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Fair Value Reporting During the Financial Crisis of 2007-2010:
Evidence from U.S. Publicly Traded Companies
Sylwia Gornik-Tomaszewski, DBA, CMA, CFM
Associate Professor
Department of Accounting and Taxation
Tobin College of Business
St. John's University
8000 Utopia Parkway
Bent Hall - Room 362
Queens, NY 11439
Phone - 718 990-2499
Fax - 718 990-1868
E-mail: gornikts@stjohns.edu
Submitted to: 2012 Cambridge Business & Economics Conference (CBEC)
Sponsored by: Association for Business & Economics Research (ABER)
International Journal of Business & Economics
Oxford Journal
June 27-28, 2012
Cambridge University, UK
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Fair Value Reporting During the Financial Crisis of 2007-2010:
Evidence from U.S. Publicly Traded Companies
ABSTRACT
Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157),
issued in September 2006, defines fair value, establishes a framework for measuring fair value,
and expands disclosure about fair value measurements. Some critics blamed FAS 157 for
contributing to the sub-prime mortgage crisis. Supporters, on the other hand, argued that fair
value accounting is merely a reflection of the underlying problem. This study examines FAS 157
fair value disclosures reported by a large sample of U.S. publicly traded companies from 2007 to
2010. Performed analysis indicates limited scope of fair value measurements and provides a new
evidence of reporting asymmetry: on average, fair value assets significantly outweighed fair
value liabilities despite fair value option being in effect. Furthermore, measurement of liabilities
was based on unobservable inputs to a greater degree than measurement of assets. These findings
are true for the financial as well as non-financial entities. In addition, this study contributes
evidence on differences in fair valuation before and after the turning point in the financial crisis
in the mid-2009. Fair value assets as percentage of total assets and fair value liabilities as
percentage of total liabilities increased after June 2009. The percentage of fair value assets
measured based on unobservable inputs declined. These results can be attributed to improved
liquidity and stabilization in the markets after June 2009. Contrary to expectations, however, the
percentage of fair value liabilities measured based on unobservable inputs increased significantly
after June 2009. These results have implications for investors, auditors, and educators.
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INTRODUCTION
The recent financial crisis has led to a major debate about fair-value accounting. Many critics
argue that fair-value accounting, and especially its mark-to-market form, has significantly
contributed to the financial crisis or, at least, made it worse (see, e.g., Ely (2009), Forbes (2009),
and Wallison (2008)). From a few-years perspective we can say now that a lot of this criticism
resulted from unfortunate timing of the release of fair value accounting standards by the
Financial Accounting Standards Board (FASB), and was politically motivated.
In September 2006, FASB issued Statement of Financial Accounting Standards No. 157, Fair
Value Measurements (FAS 157), now codified in the FASB Accounting Standards
CodificationTM Topic 820 (ASC 820).1 The standard does not increase the use of fair value
measurement, but instead provides a uniform authoritative definition of fair value, establishes a
framework for measuring fair value, and expands disclosure about fair value measurements. Six
months later FASB issued FAS 159, The Fair Value Option for Financial Assets and Financial
Liabilities, Including an Amendment of FASB Statement No. 115, now codified in ASC 825,
which applies to measurements for stocks, bonds, loans, warranty obligations and interest rate
hedges, and provides entities the option (but not the requirement) to measure at fair value such
financial instruments and certain other items that are not required to be measured at fair value.
The stated objective of FAS 159 is “to improve financial reporting by providing entities with the
opportunity to mitigate volatility in reported earnings caused by measuring related assets (such
as loans held for sale) and liabilities (such as forward sales commitments) differently without
having to apply complex hedge accounting provisions” (FASB, 2007).
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Shortly after the release of these pronouncements, the subprime mortgage market problems
began to emerge. Companies and particularly financial institutions began to question whether or
not their distress was related to the new accounting standards. Although poor risk management
and faulty investments contributed to the problem, it was easy to blame fair value accounting.
U.S. Chamber of Commerce, American Bankers Association, American Council of Life Insurers,
Financial Services Roundtable, the Council of Federal Home Loan Banks, real estate and home
builders groups, and numerous politicians, among others, complained that the inability of
businesses, investors, and government to properly value assets in inactive disorderly markets has
created uncertainty and a loss of confidence. FAS 157 had a significant impact on fair value
accounting for illiquid securities as prior to this rule companies often cherry-picked information
to support valuations for illiquid positions.2 There were also perceived problems with accounting
rules on impairment of debt and equity securities — and specifically on guidance on “other-thantemporary impairment” — which have contributed to big write downs of assets.
In order to correct the unintended consequences of mark-to-market accounting, the Office of the
Chief Accountant of the Securities and Exchange Commission (SEC) and the FASB staff jointly
issued a press release on September 30, 2008 — SEC Release 2008-234: SEC Office of the Chief
Accountant and FASB Staff Clarifications on Fair Value Accounting, that provided financial
statement users, preparers, and auditors with clarification on the application of fair value
accounting (Casabona and Shoaf, 2010).
