Preserving amortized costs within a fair-value-accounting framework: reclassification of gains and losses on available-for-sale securities upon realization

Abstract

SFAS No. 115 requires firms to recognize available-for-sale (AFS) securities at fair value with accumulated unrealized gains and losses (AUGL) recorded in accumulated other comprehensive income. Firms reclassify AUGL to net income when they realize gains and losses. We refer to the amount reclassified each period by “RECLASS.” As of 1998, SFAS No. 130 requires firms to present RECLASS prominently in their financial statements. We investigate the incremental explanatory power of RECLASS for banks’ market values and market-adjusted returns. In the market value analysis, we control for AUGL, other components of book value of equity, net income before extraordinary items and RECLASS (NIBEXother), and other components of comprehensive income. In the returns analysis, we control for ΔAUGL, ΔNIBEXother, and extraordinary items. We find high positive coefficients on RECLASS in both analyses, consistent with investors pricing RECLASS as a relatively permanent component of net income. Exploring possible explanations for these pricing implications, we find no evidence that they are attributable to RECLASS remedying unreliable fair value measurement of AUGL. We provide three distinct analyses indicating that RECLASS’s pricing implications are explained in significant part by it helping investors predict banks’ future performance. Our results illustrate that an important type of amortized cost accounting information, realized gains and losses, remains highly useful to investors despite the overall fair-value-accounting framework for AFS securities.

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Notes

  1. 1.

    Schultz and Hollister (2003) and Johnson and Swieringa (1996) describe the political process and resulting compromises involved in gaining general acceptance for SFAS No. 115. Interestingly, these compromises occurred despite considerable support for fair value accounting for all investment securities from SEC Chairman Richard Breeden (see his September 14, 1990, speech, “The Proper Role of Financial Reporting: Market Based Accounting,” at Smith Barney's Fourth Annual Financial Services Conference in Washington, DC, available on the SEC website) and many bank regulators because the thrift crisis had recently revealed the limitations of amortized cost accounting. Notably, however, Federal Reserve Board Chairman Alan Greenspan strongly opposed this change in accounting (see his November 1, 1990, letter to Richard Breeden, available http://economyblog.ncpa.org/wp-content/plugins/uploads/Greenspan%20letter%20to%20SEC%20November%201990.pdf).

  2. 2.

    See the “What are the Main Aspects of the Proposed Guidance?” section on pp. 3–5 and paragraphs BC57, BC58, and BC79 of the May 2010 exposure draft. In its redeliberations of the exposure draft to date, the FASB proposes to require parenthetical presentation on the balance sheet of fair values for most financial instruments measured at amortized cost and of amortized costs for financial liabilities (but not financial assets) measured on fair value. See Financial Accounting Standards Board, Accounting for Financial Instruments: Summary of Decisions Reached to Date during Redeliberations as of June 20, 2012, available on the FASB website.

  3. 3.

    Trevor Harris points out that securities typically viewed as highly liquid may experience significant price pressures due to financial institutions’ concentrated and correlated trading behavior at certain times. This behavior may occur at the end of accounting periods due to performance evaluation of employees, end-of-period financial statement window dressing, or other reasons.

  4. 4.

    See Scholes et al. (1990), Beatty et al. (1995), Collins et al. (1995), Beatty et al. (2002), Cornett et al. (2009), and Chang et al. (2011).

  5. 5.

    Realization of gains and losses on AFS securities is only one of banks’ primary mechanisms for income management, along with the provision for loan losses, realization of gains and losses on other assets and liabilities, and Level 2 and 3 fair value estimates for trading and other positions for which unrealized gains and losses are recorded in net income. As discussed in Sect. 4, we find that RECLASS offsets a significant but relatively small portion of the variation in net income.

  6. 6.

    From 1993 to 1997, users of financial reports generally could have, with some effort, determined RECLASS from SFAS No. 115-required AFS securities footnote disclosures of AUGL, realized gains and losses, transfers of securities between the standard’s three categories (trading, AFS, and held-to-maturity), and OTT impairment write-downs.

  7. 7.

