The Necessity to Advance Disclosing
Fair Value by the Hierarchy:
Evidence from Literature Review about
Fair Value Hierarchy Information
ZHANG JIAO
Abstract This paper aims to discuss the necessity to advance disclosing fair value by hierarchy in Japan by reviewing the literature about fair value hierarchy information in the U.S. In Japan, ASBJ published the Exposure Draft “Accounting Standards on
Fair Value Measurement and Disclosure” in ２０１０ which specifies that the fair value should be reported by hierarchy. However, it has not published as formal standard until March ２０１６. Furthermore, some commenters suggested that the hierarchy and estimation process of fair value should not be disclosed because of the heavy cost. However, by surveying the empirical results, it is evident that the fair value from market （Level １）is significant different from the fair value based on manager’s valuation （Level ３）. For example, those empirical results suggest that valuation multiples
on mark-to-model estimates are generally lower than those based on unadjusted market prices. Further, by the literature review, it is even known that there is some evidence revealing that managers appear to manipulate the fair value estimates of Level ３. Furthermore, these results show that fair value assets, especially those measured using Level ２ and Level ３ inputs, are negatively related to analysts’ infor-mation quality and positively related to forecast dispersion and absolute forecast errors. Because of these differences, disclosing the fair value without the hierarchy will make the fair value less transparent and less reliable. Overall, from the views of decision usefulness and avoiding the discretionary behavior by manager, this paper concludes as follows. First, it should be accelerated to practice the ASBJ Ex-posure Draft “Accounting Standards on Fair Value Measurement and Disclosure.” Second, objecting to the comments suggesting unnecessity of the disclosure of hierarchy and estimation process of fair value, this paper concludes the disclosure is indispensable.
Key words fair value, value relevance, fair value hierarchy, illiquid market, inputs November １３, ２０１５ accepted
１. Introduction
One of the most enduring debates about accounting issues has been the impact of mandatory fair value measurements. Proponents argued that fair value has more relevance than historical measurement. On the other hand, it is critically argued that fair value suffers from a lack of reliability and introduces excessive financial volatility. Despite the argument, International Accounting Standards Board（hereinafter referred to as IASB）and Financial Accounting Standard Board （hereinafter referred to as FASB）have evolved toward greater use of fair value
for reporting assets and liabilities. In September ２００６, FASB released Statement of Financial Accounting Standards No. １５７（hereinafter referred to as SFAS １５７）,
Fair Value Measurement. Prior to SFAS １５７, neither a single coherent definition for
fair value nor detail guidance for applying the fair value measurement existed. SFAS １５７ provides a coherent framework for applying fair value measurement and enhances disclosures to increase consistency and comparability. According to SFAS １５７, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels.
However, in Japan, the fair value information is currently disclosed without the hierarchy prescribed in SFAS１５７. By surveying the status and issues involving the accounting function and the fair value measurement in stock markets, the pur-pose of this paper is to find out the difference between the three levels and discuss the necessity to advance disclosing the fair value by the hierarchy in Japan.
The composition of this paper is provided as follows. Section ２ will show the accounting function which fair value affects. Section ３ will point out the framework for application of the fair value standards and the standards about fair value hierarchy. Section ４ will present a literature review about fair value hierarchy. Section ５ will mention the Exposure Draft “Accounting Standards on Fair Value Measurement and
２. Accounting Function and Fair Value
２.１ Accounting Function
During the last hundred years, the roles of accounting have changed as evolving demands of society. In the thirteenth and fourteenth centuries, the sedentary merchants in Rome found records of their business activities a necessity. On their demand, double-entry bookkeeping originated with the Romans, and, reached a stage of maturity by the end of fifteen century. Odmark（［１９５４］, p.６３４）states that someone contends that the accounting system in the times had recording as its chief function, and, formed the basis for stewardship reports by agents and partners. However, in the late nineteenth century, the controversy between financial accounting and cost accounting hold the stage. Cost control became another important function of accounting. In recent years, accounting became an arbiter of conflicting economics interests among stockholders, managers, governmental agencies and so on. Here, I will discuss about the main accounting function presently.
Decision usefulness to the stockholders and creditors is known as the basic function fulfilled by financial accounting information. In Statement of Financial Accounting Concepts No.１（ FASB［１９７８］, par.３４, hereinafter referred to as “SFAC１”）,“Objective of Financial Reporting by Business Enterprises”, the FASB concluded
that financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. Notably, FASB views decision usefulness as the main accounting function.
