Value Relevance of Fair Values—Empirical

Evidence of the Impact of Market Volatility*

XIAOFEI SONG, Saint Mary’s University
Received on April 28, 2014; editorial decision completed on December 18, 2014

ABSTRACT
This study examines empirically the effects of market volatility on the value rele-
vance of fair values. Using the modified Ohlson model (1995) and a sample of
U.S. financial companies for the period of 2008 to 2013, this study shows that fair
values are priced at a significant discount when market volatility is high. Song
(2013) shows analytically that the effectiveness of fair value accounting is nega-
tively affected by market volatility. Findings of the current study suggest that
investors understand the effects of market volatility on fair values and price them
accordingly. The study extends the research on the determinants of the usefulness
of fair values by looking beyond factors associated with the reliability of estimated
fair values (Level 2 and Level 3 fair values). This study has practical implications:
current accounting standards for fair value measurement acknowledge the limita-
tions of the market as a source of fair values by offering a three-level fair value
hierarchy with provisions for fair values to deviate from market prices. Findings
of this study shed light on a previously little studied factor, that is, market volatil-
ity, on the usefulness of fair values.
Keywords Fair value; Value relevance; Market volatility; Fair value measurement
hierarchy

VALEUR INFORMATIVE DES JUSTES VALEURS—PREUVE EMPIRIQUE DE

L’INCIDENCE DE LA VOLATILITE DU MARCHE

RESUME

L’auteure se livre a une
etude empirique des r
epercussions de la volatilit
e du march
e
sur la valeur informative (pertinence pour l’
evaluation) des justes valeurs. A  l’aide
d’une variante du modele d’Ohlson (1995) et d’un
echantillon de soci
et
es financieres


des Etats-Unis pour la p
eriode s’
echelonnant de 2008 a 2013, elle
etablit que les
justes valeurs enregistrent une importante d
ecote lorsque la volatilit
e du march
e est

elev
ee. Dans une
etude analytique, Song (2013) d
emontre que la volatilit
e du march
e
a des r
epercussions n
egatives sur l’efficacit
e de la comptabilit
e a la juste valeur. Les
constatations de l’auteure dans la pr
esente
etude semblent indiquer que les investis-
seurs saisissent les r
epercussions de la volatilit
e du march
e sur les justes valeurs et
fixent ces valeurs en cons
equence. L’auteure
etend la recherche aux d
eterminants de

* The author would like to thank Dr. Claude Laurin and two anonymous reviewers for their valuable,
constructive, and detailed comments and suggestions; and the financial support of Saint Mary’s Uni-
versity FGSR research grant. All errors remain the author’s.

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doi:10.1111/1911-3838.12045
92 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

l’utilit
e des justes valeurs en poussant l’int
er^et au-dela des facteurs associ
es a la fiabi-
lit
e des justes valeurs estimatives (justes valeurs de niveaux 2 et 3). Les r
esultats de
l’
etude ont des cons
equences d’ordre pratique : les normes comptables actuelles en
ce qui a trait a l’
evaluation de la juste valeur reconnaissent les limites du march
e
comme source de justes valeurs en proposant une hi
erarchie des justes valeurs a trois
niveaux pr
evoyant la possibilit
e que les justes valeurs s’
ecartent des prix du march
e.
Les r
esultats de l’
etude nous
eclairent sur l’incidence de la volatilit
e du march
e — un
facteur peu
etudi
e jusque-l a — sur l’utilit
e des justes valeurs.
Mots clés : hi
erarchie d’
evaluation de la juste valeur, juste valeur, valeur informa-
tive, volatilit
e du march
e

INTRODUCTION
A primary concern of critics of fair value accounting (FVA) is the procyclical nat-
ure of fair value, that is, its propensity to amplify the “highs” and “lows” of the
markets (Ryan, 2008; Laux and Leuz, 2009; Regassa and Wink, 2010; Gladney,
2011; Fahnestock and Bostwick, 2011). Asset write-ups allowed under FVA enable
companies to increase leverage in times of market “highs,” which heightens com-
pany risk and vulnerability (Persaud, 2008; Plantin, Sapra, and Shin, 2008b). In
times of market “lows,” write-downs required under FVA magnify losses and exac-
erbate financial stress. During the recent global financial crisis, fair value losses
associated with the subprime market collapse caused certain banks to violate the
regulatory capital requirement. To restore the capital ratio, these banks were
forced to sell assets at a price below the fundamental value. Forced sales, in turn,
further drove down asset values for other institutions required by FVA to mark
their assets to market, thus setting off a downward spiral in financial markets
(Allen and Carletti, 2008; Plantin, Sapra, and Shin, 2008a).
While much FVA debate has been focused on the effects of recognizing fair value
losses associated with the market crash on financial stability (Laux and Leuz, 2009;
Power, 2010; Regassa and Wink, 2010; Chea, 2011; Gladney, 2011; Fahnestock and
Bostwick, 2011), Song (2013) demonstrates analytically that market volatility affects
the effectiveness of FVA in general. Song (2013) shows FVA could lead to inferior
financing and investing decisions under highly volatile market conditions. The objec-
tive of this study is to investigate empirically whether investors understand the effects
of market volatility on fair values and price them accordingly.
In the framework of accounting standard setting, a value relevance study is
often viewed as an operationalized test of the fundamental qualitative characteris-
tics of useful accounting information, that is, relevance and representational faith-
fulness. A value relevance study assesses “whether particular accounting amounts
reflect information that is used by investors in valuing firms’ equity” (Barth, Bea-
ver, and Landsman, 2001). Thus, value relevance of fair value and determinants
for such value relevance are of great interest to accounting standard setters, as well
as users and suppliers of accounting information.

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 MARKET VOLATILITY AND FAIR VALUE 93

Using the modified Ohlson model (1995) and the data of a sample of U.S.
financial firms from 2008 to 2013 inclusive, this study shows that market volatility
negatively affects value relevance of fair values. Specifically, market-based fair val-
ues, that is, both direct market quotes (Level 1 fair values) and fair values esti-
mated based on observable market inputs (Level 2 fair values) are priced
significantly lower when market volatility is high. In contrast, pricing of fair values
estimated based on unobservable non-market inputs (Level 3 fair values) is not
affected by market volatility.
This study is of importance to both FVA practice and FVA research. Due to
the intense criticism FVA received during the recent global financial crisis trig-
gered by the subprime markets collapse, current accounting standards for fair
value measurements acknowledge the limitation of market prices as the source of
fair values. Fair value, defined as “the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market par-
ticipants at the measurement date,” can be the “quoted prices in active markets
for identical assets or liabilities” (Level 1 inputs); adjusted direct market quotes
for similar but not identical assets or liabilities or less-active market quotes for
identical assets or liabilities, or estimated fair values, based on related observable
market data (Level 2 inputs); or estimated based on “unobservable” non-market
inputs and “the reporting entity’s own estimates about what assumptions market
participants would use” (Level 3 inputs) (FASB, 2006, 2009; IASB, 2011). Three-
level fair value hierarchy allows fair value to deviate from market price when a
direct quoted market price is not available. However, the directly quoted market
price or Level 1 input is always given the first and highest preference. When the
directly quoted market price is not available, other market information, or Level
2 inputs, is then given preference to the unobservable non-market information or
Level 3 inputs.
Under the three-level fair value hierarchy, Level 2 and Level 3 fair values
involve managerial assumptions and estimates. Empirical research on the determi-
nants of the usefulness of fair value focuses almost exclusively on factors associ-
ated with the reliability of the estimated Level 2 and Level 3 fair values. Implicitly
the usefulness of Level 1 fair values is accepted as a foregone conclusion. Indeed,
incidental evidence seems to support unadulterated value relevance of mark-to-
market fair values (Kolev, 2008; Goh, Ng, and Yong, 2009; Song, Thomas, and
Yi, 2010). Findings of this study and the analytical reasoning of Song (2013) chal-
lenge this accepted view of fair value measurements by showing that the value rele-
vance of market price as fair value is affected by market volatility. The findings of
this study raise an interesting question: when is the direct market quote as fair
value not a good measure of the value of an asset or liability? Further research is
needed to delineate the effects of unhindered inclusion of market price as fair value
in financial statements.
The remainder of this paper is organized as the following: the next section
reviews the relevant FVA literature and develops hypotheses; the third section

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94 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

describes the research design; the fourth section reports the results; and the final
section offers a concluding discussion.

