Preserving Amortized Cost within a Fair-Value-Accounting Framework Reclassification of Gains and Losses on Available-for-Sale Securities upon Realization

Preserving Amortized Cost within a Fair-Value-Accounting Framework: Reclassification of Gains and Losses on Available-for-Sale Securities upon Realization Minyue Dong† University of Lausanne Stephen Ryan‡ New York University Xiao-Jun Zhang* University of California, Berkeley First draft: December 2008 Current draft: October 2010 (Revision in Process, for Columbia Burton Conference Participants Only: Please Do Not Cite without Permission) † Universite de Lausanne, Faculty of Business and Economics, Quartier UNIL-Dorigny, Baliment Internef Bureau 595, CH-1015 Lausanne, Switzerland, (41)216923367 ‡ Stern School of Business, Kaufman Management Center, 44 West 4th Street, New York, NY 10012 (01)2129980020 * 545 Student Services Building #1900, Berkeley, CA 94720, USA, (01)5106424789 Comments and suggestions from Anne Cristine dArcy, Jonathan Glover, Pierre Liang, Jack Stecher, Danqing Yang and seminar participants at Carnegie Mellon University, Chinese University of Hong Kong, and University of Lausanne are gratefully acknowledged We thank Jialu Shan and Joseph Cadora for research and editorial assistance Preserving Amortized Cost 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 record available-for-sale (“AFS”) securities on the balance sheet at fair value, with accumulated unrealized gains and losses (“AUGL”) recorded in accumulated other comprehensive income (“AOCI”), a component of owners’ equity Firms reclassify AUGL to net income when they realize gains and losses either economically through sale of AFS securities or for accounting purposes through transfer of the securities to trading or other-than-temporary impairment write-downs We refer to the amount of this reclassification each period as “RECLASS.” For a sample of 200 large U.S commercial banks from 1998-2006, we examine the incremental value relevance of RECLASS beyond AUGL and other components of book value of equity and comprehensive income We find that the market value of equity is significantly positively associated with RECLASS, with the coefficient on RECLASS being closer to the coefficient on the relatively permanent net income before extraordinary items and discontinued operations than to the much lower coefficients on the remaining more transitory components of comprehensive income We also find that the coefficient on RECLASS is much higher than the coefficients on AUGL and other components of book value This result obtains despite also finding that the coefficient on AUGL is significantly positive in a pure balance-sheet model and higher than the coefficient on the remainder of book value in a combined balance-sheet/comprehensive-income model, consistent with investors placing at least a normal amount of credence in AUGL We conduct three analyses investigating possible explanations for the incremental value relevance of RECLASS First, we consider the possibility that unrealized gains and losses are unreliable, as opponents of fair value accounting often allege Contradicting this possibility, we find that the coefficient on RECLASS is higher and more significant for banks that hold more liquid securities Second, we consider the possibility that RECLASS interacts with or is an indicator of future bank growth Consistent with this possibility, we find that the incremental value relevance of RECLASS is greater for higher growth banks Third, and further supporting this possibility, we find that RECLASS is significantly positively associated with one-year-ahead comprehensive income, controlling for other components of current book value and comprehensive income, more so for banks holding liquid securities and growing faster Overall, our findings suggest that the value relevance of RECLASS is primarily attributable to the importance of the realization of realized gains and losses as an indicator of bank growth rather than to the limitations of fair value accounting for AFS securities At a minimum, these findings suggest that the FASB should continue to require information about realized gains and losses, an amortized cost accounting construct, within the fair value accounting framework for AFS securities Key words: Available-for-sale securities; Reclassification; Fair value accounting; Realization principle INTRODUCTION In this paper, we examine the incremental value-relevance of realized gains and losses beyond unrealized gains and losses and other components of book value and comprehensive income for commercial banks’ available for sale (“AFS”) securities We focus on AFS securities because they are reported at fair value on the balance sheet, but amortized cost information about realized gains and losses is preserved and reported on the income statement through the use of “dirty surplus” accounting