Statement of Financial Accounting Standards No. 157 (FAS No. 157), Fair Value Measurements, prioritizes the source of information used in fair value measurements into three levels: (1) Level 1 (observable inputs from quoted prices in active markets), (2) Level 2 (indirectly observable inputs from quoted prices of comparable items in active markets, identical items in inactive markets, or other market-related information), and (3) Level 3 (unobservable, firm-generated inputs). Using quarterly reports of banking firms in 2008, we find that the value relevance of Level 1 and Level 2 fair values is greater than the value relevance of Level 3 fair values. In addition, we find evidence that the value relevance of fair values (especially Level 3 fair values) is greater for firms with strong corporate governance. Overall, our results support the relevance of fair value measurements under FAS No. 157, but weaker corporate governance mechanisms may reduce the relevance of these measures.
SUMMARY:
Using publicly traded bank holding company data from 2008 through 2011, this paper documents that the proportions of fair-valued assets held by banks are positively associated with audit fees. The positive association between audit fees and the proportions of total assets that are fair-valued using Level 3 inputs is greater than its positive association with the proportions of total assets that are fair-valued using Level 1 or Level 2 inputs. These results are consistent with a hypothesized scenario in which audit effort increases in the difficulty of verifying asset fair values. We also document that bank specialist auditors, defined as in Behn, Choi, and Kang (2008), charge lower audit fees to bank clients on average, suggesting cost efficiencies passed to clients as lower fees. However, bank expert auditors charge more for auditing the proportions of total assets that are fair-valued. Overall, the results support concerns expressed by some observers that greater use of fair value measurements for financial instruments will trigger increased audit fees.
Data Availability: All data used in this study are publicly available from the sources identified in the text.
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