LITERATURE REVIEW AND HYPOTHESES

Fair value is a specific manifestation of a wide range of accounting measurements
that can be generally termed as current value. Fair value differs from historical cost
mainly because fair value reflects value changes subsequent to the original transac-
tion, while historical cost does not. Supporters of FVA argue that information
based on prices that reflect current market assets is more “relevant” to investors
(e.g., Koonce, Nelson, and Shakespeare, 2009). On the other hand, supporters of
historical cost accounting maintain that the measure that reflects the effects of
transactions in which a company actually participated is most “relevant” (e.g.,
Isaac, 2008). While the conceptual and theoretical debate over fair value versus
historical cost has been vigorous and ongoing among policymakers, accounting
standards setters, and other interested parties, researchers have also been examin-
ing empirically the relative informativeness of fair value versus historical cost.
A significant volume of empirical literature is devoted to studying value rele-
vance of fair value (Barth, 1994; Petroni and Wahlen, 1995; Ahmed and Takeda,
1995; Eccher, Ramesh, and Thiagarajan, 1996; Nelson, 1996; Barth and Clinch,
1998; Aboody, Barth, and Kasznik, 1999; Bell, Landsman, Miller, and Yeh, 2002;
Khurana and Kim, 2003; Eng, Sandagaran, and Yoon, 2009; Landsman, Peasnell,
Pope, and Yeh, 2006; Landsman, 2007; Kolev, 2008; Goh et al., 2009; Song et al.,
2010). Specifically, these studies investigate whether an association between a fair
value amount and a market-based value such as share price, share returns, and risk
indicators exists. From an accounting standards-setting perspective, an accounting
amount is relevant if it is capable of making a difference to financial statement
users; an accounting amount is representationally faithful only if it represents what
it purports to represent. “Relevance” and “representational faithfulness” are the
two fundamental qualitative characteristics of useful accounting information
(IASB, 2010). A value relevance study operationalizes the test of relevance and
reliability because if an accounting number is value relevant, that is, if it has a pre-
dicted significant relation with the share price or share return, then the number
“must reflect information relevant to investors in valuing the firm and is measured
reliably enough to be reflected in share prices” (Barth et al., 2001).
Prior to the enactment of SFAS No. 157—Fair Value Measurement, empirical
studies on value relevance of fair value in North America focused mainly on specific
types of financial assets and liabilities of banks and other financial institutes. Fair
values of equity securities and fixed maturity debt securities are generally found to
be incrementally associated with stock price (Barth, 1994; Petroni and Wahlen,
1995; Barth and Landsman, 1995; Eccher et al., 1996; Nelson, 1996). However, fair
value of other items, such as municipal and corporate bonds and loans, deposits,
long-term debt, off-balance sheet financial instruments, and energy trading assets
are not found to be associated with stock price (Petroni and Wahlen, 1995; Nelson,

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 MARKET VOLATILITY AND FAIR VALUE 95

1996; Khurana and Kim, 2003; Eng et al., 2009). These studies identify measure-
ment errors associated with fair value as the explanation of the mixed results. For
example, equity investments generally have a well-established market and are more
actively traded than loans and deposits and, thus, have a more objectively deter-
mined fair value (Khurana and Kim, 2003). Excess of fair value over original value
of energy trading assets of companies that enter into energy contracts, on the other
hand, are subject to management estimates and are not verifiable and thus could be
seen as poor signals of worth and performance (Eng et al., 2009).
Findings on the relationship between stock returns and fair value gains and
losses are also mixed. Both realized and unrealized fair value gains and losses and
estimated expenses from employee stock options (fair value) are found to be asso-
ciated with stock returns (Barth, 1994; Ahmed and Takeda, 1995; Bell et al., 2002;
Aboody et al., 1999; Landsman et al., 2006). However, unrealized gains and losses
are discounted significantly more when incentives for managers to manage earnings
are stronger (Ahmed and Takeda, 1995). For instance, managers of banks that are
less healthy, that is, with low earnings and low regulatory capital, are found to be
more likely to exercise income-increasing discretions associated with fair value esti-
mation (Barth, 1994; Ahmed and Takeda, 1995).
The relationship between fair value and risk factors has also been a focus of
fair value study with mixed findings. Hodder, Hopkins, and Wahlen (2006) find
that the constructed measure of full fair value income for a sample of 202 U.S.
commercial banks is significantly more volatile than both net income and compre-
hensive income; full fair value income volatility reflects certain risks not captured
by volatility in net income or comprehensive income; and full fair value income
volatility relates more closely to capital market pricing of these risks. Arouri, Bel-
lalah, Ben Hamida, and Nguyen (2012), using French listed companies, find that
volatility of fair value income does not significantly affect stock price and price
volatility, and thus has no risk-relevant information. Hirst, Hopkins, and Wahlen
(2004) find that bank analysts’ risk and value judgments distinguish banks’ expo-
sure to interest rate risk only under full fair value income measurement. Evidence
shows that fair values capture certain risks beyond those captured by non-fair
value accounting information.
The enactment of SFAS No. 157—Fair Value Measurement in late 2007 made
it possible to examine value relevance of total fair values, as well as fair values of
each level of the fair value hierarchy. Three studies, Song et al. (2010); Goh et al.
(2009), and Kolev (2008), take advantage of the new fair value disclosure require-
ments and find similar results: (i) all three levels of fair values are value relevant;
(ii) differences exist among the three levels of fair value in their value relevance—
while evidence generally shows no significant difference between Level 1 and Level
2 fair values, Level 3 fair value is discounted significantly more than Levels 1 and
2 fair values; and (iii) value relevance of Level 2 and Level 3 fair value is affected
by factors associated with “management’s opportunity and implied incentives to
bias the reported estimates” (Kolev, 2008; Song et al., 2010). Specifically, Kolev