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The FASB followed up on October 10, 2008, with the posting of FASB Staff Position (FSP)
FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is
Not Active (ASC 820-10-35). In this staff position FASB advised their constituents that
determining fair value in a dislocated market depends on the facts and circumstances and may
require the use of significant judgment about whether individual transactions are forced
liquidations or distressed sales. Furthermore, the use of the reporting entity’s own assumptions
about future cash flows and appropriately risk-adjusted discount rates is acceptable when
relevant observable inputs are not available (FASB, 2008).
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into
law. The EESA granted authority to the SEC to suspend FAS 157. Section 133 of the Act
mandated that the SEC conduct a study on mark-to-market accounting. The SEC was required to
consider the impact of accounting standards on bank failure, the process used by FASB in
developing accounting standards, and modifications or alternatives to existing standards.
The SEC provided its study, Report and Recommendations Pursuant to Section 133 of the
Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting, to U.S.
Congress on December 30, 2008. The Commission concluded that existing mark-to-market
accounting should not be suspended. One of the recommendations in the study stated that
“additional measures should be taken to improve the application and practice related to existing
fair value requirements...” This recommendation further noted that “fair value requirements
should be improved through development of application and best practices guidance for
determining fair value in illiquid or inactive markets” (SEC, 2008). Although there are built-in
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implementation flexibilities in FAS 157, the SEC’s suggestions for additional guidance included:
(a) how to determine when markets become inactive and thus may require significant adjustment
to transactions or quoted prices; and (b) how to determine if a transaction (group of transactions)
is not orderly but rather forced or distressed. In response to the recommendations FASB issued
several pronouncements addressing the credit crisis and providing additional guidance to companies.3
This study examines FAS 157 fair value disclosures reported by U.S. publicly traded companies
during the first four fiscal periods since the standard have become effective. Data analysis
focuses on three research questions: (1) to what extent assets and liabilities are measured at fair
value, (2) to what extent unobservable inputs are used to measure fair value; and (3) how (1) and
(2) compare before and after the turning-point in the financial crisis in the mid-2009.
The results show evidence of reporting asymmetry: on average, fair value assets significantly
outweigh fair value liabilities. Furthermore, fair value measurement of liabilities is based on
unobservable inputs to a greater degree than fair value measurement of assets. These findings are
true for the financial as well as non-financial entities. Also, the fair value assets and liabilities, as
well as the fair value assets and liabilities categorized as based on unobservable (entitygenerated) inputs differ before and after June 2009.
The remainder of the paper is organized as follows. In next section provisions of FAS 157 and
the implementation guidance are described to provide background for this study. This section
also addresses recent international convergence on fair value measurements. Next, prior
empirical studies on fair value reporting under FAS 157 are discussed, followed by description
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of empirical tests and their results. Concluding remarks from the study are offered in the final
section.
BACKGROUND
FASB issued FAS 157 in September 2006 with the objective to increase consistency and
comparability in fair value measurements. FAS 157 does not require any new fair value
measurements but establishes a single definition of fair value and a framework for measuring fair
value. It improves transparency by expending disclosures about fair value measurements.
Single Authoritative Definition of Fair Value
Prior to FAS 157, neither a single coherent definition for fair value nor detailed guidance for
applying the fair value definition existed. This Statement defines fair value as the price that
would be received to sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date (FASB, 2006, ¶5)4. FASB clarifies that the basis for
a fair value measure is an exit price – the price in an orderly transaction between market
participants to sell the asset or transfer the liability in the principal (or most advantageous)
market for the asset or liability; not an entry price – that is the market price at which an asset is
acquired or a liability is assumed.5 The Board affirmed that the transaction to sell the asset or
transfer the liability is an orderly transaction, not a forced transaction (for example, if the seller is
experiencing financial difficulty). The transaction to sell the asset or transfer the liability is a
hypothetical transaction at the measurement date. Therefore, regardless of the management intent
to hold or sell the asset or transfer the liability, the definition focuses on the exit price.
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Valuation Techniques
FASB indicates that three valuation techniques could be used to measure fair value: market
approach, income approach, and cost approach. The market approach uses prices and other
relevant information generated by market transactions involving identical or comparable assets
and liabilities. This valuation technique, also referred to as the mark-to-market approach, utilizes
an unadjusted market quoted price for the security available from the financial press or other
sources. When a security has no readily available direct market quote but quotes are available for
similar securities, relative value analysis or a matrix pricing approach may be used. This
approach may utilize a simple price interpolation or involve more complex analysis or
algorithms. A consensus price derived from several quoted prices may be also useful.
The income approach uses valuation techniques to convert future amounts, such as cash flows or
earnings, to a single discounted present amount. Also referred to as mark-to-model approach, the
technique involves the application of mathematical models that are calibrated to market quoted
prices and reflect current market expectations about future amounts. Those valuation techniques
include present value techniques; option-pricing models, such as the Black-Scholes-Merton
formula and a binomial model.
Finally, the cost approach is based on the current replacement cost that is the amount that
currently would be required to replace the service capacity of an asset. From the perspective of a
market participant (seller), the price that would be received for the asset is determined based on
the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable
utility, adjusted for obsolescence.
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FASB encourages use of multiple valuation techniques, if needed. The board also suggests, that
although valuation techniques used to measure fair value should be applied consistently, a
change in a valuation technique or its application is appropriate if the change results in a
measurement that is equally or more representative of fair value (FASB 2006).
