considerable amount of market-related information in the footnotes of their financial reports. In

2001 such an accounting method was further extended to cover the measurement of hedging

activities. In this study we compile a dataset of the disclosed details regarding the Unrealized

Holding Gain and Losses (UHGL) account of the top U.S. banks. We examine the market

valuation and firm’s activity associated with the reclassification of unrealized gains and losses

from available-for-sale securities as well as cash-flow-hedge.

The issue of how to account for marketable securities and hedging activities reflects one

of the core problems in financial accounting. Our current accounting system was primarily built

on the principle of historical-cost. This is a result of the accounting profession’s emphasis on

reliability as a primary property of the accounting information. On the other hand, accountants

have also been constantly trying to search for an alternative measure which may provide more

relevant, albeit being less reliable, information. Market value has become the most promising

candidate for such an alternative measure.

Proponents of the fair value accounting method argue that market price provides the most

relevant, comprehensive, and timely measure of their intrinsic value. Former Securities and

Exchange Commission (SEC) Chairman Breeden advocated a move to fair value accounting for

financial institutions as well as all publicly-held companies, and stated his belief that market-

based information is the most relevant financial data attribute (testimony before the Committee

on Banking, Housing, and Urban Affairs, U.S. Senate, September 10, 1990). Opponents to the

fair value accounting method, however, are concerned about the usefulness and the lack of

reviews about fair value and historical cost

reliability of such measures. In addition, they argue that mingling market-based information

with the rest of data, which is based on historical cost, will reduce rather than enhance the overall

usefulness of accounting information.

After a long and heated debate, the Financial Accounting Standards Board (FASB)

decided to adopt the fair value accounting method by issuing the Statement of Financial

Accounting Standards 130 (SFAS 130), “Reporting Comprehensive Income.” However, the new

set of rules is mixed. For securities classified as “held-to-maturity,” historical cost accounting

still applies. Mark-to-market accounting, on the other hand, applies to all “trading” securities.

For securities which are neither “held-to-maturity” nor “trading,” which often represents the

major portion of a firm’s security holdings, a mixed method of mark-to-market and historical

cost accounting is used. For this class of securities, classified as “available-for-sale,” market

value is used as the measurement base on the firm’s balance sheet. However, unrealized holding

gains and losses of available-for-sale securities bypass the income statement and directly

debit/credit the shareholders’ equity section of the balance sheet. In addition, to preserve the

integrity of the income measure based on historical cost accounting, firms are required to

“reclassify” the gains and losses previously recognized in the shareholders’ section into the

income statement when the securities are finally sold. In 2001 a similar accounting me …… 此处隐藏：23610字，全部文档内容请下载后查看。喜欢就下载吧 ……