Paper 2

THE ACCOUNTING REVIEW American Accounting Association
Vol. 93, No. 6 DOI: 10.2308/accr-52007

November 2018
pp. 257–279
Does Fair Value Accounting Provide More Useful Financial

Statements than Current GAAP for Banks?
John M. McInnis
Yong Yu
The University of Texas at Austin
Christopher G. Yust
Texas A&M University
ABSTRACT: Standard setters contend that fair value accounting yields the most relevant measurement for financial
instruments. We examine this claim by comparing the value relevance of banks’ financial statements under fair value
accounting with that under current GAAP, which is largely based on historical costs. We find that the combined value
relevance of book value of equity and income under fair value is less than that under GAAP. We also find that fair
value income is less value-relevant than GAAP income because of the inclusion of transitory unrealized gains and
losses in fair value income. More surprisingly, we find that book value of equity under fair value is not more value-
relevant than under GAAP, due both to divergence between exit value and value-in-use and to measurement error in
fair value estimates. Overall, our results suggest that financial statements under fair value accounting provide less
relevant information for bank valuation than financial statements under current GAAP.
Keywords: fair value; historical cost; ﬁnancial instrument; bank; value relevance.
I. INTRODUCTION
U
nder current generally accepted accounting principles (GAAP), the majority of financial instruments are measured
using historical cost. Standard setters, however, contend that fair values are more relevant and have advocated
measuring all financial instruments at fair value (Financial Accounting Standards Board [FASB] 1998, 2006, 2010a).
Surprisingly, there is little evidence on whether measuring financial instruments using fair value in lieu of current GAAP
enhances overall financial statement relevance. Extant literature has investigated whether fair values of financial instruments
have incremental value relevance beyond that of historical costs (Landsman 2007). In contrast, less attention has been paid to
the relative value relevance, which is critical when policy makers must make ‘‘either/or’’ choices among competing accounting
methods (Biddle, Seow, and Siegel 1995). We aim to fill this void by comparing the value relevance of banks’ financial
statements (balance sheets and income statements) under fair value and current GAAP.
We focus on banks because financial instruments comprise a substantial part of their balance sheets and, therefore, allow us
to compare financial statements measured almost exclusively under both fair values and historical costs. Banks are, thus, one of
the cleanest and most powerful settings in which to test the notion that fair value accounting enhances financial statement
relevance relative to current GAAP. Prior work (Hann, Heflin, and Subramanyam 2007) finds that pension fair values impair
the value relevance of financial statements for industrial firms. However, pensions are not financial instruments, do not relate to
the core business of industrial firms, and represent a relatively smaller part of their financial statements. In contrast, fair values
are arguably easier to estimate for financial instruments than for pensions, and banks’ operations center around holding
We especially thank K. R. Subramanyam (editor) for many helpful comments and suggestions. We also appreciate constructive comments from Brett
Cantrell, Lisa De Simone, Robert Freeman, Mingyi Hung, Bin Ke, Lisa Koonce, Brian White, Guochang Zhang, two anonymous referees, and workshop
participants at The Hong Kong University of Science and Technology, National Taiwan University, National University of Singapore, Texas A&M
University, The University of Hong Kong, and The University of Texas at Austin. We are grateful to the McCombs School of Business at The University
of Texas at Austin for financial support.
Editor’s note: Accepted by K. R. Subramanyam, under the Senior Editorship of Mark L. DeFond.
Submitted: February 2015
Accepted: November 2017
Published Online: January 2018
257
258 McInnis, Yu, and Yust
financial instruments. Thus, if fair value accounting does improve the value relevance of financial statements at all, it is most
likely to do so for banks or similar financial institutions.
Theoretically, it is unclear whether exit value-based fair value accounting or historical cost-based GAAP provides more
value-relevant bank financial statements. Both regimes, in their ‘‘ideal’’ forms, provide complete information for valuation
through either the balance sheet or the income statement. In perfect and complete markets, exit values contain no measurement
error and coincide with total value to shareholders (i.e., value-in-use), so the market value of the firm simply equals the sum of
stand-alone exit values, much like a mutual fund. Here, fair (exit) values produce a balance sheet where accounting equity
equals market value of equity, so the income statement is unnecessary for valuation (Barth and Landsman 1995). Conversely,
in its ideal form, historical costs under GAAP yield ‘‘permanent’’ income, the capitalized value of which equals market value,
thus making the balance sheet unnecessary for valuation (Nissim and Penman 2008).
In practice, however, neither regime satisfies these ideals. Markets are neither perfect nor complete, so exit values must be
estimated and contain measurement error. Further, banks manage financial instruments under a business plan, causing value-in-
use to differ from exit value because of non-separable intangibles (e.g., core deposits, customer relationships, and asset
synergies). Thus, an exit value-based balance sheet fails to capture total shareholder value. Likewise, GAAP income for banks
contains transitory components (e.g., loan losses and realized gains/losses) and does not equal permanent income. Therefore,
both the balance sheet and the income statement are needed to explain share prices under either regime, and which regime
provides a more value-relevant set of financial statements is ultimately an empirical question.
We use banks’ fair value disclosures for financial instruments to construct financial statements under fair value accounting
for a large sample of 9,844 bank-years over 1996–2013. We use the Ohlson (1995) framework to compare the value relevance
of banks’ financial statements under fair value and GAAP. We use explanatory power (Adjusted R2) for stock prices to gauge
value relevance and examine both levels (price) and changes (returns) specifications. First, we find that GAAP financial
statements, on a combined basis (i.e., book value of equity and income together), have significantly more explanatory power for
prices than fair value financial statements, suggesting that banks’ financial statements measured under current GAAP are more
value-relevant than those measured using fair values. Next, we test the value relevance of income statements and balance sheets
separately. Not surprisingly, GAAP net income has much more explanatory power for prices than fair value income. More
surprisingly, GAAP equity has statistically more explanatory power for prices than fair value equity, although the magnitude of
the difference is small. Thus, even for book value of equity, fair values do not appear to have higher value relevance than
current GAAP measurement.
We next investigate whether transitory unrealized gains and losses explain the lower value relevance of fair value income,
as in Hann et al. (2007). We find that fair value income is more volatile and less persistent than GAAP net income, and the
disaggregation of income into transitory and persistent components significantly improves the explanatory power of fair value
income for prices relative to GAAP net income. These results suggest that the aggregation of transitory gains and losses with
more persistent components drives the lower value relevance of fair value income.
We then investigate two reasons why fair value accounting fails to provide more value-relevant book value of equity than
GAAP. The first is the divergence between value-in-use and exit value. To test this possibility, we examine the relative
explanatory power of fair value equity over GAAP for distressed banks, because distress should increase the threat of
liquidation and the relevance of exit values for stock prices (Barth, Beaver, and Landsman 1998). We use two methods to
identify distressed banks (their respective control group): (1) failed banks in the two-year period immediately preceding failure
(the same banks three and four years before failure or a sample of non-failed banks matched concurrently on year, size, and loan
composition); and (2) banks during the financial crisis (2007–2009) (the same banks pre-crisis [2004–2006]). We find that the
explanatory power of fair value equity improves relative to GAAP equity for distressed banks under either method of
identifying distressed banks. These results are consistent with the failure of exit values to capture value-in-use impairing the
value relevance of the fair value balance sheet.
The second reason why fair value accounting fails to provide more value-relevant book value of equity than GAAP is
measurement error in fair values estimates (e.g., Barth 1994; Nelson 1996; Song, Thomas, and Yi 2010). We test this
possibility using three complementary tests based on the fair value hierarchy. First, we examine the impact of excluding the
recognized fair values measured at Level 1 versus Level 3 on the explanatory power of fair value equity for prices.1 We find
that excluding Level 1 recognized fair values significantly reduces the explanatory power of fair value equity, while excluding
Level 3 recognized fair values has little impact. Second, we compare the pricing coefficients for recognized Level 1 versus
Level 3 fair value net assets. Consistent with Song et al. (2010), we find that compared with recognized Level 3 fair value net
1
This test allows us to compare the value relevance of Level 1 and Level 3 fair values, while holding their asset type (mostly available-for-sale [AFS]
securities) and magnitude relatively constant. A caveat of this test, however, is that it excludes all recognized Level 1 or Level 3 assets from the
analysis, rather than just their fair value difference.
The Accounting Review

