HIJERARHIJSKI NIVOI

Recent research on fair value measurements show that fair value assets and liabilities based on
unobservable (level 3) or indirectly observable inputs (level 2) are less value relevant (Song,
Thomas, & Yi, 2010), are associated with more information risk (Riedl & Serafeim, 2011) and
information asymmetry (Liao, Kang, Morris, & Tang, 2013), and are less priced (Goh, Li, Ng,
& Yong, 2015), compared with assets and liabilities measured by more transparent fair value
inputs (level 1).2 Thus, auditors increase audit efforts to verify such fair values, resulting in
higher audit fees (Ettredge, Xu, & Yi, 2014). In order to mitigate market discounting of the
lower-level (level 2 or level 3) fair value measurements, Badia, Duro, Penalva, and Ryan (2017)
provide evidence that firms with higher proportions of level 2 and level 3 fair value assets and
liabilities report more conditionally conservative comprehensive income. Generally speaking,
prior studies on fair value measurements imply that assets and liabilities based on lower-level
fair value inputs (level 2 or level 3), inputs which do not have quoted prices directly observable
from liquid and active markets, are less transparent, associated with greater valuation
uncertainty and subject to more discretion.
Prior studies find that fair value assets and liabilities based on lower-level inputs are less value
relevant (Song et al., 2010) and are associated with a higher cost of capital (Riedl & Serafeim,
2011), larger bid-ask spreads (Liao et al., 2013), higher audit fees (Ettredge et al., 2014), a
larger market discount (Goh et al., 2015) and more conditional conservatism in reporting
comprehensive income (Badia et al., 2017).
Some researchers and practitioners criticize the difficulties in applying and verifying fair value
measurements. For example, Benston (2008) points out that “fair values other than those taken
from quoted prices (level 1) could be readily manipulated by opportunistic and overoptimistic
managers, would be costly to make, and very difficult for auditors to verify and challenge”
(Benston, 2008, p. 104).
Although it is generally considered that level 3 fair value inputs are the least transparent, the
most subjective and subject to the greatest discretion among the three levels, level 2 fair value
measurements are also subject to managerial discretion and could be manipulated. First,
companies hold a much larger amount of level 2 assets and liabilities than level 3 assets and
liabilities. Taking the sample in this study as an example, level 2 fair value assets and liabilities
account for about 92% of the total fair value assets and liabilities while level 3 fair value assets
and liabilities account for only about 2%. This suggests that there could be more room to
manage earnings through level 2 fair value measurements. Second, there are mandatory detailed
disclosures for level 3 fair value assets and liabilities but there is no such disclosure requirement
for level 2 assets and liabilities. SFAS 157 requires companies to reconcile the beginning and
ending balances of level 3 fair value assets and liabilities and to disclose changes due to 1) total
gains and losses for the period; 2) purchases, sales, issuances, and settlements; 3) transfers in
and out of level 3 (SFAS157, p.12). The more detailed disclosure requirement for level 3 fair
value measurements makes it more difficult to manipulate level 3 fair value measurements since
they will receive more attention from investors, auditors and regulators. Ryan (2008, p.1628)
points out that “The required disclosures are considerably more detailed for level 3 fair value
measurements” and “These disclosures make the effects of level 3 measurements on the
financial statements considerably more transparent than they would have been under prior
GAAP.” He also mentions that “Indeed, given the poor quality market signals currently being
generated, I believe level 3 fair value measurements supported by disclosures of critical inputs
and the sensitivity of the measurements to the inputs often would be considerably more
informative to users of financial reports than poor quality level 2 fair value measurements.”
(Ryan, 2008, p. 1628) In addition, discussion with practitioners indicates that level 3 fair value
measurements have small dollar values and managers are conservative in reporting level 3
assets and liabilities. Generally speaking, although level 3 inputs are the least transparent and
the most subjective by definition, both level 2 and level 3 fair value inputs are subject to
discretion so assets and liabilities based on both level 2 and level 3 fair value inputs could be
associated with banks' discretionary accounting choices.
Researchers have expressed concerns that fair value measurements described in SFAS 157 give
managers more discretion over asset and liability valuation and fair values are more difficult
and costly to audit (Benston, 2008). Martin, Rich, and Wilks (2006) conclude from a stream of
judgment and decision-making research that there are unintentional and intentional biases when
managers prepare fair values. Specific knowledge and skills are required but difficult to gain to
audit fair values. In response to these concerns, studies examine how fair value measurements
in SFAS 157 affect auditing. Ettredge et al. (2014) find that fair value assets, especially level 3
assets, increase audit fees. Overall, these studies suggest that assets and liabilities based on level
3 fair value inputs are less transparent and less objective, are associated with greater valuation
uncertainty and are difficult to verify.