Another accounting function is known as stewardship which is no explicit reference to in SFACs. However, FASB（［１９７８］, par.５０）concluded that financial reporting should provide information about how management of an enterprise has discharged
Since the publication of the SFAC7 in 2000, FASB has undertaken a project with the IASB to improve and converge their frameworks. In 2010, FASB issued SFAC8（Conceptual
Framework for Financial Reporting, Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information）to replace SFAC1
its stewardship responsibility to owners（stockholders）for the use of enterprise resources entrusted to it in SFAC１.
FASB proposes a decision usefulness objective, and argued that the objective of financial reporting（decision usefulness）encompasses providing information useful in assessing management’s stewardship. That means they support a de-cision usefulness objective will encompass information that is useful for an assessment of stewardship. While someone else has set out an Alternative View’ which argues that stewardship and decision usefulness are parallel objectives with different emphases that should therefore be defined as separate objectives. The question of whether the objective of financial reporting should be based solely on decision usefulness or whether stewardship should be recognized as a separate objective is controversy.
In SFAC８, FASB limited the primary user group to existing and potential investors, lenders, and other creditors. While, the primary user group focuses mostly on the generation of cash flow because it helps their decisions about whether to purchase or sell their investment or continue to hold it（or in the case of creditors to extend credit）. According to Lennard（［２００７］, p.８）, if one makes conventional assumptions about markets, the most useful information to make these decisions is the value of the company. If that amount is greater than the current market price, a buy decision is indicated, as the purchaser will be rewarded as the market moves towards true value. Conversely, a sale where true value is less than market value will obviate a loss as the market price declines. Thereby, the role of financial reporting should be to report the value of the firm, or at least of its individual as-sets and liabilities. And to an investor value is generally about future cash flows. Market values（fair value）, where available, could be used on the reasoning that they reflect the amount timing and certainty of all future cash flows, even if they are not available, the cash flows could be discounted to arrive at an amount that can be reasoned to reflect a market price.
In SFAC8（［2010］,BC1.24）, IASB and FASB state that both their previous frameworks focused on providing information that is useful in making economic decisions as the fun-damental objective of financial reporting. Those frameworks also state that financial information that is useful in making economic decisions would also be helpful in assessing how management has fulfilled its stewardship responsibility.
mar-２.２ Qualitative Characteristics
In SFAC８（FASB［２０１０a］, QC４-QC５）, IASB and FASB state that if financial informa-tion is to be useful, it must be relevant and faithfully represent what it purports to represent. The fundamental qualitative characteristics are relevance and faithful representation. It is explained in Preliminary View（IASB［２００６］, p.１４６）that once relevance is applied to determine which economic phenomena are pertinent to the decisions to be made, faithful representation is applied to determine which depictions of those phenomena provide the best correspondence of relevant phenomena with their representations.
Thus, one of the main changes of IASB’s and FASB’s frameworks is the replacement of reliability by faithful representation. The definition of faithful representation in SFAC８（FASB［２０１０a］, QC１２）is: Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible.
Whittington（［２００８］, p.１４７）argues the essence of faithful representation is that it requires judgments about economic substance and real-world economic phenomena, rather than merely the accuracy with which information represents that［which］it purports to represent’. Thus, if fair value were deemed to better capture economic substance’, historical cost might be deemed to be an inappropriate
kets are relatively imperfect and incomplete and that, in such a market setting, financial reports should also meet the monitoring requirements of current shareholders（stewardship） by reporting past transactions and events using entity-specific measurements that reflect the opportunities actually available to the reporting entity（alternative view）. On the other side, the proponents of fair value assume that markets are relatively perfect and complete and that, in such a setting, financial reports should meet the needs of passive investors and creditors by reporting fair values derived from current market prices（fair value view）.
Preliminary Views on an Improved Conceptual Framework for Financial Reporting: The Objective
of Financial Reporting and Qualitative Characteristics of Decision -useful Financial Reporting Information.
measure, despite the latter possibly being a more accurate representation of what it purports to represent（historical cost）.
The other important change is that the removal of the phrase free from ma-terial error and bias’, which is in the definition of reliability in the former framework but absent from the new definition of faithful representation. Whittington（［２００８］, p.１４７）states that many critics of fair value believe that it often involves more estimation and subjectivity（leading to error and bias）than some alternative measures, and the change reduces the force, within the framework criteria, of this objection.
