The Reliability of Fair Value versus Historical Cost Information: Evidence from Closed-End Mutual Funds

Presented by:Ira GeraldinaNova Novita

Intan Oviantari

Outline

Introduction

Research Questions & Theoretical Frameworks

Methodology

Results

Conclussions

Introduction

JWA, Basis for Conclusions:

fair value more relevant than historical cost

fair value represents unbiasedmeasured (consistent within year

and between enterprise) economic effect of risk is

reflected in current periodincome

Fair value is measured at marketprice or based on estimates

(FASB)

Recognizing fair value in the Balance Sheet (JWG)

Subjective in estimate far valuefor non-traded instrument (IASC)Proponents of fair value measurement:

• Fair value valuation has more advantages than historical cost

Opponents of fair value measurement:• Reliability problems for some fair

value estimates•Suggest that these instruments are

recognized at historical cost

Research Questions

Primary Research Questions:

When compared to historical measures, is the valuerelevance of some financial instrument (Closed-End

Mutual Funds) fair values eliminated due toreliability issues relating to fair value estimation?

Research Questions-1

ONA

HC

FV

PRICE

Research Questions-2

INC

GRL

FVGL

RETURN

Research Questions-3

Reliability across fund types:

G7PUB NG7FUB

GOV

CBONDS

OTHER

UNCLASS

Theoretical FrameworkPrevious Studies

Barth (1994) • Unable to consistently document incremental explanatory power for fair value securities gains and loses• Found significant incremental explanatory power for fair value disclosures

Ahmed & Takeda (1995)

• Include a variable controlling for the interest rate sensitivity of other balance sheet items• Found that bank’s fair value securities gains and loses exhibit incremental explanatory power over historical cost measures of realized securities gains and loses

Petroni & Wahlen (1995)

• Use property casualty insurance companies• Performing test to examine whether there are cross- sectional differences for securities traded in active and thin market• do not test on fair value and historical cost gains and losses because of insufficient data

Carroll at al (2002) Vs Previous Studies

Carroll at al (2002) used closed end mutual funds which hasseveral advantages:

Provide sufficient data to evaluate the incremental informativeness of both fair value balance sheet and

income statement information

Potential problem with correlated omitted variablesIs basically nonexistent

There is great variation in the securities invested in bydifferent funds

The results support the hypotheses

Solve the problem of previous studies about omitted variables

Explain that reliability problems in measuring the fair valuesof investment are not the primary explanation for the

inconsistency in prior results

General Description

Mutual Funds

Open-End

Closed-End

General Description

Open-End:

Companies issue and redeem shares at the current market value

per share

There is no secondary trading market

Equity capitalization and netassets are directly changed bymagnitude of the traded share

price when shares sold or redeem

Closed-End:

•Companies operate more likea traditional companies

• Shares are available only fortrade in secondary market

•Subsequent purchases and salesof shares do not effect the equity

and assets of the fund

The traded price may fluctuate inresponse to supply and demand

• Trade at discount/premium

General Description

t

ttt NAV

PNAVD

Discount/premium has been widely studied over 30 years

Early explanation of discount/premium focused on problem

of measuring NAV

They derive from managerial performance that are not reflected in NAV(Boudreaux, 1973; Ingersoll, 1976; Chance, 1997)

Discount/premium explanations

Tax liability on unrealized capital appreciation does not show up in NAV (Malkiel, 1977)

Liquid asset are overvalued in NAV (Malkiel, 1977)

Indicate mispricing regarding individual investor sentiments causesystematic noise trading (Lee, Shleifer, Thaler, 1991)

Mispricing exist in the presence of rational traders who taking fulladvantages of mispricing

Accounting Requirement

Accounting Requirement

Accounting Requirement

Sample selection and Descriptive Statistics

Descriptive statistics

Table 2

Empirical tests

Empirical tests

Empirical tests

Investment Securities Fair Value Gains and Losses

Reliability Test

Reliability Across Fund Type

Investment Securities Fair Value Gains and Losses Test

Using Earning Capitalization Model to determine if investor view income statement fair value security

gains and losses as value relevance in a setting with no correlated omitted variables.