Recent studies on fair value measurements suggest that both level 2 and level 3 fair value
measurements are opaque, less reliable and subject to discretion. Bens, Cheng, and Neamtiu
(2016) show that the information uncertainty associated with level 2 and level 3 fair value assets
are significantly reduced after the issuance of SEC fair value comment letters. Badia et al.
(2017) provide evidence that firms with higher proportions of level 2 and level 3 fair value
assets and liabilities report more conditionally conservative comprehensive income. Wang and
Zhang (2017) show a positive association between fair value measurements, especially level 2
and level 3 measurements, and demand for convertible debt and short-term debt.
For instance, Level 3 fair values are estimated using management's own assumptions or
expectations, and are therefore complex, discretionary, and difficult for auditors to verify. They
may also contain significant measurement errors and induce managerial manipulation
(Landsman, 2007; Penman, 2007; SEC, 2008; Song, Thomas, & Yi, 2010). Previous studies on
the benefits of fair value accounting provide rather mixed results. For instance, Barth,
Landsman, and Rendleman (1998) find that managers are able to use their private information
to credibly report fair values. Aboody, Barth, and Kasznik (2006) and Bartov, Mohanram, and
Nissim (2007), however, find that managers may manipulate fair value inputs for their own
interest.
The CFA Institute also notes that “there are some limitations and implementation difficulties
associated with the fair value measurement approach including measurement error” (SEC,
2008, 140–141).2 Auditors and capital market participants have also been found to anticipate
potential financial misstatements when firm managers disclose more Level 3 fair values,
especially when the sluggish economy exacerbates the liquidity of certain financial instruments
(Fiechter & Meyer, 2011).
We argue that most business transactions related to Level 3 fair values are complex in nature.
Moreover, Level 3 fair values are determined by management discretion, and are considered
less reliable than Level 1 and Level 2 fair values that are based on observable market prices.
Hence, self-interested managers may be induced to overstate Level 3 inputs in order to
manipulate financial position and performance.
Many studies provide evidence on the use of Level 3 fair values for opportunistic activities. For
instance, Benston (2006) argues that Enron's failure is mainly attributable to its extensive use
of Level 3 fair value inputs (and Level 2 to a lesser extent) according to a chronologically
ordered analysis of Enron's investing transactions.8 Fiechter and Meyer (2011) investigate
whether managerial discretion over fair value measurements plays a role in earnings
management among U.S. banks during the recent financial crisis. They find a negative relation
between fair value income and earnings before fair value, and argue that managerial discretion
over fair value measurements is used to smooth earnings. Because Level 3 fair values also
reflect unobservable, firmgenerated data, they could contain serious estimation errors. As noted
earlier, Kohlberg Capital Corporation reported an estimation error in illiquid investments of
$53 million, which is around 12% of its total Level 3 financial assets in 2008. Taken together,
compared to Level 1 and Level 2 fair values that are based on observable market prices,
unobservable Level 3 fair value inputs can have a more significant negative impact on financial
reporting quality because they are less reliable, mainly reflect managerial discretion, and may
impair auditors' ability to discover management's opportunistic behavior.
A Level 1 asset is considered the best fair value measurement. According to paragraph 24:
‘‘Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities
that the reporting entity has the ability to access at the measurement date.’’ This measurement
is intended for stock and bond investments that are traded in significant volume on large public
exchanges. ‘‘Level 2 inputs are inputs other than quoted prices included within Level 1 that are
observable for the asset or liability, either directly or indirectly.’’ This measurement is intended,
as an example, for financial derivatives whose values can be estimated by a model based on
market inputs. Specifically, a stock option can be valued using an option pricing model and
market inputs including stock prices and stock volatility. ‘‘Level 3 inputs are unobservable
inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the
extent that observable inputs are not available, thereby allowing for situations in which there is
little, if any, market activity for the asset or liability at the measurement date.’’ Level 3 can be
applied, as a case in point, to custom-made financial derivatives which lack a well-defined
valuation model. Hence, Level 3 would be used for credit default swaps, a financial derivative
of mortgagedbacked securities that is normally classified as a Level 2 asset in a broad market.
Prior research shows that managers use discretion in estimating Level 3 financial instruments
to opportunistically manage capital and earnings. We investigate an earlier decision, subsequent
classification changes that result in net transfers into the Level 3 classification, to examine
whether firms use their discretion to engage in opportunistic transfers. We then investigate
whether auditors influence the decision to transfer into the Level 3 classification and/or alter
audit fees. Using a hand collected sample of public bank fair value disclosures from 2008
through 2010, we find evidence consistent with firms engaging in opportunistic transfers into
the Level 3 classification. We further find evidence that high quality auditors appear to
constrain this behavior, consistent with higher quality auditors mitigating some risks associated
with Level 3 instruments. We also find evidence that auditors increase fees when managers
transfer instruments into the Level 3 classification. Collectively, our findings suggest that
auditors manage risks related to Level 3 by both restricting transfers into the Level 3
classification and charging higher audit fees when transfers occur.
