Conditionally Conservative Fair Value Measurements

Abstract

We provide evidence that firms holding higher proportions of financial instruments measured at Level 2 and 3 fair values report more conditionally conservative comprehensive income attributable to fair value measurements, contrary to the widespread belief that fair value measurements are unbiased. Firms measure fair values using Level 2 or 3 inputs when instruments do not trade in liquid markets, limiting market discipline over the measurements. Our findings are consistent with the prediction that firms measure Level 2 and 3 fair values conditionally conservatively to mitigate investors’ discounting of the measurements. We further predict and find that this conditional conservatism (1) increases with governance mechanisms that increase the strength and persistence of firms’ incentives to report conservatively and (2) decreases with earnings management incentives. We conduct similar analysis on oil and gas firms’ measurements akin to the fair value of their reserves and obtain consistent results.