[Commercial bank loan portfolios are typically 10 to 15 times larger than bank equity; therefore bank loan portfolio cash flows and default risks are likely to have an important impact on bank stock market values. Bank financial statements provide three separate disclosures of changing default risks: non-performing loans, loan loss provisions, and loan chargeoffs. This study analyzes each of these disclosures for information about future bank cash flows and examines how investors impound this information in bank stock prices. Non-performing loans include all loans in the portfolio more than 90 days overdue on interest or principal payments, and are disclosed as supplemental financial statement information. Loan loss provisions reflect the current period increase in the level of expected future loan losses, and are disclosed as accrued expenses on the income statement. Loan chargeoffs measure all loans deemed uncollectible during the period. Chargeoffs are asset writeoffs that are reported separately in financial statement footnotes, and can also be derived from balance sheet and income statement data. Together these three disclosures represent an integrated, contextual set of potentially value-relevant information spanning the income statement, balance sheet, and footnotes. Recent empirical studies obtain evidence consistent with a positive relation between stock returns and loan loss provisions (cf., Beaver et al. 1989; Elliott et al. 1991; Griffin and Wallach 1991; Johnson 1989). This evidence is surprising because it contradicts the notion that loan loss provisions are interpreted as expenses that reflect expected future loan losses. These papers conjecture that perhaps the market interprets provisions as revelations of bank managers' private information about expected future earnings, but do not test this idea. One potential explanation for these findings is that investors condition their interpretation of unexpected provisions on contemporaneous unexpected changes in non-performing loans and unexpected loan chargeoffs. These relatively non-discretionary pieces of loan loss information may enable investors to estimate discretionary components in unexpected loan loss provisions. If investors observe discretion being exercised over reported provisions, then they can make inferences about managers' private information. The conjecture of prior research is that investors infer that managers reveal "good news" when they exercise discretion to increase provisions. The evidence presented here suggests bank managers increase the discretionary component of unexpected loan loss provisions when future cash flow prospects improve. Specifically, unexpected provisions are positively related to future changes in cash flows, after controlling for current changes in cash flows, unexpected changes in non-performing loans, and unexpected loan chargeoffs. Annual unexpected provisions are positively related to future changes in cash flows as far as three years ahead. Contemporaneous annual (and quarterly) stock returns, as well as earnings announcement date stock price reactions, confirm that investors interpret discretionary components of unexpected provisions as "good news." These findings contribute new evidence on earnings management and its impact on the capital markets. The positive relations between unexpected provisions and both returns and future cash flows emerge only when unexpected provisions are conditioned on unexpected changes in non-performing loans and unexpected loan chargeoffs. These results suggest unexpected changes in non-performing loans and unexpected loan chargeoffs, both of which are negatively related to changes in future cash flows and current stock returns, and enable investors to observe discretionary components of unexpected provisions. These findings provide new evidence of a context in which the market's interpretation of a component of income is conditioned on related disclosures found on the balance sheet and in the financial statement footnotes.]

Analyzes three separate disclosures of changing default risks for information about future bank cash flows and examines how investors impound this information in bank stock prices. Impact of bank loan portfolio cash flows and default risks on bank stock market values; Commercial bank loan loss accounting; Set of cash flow prediction tests.

[Prior research has found that loan loss provisions are positively associated with bank stock returns and future cash flows, conditional on less discretionary information about loan default. We find that these positive valuation implications obtain only for loan loss provisions for low regulatory capital banks in the fourth fiscal quarter. Our regulatory capital-based tests are motivated by the idea that increased discretionary loan loss provisions are plausibly good news only for banks which appear to have loan default risk problems based on prior information. Our fiscal quarter tests are motivated by findings in prior literature that suggest that managers have incentives to delay income decreasing accruals until the fourth quarter when the audit occurs, implying that income decreasing accruals are more likely, and therefore more expected, in the fourth quarter than in other fiscal quarters (Mendenhall and Nichols 1988; Boyd et al. 1994).]

This study examines the extent to which parsimonious and general cross‐sectional valuation models, restricted to include only publicly available historical accounting information, explain share prices in the cross section, identify periods when market mispricing may be more pervasive, and also identify which shares within those cross sections are more likely to be mispriced. Our model simply includes historical book value, earnings, dividends, and growth, but it explains on average over 60 percent of the cross‐sectional variation in share prices in annual estimations across 1975–2011. We also examine the extent to which the residuals indicate mispricing. The quintile of stocks picked by our model as most likely underpriced outperform the quintile of stocks picked as most likely overpriced by an average of 9.9 percent over the following 12 months, after controlling for size. We also predict and find that value residuals are better predictors of future abnormal returns: (i) among firms that are not covered by analysts; (ii) among firms that face fewer accounting measurement challenges; and (iii) when we estimate value model parameters by industry/year. We also predict and find our approach works better in periods when the mapping of fundamentals into prices is weaker. This study contributes a novel and straightforward approach to map accounting fundamentals into share prices in order to identify mispricing in time‐series and in the cross section.

Banking, Regulatory capital, Financial reporting, Tax incentives

Empirical accounting research provides surprisingly little evidence on whether accounting earnings numbers capture cross-sectional differences in risk that are associated with cross-sectional differences in share prices. We address two questions regarding the risk-relevance of accounting numbers: (1) Are accounting-related risk measures (i.e., the systematic risk and total volatility in a firm's time-series of residual return on equity) associated with the market's assessment and pricing of equity risk? (2) If so, then are these accounting-related risk measures incrementally associated with the market's assessment and pricing of equity risk beyond other observable factors, such as those in the Fama and French (1992) three-factor model? We develop an accounting-fundamentals-based measure of the market's pricing of risk—the difference between actual share price and a residual income valuation model estimate of share value using risk-free rates of return. Our results show that both systematic risk and total volatility in residual return on equity partially explain this pricing differential, and that the explanatory power of total volatility is incremental to the Fama and French (1992) factors—market beta, firm size, and the market-to-book ratio.