    Consistent with evidence of functional fixation on earnings and other forms of mispricing in the literature (e.g., Lakonishok et al. 1994; Sloan 1996; Teohe et al. 1998; and Penman and Zhang 2002), we also considered the possibility that investors undervalue periodic unrealized gains and losses (UGL). We regressed returns for the 12 months beginning five months after fiscal year-end on UGL, Fama and French’s (1992, 1993) three factors, and stock return momentum (Jegadeesh and Titman 1993). We found statistically weak (at the 10 % level) evidence that banks with higher unrealized gains and losses experience economically modest higher future excess returns (0.5 % higher for the highest versus lowest deciles of UGL). Including the year-ahead change in RECLASS in the regression model weakened the drift and rendered it statistically insignificant, consistent with investors mispricing unrealized gains and losses in part because they do not fully incorporate their association with future RECLASS. Given the statistically weak and economically modest return drift, we concluded that investor mispricing explains at most a small portion of the high pricing implications of RECLASS.

  8. 8.

    Badertscher et al. (2012) examine the pricing implications of banks’ OTT impairments, which may but need not involve reclassifications of AOCI, depending on the extent to which the deteriorations of value captured in these impairments develop prior to the reporting quarter. We discuss this extent in Sect. 2.

  9. 9.

    Barth (1994) hand collected the fair values of marketable securities for a sample of banks from 1970 to 1990 that appear to have disclosed the fair values of marketable securities in financial reports under industry GAAP or practice. Ahmed and Takeda (1995) obtained similar data from commercial bank holding companies’ regulatory Y-9C filings from the second quarter of 1986 to the fourth quarter of 1991.

  10. 10.

    Ahmed and Takeda (1995) also examine the effects of income, capital, and tax management on the pricing implications of unrealized and realized gains and losses.

  11. 11.

    Equation (7) in Ohlson (1995) differs in four primary respects from our Eq. (5). First, Ohlson’s comprehensive income term is a capitalization of comprehensive income reduced by dividends. Second, the weights on the book value and income terms are inversely related. Third, he allows for non-accounting information. Fourth, his equation does not include an intercept.

  12. 12.

    If dividend payout is not constant, then dividends should be incorporated in Ohlson’s (1995) capitalized comprehensive income term. However, prior research by Hand and Landsman (1998) finds that including dividends in the Ohlson model empirically appears to capture dividends signaling future income rather than dividend payout.

  13. 13.

    RECLASS also affects AUGL and, depending on the type of realization of gains and losses, one of COST or BVother in Eq. (6) [This issue does not arise in Eq. (7)]. For example, for economic realizations of gains, RECLASS also appears as an increase in BVother (its effect on cash) and a decrease in AUGL (its effect on AFS securities). However, unlike RECLASS’s direct and indirect effects discussed in the text, these two additional effects would exist in a clean surplus fair value accounting system that does not report RECLASS or otherwise preserve amortized cost information about realized gains and losses. We conduct our tests using the total coefficient β47 because it better corresponds to our focus. However, we have also conducted all tests using the alternative total coefficient (β3 + β4) − (β2 + β7), which yields the same conclusions as for our tests using β4 − β7, albeit with slightly lower significance levels (e.g., 5 % instead of 1 % in our primary tests reported in column III of Table 3, Panel A).

  14. 14.

    We do not consider the effect of taxes on the total coefficient on RECLASS (an aftertax variable). Warfield and Linsmeier (1992) examine the effect of cross-sectional differences in taxes on the coefficient on realized gains and losses. They argue and provide evidence that realized losses for tax-paying firms and realized gains for nontax-paying firms convey good news, at least for the first three quarters of the fiscal year. In principle, these differences could affect the coefficients on RECLASS in our empirical models. Due to the almost universal good health of the banking industry during our sample period—far better than the 1980–1985 period examined by Warfield and Linsmeier—our sample banks invariably paid taxes.

  15. 15.

    We do not investigate whether realization of gains and losses smooths net income in a fashion deemed credible by investors. We note, however, that costs that might yield such credibility include regulatory costs associated with realization of losses, tax costs associated with realization of gains, and reputational consequences for managers who manage income along an ex post unsmooth path.

  16. 16.

    Possibly this low frequency reflects nondisclosure by banks of immaterial realizations for accounting purposes only, given that SFAS No. 115’s provisions need not be applied to immaterial items. Partly for this reason, we do not remove these 11 observations from the sample. Our results are not noticeably affected by the removal of these observations from the sample.

  17. 17.

    Alternatively, summing the coefficients across the relevant book value and comprehensive income terms involving AUGL in the full market value model Eq. (6) yields a total coefficient on AUGL of β2 + β7 = 0.72 + 0.56 = 1.28. This coefficient remains fairly close to the expected coefficient of one for transitory gains and losses and is insignificant. We do not use this alternative approach in the text because, in our observation, researchers generally do not sum coefficients across overlapping book value and comprehensive income terms in Ohlson’s market value models this fashion. See footnote 13 for related discussion.

