Mixing Fair-Value and Historical-Cost Accounting: Predictable Other-Comprehensive-Income and Mispricing of Bank Stocks

46 Pages Posted: 10 Nov 2016 Last revised: 17 Aug 2017

See all articles by Peter D. Easton

Peter D. Easton

University of Notre Dame - Department of Accountancy

Xiao-Jun Zhang

University of California, Berkeley; China Academy of Financial Research (CAFR)

Date Written: August 16, 2017

Abstract

Other comprehensive income (OCI) items are often considered to be transitory (Chambers et al. 2007; IASB 2013; CFA2014). In this paper we show that a significant portion of OCI, namely unrealized gains and losses (UGL) from available-for-sale (AFS) debt securities, is non-transitory: a negative correlation between accumulated unrealized gains and losses in the current period and next period UGL is predicted and we show that this correlation is economically and statistically significant. This correlation is due to a mix of accounting methods of measurement of income from fixed-income securities: UGL are recognized based on fair values, whereas interest income is measured based on historical cost.

We document that:

(1) this negative correlation helps explain a previously unexplained negative correlation in other comprehensive income (OCI); and,

(2) investors seem to price total UGL disregarding (or not understanding) the predictable, accounting-driven component of UGL.

Keywords: Market mispricing; Bank risk factors; Holding gains and losses; Available-for-sale securities; Commercial banks; Fair value accounting; Other comprehensive income

JEL Classification: M41; G14

Suggested Citation

Easton, Peter D. and Zhang, Xiao-Jun, Mixing Fair-Value and Historical-Cost Accounting: Predictable Other-Comprehensive-Income and Mispricing of Bank Stocks (August 16, 2017). Available at SSRN: https://ssrn.com/abstract=2867043 or http://dx.doi.org/10.2139/ssrn.2867043

Peter D. Easton

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
574-631-6096 (Phone)
574-631-5127 (Fax)

Xiao-Jun Zhang (Contact Author)

University of California, Berkeley ( email )

545 Student Services Building
SPC 1900
Berkeley, CA 94720
United States
(510) 642-4789 (Phone)
(510) 642-4700 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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