Volume 93, Number 6, 2018
Does Fair Value Accounting Provide More Useful Financial Statements than Current GAAP for Banks? 259
assets, recognized Level 1 fair value net assets have a significantly larger pricing coefficient and contribute more to the
regression’s explanatory power. Third, we use a subsample where we have the fair value hierarchy for all financial instruments,
rather than just those recognized at fair value. We calculate Level 3 percentage (Level 3 net assets divided by the sum of Levels
1–3 net assets) for each bank and then partition this sample based on the median percentage. We find that the relative
explanatory power of fair value equity is higher for banks with fewer Level 3 financial instruments. Collectively, these results
suggest that measurement error in fair value estimation also contributes to the failure of fair values to generate a more value-
relevant balance sheet than GAAP.
Our study contributes to the literature on fair value accounting for financial instruments by examining the relative value
relevance of banks’ financial statements under fair value versus current GAAP. Prior work has examined relative risk relevance
and finds evidence that fair values provide more information about volatility and credit risk than GAAP (Hodder, Hopkins, and
Wahlen 2006; Blankespoor, Linsmeier, Petroni, and Shakespeare 2013). Past studies on value relevance, however, have largely
examined incremental value relevance, finding some evidence that certain fair value items are incrementally value-relevant
beyond GAAP measures (e.g., Barth, Beaver, and Landsman 1996; Eccher, Ramesh, and Thiagarajan 1996; Nelson 1996;
Venkatachalam 1996). One notable exception is Khurana and Kim (2003), who find no difference in the relative value
relevance of GAAP and fair value bank balance sheets. However, they do not examine the combined financial statements or the
income statement. Thus, the key takeaway from our paper that cannot be discerned from prior work is that, relative to current
GAAP, fair values produce balance sheets and income statements that together are less relevant for bank valuation.
This study is related to Hann et al. (2007), who show that pension fair values impair the value relevance of the combined
financial statements and income statements for industrial firms. We contribute beyond Hann et al. (2007) in two ways. First, we
demonstrate that the impaired value relevance from fair value accounting applies to banks, as well. This is an important
extension that has broader implications for the ongoing fair value debate because banks are arguably one of the most likely
settings where fair value accounting would provide more relevant measurement than historical cost-based current GAAP. That
fair value-based financial statements are not more value-relevant than current GAAP statements even for banks raises
significant doubts about the ability of fair value accounting to generally improve the relevance of financial statements. Second,
unlike Hann et al. (2007), we investigate reasons why fair value book equity is not more value-relevant than GAAP equity.
Specifically, we show that both the divergence between value-in-use and exit value and measurement error in fair value
estimation impair the value relevance of fair value-based book equity.
Two caveats are in order. First, because GAAP measurements are recognized on the financial statements while fair value
measurements are only disclosed in footnotes, stock prices could mechanically correlate more with GAAP numbers than with
fair values if investors put greater weight to recognized than disclosed information. However, we mitigate this concern by
finding similar results using ex post intrinsic value in place of stock prices (Subramanyam and Venkatachalam 2007). Second,
while our explanatory power results indicate that fair value book equity is not more value relevant than GAAP book equity, we
also find that the coefficient on fair value book equity is closer to the theoretical value of 1. This result could indicate that fair
value book equity has higher representational faithfulness (Barth 1991).
Section II provides background and theoretical discussion. Section III describes our design, and Section IV discusses the
sample. Section V reports the results, and Section VI concludes.
II. BACKGROUND AND THEORETICAL DISCUSSION
Background
Virtually all bank assets and liabilities are financial instruments. Panel A of Table 1 shows the major financial instruments
on banks’ balance sheets as a proportion of the total assets or liabilities for banks in our sample (described in Section IV).
Loans are banks’ largest asset, comprising, on average, about 66 percent of total assets, followed by securities (22 percent).
Deposits are banks’ largest liability, representing, on average, about 83 percent of total liabilities, followed by debt (15
percent).
The vast majority of banks’ financial instruments are currently recognized on the balance sheet on a historical cost basis
under GAAP. Loans held for investment are generally reported at amortized historical cost on the balance sheet, net of loan loss
reserves for uncollectibility. Most banks similarly account for deposits and debt using historical cost. The measurement basis
for securities, on the other hand, is mixed. Securities intended to be held-to-maturity (HTM) are accounted for on a historical
cost basis, with unrealized changes in fair value generally unrecognized unless realized through sale. Trading and AFS
securities are reported at fair value.
Other financial instruments not included in Table 1 include loans held for sale, which are measured at the lower of cost or
fair value, and derivative assets and liabilities, which are measured at fair value (Accounting Standards Codifications [ASC]

TABLE 1
Banks’ Financial Statements under Current GAAP versus Fair Value Accounting
Panel A: Magnitude and Measurement of Banks’ Major Assets/Liabilities under Current GAAP and Fair Value
Accounting
Mean % Mean % of Levels 1, 2, or 3 Measurement if Measured
of Bank Fully at FV
Major Bank Assets/ Measurement
Assets/Liabilities Liabilities under GAAP Level 1 Level 2 Level 3
Assets
Securities 22.1% Mixed 3.9% 92.3% 3.9%
Loans Held for Investment 66.4% Cost 0.0% 14.4% 85.6%
Liabilities
Deposits 83.2% Cost 19.0% 71.7% 9.3%
Debt 15.1% Cost 9.6% 81.7% 8.8%
Panel B: Magnitude of Percentage Changes in Banks’ Book Equity and Income from Current GAAP to Fair Value
Accounting
n Mean P10 P25 P50 P75 P90
jEQUITY_FV EQUITY_GAAPj/EQUITY_GAAP 9,844 8.33% 0.74% 2.04% 4.80% 10.31% 20.23%
jINCOME_FV INCOME_GAAPj/jINCOME_GAAPj 9,844 139.96% 8.33% 22.69% 57.03% 135.50% 305.94%
This table presents current GAAP rules and fair value measurements for banks’ major assets and liabilities and the impact of switching from current GAAP
to fair value accounting on banks’ book equity and income. Panel A reports the magnitude of banks’ major assets and liabilities scaled by total assets or
total liabilities, respectively, and reported as a percentage based on the full sample of 9,844 bank-years and the measurement basis under current GAAP for
each item. The mixed measurement under GAAP for securities is due to trading and AFS securities being measured at fair value, with unrealized gains and
losses for trading (AFS) recorded in NI (OCI) and HTM securities being measured at cost. Panel A also presents, for each major asset or liability category,
the average percentage of that category that would be measured at Level 1, 2, and 3 fair values, assuming each item was required to be recognized fully at
fair value. For example, for securities in the fourth column, we scale the dollar value of securities measured at Level 1 by the total dollar value of all
securities and take the mean of this value across banks. This Level 1/2/3 information for each item is based on a random sample of 100 banks since this
information is not available in commercial databases. Panel B reports the magnitude of percentage changes in banks’ book equity and income if banks
were to switch from current GAAP to fair value accounting for all major assets and liabilities based on the full sample of 9,844 bank-years. The percentage
change in banks’ book equity is calculated as the absolute difference between fair value book equity and GAAP book equity, scaled by GAAP book
equity, and the percentage change in banks’ income is calculated as the absolute difference between fair value income and GAAP income, scaled by the
absolute value of GAAP income. All variables are winsorized at the 1 percent and 99 percent levels.
See Appendix B for variable definitions.
320, 815, and 942).2 Current GAAP (ASC 825, formerly Statement of Financial Accounting Standards [SFAS] 107) also
requires disclosure of the fair value of all financial instruments, including the items above (e.g., HTM securities, loans, deposits,
and debt) recognized at historical cost. These disclosed fair values are verified as part of the annual audit (Barth et al. 1996).
Under current GAAP (ASC 820, formerly SFAS 157), all fair values are required to be an exit price, defined as ‘‘the price
that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date’’ (FASB 2010c). Thus, all fair value estimates under GAAP, whether recognized or disclosed, are exit values
and do not necessarily represent value-in-use (i.e., total value to shareholders). For example, the disclosed fair value of a loan
portfolio represents a hypothetical stand-alone selling price and excludes inseparable intangibles such as customer
relationships.
ASC 820 categorizes the inputs to fair value measurement into Level 1 (quoted prices in active markets for identical items),
Level 2 (market prices other than those included within Level 1 that are observable), and Level 3 (firm-specific significant
unobservable inputs that are used in a valuation model), with Level 1 (3) fair value estimates being the most (least) reliable.
2
Banks can choose the fair value option for specific financial instruments after 2007 (ASC 825), but most banks did not use this option (Chang, Liu, and
Ryan 2011).

Panel A of Table 1 lists the percentage of banks’ financial instrument fair values measured at each of these levels, based on a
random sample of 100 bank-years with disclosures of the fair value hierarchy.3 Note that for HTM securities, loans, deposits,
and debt, these fair values are not recognized on the balance sheet, but instead are only disclosed under ASC 825.
For the average bank in our sample, the vast majority of loan fair values (86 percent) are Level 3 estimates, while most
security (92 percent), deposit (72 percent), and debt (82 percent) fair values are Level 2 estimates (see Table 1, Panel A). Thus,
compared with other instruments, loan fair values tend to be less reliably estimated and contain greater measurement error. This
is not surprising because most loans have no quoted market prices, so banks estimate fair values using valuation models. The
estimation involves substantial uncertainty and judgment in choosing a valuation method, implementing the method, assessing
determinants of fair value, and making assumptions and forecasts (see Nissim 2003; Nissim and Penman 2007).4
Standard setters have long advocated the goal of eventually requiring all financial instruments to be measured at fair value.
For example, in 2008, the FASB and IASB requested comment letters on reducing accounting complexity for financial
instruments, and noted, ‘‘a long-term solution is to measure in the same way all types of financial instruments within the scope
of a standard for financial instruments . . . fair value seems to be the only measurement attribute that provides relevant
information for all types of financial instruments’’ (FASB 2008, 12). This long-term objective culminated in the FASB’s
proposal that virtually all financial instruments be recognized at fair value, with changes in fair value recognized in net income
(NI) or other comprehensive income (OCI), with limited exceptions (FASB 2010a), and that OCI be reported on the income
statement, with NI becoming a subtotal and ‘‘total’’ comprehensive income (CI) becoming the new bottom line (FASB 2010b).
Collectively, banks would report fair value for virtually all assets and liabilities on the balance sheet with an income measure
fully based on fair value as the bottom line on the income statement. However, after much controversy, the FASB decided not
to adopt these proposals and to instead retain existing historical cost measurement for most financial instruments (FASB 2016).
Regardless of these policy decisions, it is interesting to consider the potential impact of switching from current GAAP to
fair value accounting on banks’ financial statements. Panel B of Table 1 reports the absolute percentage changes in book value
of equity and income if banks were required to report all financial instruments at fair value using our sample. Specifically, for
each bank-year, we first compute book equity and income under fair value accounting (i.e., as if all instruments were reported at
fair value), and then compute the absolute difference between GAAP equity (income) and fair value equity (income), scaled by
GAAP equity (the absolute value of income). We report absolute changes because switching to fair value accounting can either
increase or decrease book equity and income across banks.
Relative to current GAAP, the mean (median) absolute percentage change in book equity is about 8 (5) percent if banks
reported all financial instruments at fair value (see Table 1, Panel B). For the top 25 (10) percent of banks with the largest
changes, the changes would be in excess of 10 (20) percent of equity. To assess economic significance, we benchmark these
hypothetical changes in equity from switching to fair value accounting against actual year-to-year changes in GAAP equity. In
our sample, the mean (median) actual absolute percentage change in GAAP equity in a year is 18 (9) percent (untabulated).
Thus, adopting fair value accounting would change equity by about 50 percent of the average yearly change in equity for bank.
Untabulated results indicate that the biggest changes in equity from switching to fair value accounting come from loans, with an
average absolute change from reporting loans at fair value equal to about 8 percent of equity.
Even more significant changes would result in income. The mean (median) absolute percentage change in income is about
140 (57) percent, respectively, if banks reported all financial instruments at fair value, with all fair value changes flowing
through income. Given that the mean (median) actual absolute year-to-year percentage change in GAAP income is 93 (23)
percent in our sample (untabulated), adopting fair value accounting would increase both the mean and median percentage
changes in income by more than 50 percent (i.e., 140/93 for the mean and 57/23 for the median) for an average bank.
Untabulated results indicate that the biggest contributor is fair value changes for loans, which result in a mean (median)
absolute change of about 148 (50) percent of income, with securities (mean [median] changes of 48 [17] percent of income) and
loans and deposits (mean [median] change of 76 [24] percent of income) contributing to significant changes in income, as well.
Overall, Table 1, Panel B shows that adopting fair value accounting for all financial instruments would have an economically
significant effect on both banks’ book value of equity and income, with the latter being more affected.
Theoretical Discussion
Given that book value of equity and income are the primary summary measures in accounting, prior literature examines
how well these two constructs explain market equity prices (e.g., Barth et al. 1998; Francis and Schipper 1999; Collins,
3
Banks were required to disclose data on the fair value measurement hierarchy for all major assets and liabilities in 2012. However, the data are
unavailable from commercial databases. Thus, we randomly select 100 bank-years from our sample with such disclosure available from their 10-K
filings and hand-collect the data.
4
See Nissim and Penman (2007) for detailed discussions of the estimation and sources of measurement error.

