Valuation for Financial Reporting - CMA Ankur Pandey

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Academic Research on the Relevance of Fair Value Accounting 15BANKS: BALANCE SHEET RELEVANCEA journal article by Mary E. Barth (the Barth Study) 30 studies the relevancy of fairvalue accounting to investors. It examined two different accounting measurements,historical cost and fair value, on the same financial statement components. Priorresearch had not found strong evidence on the relevance of fair value accounting.Researchers argued that management errors in estimating the fair values of assetswere the primary cause for earlier findings. These earlier findings were based onstudies that examined multiple industries and cross-sectional differences, whichmay have led to findings of weak evidence.In contrast, the Barth Study examined the relevance of fair value accounting in asingle industry: banking. The study investigated how financial-instrument assetsmeasured at fair value and the related securities gains and losses are reflected in bankstock prices compared with historical cost measurements, to determine which is morerelevant to investors for valuing bank stocks. The Barth Study examined U.S. bankswhose financial data appeared on the 1990 Compustat Annual Bank Tape. Thefinancial statement data covered periods from 1971 to 1990. The investment assets inthe banks in this study averaged about 15% to 20% of total assets. The averagedifferences between historical cost and fair value were large: 37% of the book valueand 57% of the market value of equity.The Barth Study showed that financial-instrument assets measured at fair valuesprovide statistically significant explanatory power over historical costs in the shareprices of banks. The study also found that the historical costs of financial instrumentsprovide no significant explanatory power incremental to fair values. The Barth Studyconcluded that using fair values to measure financial instruments appeared to berelevant to investors in valuing bank equities.BANKS: INCOME STATEMENT RELEVANCEThe Barth Study found inconsistent results on securities gains and losses. Thesignificance of any explanatory power of securities gains and losses based on fairvalue measurements beyond historical costs depended on the statistical model used.Models that offered explanatory power were not robust. Some models revealed thatfair values offered no statistically significant explanatory power. However, historicalcosts always provided explanatory power beyond fair values.Barth argued that the evidence suggested that the inability of fair values to offerany incremental explanatory power was a result of management errors in estimatingthe securities’ fair values. (Valuation errors are still a principle argument of those whoare generally opposed to fair value accounting.) Measurement errors are a largerpercentage relative to securities gains and losses than they are to the securities fairvalues, causing a greater relative impact. Barth acknowledged this argument wasunverifiable. The Barth Study concluded that using fair values to measure gains andlosses of financial instruments did not appear to be relevant to investors in valuingbank equities.
16 Valuation for Financial ReportingIn contrast, a journal article by Anwer S. Ahmed and Carolyn Takeda (the Ahmed/Takeda Study) 31 studied the same issues as the Barth Study but controlled for theeffects of interest rate sensitivity on other assets and liabilities (on-balance sheet).The Ahmed/Takeda Study found securities gains and losses using fair valueshave incremental explanatory power over historical costs. These findings suggestthe inconsistent results in the Barth Study may not be attributed to securities’ fairvalue measurement problems and arguably offer evidence that fair values to measuregains and losses are relevant to investors in valuing bank stocks.CLOSED-END FUNDS: BALANCE SHEET AND INCOMESTATEMENT RELEVANCEA journal article by Thomas J. Carroll, Thomas J. Linsmeier, 32 and Kathy R. Petroni(the Carroll et al. Study) 33 studied a sample of 143 closed-end funds using data from1982 to 1997. They argue that closed-end funds offer better evidence on the relevanceof fair value accounting than other financial instruments. One reason the authors offeris that substantially all of the assets appearing on the financial statements of funds arereported at their fair values. (Liabilities in the funds are negligible.) The Carroll et al.Study also argues that the broader types of investments owned by funds offers betterevidence than other financial instruments. This data allowed the researchers toperform additional tests on usefulness based on varying degrees of reliability offair value measurements.The Carroll et al. Study found a statistically significant association between stockprices of the funds and the funds’ investments when they were measured with fairvalues after controlling for historical costs. It also found a significant relation betweenstock returns and the investment gains and losses. The research suggests thatsecurities measured at fair value are relevant to investors in valuing stocks ofclosed-end funds.The authors of the Carroll et al. Study also tested their hypothesis across differentfund types and compared the results to one another. Tests included funds with publiclyheld equities from G7 countries and those with equities other than those publicly heldfrom G7 countries. The results across all fund types showed a statistically significantassociation between fund stock prices and the fund investments using fair values. TheCarroll et al. Study argues that the findings suggest the need to express all securities attheir estimated fair values, including those that are traded in thin markets, such asprivate or non-G7 markets.ENDNOTES1. Michael A. Crain, CPA/ABV, ASA, CFA, CFE, is a contributing author to this chapter.Crain is Managing Director of The Financial Valuation Group in Ft. Lauderdale, Florida,and Chair of the American Institute of Certified Public Accountants Business ValuationCommittee.
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210 IndexBusiness Enterprise Analys
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214 IndexLong-termcapital, 71debt,
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216 IndexSecurities and Exchange Co
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Valuation for Financial Reporting - CMA Ankur Pandey

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