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(2008) and Song et al. (2010) find that Level 2 and Level 3 fair values, both
required managerial assumptions and estimates, are discounted by investors when
markets are less liquid, information risk is high, or corporate governance is weak.
The value relevance of Level 1 fair values is generally not affected by such factors.
The findings of Song et al. (2010); Goh et al. (2009), and Kolev (2008) are con-
sistent with the findings of earnings management studies. This stream of studies
has documented that managerial discretions and judgment required in estimating
fair value are used to serve earnings management purposes in various settings, such
as gains and losses of assets securitizations (Shakespeare, 2002; Dechow, Myers,
and Shakespeare, 2010); managerial decisions on fair value options choices (Guth-
rie, Irving, and Sokolowsky, 2011); and managerial estimates of investment income
by utility companies (Liu and Yu, 2013). Furthermore, Dechow et al. (2010) show
that boards of directors do not appear to exert any control over earnings manage-
ment behavior in estimating assets securitization gains or losses. Barth and Lands-
man (1995) find that fair value based measures of net income are more volatile,
but incremental volatility is not reflected in bank stock prices, indicating that
investors see through the effects of managerial discretion on such volatility.
The purpose of this study is to extend the studies of the determinants of useful-
ness of fair values by examining empirically the effects of market volatility on
value relevance of fair values. A main criticism of FVA is its procyclicality, that is,
its tendency of amplifying the “highs” and “lows” of the markets. The effects of
fair value’s ability to magnify losses during recent global financial crisis have
attracted intense scrutiny following the subprime crisis (Laux and Leuz, 2009;
Power, 2010; Regassa and Wink, 2010; Chea, 2011; Gladney, 2011; Fahnestock
and Bostwick, 2011). Abdel-Khalik (2008) lists the followings concerns regarding
current practice on fair value measurements in the financial statements: (i) poten-
tial redistribution of capital as dividends due to confusing “earned income” with
“expected or holding capital gains and losses”; (ii) reporting failure as success, and
vice versa, because increase/decrease in the cost of capital causes fair value of debts
to decrease/increase, which in turn, will result in gains/losses; and (iii) increasing
information asymmetry and reducing transparency.
Song (2013) quantifies the effects of market volatility on the effectiveness of
fair value information through modeling. Using a model with two periods and
three reporting dates, Song (2013) shows that if market volatility is high, that is,
interim market-price change is counterindicative of the overall price change so that
a subsequent market correction will ensue, interim financing and investing deci-
sions based on FVA information will result in suboptimal allocation of resources,
which, in turn, leads to equity contraction. If market volatility is low, that is,
interim market price change is indicative of overall price change, interim financing
and investing decisions based on FVA information will result in more efficient allo-
cation of resources, which, in turn, leads to greater equity appreciation.
This study builds on the analytical result of Song (2013). Under the efficient
market hypothesis, Song’s (2013) finding that fair values could lead to suboptimal

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 MARKET VOLATILITY AND FAIR VALUE 97

decisions when market volatility is high should affect how fair value information is
used by market participants. In times of high market volatility, management
should adjust the affected fair values in allocating resources and making investing
and financing decisions; and investors should price the affected fair value amounts
at a discount in valuing a firm. To test whether investors understand the effects of
market volatility on fair values and price fair values accordingly, the first hypothe-
sis stated in alternative form is:
HYPOTHESIS 1: Ceteris paribus, the value relevance of a fair value asset is negatively
affected by the volatility of the market for the asset.
Prior studies have documented a number of determinants of value relevance of
fair values (Barth, 1994; Ahmed and Takeda, 1995; Barth and Clinch, 1998; Goh
et al., 2009; Song et al., 2010). Some of these determinants are closely associated
with market volatility. For instance, Goh et al. (2009) find that deteriorating mar-
ket liquidity and heightened information risk associated with the market crisis of
the third quarter of 2008 have negative effects on the value relevance of fair values.
Since market downturns are often accompanied by high market volatility, it would
be necessary to separate the effects of these confounding factors before any conclu-
sion can be drawn regarding the effect of market volatility on value relevance of
fair value. Goh et al. (2009) were able to conclude that the valuation discount on
fair values of the third quarter of 2008 documented in their paper was due to dete-
riorated market liquidity and heightened information risk because only the esti-
mated fair values, that is, Level 2 and Level 3 fair values, were discounted in the
third quarter of 2008. Fair values that were not subjected to assumptions and esti-
mations, that is, Level 1 fair values, were not.
In contrast to the effects of market illiquidity and information risk on esti-
mated fair values, the effects of market volatility should be on fair values that are
directly or indirectly based on market prices. Level 1 fair values are the quoted
market prices of identical assets or liabilities and, thus, would be most directly
affected by market volatility. Level 2 fair values are market prices of similar but
not identical items, or market prices of identical items but at different times, or
market prices adjusted otherwise. Thus, Level 2 fair values should also be affected
by market volatility, although assumptions and estimates also play a part, so they
would not be as directly affected by market volatility as Level 1 fair values. In con-
trast, Level 3 fair values are estimated based on unobservable, non-market assump-
tions and inputs. There should be no direct connections between Level 3 fair
values and market volatility. Two additional hypotheses below are developed based
on these specifics of the effects of market volatility:
HYPOTHESIS 2: Ceteris paribus, the value relevance of a Level 1 or Level 2 fair value asset
is negatively affected by the volatility of the market for the asset.
HYPOTHESIS 3: Ceteris paribus, the value relevance of a Level 3 fair value asset is not
affected by the volatility of the market for the asset.

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98 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

RESEARCH DESIGN

The Modified Ohlson Model

To assess value relevance of fair values, the modified Ohlson (1995) model that
associates share price with financial statement amounts is used (Barth and Clinch,
1998; Goh et al., 2009; Kolev, 2008). Goh et al. (2009) and Kolev (2008) argue
that since companies report fair value liabilities infrequently, net fair value assets
are preferred. The first regression thus follows:
Price ¼ a0 þ a1 EPS þ a2 NBVE þ a3 NBVED þ b0 NFVA þ d0 NFVAD
X
þ fi Controls þ e: ð1Þ

The model is scaled by the number of common shares outstanding at the end of
each period. In (1), Price denotes price per share; EPS is earnings per share before
extraordinary items; NBVE is net book value of equity per share, that is, the difference
between total book value of equity per share and the net assets measured at fair value
per share; NFVA is net fair value assets per share, that is, the difference between total
fair value assets per share and total fair value liabilities per share. D is a dummy with
value of 1 for high market volatility and 0 for low market volatility (high market stabil-
ity). Controls represents a vector of control variables that prior studies have identified
as having an impact of the relationship between market price and book values. Specifi-
cally, the variables in the control vector include size, profitability, industry, growth,
default risk, and information risk. Respectively, a0 and e are intercept and error terms.
The first hypothesis predicts that the regression coefficients for the interactive term
NFVA9D, d0, to be negative and statistically significant.
To test the second and third hypotheses, net fair value assets are separated
according to the levels of inputs defined in the fair value hierarchy: NFVA1—Level
1 net fair value assets; NFVA2—Level 2 net fair value assets; and NFVA3—Level
3 net fair value assets. The second regression thus follows:
Price ¼ a0 þ a1 EPS þ a2 NBVE þ a3 NBVED þ b1 NFVA1 þ b2 NFVA2 þ b3 NFVA3
X
þ d1 NFVA1D þ d2 NFVA2D þ d3 NFVA3D þ fi Controls þ e: ð2Þ

The second hypothesis predicts that the regression coefficients for the interac-
tive terms NFVA19D and NFVA29D, d1 and d2, to be negative and statistically
significant. The third hypothesis predicts that the regression coefficient for the
interactive term NFVA39D, d3, to be insignificant.
Prior studies find that markets often price fair value assets and fair liabilities at
different rates (e.g., Song et al., 2010). Using net asset value forces the coefficients
of assets and liabilities to be equal, which could mask price differences. To ensure
the result is not induced by forced equality of regression coefficients, the above (1)
and (2) are modified similarly to that in Song et al. (2010) with fair value assets
and liabilities separated:

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 MARKET VOLATILITY AND FAIR VALUE 99

Price ¼ a0 þ a1 EPS þ a2 NBVE þ a3 NBVED þ b0 FVA þ c0 FVL

X
þ d0 FVAD þ fi Controls þ e; ð3Þ

Price ¼ a0 þ a1 EPS þ a2 NBVE þ a3 NBVED þ b1 FVA1 þ b2 FVA2 þ b3 FVA3

þ c1 FVL1 þ c2 FVL2 þ c3 FVL3 þ d1 FVA1D þ d2 FVA2D
X
þ d3 FVA3D þ fi Controls þ e: ð4Þ

FVA and FVL in (3) are total fair value assets per share and total fair value
liabilities per share, respectively. All other variables remain the same as in (1). The
first hypothesis predicts that the regression coefficients for the interactive term
FVA9D, d0, to be negative and statically significant.
FVA1, FVA2, and FVA3 in (4) are Level 1, Level 2, and Level 3 total fair
value assets per share, respectively; FVL1, FVL2, and FVL3 are Level 1, Level 2,
and Level 3 total fair value liabilities per share, respectively. All other variables
remain the same as in (1). Negative and significant regression coefficients for the
interactive terms FVA19D and FVA29D, d1 and d2, will support the predictions
of the second hypothesis. A statistically insignificant regression coefficient for the
interactive term FVA39D, d3, will support the prediction of the third hypothesis.

The Sample
The initial sample is comprised of all U.S. financial companies as identified by
Global Industry Classification Standard (GICS) industry sector (40) from COM-
PUSTAT from 2008 to 2013 inclusive, which includes a total of 1,402 companies
(35,230 firm-quarters). The sample period is so determined because the SFAS No.
157—Fair Value Measurement became effective for financial statements issued for
fiscal periods beginning after November 15, 2007 in the United States. Since the
construct of the market volatility variable requires the alignment of the fiscal quar-
ters of all companies, companies with fiscal year-ends on any date other than
December 31 are eliminated, thus reducing the sample to 1,316 companies (33,570
firms-quarters).
The following data from COMPUSTAT are required for hypothesis testing:
total assets, total liabilities, shareholders’ equity, total Level 1 assets, total Level 2
assets, total Level 3 assets, total Level 1 liabilities, total Level 2 liabilities, total
Level 3 liabilities, number of shares outstanding, and earnings per share before
extraordinary items. After eliminating observations with missing values for these
variables, 670 companies (11,110 firm-quarters) remain. Eliminating the observa-
tions without the closing stock price of the day immediately following the day the
company files the 10Q or 10K with the SEC in CRSP reduces the sample further
to 303 companies (7,088 firm-quarters). To mitigate the effects of outliers, the sam-
ple is further winsorized to eliminate observations with total assets, total liabilities,
total shareholders’ equity, or earnings per share before extraordinary items of less

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100 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

than 1 percentile or more than 99 percentile of the total sample. This further
reduces the sample to 299 companies (6,851 firm-quarters). Finally, eliminating
observations with missing data for the non-COMPUSTAT control variables gives
the final sample of 295 companies (5,956 firm-quarters). Panel A of Table 1 sum-
marizes the sample selecting process. Panel B of Table 1 reports the sample break-
down by year and quarter. Note that there is no observation for the fourth
quarter of 2013 due to CRSP data unavailability. The sample size of this study is
similar to that of prior studies (Song et al., 2010; Goh et al., 2009; Kolev, 2008).

The Variables
Dependent variable price per share (Price); independent variables earnings per
share (EPS); net book value of equity per share (NVBE); total net fair value per
share and net fair value per share of each level (NFVA, NFVA1, NFVA2, and
NFVA3); total fair value assets per share and fair value assets per share of each
level (FVA, FVA1, FVA2, and FVA3); and total fair value liabilities per share
and fair value liabilities per share of each level (FVL, FVL1, FVL2, and FVL3)
are described in the previous section. Following Song et al. (2010), Goh et al.
(2009), and Kolev (2008), the control variable firm size (Size) is the period begin-
ning total assets translated to industry-quarter deciles, with industry being the
same GICS industry code. Profitability is return on assets (ROA) transferred to
industry-quarter deciles. Transferring control variables into industry-quarter de-

TABLE 1
The sample

Selection criteria Firms Observations

Panel A: Sample selection

All firm with Industry Section code of 40 1,402 35,230

Less:
Fiscal year not ending on December 31 86 7,660
COMPUSTAT variables unavailable 464 22,460
Price unavailable on CRSP 367 4,200
Non-COMPUSTAT control variables data unavailable 8 1,132
Final sample 295 5,956

Panel B: Quarterly distribution of the final sample

First quarter 1,538

Second quarter 1,548
Third quarter 1,550
Fourth quarter 1,320

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 MARKET VOLATILITY AND FAIR VALUE 101

ciles also helps to control for any possible industry effects. Growth rate (Growth)
is computed as percentage changes of total assets from one quarter ago, trans-
lated to industry-quarter deciles. Default risk is captured by three variables: Stan-
dard & Poor’s domestic, long-term issue credit rating (S&P Rating), recoded
from 1 (B) to 16 (AAA), a dummy variable indicating whether a company is
rated by Standard & Poor’s (Not Rated) with value of 1 if not rated by S&P (0
if rated), and Tier 1 capital ratio (CPAR1) (Goh et al., 2009).
Information risk is measured by three variables, as well. The first is an auditor
dummy variable, Big4, with a value of 1 if the auditor is one of the Big 4 audit
firms and 0 otherwise. The second information risk control is NYSE, with value of
1 if a company is listed on New York Stock Exchange and 0 otherwise. The third
information risk control is AMEX, with value of 1 if the company is listed on
American Stock Exchange and 0 otherwise.
Market volatility is captured by the standard deviation of the leading market
index, Dow Jones Industry Average (DJIA). The dummy variable for market vola-
tility is given a value of 1 if the standard deviation of DJIA of a particular quarter
is above the median standard deviations of all quarters in the sample period, 0 if
below the median. On average, companies file 10-Ks and 10-Qs with the SEC
45 days after a fiscal quarter closing. Investors’ pricing of a company should be
influenced by all information available at the time, including market movements
up to a filing date. Thus, the periods for which the standard deviations of DJIA
are computed on are not fiscal quarters, but the three-month periods between the
average SEC filing dates.
Table 2 shows the summary statistics of the key variables of the subsamples
of high and low market volatility, as well as the entire sample. There are signifi-
cantly more fair value assets than fair value liabilities and more than 90 percent
of the fair value assets are measured using Level 2 inputs. Differences are not
obvious in the means, medians, and standard deviations of these variables
between a high market volatility subsample and a low market volatility subsam-
ple. This is not surprising because the same company is likely to be included in
both the high volatility and the low volatility subsamples as the standard devia-
tion of DJIA of half of the quarters are below the median and other half above
the median.
The Spearman and Pearson correlation coefficients of the key variables are
presented in Table 3. Net book value of assets (NBVE) is highly correlated with
Level 2 fair value assets (FVA2) with a Spearman (Pearson) correlations
coefficient of 0.9155 (0.8973). Since most fair value assets are Level 2 fair
value assets, the high correlation between NBVE and FVA2 also leads to high
correlation between these two variables and NFVA. These characteristics of the
sample are similar to those of prior studies (Song et al., 2010; Goh et al., 2009;
Kolev, 2008).