Maydew, and Weiss 1997). Ohlson (1995) formulates the market value of equity for a firm as a weighted average of its book
value of equity (the balance sheet) and income (the income statement). In the Ohlson (1995) model, the more (less) persistent
abnormal income is, the greater the weight on income (book value of equity) is in explaining market value.
Under ideal fair value accounting for banks, input and output markets are perfect and complete, so there is no difference
between the exit value of an asset and its value-in-use. Under these ideal conditions, the sum of the exit values of the net assets
of a bank equals the market value of the bank, which is the discounted expected cash flows accruing to shareholders (i.e., the
value-in-use of the net assets). In addition, income is simply the change in the exit values of the net assets in each period (the
Hicksian definition of economic income) and is completely transitory and unpredictable. The weight on book value of equity
(income) in the Ohlson (1995) framework is 1 (0), as income is unnecessary to provide information about market value. Thus,
ideal fair value accounting generates a book equity measure that provides complete information for valuation and an income
measure that is redundant.
Under ideal historical cost accounting for banks, income measures the long-run persistent difference between (1) income
from investing in loans and other instruments, and (2) the cost of raising funds for these investments, including interest costs
and credit losses. Current income captures permanent income and perfectly predicts long-run expected income, and the market
value of the bank is simply current income divided by the appropriate discount rate. In the Ohlson (1995) framework, under
these conditions, book value of equity is unnecessary to provide information about the market value (Nissim and Penman
2008). Thus, ideal historical cost accounting generates an income measure that provides complete information for valuation and
a book equity measure that is redundant.5
In practice, fair value accounting for banks deviates from the ideal form in at least two ways. First, input and output
markets are neither perfect nor complete, so stand-alone exit value deviates from value-in-use because of inseparable
intangibles, such as core deposits, customer relationships, and asset synergies. For example, rising interest rates decrease the
exit price of a fixed-rate loan portfolio. However, bank managers can leverage their customer relationships to generate new
loans at these higher rates to boost future income. Further, the core deposit intangible—banks’ ability to borrow money from
‘‘sticky’’ depositors at below-market rates—rises in value as interest rates rise. Thus, a rise in interest rates may lower loan exit
values, but have little impact on expected income accruing to bank shareholders from the loan portfolio and related intangible
assets (i.e., value-in-use). As a result, book value of equity measured using fair value (i.e., exit values), even if measured with
no error, will not equal market value.
Second, the majority of banks’ assets and liabilities, including most loans, deposits, and debt, are not traded in active
markets, so exit prices must be estimated. Such estimates frequently use unobservable measures and require bank-specific
assumptions, which can involve both intentional and unintentional measurement error (see hierarchy levels in Panel A of Table
1). Thus, book value of equity under fair value will no longer be perfectly value-relevant, and fair value income may play some
valuation role in forecasting cash flows accruing to shareholders. For example, if equity at exit prices measures the discounted
expected cash flows accruing to bank shareholders with error, then fair value income, which includes the current-period net
interest margin, may help incrementally forecast these cash flows.
Similarly, in practice, current GAAP for banks also deviates from the ideal historical cost accounting discussed above.
GAAP income contains transitory components, such as changes in loan losses across the business cycle and realized gains and
losses from securities sales. Although largely based on historical cost, GAAP income also contains transitory fair value gains
and losses on items such as derivatives and trading assets. Further, because GAAP income is based on historical, not current,
interest rates, income ‘‘persistence’’ may be illusory because as soon as existing positions (e.g., loans and borrowings) mature,
the bank must replace these positions at current market rates, creating a transitory element in the net interest margin (Ryan
2008). Likewise, the persistence of GAAP income is also illusory to the extent that it ignores changes in current credit
conditions and focuses only on incurred credit losses (Trott 2009). Additionally, critics contend that by focusing on just
realized income, GAAP allows for ‘‘gains trading’’ (Ryan 2008). As a result, book value of equity under GAAP will likely play
at least some role in forecasting expected cash flows accruing to bank shareholders.
In sum, since the ideal forms do not hold, we expect the valuation usefulness of GAAP and fair value financial statements
to come from a mix of the balance sheet (book value of equity) and the income statement (income). However, which regime
yields more useful combined information for assessing expected cash flows for bank shareholders is unclear. Therefore,
whether the combined value relevance of banks’ book value of equity and income under current GAAP is higher or lower than
that under fair value accounting is an empirical question. However, given the above discussion, we expect GAAP to yield a
more value-relevant income measure, and fair value accounting to yield a more value-relevant book equity measure.
Although we predict the opposite, we note that it is theoretically possible for GAAP book equity to have higher value
relevance than fair value-based book equity, even in an ‘‘equity only’’ model. Although GAAP book equity provides
5
See Barth and Landsman (1995) and Nissim and Penman (2008) for more details.

incomplete information for valuation, it can proxy imperfectly for value-in-use accruing to shareholders (Nissim and Penman
2008). For example, the amount loaned to customers, less a reserve for credit losses, can proxy imperfectly for the capitalized
value of future income from loan customers. Additionally, fair value-based book equity can be viewed as GAAP book equity
plus or minus fair value adjustments. If fair value adjustments do not capture changes in value-in-use or are sufficiently noisy,
then fair value-based book equity can be less value-relevant than GAAP book equity (e.g., imagine adding pure noise to GAAP
book equity).
III. RESEARCH DESIGN

We use the Ohlson (1995) framework to evaluate the usefulness of GAAP versus fair value financial statements in
explaining banks’ market value. In this framework, market equity can be expressed as a linear function of book value of equity
(the balance sheet) and income (the income statement). We examine both levels (price) and changes (returns) specifications.
Our levels (price) specification is as follows (firm and year subscripts omitted for brevity):
PRICE ¼ b0 þ b1 EQUITY GAAP þ b2 INCOME GAAP þ e ð1Þ
PRICE ¼ b0 þ b1 EQUITY FV þ b2 INCOME FV þ e ð2Þ

PRICE is the market price per share three months after fiscal year-end. We include year fixed effects and cluster standard errors
by bank in all regressions. For Equation (1), we calculate book equity and income using current GAAP: EQUITY_GAAP is the
reported equity per share, and INCOME_GAAP is the reported net income before extraordinary items per share. Consistent with
prior research (e.g., Barth and Clinch 1998; Hann et al. 2007; Song et al. 2010), we use per-share numbers for variables in
Equations (1) and (2) because Barth and Clinch (2009) show that share deflation performs the best in mitigating scale effects in
the Ohlson (1995) model.6
For Equation (2), we calculate book equity and income based on fair values (denoted EQUITY_FV and INCOME_FV).
EQUITY_FV is equal to EQUITY_GAAP plus the difference between reported assets at fair value and book value less the
difference between reported liabilities at fair value and book value, net of tax effects. Similar to prior research (e.g., Hodder et
al. 2006), we use fair value disclosures to obtain differences between current fair values and book values of assets and
liabilities. The biggest drivers of the difference between EQUITY_FV and EQUITY_GAAP are fair value adjustments (i.e.,
accumulated unrealized gains and losses) for loans held for investment, deposits, and debt. INCOME_FV is essentially the net
change in equity from non-owner transactions when all financial instruments are measured at fair value. Similar to prior
research (e.g., Hodder et al. 2006), we calculate INCOME_FV as INCOME_GAAP plus items in OCI (mostly fair value gains/
losses on AFS securities), plus any fair value gains or losses on HTM securities, loans, deposits, bank debt, and other financial
instruments recognized at historical cost on the balance sheet, net of tax.7 Thus, the difference between INCOME_GAAP and
INCOME_FV largely comes from the inclusion in INCOME_FV of unrealized gains/losses on securities, loans, deposits, and
debt. Appendix A provides an example of how we calculate INCOME_FV.
Similar to Dechow (1994), we compare the explanatory power of Equations (1) and (2) via Vuong (1989) tests.8 If the
combined value relevance of book value of equity and income under fair value accounting is higher than that under GAAP,
then Equation (2) will have higher (lower) explanatory power (Adjusted R2) than Equation (1). Further, to test the value
relevance of GAAP versus fair value income, we compare the explanatory power of the income-only version of these
regressions (i.e., Equations (1) and (2) that include income only). Similarly, to test the value relevance of GAAP versus fair
value book equity, we compare the explanatory power of the equity-only version of these regressions.
Along with the levels (price) specification above, we also examine a changes (returns) specification. The price specification
seems more appropriate for our research question, because we are interested in testing how well GAAP and fair value financial
statement information is ‘‘reflected in firm value,’’ rather than ‘‘reflected in changes in value over a specific period of time’’
(Barth, Beaver, and Landsman 2001, 95). However, prior research (e.g., Kothari and Zimmerman 1995) shows that both
specifications are subject to different sets of econometric concerns and suggests that it can be useful to examine both.
6
Our results are robust to scaling by total assets or using an unscaled specification (not tabulated).
7
While OCI includes other items, AFS unrealized gains/losses are the most material component (Hodder et al. 2006). In our sample, the correlation
between AFS unrealized gains/losses and total OCI is 0.934 (not tabulated).
8
We follow the standard approach in Dechow (1994) to calculate the Vuong (1989) statistic, which assumes independent and identically distributed
errors. This assumption, however, may be violated in our setting because our panel data are from one single industry. As a sensitivity check, we also use
the Fama-MacBeth methodology to test whether the average Adjusted R2 from annual regressions is significantly different for GAAP versus fair value
financial statements, and find similar inferences (not tabulated).

