The implication of unrecognized asset value on the relation between market valuation and debt valuation adjustment
Under SFAS No. 159, U.S. firms can measure debt liabilities at fair value, which results in recognition of unrealized gains and losses from debt valuation adjustments (DVA) when a firm’s own credit risk changes. Critics have raised concerns about the counterintuitive income consequences of DVA; that is, when a firm’s credit risk increases (i.e., bad news), debt values decrease, and resulting DVA gains increase the firm’s income (i.e., good news), and vice versa. In this paper, we examine the relation between market valuation and DVA gains and losses, conditioning on the level of unrecognized asset value (UAV). We develop a model to demonstrate the mitigating effect of UAV on the relation between equity returns and DVA. We show that, while the association between equity returns and DVA is positive when the level of UAV is low, the association decreases and eventually turns negative with increasing levels of UAV.
KeywordsDebt valuation adjustment Unrecognized asset value Market valuation Fair value of liabilities Balance sheet incompleteness
JEL classificationG12 G21 M41
This paper has benefited from comments of workshop participants at the University of Waterloo, Central University of Finance and Economics, Zhongnan University of Economics and Law, University of Texas at Austin, Georgia State University, Tsinghua University, NYU Pollack Center for Law & Business Corporate Governance Luncheon, American Accounting Association Annual Meeting, Canadian Academic Accounting Association Annual Conference, and Transatlantic Doctoral Conference at London Business School. We particularly thank Stephen Ryan, Patricia O’Brien, Christine Wiedman, Sati Bandyopadhyay, and the anonymous referee, for their insightful comments. We are grateful for the funding provided by Social Sciences and Humanities Research Council of Canada and CPA/Laurier Centre for the Advancement of Accounting Research and Education.
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