Wilcox: Fair Value Materially Affects Reported Earnings

In a contribution to the American Association of Individual Investors Journal, Minnesota State University professor Stephen E. Wilcox discussed Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE) method of valuation.

A newly popular method of valuation, CAPE relies on inflation-adjusted earnings statements as well as averaging 10 years of reported earnings to account for business cycle effects. Wilcox says that CAPE provides “an overly bearish view of the stock market” and should be used with caution.

Fair value accounting, says Wilcox, showed how a change in accounting regulations had a material impact on reported earnings and is a key flaw in Shiller’s CAPE method.

When the Financial Accounting Standards Board (FASB) issued the fair value ruling in 2006 (and up through the financial crisis in 2008), investment securities and mortgage-backed securities made up a significant percentage of banks’ assets. Wilcox says, “The move toward more fair value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions” in the fourth quarter of 2008. CAPE, says Wilcox, must continue to reflect the impact of a single quarter’s massive loss even though it’s unlikely it will happen again in the next 10 years.