TABLE 2
Descriptive Statistics
Variable Name Mean Median Std. Dev.
PRICE 20.231 17.066 13.591
EQUITY_GAAP 14.138 12.705 7.565
EQUITY_FV 14.471 13.034 7.953
INCOME_GAAP 1.118 1.092 1.401
INCOME_FV 1.112 1.045 2.294
This table reports the descriptive statistics for the variables in our levels (price) regressions (Equations (1) and (2)). The sample includes 9,844 bank-years
over 1996–2013. All variables are measured in dollars per share and winsorized at the 1 percent and 99 percent levels.
IV. SAMPLE AND DESCRIPTIVE STATISTICS

We obtain financial statement and other banking data from the SNL Financial Institutions database and price data from
CRSP. SNL collects regulatory data for all financial institutions and financial statement data from their Securities and Exchange
Commission (SEC) filings, including disclosures of the fair value of financial instruments. Our sample consists of all
commercial banks and thrifts (referred to simply as ‘‘banks’’ throughout the paper) from 1996 to 2013 with the data required for
the tests. We start the sample in 1996 and use annual data because SFAS 107 fair values are annual disclosures that became
fully required in 1996. Our full sample contains 9,844 bank-year observations, representing 1,332 unique banks.9 The sample
size for returns specifications is slightly smaller due to requiring the change in income.
Table 2 presents descriptive statistics for the regression variables in Equations (1) and (2). To minimize the influence of
outliers, all variables are winsorized at the 1 percent and 99 percent levels.10 The mean book equity per share under GAAP
(EQUITY_GAAP) and fair value (EQUITY_FV) is $14.138 and $14.471, respectively, for a difference of about 2 percent. For
the income statement, the mean income per share under GAAP (INCOME_GAAP) and fair value (INCOME_FV) is $1.118 and
$1.112, respectively, for a difference of only about 0.5 percent. Thus, although Table 1 shows that the absolute (unsigned)
differences between GAAP and fair value equity and income are large, their signed means are close because fair value
adjustments both increase and decrease GAAP equity and income, leaving the averages similar.
Table 3 presents correlations among the variables in Equations (1) and (2). We discuss Pearson correlations for brevity.
The correlation between PRICE and EQUITY_FV is similar to that between PRICE and EQUITY_GAAP (0.656 versus 0.655).
Thus, stating all financial instruments at fair value does not seem to lead to more value-relevant book equity, perhaps due to the
concerns about fair values discussed in Section II. For the income statement, we find that PRICE is more strongly correlated
with INCOME_GAAP (0.726) than with INCOME_FV (0.481), likely because of the lower persistence of INCOME_FV
relative to INCOME_GAAP.
V. RESULTS
Main Tests
Table 4 presents results of estimating Equations (1) and (2) to compare the value relevance of banks’ financial statements
under fair value versus current GAAP. The Adjusted R2 (hereafter, Adj. R2) from the combined GAAP financial statements
(book equity and income together) is 0.690, compared to 0.594 for the combined fair value-based financial statements (p ,
0.01). This evidence suggests that GAAP financial statements are more value-relevant than fair value-based financial
statements. For the income-only regressions, we find that the model with INCOME_GAAP has a higher Adj. R2 than the model
with INCOME_FV (0.582 versus 0.325, p , 0.01).
9
Our sample includes thrifts because most thrifts and commercial banks began to operate similarly and compete for the same customers for loans
and deposits following deregulation in the 1980s (Federal Deposit Insurance Corporation [FDIC] 1997). In fact, many thrifts have been converted
into commercial banks or acquired by bank holding companies (Ryan 2007). However, excluding thrifts does not affect our inferences (not
tabulated).
10
Results are similar if we truncate all variables at the 1 and 99 percent levels (not tabulated).

TABLE 3
Correlations
Variable Name (1) (2) (3) (4) (5)
(1) PRICE 0.655 0.656 0.726 0.481
(2) EQUITY_GAAP 0.590 0.974 0.551 0.357
(3) EQUITY_FV 0.590 0.963 0.562 0.450
(4) INCOME_GAAP 0.802 0.572 0.579 0.658
(5) INCOME_FV 0.520 0.369 0.459 0.614
This table reports the correlations between the variables in our levels (price) regressions (Equations (1) and (2)). The sample includes 9,844 bank-years
over 1996–2013. Pearson (Spearman) correlations are presented above (below) the diagonal. All correlations are significant at the 1 percent level. All
variables are winsorized at the 1 percent and 99 percent levels.
For the equity-only regressions in Table 4, we find that the model with EQUITY_GAAP actually has a statistically higher
Adj. R2 for share prices than the model with EQUITY_FV (p , 0.01), but the magnitude of the Adj. R2 difference is quite small
(0.584 versus 0.578).11 In addition, while the coefficients on both EQUITY_GAAP and EQUITY_FV are significantly larger
than the theoretical value of 1 (p , 0.01), the coefficient on EQUITY_FV is relatively closer to 1 (1.14 versus 1.20), consistent
with slightly higher representational faithfulness (see Barth 1991). Overall, there is little meaningful difference between the
value relevance of GAAP equity and that of fair value equity.
Table 5 repeats the tests in Table 4 using a changes (returns) specification, which are essentially a first difference of
Equations (1) and (2):
RETURNS ¼ b0 þ b1 INCOME GAAP MV þ b2 DINCOME GAAP MV þ e ð10 Þ
RETURNS ¼ b0 þ b1 INCOME FV MV þ b2 DINCOME FV MV þ e ð20 Þ

where RETURNS is the buy-and-hold stock return cumulated over the fiscal year; INCOME_GAAP_MV (INCOME_FV_MV) is
GAAP net income (fair value income) scaled by the beginning-of-year market value; and DINCOME_GAAP_MV (DINCOME_
FV_MV) is the change in GAAP net income (fair value income) scaled by the beginning-of-year market value. Similar to the
price test in Table 4, we also estimate Equations (1 0 ) and (2 0 ) regressing returns only on income and, separately, changes in
income. Overall, the explanatory power results from the returns specification are directionally consistent with those in Table 4.
The Adj. R2s are all significantly higher under GAAP than fair value (0.497 versus 0.464 for the combined income measures;
0.457 versus 0.437 for changes in income; and 0.488 versus 0.463 for levels of income, p , 0.01).12 We also find similar
inferences when comparing the explanatory power of GAAP and fair value accounting in all remaining tests using return
specifications when possible. For brevity, we tabulate the levels (price) specification only.
Table 5 also shows that the coefficient on changes in income is significantly higher under GAAP than under fair value
(0.507 versus 0.340, p , 0.01). This result is consistent with the expectation that historical cost accounting explains stock
returns mainly through changes in income (Ohlson 1995).13 In contrast, the coefficient on income is significantly lower under
fair value than under GAAP (0.035 versus 0.271, p , 0.01), inconsistent with the expectation that fair value accounting
explains returns mainly through levels of income.
Overall, the results in Tables 4 and 5 indicate that GAAP financial statements appear to be more value-relevant on a
combined basis because (1) GAAP income is more value-relevant than fair value income, and (2) fair value accounting does not
11
The Adj. R2 difference between EQUITY_GAAP and EQUITY_FV becomes larger (approximately two percentage points) when we examine the top
quartile with the largest absolute differences between EQUITY_GAAP and EQUITY_FV (not tabulated).
12
The Adj. R2s in Table 5 are relatively high due to the inclusion of year fixed effects. Excluding year fixed effects reduces the Adj. R2s substantially (i.e.,
the Adj. R2s for the specification including both earnings levels and earnings changes become 0.146 and 0.086 for the GAAP and FV models,
respectively). However, our inferences remain unchanged (not tabulated).
13
Ohlson (1995) suggests that returns can be expressed as a function of earnings and changes in earnings (to see this, take the first difference of his
Equation (7), ignoring dividends and other information for simplicity), and the weight on earnings versus changes in earnings depends on earnings
persistence. Under ideal fair value accounting, earnings are purely transitory, so returns for the period simply equal earnings and earnings changes
receive a weight of 0. In contrast, under ideal historical cost accounting, earnings are permanent, so returns for the period equal the change in earnings
times the discount rate multiplier and earning levels receive a weight of 0. Thus, we would expect fair value accounting to explain returns mainly
through earnings levels, while historical cost (GAAP) accounting should explain returns mainly through earnings changes. In other words, we would
expect fair value accounting to have a larger weight on earning levels, and GAAP to have a larger weight on earnings changes.