From the two main changes in the recent framework, it should be noted that the IASB and FASB are giving more emphasis to representational faithfulness, and less to measurement certainty. They appear to be saying that some representation of what is taking place economically, even if its measurement is estimated and uncertain, is better than deferring recognition until a transaction is completed. That perhaps notes the possible implication for the future extension of fair value measurement.
２.３ Fair Value Accounting
In view of the above, putting aside the question of whether the objective of fi-nancial reporting should be based solely on decision usefulness or whether stewardship should be recognized as a separate objective. It is can be presumed that the users （existing and potential investors, lenders, and other creditors）require financial
information mainly for two purposes:
ａ．Making economic decision（valuation）. Existing and potential investors, lenders, and other creditors need information to help them assess the prospects for future net cash inflows to an entity.
ｂ．Stewardship. Existing and potential investors, lenders, and other creditors need information about how efficiently and effectively the entity’s management has discharged their responsibilities to use the entity’s resources.
In regard to this, Penman（［２００７］, p.４２）argues that at a conceptual level, fair value accounting is a plus; equity value is read from the balance sheet, with no
further analysis needed, and the income statement reports realizations for determining value at risk.
Penman（［２００７］, p.４２）also concluded that fair value accounting works well for both valuation and stewardship, with investment funds（where shareholders trade in and out of the fund at net asset value）. This case is instructive for it is the situation where the one-to-one relationship between exit prices and fair value
to shareholders holds.
３. Fair Value Hierarchy
３.１ Framework for Application of the Fair Value Standards
The fair value standards provide an overall framework for purposes of measuring fair value. Key elements of the framework are depicted in the flowchart below.
Step １ Determine Unit of Account
First, the reporting entity must determine the unit of account, that is to say what is being measured. It may be a contract, a reporting entity or an asset or a liability.
Step ２ Determine Valuation Premise
After determining the unit of account, the reporting entity must assess the valuation premise based on the attributes of the asset or liability being measured（Pricewa-terhouseCoopers LLP［２０１３］, p.３３）.
Step ３ Determine Markets for Basis of Valuation
According to FASB（［２０１０b］, par.８）, once a reporting entity has determined Penman（［2007］p.42）considered the conceptual level and implement level of fair value separately. He concluded that at a conceptual level, fair value accounting is a plus, but concepts are one thing and implementation another. With fair value defined as exit price, the minuses add up.
Penman（［2007］, p.39）states that the one-to-one condition says that fair value is a minus where firms are involved in（expectational）arbitrage（of input and output） prices in their business model; that is, the business model adds value to market prices. For example, a marketable bond in which a firm invests its excess cash’ is exposed to changes in market price that determines the amount of cash on liquidation, and shareholder welfare is tied to the market price, one-for-one. On the other side, Raw material used in manufacturing does not get its value from a change in its exit market price, but as an input into a process that adds value to its market price by producing a product and selling it to customers; change in shareholder value is not one-to-one with the change in the market price of the input.
the unit of account and the valuation premise, it must assess whether it has access to any observable markets. If access is available, a reporting entity must consider whether there is a principal market for the asset or liabilities. If there is a
prin- According to FASB（［2010b］, par.8）, the principal market is the market in which the reporting entity would sell the asset or transfer the liabilities with the greatest volume and level of activity for the asset or liabilities.
Figure １ Framework for Application of the Fair Value Standards
cipal market for the asset or liability, the fair value measurement shall represent the price in that market（whether that price is directly observable or otherwise determined using a valuation technique）, even if the price in a different market is potentially more advantageous at the measurement date（FASB［２０１０b］, par.８）.
If the reporting entity does not have a principal market, it should determine the most advantageous observable market for sale of the asset or transfer of liabil-ity（PricewaterhouseCoopers LLP［２０１３］, p.３４）. If there are no observable markets for the asset or liability or the market is not active, the reporting entity must
develop a hypothetical market based on the assumptions of potential market participants （PricewaterhouseCoopers LLP［２０１３］, p.３４）.
Step ４ Apply the Appropriate Valuation Technique（s）
Valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value.
Step ５ Determine Fair Value
The outcome of the market determination and the application of valuation techniques will be a fair value measurement（PricewaterhouseCoopers LLP［２０１３］, p.３５）.