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 TABLE 2
102

Summary statistics

Low volatility High volatility Overall

Mean Median SD Mean Median SD Mean Median SD

N 3,176 3,176 3,176 2,780 2,780 2,780 5,956 5,956 5,956

Price 17.323 14.735 18.004 15.622 12.630 17.354 16.529 13.815 17.723
EPS 0.277 0.270 0.538 0.186 0.130 0.736 0.234 0.250 0.639
BVE 17.143 15.020 12.809 17.448 15.259 12.711 17.285 15.156 21.763
NBVE 12.044 5.725 31.289 18.448 10.191 30.366 15.033 7.782 31.024
NFVA 29.187 19.716 38.000 35.896 26.255 38.224 32.319 23.028 38.248

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FVA1 1.724 0.000 15.320 2.447 0.044 19.774 2.061 0.011 17.542
FVA2 27.276 18.814 32.850 33.218 25.070 31.250 30.050 22.148 32.247
FVA3 0.669 0.000 2.505 0.947 0.0238 3.126 0.799 0.000 2.815
FVL1 0.030 0.000 0.243 0.041 0.000 0.308 0.035 0.000 0.276
ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

FVL2 0.419 0.000 2.818 0.614 0.000 2.896 0.510 0.000 2.856
FVL3 0.033 0.000 0.212 0.012 0.000 0.425 0.016 0.000 0.329
Size 2.719 3.000 1.025 2.701 3.000 1.029 2.711 3.000 1.027
ROA 2.525 3.000 1.091 2.514 3.000 1.100 2.520 3.000 1.095
Growth 1.244 0.007 23.991 0.102 0.007 4.552 0.711 0.007 17.801
CAPR1 13.188 12.820 3.201 13.099 12.700 3.089 13.146 12.795 3.150

Notes:
Variable definitions: Price, closing stock price of the day following 10-Q or 10-K file date; EPS, quarterly earnings per share before extraordinary
items; BVE, book value of equity per share; NBVE, book value of equity minus net assets measured at fair value, divided by number of shares
outstanding; NFVA, total fair value assets per share minus total fair value liabilities; FVA1, Level 1 fair value assets per share; FVA2, Level 2
fair value assets per share; FVA3, Level 3 fair value assets per share; FVL1, Level 1 fair value liabilities per share; FVL2, Level 2 fair value
liabilities per share; FVL3, Level 3 fair value liabilities per share; Size, the GICS industry-quarter deciles of period beginning total assets; ROA,
the GICS industry-quarter deciles of return on assets; Growth, changes of the total assets from one year ago; CAPR1, Tier 1 capital ratio.
 TABLE 3
Selected variable correlations (n = 5,956)

Spearman correlation

Pearson correlation Price EPS BVE NBVE NFVA FVA1 FVA2 FVA3 FVL1 FVL2 FVL3

Price 0.7216 0.6138 0.1275 0.2996 0.1986 0.2870 0.1148 0.1124 0.2626 0.0954
EPS 0.4873 0.5324 0.1893 0.3117 0.1156 0.3031 0.0378 0.0251 0.1249 0.0417
BVE 0.7440 0.4073 0.2815 0.5541 0.2085 0.5399 0.1899 0.1508 0.2617 0.1549
NBVE 0.3246 0.2213 0.4262 0.9293 0.3127 0.9155 0.2309 0.0564 0.1314 0.0868
NFVA 0.5115 0.3154 0.6794 0.9534 0.3587 0.9822 0.3014 0.1204 0.2446 0.1569
FVA1 0.4535 0.2403 0.5912 0.4054 0.5261 0.2979 0.3012 0.3034 0.3393 0.2457
FVA2 0.3570 0.2403 0.4754 0.8973 0.8864 0.0821 0.2804 0.1207 0.2514 0.1598
FVA3 0.2410 0.1195 0.3640 0.3309 0.3899 0.0324 0.3941 0.3111 0.4363 0.4060
FVL1 0.1135 0.0423 0.1872 0.0788 0.1264 0.0488 0.1482 0.3102 0.4275 0.3812
FVL2 0.1841 0.0789 0.2251 0.1636 0.2078 0.0502 0.2831 0.3568 0.4718 0.3553
FVL3 0.0738 0.0037 0.1418 0.0734 0.1069 0.0122 0.1330 0.2285 0.1501 0.2402

Notes:
Variable definitions: Price, closing stock price of the day following 10-Q or 10-K file date; EPS, quarterly earnings per share before extraordinary
items; BVE, book value of equity per share; NBVE, book value of equity minus net assets measured at fair value, divided by number of shares
outstanding; NFVA, total fair value assets per share minus total fair value liabilities; FVA1, Level 1 fair value assets per share; FVA2, Level 2
fair value assets per share; FVA3, Level 3 fair value assets per share; FVL1, Level 1 fair value liabilities per share; FVL2, Level 2 fair value
liabilities per share; FVL3, Level 3 fair value liabilities per share.
MARKET VOLATILITY AND FAIR VALUE

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103
104 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

RESULTS

Hypothesis Testing Results

Use of pooled firm-quarter observations often creates a cross-sectional dependence
(firm effect) and time-series dependence (time effect) associated with panel data. To
control for this firm effect, Rogers standard errors are used for tests of regression
coefficients. To control for the time effect, time dummies for all quarters are
included in all regressions (Petersen, 2009; Gow, Ormazabal, and Taylor, 2010).
Table 4 shows the regression results using net fair value assets. Column I of
Table 4 presents the results of the “base” regression for the purpose of confirming
the model specifications are consistent with those in other studies (Goh et al., 2009).
The regression coefficient for net fair values is 0.815 and significant, similar to that
of Goh et al. (2009), indicating the “base” model specifications are in line with those
of previous studies. The regression coefficients for EPS and NBVE are both positive
and significant as expected. The regression coefficients for Size are consistently posi-
tive and significant in this study but generally not significant in Kolev (2008). The
regression coefficients for ROA, S&P Rating, and Not Rated are all positive, consis-
tent with those of Kolev (2008). The regression coefficient for CAPR1 is negative
and marginally significant; however, it is not significant in Goh et al. (2009). The
regression coefficient for Big4 is positive and marginally significant, similar to that
of Goh et al. (2009). Finally, the regression coefficient for NYSE is not significant,
the same as that of Goh et al. (2009). While for Growth and AMEX the regression
coefficients are not significant in this study, but are significant in some quarters in
Goh et al. (2009). The regression coefficients for the EPS, NBVE, and the control
variables do not vary qualitatively for the various regressions of this study; thus,
these are not discussed further for the sake of brevity.
The regression results of (1) are in column II of Table 4. The coefficient for the
interactive term NFVA9D is 0.111, negative and statistically significant at 1 per-
cent level of confidence, indicating that each dollar of fair value assets is dis-
counted by 11 cents on average when the market is more volatile. The result is
consistent with the prediction of Hypothesis 1: value relevance of fair value is neg-
atively affected by market volatility.
Column III of Table 4 show results of the “base” regression with net fair val-
ues separated according to the levels of inputs in the fair value hierarchy. The
regression coefficients for Levels 1, 2, and 3 net fair values are 0.841, 0.772, and
0.534, respectively, all statistically significant. These coefficients and their relative
differences are comparable to that of Goh et al. (2009) and Kolev (2008),
indicating the “base” model specifications are in line with those of the previous
studies.
The regression results of (2) are presented in column IV of Table 4. The regres-
sion coefficients for NFVA1, NFVA2, and NFVA3 are 0.886, 0.844, and 0.612,
respectively, all significant at 1 percent level. The regression coefficients for interac-

