Relative value relevance of historical cost vs. fair value: Evidence from bank holding companies

Journal of Accounting and Public Policy 22 (2003) 19–42 www.elsevier.com/locate/jaccpubpol

Relative value relevance of historical cost vs. fair value: Evidence from bank holding companies Inder K. Khurana *, Myung-Sun Kim

1

School of Accountancy, College of Business, University of Missouri––Columbia, 317 Middlebush, Columbia, MO 65211, USA

Abstract This study complements the growing literature on the value relevance of fair value by examining the validity of the hypothesis that fair value is more informative than historical cost as a financial reporting standard for financial instruments. Using the fair value disclosures made under Statement of Financial Accounting Standards (SFAS) No. 107 and SFAS No. 115 by bank holding companies (BHCs) over the 1995–98 period, we compare the relative explanatory power of fair value and historical cost in explaining equity values. For our entire sample, we are unable to detect a discernible difference in the informativeness of fair value measures collectively relative to historical cost measures. However, for small BHCs and those with no analysts following, we find that historical cost measures of loans and deposits are more informative than fair values. Anecdotal evidence indicates that loans and deposits are not actively traded and often involve more subjectivity with respect to the methods and assumptions used in estimating their fair values. In contrast, fair value of available-for-sale securities, which are more actively traded in well-established markets, explains equity values more than historical cost. Taken together, our results are consistent with the notion that fair value is more (less) value relevant when objective market-determined fair value measures are (not) available. More importantly, our results suggest that simply requiring fair value as the reported measure for financial instruments may not improve the quality of

*

Corresponding author. Tel.: +1-573-882-3474; fax: +1-573-882-2437. E-mail addresses: [email protected] (I.K. Khurana), [email protected] (M. Kim). 1 Tel.: +1-573-882-1071.

0278-4254/03/$ - see front matter Ó 2003 Elsevier Science Inc. All rights reserved. doi:10.1016/S0278-4254(02)00084-4

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information for all BHCs unless appropriate estimation methods or guidance for financial instruments that are not traded in active markets can be established. Ó 2003 Elsevier Science Inc. All rights reserved.

1. Introduction Recently the Financial Accounting Standards Board (FASB) made a fundamental decision that fair value is the most relevant attribute for financial instruments (FASB, 2000, p. 8). Although the quoted market value is the prescribed measure of fair value, the FASB adopted the term ‘‘fair value’’ instead of market value to encompass estimated values for financial instruments that are not traded in active markets. The decision to mandate fair value disclosures was made amidst a long-standing debate between the advocates of fair value accounting and advocates of historical cost accounting. The basic premise underlying the FASBÕs decision is that fair value of financial assets and liabilities better enables investors, creditors and other users of financial statements to assess the consequences of an entityÕs investment and financing strategies. 2 Advocates of historical cost, on the other hand, point to the reduced reliability of fair value estimates relative to historical cost. Their arguments suggest that investors would be reluctant to base valuation decisions on the more subjective fair value estimates (Barth, 1994, p. 3). Given the FASBÕs stated long-term goal of having all financial assets and liabilities recognized in statements of financial position at fair value rather than at amounts based on historical cost, the purpose of this study is to test claims that fair value is more informative relative to historical cost. Specifically, we examine whether fair value of financial instruments is more informative than historical cost in explaining equity market values of bank holding companies (BHCs). The goal is to determine whether fair value has a higher association with equity market values of BHCs than historical cost. We focus on BHCs for several reasons. First, financial statements of BHCs are dominated by the financial instruments covered under the FASBÕs pronouncements on fair value disclosures. For our sample of BHCs, assets and liabilities subjected to fair value disclosures constitute, on average, 87% and 88% of total book value of assets, respectively. Second, fair value disclosures are more comprehensive and standardized for BHCs than for firms in other industries. Finally, BHCs enable us to evaluate which financial instruments, if any, contribute to the higher association between fair value and equity values.

2

The FASBÕs Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, explicitly states that fair values for financial assets and liabilities provide more relevant and understandable information than cost based measures (FASB, 1998, – 222).

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We use the fair value disclosures made under SFAS No. 107, Disclosures about Fair Value of Financial Instruments, and SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, by 302 BHCs over the 1995– 98 period. For our entire sample of BHCs, we are unable to detect a statistically significant difference between the explanatory power of historical cost and fair value measures of financial instruments collectively in explaining equity values. We also provide evidence on whether the explanatory power of fair value relative to historical cost depends on additional firm characteristics. Fair value disclosures are likely to be more informative than historical cost for large BHCs, if they are more capable (than small BHCs) of precisely estimating fair value, and for BHCs operating in more transparent information environment, if this implies that information disclosed by these firms is more reliable. Our results indicate that historical cost is more informative than fair value for a subset of BHCs that are classified as small (based on market value of equity) and for a subset of BHCs with no analysts following. Additional analysis undertaken to identify the source of these results indicates that loans and deposits drive the higher informativeness of historical cost over fair value of the two subsets of BHCs. Anecdotal evidence indicates that loans and deposits are not actively traded and often involve more subjectivity with respect to the methods and assumptions used in estimating fair value. In contrast, fair value of available-for-sale securities, which are more actively traded in well-established markets, explains equity values more than historical cost. Taken together, our results are consistent with the notion that fair value is more value relevant when objective market-determined fair value measures are available. For the remaining financial instruments (i.e., held-to-maturity debt securities and financial liabilities other than deposits), we find neither fair value nor historical cost to provide greater information. Our inability to detect the dominance of one measure over the other may be due to a small difference between historical cost and fair value in our sample period (1995–98). 3

3 For example, if the difference between fair value and historical cost were recognized in the income statement, the average effect on earnings would be 6% of income before extraordinary items for our sample, whereas the average effect (recalculated after adjusting for the differences in denominators) would be )11% and )26% for samples in Nelson (1996, p. 168) and Park et al. (1999, p. 357), respectively. To the extent that the differences between historical cost and fair value is due to changes in interest rates, the small differences (in absolute terms) between historical cost and fair value for our sample compared to those in prior studies can be due to the magnitude of changes in interest rates in our sample period. During the 1995–98 sample period covered by our study, the average annual unexpected interest rate changes in absolute terms (computed as the absolute value of the difference between actual annual three month Treasury bill rate less the prior year monthly average interest rate deflated by the prior interest rate) is 11%. The corresponding numbers during 1992–93 (sample period covered by Nelson, 1996, p. 167) and 1993–95 (sample period covered by Park et al., 1999, p. 353) are 24% and 28%, respectively.

