Informativeness of Fair Value Adjustments on Investment Properties: Relevance of Covenant Violation Concerns, Auditor Expertise, and Supplementary Disclosures
Laura, Mehnaz Roushan
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Even a decade after the enactment of IFRS 13 Fair Value Measurement, questions remain about faithful representation and usefulness vis-à-vis the perceived informativeness of fair values, especially those with unobservable inputs (i.e., Level 3 estimates). Prior studies show that fair value adjustments reflect private information and improve the relevance of the asset valuation if managers adopt efficient accounting choices. However, the permitted discretion also allows managers to act opportunistically and hinder faithful representation. Contracting incentives can exacerbate the opportunistic exercise of the fair value measurement discretion, and effective monitoring can mitigate it. Firms may also signal the quality of fair values by providing extended measurement-related disclosures. This thesis investigates the factors affecting the perceived informativeness of the changes in fair value estimates of investment properties, specifically focusing on three areas: the borrowing covenant violation concerns of investors, the fair value expertise of auditors, and supplementary fair value disclosures in times of market uncertainty. The investigation is conducted in three separate but related empirical studies in the context of fair value accounting for investment properties under IAS 40 in the Australian real estate sector. The first study investigates the influence of closeness to the violation of borrowing covenants on investors’ valuation of Level 3 fair value adjustments. Utilising the high-levered nature of the real estate sector, I reason that the concern of managerial bias in fair value estimation is greater for firms that are closer to violating, or have violated, borrowing covenants than those that are far from violation. Results indicate that while fair value adjustments are priced positively, investors incrementally apply a discount for real estate firms closer to violation or in technical default of their borrowing covenants. Breaking down borrowings by maturity and security shows that investors’ pricing of fair value adjustments is significantly lower among firms with higher secured borrowing and higher long-term borrowing but greater for firms with higher long-term unsecured borrowing. The second study examines the influence of auditor fair value expertise, gained through engagement tenure and industry specialisation, on the perceived reporting quality of the changes in Level 3 fair values. I capture auditor fair value expertise both at the audit firm and partner level. Findings suggest that investors’ valuation of fair value adjustments is higher for medium-tenure audit firms, whereas longer-tenure firms have no significant influence. However, when upward adjustments are examined separately, results show that the benefits of firm tenure accrue even for the longer engagements. Further, the perceived reporting quality of fair value adjustments is higher when partners have more than two years of experience. Contrary to expectation, I find no incremental valuation implication in engaging industry specialists, either at the firm level (city or national) or at the partner level. The third study examines the relevance of supplementary disclosures during the uncertain market of 2020. I develop a disclosure index based on the supplementary disclosures about Level 3 fair values and ascertain their effects on audit fees and the market value of fair value adjustments. Results suggest that managers considered the potential negative impact of the market uncertainty during the COVID-19 pandemic on the representational faithfulness of fair values and enhanced fair value disclosures. The finding that the audit fee is negatively associated with the supplementary disclosures indicates the relevance of additional disclosures in alleviating the perceived audit risk. Further, I find that supplementary disclosures increased the value relevance of fair value adjustments during 2020 but, in the pre-uncertainty period, they had no significant valuation implication. Overall, this thesis contributes to the growing body of literature on the value relevance of fair value measurements by adding closeness to borrowing covenant violation as a potential driver of perceived managerial bias and discount on fair values. Addressing the recent discussion around the deficiencies in the auditing of Level 3 fair value estimates even by Big 4 audit firms, the findings of this thesis highlight the importance of auditor fair value expertise obtained through engagement tenure in mitigating faithful representation concerns. Furthermore, the results contribute to the ongoing debate about the usefulness of additional fair value disclosures by providing evidence that supplementary disclosures can reduce the audit risk effect by signalling higher transparency and ensuring more reliable fair value reporting, particularly in volatile times. These results are, therefore, of interest to standard setters, regulators, managers of real estate firms, and other financial reporting stakeholders.