The Association between SFAS No. 157 Fair Value Hierarchy Information and Conditional Accounting Conservatism

Abstract

Investors demand conditional conservatism to restrict managers’ ability to opportunistically exploit unverifiable accounting estimates. The fair value estimation process is subject to verifiability concerns when market prices are unavailable, and thus susceptible to managerial discretion. We explore whether banks’ exposure to less-verifiable fair value estimates is associated with conditional conservatism. General and bank-specific conservatism measures indicate that banks with greater proportions of less-verifiable fair value assets exhibit more conditional conservatism. Cross-sectional analyses provide evidence that this relation varies predictably with investor-demand and manager-supply proxies. Further analyses indicate that monitoring institutional investors drive the demand for conservatism. We identify high-quality auditors and board independence as two mechanisms used to invoke conservatism. Findings are robust to the exclusion of fair value earnings components, suggesting that the effect is not confined to fair value accounts. Together, our results indicate that less-verifiable fair value estimates generate demand for conditional conservatism in the financial industry.

Keywords: SFAS No. 157, fair value hierarchy, conditional conservatism, verifiability

JEL Classification: M41, G21