The curious case of Level 3 instruments

Abstract

Standard setters and regulators face an ever-present concern over the discretionary influence firms have in financial reporting. For information to have enhanced relevance, some level of discretion in financial reporting is often necessary. Prior work suggests that firms may be opportunistic in exercising choice and influence where discretion is available to advantageously affect reported results. This study examines if aggressive firms take the opportunity afforded by the wide discretion in Level 3 valuations under the original Accounting Standards Codification (ASC) 820 standard to manipulate financial reporting. Minimal evidence is found to support an association between Level 3 valuations and other metrics reflecting earnings management. The findings may be driven by the high-level, and typically limited, disclosures that firms are required to make under the originally promulgated ASC 820. This primary finding suggests that FASB's move to increase the disclosures required under the standard was warranted.