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In light of the fact that our sample of BHCs exhibit small differences between historical cost and fair value of financial instruments, it is conceivable that fair value disclosures in an environment where fair value deviates dramatically from historical cost may have different implications for BHCsÕ equity values than in the environment covered by this study. Our study differs from prior research on fair value disclosures in that we test for the relative information content of fair value and historical cost as opposed to incremental information content of fair value over and above historical cost. Incremental information content tests conducted in prior research assess whether fair value provides information content beyond historical costs (Biddle et al., 1995, p. 3). Such incremental information tests ask whether the two measures (fair value and historical cost) together are more informative than one measure alone. On the other hand, relative information test conducted here ask whether fair value alone is more informative than historical cost alone and vice versa. Prior research on fair value disclosures has focused on incremental information content tests without explicitly testing whether fair value alone is more, equally, or less informative than historical cost. While results of incremental tests have been informative in the FASBÕs deliberations on fair value disclosure requirements (Barth et al., 2001, p. 79), Ryan (1999, p. 374) notes that the FASB has moved on to the next logical step of asking whether fair value as a basis is preferable to historical cost for balance sheet recognition. Our study is the first to conduct relative information content tests to assess whether fair value is more informative than historical cost and vice versa. In doing so, it complements the growing literature on the value relevance of fair value. Empirical evidence (provided in our study) on the informativeness of fair value measures relative to historical cost measures should be useful to the FASB, which is interested in fair value as a replacement (or complement) to historical cost as a key measure for financial instruments. This knowledge can impart input into policy deliberations by allowing informed tradeoffs between benefits and costs of providing information about fair value. The remainder of this paper is organized as follows: Section 2 provides background information on fair value and discusses the findings of prior research on fair value disclosures. Section 3 describes the motivation behind the empirical tests conducted in this study. Section 4 describes the methodology used to test the informativeness of fair value relative to historical cost using market value of equity. In Section 5, we describe our data and sample selection procedure. Section 6 presents our empirical findings, and Section 7 concludes the paper.

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2. Background and prior research The FASB (2000, p. 8) has stated that its long-term goal is to have all financial assets and liabilities recognized in statements of financial position at fair value rather than at amounts based on historical cost. It has also issued several significant pronouncements on fair value disclosures, SFAS No. 107, Disclosures about Fair Value of Financial Instruments (FASB, 1991), SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (FASB, 1993), and SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (FASB, 1998). Underlying the issuance of these pronouncements is the belief that fair value provides information about financial assets and liabilities that is more relevant than amounts based on historical cost. The FASBÕs (2001, p. 9) intermediate objective is to issue a statement that would describe more specifically how to determine fair value for financial instruments and improve the form and content of the disclosures required by SFAS No. 107. Fair value of a financial instrument represents the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale (FASB, 1991, – 5). Although the market prices quoted in an active market provide the most reliable measure of fair value, market prices are often not available for many financial instruments appearing on the balance sheets of BHCs. In such situations, BHCs must provide the best available estimate of a current market price by exercising judgments about the methods and assumptions to be used (FASB, 1991, – 22). As a result, fair value measures reported in the financial statements depict the managementÕs estimate of the present value of the net future cash flows embodied in an asset or liability, discounted to reflect both the current interest rate and the managementÕs assessment of the risk associated with those cash flows. Willis (1998, p. 5) notes that fair values provide information about benefits expected from assets and burdens imposed by liabilities based on current economic conditions and expectations. The FASB (1991, – 40) contends that periodic information about the fair value of an entityÕs financial instruments under current conditions and expectations should help users both in making their own predictions and in confirming or correcting their earlier expectations. Furthermore, the FASB maintains that fair values for financial assets and liabilities provide more relevant and understandable information than historical cost measures: . . . fair value is more relevant to financial statement users than cost for assessing the liquidity or solvency of an entity because fair value

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reflects the current cash equivalent of the entityÕs financial instruments rather than the price of a past transaction. With the passage of time, historical prices become irrelevant in assessing present liquidity or solvency (FASB, 1998, – 222). Critics of fair value accounting point to the reduced reliability of fair value estimates relative to historical cost (Barth, 1994, p. 3). Historical cost information can be based on internally available information about prices in past transactions, without reference to outside market data. Fair value, in contrast, is based on current prices, which may require estimation and can lead to reliability problems. Since fair values must be estimated for several financial instruments that are not actively traded, estimation error could impair their value-relevance. 2.1. Prior research Prior research on value relevance (defined as the association between accounting numbers and security market values) has focused on whether fair value disclosures in the banking industry have incremental information content over and above historical cost. 4 Tests for incremental information content assess whether one measure provides information content in addition to that of another measure and are often used when one or more measures are given or required and another is supplemental (Biddle et al., 1995 p. 3; Jennings, 1990 p. 925). Biddle et al. (1995, p. 3) point out that in the absence of an explicit test to examine whether one measure (e.g., fair value) alone is equally, less, or more informative than another measure (e.g., historical cost), incremental information content tests of fair value over historical cost measures can imply several different outcomes. Finding that fair value is incrementally informative can imply that fair value is as, more, or less informative than historical cost. Alternatively, finding that fair value is not incrementally informative can imply fair value is either equally or less informative than historical cost. Therefore, the mapping between an incremental and a relative information content test is not one-to-one. While incremental comparisons assess the incremental con-

4

Two notable exceptions of studies examining information content of fair value disclosures outside the banking industry are Simko (1999, p. 247), who focuses on non-financial firms, and Petroni and Wahlen (1995, p. 719), who focus on property-liability insurance companies. Simko (1999, p. 270) finds that financial instrument liability fair value disclosures are generally valuerelevant for non-financial firms, while Petroni and Wahlen (1995, p. 735) find that the fair values of only certain categories of investments (equity investments and US Treasury investments) are reflected in share prices and returns of property-liability insurers. For a review of the literature and the methodological issues (see Barth et al., 2001; Barth, 2000; Holthausen and Watts, 2001).

