When a firm suffers from a credit downgrade, will it be possible for the firm to record a large unrealized gain in its income? The answer is yes under the accounting standard SFAS No. 159 of the U.S. GAAP. This accounting rule allows firms to choose fair valuing their debt liabilities, which results in recognition of unrealized gains and losses from debt valuation adjustments (DVA) when a firm’s own credit risk changes. For example, during the recent financial crisis, Goldman Sachs reported a pretax profit of $2.3 billion in 2008, approximately half of which represented unrealized gains from DVA.
Critics have raised concerns about the counterintuitive income consequences of Debt Valuation Adjustment (DVA), namely, when a firm’s credit risk increases (i.e., bad news), debt values decrease, and resulting DVA gains increase the firm’s income (i.e., good news).
Associate Professor Changling Chen from the School of Accounting and Finance and her co-authors Matthew Cedeegreen (University of Pennsylvania) and Kai Chen (Wilfrid Laurier University) provide insights into the implication of balance sheet incompleteness for the counterintuitive income effect of DVA. Specifically, DVA gains and losses are not properly offset by corresponding adjustments of unrecognized asset value (UAV), either because some assets are not recorded at fair value, or because some assets are not recorded on the balance sheet, to begin with.
Using a sample of U.S. bank holding companies during 2007–2013, Changling Chen and her colleagues show that while the association between equity returns and DVA is positive when the level of UAV is low, the association decreases and eventually turns negative with increasing levels of UAV. Their findings suggest that the relation between equity returns and DVA gains and losses is influenced by UAV.
Matthew Cedegren, Changling Chen and Kai Chen. 2019. The Implication of Unrecognized Asset Value on the Relation between Market Valuation and Debt Valuation Adjustment.
Review of Accounting Studies, forthcoming.