The Decision Usefulness of Fair Value Accounting in the Debt Market

As the two major accounting standard setters, Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), are jointly advocating a full fair value disclosure regime, there have been heated discussions regarding the pros and cons of fair value versus historical cost among accounting researchers, practitioners, and regulators. Current accounting research basically examines the value relevance of fair value accounting from a shareholder perspective (e.g., Barth, 1994; Petroni and Wahlen, 1995; Song et al., 2010). In comparison, the impact of fair value accounting on the debt market is largely under-investigated. As noted by Baker, Greenwood and Wurgler (2003, p.262), “Relative to the literature on equity financing patterns, and relative to the actual importance of debt finance in the U.S. economy, the literature on debt financing patterns is surprisingly underdeveloped”. Hence, the interface between accounting regime and debt financing has recently emerged as a fruitful area for research. In fact, creditors, especially public debtholders, have informational and pay-off disadvantages that they seek useful accounting information to compensate for. The purpose of this dissertation is twofold: (1) to examine the impact of fair value accounting on the debt market; (2) to examine the influence of specialized auditors on the association between fair value accounting and the debt market effects. The investigation focuses on U.S. bank holding companies issuing debt as they are the reporting entities most affected by the advent of fair value accounting. The first essay focuses on the relative explanatory power of fair value accounting versus historical cost in explaining credit ratings, a common proxy for firm credit quality. I consider both short-term and long-term credit ratings. Results show that fair value accounting outperforms historical cost in explaining firm short-term credit ratings. On the contrary, I do not find evidence that fair value accounting is a better predictor of firm long-term credit ratings. Additional tests further reveal that auditor industry expertise improves fair value’s explanatory power for short-term credit risk. The second essay concentrates on the impact of fair value accounting on banks’ cost of debt, proxied by yield spread. Results suggest that greater use of fair value accounting measurement in the financial statements is generally associated with a lower cost of debt, which supports the argument that fair value accounting improves the decision usefulness of accounting information. Findings further show that Level 1 and Level 2 fair value inputs are related with a lower cost of debt, while Level 3 fair value inputs are associated with a higher cost of debt. In addition, evidence suggests that auditor industry expertise improves the decision usefulness of fair value accounting information, especially of Level 3 inputs, resulting in lower cost of debt. Overall, these results lead to the conclusion that fair value accounting is generally decision useful, although the extent of decision usefulness of fair value varies across the three tiers of fair value levels. Besides, the existence of industry specialized auditors improves the decision usefulness of fair value accounting to debtholders. However, cautions are advised with regard to the implications based on the empirical results, due to the limitations of the methodologies used in this dissertation. Key Words: Decision Usefulness; Fair Value Accounting; Credit Ratings; Cost of Debt; Auditor Industry Expertis