３.２ Inputs to Valuation Techniques
According to SFAS１５７-Fair Value Measurements（FASB［２０１０b］, par.２１）, inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk, for example, the risk in-herent in a particular valuation technique used to measure fair value（such as a pricing model）and/or the risk inherent in the inputs to the valuation technique.
The fair value standards distinguish between observable inputs, which reflect the assumption market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity, unobservable inputs, which reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability
de- FASB（［2010b］, par.24）uses the words both principal markets’ and active markets’. An active market means a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. In this paper, I don’t distinguish them and use the two words as the same meaning.
veloped based on the best information available in the circumstances.
The fair value standards emphasize that a reporting entity’s valuation technique for measuring fair value should maximize observable inputs and minimize unobservable inputs, regardless of whether the reporting entity is using the market approach, income approach, or cost approach.
３.３ Fair Value Hierarchy
According to SFAS１５７（FASB［２０１０b］, par.２２）, to increase consistency and compara-bility in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Some of the three hierarchy’s key differentiating factors are depicted in table １.
３.３.１ Level １ Inputs
Level １ inputs are quoted prices（unadjusted）for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active
Table １ Fair value Hierarchy
Examples Characteristics
level
① New York Stock Exchange（NYSE） process for equity securities
② London Metal Exchange（LME）fu-tures contract prices
ａ．Observable
ｂ．Quoted prices for identical assets or liabilhies in active markets（unadjusted） １
① Posted or published clearing prices, if corrobrated with market transactions ② A dealer quote for a non-liquid secu-rity, provided the dealer is standing ready and able to transact
ａ．Quoted; similar items in active markets ｂ．Quoted; identical/similar items, no
active market
ｃ．Inputs other than quoted prices that are observable
ｄ．Inputs that are derived from observable market data
２
① Inputs obtained from broker quotes that are indicative（i.e., not firm and able to be transacted upon）or not corrobo-rated with market transactions ② Models that incorporate management
assumptions that cannot be corroborated with observable market data
ａ．Unobservable inputs（e.g. a company’s own data）
ｂ．Market perspective is still required ３
Source: PricewaterhouseCoopers LLP［２０１３］A Global Guide to Fair Value Measurements, p.４２８.
market（e.g., an equity security traded on a major exchange）provides the most reliable fair value measurement and, if available, should be used to measure fair value in that particular market.
３.３.２ Level ２ inputs
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. According to FASB（［２０１０b］, par.２８）Level ２ inputs include the following:
ａ．Quoted prices for similar assets or liabilities in active markets
ｂ．Quoted prices for identical or similar assets or liabilities in markets that are not active
ｃ．Inputs other than quoted prices that are observable for the asset or liability ｄ．Inputs that are derived principally from or corroborated by observable
market data by correlation or other means
３.３.３ Level ３ Inputs
According to FASB（［２０１０b］, par.３０）, level ３ inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liabil-ity at the measurement date. However, the fair value measurement objective re-mains the same, that is, an exit price from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability（including assumptions about risk）. Unobservable inputs shall 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. Therefore,
the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.
４. Literature Review
４.１ Debate on Value Relevance of Fair Value Measurement
The fair value estimates in financial reporting have drawn the attention of standards setters, practitioners, academics, and even pundits, fueling a heated debate on mer-its and demermer-its of fair value for recent decades. Proponents of fair value accounting argue that fair value information is value relevant to investors（Easton, Eddey and Harris,［１９９３］; Barth［１９９４］; Ahmed and Takeda［１９９５］; Barth, Beaver and Landsman,［１９９６］; Eccher, Ramesh and Thiagarajan［１９９６］; Nelson［１９９６］; Venkatacha-lam［１９９６］; Barth and Clinch,［１９９８］; Park, Park and Ro［１９９９］; Beaver and Venkatacha-lam［２００３］; Wang, Alam and Makar［２００５］; Hodder, Hopkins and Wahlen［２００６］）. Barth［１９９４］indicates that investment securities’ fair values have explanatory power beyond historical costs. Strikingly, historical costs have no explanatory power incremental to fair values. Additionally, the fair value securities gains and losses are relevant to investors in valuing bank equity. Venkatachalam［１９９６］
investigates value-relevance of disclosed fair values of banks’ off-balance sheet derivative financial instruments used for risk-management purposes. The results suggest that the fair value disclosures for derivatives help explain cross-sectional differences in bank stock prices and the fair values have incremental explanatory power over and above notional amounts of derivatives. Barth and Clinch［１９９８］investigate whether relevance, reliability, and timeliness of Australian asset revaluations differ across types of assets, including investments, property, plant and equipment, and intangibles. Moreover they find that revalued financial, tangible, and intangible assets are
Barth［1994］stated that fair value securities gains and losses are calculable because banks disclose realized securities gains and losses. Thus, banks’ investment securities provide an opportunity to examine two measurement methods, historical cost and fair value, for both an asset and its related earning component. Therefore, she selected the industry of bank as the sample firms.
