What is cross-sectional valuation and how has this approach been used in research studies?

Question

What will be an ideal response?

Answer 1

ANSWER:
Cross-sectional valuation examines the association between accounting data reported in annual financial statements and the levels of stock prices. This approach has been used to investigate how specific components of the financial statements are associated with the market valuation of the firm. If an item is considered an asset/revenue, it should normally have a positive relation to market value, whereas if the item is considered a liability/expense, it should normally have a negative relation with market value.

Several studies have used this framework to determine that a firm’s pension plan assets and liabilities, as reported in footnote disclosures, are consistent with their being viewed as real (on-balance sheet) assets and liabilities. Another study determined that components of pension expense are not weighted equally in terms of their association with market valuation. The transitional asset amortization component of pension expense was implicitly valued at zero, which is consistent with the fact that there are no cash flows associated with the item.

Another study examined the association of research and development expenditures with firm value. On average, each dollar of R&D was associated with a five-dollar increase in market value. This shows that the market interprets R&D as an asset rather than an expense, contrary to the required accounting treatment.

Studies have also examined supplemental disclosures of non-performing loans and interest rate risk in banks and thrifts. Non-performing loans were negatively associated with firm value and interest rate risk was negatively associated with firm value only for banks. Another study reported that banks’ supplemental disclosures of the “fair market value” of investment securities is associated with market value over and above that explained by historical costs alone, a finding that gives credence to the SEC’s and FASB’s recent push for market-to-market accounting.