described below The financial reporting for AFS securities contrasts with the typical accounting for financial instruments under current U.S GAAP, in which one of fair value and amortized cost information is reported only in footnote disclosures or not at all Prior research generally shows that investors react more strongly to recognized than disclosed information, either because they not have the ability or inclination to evaluate the many disclosures in financial reports or because they deem recognized amounts more reliable (Schipper 2007) Hence, AFS securities constitute a relatively unambiguous setting in which to test for the incremental value relevance of information about the fair values and amortized costs of financial instruments Statement of Financial Accounting Standards (“SFAS”) No 115, Accounting for Certain Investments in Debt and Equity Securities, requires a hybrid fair-value-on-the-balancesheet/amortized-cost-on-the-income-statement approach to accounting for AFS securities Specifically, firms record AFS securities on the balance sheet at fair value, with accumulated unrealized gains and losses (“AUGL”) recorded in accumulated other comprehensive income (“AOCI”), a component of owners’ equity distinct from retained earnings This is dirty surplus accounting because changes in owners’ equity occur without corresponding changes on net income Subsequently, firms reclassify AUGL to net income when gains and losses are realized economically through sale of AFS securities or for accounting purposes through transfer of the securities to trading or other-than-temporary (“OTT”) impairment write-downs We refer to the amount of this reclassification each period as “RECLASS.” Advocates of fair value accounting often criticize this accounting for AFS securities as politically motivated and convoluted, particularly for liquid securities for which fair value is the most relevant, comprehensive, and timely measure of the value of the securities However, this accounting has the desirable feature of preserving certain aspects of amortized cost accounting for AFS securities—particularly the realization of gains and losses reported on the income statement via RECLASS—within a primarily fair value accounting framework Even if fair values are well measured, amortized costs may be incrementally value relevant beyond fair values for various reasons The FASB recognizes this fact in its May 2010 Exposure Draft, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (“the ED”), in which it observes that amortized costs may have incremental value relevance due to their verifiability, association with contractual cash flows, or correspondence with the firm’s business strategy Consistent with this observation, in the ED the FASB proposes dual presentation on the balance sheet of the amortized costs and fair values of many financial instruments The FASB’s proposal is consistent with at least two positions expressed by opponents of fair value accounting First, most of these opponents question the reliability of fair values (e.g., Wallison 2008, Forbes 2009) In our view, reliability is a minor concern for most of banks’ AFS securities, which are dominated by federal governmental, government-sponsored agency (e.g., Fannie Mae), and other liquid securities, although it is a significant concern for some of these For example, in testimony before the Committee on Banking, Housing, and Urban Affairs, U.S Senate, September 10, 1990, former Securities and Exchange Commission (SEC) Chairman Richard Breeden advocated a move to fair value accounting, stating that market-based information is more relevant than cost-based information (e.g., structured asset-backed) securities More interestingly, some opponents of fair value accounting point out that realization of gains and losses is important for various purposes, such as contracting and stewardship assessment (Watts 1993 and Holthausen and Watts 2001), capital regulation (Moyer 1990 and Ahmed and Takeda 1995), other aspects of firms’ business strategies (Nissim and Penman 2008), and managerial signaling of their private information (Abdel-Khalik 2008 and Ronen 2008) In this study, we provide evidence regarding the benefit of preserving amortized cost information within a fair value accounting framework in the specific context of the value relevance of RECLASS RECLASS constitutes a somewhat more limited and less visible preservation of amortized costs in a fair value accounting framework than the FASB’s proposal in the ED to require dual presentation on the balance sheet of the amortized costs and fair values of many financial instruments However, our examination of the value relevance of RECLASS is meaningful because this variable embodies the realization principle that is central to amortized cost accounting We hand collected RECLASS for the 200 largest publicly traded U.S commercial banks (based on total assets in 1998) for the period 1998-2006 We limit our sample to banks because total (realized) gains and losses on AFS securities often constitute significant portions of their owners’ equity (net income) Our sample period necessarily begins in fiscal year 1998, when FAS No 130, Reporting Comprehensive Income, first required firms to disclose RECLASS in a visible fashion.2 Our primary findings are as follows First, we find that banks’ market values are significantly positively associated with AUGL in a pure balance sheet model and higher than the From 1993-1997, users of financial reports generally could have inferred 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 coefficient on the remainder of book value in a combined balance-sheet/comprehensive-income model, consistent with investors placing at least a normal amount of credence in AUGL This suggests that the incremental value relevance of RECLASS that we document in this paper is not solely attributable to RECLASS remedying the unreliability of the fair value accounting-based AUGL Second, we find that investors ascribe considerable incremental value relevance to RECLASS, controlling for the other components of book value and comprehensive income Specifically, we find that the market value of equity is significantly positively associated with RECLASS, with the coefficient on RECLASS being closer to the coefficient on the relatively permanent net income before extraordinary items and discontinued operations (NIBEX) than to the much lower coefficients on the more transitory components of comprehensive income The coefficient on RECLASS is also much higher than the coefficients on AUGL and other components of book value These findings imply that stock investors ascribe considerable significance to the realization of gains and losses recorded in RECLASS These findings obtain even though RECLASS effectively just reclassifies one component of owners’ equity, AOCI, to another, retained earnings Our remaining primary findings pertain to analyses that we conduct to investigate possible explanations for the significance of the realization of gains and losses recorded in RECLASS Third, we consider the possibility that unrealized gains and losses are unreliable, as opponents of fair value accounting often allege This possibility is inconsistent with our aforementioned findings for AUGL and with the high liquidity of most AFS securities Directly contradicting this possibility, we find that the incremental value relevance of RECLASS is stronger for banks that hold more liquid securities This implies that this incremental value relevance is not primarily attributable to the lack of verifiability of fair values Fourth, we consider the possibility that RECLASS interacts with or is an indicator of future bank growth Consistent with this possibility, we find this incremental value relevance is larger for higher growth banks This suggests RECLASS conveys incremental information about future valuation attributes, which have greater valuation consequences for higher growth firms Fifth, consistent with this suggestion, we find that RECLASS is significantly positively associated with year-ahead comprehensive income, controlling for the other components of book value and comprehensive income Consistent with the valuation model results, this association is stronger for banks holding more liquid securities and growing faster Sixth, we consider the possibility that investors undervalue unrealized gains and losses, say because they fixate on reported net income We conduct regression analyses controlling for Fama and French’s (1992, 1993) three factors and stock return momentum (Jegadeesh and Titman 1993) as well as portfolio analyses grouping banks into terciles each year based on the amount of unrealized gains and losses Both analyses yield weak statistical evidence that banks with higher unrealized gains and losses experience economically modest higher future excess returns In the portfolio analysis, we find that the return drift is stronger when excess returns for the tercile observations are value-weighted rather than equally weighted, implying that the market under-reaction is stronger for larger banks While there are various possible explanations for this finding, we conjecture it may be attributable to the greater difficulty that investors face in evaluating unrealized gains and losses for larger banks, given their more diverse holdings of AFS securities and greater overall complexity Given the statistically weak and economically modest return drift, investor mispricing appears to explain at most a small portion of the value-relevance of RECLASS To our best of our knowledge, our paper is the first to document the value relevance of RECLASS or the reclassification of any other component of AOCI Our results have implications for the ongoing debate about the