value relevant.
On the other side, opponents argue that fair value accounting suffers from a lack of reliability and introduces excessive financial volatility which may lead to contagion effects such as premature needs for additional capital, premature violation of debt covenants, and even premature liquidations（Ronen［２００８］; Plantin, Sapra and Shin［２００８］; Allen and Carletti［２００６］; Fiechter and Meyer［２０１０］; Bowen, Khan and Rajgopal［２０１０］）. Some researchers also suggest that managers will use discretion in their valuation model opportunistically（Penman［２００７］; Fiechter and Meyer［２０１１］）.
Penman［２００７］discusses that fair value works well, for both valuation and stewardship, with investment funds. However, this case is instructive for it is the situation where the one-to-one relationship between exit prices and fair value to shareholders holds. That one -to -one condition fails, however, when a firm holds net assets whose value comes from execution of a business plan rather than fluctuations in market prices, even when exit prices are observed in active markets. Ronen［２００８］argues that fair value particular included in Level ３ measures, suffer from a lack of reliability and can be subject to bias and abuse. Fiechter and Meyer ［２０１０］find empirical evidence that banks with a poor pre-managed performance
report significant higher discretionary Level ３ losses than the control group. These banks are more likely to switch in the subsequent quarter from non-managed negative earnings to reported positive earnings, which is consistent with the big bath hypothesis. Khan［２０１４］finds that increase in the use of fair values in
fi-nancial reporting is associated with additional bank contagion. Further the in-crease in bank contagion is most severe during periods of market illiquidity.
Even though the critics of fair value measurement are continuing, FASB and IASB are making extension of fair value measurement. In ２００６, FASB issued SFAS１５
７-Fair Value Measurements which requires the classification and disclosure of fair value
under a hierarchy of three levels. As stated above, the ones be given the highest
The question arises as to whether banks intentionally overstated the losses they recognized, in order to be in a position to present positive earnings in subsequent quarters. This practice is known as big bath accounting.
priority are Level １ inputs which reflect quoted prices in active markets for identical assets or liabilities. Next, Level ２ inputs include quoted prices in active markets for similar assets or liabilities. Level ３ inputs are unobservable inputs for the as-set or liability. SFAS １５７ stated that reporting entity should use Level １ and Level ２ valuations if possible, but the standard allows the use of Level ３ valuations when observable inputs are not available.
Thus, at the core of the debate is the issue of whether quoted prices in illiquid markets provide an accurate and unbiased measure of fair value. Hereafter, the papers which provide tests of relevance of fair value hierarchy information will be reviewed.
４.２ Value Relevance of Fair Value Hierarchy Information
Kolev［２００８］uses the expanded disclosure mandated by SFAS １５７, Fair Value
Measurements, to examine the value relevance of fair value estimates of assets and
liabilities for which active markets do not exist. Using a sample of large financial institutions for the first and second quarters of ２００８, Kolev interprets a positive and significant association between net assets and stock price as evidence that the fair value estimates are relevant to equity investors and deemed sufficiently reliable to be impounded in firm value. Kolev documents a significant association between stock prices and fair values measured using Level １ inputs. At odds with concerns expressed by opponents of fair value accounting, Kolev also documents a positive and significant association between prices and Level ２ and Level ３ estimates, suggesting that, on average, equity investors perceive even the estimates reflecting management’s assumptions as sufficiently reliable to be reflected in firm value. An examination of the relative association of stock prices and fair value estimates across the three categories under the hierarchy, however, indicates that the valuation multiples on mark-to-model estimates are generally lower than those based on unadjusted mar-ket prices.