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 MARKET VOLATILITY AND FAIR VALUE 105

TABLE 4
Regression of share price on net book value of equity, net fair value assets, and the controls
(n = 5,956)

(I) (II) (III) (IV)

Intercept a0 25.358 26.397 26.061 27.608

(5.88 ***) (6.16***) (5.99***) (6.32***)
EPS a1 2.362 2.312 2.301 2.188
(4.72***) (4.73***) (4.67***) (4.54***)
NBVE a2 0.783 0.845 0.745 0.828
(10.22***) (8.94***) (10.06***) (11.44***)
NBVE9D a3 0.142 0.202
(4.82***) (2.93***)
NFVA b0 0.815 0.863
(11.86***) (14.48***)
NFVA1 b1 0.841 0.886
(19.68***) (23.96***)
NFVA2 b2 0.772 0.844
(11.75***) (13.08***)
NFVA3 b3 0.534 0.612
(2.78*) (2.66***)
NFVA9D d0 0.111
(4.93***)
NFVA19D d1 0.115
(3.26***)
NFVA29D d2 0.179
(2.86***)
NFVA39D d3 0.145
(1.31)
Size f1 3.961 3.959 3.991 4.003
(8.59***) (8.57***) (8.78***) (8.81***)
ROA f2 2.858 2.857 2.907 2.922
(9.11***) (9.13***) (9.33***) (9.45***)
Growth f3 0.007 0.006 0.007 0.005
(1.29) (1.22) (1.16) (1.00)
CAPR1 f4 0.234 0.236 0.215 0.215
(2.07**) (2.08**) (1.89*) (1.90*)
S&P Rating f5 1.869 1.882 2.040 2.068
(3.68***) (3.71***) (4.07***) (4.13***)
Not Rated f6 17.406 17.502 18.108 18.316
(4.70***) (4.73***) (4.85***) (4.19***)

(The table is continued on the next page.)

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106 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

TABLE 4 (continued)

(I) (II) (III) (IV)

Big4 f7 0.090 0.111 0.049 0.028

(0.07) (0.09) (0.01) (0.03)
NYSE f8 0.347 0.331 0.105 0.094
(0.18) (0.17) (0.96) (0.05)
AMEX f9 2.587 2.530 3.097 3.169
(0.64) (0.62) (0.74) (0.76)
Adjusted R2 0.7037 0.7050 0.7083 0.7107

Notes:
***, **, and * indicate the t-test of regression coefficient is statistically significant at 1 percent, 5
percent and 10 percent, respectively.
Variable definitions: Price, closing stock price of the day following 10-Q or 10-K file date; EPS,
quarterly earnings per share before extraordinary items; NBVE, book value of equity minus net
assets measured at fair value, divided by number of shares outstanding; NFVA, total fair value
assets per share minus total fair value liabilities; NFVA1, Level 1 fair value assets per share
minus Level 1 fair value liabilities; NFVA2, Level 2 fair value assets per share minus Level 2 fair
value liabilities; NFVA3, Level 3 fair value assets per share minus Level 3 fair value liabilities;
Size, the GICS industry-quarter deciles of period beginning total assets; ROA, the GICS
industry-quarter deciles of return on assets; Growth, the GICS industry-quarter deciles of the
percentage changes of the total assets from one year ago; S&P Rating, the Standard & Poor’s
domestic long-term issue credit rating, recoded from 1 (B) to 16 (AAA); Not Rated, a dummy
variable with value of 1 if not rated by S&P, 0 if rated; CAPR1, Tier 1 capital ratio; Big4, a
dummy variable with value of 1 if the auditor is one of the Big 4 audit firms, 0 otherwise;
NYSE, a dummy variable with value of 1 if the company is listed on New York Stock
Exchange, 0 otherwise; AMEX, a dummy variable with value of 1 if the company is listed on
American Stock Exchange, 0 otherwise; D, market volatility dummy variable with value of 1 if
the standard deviation of the DJIA of a particular quarter is above the median, 0 otherwise.

tive terms NFVA19D and NFVA29D are 0.115 and 0.179, both significant at
1 percent level. The negative and statistically significant coefficients for NFVA19D
and NFVA29D are consistent with the prediction of the second hypothesis that
investors discount Levels 1 and 2 fair values significantly when the markets are
more volatile. The regression coefficient for the interactive term NFVA39D is
0.145, also negative but not statistically significant at a conventional level of con-
fidence. The statistically insignificant coefficient for NFV39D indicates that value
relevance of fair value with non-market inputs is not affected by market volatility.
This result supports the prediction of the third hypothesis.
The results of alternative regressions with fair value assets and fair values lia-
bilities separated are presented in Table 5. Column I, the base model, shows that
the regression coefficient for fair value assets (FVA) is 0.817 and that for fair value
liabilities is 1.00, both statistically significant at 1 percent. The coefficients for fair
value assets and fair value liabilities are in line with the coefficients for assets and
liabilities, respectively (e.g., Barth and Clinch, 1998; Song et al., 2010). Column II

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 MARKET VOLATILITY AND FAIR VALUE 107

TABLE 5
Regression of share price on net book value of equity, fair value assets and liabilities, and
the controls (n = 5,956)

(I) (II) (III) (IV)

Intercept a0 26.710 27.836 27.966 29.220

(6.04***) (6.29***) (6.32***) (6.58***)
EPS a1 2.372 2.314 2.207 2.119
(4.73***) (4.73***) (4.69***) (4.55***)
NBVE a2 0.786 0.846 0.758 0.820
(10.54***) (11.96***) (10.82***) (11.37***)
NBVE9D a3 0.136 0.156
(4.69***) (2.53***)
FVA b0 0.817 0.864
(12.29***) (14.21***)
FVA1 b1 0.850 0.883
(21.49***) (24.19***)
FVA2 b2 0.783 0.834
(12.50***) (12.87***)
FVA3 b3 0.601 0.681
(3.53***) (3.29***)
FVL c0 1.000 0.996
(5.97***) (6.20***)
FVL1 c1 4.540 4.372
(3.82***) (3.46***)
FVL2 c2 0.701 0.701
(5.23***) (4.75***)
FVL3 c3 1.990 1.690
(1.99**) (1.79*)
FVA9D d0 0.103
(5.50***)
FVA19D d1 0.086
(2.75***)
FVA29D d2 0.135
(2.45**)
FVA39D d3 0.147
(1.39)
Size f1 3.973 3.971 3.984 3.994
(8.63***) (8.61***) (9.91***) (8.93***)
ROA f2 2.812 2.808 2.880 2.889
(8.99***) (9.01***) (9.63***) (9.70***)

(The table is continued on the next page.)