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tribution of one measure over the other, relative comparisons reflect differences in incremental information content of the two measures. Prior studies examining incremental information content of fair value disclosures by BHCs report mixed findings regarding their ability to explain market value of equity or returns. Barth (1994, p. 2), using the sample of BHCs over 20 years between 1971 and 1990, finds that fair value of investment securities, which were disclosed even prior to SFAS 107 (FASB, 1991), is significantly associated with market value of equity; and that historical cost provides no explanatory power incremental to fair value. Based on these two findings, Barth concludes that investment securitiesÕ fair value (level variable) has more explanatory power than historical cost. 5 However, she finds that unrealized gains and losses on investment securities as a group (change variable) do not possess explanatory power incremental to earnings in explaining returns. She attributed the observed lack of incremental information to possible measurement error in the unrealized gains and losses on investment securities. During the time period covered by her study, the average annual unexpected interest rate change in absolute terms was 21%. 6 Three other studies examine the relation between BHC share prices and fair value disclosures for financial instruments provided under SFAS 107 for 1992 and 1993, and one other study focuses on the 1993–95 time period. 7 Using a market-to-book specification, Nelson (1996, p. 173) finds that SFAS No. 107 fair value disclosures have no incremental power to explain market values of equity relative to book values, with the exception of investment securities in 1992. She finds that none of the fair value measures are associated with stock returns. Eccher et al. (1996, p. 114) find that fair value of investment securities has significant incremental explanatory power in explaining market value of equity, but that evidence on the other asset and liability variables examined is mixed and weak. In contrast, Barth et al. (1996, p. 535) document that fair value estimates of loans during 1992–93 provide significant incremental explanatory power for BHCsÕ market value of equity beyond that provided by related book values when additional variables (e.g., non-performing loans and interest-sensitive assets and liabilities) are controlled for. Similarly, Park et al. (1999, p. 368) find that for a pooled sample of BHCs during 1993–95, unrealized gains and losses on available-for-sale securities, held-to-maturity debt

5

Her results apply only to investment securities and disclosures made before SFAS 107 and SFAS 115. 6 We used the prior year monthly average interest rate of three month Treasury bills as a proxy for expected interest rate and deflated the unexpected interest rate change by the prior year interest rate. 7 The average annual unexpected interest rate changes (in absolute terms) during the sample periods covered in these studies were 24% (1992–93) and 28% (1993–95), respectively, whereas the corresponding interest rate change during our sample period is 11%.

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securities, and loans are incrementally value relevant in explaining annual returns when these variables are entered simultaneously into a regression model. Overall, the results of prior studies documenting the incremental informativeness of fair value imply that fair value is either equally, less, or more informative than historical cost depending on the amount of unique information contained in fair value.

3. Empirical tests Our first set of tests of relative information content is motivated by the mixed findings on the incremental information content of fair value disclosures as well as the fact that there has been little empirical research testing the relative information content of fair value disclosures. Tests for relative information content assess whether one measure has greater information content than another and are often used when assessing mutually exclusive choices (e.g., Biddle et al., 1995, p. 3). The FASB views fair value to be the most relevant attribute for financial instruments. If disclosed fair value estimates measure underlying fair values of financial assets and liabilities reliably, then fair value measures are more likely to be related to market value of equity than historical cost measures. Therefore, relative information content comparisons between fair value and historical cost measures can provide useful input into the FASBÕs policy deliberations. Our second set of tests examines whether differential firm characteristics are related to differential reliability of fair value information and therefore, differential information content of fair value measures. Many financial instruments appearing on the balance sheets of BHCs are not traded in established markets. As a result, obtaining a reliable fair value estimate could be problematic. We consider two firm characteristics that may affect the reliability of fair value measures, namely, size and information environment. Many contend that fair value of loans cannot be estimated reliably, especially those subject to non-trivial default risk (Barth et al., 1996, p. 514). If large banks have more resources (e.g., more sophisticated investment departments) available for estimation of fair value than small banks, then large banks are more likely to provide fair value estimates with less measurement error. 8 We provide evidence on this issue by conducting relative information content tests for subsets of sample BHCs classified by size. Moreover, Ryan (1999, p. 375) suggests that the richer the bankÕs information environment, the smaller the likelihood of reliability problems associ8

It is also possible that large banks could have lower risk because of greater opportunities for diversification.

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ated with fair value estimates. There is considerable empirical evidence that suggests forecast dispersion is related to the quality of financial disclosures. Swaminathan (1991, p. 36) finds that forecast dispersion decreased following the release of newly mandated segment disclosures by the SEC. Dechow et al. (1996, p. 26) find that forecast dispersion increased following alleged violations of generally accepted accounting principles. High forecast dispersion is also associated with financial disclosures that are given a low rating by financial analysts (Lang and Lundholm, 1996, p. 486). The implication is that the more reliable the firmÕs overall financial reporting system, the less diverse should be the analystsÕ opinion on the firmÕs future prospects. We test whether fair value disclosures are more informative for BHCs operating in more transparent information environment by using financial analystsÕ forecast dispersion to classify BHCs. 9 Our third set of tests examines the information content of an individual financial instrument. Certain financial instruments held by BHCs are likely to be actively traded in securities markets (e.g., marketable securities). Fair value disclosures of such financial instruments are based on readily observable market prices (Petroni and Wahlen, 1995, p. 725). However, loans are not actively traded and therefore involve more subjectivity with respect to the methods and assumptions used in estimating their fair values (Barth et al., 1996, p. 530). Thus, fair value disclosures for certain financial instruments require more estimation than those for other financial instruments. We provide evidence on the relative informativeness of historical cost and fair value measures of individual financial instruments.

4. Model We utilize a cross-sectional valuation model based on the balance sheet identity that has been used extensively in the prior literature (Beaver et al., 1989, p. 165; Barth, 1991, p. 438; and Barth et al., 1996, p. 519). This model relates the market value of common equity to the historical cost and fair value measures of broad asset and liability categories of financial institutions. The FASB (1993, – 12) requires recognition of fair value for available-for-sale 9

It is important to note that financial analystsÕ forecast dispersion measure should not be interpreted as implying that estimation quality of fair value per se is reflected in the analystsÕ forecasts. Since earnings do not include unrealized gains or losses on securities other than trading securities, analystsÕ forecast dispersion is not a direct indicator of the reliability of fair value estimates. Our empirical tests are based on the assumption that the measurement quality of earnings will be positively related to that of non-earnings information such as fair value measures. To the extent that this relation is weak, our empirical tests may be unable to detect the hypothesized effect. We thank an anonymous reviewer for this comment.

