Fair Value Accounting and the Predictive Ability of Earnings: Evidence from the Banking Industry

Abstract

This paper examines whether fair value adjustments included in other comprehensive income (OCI) can predict future performance in banks. We also examine whether the reliability of these fair value estimates affects their predictive value. Using a sample of bank holding companies, we find that fair value adjustments included in OCI can predict bank earnings both one and two years ahead. However, not all fair value related unrealized gains and losses included in OCI have similar implications for future performance. While unrealized gains and losses on available-for-sale securities are positively associated with future earnings, unrealized gains and losses on derivative contracts classified as cash flow hedges are negatively associated with future earnings. We also find that the predictive value of fair value estimates is enhanced when fair values are measured more reliably. Finally, we show that fair value adjustments recorded in OCI during the 2007-2009 financial crisis were predictive of future profitability, contradicting the criticism that fair value accounting forced banks to record excessive downward adjustments. Overall, our findings support the view of the Financial Accounting Standards Board and International Accounting Standards Board that use of fair value estimates in financial reporting meets their objective of providing decision-useful information about future firm performance.