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108 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

TABLE 5 (continued)

(I) (II) (III) (IV)

Growth f3 0.007 0.006 0.006 0.005

(1.18) (1.07) (1.07) (0.93)
CAPR1 f4 0.223 0.223 0.204 0.203
(1.96*) (1.95*) (1.81*) (1.80*)
S&P Rating f5 2.041 2.068 2.246 2.278
(3.95***) (4.01***) (4.50***) (4.55***)
Not Rated f6 18.551 18.756 19.665 19.904
(4.88***) (4.86***) (5.15***) (5.19***)
Big4 f7 0.132 0.166 0.012 0.029
(0.10) (0.12) (0.01) (0.03)
NYSE f8 0.163 0.136 0.413 0.410
(0.08) (0.07) (0.22) (0.22)
AMEX f9 2.570 2.514 3.055 3.128
(0.63) (0.62) (0.74) (0.75)
Adjusted R2 0.7044 0.7058 0.7115 0.7132

Notes:
***, **, and * indicate the t-test of regression coefficient is statistically significant at 1 percent, 5
percent, and 10 percent, respectively.
Variable definitions: Price, closing stock price of the day following 10-Q or 10-K file date; EPS,
quarterly earnings per share before extraordinary items; NBVE, book value of equity minus net
assets measured at fair value, divided by number of shares outstanding; FVA, total fair value
assets per share; FVA1, Level 1 fair value assets per share; FVA2, Level 2 fair value assets per
share; FVA3, Level 3 fair value assets per share; FVL, total fair value liabilities per share; FVL1,
Level 1 fair value liabilities per share; FVL2, Level 2 fair value liabilities per share; FVL3, Level
3 fair value liabilities per share; Size, the GICS industry-quarter deciles of period beginning total
assets; ROA, the GICS industry-quarter deciles of return on assets; Growth, the GICS industry-
quarter deciles of the percentage changes of the total assets from one year ago; S&P Rating, the
Standard & Poor’s domestic long-term issue credit rating, recoded from 1 (B) to 16 (AAA);
Not Rated, a dummy variable with value of 1 if not rated by S&P, 0 if rated; CAPR1, Tier 1
capital ratio; Big4, a dummy variable with value of 1 if the auditor is one of the Big 4 audit
firms, 0 otherwise; NYSE, a dummy variable with value of 1 if the company is listed on New
York Stock Exchange, 0 otherwise; AMEX, a dummy variable with value of 1 if the company is
listed on American Stock Exchange, 0 otherwise; D, market volatility dummy variable with
value of 1 if the standard deviation of the DJIA of a particular quarter is above the median, 0
otherwise.

of Table 5 shows the results of (3). The negative and statistically significant regres-
sion coefficients for the interactive term, FVA9D, 0.103, supports the prediction
of Hypothesis 1 that investors price each dollar of fair value assets at $0.10 dis-
count when the market volatility is high.
Results of the “base” model when fair value assets and fair value liabilities of
each level in the fair value hierarchy are separated are in Column III of Table 5.

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 MARKET VOLATILITY AND FAIR VALUE 109

The regression coefficients for fair value assets of all three levels are positive and
significant; regression coefficients for fair value liabilities of all three levels are neg-
ative and significant. These coefficients are comparable to those of Song et al.
(2010) for all fair value measures except FVL1. The coefficient for Level 1 fair
value liabilities is 4.372, more than four times 1, the expected value of the
regression coefficient of liabilities. Song et al. (2010) combined Level 1 and Level 2
fair value liabilities in their model, citing low frequency of fair value liabilities
reporting as the reason. Consequently, it is unclear whether my results would have
been comparable or not. When I combine the Levels 1 and 2 fair value liabilities
for the “base regression” the resulting coefficient is 0.776, which is comparable to
that of Song et al. (2010).
The regression results of (4) are presented in Column IV of Table 5. The
regression coefficient for interactive terms FVA19D is 0.086, negative and statis-
tically significant at 1 percent level of confidence. The regression coefficient for
interactive term FVA29D is 0.135, also negative but statistically significant at 5
percent level of confidence. The regression coefficient for interactive terms
FVA39D is 0.147, negative but not statistically significant. These results are con-
sistent with the predictions of Hypotheses 2 and 3 that investors discount Level 1
and Level 2 fair value assets significantly when the markets are relatively more vol-
atile; investor pricing of Level 3 fair value assets is not affected by market volatil-
ity.
Overall, the regression results support the hypotheses of this paper. Market
volatility affects the value relevance of fair values, particularly the fair values
that are either direct market quotes or estimated based on observable market
inputs.

Tests for Robustness

The high correlation between NBVE and FVA2 and variables of which FVA2 is a
main component gives rise to concerns about multicollinearity. A multicollinearity
diagnostic test indeed shows that the variance inflation factors (VIF) of NBVE and
FVA2, the related variables, are greater than the conventional tolerance level of
10, thus indicating that the estimated coefficients could be unstable. However, the
VIFs for key hypothesis variables, for example, NFVA9D, NFVA29D, FVA9D,
and FVA29D do not exceed the conventional tolerance level. In addition, when
NBVE is removed, the regression coefficients for key hypothesis variables remain
qualitatively unchanged. Thus, I conclude that the hypothesis testing results are
stable despite the presence of multicollinearity.
A prior study (Goh et al., 2009) finds that the value relevance of Level 3 fair
value declines significantly when markets are less liquid and information uncer-
tainty increases. In this paper, the value relevance of Level 1 and Level 2 assets
declines significantly when markets are more volatile. To ensure that market vola-
tility and market liquidity capture different factors affecting value relevance of fair

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110 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

value, regressions (2) and (4) are expanded to include the interaction terms of mea-
sure or market liquidity and fair value to form regressions (5) and (6) below:

Price ¼ a0 þ a1 EPS þ a2 NBVE þ a3 NBVED þ b1 NFVA1 þ b2 NFVA2

þ b3 NFVA3 þ d1 NFVA1D þ d2 NFVA2D þ d3 NFVA3D
þ h1 NFVA1L þ h2 NFVA2L þ h3 NFVA3L
X
þ fi Controls þ e; ð5Þ

Price ¼ a0 þ a1 EPS þ a2 NBVE þ a3 NBVED þ b1 FVA1 þ b2 FVA2 þ b3 FVA3

þ c1 FVL1 þ c2 FVL2 þ c3 FVL3 þ d1 FVA1D þ d2 FVA2D
þ d3 FVA3D þ h1 FVA1L þ h2 FVA2L þ h3 FVA3L
X
þ fi Controls þ e: ð6Þ

L in (5) and (6) is a dummy variable with value of 1 if the DJIA remained
below 10,000 throughout a quarter, 0 otherwise. This construct of market liquidity
is consistent with that of Goh et al. (2009). The results are presented in Table 6.
The introduction of the control for market liquidity did not change the key find-
ings, that is, the relevance of Levels 1 and 2 fair values are still negatively affected
by market volatility. Furthermore, consistent with Goh et al. (2009), the coeffi-
cients of the interaction of market-liquidity dummy variable (L) and fair value
assets indicate only the value relevance of Level 3 fair value assets is negatively
affected by market liquidity. The results of these additional regressions indicate
that market volatility captures the factors affecting value relevance of fair value
that are not captured by market liquidity.
The standard deviation of market price is a well-established proxy of market
volatility (e.g. Goldstein and Taleb, 2007). The market volatility dummy variable
of this study is based on the standard deviation of DJIA, a leading market index.
As a test of robustness, regressions are also conducted using an alternative mea-
sure of market volatility based on a quarterly high-low range of DJIA. Market
volatility of a particular quarter is considered high if the high-low range of DJIA
is above the median of all quarters, low if below the median. Regressions with the
alternative market volatility measure yield qualitatively identical results, indicating
that the results are not dependent on the specific measure of market volatility.
Construction of the market volatility dummy variable of this paper takes con-
sideration of market movements up to the average SEC filing date. Using market
movements of fiscal quarters weakens the results’ consistency. However, incorpo-
rating the most recent market movement information in the assessment of market
volatility makes more sense than cutting off all information after a fiscal quarter
ends but prior to the release of quarterly financial information. Therefore, I do not
consider a lack of consistency in the results from using fiscal quarter market vola-
tility proxy an indication of a lack of robustness of the findings of this paper.