Fair Value Hierarchy
The Statement established a fair value hierarchy with the purpose to prioritize the market inputs
to valuation techniques used to measure fair value into three broad levels.6 The availability of
market inputs relevant to the asset or liability and the faithful representation of the inputs may
affect the selection of appropriate valuation techniques. However, the fair value hierarchy
focuses on the market inputs to valuation techniques, not the valuation techniques themselves
(Casabona & Shoaf, 2007). Fair value is a market-based measurement, not an entity-specific
measurement. Therefore, a fair value measurement should be determined based on the
assumptions that market participants would use in pricing the asset or liability. As a basis for
considering market participant assumptions in fair value measurements, FAS 157 establishes a
fair value hierarchy that distinguishes between (1) inputs that reflect market participant
assumptions developed based on market data obtained from sources independent of the reporting
entity (observable inputs); and (2) inputs that reflect the reporting entity’s own assumptions
about market participant assumptions developed based on the best information available in the
circumstances (unobservable inputs). The notion of unobservable inputs was intended by FASB
to allow for situations in which there is little, if any, market activity for the asset or liability at
the measurement date.
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Observable inputs are classified into Levels 1 and 2. Level 1 inputs are unadjusted quoted prices
in active markets for identical assets or liabilities that the reporting entity has the ability to access
at the measurement date. An active market for the asset or liability is a market in which
transactions for the asset or liability occur with sufficient frequency and volume to provide
pricing information on an ongoing basis. Level 2 inputs are other directly or indirectly
observable inputs, such as (FASB, 2006):
a. Quoted prices for similar assets or liabilities in active markets;
b. Quoted prices for identical or similar assets or liabilities in markets which are not active;7
c. Inputs other than quoted prices that are observable for the asset or liability, such as
interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment
speeds, loss severities, credit risks, and default rates; and
d. Inputs that are derived principally from or corroborated by observable market data by
correlation or other means (market-corroborated inputs).
Unobservable Level 3 inputs should be used to measure fair value to the extent that observable
inputs are not available. However, the fair value measurement objective remains the same, that
is, an exit price from the perspective of a market participant that holds the asset or owes the
liability. Unobservable inputs should be developed based on the best information available in the
circumstances, which might include the reporting entity’s own data. In developing unobservable
inputs, the reporting entity need not undertake all possible efforts to obtain information about
market participant assumptions. However, the reporting entity shall not ignore information about
market participant assumptions that is reasonably available without undue cost and effort.
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Table 1 summarizes the fair value hierarchy providing examples of inputs at each of the three
levels and instruments which could be valued using these inputs. Furthermore, the inputs are
linked to the respective valuation techniques (approaches).
{TABLE 1 ABOUT HERE}
FAS 157 expands disclosures about the use of fair value to measure assets and liabilities in
interim and annual periods subsequent to initial recognition. Disclosures about fair value
measurements are designed to provide users of financial statements with additional transparency
regarding the extent to which fair value is used to measure assets and liabilities, valuation
techniques, inputs and assumptions used in measuring fair value, and effect on earnings.
Additional Implementation Guidance
During 2009 FASB, responding to criticism, issued two pieces of guidance clarifying
requirements of FAS 157. The first was FSP FAS 157-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly, and the second Accounting Standards Update
(ASU) 2009-05, Measuring Liabilities at Fair Value. FSP FAS 157-4 affirms the core principles
of FAS 157 and provides additional guidance in determining when observable transaction prices
or quoted prices in markets that have become less active require significant adjustment to
estimate fair value.8 It became effective for interim and annual reporting periods ending after
June 15, 2009, although early adoption was permitted for periods ending after March 15, 2009.
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FASB reaffirmed that further analysis and significant judgment may be necessary to estimate fair
value, especially in circumstances where the volume and level of activity has significantly
decreased. In addition, multiple valuation techniques may be appropriate for estimating fair
value. The reasonableness of the range of fair value estimates resulting from multiple techniques
must be considered with the objective of determining the point within the range that is most
representative of fair value under current market conditions.
The FSP FAS 157-4 provides examples of factors to be considered in determination whether
there has been a significant decrease in the volume and level of activity for the asset or liability
compared with normal market activity, such as few recent transactions, price quotations are not
based on current information, and price quotations vary substantially over time or among market
makers (FSP FAS 157-4, ¶12). If it is concluded that there has been a significant decrease in the
volume and level of activity in relation to normal market activity, then observable transaction
prices may not be determinative of fair value, further analysis is needed and a significant
adjustment to such prices may be necessary to estimate fair value.
In the next step an evaluation should be made whether the transaction is orderly. This evaluation
would be based on the weight of the evidence because even if there has been a significant
decrease in the volume and level of activity, it should not be concluded that all observable
transactions are not orderly (that is, distressed or forced). The FSP FAS 157-4 provides examples
of characteristics of transactions that are not orderly. If, based on weight of evidence, an entity
concludes that the transaction is not orderly than little, if any, weight is assigned to the
transaction in estimating fair value. The FSP FAS 157-4 also requires additional disclosures for
interim and annual periods for equity and debt securities by major security type.
