Relevance of Fair Value Accounting for Financial Instruments: Some French Evidence

I. INTRODUCTION The recent global financial crisis 2007-2009 has highlighted some of the drawbacks of fair value. It firstly exacerbated one of the most controversial features of IAS 39, namely the procyclical effect of valuation systems on financial instruments (Laux and Leuz, 2010). Banks that had evaluated certain financial instruments on the basis of pre-crisis market prices were forced, for need of liquidity on the financial markets, to make ever-greater use of assessments based on models employing non-observable data. These models were in fact developed in a favorable economic situation, making no allowance for the deterioration of the financial markets during periods of turbulence or crisis. For this reason they do not incorporate all of the relevant risk factors, including in particular market risk, and liquidity and counterparty risk. Second, the debate surrounding the valuation of financial instruments has led to another debate concerning the concept of reported income. Should the term be limited to the items that have hitherto comprised the net income, or would it be wiser to move towards a broader definition of income, even to an income in which all the unrealized capital gains and losses in financial instruments would be reflected? Further, from the financial accounting perspective will the adoption of fair value income provide risk-relevant information for evaluating a company's market price? This paper contributes to the above debate by investigating the value-relevance of fair value accounting for major CAC 40 companies listed in the French stock market. We particularly examine whether the incremental volatility in fair value incomes provides risk-relevant information to the forecasting of stock prices. Indeed, unlike the net income, the fair value incomes established under IFRS7 and IAS 39 standard (i.e., comprehensive income and full fair value income) are supposed to disclose a more faithful reflection of the market's valuations of the balance-sheet's assets and liabilities by taking into consideration the unrealized capital gains and losses on the items in the accounts. Since the primary role of accounting is to provide investors with means of the pricing of listed companies' stocks, fair value accounting is justified only if the fair value incomes contain useful and relevant information regarding the price determination in the financial markets. We also address the questions of whether mark-to-market valuation drives stock price changes (or stock returns) and stock volatility. Examination of the relationship between fair value incomes and stock returns permits to check the robustness of the results for price analysis since the majority of investors usually hold stocks over a certain period. If the fair value incomes become really more uncertain due to the volatility of profits (or losses) of financial instruments, expected returns on financial assets would increase to offer investors a fair reward for their higher level of risk-taking. On the other hand, if fair value incomes do not generate excess volatility in the financial markets, it would be unlikely that they contributed to the rise of market panics and instability as well as to the severity of the 2007-2009 global financial crisis (Plantin et al., 2008). The sample period is intentionally set before the occurrence of the subprime and global financial crisis in order to shed light on the effects of changes in accounting method. The study is thus concerned by the French stock market reaction to the 2005 adoption of the International Financial Reporting Standards (IFRS) in Europe, and especially to IFRS 7 and IAS 39. An examination of the French case is of great interest because French companies, unlike those in Germany, Austria, and Switzerland, were not allowed a transition period for adapting to IFRS before they were introduced in January 2005. In addition, among a number of differences between the IFRS and French standards, we note a profound divergence between these two systems in the use of the fair-value principle to the detriment of historical costs in the valuation of assets and liabilities. …