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 MARKET VOLATILITY AND FAIR VALUE 111

TABLE 6
Regression of share price on net book value of equity, fair value assets, and the controls
with the effects of market liquidity controlled for (n = 5,956)

(I) (II)

Intercept a0 27.763 Intercept a0 29.576

(6.37***) (6.61***)
EPS a1 2.184 EPS a1 2.099
(4.57***) (4.58***)
NBVE a2 0.827 NBVE a2 0.820
(11.41***) (11.40***)
NBVE9D a3 0.211 NBVE9D a3 0.166
(3.10***) (2.70***)
NFVA1 b1 0.886 FVA1 b1 0.883
(23.95***) (24.33***)
NFVA2 b2 0.843 FVA2 b2 0.835
(13.05***) (12.89***)
NFVA3 b3 0.615 FVA3 b3 0.689
(2.67***) (3.36***)
FVL1 c1 4.561
(3.45***)
FVL2 c2 0.699
(4.77***)
FVL3 c3 1.642
(1.80*)
NFVA19D d1 0.120 FVA19D d1 0.092
(3.59***) (2.99***)
NFVA29D d2 0.186 FVA29D d2 .144
(2.98***) (2.59**)
NFVA39D h3 0.182 FVA39D d3 0.226
(1.39) (1.79*)
NFVA19L h1 0.002 FVA19L h1 0.002
(0.17) (0.21)
NFVA29L h2 0.025 FVA29L h2 0.23
(1.44) (1.31)
NFVA39L h3 0.553 FVA39L h3 0.626
(2.86***) (3.45***)
Size f1 4.021 Size f1 4.014
(8.88***) (9.02***)
ROA f2 2.946 ROA f2 2.911
(9.45***) (9.70***)

(The table is continued on the next page.)

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TABLE 6 (continued)

(I) (II)

Growth f3 0.005 Growth f3 0.005

(0.97) (0.89)
CAPR1 f4 0.208 CAPR1 f4 0.193
(1.84*) (1.71*)
S&P Rating f5 2.054 S&P Rating f5 2.285
(4.05***) (4.48***)
Not Rated f6 18.288 Not Rated f6 20.041
(4.89***) (3.62***)
Big4 f7 0.026 Big4 f7 0.042
(0.02) (0.04)
NYSE f8 0.031 NYSE f8 0.498
(-0.02) (0.26)
AMEX f9 3.369 AMEX f9 3.353
(0.80) (0.80)
Adjusted R2 0.7121 0.7149

Notes:
***, **, and * indicate the t-test of regression coefficient is statistically significant at 1 percent, 5
percent, and 10 percent, respectively.
Variable definitions: Price, closing stock price of the day following 10-Q or 10-K file date; EPS,
quarterly earnings per share before extraordinary items; NBVE, book value of equity minus net
assets measured at fair value, divided by number of shares outstanding; NFVA1, Level 1 fair
value assets per share minus Level 1 fair value liabilities; NFVA2, Level 2 fair value assets per
share minus Level 2 fair value liabilities; NFVA3, Level 3 fair value assets per share minus Level
3 fair value liabilities; FVA1, Level 1 fair value assets per share; FVA2, Level 2 fair value assets
per share; FVA3, Level 3 fair value assets per share; FVL1, Level 1 fair value liabilities per
share; FVL2, Level 2 fair value liabilities per share; FVL3, Level 3 fair value liabilities per share;
Size, the GICS industry-quarter deciles of period beginning total assets; ROA, the GICS
industry-quarter deciles of return on assets; Growth, the GICS industry-quarter deciles of the
percentage changes of the total assets from one year ago; S&P Rating, the Standard & Poor’s
domestic long-term issue credit rating, recoded from 1 (B) to 16 (AAA); Not Rated, a dummy
variable with value of 1 if not rated by S&P, 0 if rated; CAPR1, Tier 1 capital ratio; Big4, a
dummy variable with value of 1 if the auditor is one of the Big 4 audit firms, 0 otherwise;
NYSE, a dummy variable with value of 1 if the company is listed on New York Stock
Exchange, 0 otherwise; AMEX, a dummy variable with value of 1 if the company is listed on
American Stock Exchange, 0 otherwise; D, market volatility dummy variable with value of 1 if
the standard deviation of the DJIA of a particular quarter is above the median, 0 otherwise; L,
market illiquidity dummy variable with value of 1 if the DJIA is below 10,000 throughout the
quarter, 0 otherwise.

Criteria used to eliminate outliers in this study are: (i) less than 1 percent, and
(ii) more than 99 percent of total assets, total liabilities, shareholders equity, and
earnings per share before extraordinary items of the pooled sample. The outlier
elimination criteria result in a 3.3 percent sample reduction. Compared to the

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 MARKET VOLATILITY AND FAIR VALUE 113

outlier elimination criteria of other studies, those used in this paper are less restric-
tive. Song et al. (2010), for instance, eliminates observations that have studentized
residuals greater than two, which resulted in a 4.4 percent sample reduction. Kolev
(2008) uses less than 1 percent and more than 99 percent of the same variables as
this paper but on a quarterly basis. Using alternative outline elimination criteria,
however, does not change the results of this paper qualitatively.
The pooled sample of this study includes fourth quarter as well as interim
quarter data. Since the fourth quarter is also fiscal year-end, market dynamics and
investor reactions may be different surrounding fiscal year-end from that surround-
ing interim quarters ends. Regressions using a subsample of interim quarters only,
however, yield qualitatively similar results.
In summary, the effects of market volatility on value relevance of fair value are
not affected by multicollinearility in the data, are uniquely different from the
effects of market liquidity, and are not specific to choice of market volatility mea-
sure, outlier elimination criteria, and whether only interim quarter data are used or
all quarter data are included.

CONCLUSIONS
This study examines empirically the effect of market volatility on the value rele-
vance of fair values. By isolating confounding factors and controlling for other
known determinants of the value relevance of fair values, this study establishes
that market volatility affects how investors price fair values, especially fair values
based on market inputs. Specifically, investors discount market-based Level 1 and
Level 2 fair values significantly when market volatility is high. Investor pricing of
non-market-based Level 3 fair values is not affected by market volatility. Findings
of this study challenge the implicit acceptance of unadulterated relevance and reli-
ability of market quotes as fair values, and also underscore the importance of fur-
ther studies that help to clearly delineate the conditions under which fair values
represent more useful information.

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