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The second major pronouncement was ASU 2009-05, finalized in August 2009, which clarified
FAS 157’s guidance on the fair value measurement of liabilities. The ASU 2009-05 emphasized
the importance of maximizing the use of relevant observable inputs and minimizing the use of
unobservable inputs, regardless of the method employed (Casabona and Shoaf, 2010).
Recent Developments in Fair Value Accounting
On May 12, 2011 FASB and the International Accounting Standards Board (IASB) completed
their Fair Value Measurement joint convergence project by issuing guidance on fair value
measurement and disclosure heralded in a press release as “largely identical” across International
Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (U.S.
GAAP) (FASB, 2011). The guidance is set out in IFRS 13, Fair Value Measurement, and FASB
ASU 2011-04, Fair Value Measurement (Topic 820)—Amendments to Achieve Common Fair
Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The boards stated
that the harmonization of fair value measurement and disclosure requirements internationally
forms an important element of the boards’ response to the global financial crisis.
Like FAS 157, the new standards do not extend the use of fair value accounting, but provide
guidance on how it should be applied where its use is already required or permitted by other
standards within IFRS or U.S. GAAP. For IFRS, IFRS 13 will improve consistency and reduce
complexity by providing, for the first time, a precise definition of fair value and a single source
of fair value measurement and disclosure requirements for use across IFRS. For U.S. GAAP,
ASU 2011-04 supersedes most of the guidance in FASB ASC Topic 820 although many of the
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changes are clarifications of existing guidance or wording changes to align with IFRS 13. It also
reflects FASB’s consideration of the different characteristics of public and nonpublic entities and
the needs of users of their financial statements. Nonpublic entities will be exempt from a number
of the new disclosure requirements.
REVIEW OF PRIOR STUDIES ON FAIR VALUE REPORTING UNDER FAS 157
The relation between fair value applications and economic cycles has been discussed in many
studies (see, e.g., Enria et al. (2004) and Novoa et al. (2009)). This literature review is limited to
studies focusing on fair value reporting under FAS 157.
Several empirical studies concentrated on fair value hierarchy under FAS 157; some researchers
investigated value relevance of inputs used to derive the fair value of an asset or liability. Using
quarterly reports of banking firms in 2008, Song et al. (2010) found that the value relevance of
Level 1 and Level 2 fair values is greater than the value relevance of Level 3 fair values. They
also produced evidence that the value relevance of fair values (especially unobservable Level 3
fair values) is greater for firms with strong corporate governance.
Bhamornsiri et al. (2010) examined disclosures on fair value measurements, required by FAS
157, in quarterly reports (Form 10-Q’s) issued by the Fortune 500 companies for quarter ended
March 31, 2008. Their results show that a large majority of inputs are observable. More
specifically, 93.5% of the sample financial assets and 93.1% of the sample financial liabilities
were measured by Level 1 or 2 inputs.
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Laux and Leuz (2010) examined the role of fair-value accounting in the financial crisis using
descriptive data and empirical evidence. They concluded that it is unlikely that fair-value
accounting added to the severity of the 2008 financial crisis in a major way. While there may
have been downward spirals or asset-fire sales in certain markets, Laux and Leuz (2010) find
little evidence that these effects were the result of fair-value accounting. They also find little
support for claims that fair-value accounting led to excessive write-downs of banks' assets. If
anything, empirical evidence to date points in the opposite direction, that is, toward the
overvaluation of bank assets during the crisis.
While previous studies on fair value reporting under FAS 157 concentrate on financial
institutions and fair value assets, this study expands the analysis to all U.S. publicly traded
companies representing cross-section of industries, and compares reported fair value assets and
fair value liabilities. Moreover, because several years past since FAS 157 became effective,
analysis of changes in reported fair values over the period 2007-2010 is performed.
EMPIRICAL STUDY
Sample Selection
The data was obtained from Compustat (North America – Fundamentals Annual). The sample
covers fiscal years 2007 to 2010. The data was collected within a date range November 2007 to
May 2011. FAS 157 became effective for fiscal years beginning after November 15, 2007 9 and
2010 was the last fiscal year for which data were available in Compustat at the time the analysis
was performed. The date range was extended to early months of 2011 to include as many
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companies with fiscal year ends other than December 31, as possible. Companies with foreign
incorporation code were excluded from the sample.
There were 27,187 observations collected from the Industrial files (INDL),10 adjusted as follows.
First, 5,571 observations were deleted with missing values for total assets or total liabilities.
Next, 11,259 observations were deleted with missing values under all levels in the fair value
hierarchy. The elimination process produced a final sample of 10,357 observations included in
the analysis.
Research Design and Results
To examine the extent of fair value reporting during the period 2007-2010, two variables were
created. The first variable, FVA, measures assets reported at fair value as percentage of total
assets. It is computed as follows: 11
FVA = [(AQPL1 + AOL2 + AUL3)/AT] * 100
(1)
where:
AQPL1 - Level 1 Assets (Quoted Prices);
AOL2 - Level 2 Assets (Observable);
AUL3 - Level 3 Assets (Unobservable);
AT – Total Assets.
