The Impact of SEC Disclosure Monitoring on the Uncertainty of Fair Value Estimates

Fair Value Accounting is arguably the most controversial financial reporting topic debated over the past decade. Conceptually, the idea behind fair value accounting is appealing: if a Balance Sheet is dated as of December 31, 2015, then all of the items reported on that report should be valued as of that same day. After all, the objective of the Balance Sheet is to provide a “snapshot” of the makeup of the firm – its assets and whether these are financed by debt or equity – at a point in time. With this objective, why not value these components at their current, or “fair”, values?

The answer is that this valuation process can be incredibly difficult if the assets and liabilities do not trade frequently. That is, there may not be a daily process where the prices are set in an independent market. Of course, prices are set daily for some assets, say stocks in well-known companies such as Apple, Ford, or Google. But other items, such as derivatives or securities tied to home mortgages, do not trade frequently.

Despite this challenge of establishing a daily price, both U.S. and global accounting standards require firms to report their financial assets and liabilities at fair value on the Balance Sheet. As such, companies need to establish processes and methods to estimate such values – even when there are not active markets for the securities. Investors, therefore, need high quality disclosure about management’s fair value estimation process to form their own perceptions.

Our research examines the uncertainty that stock market investors display around the estimates of fair value assets made by companies. We are interested in whether the SEC impacts the stock market’s perception of uncertainty by their scrutiny of disclosure about these fair value estimates. The specific enforcement mechanism we study is the SEC’s use of comment letters. These letters come from the SEC and are sent to publicly traded firms with disclosure deficiencies. The letters request that the firms justify/explain further any number of accounting and disclosure choices. Firms must address the SEC’s requests for more information within 10 days. Moreover, as a result of the SEC enquiries, firms might choose to improve future disclosures in investor reports (e.g., the 10-K).

Disclosures related to fair values are likely to be very important to investors, as they provide a window to how managers arrive at valuation estimates for securities that are not regularly traded. Our research question focuses on whether investors’ uncertainty regarding these fair values changes following the completion of the comment letter process with the SEC. We view this question as important because one of the SEC’s functions is to monitor corporate disclosure and ensure that it is effective. We examine whether the SEC’s actions bring about measurable changes in investor perceptions in this particular setting – fair value reporting – as the accounting issues involved are particularly complex.

We examine firms that received SEC comment letters over the period 2007-2012. Following the Sarbanes-Oxley act, the SEC must review every registrant’s filings at least once every three years and, if necessary, issue a comment letter seeking further explanation. We identify approximately 1,400 firms that received letters where fair value reporting was a specific issue raised, and then study the changes in investor uncertainty from the period before the letter to the period after. We measure investor uncertainty as both the bid-ask spread in the stock market, as well as the volatility in stock returns. The bid-ask spread captures the risk that a broker or market-maker faces when maintaining an inventory of shares to meet trades. If that broker perceives a great deal of uncertainty in the market he will widen the difference between the price that shares can be sold for (the ask) and what they must be purchased at (the bid). Our second measure of uncertainty calculates the standard deviation in daily stock returns over a one month period; if the share price changes drastically from one day to the next, this reflects the stock market’s inability to settle on a stable price – hence higher uncertainty.

A major challenge with this study is trying to estimate what would have happened to these uncertainty measures if the firm had not received the comment letter. That is, would they have changed naturally – perhaps “mean reverting” to some average value? We used several alternative research designs to address this issue, including: (1) estimating expected changes in bid-ask spreads and stock volatility based on economic fundamentals; (2) using a matched sample of firms that did not receive a comment letter; and (3) identifying characteristics of the comment letters where we expected a more significant reduction in the uncertainty measures.

We find that both measures of uncertainty, bid-ask spreads and daily return volatility, declined after the firms addressed the issues raised by the SEC in the comment letter. They each decline by approximately 43%. Moreover, we find that letter firms exhibit greater post-letter improvements in disclosure than non-letter firms. For example, letter firms increased the length of their discussion about their fair value assumptions by 16% while non-letter firms increase by only 11%. In addition, letter firms increased the number of categories they used to describe their fair value investments by 28% while non-letter firms increase by only 11%.

Interestingly, our strongest results came during the years 2007-2009, which coincide with the height of the financial crisis. This finding suggests that the SEC comment letter process was particularly useful to investors during a period when uncertainty in the market was at its peak.

Overall, we conclude that by using the comment letter process the SEC plays an important role in monitoring firms and thereby increasing the quality of their disclosures about fair value accounting. We document a tangible measure of the benefits of this process by examining stock market uncertainty before and after the resolution of the letter with the SEC. We believe this research is important as it highlights some of the institutional features, mainly an active securities regulator, that investors find valuable in an accounting regime that uses fair value reporting.

The preceding post comes to us from Daniel A. Bens, Associate Professor of Accounting and Control at INSEAD, Mei Cheng, Associate Professor of Accounting at the University of Arizona, Eller College of Management, and Monica Neamtiu, Associate Professor of Accounting at the University of Arizona, Eller College of Management. The post is based on their recent article, which is entitled “The Impact of SEC Disclosure Monitoring on the Uncertainty of Fair Value Estimates” and is available here.