Fair Value Income

INC FVGL

Earning Capitalization Model

Rit = γ1t + γ2 INCit + γ3 RGLit + γ4 FVGLit + εit² (3)

Tabel 4. Investment Securities Fair Value Gains and Losses Test

Mean Estimate

Mean t statistic

Z statistic

γ1it 0.01 0.07 0.12

γ2 it 0.93 2.92 4.32**

γ3it 0.11 0.63 0.79

y4it 0.87 8.70 6.30**

Mean Estimate

Mean t statistic

Z statistic

γ1it Not tabulated

γ2 it 0.85 0.14 6.26**

γ3it -0.03 0.13 -0.25

γ4it 0.89 0.07 12.14**

Panel ASeparately Yearly Regression

Panel BPooled Estimation

Rit = γ1t + γ2 INCit + γ3 RGLit + γ4 FVGLit + εit²Mean R² 0,68Mean n= 65

White’s (1980) Adjusted Standar Errors as needed

Rit = γ1t + γ2 INCit + γ3 RGLit + γ4 FVGLit + εit²Mean R² = 0,67Mean n= 971

Newey-West (1987) Adjusted Standar Errors

In the close-end mutual fund setting, Carrol et al find that fair value securities gains and losses consistently provide information incremental

to historical cost income measures

Reliability Across Fund Types Test

Rit = γ1t + γ2 INCit + γ3 RGLit + γ4 FVGLit + εit² (3)Pit = β 1t + β2t ONAit + β3t HCit + β 4t FVit + it² (2)

The researcher examine the incremental informativeness of balance sheet and income statement fair value s by modifying the price and returns regressions

specified previously to allow the intercept and all of the coefficient to vary across the six fund types.

Tabel 5. Reliability Across Fund Types Test

ONA HC FV

G7PUB 1.08(11.89)**

0.09(0.68)

0.93(7.54)**

NG7PUB 0.12(0.24)

0.09(0.64)

0.78(8.35)**

GOV 1.01(8.16)**

-0.17(-1.34)

1.18(8.40)**

CBONDS 0.85(13.13)**

-0.21(-1.56)

1.18(9.26)**

OTHER 0.68(13.57)**

-0.10(-0.74)

1.00(7.89)**

UNCLASS 0.85(5.02)**

-0.10(-0.34)

1.14(4.60)**

INC RGL FVGL

0.61(1.70)

-0.30(-1.75)

1.14(10.63)**

0.23(0.46)

0.09(0.39)

0.84(10.38)**

1.18(3.12)**

1.28(3.12)**

0.41(2.00)*

2.20(4.69)**

-0.09(-0.52)

0.89(5.46)**

0.60(2.29)*

0.30(1.49)

0.50(3.72)**

1.52(6.62)**

-0.01(0.06)

1.04(8.62)**

Price Regression

Return Regression

Pit = β 1t + β2t ONAit + β3t HCit + β 4t FVit + it²Mean R² = 0,94Mean n= 1118

Rit = γ1t + γ2 INCit + γ3 RGLit + γ4 FVGLit + εit²Mean R² = 0,67Mean n= 971

Newey-West (1987) Adjusted Standar Errors

Coefficient Estimate t statistic based on Newey-West (1987) adjusted standar errors

Reliability Across Fund Types Result

Table 5 result consistent with fair value providing information incremental toHistorical cost for both balance sheet and income statement information

This finding is consistent with investor perceiving that the fair value estimatesfor equities traded in less active markets, such as private markets and markets in non G7 countries are less reliable than fair value of

publicly traded equity securities from G7 countries that are traded in active markets

Conclusion

• Investment securities fair values provide relevant information to close-end fund investors : a significant association between stock price and fair value securities gain and losses

• Provide evidence consistent with close-end investors viewing fair value estimates for G7 publicly traded equities as more reliable than those for private and non-G7 equities.

• The reliability problem in measuring fair value of investment securities are not the primary explanation for the inconsistency in prior research result, instead incomplete availability of fair value measures in other settings.

• Suggest to standard setters : their greatest challenge in requiring the recognition of all financial instruments at fair value may not be the reliable estimation of the fair value of investment security assets not traded in active market.

• This economic problem is virtually absent in their setting because all the net assets of close-end mutual funds are recognized in financial statements at their fair value or its equivalent. .