The second variable, FVL, measures liabilities reported at fair value as percentage of total
liabilities. It is computed as follows:
FVL = [(LQPL1 + LOL2 + LUL3)/LT] * 100
(2)
where:
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LQPL1 - Level 1 Liabilities (Quoted Prices);
LOL2 - Level 2 Liabilities (Observable);
LUL3 - Level 3 Liabilities (Unobservable);
LT – Total Liabilities.
To examine the extent of reliance on unobservable (entity-generated) inputs during the period
2007-2010, two variables were created. The first variable, Level 3_Assets, represents Level 3
assets as percentage of total fair value assets. The variable is computed as follows:
Level 3_Assets = (AUL3/TotalFVA) * 100
(3)
where:
AUL3 - Level 3 Assets (Unobservable), and
TotalFVA = AQPL1 + AOL2 + AUL3.
The second variable, Level 3_Liabilities, represents Level 3 liabilities as percentage of total fair
value liabilities:
Level 3_Liabilities = (LUL3/TotalFVL) * 100
(4)
where:
LUL3 - Level 3 Liabilities (Unobservable), and
TotalFVL = LQPL1 + LOL2 + LUL3.
Figure 1 presents graphically mean values for these variables per year. The vertical numbers on
the columns represent number of observations on which each mean ratio (percentage) is based.
Because the data is derived from annual reports, these numbers also represent number of
companies which reported fair value measurements.
{FIGURE 1 ABOUT HERE}
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On average, compare to total assets, fair value assets dropped from 22.6 percent in 2007 to 18.4
percent in 2010. Compare to total liabilities, fair value liabilities dropped from 14.1 percent in
2007 to 4.6 percent in 2010.12
On average, compare to total fair value assets, Level 3 assets oscillated between 9.8 percent in
2007 and 8.0 percent in 2010, with a peak of 12.3 percent in 2008. This is somewhat consistent
with Laux and Leuz (2010) who observed that transfers of assets by U.S. banks to Level 3
category were substantial and took place early in the financial crisis.13 Compare to total fair
value liabilities, Level 3 liabilities jumped from 9.4 percent in 2007 to 22.4 percent in 2009, and
later declined slightly to 20.9 percent in 2010.
Data presented in Figure 1 lead to at least two conclusions: first, for U.S. publicly traded
companies FVA are significantly greater than FVL, despite fair value option being in effect; and
second, U.S. publicly traded companies use unobservable inputs to measure liabilities more often
than they use such inputs to measure assets. This may result from unavailability of observable
inputs as well as from the higher risk factor affecting negatively present value of liabilities.14
Figure 2 presents means for the same four variables as Figure 1, but only for a subsample of
finance, insurance and real estate companies.
{FIGURE 2 ABOUT HERE}
Pattern emerging from Figure 2 is very similar to pattern presented in Figure 1. Percentage of
fair value assets significantly outweighs percentage of fair value liabilities and more liabilities
are classified in Level 3 than assets. Compare to total assets, the mean fair value assets dropped
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from 27.3 percent in 2007 to 23.8 percent in 2008. Over the next two years the percentage
increased to 24.8 percent in 2009 and 26.8 percent in 2010. Compare to total liabilities, the mean
fair value liabilities dropped from 15.7 percent in 2007 to 4.1 percent in 2010.
Compare to total fair value assets, the mean Level 3 assets oscillated between 9.1 percent in 2007
and 9.4 percent in 2010, with the highest mean of 11.9 percent in 2009. Compare to total fair
value liabilities, the mean Level 3 liabilities jumped from 7.2 percent in 2007 to 22.2 percent in
2008 and later increased again to 22.5 percent in 2010.
These means are higher than those reported by Song et al. (2010) in their study based on 1,260
firm-quarters representing banking industry in 2008. Their mean ratios of fair value assets and
liabilities to total assets and liabilities were about 15 percent and 0.4 percent, respectively. The
means presented above are lower, however, than those reported by Laux and Leuz (2010) and
Bhamornisiri et al. (2011). Laux and Leuz (2010) report that three major U.S. investment banks
measured about 45 percent of their assets at fair value in 2007 Q1, and increased the fair value
component to 55.2 percent in 2009 Q1. As for the four major bank holding companies, the fair
value assets percentage oscillated between 32.4 percent in 2007 Q1 and 31.6 percent in 2009 Q1.
Bhamornisiri et al. (2011) collected data for Fortune 500 companies that issued quarterly reports
dated March 31, 2008. These companies reported 51 percent of assets and 23 percent of
liabilities at fair value. Bhamornisiri et al. (2011) findings add evidence supporting a notion of
asymmetry between fair value assets and fair value liabilities.
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In the next stage of the analysis tests are designed to determine whether there were any
significant changes in the fair value disclosures over the period 2007-2010. The financial crisis
officially ended in the mid-2009, although we still experience aftershocks and the global
financial and economic situation is far from being stable. Also, as previously discussed, in 2009
FASB issued FSP FAS 157-4, which became effective June 15, 2009. Therefore it is expected
that the reporting of fair value assets and liabilities may have changed after the mid-2009, as
compared to the period 2007-2008 marked by severe financial crisis and luck of sufficient
guidance on the implementation of requirements of FAS 157 in inactive and disorderly markets.
