Does Fair Value Accounting Reduce Prices and Create Illiquidity?

Abstract

Concerns about the use of fair value accounting commonly focus on the sensitivity of market prices to exogenous liquidity shocks. In this paper, we show that the use of fair value accounting for assets without an active market endogenously creates illiq- uidity. The underlying mechanism is the discretion in fair value reports when prices are unavailable. Firms use this discretion to report aggressively, leading to two market e ects. On the plus side, by revealing an upper bound on an asset's value, fair value reporting leads to lower prices than would occur in a conservative regime. This is an indication that prices are more e cient than under conservatism, as the reports protect investors from paying information rents. The downside is that fair value reports cannot credibly convey a lower bound on an asset's value, causing illiquidity. We con rm these e ects in a laboratory experiment.