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securities and does not alter the rules for marking trading securities to market. 10 For financial instruments other than available-for-sale securities and trading securities, historical cost (fair value) is the amount recognized (disclosed) in the balance sheet (footnotes). We estimate the following model with either historical cost or fair value: MVitþ3 ¼ b0 þ b1 AFSit þ b2 HTMit þ b3 LOANit þ b4 DEPOit þ b5 OFINLit þ b6 OASSETit þ b7 OLIABit þ uit

ð1Þ

where i, t denote firms and fiscal year-end, and MV is the market value of equity three months after the fiscal year-end, AFS is the available-for-sale securities at fiscal year-end, HTM is the held-to-maturity debt securities at fiscal year-end, LOAN is the loans at fiscal year-end, DEPO is the deposits at fiscal year-end, OFINL is the financial liabilities other than deposits at fiscal yearend, OASSET is the assets other than AFS, HTM, and LOAN at fiscal year-end, 11 OLIAB is the liabilities other than DEPO and OFINL at fiscal year-end. To mitigate the size or scale effect, we deflate all the variables with the market value of equity at the close of year t  1 (see Brown et al., 1999, p. 104). Consistent with prior research (Barth et al., 1996, p. 519), non-financial assets (liabilities) are measured as the book value difference between total assets (liabilities) and financial assets (liabilities). 12 We test the relative informativeness of fair value and historical cost measures by comparing the R2 from each model using the Vuong (1989, p. 307) test, a likelihood ratio test of model selection. The test compares the R2 s of two non-nested regression models and selects the model with the higher explanatory power, consistent with assessing the relative informativeness of two mutually exclusive measures. A negative and significant Z-statistic would indicate that the residuals produced by the historical cost model are larger in magnitude than those produced by the fair 10 Trading securities are marked to market both before and after SFAS No. 115 (FASB, 1993, – 12). 11 Because trading securities are recognized at fair value, BHCs do not provide historical cost information for trading securities. As a result, we do not examine trading securities separately. Instead, we include them as part of OASSET (defined as assets other than available-for-sale securities, held-to-maturity securities, and loans). 12 We exclude off-balance sheet items from our models because of limitations in interpreting many of the off-balance sheet fair value disclosures required under SFAS No. 107. Consistent with the limitations outlined by Barth et al. (1996, p. 523), we find that a majority of our sample BHCs (1) fail to indicate clearly whether the net position with respect to off-balance sheet items is an asset or a liability; (2) net several off-balance sheet amounts, making it difficult to determine the asset and liability positions for the individual items; and (3) have inadequate disclosures making it impossible to compute an estimate of fair value for off-balance sheet items.

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value model, thereby suggesting that fair value provides greater relative informativeness than historical cost. 5. Sample and data The set of initial candidates for inclusion in the sample was all BHCs with SIC codes 6021–6022 on the 1999 Compustat Annual tape for the 1995–98 period. A total of 1249 firm-year observations from 320 distinct BHCs with December 31 as their fiscal year-end were found from this source. 13 We then deleted individual firm-year observations for the following reasons: 1. Data considerations: Observations were deleted if (i) data on fair value measures were not available from annual reports and/or 10-K filings from the SECÕs EDGAR database (202 observations); or (ii) market value of equity information as of December 31 and March 31 and accounting data as of December 31 could not be determined from the 1999 Compustat Annual and Quarterly tapes (59 observations). 2. Outliers: Observations were deleted if they fell in the top or bottom 0.5% of the dependent or independent variables used in historical cost model or fair value model (35 observations). This procedure yielded the final sample of 953 firm years representing 302 distinct BHCs. Of these, 162, 249, 264, and 278 firm-year observations are for 1995, 1996, 1997, and 1998, respectively. Financial analystsÕ forecast data are collected from I/B/E/S. We use the dispersion in analystsÕ forecast as a proxy for BHCsÕ information environment reflecting the quality of information disseminated throughout the period and compute dispersion in analystsÕ forecasts made in the month of December or the month immediately preceding the December fiscal year-end. 14 AnalystsÕ forecast dispersion is computed as the standard deviation of analystsÕ forecasts of annual earnings per share on I/B/E/S deflated by stock price per share. Of 302 BHCs in our sample, financial analystsÕ forecasts were available for 259 BHCs (869 firm-year observations). The number of firm-year observations is further reduced to 496 when we restrict our sample to include BHCs that are followed by at least two analysts.

13 Of these, 298, 314, 318, and 319 firm-year observations are for 1995, 1996, 1997, and 1998, respectively. 14 Although analysts still revise their forecasts after the fiscal year-end, we do not use the dispersion measure immediately preceding the earnings announcement because of a significant drop in firm-year observations when such a condition is imposed.

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Panel A of Table 1 presents descriptive statistics for the market and book value of equity and the historical cost and fair value of selected individual assets and liabilities. The market value of equity for our sample firms has an inter-quartile range from $75 million to $700 million with a median of $192 million. The book value of total assets for our sample BHCs has an interquartile range from $433 million to about $3741 million, with a median of $1044 million. An examination of the historical cost of the individual balance sheet components expressed as a percentage of total assets indicates that net loans and investment securities comprise a large portion of the assets of sample firms. The average BHC during the 1995–98 sample period (using means) has 62.8% ($4267 million/$6794 million) of its assets invested in net loans, 15% ($1022 million/$6794 million) in available-for-sale securities, and 3.8% ($258 million/$6794 million) in held-to-maturity debt securities. The assets are financed mostly by deposits representing 69.9% ($4729 million/$6794 million) of the total, followed by 16.8% ($1140 million/$6794 million) in other financial liabilities. Panel B of Table 1 presents descriptive statistics for the variables used in regressions. The mean market value of equity deflated by beginning market value of equity is 1.45, which represents an average annual increase of 45% in market value of our sample BHCs over the 1995–98 period. 15 This statistic is consistent with favorable economic conditions under which BHCs were operating during the sample period. The distributions of historical cost and fair value measures for each financial instrument are almost identical, although the mean fair value measures of financial instruments are slightly higher than those for the historical cost measures. Small differences between historical cost and fair value reflect the small changes in interest rates during the 1995–98 sample period. The average annual unexpected interest rate changes in absolute terms for 1971–90 (time period covered in Barth, 1994, p. 10), 1992–93 (time period covered in Nelson, 1996, p. 167; and Eccher et al., 1996, p. 1992), and 1993–95 (time covered in Park et al., 1999, p. 353) are 21%, 24%, and 28%, respectively. 16 The average annual unexpected interest rate change during our sample period is 11%. The mean value of difference between fair value and historical cost measures in deflated amount and dollar amount is the largest for loans (DLOAN of 4.7%