relative and incremental usefulness of fair value versus amortized cost accounting for financial instruments Our findings collectively support the FASB’s view expressed in the ED that it is incrementally value relevant to preserve amortized cost information based on the realization principle within a fair value accounting framework Prior Research Our study is primarily related to two areas of prior research: (1) studies on the incremental and relative value relevance of the fair values versus amortized costs of financial instruments and (2) studies on the incremental and relative value relevance of other comprehensive income versus net income We discuss these two literatures in turn Advocates of fair value accounting generally claim that the fair values of financial instruments have higher or incremental value relevance compared to the amortized costs of the instruments Numerous empirical studies have tested this claim, typically using disclosed fair values under SFAS No 107, Disclosures about Fair Values of Financial Instruments While generally supportive of this claim, the results of these studies vary somewhat depending the type and liquidity of the financial instruments considered, the type of firms involved, as well as aspects of the research design such as the use of levels versus first differences valuation models These studies often but not always find that market values are significantly incrementally associated with fair values controlling for amortized costs, but not vice-versa The most related prior study to ours, Barth (1994), examines the value relevance of disclosures about the fair values of banks’ investment securities Barth estimates levels and first differences models in annual cross-sectional regressions and pooled regressions with fixed effects In her levels model, the market value of equity is regressed on the book value of equity and the fair value and amortized costs of marketable securities The levels model estimation yields a highly significantly positive coefficient on the fair value of marketable securities and an insignificant or negative significant coefficient on the amortized cost of marketable securities Barth concludes that the fair values of marketable securities provide significant explanatory power beyond amortized costs, but not vice versa In her first differences model, returns is regressed on net income before securities gains and losses (alternatively, the change in that net income measure) and realized gains and losses and total gains and losses The first differences model estimation yields a negative coefficient on realized gains and losses and a positive coefficient on total gains and losses that usually is insignificant except for large and firms holding liquid securities Barth interprets the weaker result for the income statement variables in the first differences model as attributable to greater noise in these variables Barth’s (1994) results suggest that RECLASS should have little value relevance, partly because it is an amortized cost number and partly because of the aforementioned noise issues However, our study differs from Barth (1994) on two important dimensions First, we use amortized costs, fair values, and gains and losses—in particular RECLASS—that are recognized in financial statements rather than simply disclosed One explanation for Barth’s weak results for gains and losses is investors put less weight on disclosures rather than recognized amounts Second, our levels valuation models include considerably more extensive breakdowns of book Barth (1994) hand collected the fair values of marketable securities for a sample of banks from 1970-1990, a period entirely prior to the issuance of SFAS No 107 During this period, banks appear to have disclosed the fair values of marketable securities under industry GAAP or practice value, net income, and other comprehensive income, consistent with subsequently developed combined balance sheet and income statement valuation models (e.g., Ohlson 1995) Barth, Beaver, and Landsman (1996), Nelson (1996), and Eccher, Ramesh, and Thiagarajan (1996) examine the incremental value relevance of the fair values of essentially all banks’ financial instruments—such as loans, deposits, and debt—which they disclose under SFAS No 107 The results of the three studies differ somewhat due to their differing model specifications This is particularly true for loans, for which only Barth, Beaver, and Landsman find fair values to be incrementally value relevant By and large, however, these studies find that the fair value of most financial instruments are incrementally value relevant beyond the amortized costs of those instruments Studies investigating the value relevance of comprehensive income and the components of other comprehensive income items generally find that comprehensive income and its components are less value relevant prior to