Are Level 3 Fair Value Gains and Losses Return Relevant? Evidence from Fas 157 Rollforward Disclosures

Abstract

We examine whether fair value re-measurements on illiquid assets convey useful information to investors. Specifically, we investigate the return relevance of unrealized Level 3 fair value gains and losses (FVGL) for a sample of 219 listed U.S. banks from 2008 to 2017. We find that Level 3 FVGL are generally priced. Importantly, our results show that FVGL recognized in net income, reflecting largely changes in expected cash flows, are more return relevant than FVGL recognized in other comprehensive income (OCI), which mainly reflect changes in illiquidity. Therefore, for illiquid assets, the distinction between cash flow revisions and illiquidity-induced value changes matters for equity investors. Further, we find that non-trading FVGL are more return relevant than trading FVGL due to greater uncertainty about the cash flow implications of trading FVGL. Finally, Level 3 fair value losses are more relevant than gains, indicating that losses are perceived as more credible than gains.

Keywords: Fair value accounting, Level 3, fair value gains and losses, value relevance, return relevance, FAS 157 (ASC 820), U.S. banks, other comprehensive income (OCI), illiquidity