The Level 3 classification permits managers to use internal valuation techniques to determine
fair values of financial instruments for which observable inputs are either unreliable or
unavailable (FASB, 2006, ASC 820). If used appropriately, the disclosure of the Level 3
classification provides useful information to external stakeholders about the financial position
of the firm (Barth, Landsman, & Rendleman, 1998). However, recent evidence suggests that
once an instrument is in the Level 3 classification, managers use the subjectivity inherent in the
Level 3 valuations to opportunistically boost income (Laux & Leuz, 2009; Penman, 2007;
Robinson, Smith, & Valencia, 2015). In addition, auditors appear to charge a fee premium to
audit assets in Level 3 relative to the more verifiable Level 1 and Level 2 instruments (Ettredge,
Xu, & Yi, 2014).
Level 3 classification is supposed to be determined by the nature of the financial instrument,
and thus the transfer decision should be a nondiscretionary product of changing circumstances
for said instrument. However, Early, Hoffman, and Joe (2014) suggest that management often
has the ability to make the case for using either a Level 2 or a Level 3 classification. Managers
may exercise this discretion upon acquiring the investments or in a subsequent reclassification.
We also examine whether auditors appear to consider transfers into the Level 3 classification
in audit pricing. Prior research shows that the magnitude of Level 3 instruments is positively
associated with audit fees, and that auditors charge a premium to audit Level 3 relative to Level
1 or 2 instruments (Ettredge et al., 2014). We control for the amount of Level 3 assets and find
evidence that transfers into Level 3 are also associated with higher audit fees. This result is
consistent with auditors increasing fees in response to either the increased effort required to
audit Level 3 instruments and/or the increased risk associated with auditing Level 3 instruments.
The fair value hierarchy provides a structure intended to help determine fair values as follows:
Level 1 values reflect quoted prices in active markets for identical assets or liabilities; Level 2
values include quoted prices in active markets for similar assets or liabilities; and Level 3 values
represent managers' estimates based on internally generated valuation models and assumptions
(ASC 820). A company uses Level 3 valuations when neither Level 1 nor 2 values are available.
For example, Level 3 valuations would be used in periods when no market exists for an
underlying instrument or when a market violates the orderly market requirement for Level 1
and Level 2 values because there are too few buyers or too few sellers (markets are therefore
illiquid or inactive).
Fair values are difficult to audit, due to both preparer and auditor biases (Martin, Rich, & Wilks,
2006). Fair values, especially Level 3, have a high degree of uncertainty that increases the risk
of material misstatement, including the potential for management bias (AICPA, 2012, AU-C
540.A5 and A9). In a field study, Cannon and Bedard (2014) find that financial instruments are
the most difficult account to audit. Further, their study identifies factors that make fair values
difficult to audit including the number of significant and/or complex assumptions, high degree
of subjectivity associated with these assumptions, high degree of outcome uncertainty, and the
lack of objective data. Their field data emphasize major challenges in auditing fair values.
Echoing these findings, inspection reports suggest the PCAOB is concerned that auditors are
not adequately prepared for the challenges in auditing fair value measurements (Bratten et al.,
2013). Auditing fair values therefore poses significant risks to auditors, which are further
magnified if management acts opportunistically.
The inherent management discretion involved in the determination of Level 3 fair values also
led researchers to examine if managers are taking advantage of this discretion to improve
reported numbers, as well as if the market differentially interprets the information conveyed by
Level 3 instruments relative to other instruments. Prior research on whether managers use the
Level 3 classification opportunistically is limited. For example, Laux and Leuz (2009) and
Penman (2007) discuss the use of fair values, specifically Level 3, in their respective
commentaries. They identify the managerial information advantage in the estimation of fair
values based on Level 3 inputs and the potential for opportunism as a significant
implementation issue. Empirically, Robinson et al. (2015) provide evidence that bank managers
use the discretion in Level 3 fair value estimates to opportunistically achieve desired capital
and earnings targets.