effective date of SFAS No 130 than afterwards, consistent with the greater salience to investors of amounts recognized in financial statements rather than simply disclosed For a sample prior to the effective date of SFAS No 130, Dhaliwal, Subramanyam, and Trezevant (1999) find that comprehensive income does not have a stronger association with stock returns than net income, except for financial firms They also find that the AFS securities adjustment is the only component of other comprehensive income that improves the association between income and returns, again primarily for financial firms O’Hanlon and Pope (1999) report similarly negative results for other comprehensive income items for a sample of U.K firms For samples after the effective date of SFAS No 130, Biddle and Choi (2006) find that comprehensive income dominates other income measures in explaining equity returns Separate Table Example: (Source: National City Corp., 2007 Annual Report, p 107) Reclassification Disclosures Banks typically disclose reclassifications in a separate table, as shown in the following example 27 (Source: JPMorgan Chase & Co., 2007 Annual Report, p.163) Some banks also provide this reclassification information along with a rollforward of the balances of accumulated other comprehensive income in a table (Source: Fifth Third Bancorp, 2007 Annual Report, p 75) As evidenced in both of these sample disclosures, most banks report both the pretax and aftertax reclassifications For those that report only the pretax reclassifications, we use the standard federal tax rate of 35% to calculate the aftertax reclassifications 28 Table Descriptive Statistics The sample includes the 200 largest (based on total assets in 1998) U.S commercial banks traded on NYSE, AMEX and NASDAQ for the years 1998-2006 Stock return data are obtained from CRSP and most financial data are obtained from COMPUSTAT Accumulated unrealized gains and losses on AFS securities (AUGL) and reclassification of AUGL upon realization of gains and losses (RECLASS) are hand collected from banks’ annual Form 10-K filings Sample observations must have non-missing AUGL, RECLASS, and total gains and losses (TGL) for AFS securities SIZE denotes the natural logarithm of the market value of equity at the end of the fourth month after fiscal year end NI denotes net income AUGL is deflated by end of year shares outstanding, while RECLASS, TGL, and NI are deflated by the shares outstanding used in calculating earnings per share Panel B reconciles the change in mean AUGL during the year with the means of TGL and RECLASS for the year; to maintain consistency in this panel all variables are deflated by end of year shares outstanding Panel A: Statistics (1,033 observations) Variable SIZE AUGL per share RECLASS per share TGL per share |RECLASS|/|NI| |TGL|/|NI| Mean 6.95 0.08 0.03 -0.02 0.06 0.26 STDEV 1.49 0.68 0.16 0.57 0.33 0.95 Q1 5.84 -0.16 0.00 -0.25 0.01 0.05 Median 6.71 0.04 0.01 0.01 0.01 0.13 Q3 7.70 0.30 0.05 0.23 0.05 0.26 Panel B: Reconciliation of Mean AUGL, TGL, and RECLASS (1,004 observations) beginning mean AUGL per share 0.13 plus mean TGL per share -0.03 minus mean RECLASS per share 0.03 29 ending mean AUGL per share 0.07 Table Reclassifications, Income Smoothing, and Gradual Realization of Total Gains and Losses This table reports the results of regressing RECLASS on other net income before extraordinary items (NIBEXother) and accumulated unrealized gains and losses (AUGL) for the current year (Panel A), and on current NIBEX other and total gains and losses (TGL) for the current and prior three years AUGL is deflated by the number of shares outstanding at fiscal year end NIBEXother and UGL are deflated by the number of shares used in calculating earnings per share Year dummies are included in all regression, with t-statistics adjusted for clustering among observations for the same firm (Petersen 2009) *, **, and *** indicate statistical significance at 10, 5, and percent levels in two-tailed tests Panel A: Intercept NIBEXother AUGL N R2 Dependent Variable: RECLASS 0.02* -0.01*** 0.05*** 1,158 0.08 Panel B: Intercept NIBEXother TGL, year TGL, year-1 TGL, year-2 TGL, year-3 N R2 Dependent Variable: RECLASS 0.06** -0.01* 0.12*** 0.10*** 0.07** 0.05*** 679 0.18 30 Table Value Relevance of Reclassifications This table reports the results of pooled estimations of various nested versions of equation (6), in which the market value of owners’ equity (MV) is regressed on the aftertax components of book value of owners’ equity (BV) and comprehensive income (CI) The components of BV are: the amortized cost of AFS securities (COST); the accumulated unrealized gains and losses on AFS securities at the end of each fiscal year (AUGL); the book value of available-for-sale securities (BVafs=COST + AUGL); and the net book value of assets and liabilities other than AFS securities (BVother=BV-BVafs) The