The Relevance of Fair Value Accounting and the Merits of Transparency

Abstract: The outburst of the financial crisis in late 2007 in the US coincided with a wave of new accounting regulations related to Fair Value Accounting. One of the new standards, SFAS 157, introduced new disclosure requirements related to the way fair values should be estimated and thus had a significant impact over the financial reports of banks and other financial institutions. The newly established three-level measurement hierarchy for fair values gives us the opportunity to test the impact of management discretion over the usefulness of financial information. Using an extensive sample of US financial institutions between 2007 and 2012, we find, contrary to expectations and prior research, that the relevance and reliability of fair values is rather unrelated to the amount of management discretion used in determining the values. In general, our findings suggest that investors perceive all fair values as almost equally relevant, irrespective of the inputs used to determine those values. Furthermore, we document an increase in the decision usefulness of balance sheet information in the years after the introduction of SFAS 157 in comparison to the period 2003-2007. Therefore, our general conclusion is that the increased transparency has eliminated much of the uncertainty related to mark-to-model estimates. Hence, even if investors do not differ much in their valuation of the three categories of fair values, they do value the increased transparency and comparability arising from the increased disclosure requirements.