15

Our sample BHCs are representative of the banking industry in terms of market returns during 1995–98. The S&P bank composite index at the beginning and end of each year (in parentheses) was: 1995 (219.58, 330.5), 1996 (332.26, 453.81), 1997 (454.51, 640.15), and 1998 (620.38, 667.21). The data indicate that the average annual return during 1995–98 on the S&P bank composite stock index was approximately 34%. 16 The average annual unexpected interest rate changes in absolute terms is computed by taking the absolute value of the difference between actual annual three month Treasury bill rate less the prior year monthly average interest rate deflated by the prior interest rate.

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Table 1 Descriptive statistics for selected variables: 1995–98 Variable

N

Mean

Median

Panel A: Undeflated variables ($ in millions) MV 953 1440 192 BV 953 547 98 ASSETS 953 6794 1044 AFSHC 953 1022 180 AFSFV 953 1041 181 DAFS 953 18 1 HTMHC 953 258 35 HTMFV 953 260 36 DHTM 953 2 0.2 LOANHC 953 4267 630 LOANFV 953 4331 634 DLOAN 953 65 4 DEPOHC 953 4729 825 DEPOFV 953 4736 827 DDEPO 953 7 1 OFINLHC 953 1140 67 OFINLFV 953 1149 67 DOFINLIAB 953 9 0

Std. dev.

Lower quartile

Upper quartile

4615 1653 21,571 2876 2924 155 731 736 19 14,043 14,237 275 14,729 14,735 77 4477 4506 110

75 41 433 67 68 0.12 2 2 0 272 273 0.4 348 348 0.2 13 13 0

700 321 3741 598 607 6 43 146 1.5 2216 2257 24 2865 2870 6 387 387 1

Panel B: Ratios (variables deflated by market value of common stock at the close of previous fiscal year) MV 953 1.45 1.40 0.50 1.09 1.73 AFSHC 953 1.43 1.26 0.90 0.78 1.91 AFSFV 953 1.44 1.27 0.90 0.80 1.93 DAFS 953 0.014 0.008 0.028 0.001 0.018 HTMHC 953 0.55 0.29 0.73 0.01 0.79 HTMFV 953 0.56 0.30 0.74 0.01 0.80 DHTM 953 0.005 0.002 0.012 0.00 0.007 LOANHC 953 4.91 4.44 2.28 3.41 5.73 LOANFV 953 4.96 4.50 2.30 3.45 5.78 DLOAN 953 0.047 0.035 0.102 0.005 0.083 DEPOHC 953 6.34 5.80 3.07 4.35 7.63 DEPOFV 953 6.35 5.79 3.08 4.33 7.62 DDEPO 953 0.003 0.010 0.177 0.002 0.021 OFINLHC 953 0.73 0.49 0.76 0.19 0.98 OFINLFV 953 0.73 0.49 0.76 0.19 0.98 DOFINLIAB 953 0.002 0.0 0.022 0.0 0.003 MV: Market value of common stock at the end of the third month after fiscal year-end. BV: Book value of common stockholdersÕ equity. ASSETS: Total assets. AFSHC (FV): Available-for-sale securities, historical cost (fair value). HTMHC (FV): Held-to-maturity securities, historical cost (fair value). LOANHC (FV): Loans, historical cost (fair value). DEPOHC (FV): Deposits, historical cost (fair value). OFINLHC (FV): Other financial liabilities, historical cost (fair value). DAFS (DHTM, DLOAN, DDEPO, DOFINLIAB): Difference between fair value of AFS (HTM, LOAN, DEPO, OFINL) and historical cost of AFS (HTM, LOAN, DEPO, OFINL).

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and $65 million), followed by available-for-sale investment securities (DAFS of 1.4% and $18 million), held-to-maturity debt securities (DHTM of 0.5% and $2 million), deposits (DDEPO of 0.3% and $7 million) and other financial liabilities (DOFINLIAB of 0.02% and $9 million). Thus, the recognition of fair value for financial reporting for all financial instruments during our sample period would cause sample BHCs to, on average, experience an increase in profits and stockholdersÕ equity. The average change in stockholdersÕ equity due to the additional net unrealized gain (cumulative) from financial instruments other than available-for-sale securities is 7%, with values ranging from a 32% decrease to a 65% increase. Table 2 shows Pearson correlations among variables used in estimating the historical cost and fair value model, respectively. Historical cost and fair value measures for each category of financial assets and liabilities are positively correlated with each other. Correlations between historical cost and fair value for each category of financial assets and liabilities are 0.99 and are statistically significant at the 0.01 level. 17 We also find that the correlations of the dependent variable (MV) and the historical cost variables are almost identical to those between MV and fair value variables, suggesting that historical cost and fair value measures have almost equal relative informativeness in a univariate sense. Loan values have the highest correlations with market value of common stock, followed by deposits. Correlations between independent variables (except for those between AFSHC and HTMHC and between AFSFV and HTMFV are all positive and significant at the 0.01 level. The magnitude of the correlations suggests that the independent variables (not surprisingly) are collinear, which may erode the statistical significance of the regression coefficient estimates (Neter et al., 1985, p. 383).

6. Empirical results 6.1. Full sample results Table 3 presents the regression estimation results for overall sample. Despite the high correlations among the independent variables (reported in Table 2, all of the regression coefficients have the expected signs. Market value is positively (negatively) related to different categories of assets (liabilities). Historical cost measures collectively explain 23.2% of the cross-sectional variation in market 17

To address the possibility that deflation by market value of equity at the end of the previous fiscal year might induce spurious correlations, we re-estimated Pearson correlations using undeflated numbers and found that the undeflated variables have correlations of about the same magnitude as those reported in Table 3.