components of CI are net income before extraordinary items and discontinued operations (NIBEX); reclassification of previously unrealized gains and losses on AFS securities upon realization (RECLASS); other net income before extraordinary items (NIBEXother); extraordinary items (EX); other comprehensive income (OCI); the change in AUGL; and other comprehensive income other than ΔAUGL (OCI other) All stock variables (e.g., book value) are deflated by the number of shares outstanding at fiscal year end All flow variables (e.g., RECLASS) are deflated by the number of shares used in calculating earnings per share β4-β7 denotes the difference of the coefficients on RECLASS and ΔAUGL Year fixed effects are included in all regressions and t-statistics are adjusted for clustering of observations by firm (Petersen 2007) *, **, and *** indicate two-tailed statistical significance at 10, 5, and percent levels, respectively Intercept BV BVafs COST AUGL other BV CI NIBEX RECLASS NIBEXother EX OCI ΔAUGL OCIother N R2 β4-β7 I 9.09*** Dependent Variable: MV II 4.39* 1.44*** 3.25** 1.37*** III 2.35 40*** 0.72 0.37*** 1,033 0.55 31 9.88*** 13.34*** 2.05 7.84*** 10.84*** 1.82 0.42 1.49*** 1,033 0.72 9.46*** 0.56 1.29*** 1,033 0.75 7.28*** Table Effect of AFS Security Liquidity (Reliability of Fair Values) on the Value Relevance of Reclassifications This table reports the results of estimating equation (6) (the model in column III of Table 3) for banks with above and below median liquid AFS securities (more and less reliable fair values, respectively) See Table for description of the model and variables Liquidity is measured as the percentage of available-for-sale securities invested in U.S Treasury securities β 4-β7 denotes the difference of the coefficients on RECLASS and ΔAUGL Year fixed effects are included in all regressions and t-statistics are adjusted for clustering of observations by firm (Petersen 2007) *, **, and *** indicate two-tailed statistical significance at 10, 5, and percent levels Intercept BV BVafs COST AUGL BVother CI NIBEX RECLASS NIBEXother EX OCI ΔAUGL OCIother N R2 β4-β7 (β4-β7)High - (β4-β7)Low High Liquidity 3.89*** Low Liquidity 4.10* 0.64*** 1.90 0.62*** 0.66*** 2.21* 0.65*** 11.41*** 7.64*** -2.84 3.18* 8.17*** 3.48 3.77** 0.85 462 0.84 7.64*** -1.19 1.64** 509 0.75 4.37 3.27** 32 Table Effect of Bank Growth on the Value Relevance of Reclassifications This table reports the results of estimating equation (6) (the model in column III of Table 3) for banks with above and below median growth in net interest income See Table for description of the model and variables β4-β7 denotes the difference of the coefficients on RECLASS and ΔAUGL Year fixed effects are included in all regressions and t-statistics are adjusted for clustering of observations by firm (Petersen 2007) *, **, and *** indicate two-tailed statistical significance at 10, 5, and percent levels Intercept BV BVafs COST AUGL other BV CI NIBEX RECLASS NIBEXother EX OCI ΔAUGL OCIother N R2 β4-β7 (β4-β7)High - (β4-β7)Low High Growth 4.44 Low Growth 1.12 0.39*** 0.94 0.32* 0.43*** 0.63 0.43*** 11.63*** 11.10*** -3.91 2.75* 10.35*** 8.14* 0.31 1.69** 516 0.72 11.32*** -0.39 0.37 516 0.80 3.14 7.18*** 33 Table Association between Year-Ahead Comprehensive Income and Reclassifications This table reports the results of regressions of year-ahead comprehensive income (CI) and two components of year-ahead CI—net income before extraordinary items and discontinued operations (NIBEX) and reclassification of gains and losses on AFS securities upon realization (RECLASS)—on the same explanatory variables as in equation (6) (the model in column III of Table 3) See Table for description of the model and explanatory variables γ 4-γ7 denotes the difference of the coefficients on RECLASS and ΔAUGL Panel A reports results for the overall sample, Panel B1 (B2) reports results for the high (low) AFS security liquidity subsamples, and Panel C1 (C2) reports result for the high (low) growth in net interest income subsamples Liquidity is measured as the percentage of AFS securities invested in U.S Treasuries Year fixed effects are included in all regressions and t-statistics are adjusted for clustering of observations for the same firm (Petersen 2007) *, **, and *** indicate two-tailed statistical significance at 10, 5, and percent levels, respectively Panel A: Overall Sample Intercept BV BVafs Costafs AUGL BVother CI NIBEX RECLASS NIBEXother EX OCI ΔAUGL OCIother N R2 γ4-γ7 CIt+1 -0.15 Dependent variable NIt+1 RECLASSt+1 * -0.35 0.00 0.01 -0.23* 0.01 0.03*** 0.03 0.03*** -0.00 0.06*** -0.00 0.61* 0.90*** -0.08 0.29* 0.78*** -0.35 0.39*** 0.01 0.11** -0.23 0.24** 973 0.54 0.84** -0.12 0.03 973 0.69 0.41* 0.05** -0.01* 959 0.19 0.34*** 34 Table (Continued) Panel B1: High AFS Security Liquidity Sub-sample Dependent variable CIt+1 NIt+1 RECLASSt+1 Intercept -0.25 -0.44 