An Empirical Study On The Motivations And Economical Consequences Of Holding Fair Value Financial Assets

Fair value accounting has experienced a long history, but it was not widely adopted in the U.S until the end of the last century. There are two reasons that account for its fast development. One is the marketization of stock investment in the U.S., which has now become a main financing resource. The agency problem between enterprises and shareholders,especially the small and medium shareholders has emerged since then. The other one lies upon the deepened study and explorations into market efficiency, behavioral finance and market anomaly. Investors are regarded as bounded rational. The accounting information at historical cost cannot be fully understood by investors, which increases the cost of acquiring information for investors. Managers of the company possess more information in the process of valuation. Therefore, fair value accounting is viewed to be able to provide more value relevant information to investors.Under the assumption of established operating environment, most existing studies analyze and empirically test the influence of fair value accounting on the value relevance and decision efficiency on firm accounting information. This paper proposes that fair value accounting may not only affect the accounting information of a company, but also the management decisions of the company. Specifically, the paper investigates the motivations of holding financial assets that are measured at fair value. From the perspective of business interests, financial assets held by the company may be the result of the balance between the investment income and the demand for liquidity.This paper analyses within the framework of behavioral economics. It firstly discusses the abnormal incentives of listed companies to hold financial assets measured at fair value. For a non-financial company, there are usually three rational reasons to hold fair value financial assets, which are demand for liquidity, hedging and capital investment to maximize shareholders’ wealth. However, when the contracts are imperfect and the market supervision is not strict enough, managers may choose to hold this kind of financial assets only to benefit themselves. Flexible contract is just one kind of imperfect contract. It rewards managers for good performance but seldom punishes them for bad performance, thereby motivates managers to hold more highly-risky assets. Besides, when there isn’t strong governance, the supervision over managers may be weak, allowing managers to hold more highly-risky assets. The strength of supervision can be reflected in the transparency of financial information. After studying these two irrational motivations to hold fair value financial assets, this paper further investigates how the holdings of these assets affects earnings persistence and how capital market reacts to these decisions of managers. If companies hold these assets to maximize corporate wealth, earnings persistence shall be enhanced and the market shall offer a higher price and the price volatility shall be lower. If companies hold these assets irrationally, we shall observe a contrary result.From the aspect of imperfect contract, this paper, combined with agency theory and real option theory,discusses the potential incentive for managers to hold more fair value assets. These incentives are brought by the compensation stickiness in the compensation contracts of the managers and earnings management incentives. Specifically, the study reveals that compensation policies may influence the accounting decisions of managers. Past studies show that imperfect contracts may affect the accounting decisions of company managers, which shall be reflected in the decisions of holding financial assets. While evaluated by the short-term performance,managers are motived to hold more fair valued assets to gain more personal profits. Since the value of financial assets are highly volatile and imperfect contracts reward for good performance while seldom punish for bad performance, holding financial assets always brings benefit for company managers, therefore motivating them to hold more fair value financial assets. Empirical tests support these analyses. The study shows a significantly positive relationship between the compensation stickiness of managers and the holdings of trading securities, but not significant relationship is found between compensation stickiness and the holding of available-for-sale assets. That means, when the compensation is more sticky, managers are more likely to suffer from moral hazard under the modern agency system. When they are only slightly punished for poor performance but amply rewarded for good performance,managers are more likely to be involved in aggressive investment decisions, which make their investment decision against the welfare of shareholders. After the financial crisis, financial assets that are measured with fair value provide convenience for these aggressive investment decisions. Moreover, this paper finds that the positive correlation between compensation stickiness and the holding percentage of fair value accounting is even more significant in non-state-owned enterprises(NSOEs) in which the compensation of managers are more sensitive to firm performance. This part of the study not only confirms the widely existing stickiness in the compensation contracts of company managers, but also provides evidence that the imperfection in compensation contracts affects the holding of financial assets.Besides,this paper also discusses about the earnings management incentive associated with fair value financial assets. Companies may be supervised by internal department, external supervision department, shareholders and debtors. This paper uses earnings management to measure the level of supervision. Studies show that companies engage in more earnings management when supervision is weak. I also come up with that fair value financial assets may be used as a substitution for earnings management. Therefore, the paper argues that companies are more motivated to hold fair value financial assets if they engage in more earnings management in earlier periods. Tests show that,consistent with the theoretical hypotheses,companies are likely to hold more fair value assets when they are more involved in earnings management in the early periods. This method provides the companies a substitutive way to manage earnings when necessary. When companies actually need to manage earnings and the way of using discretionary accruals is restricted,companies can manage the book value of fair value assets achieve their goal of manipulating earnings. Similarly,compared with SOEs which has less incentive to management earnings,these findings are more pronounced in NSOEs,which provides further support for our hypothesis that fair value accounting can be used as a substitutive way for earnings management.In the end,upon the above stated incentives of holding fair value assets,the paper examines the economic consequences of holding fair value asset. The economic consequences can be divided into two types. The first is earnings persistence. Rational holdings of financial assets shall enhance earnings persistence. For example, if a firm holds financial assets to hedge potential risks, there shall be increase in earnings persistence. However, when the contracts are imperfect and the supervision is weak, holding financial assets to benefit managers may impair the interests of shareholders and lower earnings persistence. Furthermore, holding financial assets to benefit managers may increase the operational risk of the firms, which may be reflected in their market price. The opaque accounting information may also increase the volatility of stock price. Empirical tests show that holding fair value assets lowers both accounting profit persistence and market return persistence. Especially,the paper explores the effect of fair value accounting on earnings persistence which is seldom mentioned in earlier studies,which amplifies the existing literation on the value relevance of fair value accounting. To echo the above parts of the paper, tests also show that these findings are more significant in NSOEs.The main contribution of the paper is that it demonstrates,with empirical evidence,that simply adopting fair value accounting does not eliminate the information asymmetry and irrational behaviors of investors in the market. On the contrary,without strict supervision,adopting fair value accounting provide more opportunities for manager to manage earnings,mislead investors and expropriate personal profit. Therefore,to take full advantage of fair value accounting,we need to perfect accounting standards and market mechanism and improve the reliability of fair value accounting information.