MV AFSHC AFSFV HTMHC HTMFV LOANHC LOANFV DEPOHC DEPOFV OFINLHC OFINLFV

MV

AFSHC

AFSFV

HTMHC

HTMFV

LOANHC

LOANFV

DEPOHC

DEPOFV

OFINLHC

OFINLFV

1 0.22 0.22 0.12 0.12 0.46 0.46 0.43 0.43 0.17 0.18

1 0.99 0.00 0.00 0.33 0.33 0.48 0.48 0.31 0.32

1 )0.01 )0.01 0.32 0.32 0.48 0.48 0.31 0.31

1 0.99 0.15 0.15 0.34 0.34 0.06 0.06

1 0.15 0.15 0.34 0.34 0.06 0.06

1 0.99 0.88 0.88 0.26 0.26

1 0.88 0.88 0.26 0.26

1 0.99 0.10 0.10

1 0.10 0.10

1 0.99

1

All correlations greater than the absolute value of 0.06 are significant at the 0.01 level. MV: Market value of common stock at the end of the third month after fiscal year-end. AFSHC (FV): Available-for-sale securities, historical cost (fair value). HTMHC (FV): Held-to-maturity securities, historical cost (fair value). LOANHC (FV): Loans, historical cost (fair value). DEPOHC (FV): Deposits, historical cost (fair value). OFINLHC (FV): Other financial liabilities, historical cost (fair value). All variables are deflated by market value of common stock at the close of previous fiscal year.

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Table 2 Pearson correlations among variables

33

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Table 3 Regression results of relative informativeness of historical cost and fair value. Modela : MVitþ3 ¼ b0 þ b1 AFSit þ b2 HTMit þ b3 LOANit þ b4 DEPOit þ b5 OFINLit þ b6 OASSETit þ b7 OLIABit þ eit Parameter estimates (t-statistics in parentheses) Historical cost model Intercept AFS HTM LOAN DEPO OFINL OASSET OLLAB Adj. R2 N VuongÕs Z-statistic



0.86 (22.08) 0.27 (4.08) 0.26 (4.03) 0.33 (4.93) )0.26 ()3.64) )0.22 ()3.10) 0.28 (3.84) )0.26 ()3.44) 0.232 953 1.22

Fair value model 0.88 (22.78) 0.13 (2.57) 0.12 (2.48) 0.18 (3.66) )0.10 ()1.89) )0.07 ()1.23) 0.12 (2.18) )0.10 ()1.71) 0.225 953

 ð; Þ significant at 10% (5%, 1%) level (two-tailed). MV: Market value of common stock at the end of the third month after fiscal year-end. AFS: Available-for-sale securities. HTM: Held-to-maturity securities. LOAN: Loan. DEPO: Deposits. OFINL: Other financial liabilities. OASSET: Assets other than AFS, HTM, and LOAN. a All financial instrument variables are at historical cost (fair value) at fiscal year-end in the historical cost (fair-value) model. All variables are deflated by the market value of common stock at the close of previous fiscal year.

values and fair value measures collectively explain 22.5% of the variation in market values. Although the adjusted-R2 of the historical cost model is higher than that of the fair value model, the difference is not statistically significant. The VuongÕs Z-statistic of 1.22 indicates that neither the historical cost model nor the fair value model is more informative than the other. That is, the difference between the incremental information content of historical cost beyond fair value and the incremental information content of fair value beyond historical cost is not discernible. A potential explanation for this result could be the small difference in the magnitude of fair value and historical cost measures. 6.2. Sub-sample results Panel A of Table 4 summarizes the results of testing relative information content by partitioning the sample using market value of equity as a proxy for size. For firms in the first quartile (smallest firms in the sample) of size distribution, historical cost is more informative than fair value (VuongÕs Z-sta-

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Table 4 Regression results of relative informativeness of historical cost and fair value by size and information environment. Modela : MVitþ3 ¼ b0 þ b1 AFSit þ b2 HTMit þ b3 LOANit þ b4 DEPOit þ b5 OFINLit þ b6 OASSETit þ b7 OLIABit þ eit Panel A: Partition based on size (market value of equity) Market value of equity

N Adj. R2 historical cost model Adj. R2 fair value model VuongÕs Z-statistic

Quartile 1 (small)

Quartile 2

Quartile 3

Quartile 4 (large)

238 0.34 0.25 2.19

238 0.36 0.35 1.21

239 0.24 0.24 0.57

238 0.27 0.28 )1.04

Panel B: Partition based on information environment (analysts’ forecast dispersion) AnalystsÕ forecast dispersionb

N Adj. R2 historical cost model Adj. R2 fair value model VuongÕs Z-statistic

No analysts

High

Medium

Low

457 0.27 0.23 1.96

165 0.27 0.27 0.58

166 0.29 0.29 )0.20

165 0.15 0.18 )1.58

 ð; Þ

significant at 10% (5%, 1%) level (one-tailed). MV: Market value of common stock at the end of the third month after fiscal year-end. AFS: Available-for-sale securities. HTM: Held-to-maturity securities. LOAN: Loan. DEPO: Deposits. OFINL: Other financial liabilities. OASSET: Assets other than AFS, HTM, and LOAN. OLIAB: Liabilities other than DEPO and OFINL. a All financial instrument variables are at historical cost (fair value) at fiscal year-end in the historical cost (fan-value) model. All variables are deflated by the market value of common stock at the close of previous fiscal year. b AnalystsÕ forecast dispersion is deflated by the share price provided in the I/B/E/S tape.

tistic is 2.19). For the other three quartiles, neither measure dominates the other; the closest to statistical significance is the historical cost model with relatively more information content than the fair value model (p-value ¼ 0.16). Panel B of Table 4 presents the results of testing relative information content by partitioning the sample using analystsÕ forecast dispersion (high, medium, and low) or no analysts following as a proxy for the information environment. Consistent with the results for the smallest BHCs (quartile 1) reported in Panel A, historical cost is more informative than fair value for BHCs with no analysts following. An examination of the ‘‘no-analyst’’ following partition revealed that 209 out of the 457 firm-year observations also belong to ‘‘smallest’’ firms partition. To ensure that our results for the ‘‘no-analyst’’ following partition