Lev and Zhou［２００９］investigate investors’ reaction to crisis events during the last four months of ２００８－the peak of the financial crisis－conditioned on the fair value disclosures of financial and nonfinancial firms under SFAS １５７. They identify
４４ crisis events and find that the three levels fair value information disclosed by nonfinancial and financial firms affected investors’ reaction to the crisis events. They also find a complex reaction to the liquidity risk information conveyed by the three fair value levels. For nonfinancial firms whose fair value assets are mostly liquid securities（e.g., traded bonds and stocks）, the fair value items had a positive effect on investors’ reaction to liquidity decreasing events. On the li-abilities side of nonfinancial firms, the liquidity risk, particularly of Level ３ liabili-ties, reflects the anticipated difficulty of refinancing short term liabilities. Actually, Level ２ and Level ３ liabilities, particularly the latter, exert a significant negative effect on investors’ reaction to liquidity constraining crisis events. For financial firms, the fair value assets are mostly Level ２ and Level ３ with significant liquidity risk and these assets exert a negative effect on investors’ reaction to liquidity constraining crisis events. On the whole, they conclude that the liquidity risk information con-veyed by the fair value level separation is very useful to investors indeed. However, Obinata［２０１２］states that it is not clear whether the fair value information is meaningful for entity valuation just by event study. Obinata points out that the event study has its peculiar limitation.
Goh, Ng, Yong［２００９］examine the association between stock prices and the different levels of fair value assets of banks for fiscal quarters ending in the first nine cal-endar months of ２００８. The results show that the coefficients on all the three
lev-els of fair value assets are significantly different from zero, suggesting that investors price fair value assets by both mark-to-model and mark-to-market positively. However, they find that the coefficients of all the three levels of fair value assets are significantly less than one, implying that investors are discounting the fair value estimates, especially with regard to mark-to-model assets. Specifically, investors price each dollar of Level １, Level ２, and Level ３ assets at $０.８５, $０.６３, and $０.４９, respectively. In addition, while the pricing of each dollar of Level １ assets is significantly different from that of each dollar of Level ２ and Level ３ assets, the pricing of each
Fair value assets mean assets measured by fair value and recognized in the carrying amounts.
dollar of Level ２ assets is not significantly different from the pricing of each dollar of Level ３ assets.
After the above study, they examine how market pricing of the reported fair values varied as the economic crisis worsened in ２００８. They observe a pronounced decline in the pricing of each dollar of Level ２ and Level ３ assets from the first to the third quarter of ２００８. In contrast, the pricing of each dollar of Level １ assets remains relatively stable over the course of ２００８. These results suggest that as the financial crisis worsened in ２００８, it exacerbated investors’ concerns over illiquidity and information risk of the mark-to-model assets.
Song, Thomas and Yi［２０１０］provide tests of value relevance similar to Kolev ［２００８］and Goh, Ng, Yong［２００９］. They test the value relevance of fair value measures
for each of the three disclosure levels. They are particularly interested in testing the value relevance of Level １ fair values versus Level ３ fair values. They discuss the reliability and the potential information asymmetry problems associated with Level ２ fair values potentially fall between those of Level １ and Level ３ fair values. Using a sample of quarterly reports by banking firms in ２００８, they find evidence that fair value measurements of Level １, Level ２ and Level ３ inputs are value relevant. They also find that the valuation coefficient of Level ３ liabilities is significantly more negative than those of Level １ and Level ２ liabilities, consistent with less re-liable amounts for Level ３ liabilities.
For their second test, they examine whether the value relevance of fair values varies across six individual governance mechanisms. They find that governance
has a significant impact on Level ２ and Level ３ fair values. As the strength of corporate governance increases, investors’ valuation of these fair value assets and liabilities increases toward the theoretically predicted coefficient values of １ and －１. Consistent with the notion that Level １ fair value information suffers the least from information asymmetry, they find little impact of corporate governance on these fair values.
Board independence, audit committee financial expertise, the frequency of annual audit committee meetings, the percent of shares held by institutional investors, the auditor’s office size, and no material control weakness problem under Sections 302 and 404 of the Sarbanes-Oxley Act.
Riedl and Serafeim［２０１１］use a sample of U.S. financial institutions to test whether greater information risk in financial instrument fair values leads to higher cost of capital. They conclude that greater exposure to more opaque financial in-struments, reflected in the Level ３ fair value designation, leads to higher information risk, and thus a higher cost of capital, consistent with previous findings of lower value relevance for Level ３ fair values（e.g., Song, Thomas, and Yi［２０１０］）.