0.01 BV BVafs Costafs 0.01 0.02*** -0.00 * AUGL -0.26 0.05 0.04** BVother 0.00 0.02*** -0.00 CI NIBEX RECLASS 0.58* 0.72* 0.66*** NIBEXother 1.11*** 0.92*** -0.00 EX -0.66 -1.20 0.15* OCI ΔAUGL 0.11 0.05 0.08* other ** OCI 0.33 0.01 -0.00 N 430 430 424 R2 0.63 0.74 0.37 γ4-γ7 0.47* 0.67* 0.58*** Panel B2: Low AFS Security Liquidity Sub-sample Dependent variable CIt+1 NIt+1 RECLASSt+1 Intercept 0.11 -0.19 0.02 BV BVafs Costafs 0.01 0.03*** -0.01** AUGL -0.11 0.13 0.07*** BVother 0.01 0.03*** -0.00 CI NIBEX RECLASS 0.25 0.22 0.24*** NIBEXother 0.75*** 0.66*** 0.02 EX -0.53 -0.53 0.10* OCI ΔAUGL -0.47* -0.25* -0.00 other ** ** OCI 0.22 0.07 -0.01 N 484 484 477 R 0.54 0.69 0.13 γ4-γ7 0.72* 0.47 0.24*** 35 Table (Continued) Panel C1: High Interest Income Growth Sub-sample Dependent variable CIt+1 NIt+1 RECLASSt+1 Intercept -0.22 -0.17 0.04 BV BVafs Costafs 0.02 0.02** -0.00 * AUGL -0.36 0.00 0.07** BVother 0.01 0.02** -0.01* CI NIBEX RECLASS 1.13* 0.79** 0.57*** NIBEXother 0.99*** 0.81*** 0.01 EX -0.59 -0.97* 0.07* OCI ΔAUGL 0.11 -0.15 0.07** other ** ** OCI 0.29 0.10 -0.01 N 487 487 482 R2 0.59 0.70 0.27 γ4-γ7 1.02* 0.94*** 0.64*** Panel C2: Low Interest Income Growth Sub-sample Dependent variable CIt+1 NIt+1 RECLASSt+1 *** Intercept -0.05 -0.42 -0.00 BV BVafs Costafs 0.02 0.03*** -0.00 AUGL -0.12 0.04 0.05** BVother 0.02 0.03*** 0.00 CI NIBEX RECLASS -0.11 -0.11 0.22*** NIBEXother 0.75*** 0.75*** 0.01 EX 0.42 -0.39 0.26* OCI ΔAUGL -0.47* -0.14 0.01 other ** OCI 0.14 -0.08 -0.01 N 485 485 476 R 0.54 0.71 0.17 γ4-γ7 0.36 0.03 0.21*** 36 Table Earnings Fixation Panel A reports the association between stock returns for year beginning with the fifth month after fiscal year end and total gains and losses (TGL) during the year, controlling for four factors known to explain the cross-section of future stock returns Systematic risk (BETA) is estimated using the market model over the 60 months up to the fourth month after fiscal year end Firm size (SIZE) is the logarithm of the market value of equity at the end of the fourth month after fiscal year end The book-to-market ratio (BTM) is the book value of owners’ equity at the end of the fiscal year divided by market capitalization measured at the end of the fourth month after fiscal year end Stock return momentum (MOM) is calculated as the cumulative stock return during the past 12 months up to the fourth month after fiscal year end Panel B reports the average portfolio returns for firms sorted based on the reclassification of gains and losses on AFS securities (RECLASS) divided by the absolute value of the reported net income Each year firms are grouped into equal-sized terciles (Low, Medium, and High) based on TGL divided by the absolute value of net income The mean portfolio size-adjusted returns are then calculated for each sample year The following tables report the average of the mean excess portfolio returns over all sample years t statistics in panel A are based on standard errors clustered by firm with year fixed effects t statistics in Panel B are based on the distribution of the mean portfolios returns across sample years *, **, and *** indicate two-tailed statistical significance at 10, 5, and percent levels Panel A: Future Return Regression Dep Variable: RETt+1 -0.163*** Intercept BETA 0.003 BTM 0.006** SIZE -0.009*** MOM -0.005* TGL 0.005* N R-square 1,150 0.39 Panel B: Average Excess Returns to TGL Terciles Equal-weighted Return Value-weighted Return Low -0.79% -1.96% Medium -1.08% 2.67% High 2.79% 4.11%* High-Low 3.58%* 6.07%** 37 REFERENCES Abdel-Khalik, R 2008 The Case Against Fair Value Accounting SEC Comment Letter 4-573 Ahmed, A and C Takeda 1995 Stock Market Valuation of Gains and Losses on Commercial Banks’ Investment Securities: An Empirical Analysis Journal of Accounting and Economics 20: 207-225 Barth, M 1994 Fair Value Accounting: Evidence from Investment Securities and the Market Valuation of Banks The Accounting Review 69 (January): 1-25 Barth, M, W Beaver and W Landsman 1996 Value-relevance of Banks’ Fair Value Disclosures under SFAS No 107 The Accounting Review 71 (October): 513-537 Beatty, A., S Chamberlain, and J Magliolo 1995 Managing Financial Reports of Commercial Banks: the Influence of Taxes, Regulatory Capital and 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COMPUSTAT Accumulated unrealized gains and losses on AFS securities (AUGL) and reclassification of AUGL upon realization of gains and losses (RECLASS) are hand collected from banks’ annual Form.. .Preserving Amortized Cost within a Fair-Value-Accounting Framework: Reclassification of Gains and Losses on Available-for-Sale Securities upon Realization ABSTRACT: SFAS No 115 requires... year-ahead CI—net income before extraordinary items and discontinued operations (NIBEX) and reclassification of gains and losses on AFS securities upon realization (RECLASS)? ?on the same explanatory