Other studies specifically examine the value relevance of Level 3 fair value estimates and
produce somewhat mixed results. For example, Kolev (2008) finds investors price Level 3 fair
values evenwhen implied incentives and opportunities to influence the estimates are high. Song,
Thomas, and Yi (2010) find that investors' valuation of Level 3 fair values is greater for banks
with stronger corporate governance measures. In contrast, Khurana and Kim (2003) find that
the fair values of loans and deposits (which are traditionally not traded in active markets and as
such resemble Level 3 assets) reported by small bank holding companies are less informative
than their historical cost counterparts due to the inherent difficulty in estimation and
verification. Using a sample of financial institutions from 2008 through 2011, Goh, Ng, and
Yong (2015) find that investors initially price Level 3 instruments significantly lower than
Level 1 and 2 instruments. Further, they find the valuation discount dissipates somewhat as
overall market conditions stabilized and investors became more familiar with the Level 3
classification. Eng, Saudagaran, and Yoon (2009) investigate the value relevance of energy
contracts. They find that while the original value of trading assets related to energy contracts is
value-relevant, the excess of fair value over original value is not. Riedl and Serafeim (2011)
find higher costs of capital for firms with larger amounts of Level 3 instruments, suggesting
Level 3 instruments are associated with more information asymmetry. Finally, Magnan,
Menini, and Parbonetti (2015) provide evidence that banks with higher proportions of Level 3
instruments have higher analyst forecast dispersion.
Collectively, the Level 3 fair value research generally finds that managers use the discretion
afforded to them by the Level 3 classification to opportunistically report better financial
information. In addition, market participants appear to discount this information relative to non-
Level 3 instruments to adjust for the estimation noise and potential management bias present in
the reported numbers.
Early et al. (2014) experimentally examine auditor reactions to management's preferred fair
value-classification using professional auditors. They find evidence that auditors are more
diagnostically skeptical of management's preference to classify instruments as Level 2 relative
to Level 3. This preference of Level 2 over Level 3 arises due to the increased valuation that
outside stakeholders (investors and creditors) place on Level 2 relative to Level 3. Their
evidence suggests that managers may have an incentive to opportunistically transfer
instruments out of Level 3
However, Robinson et al. (2015) find evidence suggesting that managers use the discretion
inherent to the self-generated inputs of the Level 3 assets to opportunistically achieve desired
capital and earnings based targets. Managers can use the discretion allowed in Level 3 to boost
valuations thereby increasing the unrealized gains are recognized on trading securities and/or
reducing the impact of other than temporary impairments among available for sale securities
and held to maturity securities.5 Therefore, bank managers may be motivated to
opportunistically transfer instruments into Level 3 to recognize higher Level 3 valuations.
Agency theory predicts that managers make decisions that benefit themselves (Jensen &
Meckling, 1976). It is therefore likely that managers use the available discretion to
opportunistically transfer instruments into and out of Level 3. We expect that managers will be
more inclined to engage in opportunistic transfers when they have greater incentives to engage
in opportunistic behavior.
We investigate transfers inwith the first hypothesis.While transfers out of Level 3 may also be
opportunistic, there is a greater potential for management opportunism with transfers in. Prior
research of opportunistic behavior focuses on the source of opportunism. In our study, the
heightened incentives are based on contractual implications from earnings and capital
management. These aspects are not present or more limited with respect to transfers out.
Further, situations of decreased opportunism are not necessarily associated with opposite
behavior. Finally, prior research provides evidence that transfers out of level 3 have valuation
implications (Goh et al., 2015; Song et al., 2010), not the contractual implications that we study.
With respect to Level 3 fair values, auditors perform procedures (such as ASC 820 leveling)
that test the appropriateness and reasonableness of managements' classification decisions (Early
et al., 2014). These procedures are especially important during our sample period because the
reasons underlying management's classifications were not disclosed publicly during our sample
period. We suggest that these types of procedures allow the auditor to constrain opportunistic
classifications of Level 3 fair values, because the auditors closely examine and challenge the
basis for managements' decision.
Theoretically, audit fees are a function of audit effort and audit risk (Simunic, 1980). Level 3
investment instruments are more complex than Level 1 and 2 as the fair value estimates are
based on valuation models subject to management assumptions. Auditors likely react to this
increased complexity by increasing their effort and increase the audit fee for the client as a
consequence. Ettredge et al. (2014) suggest that auditors charge a higher fee to audit instruments
that are less verifiable. Therefore, if Level 3 instruments require more effort, we expect to
observe a positive association between transfers into Level 3 and audit fees.
Transfers into Level 3 also represent an increase in risk to the auditor. The increased complexity
is accompanied by an increase in uncertainty with respect to auditor judgments. As a result,
there is an increase in the risk of material misstatement as well as a greater potential for
management bias (AICPA, 2012, AU 540). The increased audit risk also likely results in an
increased fee for the client.
We therefore expect that transfers into Level 3, representing increasing measurement
complexity, increases audit effort and/or audit risk and leads to audit fee increases.6