Patrick［２０１２］examines the reliability of fair value hierarchy for financial instruments in a value relevance research setting similar to Song, Thomas and Yi ［２０１０］. Patrick uses a longer time period data which is from ２００６ to ２０１０ of bank-ing sector. These results show that all fair value assets and liabilities, even Level ３ fair values, are value relevant, because their coefficients are significantly different from zero. Hence, the value relevance of fair value assets decreases with decreasing hierarchy level. The study also analyzes the impact of regulatory capital on the
reliability of mark-to-model fair values. In contrast to the results of Goh, Ng, Yong［２００９］, it can be shown that the regulatory capital ratio has no significant
influence on the reliability of Level ３ fair values.
４.３ Managerial Opportunism and Fair Value Measurement
Another stream of fair value accounting research examines how managerial opportunism affects the value relevance and reliability of fair value measurement. Xu and Du［２０１０］）document that the early adoption banks of SFAS １５７ have more Level ２ and Level ３ assets than the non-early adopter. Moreover they also find evidence that the early adoption banks use the Level ２ and Level ３ assets to Banks have a capital regulatory requirement to ensure risk-adjusted capital adequacy. Simply stated, a bank’s capital is the “cushion” for potential losses, which protect the bank’s depositors or other lenders. Bank regulators track a bank’s capital adequacy to ensure that it can absorb a reasonable amount of losses and are complying with their statutory capital requirements（Goh, Ng, Yong［2009］, p.11）. The capital adequacy of a bank is likely to be an important factor that investors consider when they assess the banks’ reported fair values. This is because the fair value of an asset is based on the price that would be received when the asset is sold in an orderly fashion（Goh, Ng, Yong ［2009］, p.10）.
Goh, Ng, Yong［2009］find some evidence that mark-to-model assets are priced higher by investors for banks with higher capital adequacy. Since higher capital adequacy mitigates concerns that banks will be forced to sell their assets at unfavorable prices, especially for less liquid assets, they conclude that this evidence supports the argument that asset liquidity is an important consideration when investors price the banks’ assets.
boost their core capital reserves and to avoid reporting losses. Valencia［２０１１］ investigates if managers are applying managerial discretion with respect to Level ３ instruments. He examines if bank managers use their discretion opportunistically when faced with capital adequacy and earnings targets incentive. Using capital adequacy thresholds as an incentive setting, Valencia finds no evidence supporting the idea that bank manages use Level ３ instruments opportunistically. However, Valencia finds evidence revealing that bank managers appear to be manipulating the fair value estimates of Level ３ instruments in order to report current earnings that are positive and more than prior quarter earnings. He argues most studies examining Level ３ valuations have concentrated on the value relevance of these estimates with no direct tests of the potential for opportunistic behavior. He states the potential for both opportunism and unintentional error in fair-value estimates may contribute to their lack of value relevance.
４.４ Usage of Quality of Fair Value Information by Financial Analysts Parbonetti, Menini and Magnan［２０１１］provide test focusing on the relation between fair value accounting and the quality of the information used by financial analysts, a key group of financial markets’ participants. Using a sample of U.S. commer-cial banks during the period between １９９６ and ２００９, their results show that the larger the extent of a bank’s asset and liabilities reported at fair value, the more dispersed are analysts’ earnings forecasts. That is to say the fair value compromises the reliability of financial reporting and induces artificial volatility. Furthermore, the results show that within fair value assets and liabilities, the less reliable the measurement basis, the lower the quality of information available（i.e., moving from Level １ to Level ３）.
Li［２０１４］provides the test similar to Parbonetti, Menini and Magnan［２０１１］. He examines how SFAS １５７ affects financial analysts’ information quality for a sample of financial firms. The paper finds that analysts’ information quality
Financial analysts serve the capital market as an important information intermediary. They gather, research, interpret, and disseminate information that makes up an important input to investors’ decision-making.
declines after SFAS １５７ comes into effect and the drop is more pronounced for firms having relatively high information quality previously. Information quality is also found to be correlated with the proportion of the firm’s assets measured at fair value using Level １, Level ２, and Level ３ inputs under SFAS １５７. Overall, these results show that fair value assets, especially those measured using Level ２ and Level ３ inputs, are negatively related to analysts’ information quality and positively related to forecast dispersion and absolute forecast errors. The evidence is consistent that these fair value measures are less transparent and reliable and additional disclosures on their estimation process can potential improve the firm’s information quality.
