The implication of unrecognized asset value on the relation between market valuation and debt valuation adjustment

Matthew C. Cedergren, Changling Chen, Kai Chen

Review of Accounting Studies · 2019 · Volume 24 · Issue 2

Abstract

Under SFAS No. 159, U.S. firms can 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; that is, 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), and vice versa. In this paper, we examine the relation between market valuation and DVA gains and losses, conditioning on the level of unrecognized asset value (UAV). We develop a model to demonstrate the mitigating effect of UAV on the relation between equity returns and DVA. 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.

Keywords

Debt valuation adjustment, Unrecognized asset value, Market valuation, Fair value of liabilities, Balance sheet incompleteness

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