Unintended Consequence: Fair Value Accounting Informs on Liquidity Risk

Abstract:     
We examine in this study the usefulness to investors of the three-level liquidity risk disclosure under SFAS No. 157 through the innovative prism of investors’ reaction to 44 key events (e.g., Lehman’s demise) during late 2008, the peak of the world-wide financial crisis. If fair value accounting informs about the risks (illiquidity) of financial items, then investors’ reaction to the crisis events should be conditional on the three-level disclosure. We indeed find a pecking order of investors’ reaction: For negative - liquidity shrinking - events, investors’ adverse reaction is strongest for Level 3 (highest risk) items, followed by Levels 2 and 1 (often no reaction at all). The reverse holds for positive - liquidity expanding (TARP program, for example) - events. We thus document, for both financial and nonfinancial firms, an important, yet rarely discussed attribute of fair value accounting: Informing on liquidity risk.

Number of Pages in PDF File: 61

Keywords: Fair value accounting, Economic Crisis, SFAS 157

JEL Classification: M41, G14

working papers series