５. Exposure Draft about Fair Value Measurement
and Disclosure in Japan
In ２０１０, ASBJ published the Exposure Draft “Accounting Standards on Fair Value
Measurement and Disclosure” which has not been published as formal standard until March ２０１６. In this Exposure Draft, ASBJ stated that in order to improve the consistency and comparability in fair value measurements, they establish a fair value hierarchy that prioritizes the inputs used to measure fair value into three broad levels. In this Exposure Draft, ASBJ requires fair value measurements also requires disclosures about those measurements. They stated the disclosure about fair value in the Exposure Draft as follows.
For assets and liabilities that are reported on balance sheet with a fair
developed by Barron, Kim, Lim, and Stevens［1998］. In Barron, Kim, Lim, and Stevens ［1998］, it is assumed that there are financial analysts issuing earnings forecasts for
a firm and that each financial analyst has two pieces of information: one is available to all analysts, that is, the common information, and the other is available only to individual analysts. The quality of the common information is denoted as and the quality
of the private information is denoted as . They define that ,
, SE is the expected squared error in the mean forecast, D is the
ex-pected forecast dispersion, and N is the number of forecasts. The quality of total information is simply the sum of the two, i.e., h＋s.
value on a recurring basis, the reporting entity shall disclose the accounting items of those assets and liabilities on balance sheet and the possession purpose for securities. As well as the reporting entity should disclose the follows（ASBJ［２０１０］, par.１７）.
① Valuation techniques of level ３ fair value ② Information about fair value of different levels ③ Items relating to level ３ fair value
For assets and liabilities that are disclosed with a fair value on a recurring basis, the reporting entity also shall disclose the accounting items of those assets and liabilities on balance sheet, the possession purpose for securities and the detail information about different levels（ASBJ［２０１０］, par.１７）. Most of the respondents agreed with this disclosure, however, some respondents argued that the disclosure of fair value by hierarchy is not rational because of the heavy cost.
６. Conclusions
According to the survey of the empirical results in the U.S., we know that the fair value from market（Level １）is so different from the fair value based on manager’s valuation（Level ３）. For example, most of the literatures reviewed show that the fair values have associations with equity market values whether the mark-to-mar-ket fair values or the mark-to-model fair values. However, those empirical results also suggest that the valuation multiples on mark-to-model estimates are generally lower than those based on unadjusted market prices. Moreover, by the literature review, there is evidence revealing that managers appear to manipulate the fair value estimates of Level ３. Furthermore, these results show that fair value assets, especially those measured using Level ２ and Level ３ inputs, are negatively related to analysts’ information quality and positively related to forecast dispersion and absolute forecast errors.
For example, in the comment from Institute of Life Insurance, they argued that the disclosure of fair value by hierarchy is impossible because of the heavy practice burden.
Contrary to the accounting practice of fair value measurement in the U.S., there are currently no disclosures, in Japan, about the hierarchy of fair value mea- surement and the estimation process of fair value on the financial reports. Under this situation, the problem is that the users of financial reports can’t access the information about what the source of the fair value is, for example, market price or price estimated by managers. Because there are so much difference between the fair value from market and the fair value from the manager’s valuation, disclosing the fair value without the hierarchy will make the fair value information less transparent and less reliable.
Overall, from the views of decision usefulness and avoiding the discretionary behavior by managers, there are two suggestions of this paper.
One suggestion of this paper is ASBJ should advance to practice the Exposure Draft “Accounting Standards on Fair Value Measurement and Disclosure” which specifies that the fair value should be reported by hierarchy. On the other hand, disagree with some commenters, the other suggestion of this study is the disclosure of fair value by the hierarchy and the estimation process will also be necessary in Japan.
However, it is true that this study is subject to a few caveats. Firstly, the empirical results are obtained from the analysis of financial accounting information of for-eign companies to discuss the accounting system in Japan. The empirical results about foreign companies may not be generalizable to Japanese accounting system. Secondly, reporting the fair value by the hierarchy will take a cost which is not considered in this study. If the cost is higher than the benefit which obtains from the disclosing of fair value by the hierarchy, suggestions of this study is not practically feasible.
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