information about the amount, timing and uncertainty of future cash flows. While we have a lot of evidence regarding the relevance and reliability of assets measured at fair value, the evidence is much more limited regarding liabilities. This is driven mainly by firms typically measuring most of their liabilities at historical cost. ANOPTION TOMEASURE LIABILITIES AT FAIR VALUE Our study uses the introduction of the fair value option (FVO) for liabilities to provide evidence on the reliability and relevance of fair value measurement for liabilities. The FVO, introduced by both the US and International accounting standard setters, gives firms the option to measure financial liabilities at fair value. If the option is adopted, firms are required to recognize and separately disclose in the financial statements debt valuation adjustments (DVAs). DVAs represent changes in the fair value of liabilities that result from changes in the firm’s own credit risk. Using a sample of US banks that elect the FVO for liabilities, we show that DVAs generally cannot be explained by the same factors that explain changes in market-based measures of credit risk (for example, changes in bond and CDS spreads). This finding may reflect the use of fair value measurement for opportunistic reasons, or it may reflect the role of fair values in providing additional information about the credit risk of the firm that is not captured by the market. To investigate whether information about credit risk is conveyed, we use information from annual reports on whether the fair value estimates for liabilities are based on market information or unobservable inputs. This enables us to distinguish between fair values that reflect mainly market information and those that reflect private managerial information about the credit risk of the banks. INFORMATION ADVANTAGE Our research shows that DVAs can explain future changes in credit risk when the fair value of liabilities is based on unobservable managerial inputs. The results support the view that managers have an information advantage in estimating credit risk, and that fair value measurements based on managerial inputs offer inside information to the market. The results of our study are particularly relevant to practitioners, as we show that fair values can be used to predict credit risk. Further, our results provide a better understanding of howmanagers use their discretion in computing fair values, and contribute to the debate about the role of fair value accounting in generating financial information that is useful for decision-makers. This work has also important policy implications. I joined colleagues to prepare a comment letter to the International Accounting Standards Board, advising how financial instruments should be measured and classified under the International Financial Reporting Standards (IFRS). We presented evidence from our research on the risk and value relevance of fair value measurement for assets and liabilities, and we suggested ways to reduce the complexities and application issues associated with the current standard on financial instruments. Decision-makers need relevant and reliable accounting information. There is a potential to improve the informativeness of accounting numbers through the use of appropriate measurement basis and associated disclosures. Dr Argyro Panaretou is a enior Lecturer in the Department of Accounting and Finance. Her research focuses on financial accounting and reporting, and particularly on fair value accounting and accounting for financial instruments and credit risk. The article What canwe learn about credit risk fromdebt valuation adjustments? is co-authored with Dr Wen Lin and Professor Grzegorz Pawlina, of Lancaster University, and Professor Catherine Shakespeare, of the University of Michigan. It is accepted for publication in Reviewof Accounting Studies. a.panaretou@lancaster.ac.uk FIFTY FOUR DEGREES | 35
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