8/9/ AAA Annual Meeting1 Fair Value Measurement and Accounting Restatements James Fornaro (SUNY at Old Westbury) Solomon Huang (National Cheng Kung University) Steve Lin (Florida International University)

8/9/ AAA Annual Meeting2 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

8/9/ AAA Annual Meeting3 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

8/9/ AAA Annual Meeting4 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 Q and Q1 2009

8/9/ AAA Annual Meeting

8/9/ AAA Annual Meeting6 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

8/9/ AAA Annual Meeting7 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

8/9/ AAA Annual Meeting8 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

8/9/ AAA Annual Meeting9 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

8/9/ AAA Annual Meeting10 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

8/9/ AAA Annual Meeting11 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

8/9/ AAA Annual Meeting12 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

8/9/ AAA Annual Meeting13 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

8/9/ AAA Annual Meeting14 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

8/9/ AAA Annual Meeting15 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

8/9/ AAA Annual Meeting16 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

8/9/ AAA Annual Meeting17 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

8/9/ AAA Annual Meeting18 Hypothesis 1 (cont.) Hence, we predict H1: Level 3 fair values are positively associated with subsequent accounting restatements

8/9/ AAA Annual Meeting19 Hypotheses development Firms with internal control deficiencies have a greater number of prior SEC enforcement actions and accounting restatements (Ashbaugh-Skaife et al. 2007)

8/9/ AAA Annual Meeting20 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)

8/9/ AAA Annual Meeting21 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)

8/9/ AAA Annual Meeting22 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

8/9/ AAA Annual Meeting23 Data and Sample Selection Test period: 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)(Table 1)

8/9/ AAA Annual Meeting24 Research Methods Restatement (t+1, t+2) = α +β1LEV t +β2FIN t +β3EPR t +β4BTM t +β5SALESGW t + β6FREECASH t +β7ACCRUALS t + β8SIZE t + β9ROA t + β10 FIN_DIS t +β11LnAUD_TEN t + β12INSIDER% t +β13BLOCKHO% t + β14ICW t +β15SPEC t +β16-18FVA_VARS t + β19- 21FVL_VARS t +β22-30INDUSTRY i +ε (1)

8/9/ AAA Annual Meeting25 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

8/9/ AAA Annual Meeting26 Definition of Control Variables See pages 9 and 10 (Definition of control variables)(Definition of control variables) Leverage Growth Accruals Size ROA Managerial shareholding Block shareholding Material weakness in internal control etc.

8/9/ AAA Annual Meeting27 Research Methods (cont.) Restatement (t+1, t+2) = α +β1LEV t +β2FIN t +β3EPR t + β4BTM t + β5SALESGW t +β6FREECASH t + β7ACCRUALS t +β8SIZE t +β9ROA t +β10 FIN_DIS t + β11LnAUD_TEN t +β12INSIDER% t + β13BLOCKHO% t +β14ICW t +β15SPEC t +β16-18FVA_VARS t +β19GOV_SCORE t +β20-22FVA_VARS t * GOV_SCORE t +β23-31INDUSTRY i + ε (2) GOV_SCORE t : the governance score is constructed by the principal component factor analysis of six governance variables ( Song et al )

8/9/ AAA Annual Meeting28 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

8/9/ AAA Annual Meeting29 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

8/9/ AAA Annual Meeting30 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

8/9/ AAA Annual Meeting31 Results for Hypothesis 1 See Table 3 (Restatement and level 3 fair values)(Restatement and level 3 fair values) VariableCoefficientp-value FVA3_TA sqrtFVA3_PS LnFVA Restatement is positively associated with disclosure of level 3 fair values after controlling for other factors

8/9/ AAA Annual Meeting32 Results for Hypothesis 2 See Table 5 (Restatement and level 3 fair value and governance score)(Restatement and level 3 fair value and governance score) VariableCoefficientp-value GOV_SCORE FVA3_TA*GOV_S sqrtFVA3_PS*GOV_S LnFVA3*GOV_S Firms with stronger governance appear to reduce the positive association between restatement and disclosure of level 3 fair values

8/9/ AAA Annual Meeting33 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)(market reaction around restatement announcements) Independent variable: CAR (-1,+1) VariableCoefficientsp-value FVA3_TA sqrtFVA3_PS LnFVA

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 8/9/ AAA Annual Meeting

8/9/ AAA Annual Meeting35 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)(market reaction to restatements when firms have stronger governance) Independent variable: CAR (-1,+1) VariableCoefficientsp-value FVA3_TA*GOV_S <.0001 sqrtFVA3_PS*GOV_S LnFVA3*GOV_S

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 8/9/ AAA Annual Meeting

8/9/ AAA Annual Meeting37 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

8/9/ AAA Annual Meeting38 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

8/9/ AAA Annual Meeting39 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 ( ) 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 8/9/ AAA Annual Meeting

8/9/ AAA Annual Meeting41 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

8/9/ AAA Annual Meeting42 Thank you !! Please send your comments to