8/9/2011 2011 AAA Annual Meeting 1

Fair Value Measurement and Accounting Restatements

James Fornaro (SUNY at Old Westbury)

Solomon Huang (National Cheng Kung University)

Steve Lin (Florida International University)

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Research Questions

Are firms with disclosure of Level 3 fair values more likely to subsequently restate their financial statements? The association between restatements and

Level 3 fair values

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Research Questions (cont.)

Do corporate governance control mechanisms make a difference? Effect of corporate governance on the

association between restatements and Level 3 fair values

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Why are these questions important?

Increased amounts of assets reported as Level 3 fair value measurements Deloitte reports that 19 of the 21 financial

service firms show a significant increase in the use of Level 3 fair value measurement between Q1 2008 and Q1 2009

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Why are these questions important? (cont.)

Level 3 fair values are estimated using the entity’s own data, they appear to be more complex, discretionary, and difficult for auditors to verify

Level 3 fair values may contain significant measurement errors and induce managerial manipulation Negative effect on quality of financial

statements

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Why are these questions important? (cont.)

Corporate governance mitigates accounting errors and managerial manipulation Corporate governance may not be able to

monitor less reliable fair values because of a lack of expertise

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Findings

Firms that disclose Level 3 fair values are more likely to subsequently restate their financial statements especially when they have weaker corporate governance mechanisms

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Finding (cont.)

Negative market reaction to restatement announcements is more severe if firms disclose higher Level 3 fair values

Under stronger governance, firms that report higher Level 3 fair values appear to have more negative market reaction around restatement announcements

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Contributions Provides evidence on the potential

limitation of fair value accounting

Provides further evidence to the debate over the trade-off between relevance and reliability

Role of corporate governance in monitoring less reliable fair value measurement

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SFAS 157 and the Fair Value Hierarchy

Three levels of fair value measurement Level 1: observable prices in active markets

for identical assets or liabilities

Level 2: either observable prices in active markets for similar assets or liabilities or observable market prices in inactive markets for identical assets or liabilities

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SFAS 157 and the Fair Value Hierarchy

Level 3: inputs are unobservable from the marketplace and reflect management’s underlying assumptions that market participants would use in pricing the assets or liabilities

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Level 3 Fair Values

Pros: mark to market; timely and relevant

Cons: causes information asymmetry difficult to verify Level 3 fair values (less

reliable) contains serious measurement error induces management opportunistic behaviour

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Hypotheses development

Extensive use of Level 3 fair value inputs by Enron (Benson, 2006) Low quality of financial statements

Level 1 and Level 2 fair values are more value relevant than Level 3 fair values (Song et al. 2010) Relevant but less reliable fair value

measurement

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Hypotheses development (cont.)

A negative association between fair value income and earnings before fair value income, indicating that fair value income is used to smooth earnings (Fiechter and Myers, 2011) Managerial opportunistic behaviour

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Hypotheses development (cont.)

Most business transactions related to Level 3 fair value measurement have a complex and discretionary nature. Some restatements are attributed to transaction complexity or intentional manipulation (Plumlee and Yohn, 2010) Level 3 fair value measurement may trigger

financial restatements

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Hypotheses development (cont.)

The unobservable nature of Level 3 inputs can reduce the reliability of reported information, provide increased opportunities for subjectivity and managerial discretion, and impair the auditors’ ability to monitor management’s behaviour

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Hypothesis 1 (cont.)

Hence, we predict

H1: Level 3 fair values are positively associated with subsequent accounting restatements

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Hypotheses development

Firms with internal control deficiencies have a greater number of prior SEC enforcement actions and accounting restatements (Ashbaugh-Skaife et al. 2007)

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Hypotheses development (cont.)

Disclosure of material weaknesses in internal controls in SOX 404 opinions is associated with a higher probability of subsequent restatements (Lopez et al. 2009)

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Hypotheses development (cont.)

Financial experts on the audit committee can reduce the valuation gap of fair value assets and liabilities (Kolev, 2008)

Audit efforts and audit fees increase when evaluating Level 3 fair values (Ettredge et al. 2010)

Level 3 fair values appear to become more value relevant when firms have strong corporate governance (Song et al. 2010)

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Hypothesis 2 Audit quality and effective corporate

governance mechanisms may mitigate some financial reporting risk resulting from Level 3 fair value measurement

Hence, we predict

H2: The positive association between level 3 fair values and subsequent accounting restatements is mitigated by stronger corporate governance mechanisms

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Data and Sample Selection Test period: 2008-2009 Industries: both financial and non-

financial Accounting data is from Compustat

Focuses on financial assets instead of financial liabilities

Governance data is from Audit Analytics Sample size: 339 restatement and 6,123

control firms (Table 1)

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Research Methods

Restatement (t+1, t+2) = α +β1LEVt +β2FINt +β3EPRt +β4BTMt +β5SALESGWt + β6FREECASHt +β7ACCRUALSt + β8SIZEt + β9ROAt + β10 FIN_DISt +β11LnAUD_TENt + β12INSIDER%t +β13BLOCKHO%t + β14ICWt +β15SPECt +β16-18FVA_VARSt + β19-21FVL_VARSt +β22-

30INDUSTRYi +ε (1)

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Research Methods (cont.)

