Auditors and Net Transfers Into Level 3 Fair-Valued Financial Instruments
Advances in Accounting 36: 27-39.
56 Pages Posted: 10 Sep 2018
Date Written: September 12, 2016
Prior research shows that managers use discretion in estimating Level 3 financial instruments to opportunistically manage capital and earnings. We investigate an earlier decision, subsequent classification changes that result in net transfers into the Level 3 classification, to examine whether firms use their discretion to engage in opportunistic transfers. We then investigate whether auditors influence the decision to transfer into the Level 3 classification and/or alter audit fees. Using a hand collected sample of public bank fair value disclosures from 2008 through 2010, we find evidence consistent with firms engaging in opportunistic transfers into the Level 3 classification. We further find evidence that high quality auditors appear to constrain this behavior, consistent with higher quality auditors mitigating some risks associated with Level 3 instruments. We also find evidence that auditors increase fees when managers transfer instruments into the Level 3 classification. Collectively, our findings suggest auditors manage risks related to Level 3 by both restricting transfers into the Level 3 classification and charging higher audit fees when transfers occur.
Keywords: Audit Quality, Fair Values, Level 3 Transfers
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