The Implication of Unrecognized Asset Value on the Relation between Market Valuation and Debt Valuation Adjustment

Under SFAS No. 159, U.S. firms have the option to measure debt liabilities at fair value, which results in recognition of unrealized gains and losses from debt valuation adjustments (DVA) when a firm's own credit risk changes. Critics have raised concerns about the counterintuitive income consequences of DVA, namely, when a firm's credit risk increases (i.e., bad news), debt values decrease, and resulting DVA gains increase the firm's income (i.e., good news). Prior research posits that the counterintuitive income effect of DVA is attributable to incomplete accounting on the asset side of the balance sheet. Specifically, DVA gains and losses are not properly offset by corresponding adjustments of unrecognized asset value (UAV), either because some assets are not recorded at fair value, or because some assets are not recorded on the balance sheet to begin with. In this paper, we examine the relation between market valuation and DVA gains and losses, conditioning on the level of UAV. We develop a model to demonstrate the mitigating effect of UAV on the relation between equity returns and DVA. Using a sample of U.S. bank holding companies during 2007–2013, we show that while the association between equity returns and DVA is positive when the level of UAV is low, the association decreases and eventually turns negative with increasing levels of UAV. Our findings suggest that the relation between equity returns and DVA gains and losses is influenced by UAV