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are not driven by the ‘‘smallest’’ BHCs, we re-estimated the historical cost and fair value models for sub-samples of 209 and 248 firm-year observations. The result of the Vuong test (not reported) for the 209 firm-year observations (noanalyst following and smallest quartile) indicates that the relative informativeness of historical cost is statistically higher than fair value (Adjusted-R2 of 0. 37 vs. 0.30, statistically different at the 0.05 level). Similarly, the result of the Vuong test (not reported) for the 248 firm-year observations (no-analyst following and three larger size quartiles) indicates that the relative informativeness of historical cost is statistically higher than fair value (Adjusted-R2 of 0.30 vs. 0.28, statistically different at the 0.10 level). In the tests for the high, medium, and low partitions based on analystsÕ forecast dispersion, there is no difference between the explanatory power of the historical cost and fair value measures using the Vuong test, suggesting that neither measure dominates the other. However, in light of the smaller sample sizes for the partitions based on analystsÕ forecast dispersion, it is possible that our inability to detect a difference in the adjusted-R2 of historical cost and fair value model for these partitions may be due to the low power of the statistical tests. In fact, the Vuong Z-statistic becomes more negative (fair value being more informative, although not significant), as forecast dispersion decreases. The partitions used in Table 4 are a means of testing the effect of BHCsÕ ability to generate reliable information (as proxied by market value of equity) and the effect of BHCsÕ information environment (as proxied by analystsÕ forecast dispersion). However, it is possible that size and analystsÕ forecast dispersion are proxies for the same construct. To check for such a possibility, we compute the Spearman correlation coefficient between market value of equity and analystsÕ forecast dispersion. We find the correlation between the two variables is small ()0.04) and statistically not significant at the 0.10 level. Thus, it appears that forecast dispersion is capturing something about measurement error that is not captured by the size proxy. More importantly, the results indicate that historical cost is more informative than fair value when fairvalue is not measured reliably. 6.3. Results for individual financial instruments To identify the individual financial instruments that drive the relative information content results, we modify the fair value model such that all financial instruments except one are measured at historical cost and compare the adjusted-R2 of the historical cost model to the adjusted-R2 of the modified fair value model. Panel A of Table 5 presents results of relative informativeness tests of historical cost and fair value measures of individual financial instruments for the full sample. Results reported in Panel A of Table 5 indicate that the fair value of available-for-sale investment securities is more informative than the historical

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Table 5 Regression results of relative informativeness of historical cost and fair value for individual financial instruments. Modela : MVitþ3 ¼ b0 þ b1 AFSit þ b2 HTMit þ b3 LOANit þ b4 DEPOit þ b5 OFINLit þ b6 OASSETit þ b7 OLIABit þ uit AFS

HTM

LOAN

DEPO

OFINL

0.23 0.23 0.15

0.23 0.23 0.60

0.23 0.22 1.41

0.23 0.23 1.43

Panel B: Partition based on size (market value of equity) Quartile 1 (small, N ¼ 238) 0.34 0.34 0.34 Adj. R2 (HCb ) Adj. R2 (FVc ) 0.34 0.34 0.30 VuongÕs Z-statistic )0.31 )0.10 1.70

0.34 0.26 2.08

0.34 0.33 1.87

Quartile 2 (N ¼ 238) Adj. R2 (HCb ) Adj. R2 (FVc ) VuongÕs Z-statistic

0.36 0.37 )1.11

0.36 0.36 1.33

0.36 0.34 2.18

0.36 0.37 )1.28

0.36 0.36 0.03

Quartile 3 (N ¼ 239) Adj. R2 (HCb ) Adj. R2 (FVc ) VuongÕs Z-statistic

0.24 0.24 )1.22

0.24 0.24 )1.21

0.24 0.24 1.33

0.24 0.24 )0.73

0.24 0.24 0.47

0.27 0.27 0.46

0.27 0.27 )1.00

0.27 0.27 )0.14

0.27 0.27 )0.38

Panel A: Full sample (N ¼ 953) 0.23 Adj. R2 (HCb ) Adj. R2 (FVc ) 0.24 VuongÕs Z-statistic )2.27

Quartile 4 (large, N ¼ 238) 0.27 Adj. R2 (HCb ) Adj. R2 (FVc ) 0.27 VuongÕs Z-statistic )0.37

Panel C: Partition based on information environment No analysts (N ¼ 457) 0.27 0.27 Adj. R2 (HCb ) Adj. R2 (FVc ) 0.27 0.27 VuongÕs Z-statistic )1.80 )0.85

(analysts’ forecast dispersion) 0.27 0.25 1.92

0.27 0.23 1.71

0.27 0.26 1.22

0.27 0.27 1.00

0.27 0.27 0.46

0.27 0.27 )0.38

Medium forecast dispersion (N ¼ 166) 0.29 0.29 Adj. R2 (HCb ) Adj. R2 (FVc ) 0.29 0.29 VuongÕs Z-statistic 0.42 0.68

0.29 0.29 )0.12

0.29 0.30 )0.94

0.29 0.29 1.13

Low forecast dispersion (N ¼ 165) Adj. R2 (HCb ) 0.15 0.17 Adj. R2 (FVc ) VuongÕs Z-statistic )1.30

0.15 0.16 )0.93

0.15 0.16 )0.83

0.15 0.15 0.46

High forecast dispersion (N ¼ 165) 0.27 Adj. R2 (HCb ) Adj. R2 (FVc ) 0.28 VuongÕs Z-statistic )1.17

0.27 0.27 )0.22

0.15 0.15 1.11

(continued on next page)

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Table 5 (continued)  ð; Þ significant at 10% (5%, 1%) level (two-tailed). MV: Market value of common stock at the end of the third month after fiscal year-end. AFS: Available-for-sale securities. HTM: Held-to-maturity securities. LOAN: Loan. DEPO: Deposits. OFINL: Other financial liabilities. OASSET: Assets other than AFS, HTM, and LOAN. OLIAB: Liabilities other than DEPO and OFINL31. a All variables are deflated by the market value of common stock at the close of previous fiscal year. b All financial instrument variables are at historical cost at fiscal year-end in the HC model. c The variables used in the FV model are the historical cost of all financial instruments except for one variable of interest in each column of the table. For example, the AFS column presents the results of comparing the historical cost model where all variables are in historical cost and modified fair value model where AFS is in fairvalue and all other variables are in historical costs.