TABLE 4
Relative Value Relevance of GAAP versus Fair Value Financial Statements Using Levels (Price) Specification
PRICE ¼ b0 þ b1 EQUITY GAAP þ b2 INCOME GAAP þ e ð1Þ
PRICE ¼ b0 þ b1 EQUITY FV þ b2 INCOME FV þ e ð2Þ
Coefficients
Equity Income Adj. R2
Combined
GAAP 0.751 4.289 0.690
(0.00) (0.00)
FV 1.018 0.912 0.594
(0.00) (0.00)
Difference 0.267 3.377 0.096
(0.00) (0.00) (0.00)
Income-Only
GAAP 6.919 0.582
(0.00)
FV 2.658 0.325
(0.00)
Difference 4.261 0.257
(0.00) (0.00)
Equity-Only
GAAP 1.204 0.584
(0.00)
FV 1.137 0.578
(0.00)
(0.00) (0.01)
Difference from 1
GAAP 0.204
(0.00)
FV 0.137
(0.00)
This table reports the results of comparing the explanatory power for prices of financial statements based on GAAP versus fair value (FV) accounting
using a levels (price) specification (Equations (1) and (2)). The sample includes 9,844 bank-years over 1996–2013. GAAP model Equity (Income) is
EQUITY_GAAP (INCOME_GAAP). FV model Equity (Income) is EQUITY_FV (INCOME_FV). We use Vuong’s (1989) Z-statistic to test the difference
in explanatory power (Adj. R2) between the GAAP and FV models. We use t-statistics to test whether each coefficient is significantly different from zero,
and Chi-squared statistics to test whether the GAAP and FV coefficients are significantly different from each other. We also use F-statistics to test whether
the GAAP and FV equity coefficients are significantly different from 1 in the equity-only model. Year fixed effects are included. Two-tailed p-values
based on standard errors clustered by firm are reported in parentheses.
significantly improve the value relevance of book value of equity relative to GAAP. The income result is not surprising and is
likely due to differences in persistence between GAAP and fair value income. The book equity result is more surprising and
may result from the weaknesses of fair value accounting discussed in Section II. We explore these results in more detail in the
next two subsections.
Further Tests of Income

As discussed in Section II, INCOME_GAAP is likely more value-relevant than INCOME_FV because INCOME_FV
contains more transitory fair value adjustments that are not indicative of a bank’s ‘‘permanent income.’’ The aggregation of
transitory gains/losses into INCOME_FV forces the weight on all gains/losses to be the same, which likely decreases the
explanatory power of the model (Hann et al. 2007). In untabulated tests, we compute bank-specific measures of income

TABLE 5
Relative Value Relevance of GAAP versus Fair Value Financial Statements Using Changes (Returns) Specification
RETURNS ¼ b0 þ b1 INCOME GAAP MV þ b2 DINCOME GAAP MV þ e ð10 Þ
RETURNS ¼ b0 þ b1 INCOME FV MV þ b2 DINCOME FV MV þ e ð20 Þ
Coefficients
Income DIncome Adj. R2
Combined
GAAP 0.507 0.271 0.497
(0.00) (0.00)
FV 0.340 0.035 0.464
(0.00) (0.11)
Difference 0.167 0.306 0.033
(0.00) (0.00) (0.00)
Earnings Changes-Only
GAAP 0.463 0.457
(0.00)
FV 0.118 0.437
(0.00)
(0.00) (0.00)
Earnings Levels-Only
GAAP 0.588 0.488
(0.00)
FV 0.315 0.463
(0.00)
(0.00) (0.00)
This table reports the results of comparing the explanatory power for returns of financial statements based on GAAP versus fair value (FV) accounting
using a changes (returns) specification (Equations (1 0 ) and (2 0 )). The sample includes 8,640 bank-years over 1996–2013. GAAP model Income (DIncome)
is INCOME_GAAP_MV (DINCOME_GAAP_MV). FV model Income (DIncome) is INCOME_FV_MV (DINCOME_FV_MV). We use Vuong’s (1989) Z-
statistic to test the difference in explanatory power (Adj. R2) between the GAAP and FV models. We use t-statistics to test whether each coefficient is
significantly different from zero, and Chi-squared statistics to test whether the GAAP and FV coefficients are significantly different from each other. Year
fixed effects are included. Two-tailed p-values based on standard errors clustered by firm are reported in parentheses.
volatility and income persistence from auto-regressions using INCOME_FV and INCOME_GAAP. We find that compared to
INCOME_GAAP, INCOME_FV is much more volatile and has much lower persistence.
To investigate the role of persistence in our income results, we estimate the income-only version of Equations (1) and (2)
after decomposing both INCOME_GAAP and INCOME_FV into their relatively persistent (PERSISTENT_INC) and transitory
(TRANSITORY_INC_GAAP/TRANSITORY_INC_FV) components based on untabulated persistence regressions. The sample
for this test includes 3,635 bank-years (representing 563 unique banks) after 2006, which is the first year that fair value data by
asset and liability type became available in SNL. In these regressions, we find that items such as interest income and expense,
the loan loss provision, and operating expenses (e.g., salaries and facility costs) are fairly persistent, while trading gains/losses
and fair value disclosure adjustments (i.e., to convert INCOME_GAAP to INCOME_FV) are fairly transitory.14 PERSISTENT_
INC includes the persistent items described above, while TRANSITORY_INC_GAAP includes trading gains/losses and
TRANSITORY_INC_FV includes both trading gains/losses and fair value gains/losses on securities, loans, deposits, and debt.
14
Untabulated tests show that the persistence coefficients are much higher for the main components of PERSISTENT_INC (e.g., loan loss provision
(0.62), loan interest (0.86), and interest expense (0.81)) than for the main components of TRANSITORY_INC_FV (e.g., net realized security gains
(0.25), trading income (0.24), net unrealized fair value gains on loans (0.19), and OCI (0.30)).

TABLE 6
Relative Value Relevance of Income with Disaggregation of Income into Persistent and Transitory Components
PRICE ¼ b0 þ b1 PERSISTENT INC þ b2 TRANSITORY INC GAAP þ e
PRICE ¼ b0 þ b1 PERSISTENT INC þ b2 TRANSITORY INC FV þ e
Coefficients
Persistent Transitory
Component Component Adj. R2
GAAP 9.736 5.478 0.515
(0.00) (0.00)
FV 9.509 4.703 0.465
(0.00) (0.00)
Difference 0.227 0.775 0.050
(0.08) (0.00) (0.00)
This table reports the results of comparing the explanatory power for prices of GAAP versus fair value (FV) income by estimating the income-only versions
of Equations (1) and (2) after disaggregating each income measure into a relatively persistent component (PERSISTENT_INC) and a relatively transitory
component (TRANSITORY_INC_GAAP or TRANSITORY_INC_FV). The sample includes 3,635 bank-years over 2006–2013 with data on the income
components. We use Vuong’s (1989) Z-statistic to test the difference in explanatory power (Adj. R2) between the GAAP and FV models. We use t-statistics to
test whether each coefficient is significantly different from zero, and Chi-squared statistics to test whether the GAAP and FV coefficients are significantly
different from each other. Year fixed effects are included. Two-tailed p-values based on standard errors clustered by firm are reported in parentheses.
This test uses the subsample where the income component data are available. Results are reported in Table 6. As expected, we
find that the pricing coefficients is higher for the persistent component of income than for the transitory component. More
importantly, allowing the coefficient on income to vary between its persistent versus transitory components eliminates most of
the Adj. R2 difference between GAAP income and fair value income: 0.050 in Table 6, compared to 0.220 from the untabulated
estimation of the income-only models in Equations (1) and (2) using the same subsample for Table 6.
Overall, the results in Table 6 suggest that the aggregation of transitory fair value gains/losses into fair value income
contributes significantly to the relatively lower value relevance of fair value income compared with GAAP income (Hann et al.
2007).
Further Tests of Book Value of Equity

In this subsection, we further examine two explanations for the failure of fair value accounting to improve the relative
value relevance of banks’ book value of equity: (1) divergence between exit value and value-in-use, and (2) measurement error.
Divergence between Exit Value and Value-in-Use

The first explanation for fair values failing to provide more relevant book equity is divergence between exit value and
value-in-use. To investigate this explanation, we examine how the explanatory power of GAAP versus fair value book equity
for stock prices varies with bank distress. For banks facing the threat of failure, current exit values should be more relevant to
investors because there is a significant chance the instruments held by the bank will be sold. Consistent with this prediction,
others also assert that fair values should be more relevant than historical costs in times of distress or for distressed banks (e.g.,
Linsmeier 2011). Thus, we expect the relative value relevance of fair value-based book equity compared to GAAP book equity
to improve during times of distress.
We use two methods to identify distressed banks. First, we consider failed banks in the period preceding their failure.
While this test uses ex post failures to identify the most distressed banks, these banks would have been distressed ex ante to the
market.15 We obtain official failures from the Federal Deposit Insurance Corporation (FDIC) failed bank list.16 We identify 61
15
For example, the mean Z-Score, a common ex ante measure of bank distress (see Laeven and Levine 2009) is significantly smaller for failed banks than
other banks, indicating that they were more distressed (not tabulated).
16
See: https://www5.fdic.gov/hsob/SelectRpt.asp?EntryTyp¼30&Header¼1

bank failures in our sample with data available for the four years prior to the failure. We then compare the relative value
relevance of EQUITY_GAAP versus EQUITY_FV for the 122 bank-years in the two years prior to failure to two benchmarks:
(1) the same failed banks for the two years prior to the pre-failure period (i.e., years 3 and 4 prior to failure), and (2) non-failed
banks matched on year, size, and loan composition. For example, for a bank that failed in 2007, the relative explanatory power
of EQUITY_GAAP compared to EQUITY_FV for stock prices would be estimated for 2005 and 2006 and would be
benchmarked against the same relative explanatory power for the same bank in 2003 and 2004, as well as a matched non-failed
bank in 2005 and 2006. Comparing a failed bank to itself in less distressed years holds relatively constant other bank
characteristics that may also affect value relevance, while comparing the failed bank to a matched non-failed bank in the same
period controls for macroeconomic factors that may also affect value relevance.
Results from this analysis (using equity-only regressions) are tabulated in Panel A of Table 7. Consistent with our primary
results, we find that in years 3 and 4 prior to failure, EQUITY_GAAP has more explanatory power for prices than EQUITY_FV
(Adj. R2 of 0.715 versus 0.689, p , 0.10). In contrast, in years 1 and 2 prior to failure, EQUITY_FV exhibits similar
explanatory power to EQUITY_GAAP (Adj. R2 of 0.792 versus 0.773, p ¼ 0.17). In other words, as banks approach failure, the
Adj. R2 of EQUITY_FV increases much more significantly than that of EQUITY_GAAP (0.103 versus 0.058, p , 0.01). We
observe a similar pattern when we compare failed banks with the matched non-failed banks: EQUITY_GAAP has more
explanatory power than EQUITY_FV (Adj. R2 of 0.599 versus 0.578, p , 0.05). These results suggest that fair value-based
book equity becomes more value-relevant relative to GAAP book equity when banks approach failure.17
For our second test, we examine banks during the financial crisis, when the average bank was more likely to be distressed.
To conduct this test, we use a constant sample of banks from 2004 to 2009 and compare the relative explanatory power of
EQUITY_GAAP compared with EQUITY_FV for prices in the pre-crisis period (2004–2006) and the crisis period (2007–2009).
As reported in Panel B of Table 7, the Adj. R2 difference across models using EQUITY_GAAP is significantly smaller than that
using EQUITY_FV during the crisis than in the pre-crisis period (0.001 versus 0.019, p , 0.05). These results suggest that the
value relevance of fair value-based book equity relative to GAAP book equity improves during the crisis period.
Overall, the above two tests of distressed banks exhibit a fairly similar pattern of results. The evidence is consistent with
fair values improving the value relevance of book value of equity in settings where exit values more closely correspond to
potential cash flows accruing to shareholders (i.e., the divergence between exit value and value-in-use is smaller). However, in
settings where the bank is more likely to be a going concern, fair values do not improve the value relevance of book value of
equity relative to GAAP.
Measurement Error in Fair Value Estimates