To examine the potential differences the following four hypotheses are set in an alternative form:
Ha1: μD1 ≠ 0
(5)
Where D1 = FVA07/09-03/11 - FVA11/07-06/09
Ha2: μD2 ≠ 0
(6)
Where D2 = Level 3_Assets07/09-03/11 – Level 3_Assets11/07-06/09
Ha3: μD3 ≠ 0
(7)
Where D3 = FVL07/09-03/11 - FVL11/07-06/09
Ha4: μD4 ≠ 0
(8)
Where D4 = Level 3_Liabilities07/09-03/11 – Level 3_Liabilities11/07-06/09
All the hypotheses are non-directional because of contradictory factors influencing fair value
reporting during the test period. For example, although FSP FAS 157-4 provided a clear
guidance as to the implementation of FAS 157 and recommended transfers from Level 2 inputs
to Level 3 inputs under certain circumstances, it became effective on June 15, 2009, when the
financial crisis showed signs of abatement and the financial market conditions improved, making
the use of Level 3 inputs less critical.
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To test the hypotheses Ha1 to Ha4, the paired-difference tests were used. First, the datasets for
each fiscal year were sorted by CUSIP number,15 and then merged by CUSIP into one dataset.
This dataset consisted of records for each company containing all the fair values disclosed in the
company’s annual reports during the period 2007-2010. Several ‘Before’ and ‘After’ variables
were created in the following manner: information derived from annual reports issued by
companies between November 30, 2007 and June 15, 2009 fell into ‘Before’ category while
information derived from reports issued after June 15, 2009 fell into an ‘After’ category.16
Paired observations were tested using both, parametric paired-difference t-test and nonparametric Wilcoxon Signed Rank Test. Although each pair of measurements is independent of
other pairs, the differences appear not to be from a normal distribution. Therefore outcomes from
the Wilcoxon Signed Rank test are more reliable.
Table 2 contains descriptive statistics for four ‘Before’ and ‘After’ categories: FVA, Level
3_Assets, FVL, and Level 3_Liabilities. Mean Differences between ‘Before’ and ‘After’
variables are also reported as well as the paired-difference tests results. The goal of this analysis
is to determine whether the average change from ‘Before’ to ‘After’ is larger than could happen
by chance alone.
{TABLE 2 ABOUT HERE}
There were 1,301 paired differences available to test hypotheses Ha1 and Ha2, and 818 paired
differences to test hypotheses Ha3 and Ha4. The results are statistically significant and provide
support to reject null hypotheses H02, H03 and H04 at the 1% significance level, and null
hypotheses H01 at the 5% significance level. It can be concluded that the average differences for
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FVA, Level 3_Assets, FVL, and Level 3_Liabilities are significantly different from zero. In
other words, fair value assets and liabilities, as compared to total assets and liabilities, and Level
3 assets and liabilities, as compare to total fair value assets and liabilities, are significantly
different before and after June 15, 2009. From the paired observations it could be concluded that
after June 15, 2009 fair value assets and liabilities constituted higher percentage of total assets
and liabilities, respectively, and fewer assets were measured based on unobservable inputs. This
would be consistent with improved market conditions and increase liquidity after June 2009. The
most interesting result, however, is a greater reliance on models based on unobservable inputs for
measurement of fair value liabilities after June 2009. This should be a matter of concern for
investors and regulators alike, as the research shows that the level of informativeness of fair
values is affected by the amount of measurement error and source of the estimates (Landsman,
2007).
Overall, the mismatch between assets and liabilities at fair value reported in other studies is also
observable here, with significant excess of fair value assets over fair value liabilities. Further
analysis and testing would be needed to gain insight into the changing patterns of reporting fair
value by U.S. companies over a longer period of time and under changing economic conditions.
CONCLUDING REMARKS
Fair value accounting endured unprecedented attack over the past few years. Many have called
for it suspension altogether. Evidence have shown that fair value accounting played a limited
role in U.S. banks’ problems during the recent financial crisis, except for few banks with large
trading positions (Laux and Leuz, 2010).
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This study has contributed to the literature by showing the extent of fair value measurements as
applied and reported by a cross-section of U.S. publicly traded companies during the period
2007-2010. A spotlight was cast on the fair value measurements categorized within Level 3
assets and liabilities. The assessment of the Level 3 items is very important for users of financial
statements as it entails use of valuation techniques and data that may not be verifiable as a great
deal of assumptions and estimates are involved. Another contribution of this study is empirical
evidence on changes in reported fair values before and after mid-2009.
The results show that, on average, fair value assets, and particularly fair value liabilities, are
limited in scope, even when reported by financial institutions. Fair value measurements are based
primarily on observable inputs, only valuation of liabilities utilizes the income approach with
unobservable inputs to a greater degree. This may result from limited trading of liabilities.
Another finding from the study is that fair value assets and liabilities, as compared to total assets
and liabilities, and Level 3 assets and liabilities, as compared to total fair value assets and
liabilities, are significantly different before and after June 2009. Congruent with the overall
improvement of the economy and liquidity of the markets after June 2009, fair value assets and
fair value liabilities increased, while percentage of fair value assets classified in Level 3
declined; contrary to expectations, however, greater percentage of fair value liabilities were
classified in Level 3 after June 1009.
