Journal Articles

The Predictive Ability of Fair Values for Future Financial Performance of Commercial Banks and the Relation of Predictive Ability to Banks’ Share Prices

2014, Contemporary Accounting Research

M. Evans, L.D. Hodder, P.E. Hopkins

Abstract

The conceptual frameworks of International Accounting Standards Board (2010, QC7-QC8) and   Financial Accounting Standards Board (2010b, QC7-QC8) both include predictive value as a fundamental qualitative characteristic of useful financial information.  Because changes in fair value are unpredictable—that is, one period’s fair value gains (losses) cannot predict future periods’ fair value gains (losses)—fair value is criticized as diminishing the predictive ability (and, therefore, the usefulness) of financial information.  We propose that the time-series relationship of fair value gains (losses) is an overly restrictive way to define predictive ability, and completely ignores the forward looking information that is impounded in fair value measures.  Specifically, the fair values of interest-bearing financial instruments capture the opportunity costs and benefits of holding below- and above-market instruments.  Thus, we propose that the relative levels of unrealized holding gains (losses) should predict relative levels of future realized gains (losses) and interest income across firms (hereafter, “cross-sectional predictive ability of fair values for future reported income”). Because of the significance of financial instruments to commercial banks’ balance sheets and the availability of detailed fair value information for these instruments in banks’ regulatory reports, we test our predictions for a sample of commercial banks during 1994-2008.  Consistent with our predictions, we find that accumulated fair value adjustments for interest-bearing securities are positively cross-sectionally associated with future interest income, future total realized investment holding returns, and future investment-security-related cash flows. Additional analyses reveal that the cross-sectional predictive ability of fair values for future reported income is positively related to the measurement precision of reported fair value measurements. Finally, we show that cross-sectional predictive ability of fair values for future reported income is positively associated with the value relevance of reported fair value measurements. Overall, our results suggest that fair values have predictive ability despite the low persistence of fair value changes. Cross-sectional predictive ability of fair values for future reported income is an important dimension of financial-information usefulness that standard setters and researchers may wish to consider in evaluating fair value as a measurement basis.

Citation

Evans, M., L.D. Hodder and P.E. Hopkins, (2014), “The Predictive Ability of Fair Values for Future Financial Performance of Commercial Banks and the Relation of Predictive Ability to Banks’ Share Prices,” Contemporary Accounting Research, 31(1): 13-44.