The second explanation for fair values failing to provide more relevant book equity is measurement error in fair value
estimates. We see in Table 1, Panel A that adding the fair value of loans, deposits, and debt to the balance sheet, as is done to
construct EQUITY_FV, adds almost exclusively Level 2 (for deposits and debt) and Level 3 (for loans) fair values. Thus,
EQUITY_FV may not improve the value relevance of book equity because (1) it contains fair value adjustments that are not
measured reliably, and (2) unreliable fair value measures impair or do not improve value relevance (e.g., Barth 1994).
Consistent with the second point, prior banking studies generally find that equity markets discount Level 3 fair values relative
to Level 1 or 2 fair values, as reflected in both lower pricing coefficients (Song et al. 2010; Goh, Li, Ng, and Yong 2015) and
higher costs of capital (Riedl and Serafeim 2011).18
We conduct three complementary tests to examine this question. In the first test, we start with the equity-only model using
EQUITY_FV and see how much the explanatory power declines if we subtract from EQUITY_FV net assets recognized at Level
1 fair value under current GAAP (RECLEVEL1) compared to how much the explanatory power declines if we subtract from
EQUITY_FV net assets recognized at Level 3 fair value under current GAAP (RECLEVEL3).19 Because currently recognized
17
Unlike the Adj. R2s, the coefficient on EQUITY_FV is not consistent with fair value accounting better capturing firm value closer to failure.
Specifically, we find that the coefficient on EQUITY_FV moves further away from its theoretical value of 1 in years 2 and 1 prior to failure,
compared to years 4 and 3 prior to failure (0.604 versus 1.154). On investigation, we find that this anomalous result is driven by the inclusion of year
fixed effects. Without year fixed effects, the coefficient on EQUITY_FV becomes marginally closer to 1 in years 2 and 1 prior to failure, compared to
years 4 and 3 (0.853 versus 1.222). Also, the improvement in Adj. R2s is much more pronounced after removing year fixed effects as the Adj. R2 of
EQUITY_FV increases, while it decreases for EQUITY_GAAP (0.072 versus 0.023, p , 0.01). Because bank failures are highly clustered in time
(with most occurring in 2008–2010), year fixed effects reduce the ability of across-year variation in EQUITY_FV to explain across-year variation in
prices, biasing the coefficient on EQUITY_FV (not tabulated).
18
Lawrence, Siriviriyakul, and Sloan (2016), however, find similar pricing coefficients for Level 1, 2, and 3 assets for a sample of closed-end funds.
19
We use recognized fair values (i.e., securities), rather than disclosed fair values (e.g., loans, deposits, and debt), for two reasons. First, the measurement
hierarchy for disclosed fair values was not required to be disclosed until 2012. Second, for disclosed fair values, variation in levels of the hierarchy is
driven mainly by variation in asset/liability type (e.g., loans are almost all Level 3, while deposits are almost all Level 2; see Table 1, Panel A). There is
little variation in hierarchy levels within asset/liability types. In contrast, for recognized fair values (i.e., securities), we can hold the asset type relatively
constant and just vary levels of the fair value hierarchy.

TABLE 7
Relative Value Relevance of Book Value of Equity for Distressed Banks
PRICE ¼ b0 þ b1 EQUITY GAAP þ e
PRICE ¼ b0 þ b1 EQUITY FV þ e
Panel A: Failed Banks in the Period Preceding the Failure (Years 1–2 Pre-Failure)
Failed Banks Failed Banks Matched Non-Failed
in Years 1–2 in Years 3–4 Banks in Years 1–2
Pre-Failure Pre-Failure Pre-Failure
(1) (2) (3) (4) (5) (6)
Equity Coeff. Adj. R2 Equity Coeff. Adj. R2 Equity Coeff. Adj. R2
GAAP 0.575 0.773 1.355 0.715 0.631 0.599
(0.00) (0.00) (0.00)
FV 0.604 0.792 1.154 0.689 0.542 0.578
(0.00) (0.00) (0.00)
GAAP versus FV Differences 0.029 0.019 0.201 0.026 0.089 0.021
(0.33) (0.17) (0.00) (0.07) (0.00) (0.03)
(a) (b) (c)
Equity Difference From 1
GAAP 0.425 0.355 0.369
(0.00) (0.02) (0.01)
FV 0.396 0.154 0.458
(0.00) (0.25) (0.00)
Adj. R2 Difference of Adj. R2 Difference of
Differences (a) (b) Differences: (a) (c)
0.045 0.040
(0.01) (0.02)
(continued on next page)
fair values on banks’ balance sheets are essentially all AFS securities (Song et al. 2010) and their Level 1 and Level 3
components are of comparable magnitude in our sample (not tabulated), this test compares fair values of different measurement
reliability while holding the type and magnitude of the underlying assets relatively constant. If poor measurement reliability
impairs the value relevance of fair value book equity, then we expect that RECLEVEL3 contributes less to the value relevance
of EQUITY_FV than RECLEVEL1, and removing the latter will have a bigger impact on the value relevance of EQUITY_FV
than removing the former. One caveat of this test, however, is that we are forced to subtract the entire recognized Level 1 and
Level 3 net assets, rather than just the fair value difference for these assets, due to a lack of data availability.20
The sample for this test includes 2,730 bank-years over 2007–2013 with available data, and results are presented in Table
8, Panel A. Removing recognized Level 3 fair value net assets has virtually no effect on the explanatory power of fair value
book equity (Adj. R2 of 0.596 for EQUITY_FV versus 0.585 for EQUITY_FV_LESS_RECLEVEL3, p ¼ 0.32). In contrast,
removing recognized Level 1 fair value net assets significantly reduces the explanatory power of fair value book equity (Adj.
R2 of 0.596 for EQUITY_FV versus 0.427 for EQUITY_FV_LESS_RECLEVEL1, p , 0.01).21 Further, EQUITY_FV_LESS_
RECLEVEL1 has significantly lower explanatory power for prices than EQUITY_FV_LESS_RECLEVEL3 (Adj. R2 of 0.427
20
Ideally, we would subtract the difference between historical costs and fair values for each level of the fair value hierarchy (e.g., the Level 1 fair value
difference for securities versus the Level 3 fair value difference for securities). However, historical costs for the recognized Level 1 or Level 3 fair value
assets are unavailable during our sample period because ASC 320 and ASC 820 do not require a reconciliation back to historical costs for items already
recognized at fair value under GAAP (e.g., securities). Further, to assess whether there is a reasonable subsample of banks that voluntarily disclosed the
historical cost data, we hand-checked the annual filings for a random sample of 30 bank-years in our sample and found that none of the banks
voluntarily provided the data.
21
We also examine the impact of removing net assets with Level 1 versus Level 3 measurements from EQUITY_GAAP (instead of EQUITY_FV) and find
similar results (not tabulated).

TABLE 7 (continued)
Panel B: Banks During the Financial Crisis
Banks During the Same Banks During the
Financial Crisis (2007–2009) Pre-Crisis Period (2004–2006)
(1) (2) (3) (4)
Equity Coeff. Adj. R2 Equity Coeff. Adj. R2
GAAP 0.903 0.470 1.464 0.656
(0.00) (0.00)
FV 0.856 0.469 1.397 0.637
(0.00) (0.00)
GAAP versus FV Differences 0.047 0.001 0.067 0.019
(0.00) (0.89) (0.00) (0.01)
(a) (b)
GAAP 0.097 0.464
(0.23) (0.00)
FV 0.144 0.397
(0.06) (0.00)
Adj. R2 Difference of
Differences: (a) (b)
0.018
(0.02)
This table presents two tests of the relation between bank distress and the relative explanatory power for prices of GAAP versus fair value-based book
equity by estimating the equity-only versions of Equations (1) and (2) separately for distressed versus control (non-distressed) bank samples. Panel A uses
failed banks to identify distressed bank-years. The distressed bank sample of 122 bank-years includes the two years prior to failure (years 1–2 pre-failure)
for the 61 failed banks in our sample (Columns (1) and (2)). The control (non-distressed) bank sample of 122 bank-years includes the period three and four
years prior to failure (years 3–4 pre-failure) for the same 61 failed banks in our sample (Columns (3) and (4)) or non-failed bank-years matched based on
year, size, and asset composition (Columns (5) and (6)). Panel B uses the financial crisis to identify distressed bank-years. The distressed bank sample of
1,086 bank-years includes bank-years during the financial crisis period (2007–2009) for 362 banks (Columns (1) and (2)), and the control (non-distressed)
bank sample of 1,086 bank-years includes bank-years during the period prior to the financial crisis (2004–2006) for the same 362 banks (Columns (3) and
(4)). We use Vuong’s (1989) Z-statistic to test the difference in explanatory power (Adj. R2) between GAAP and fair value equity. We use t-statistics to
test whether each coefficient is significantly different from zero, and Chi-squared statistics to test whether the coefficients on GAAP and fair value equity
are significantly different from each other. We also use F-statistics to test whether the coefficients on GAAP and fair value equity are significantly different
from 1. Year fixed effects are included. Two-tailed p-values based on standard errors clustered by firm are reported in parentheses.
versus 0.585, p , 0.01). These results suggest that assets and liabilities that are most reliably measured (Level 1) significantly
improve the value relevance of fair value equity, while assets measured least reliably (Level 3) add minimal value relevance to
fair value equity.
In our second test, we estimate a disaggregated model that allows for different coefficients on RECLEVEL1, RECLEVEL3,
and EQUITY_FV_LESS_RECLEVEL1&3 (which is all other components of EQUITY_FV, including recognized Level 2 fair
value net assets and all disclosed fair value net assets, such as loans, deposits, and debt). Results are presented in Panel B of
Table 8. Consistent with Song et al. (2010), the pricing coefficient on RECLEVEL1 is significantly larger than that on
RECLEVEL3 (1.62 versus 0.67, p , 0.01). Upon investigation, we find that the coefficient on RECLEVEL1 is significantly
larger than 1 (1.62) mainly due to outliers. As shown in the bottom half of Panel B, after removing 138 extreme observations
using the method in Song et al. (2010) (i.e., dropping observations with absolute studentized residuals greater than 2), the
coefficient on RECLEVEL1 decreases to 1.16. However, the coefficient on RECLEVEL1 remains significantly larger than that
on RECLEVEL3 (1.16 versus. 0.56, p , 0.01).22
Further, similar to Givoly, Hayn, and Katz (2017), we also use Shapley (1953) values to decompose the Adj. R2 to
measure the relative contribution of RECLEVEL1 and RECLEVEL3 to the total explanatory power of the regression. The
intuition for the Shapley value is that the contribution of a given variable to the total explanatory power of a regression can be
found by comparing the Adj. R2 from the regression including the variable with the Adj. R2 from the regression excluding the
variable (see Israeli 2007). We find in Table 8, Panel B that the amount of explanatory power contributed by RECLEVEL1 is
22
We also repeat all our other analyses using the same approach to eliminate outliers and find that our inferences remain unchanged (not tabulated).

