The Implication of Unrecognized Intangible Assets on the Relation between Market Valuation and Debt Valuation Adjustment

Abstract

U.S. firms have the option to measure debt liabilities at fair value, which results in unrealized gains and losses from debt valuation adjustments (DVA) when a firm’s own credit risk changes. Critics raise concern on the counterintuitive net income consequence of DVA, namely, when a firm’s credit risk increases (i.e., bad news), debt values decrease and resulting DVA gains increase the firm’s net income (i.e., good news). Prior research posits that the perplexing net income effect of DVA is attributable to incomplete fair value accounting for contemporaneous assets such as unrecognized intangible assets (UIA). Specifically, DVA gains or losses are not properly offset by opposite fair value adjustments of UIA in net income. In this paper, we examine market valuation reactions to DVA gains and losses, conditioning on the level of UIA. We first develop a model to demonstrate the mitigating effect of UIA on the relation between equity returns and DVA. Using a sample of U.S. bank holding companies during 2007–2013, we show that while the association between equity returns and DVA is positive when the level of UIA is low, the association decreases and turns from positive to negative with increased levels of UIA. Our findings suggest that the market appears to understand the offsetting relation between DVA and changes in UIA fair values resulting from a firm’s own credit risk change.