Auditing the Mark-to-Model: Evidence from Revisions of Standards in Fixed-Income Mutual Funds

Abstract

This paper examines the impact of standardized audit guidance on subjectivity in fair value reporting. We focus on the fixed-income mutual fund sector, where fair value reporting is particularly critical due to the prevalence of these funds holding illiquid fixed-income assets, which often lack sufficient market quotations as valuation benchmarks. Using two difference-in-differences research designs, we document a significant improvement in the precision of reported fair values following revisions to two PCAOB auditing standards, which introduced detailed guidance on auditing fair value estimates and auditors’ use of the work of specialists. The effects are especially pronounced for securities characterized by high estimation uncertainty and for funds with strong manipulation incentives, suggesting that the revised auditing standards alleviate management bias in fair value reporting. We also document an increase in audit fees following the revisions, suggesting enhanced auditors’ effort as a likely mechanism for the improvement in fair value reporting. Our findings highlight the effectiveness of auditing standard-setting in promoting financial reporting integrity within the asset management industry.

Keywords: AS 2501, AS 1210, fair value precision, specialists, fixed-income mutual fund

JEL Classification: M42, G23, M41