  18. 18.

    Our measures of liquidity and growth are essentially uncorrelated, so that the analyses reported in Table 4 and 5 capture different phenomena. In untabulated analyses, we estimated Eqs. (6) and (7) for the four subsamples formed by the intersections of the two liquidity and two growth subsamples. We find that the coefficients on RECLASS are highest and significant in the high liquidity and high growth subsample, about half the size but still significant at the 10 % level or better for both the high liquidity and low growth subsample and the low liquidity and high growth subsample, and approximately zero and insignificant in the low liquidity and low growth subsamples.

  19. 19.

    Because RECLASS may be associated with many future years’ CI, to maximize the power of the test, the dependent variable ideally would be future CI summed over more than one year in these analyses. We do not do this to avoid losing observations due to the limited number of years of data available.

  20. 20.

    We partition by beginning, not ending, AUGL so that the partitioning variables are not tautologically related.

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Acknowledgments

Comments and suggestions from Anne Christine d’Arcy, Jonathan Glover, Pierre Liang, Jack Stecher, Danqing Yang and seminar participants at Carnegie Mellon University, Chinese University of Hong Kong, Nanjing University, University of Lausanne, Columbia Business School’s 2010 Burton Workshop, the University of Texas at Austin’s 2011 Spring Research Conference, and two anonymous referees are gratefully acknowledged. We thank Jialu Shan and Joseph Cadora for research and editorial assistance.

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Correspondence to Minyue Dong.

Appendix

Appendix

SFAS 130 requires US firms to disclose comprehensive income and its components, including the reclassification of accumulated other comprehensive income associated with realization of gains and losses for AFS securities, in their financial reports. This appendix provides representative examples of banks’ disclosures.

Other comprehensive income disclosures

Banks typically disclose the components of comprehensive income either in the statement of owners’ equity or in a separate table. We provide an example of each of these formats below, enclosing the reclassifications in boxes for easy identification.

Statement of Owners’ Equity Example:

  Common stock Additional paid-in capital Retained earnings Accumulated other comprehensive income (loss) Total shareholders’ equity
BB&T Corporation and Subsidiaries consolidated statements of changes in shareholders’ equity
Balance, January 1, 2004 $2,710 $2,894 $4,309 22 $9,935
Add (deduct)
 Comprehensive income      
  Net income 1,558 1,558
   Unrealized holding gains (losses) arising during the period on securities available for sale, net of tax of $(56) (95) (95)
   Less: reclassification adjustment for losses (gains) on securities available for sale included in net income, net of tax of $(2) (4) (4)
   Change in unrealized gains (losses) on securities, net of tax (99) (99)
   Change in unrecognized gain (loss) on cash flow hedge, net of tax of $(20) (31) (31)
 Change in minimum pension liability, net of tax of $(2)     (3) (3)
 Total comprehensive income 1,558 (133) 1,425
 Common stock issued      
  In purchase acquisitions 81 535 616
  In connection with stock option exercises and other employee benefits, net of cancellations 17 62 79
 Redemption of common stock (56 (385 (441)
 Cash dividends declared on common stock, $1.37 (755) (755)
 Excess tax benefit from equity-based awards 16 16)
Balance, December 31, 2004 2,752 3,122 5,112 (111) 10,875)
Add (deduct)      
 Comprehensive income      
  Net income 1,654 1,654)
   Unrealized holding gains (losses) arising during the period on securities available for sale, net of tax of $(144) (250) (250)
  Change in unrealized gains (losses) on securities, net of tax (250) (250)
  Change in unrecognized gain (loss) on cash flow hedge, net of tax of $5 7 7
 Change in minimum pension liability, net of tax of $(2)     (2) (2)
 Total comprehensive income 1,654 (245) 1,409
 Common stock issued:      
  In purchase acquisitions 6 44 50
  In connection with stock option exercises and other employee benefits, net of cancellations 17 63 80
 Redemption of common stock (60) (426) (486)
 Cash dividends declared on common stock, $1.49 per share (815) (815)
Excess tax benefit from equity-based awards 16 16
Balance, December 31, 2005 2,715 2,819 5,951 (356) 11,129

Separate Table Example:

For the years ended December 31 (in thousands) 2003 2002 2001
North Fork Bancorporation consolidated statements of comprehensive income    
Net income $396,365 $416,893 $331,484
Other comprehensive income    
Unrealized (losses)/gains on securities    
 Changes in unrealized gains arising during the year (44,434) 32,166 34,197
 Less: reclassification adjustment for gains included in net income (15,762) (4,517) (8,729)
  Changes in unrealized gains arising during the year (60,196) 27,649 25,468
  Related tax effect on unrealized gains arising during the year 25,884 (11,889) (10,951)
  Net change in unrealized gains arising during the year (34,312) 15,760 14,517
 Unrealized gains/(losses) on derivative instruments    
  Changes in unrealized (losses)/gains arising during the year (5,465) (46,992) (33,833)
  Add: reclassification adjustment for expenses/losses included in net income 30,512 32,763 9,500
 Changes in unrealized (losses)/gains arising during the year 25,047   
  Related tax effect on changes in unrealized gains arising during the year (10,770) 6,119 10,463
  Net change in unrealized gains arising during the year 14,277 (8,110) (13,870)
Net other comprehensive (loss)/income $(20,035) $7,650 $647
Comprehensive income $376,330 $424,543 $332,131

Reclassification disclosures

In addition to the disclosures above, banks typically disclose reclassifications in a separate table, as shown in the following example.

The following table presents the after-tax changes in net unrealized holdings gains (losses), reclassification adjustments for realized gains and losses on AFS securities and cash flow hedges, changes resulting from foreign currency translation adjustments (including the impact of related derivatives), net gains and losses and prior service costs from pension and OPEB plans, and amortization of pension an OPEB amounts into Net Income. The tale also reflects the adjustment to Accumulated other comprehensive income (loss) resulting from initial application of SFAS 158 to the Firm’s defined benefit pension and OPEB plans. Reclassification adjustments include amounts recognized in Net income that had been recorded previously in Other comprehensive income (loss).

Year ended December 31, (in millions) 2007 2008 2009
Before tax Tax effect After tax Before tax Tax effect After tax Before tax Tax effect After tax
Unrealized gains (losses) on AFS securities
 Net unrealized holdings gains (losses) arising during the period $431 $(176) $255 $(403) $144 $(259) $(1,706) $648 $(1,058)
 Reclassification adjustment for realized (gains) losses included in Net Income 164 (67) 97 797 (285) 512 1,443 (548) 895
 Net change 595 (243) 352 394 (141) 253 (263) 100 (163)
  1. Source: JPMorgan Chase & Co., 2007 Annual Report, p. 163

Some banks also provide this reclassification information along with a roll forward of the balances of accumulated other comprehensive income in a table.

Note 17. Accumulated other comprehensive income

The Bancorp has elected to present the disclosures required by SFAS No. 130, “Reporting of Comprehensive Income,” in the Consolidated Statements of changes in Shareholders’ Equity and in the following table. Disclosure of the reclassification adjustments, related tax effects allocated to other comprehensive income and accumulated other comprehensive income as of and for the years ended December 31 were as follows:

($ in millions) Total other comprehensive income Total accumulated other comprehensive income
Pretax activity Tax effect Net activity Beginning balance Net activity Ending balance
2007
Gains on available-for-sale securities $ 60 (23) 37    
Reclassification adjustment for net gains recognized in net income (21) 9 (12)    
Unrecognized gains (losses) on available-for-sale securities 39 (14) 25 (119) 25 (94)
Gains on cash flow hedge derivatives 42 (15) 27    
Reclassification adjustment for net gains on cash flow hedge derivatives recognized in net income (1) (1)    
Unrecognized gains (losses) on cash flow hedge derivatives 41 (15) 26 (1) 26 25
Defined benefit plans       
 Net prior service cost    
 Net actuarial loss 3 (1) 2    
Total pension and other postretirement obligations 3 (1) 2 (59) 2 (57)
Total $ 83 (30) 53 (179) 53 (126)
  1. Source: Fifth Third Bancorp, 2007 Annual Report, p. 75

As evidenced in both of these sample disclosures, most banks report both the pre-tax and after-tax reclassifications. For those that report only the pre-tax reclassifications, we use the standard federal tax rate of 35 % to calculate the after-tax reclassifications.

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Dong, M., Ryan, S. & Zhang, X. Preserving amortized costs within a fair-value-accounting framework: reclassification of gains and losses on available-for-sale securities upon realization. Rev Account Stud 19, 242–280 (2014). https://doi.org/10.1007/s11142-013-9246-7

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Keywords

  • Available-for-sale securities
  • Reclassification
  • Fair value accounting
  • Realization

JEL classification

  • G21
  • M41