TABLE 8
Reliability and Relative Value Relevance of Fair Value Equity
Panel A: Subtracting Recognized Level 1 versus 3 Fair Value Net Assets from EQUITY_FV
PRICE ¼ b0 þ b1 EQUITY FV LESS RECLEVEL1 þ e
PRICE ¼ b0 þ b1 EQUITY FV LESS RECLEVEL3 þ e
Equity Adj.
Coefficients R2
FV 1.012 0.596
(0.00)
FV Excluding Recognized Level 1 0.826 0.427
(0.00)
FV Excluding Recognized Level 3 0.971 0.585
(0.00)
Differences:
FV versus FV Excluding Recognized Level 1 0.186 0.169
(0.00) (0.00)
FV versus FV Excluding Recognized Level 3 0.041 0.011
(0.01) (0.32)
FV Excluding Recognized Level 1 versus FV Excluding Recognized Level 3 0.145 0.158
(0.00) (0.00)
Differences from 1:
FV 0.012
(0.83)
FV Excluding Recognized Level 1 0.174
(0.01)
FV Excluding Recognized Level 3 0.029
(0.60)
nearly six times that contributed by RECLEVEL3 (23.4 percent versus 4.0 percent). Once we drop extreme observations, the
difference decreases, but remains economically large (15.1 percent versus 4.0 percent).
In our third test, we examine how the proportion of Level 3 fair values for disclosed items (e.g., loans, deposits, debt)
affects the explanatory power of EQUITY_FV for prices. Level 1/2/3 classifications from the fair value hierarchy for these
disclosed fair values were not required to be disclosed until 2012 and are not available in commercial databases like SNL.
However, for our hand-collected subsample of 100 bank-years with disclosures of the fair value hierarchy using post-2012 data
(see Section II), we have these Level 1/2/3 classifications for all financial instruments. Thus, we calculate the average Level 3
percentage (total Level 3 net assets divided by the sum of total Levels 1–3 net assets) for each bank in this subsample and apply
it to all bank-years in our sample, since banks’ asset/liability composition and the fair value measurement hierarchy are
relatively stable over time. We then separately assess the relative explanatory power of EQUITY_GAAP compared with
EQUITY_FV for bank-years above the median Level 3 percentage (i.e., bank-years with relatively less reliable fair value
measurements) and below the median Level 3 percentage (i.e., bank years with relatively more reliable fair value
measurements). Unlike the tests in Panel A, this test does not exclude any classes of assets. Results are presented in Table 8,
Panel C. We find that the explanatory power difference between GAAP and fair value equity is larger when fair values are less
reliably measured (0.029 versus 0.016), and the difference is marginally significant (p ¼ 0.08). Collectively, the results from
these three tests are consistent with measurement error reducing the value relevance of fair values (e.g., Barth 1994; Nelson
1996; Song et al. 2010). They help explain why fair value book equity fails to have higher value relevance than GAAP book
equity.

TABLE 8 (continued)
Panel B: Allowing Coefficients to Vary for Recognized Level 1 versus 3 Fair Value Net Assets
PRICE ¼ b0 þ b1 EQUITY FV LESS RECLEVEL1&3 þ b2 RECLEVEL1 þ b3 RECLEVEL3 þ e
Coefficients
EQUITY_FV_LESS_
RECLEVEL1
and RECLEVEL1
EQUITY_FV_LESS_ Adj. versus
RECLEVEL3 RECLEVEL1 RECLEVEL3 R2 RECLEVEL3
Full Sample with Data
FV 0.927 1.623 0.672 0.587 0.951
(0.00) (0.00) (0.00) (0.00)
Shapley Value % 63.52% 23.44% 4.03%
Differences from 1 0.073 0.623 0.328
(0.15) (0.00) (0.00)
Removing Extreme Obs.
FV 0.806 1.162 0.560 0.595 0.602
(0.00) (0.00) (0.00) (0.00)
Shapley Value % 69.02% 15.07% 3.99%
Differences from 1 0.194 0.162 0.440
(0.00) (0.31) (0.00)
To summarize, the results in Tables 7 and 8 suggest that both the divergence between exit values and value-in-use and
measurement error in fair value estimates contribute to the failure of fair values of financial instruments to yield more value-
relevant book value of equity than GAAP for banks.
Additional Analyses and Robustness Tests

Removing AOCI from EQUITY_GAAP
EQUITY_GAAP contains fair value adjustments in accumulated other comprehensive income (AOCI), which are mostly
related to AFS securities. To examine whether these fair value adjustments increase or decrease the value relevance of book
equity, we estimate a specification that strips out AOCI from EQUITY_GAAP to produce a ‘‘revised’’ version of GAAP equity
that is closer to pure historical cost accounting.23 In untabulated tests, we find that current GAAP book equity has statistically
higher explanatory power for prices than revised GAAP book equity that excludes AOCI (Adj. R2 of 0.584 versus 0.579 for the
equity-only model, p , 0.01). However, the Adj. R2 difference is small economically.
Overall, in the context of our main findings, these results indicate that AOCI fair value adjustments currently included in
GAAP book equity have little effect on value relevance, while fair value adjustments for all other financial instruments (such as
loans, deposits, and debt) impair value relevance. One possible explanation for these findings is that, unlike these other
financial instruments, banks frequently sell AFS securities in active markets, so their exit values more closely correspond to
their value-in-use, and/or can be measured more reliably.24
Using Ex Post Intrinsic Value

Note that GAAP measurements are recognized on the financial statements, while fair value measurements are merely
included in footnotes. If the stock market attaches greater weight to recognized than disclosed financial information (e.g.,
Picconi 2006), then it is possible to find that GAAP measurements better explain prices than fair value measurements, even
23
We cannot calculate book equity on a complete historical cost basis because GAAP uses mixed-attribute reporting and banks are not required to
disclose the carrying value and historical cost of all items measured at fair value (e.g., derivatives and trading securities).
24
However, exit value can still differ from value-in-use for AFS securities, because skilled bankers can extract more value by using these securities
strategically to manage bank risk or by identifying and purchasing currently undervalued securities (Nissim and Penman 2007).

TABLE 8 (continued)
Panel C: Differential Amounts of Level 3 Financial Instruments
PRICE ¼ b0 þ b1 EQUITY GAAP þ e
High Level 3 Percentages Low Level 3 Percentages

2
Equity Coeff. Adj. R Equity Coeff. Adj. R2
GAAP 1.334 0.699 1.234 0.604
(0.00) (0.00)
FV 1.256 0.670 1.162 0.588
(0.00) (0.00)
GAAP versus FV Differences 0.078 0.029 0.072 0.016
(0.00) (0.00) (0.00) (0.01)
(a) (b)
GAAP 0.334 0.234
(0.07) (0.02)
FV 0.256 0.162
(0.17) (0.08)
Adj. R2 Difference of
Differences: (a) (b)
0.013
(0.08)
This table presents three tests of how fair value measurement reliability is related to relative explanatory power for pricing of GAAP versus fair value (FV)
equity and the pricing of FV net assets. Panel A reports the results of estimating the equity-only version of Equation (2) using FV equity, and comparing its
explanatory power (Adj. R2) with that of the FV equity excluding either recognized Level 1 or Level 3 FV net assets. FV model Equity is EQUITY_FV,
and FV Excluding Recognized Level 1 (FV Excluding Recognized Level 3) model Equity is EQUITY_FV_LESS_RECLEVEL1 (EQUITY_FV_LESS_
RECLEVEL3). The sample for Panel A includes 2,730 bank-years over 2007–2013. Panel B reports the results of comparing the pricing coefficients on
recognized Level 1 FV net assets (RECLEVEL1) versus recognized Level 3 FV net assets (RECLEVEL3). We estimate the equity-only version of Equation
(2) allowing the coefficients to vary for RECLEVEL1, RECLEVEL3, and the remaining FV equity (EQUITY_FV_LESS_RECLEVEL1&3). The Shapley
(1953) value percentages of each variable are reported to assess the variable’s relative contribution to the total explanatory power (Adj. R2) of the
regression. The sample for Panel A includes 2,730 bank-years over 2007–2013. We also report the results after excluding 138 extreme observations (with
the absolute value of the studentized residuals greater than 2). Panel C reports a test of the relation between the percentage of Level 3 fair values and the
relative explanatory power (Adj. R2) of GAAP versus FV equity for prices. We estimate the equity-only versions of Equations (1) and (2) separately for
the bank-years above versus below the median Level 3 percentage, and compare the relative explanatory power (Adj. R2) of GAAP versus FV equity from
the two subsamples. Level 3 percentage is calculated as the total Level 3 FV net assets divided by the sum of total Levels 1–3 FV net assets using the FV
hierarchy data hand-collected from firms’ annual reports. GAAP (FV) model Equity is EQUITY_GAAP (EQUITY_FV). The sample for Panel C includes
1,169 bank-years over 1996–2013. We use Vuong’s (1989) Z-statistic to test the difference in explanatory power (Adj. R2) between the GAAP and FV
models, t-statistics to test whether a coefficient is significantly different from zero, and Chi-squared statistics to test whether the GAAP and FV coefficients
are significantly different from each other. We also use F-statistics to test whether the equity or net asset coefficients are significantly different from 1. Year
fixed effects are included. Two-tailed p-values based on standard errors clustered by firm are reported in parentheses.
when the ‘‘true’’ value relevance of GAAP is not greater than that of fair value. To address this concern, we follow the approach
in Subramanyam and Venkatachalam (2007) and Hann et al. (2007), and use ex post intrinsic value in place of current market
prices in our tests. Ex post intrinsic value is the sum of ex post realized dividends per share over years tþ1 to tþ3 plus market
price three months after the end of year tþ3, all discounted at 10 percent interest per year. As long as any bias in the market
prices unwinds over the three-year horizon, then our results will unlikely be driven by bias in favor of the recognized GAAP
numbers.25
This test yields qualitatively similar results to the reported results using current market prices (not tabulated). For example,
GAAP book equity and income, on a combined basis, have more explanatory power for ex post intrinsic value than fair value-
based book equity and income (Adj. R2 of 0.572 versus 0.483, p , 0.01). Thus, not only do GAAP financial statements more
25
We obtain similar results if we use a five-year horizon (not tabulated).

