Mixing fair-value and historical-cost accounting: predictable other-comprehensive-income and mispricing of bank stocks

Abstract

Other comprehensive income (OCI) items are often considered to be transitory (Chambers et al. 2007; IASB 2013; CFA2014). In this paper, we show that a significant portion of OCI, namely unrealized gains and losses (UGL) from available-for-sale (AFS) debt securities, is non-transitory: a negative correlation between accumulated unrealized gains and losses in the current period and next period UGL is predicted, and we show that this correlation is economically and statistically significant. This correlation is due to a mix of accounting methods of measurement of income from fixed-income securities: UGL are recognized based on fair values, whereas interest income is measured based on historical cost. We document that (1) this negative correlation helps explain a previously unexplained negative correlation in other comprehensive income (OCI), and (2) investors seem to price total UGL disregarding (or not understanding) the predictable, accounting-driven component of UGL.