Auditors’ Role in Level 2 versus Level 3 Fair-Value Classification Judgments

Abstract

This study addresses auditors’ role in determining the quality of their client’s fair value classification judgments for investment securities under ASC 820. The standard requires companies to classify fair value assets into one of three levels (i.e., Level 1, 2, or 3) and there is often significant subjectivity in determining whether a particular security should be classified as Level 2 or Level 3. We examine how auditors react to management’s preferred classification of securities that a pre-test indicates could reasonably be classified as either Level 2 or Level 3. We test whether experienced fair value auditors respond skeptically to management’s preferred classifications that are aligned with management’s incentives. Our experiment examines whether auditors spontaneously incorporate into their judgments the risk and regulatory scrutiny inherent in the fair value environment, even when those risks are not made salient. We find that auditors are diagnostically skeptical of management's preferred fair-value classifications. That is, auditors respond most skeptically to a classification management prefers when it is aligned with management’s reporting incentives, which is consistent with auditors having internalized regulators’ warnings not to be too lenient in such cases. We discuss the implications for audit quality in fair-value auditing settings.

Keywords: Fair Value, Skepticism, Auditor Judgment, Management Incentives