closely correspond to current share prices than fair value-based financial statements, but they also more closely correspond to
discounted future payoffs and prices. Thus, it seems less likely that our results are affected by potential market mispricing.26
However, we caution readers that we cannot completely rule out this possibility.
Constant Sample
We repeat our tests using a constant sample to ensure that over-time changes in the composition of our sample do not affect
our results. We find similar results (not tabulated).
VI. CONCLUSION
Standard setters have a longstanding contention that fair value accounting provides the most relevant measurement for
financial instruments. We test this contention by comparing the value relevance of banks’ financial statements based on fair
values with that under current GAAP, which is largely based on historical costs. Because financial instruments comprise a
substantial portion of banks’ balance sheets, banks provide a powerful setting to test whether fair value accounting enhances
financial statement relevance relative to current GAAP.
We find that the combined value relevance of book value of equity and income is higher under GAAP than under fair
value. Tests of income and book equity separately show that while fair value income is significantly less value-relevant than
GAAP income, fair value equity is not significantly different in value relevance than GAAP equity. Further, we find that the
aggregation of transitory unrealized gains and losses into the income measure drives the relatively lower value relevance of fair
value income, and that both divergence between exit value and value-in-use and measurement error in fair value estimates
contribute to the failure of fair values to provide more value-relevant book equity.
Overall, our results contradict the notion that fair value as a measurement attribute for financial instruments produces a
more useful set of financial statements for bank investors. Instead, historical costs required under current GAAP yield financial
statements that are more relevant for bank valuation. In some sense, the findings in this study support the current accounting
model for the banking industry whereby loans, deposits, and debt are recognized in the financial statements using historical
costs, while fair value information is disclosed in the notes. Thus, the main takeaway for scholars, users, and standard setters is
that banks’ financial statements based on fair values as currently disclosed seem to provide less useful information for equity
valuation compared to current GAAP.
However, we cannot definitively predict how the usefulness of fair value-based financial statements for banks would
change if the currently disclosed financial instrument fair values were required to be recognized. On one hand, preparers and
auditors might scrutinize these fair value estimates to a greater degree, which might reduce measurement error. On the other
hand, increased estimation effort and scrutiny might have little effect on measurement error if the error is primarily driven by
inherent estimation difficulty. Furthermore, even if measured perfectly, exit prices-based fair values can differ substantially
from value-in-use, which limits the value relevance of fair value-based financial statements for bank investors.
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APPENDIX A
Construction of Fair Value Income (INCOME_FV)
This appendix provides an example of how INCOME_FV is calculated in a specific year using a real bank randomly
selected from our sample, MidSouth Bancorp, Inc. (hereafter, MidSouth).
Excerpt from MidSouth 2005 10-K (in thousands)
Net income before extraordinary items 7,274

Other comprehensive income (1,405)
2005 2004
Carrying Fair Carrying Fair
Amount Value Amount Value
Financial assets:
Securities held-to-maturity 19,611 20,151 22,852 24,171
Loans, net 438,439 441,100 382,621 382,661
Financial liabilities:
Interest-bearing deposits 446,992 446,899 405,724 405,614
Junior subordinated debentures 15,465 15,253 15,465 16,165

For MidSouth in 2005, the implied gain/loss from the fair value disclosures is calculated as follows:
2005 2004
Carrying Fair Carrying Fair
Amount Value Amount Value
Total financial assets 458,050 461,251 405,473 406,832
Fair value difference 3,201 1,359
Change in fair value difference 1,842
Total financial liabilities 462,457 462,152 421,189 421,779
Fair value difference 305 (590)
Change in fair value difference 895
Net change in fair value difference 2,737
Accordingly, the INCOME_FV for MidSouth in 2005 is calculated as follows:

Pre-Tax Tax-Adjusteda
Net income before extraordinary items 7,274
Other comprehensive income (1,405)
Implied fair value disclosure gain/loss 2,737 1,779
INCOME_FV 7,649
a
To tax-adjust, we follow Hodder et al. (2006) and use the 35 percent corporate income tax rate.

APPENDIX B
Variable Definitions
Variable Definition
DINCOME_FV_MV ¼ the total change in fair value income, calculated as the sum of net income, other
comprehensive income, and the implied gain (loss) based on the net change in the fair
value of financial instruments per the fair value disclosures, less the related tax effect, from
year t1 to t, scaled by market value as of the start of the fiscal year.
DINCOME_GAAP_MV ¼ the total change in reported net income before extraordinary items from year t1 to t, scaled
by market value as of the start of the fiscal year.
EQUITY_FV ¼ total book value of equity plus the net fair value asset difference per the fair value disclosures,
less the related tax effect, scaled by outstanding shares three months after the fiscal year-
end.
EQUITY_FV_LESS_RECLEVEL1 ¼ total book value of equity plus the net fair value asset difference per the fair value disclosures,
less the related tax effect, and less Level 1 recognized fair value net assets, scaled by
outstanding shares three months after the fiscal year-end.
EQUITY_FV_LESS_RECLEVEL1&3 ¼ total book value of equity plus the net fair value asset difference per the fair value disclosures,
less the related tax effect, and less Level 1 and 3 recognized fair value net assets, scaled by
EQUITY_FV_LESS_RECLEVEL3 ¼ total book value of equity plus the net fair value asset difference per the fair value disclosures,
less the related tax effect, and less Level 3 recognized fair value net assets, scaled by
EQUITY_GAAP ¼ total book value of equity, scaled by outstanding shares three months after the fiscal year-end.
INCOME_FV ¼ total fair value income, calculated as the sum of net income, other comprehensive income, and
the implied gain (loss) based on the net change in the fair value of financial instruments per
the fair value disclosures, less the related tax effect, scaled by outstanding shares three
months after the fiscal year-end.
INCOME_FV_MV ¼ total fair value income, calculated as the sum of net income, other comprehensive income, and
the implied gain (loss) based on the net change in the fair value of financial instruments per
the fair value disclosures, less the related tax effect, scaled by market value as of the start
of the fiscal year.
INCOME_GAAP ¼ reported net income before extraordinary items, scaled by outstanding shares 3 months after
the fiscal year end.
INCOME_GAAP_MV ¼ reported net income before extraordinary items, scaled by market value as of the start of the
fiscal year.
RECLEVEL1 ¼ total Level 1 recognized fair value net assets, scaled by outstanding shares three months after
the fiscal year-end.
RECLEVEL3 ¼ total Level 3 recognized fair value net assets, scaled by outstanding shares three months after
the fiscal year-end.
PERSISTENT_INC ¼ total net income less net trading security gains and realized net security gains, the main
detailed components of INCOME_GAAP in our sample that are relatively transitory in
nature, scaled by outstanding shares three months after the fiscal year-end.
PRICE ¼ price per share three months after the fiscal year.
RETURNS ¼ buy-and-hold returns accumulated over the fiscal year.
TRANSITORY_INC_FV ¼ total net trading security gains, realized net security gains, net unrealized gains in other
comprehensive income, and the implied gain (loss) based on the net change in the fair
value of all financial instruments per the fair value disclosures, less the related tax effect,
scaled by outstanding shares three months after the fiscal year-end.
TRANSITORY_INC_GAAP ¼ total net trading security gains and realized net security gains, the main detailed components
of INCOME_GAAP that are relatively transitory in nature, scaled by outstanding shares
three months after the fiscal year-end.

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THE ACCOUNTING REVIEW American Accounting Association

Vol. 93, No. 6 DOI: 10.2308/accr-52007

Does Fair Value Accounting Provide More Useful Financial

The Accounting Review

II. BACKGROUND AND THEORETICAL DISCUSSION

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III. RESEARCH DESIGN

PRICE ¼ b0 þ b1 EQUITY FV þ b2 INCOME FV þ e ð2Þ

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IV. SAMPLE AND DESCRIPTIVE STATISTICS

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RETURNS ¼ b0 þ b1 INCOME FV MV þ b2 DINCOME FV MV þ e ð20 Þ

The Accounting Review

PRICE ¼ b0 þ b1 EQUITY FV þ b2 INCOME FV þ e ð2Þ

Further Tests of Income

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RETURNS ¼ b0 þ b1 INCOME FV MV þ b2 DINCOME FV MV þ e ð20 Þ

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PRICE ¼ b0 þ b1 PERSISTENT INC þ b2 TRANSITORY INC FV þ e

Further Tests of Book Value of Equity

Divergence between Exit Value and Value-in-Use

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Measurement Error in Fair Value Estimates

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PRICE ¼ b0 þ b1 EQUITY FV LESS RECLEVEL1 þ e

PRICE ¼ b0 þ b1 EQUITY FV LESS RECLEVEL3 þ e

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Additional Analyses and Robustness Tests

Using Ex Post Intrinsic Value

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High Level 3 Percentages Low Level 3 Percentages

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Net income before extraordinary items 7,274

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Accordingly, the INCOME_FV for MidSouth in 2005 is calculated as follows:

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The Accounting Review

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