Auditors' Influence on Transfers of Fair-Valued Instruments Into and Out of Level 3 Classification

• In Event: Continental Breakfast and Research & Education Forum
  In Roundtable Session: Table 14: Banking and Audit Issues

Abstract

Prior research has found evidence that managers use discretion surrounding level 3 instruments to opportunistically manage earnings and capital ratios. We investigate whether auditors react to this increased risk by restricting transfers into level 3 and/or increasing their fees. We find a negative association between the presence of a Big4 auditor and the level of transfers into level 3 classification, consistent with higher quality auditors mitigating increased risk by restricting the flow of instruments into level 3. However, we find that this risk restriction effect is limited to smaller banks. We also find evidence that auditors of larger banks, but not smaller banks, increase their fees when managers transfer instruments into level 3 classification, but they do not reduce their fees when managers transfer instruments out of level 3 classification. This finding is consistent with auditors pricing the transfer decision consistent with risk pricing. Collectively, our findings suggest that auditors manage risks associated with transfers into level 3 instruments by both restricting the transfer among small clients, and charging a higher audit fee for larger clients where the flow is less restricted.

Authors

• Mark Kohlbeck, Florida Atlantic University

• Thomas Joseph Smith, University of South Florida

• Adrian Valencia, Florida Gulf Coast University