Fair Value Opinion Shopping or Unbiased Reporting?

• In Event: Audit Opinions and Partner Identification

Abstract

Insurers frequently change the pricing sources of their fixed income securities. We study the causes and consequences of the pricing switch. We hypothesize that pricing switch could be driven by both managerial opportunism to inflate fair value estimation (i.e., FV opinion shopping) and/or managerial effort to more faithfully report the value of assets (i.e., unbiased reporting). We categorize pricing switches as upward switches — where the firm switches to a new source that prices the security at a higher level than the current pricing source does, and downward switches — where the opposite occurs. We find that upward switches can be explained by both unbiased reporting and FV opinion shopping, whereas downward switches are mostly driven by unbiased reporting. Further, the manager is less likely to correct a prior upward bias than a downward bias, and is more likely to exacerbate a prior upward bias than a downward bias. Pricing switch exhibits a pattern more consistent with FV opinion shopping when it is engaged by insurers with strong concerns for regulatory capital and for securities with high probability of other-than-temporary impairments (OTTI). Next, we examine the consequences of pricing switch from three perspectives. First, pricing switch leads to a more favorable fair value estimation, especially for securities that are priced based upon level 1 and level 2 inputs. However, FV opinion shopping via upward switches is mitigated by the presence of regulatory financial examination and Big 4 auditors. Second, upward switch effectively reduces both the likelihood and the magnitude of OTTI recognition, especially for securities with high probability of impairment. Third, the auditor charges higher investment-related audit fees for upwardly switched securities. Such audit fee increases further depend on whether the pricing switch seems justified. Fourth, the credit rating agency assigns greater credit risks on upwardly switched securities. In sum, we provide evidence that the manager strategically changes the pricing source of fixed income securities in order to achieve certain reporting objectives, and that there are certain costs associated with FV opinion shopping.

Authors

• Minjae Koo, University of Houston

• Yuping Zhao, University of Houston