Restatement (t+1, t+2): restatement one or two years after reporting Level 3 fair values

FVA_VARS = proxies of Level 1, 2, and 3 fair values of financial assets

FVL_VARS = proxies of Level 1, 2, and 3 fair values of financial liabilities

Three forms: fair value/total asset, per share, logged

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Definition of Control Variables

See pages 9 and 10 (Definition of control variables) Leverage Growth Accruals Size ROA Managerial shareholding Block shareholding Material weakness in internal control etc.

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Research Methods (cont.) Restatement (t+1, t+2) = α +β1LEVt +β2FINt +β3EPRt +

β4BTMt + β5SALESGWt +β6FREECASHt + β7ACCRUALSt +β8SIZEt +β9ROAt +β10 FIN_DISt + β11LnAUD_TENt +β12INSIDER%t + β13BLOCKHO%t +β14ICWt +β15SPECt +β16-18FVA_VARSt +β19GOV_SCOREt +β20-22FVA_VARSt

* GOV_SCOREt +β23-31INDUSTRYi + ε (2)

GOV_SCOREt : the governance score is constructed by the principal component factor analysis of six governance variables (Song et al. 2010)

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Governance Score Board independence (BDIND) Audit committee financial expertise

(ACFE) Audit committee size (ACSIZE) Percentage of shares held by

institutional investors (INSTHOLDPCT) Audit office size (AUDIT_OFFICESIZE) No material control weaknesses (NoMW)

under SOX 404

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Descriptive Analysis

Restatement firms have higher leverage, sales growth, financial

distress and probability of reporting material internal control weaknesses

have lower earnings price ratios, book to market ratios, free cash flows, accruals, and return-on-assets

are also smaller in size and have a lower percentage of shares owned by insiders and block-shareholders, and are less likely to be audited by an auditor industry specialist

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Descriptive Analysis (cont.) Restatement firms report lower mean and

median fair values of Level 1 and Level 2 assets for all three proxies

Mean fair values of Level 3 assets of restatement firms (FVA3_TA=2.45%) is higher than that of control firms (FVA3_TA=1.49%), suggesting that managers use a higher level of fair value inputs for Level 3 assets than inputs for level 1 and 2 assets

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Results for Hypothesis 1

See Table 3 (Restatement and level 3 fair values)

Variable Coefficient p-valueFVA3_TA 0.0949 0.087sqrtFVA3_PS 0.0072 0.033

LnFVA3 0.0007 0.058

Restatement is positively associated with disclosure of level 3 fair values after controlling for other factors

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Results for Hypothesis 2 See Table 5

(Restatement and level 3 fair value and governance score)

Variable Coefficient p-valueGOV_SCORE -0.0122 0.040 FVA3_TA*GOV_S -0.1247 0.524 sqrtFVA3_PS*GOV_S -0.0129 0.072 LnFVA3*GOV_S -0.0008 0.098

Firms with stronger governance appear to reduce the positive association between restatement and disclosure of level 3 fair values

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Additional Test 1 Market reaction around restatement

announcements when firms reported Level 3 fair values in previous years

See Table 7 (market reaction around restatement announcements)

Independent variable: CAR (-1,+1)Variable Coefficients p-valueFVA3_TA -0.3166 0.001sqrtFVA3_PS -0.0340 0.002LnFVA3 -0.0010 0.307

Additional Test 1 (cont.)

We find consistent results using CAR (-1, +5)

More negative market reaction around restatement announcements when firms previously reported Level 3 fair values

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Additional Test 2 Market reaction around restatement

announcements when firms have stronger corporate governance and reported Level 3 fair values in previous years

See table 8 (market reaction to restatements when firms have stronger governance)

Independent variable: CAR (-1,+1)Variable Coefficients p-valueFVA3_TA*GOV_S -0.4779 <.0001sqrtFVA3_PS*GOV_S -0.0669 0.013 LnFVA3*GOV_S -0.0048 0.048

Additional Test 2 (cont.)

We find consistent results using CAR (-1,+5)

Even more negative market reaction around restatement announcements when firms have stronger governance

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Additional Test 2 (cont.)

Two potential explanations

Investors do not expect firms with strong governance to restate their financial statements even when they reported Level 3 fair values

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Additional Test 2 (cont.) Firms with stronger governance provide

more detailed financial disclosures of restatement fair values. These additional disclosures may intensify market price downfalls (Myers 2010)

We find negative market reaction is mainly driven by firms that are audited by larger CPA firms and followed by more institutional investors

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Additional Test 3 We also find

Restatements were mainly requested by the SEC

Results for financial and non financial firms respectively are consistent, but the statistical significance of the variables are somewhat weaker compared to our main results

Results remain qualitatively consistent even after using data for 2008 sample only and adjusting for sample selection bias

Limitations Fair value data is available from 2008

Test period (2008-2009) is overlapping with financial crisis period

Amount of level 3 fair values is examined instead of change

Restatements may not directly relate to level 3 fair values

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Summary and Conclusion

Level 3 fair values reduces quality of accounting information because they are associated with subsequent restatements

Corporate governance can mitigate the positive association between accounting restatements and level 3 fair values

Our finding is potentially important for accounting standards setters and policy makers

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Thank you !!

Please send your comments to

lins@fiu.edu