cost, but this type of difference is not detected for other financial instruments. 18 Several competing explanations for these findings are plausible. There may be measurement error in the variables included in the regression model or the regression model may be misspecified. Alternatively, there may indeed be no difference in the information content of fair value and historical cost. 19 To the extent that the estimated regression models omit interaction terms between fair value measures of financial instruments and size (or between fair value measures of financial instruments and information environment), the full sample results suffer from misspecification. To explore the measurement error explanation, we used alternative classifications of investment securities. 20 Having a more precise partition to distinguish securities with high versus low measurement error can bolster the measurement error explanation. 21 Unreported results using alternative classifications indicate that neither the fair value of equity securities nor the fair value of US Treasury securities (both of which presumably are more actively traded) possesses more information content than historical cost. Our inability

18 Federal Reserve Board (1998), the regulator of BHCs, requires exclusion of unrealized gains or losses from available-for-sale securities from the numerator of the Tier 1 and Tier 2 capital ratios (12 CFR Ch. II Part 225, App. A, 1-1-98 Edition). Our finding that fair value of available-for-sale securities is more highly associated with the market value of equity suggests that fair value measure is more informative about equity risk. Thus, including the unrealized gains or losses from availablefor-sale securities may provide useful information on BHCsÕ risk-based capital. 19 We thank an anonymous reviewer for suggesting these competing explanations. 20 Petroni and Wahlen (1995, p. 721) suggest that different types of investment securities have different reliability. They found that only fair value of equity investments and US Treasury investments are incrementally significant in explaining share prices of property-liability insurers. 21 We thank two anonymous reviewers for suggesting this line of inquiry.

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to detect the difference for securities identified as frequently traded in wellestablished markets may be due to imperfect partitioning. To explore the model misspecification explanation, we partition the sample into subgroups with differential ability to estimate fair value for financial instruments for which quoted market price is not readily available. Size and information environment of BHCs are used as the partitioning variables. Panels B and C of Table 5 report the results of relative informativeness tests of historical cost and fair value measures of individual financial instruments for the partitions based on size and analystsÕ forecast dispersion, respectively. 22 An examination of the VuongÕs Z-statistic for available-for-sale securities indicates that fair value of available-for-sale securities explains more of the variation in market value of equity than historical cost in the full sample. However, none of the VuongÕs Z-statistics (except for no analyst partition in Panel C) are statistically significant at 0.10 level in the sub-samples. Given the small size of the sample partitions, we are unable to rule out low power of the tests as an alternative explanation for observing significant differences between fair value and historical cost of available-for-sale securities for the full sample in Panel A of Table 5 but not for the sample partitions in Panels B and C. Results for the smallest BHCs in the sample indicate that loans, deposits and other financial liabilities are the driving force behind the higher explanatory power of historical cost model over the fair value model as reported in Panel A of Table 4. For the other three size quartiles, fair value of individual financial instruments does not reliably provide greater relative information content. 23 Results for the no-analysts partition (reported in Panel C) indicate that loans and deposits drive the higher explanatory power of historical cost model over the fair value model as reported in Panel B of Table 4. Following Lang and LundholmÕs (1996, p. 483) finding that high quality of disclosure attracts more analysts, the information environment of BHCs with no analysts following can be viewed as less transparent than that of BHCs with analysts following. Overall, the evidence for the smallest BHCs and for the no-analyst partition is consistent with the notion that fair value is less informative for firms with lower ability to generate reliable information and for firms with less transparent information environment.

22

We also analyzed the data by partitioning our sample into three groups based on financial liquidity (measured as loans-to-deposits ratio used by Eccher et al., 1996, p. 103). For the two most liquid groups, we find that the explanatory power of fair value of all financial instruments collectively or individually is not statistically different from that of historical cost at the 0.10 level. However, for the least liquid group, we find that the explanatory power of fair value of availablefor-sale securities is greater than that of historical cost at the 0.05 level. 23 We cannot rule out the low power of our subsample tests as an explanation for the lack of statistical significance.

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Results for the high, medium, and low analyst forecast dispersion partitions indicate that fair value of individual financial instruments does not reliably provide greater relative information content. In other words, we are unable to detect the dominance of fair value over historical cost for the financial analystsÕ forecast dispersion partitions.

7. Conclusion The FASB is moving toward the concept of carrying all financial instruments in the balance sheet at fair value. There already exists some mixed evidence on the incremental value relevance of fair value for banks. In this paper, we examine whether fair value is more informative than historical cost (and vice-versa) in explaining equity values in the banking industry. Our results indicate that the association of historical cost of financial instruments with equity values is not different from the association of fair value of financial instruments with equity values for our sample of BHCs during 1995–98. However, historical cost is more informative to fair value for a subset of BHCs, namely small BHCs and those with less transparent information environment. Further analysis indicates that historical cost of loans and deposits are driving this result. Because loans and deposits are not as actively traded in well-established markets as investment securities, estimating fair value of these financial instruments involves more subjectivity in identifying the methods and in making assumptions. In contrast, fair value of available-forsale securities, which are more actively traded in well-established markets, explains equity values more than historical cost. Taken together, our results are consistent with the notion that fair value is more value relevant when objective market-determined fair value measures are available. Alternatively, fair value is less value relevant when objective fair value measures are not available. Given the small changes in unexpected interest rate during our sample period of 1995–98, a caution should be exercised in generalizing our results. Our evidence documenting no discernible difference between historical cost and fair value measures collectively for the entire sample in explaining equity values may be limited to our sample period. It is possible that the FASBÕs assertion of the superiority of fair value over historical cost may be more valid during the periods of large fluctuations in interest rates. Furthermore, it is possible that our results may not apply to firms in other industries. Future research may explore relative information content of fair value measures disclosed by firms in non-financial industries. Overall, our results suggest that simply requiring fair value as the reported measure may not improve the quality of information for all BHCs unless appropriate estimation methods (or guidance) for the financial instruments, that are not traded in active markets, are used by firms with less sophisticated in-

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formation systems. The efficacy of fair value accounting system is closely related to the measurement of fair value estimates. Recent announcement by the FASB to establish an objective of issuing a statement that would describe more specifically how to determine fair value for financial instruments is a step in the right direction.

Acknowledgements We gratefully acknowledge the helpful comments and suggestions of two anonymous reviewers and forum participants at the 2001 annual meeting of the American Accounting Association. We thank Bruce Bettinghaus for sharing his data to address a reviewerÕs comment. We also thank I/B/E/S International, Inc. for providing earnings per share forecast data, available through the Institutional Brokers Estimate System.

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