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Usefulness of fair values for predicting banks’ future earnings: evidence from other comprehensive income and its components

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Abstract

This paper examines whether fair value adjustments included in other comprehensive income (OCI) predict future bank performance. It also examines whether the reliability of these estimates affects their predictive value. Using a sample of bank holding companies, we find that fair value adjustments included in OCI can predict earnings both 1 and 2 years ahead. However, not all fair value-related unrealized gains and losses included in OCI have similar implications. While net unrealized gains and losses on available-for-sale securities are positively associated with future earnings, net unrealized gains and losses on derivative contracts classified as cash flow hedges are negatively associated with future earnings. We also find that reliable measurement of fair values enhances predictive value. Finally, we show that fair value adjustments recorded in OCI during the 2007–2009 financial crisis predicted future profitability, contradicting criticism that fair value accounting forced banks to record excessive downward adjustments.

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Notes

  1. Unlike for nonfinancial firms, estimation of cash flows is problematic in financial firms. As a result, prior studies have used earnings before taxes and provision for loan losses as a proxy for banks’ cash flows (e.g., Wahlen 1994; Liu et al. 1997; Kanagaretnam et al. 2014; Altamuro and Beatty 2010; Bischof and Bruggeman 2012). In additional tests, we also perform tests using residual earnings as an alternative measure of performance.

  2. For example, Jones and Smith (2011) only have 26 financial firms in their sample, and in this mixed sample, they find that unrealized gains and losses on available-for-sale securities do not predict future cash flows (p. 2066).

  3. Before the adoption of Basel III recommendations, only unrealized gains and losses on equity securities classified as available-for-sale and foreign currency translation adjustments were included in the calculation of regulatory capital.

  4. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (FASB 2006).

  5. Under a full fair value reporting system, earnings would be equal to changes in net assets and thus would be uninformative about future income because changes in fair value follow a random walk and are unpredictable (Storey and Storey 1998; Schipper and Vincent 2003; Nissim and Penman 2008). Comprehensive income is not a full fair value measure, as it does not include fair value changes in instruments such as held-to-maturity securities, loans, financial liabilities, and nonterm deposits (Hodder et al. 2006).

  6. Firms typically hedge on a rolling basis. At the expiration of the hedge, the firm can buy new hedges. However, new hedges will only protect the firm against future price changes, not the current price change.

  7. See, for example, Barth (1994), Petroni and Wahlen (1995), Barth et al. (1996), Eccher et al. (1996), Nelson (1996), Venkatachalam (1996), and Park et al. (1999).

  8. We use the more familiar term “reliability” to capture the construct currently referred to in the Conceptual Framework as “representational faithfulness”.

  9. Arguably, Liquid_Annual can be criticized for only capturing the liquidity of equity markets, as it is estimated using data of stocks listed on the NYSE, whereas banks trade assets and financial instruments in markets other than the equity markets. Chordia et al. (2005) document that liquidity co-varies across asset markets with the shocks to spreads in one market increasing the spreads in the other markets. Thus, we expect that equity market liquidity co-varies with liquidity in other asset markets.

  10. Banks whose holdings of agency securities as a proportion of their total investment securities are above (below) the sample median are assigned to the high (low) subsample. Only banks with assets in excess of $1 billion are required to provide the breakdown of their agency securities. This severely limits the data available for this test for privately held banks, so we perform this analysis only for publicly traded banks.

  11. BHCK item number mnemonics reported in parentheses indicate data items taken from Federal Reserve Board’s bank holding company database, representing financial data reported on form FR-Y9C. All variables are also defined in the Appendix.

  12. We estimate our measures of performance on a pre-tax basis to avoid confounding effects of tax avoidance on the relation between fair value adjustments and future operating performance.

  13. Continuous variables have been winsorized at 1 and 99 % to reduce the influence of outliers.

  14. Untabulated correlations reveal that pre-tax other comprehensive income (PtOCI t ) is positively and significantly correlated with Pre-tax EBP t+1 and Pre-tax ROA t+1, providing univariate evidence that fair value estimates included in other comprehensive income predict future earnings.

  15. In untabulated separate regressions of public (private) banks only, the coefficient on PtOCI is 0.1323 (0.1084), when Pre-tax ROA t+1 is the dependent variable, and 0.0858 (0.1084), when Pre-tax ROA t+2 is the dependent variable. However, when we estimate our regressions in a sample comprising both public and private banks and include an interaction between PtOCI and an indicator variable for public banks, the coefficient on the interaction is insignificant for both dependent variables. Thus we do not separate public and private banks in our subsequent tests and tabulate results only for the combined sample.

  16. 1 year ahead, the coefficient on PtOCI-Other is statistically different from PtOCI-AFS (PtOCI-Derivatives) at the 1 % (10 %) level. 2 years ahead, the coefficient on PtOCI-Other is statistically different from PtOCI-AFS (PtOCI-Derivatives) at the 10 % (1 %) level. If we replace PtOCI-Other with the other two OCI components for which data is available (i.e., foreign currency translation adjustments and additional minimum pension adjustments), results for PtOCI-AFS and PtOCI-Derivatives are qualitatively similar to those reported in Table 2. The coefficients on both of the other OCI components are negative and significant for 1-year-ahead Pre-tax ROA and statistically indistinguishable from zero for 2-year-ahead Pre-tax ROA.

  17. If we replace PtOCI-Other with the other two OCI components for which data is available (i.e., foreign currency translation adjustments and additional minimum pension adjustments), results for PtOCI-AFS and PtOCI-Derivatives are qualitatively similar to those reported in Table 3. The coefficient on the foreign currency translation adjustment component is negative and significant (insignificant) for 1-year-ahead (2-year-ahead) Pre-tax EBP, and the coefficients on the pension adjustment are insignificant for both 1- and 2-year-ahead Pre-tax EBP.

  18. In untabulated tests, we combine the high and low liquidity subsamples and interact PtOCI with an indicator for high liquidity. We predict that the coefficient on this interaction will be positive and significant. Consistent with our prediction, we find that the coefficient on the interaction of PtOCI with the indicator variable for high liquidity is positive and statistically significant for each dependent variable.

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Acknowledgments

We thank B. W. Baer, Gauri Bhat, Patricia Dechow (editor), two anonymous referees, Mark Evans, Fabrizio Ferri, Leslie Hodder, Sharon Katz, Yuri Loktionov, Doron Nissim, Jeff Payne, Stephen Penman, Robert Ramsay, Shiva Rajgopal, Miguel Duro Rivas, Joshua Ronen, Ethan Rouen, Gil Sadka, Dan Stone, Abhishek Varma, Mohan Venkatachalam, Dushyantkumar Vyas, Dave Ziebart, and seminar participants at Columbia Business School, University of Kentucky, University of Western Ontario, the 2012 American Accounting Association Annual Meeting, the 2012 Annual Congress of the European Accounting Association, the 23rd annual Conference on Financial Economics and Accounting, and the 2014 PwC Young Scholars Symposium at the University of Illinois for helpful comments and suggestions.

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  1. Von Allmen School of Accountancy, University of Kentucky, Lexington, KY, USA

    Brian Bratten & Monika Causholli

  2. Graduate School of Business, Columbia University, New York, NY, USA

    Urooj Khan

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  1. Brian Bratten
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Correspondence to Urooj Khan.

Appendix

Appendix

See Table 8.

Table 8 Variable definitions
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Bratten, B., Causholli, M. & Khan, U. Usefulness of fair values for predicting banks’ future earnings: evidence from other comprehensive income and its components. Rev Account Stud 21, 280–315 (2016). https://doi.org/10.1007/s11142-015-9346-7

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