This study looked at the big picture and was based on a large sample of U.S. publicly traded
companies representing a cross-section of industries. In addition, finance, insurance and real
estate companies were analyzed separately. In the future studies consideration should be given to
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confounding factors differentiating entities, such as size, industry, financial position and
performance during the financial crisis. Further research is required into the fair value
disclosures to understand management judgments as well as the impact of fair value
measurements on investors and other financial statement users.
Although data presented in this study indicates that, on average, only about one fifth of assets
and less than one twentieth of liabilities are currently measured at fair value, fair value
accounting is here to stay and most probably expand. FASB and IASB has recently converged on
fair value measurements and achieved a high quality standard. But this is an area of accounting
characterized by inherent complexity where significant judgments are required. Especially when
assets and liabilities are not traded in active and orderly markets and valuation is based on
unobservable inputs, an understanding of complex valuation models and subjective assumptions
is needed. Reliance on third party valuation experts, engaged by management and/or audit teams,
is common in these situations. Question arises whether this is the optimum modus operandi for
the accounting profession or more extensive education and training on valuation techniques
should be provided at the university and/or firm level.
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REFERENCES
Bhamornsiri, S., Guinn, R. E., & Schroeder, R. G. (2010). The economic impact of SFAS No.
157. International Advances in Economic Research 16: 65-79.
Carcello, J. & Williams, J. (2004). Fair value measurements. Miller GAAP Update Service 4
(17): 2-3.
Casabona, P., & Shoaf, V. (2007). New requirements for measuring and reporting fair value in
GAAP. Review of Business 27(4): 10-18.
Casabona, P., & Shoaf, V. (2010). Fair value accounting and the credit crisis. Review of Business
30 (2): 19-30.
Cascini, K.T., & DelFavero, A. (2011). An evolution of the implementation of fair value
accounting: Impact on financial reporting. Journal of Business & Economic Research 9(1): 1-16.
Ely, B. (2009). Bad rules produce bad outcomes: Underlying public-policy causes of the U.S.
financial crisis. Cato Journal 29.1 (Winter 2009): 93-114.
Enria, A., Capiello, L., Dierick, Grittini, S., Haralambous, A., Maddoloni, A., Molitor, P., Pires,
F., & Poloni, P. (2004). Fair value accounting and financial stability. European Central Bank
Occasional Paper Series, No: 13.
Financial Accounting Standards Board. (2006). Fair value measurements. Statement of Financial
Accounting Standards No. 157, Norwalk, CT: FASB.
___________. (2007). The Fair value option for financial assets and financial liabilities,
including an amendment of FASB Statement No. 115. Statement of Financial Accounting
Standards No. 159, Norwalk, CT: FASB.
___________.(2008). Determining the fair value of a financial asset when the market for that
asset is not active. FASB Staff Position (FSP) FAS 157-3. Norwalk, CT: FASB.
___________. (2009). Determining fair value when the volume and level of activity for the asset
or liability have significantly decreased and identifying transactions that are not orderly. FASB
Staff Position (FSP) No. 157-4. Norwalk, CT: FASB.
___________.(2011). News release May 12, 2011: IASB and FASB issue common fair value
measurement and disclosure requirements Norwalk, CT: FASB.
Forbes. S. (2009). End mark-to-market. Forbes.com, March 29, 2008.
Landsman, W.R. (2007). Is fair value accounting information relevant and reliable? Evidence
from capital market research. Accounting and Business Research Special Issue: International
Accounting Policy Forum: 19-30.
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Laux C. & Leuz C. (2010). Did fair-value accounting contribute to the financial crisis? Journal
of Economic Perspectives 24 (1): 93-118.
Novoa, A., Scarlata, J. and Sole, J. (2009). Procylicality and fair value accounting, IMF Working
Paper No: 09/39.
OTC Valuations, Inc. (2007). FAS 157 – derivative valuation insights™, an OTC Valuations
White Paper, November 2007.
Robak, E. (2009). Fair value is here to stay. The CPA Journal 79 (10): 6-9.
Securities and Exchange Commission. (2008). Report and recommendations pursuant to section
133 of the Emergency Economic Stabilization Act of 2008: Study on mark-to-market accounting.
Office of the Chief Accountant Division of Corporation Finance, United States Securities and
Exchange Commission, Washington DC: December 30, 2008.
Song, C.J, Thomas W.B. and Yi, H. (2010). Value relevance of FAS No. 157 fair value hierarchy
information and the impact of corporate governance mechanism. The Accounting Review 85(4):
1375-1410.
Wallison, P.J. (2008). Judgment too important to be left to the accountants. Financial Times,
May 1, 2008.
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Table 1: Fair value hierarchy – examples and links to valuation approaches
Source: OTC Valuations, Ltd., 2007.
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Table 2: Descriptive statistics and paired-differences test results
Variable
N
Mean
Standard
Deviation
FVA Reported After
June 15, 2009 (A1)
FVA Reported
Before June 15,
2009 (B1)
Difference = A1-B1
2,795
20.47
21.30
1,312
19.94
15.05
1,301
2.55
24.72
Level 3_Assets
Reported After June
15, 2009 (A2)
Level 3_Assets
Reported Before
June 15, 2009 (B2)
Difference = A2-B2
2,795
8.78
20.07
1,312
60.30
21.42
1,301
-52.02
28.28
FVL Reported After
June 15, 2009 (A3)
FVL Reported
Before June 15,
2009 (B3)
Difference = A3-B3
1,714
9.45
17.97
831
4.98
10.91
818
7.67
21.17
Level 3_Liabilities
Reported After June
15, 2009 (A2)
Level 3_Liabilities
Reported Before
June 15, 2009 (B2)
Difference = A4-B4
1,714
19.00
30.54
831
8.68
17.99
818
13.72
31.96
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Paired-Difference Test
t-test
Wilcoxon
Signed Rank
Test
3.7175
(p=0.002)
36,360.5
(p=0.0073)
-66.33
(p<.0001)
-390,998
(p<.0001)
10.37
(p<.0001)
86,726
(p<.0001)
12.27
(p<.0001)
37,631.5
(p<.0001)
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Figur 1: Mean values for FVA, Level 3_Assets, FVL and Level 3_ Liabilities
during the period 2007-2010 – all companies
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Figure 2: Mean values for FVA, Level 3_Assets, FVL and Level 3_ Liabilities
during the period 2007-2010 - finance, insurance and real estate companies (SIC
code: 6011-6799).
1
In the paper I continue to refer to the standard as FAS 157, rather than ASC 820, as the study covers mostly the
pre-codification period (FASB ASC is effective for interim and annual periods ending after September 15, 2009).
2
Under FAS 157 companies are required to consider all “reasonably available” information and use the best data
available to support their market assumptions (Robak, 2009).
3
The most prominent among them are: FSP FAS 157-4 (ASC 820-10), Determining Fair Value When the Volume
and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are
Not Orderly; FSP FAS 107-1 and APB 28-1(ASC 825-10), Interim Disclosures about Fair Value of Financial
Instruments, FSP FAS 115-2 and FAS 124-2 (ASC 320-10), Recognition and Presentation of Other-ThanTemporary Impairment; and ASU 2009-05, Measuring Liabilities under FASB Statement 157.
4
FASB ASC 820-10-20 (Glossary)
5
Carcello and Williams (2004) suggested that FAS 157 might have affected or amended as many as 30 previously
issued accounting standards. Robak (2009) determined that FAS 157 amended, deleted, or otherwise affected more
than 40 areas of accounting guidance.
6
The term “input” is meant to refer broadly to the assumptions that market participants would use in pricing the
asset or liability, rather than the more narrow consideration of only actual data entered into a pricing model.
7
Not active markets means markets in which there are few transactions for the asset or liability, the prices are not
current, or price quotations vary substantially either over time or among market makers, or in which little
information is released publicly.
8
FSP FAS 157-4, issued April 9, 2009, superseded FSP FAS 157-3, Determining the Fair Value of a Financial
Asset When the Market for That Asset Is Not Active.
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9
FASB Staff Position (FSP) FAS 157-2, Effective Date of FASB Statement No. 157, amended FAS 157 to delay the
effective date of FAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or
disclosed at fair value in the financial statements on a recurring basis (at least annually) until fiscal years beginning
after November 15, 2008.
10
Financial Services files (FS) do not contain any FAS 157 data. The FAS 157 inputs for the financial institutions,
as for all other companies, were collected from the INDL files.
11
Alternatively, variable Total Fair Value Assets (TFVA) could be use in this study, but because it equals the sum
of assets under Levels 1, 2, and 3, plus any "netting" or other adjustments (including assets measured at fair value discontinued operations), sum of fair values classified under Levels 1, 2 and 3 is used instead.
12
Results for 2007 should be interpreted with caution for two reasons: (1) they are based on a very limited number
of observations, and (2) FSP FAS 157-2 delayed the effective date of FAS 157 for nonfinancial assets and liabilities
recognized and disclosed at fair value on nonrecurring basis until after November 15, 2008.
13
By the first quarter of 2008, the cumulative net transfers into Level 3 amounted to over 50 percent for the three
largest investment banks (Goldman Sachs, Morgan Stanley, and Merrill Lynch) and to over 80 percent for the four
largest bank holding companies (JP Morgan Chase, Bank of America, Citigroup, and Wells Fargo) relative to the
original balance of Level 3 assets in the first quarter of 2007.
14
Cascini and DelFavero (2011) discuss the counterintuitive impact of fair value accounting on liabilities. If a
company encounters financial difficulties the increased default risk results in decrease in the present value of the
debt instruments (such as bonds or notes) generating gains to income.
15
CUSIP number is a nine-character number that uniquely identifies a particular security.
16
For companies operating on a calendar year and those with fiscal year end on or after June 30, data derived from
2007 and 2008 annual reports were classified as ‘Before’ and data derived form 2009 and 2010 reports were
classified as ‘After.’ For companies with the fiscal year end falling before June, however, the ‘After’ category
consisted only of the 2010 data and the ‘Before’ category consisted of 2007, 2008 and 2009 data.
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