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Review of Quantitative Finance and Accounting

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01-01-2016 | Original Research

Corporate governance, SFAS 157 and cost of equity capital: evidence from US financial institutions

Authors: Hua-Wei Huang, Mai Dao, James M. Fornaro

Published in: Review of Quantitative Finance and Accounting | Issue 1/2016

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Abstract

This study examines the association between fair value measurements and the cost of equity capital under different fair value valuation methods, and assesses the impact of corporate governance on this relationship for US financial firms. We find that firms’ cost of equity capital is negatively associated with more verifiable fair value assets and positively related to less verifiable fair value assets. Furthermore, the positive association between less verifiable fair value assets and the cost of equity capital is mitigated under better corporate governance. The differential impact between more and less verifiable assets becomes smaller for firms with stronger governance. Our findings contribute to the ongoing debate on fair value regulation by investigating the economic consequences of adopting Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) and the importance of audit committee financial expertise on fair value reporting. We also provide evidence on the importance of board independence, internal control strength, auditor industry specialists, and audit committee financial experts in fair value reporting.

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Some argue that fair values based on short-term market fluctuations served to exacerbate the recent financial crisis. In order to avoid further decreases in share price, investors are more likely to dispose of their financial investments earlier than planned, which in turn increases downward pressure in a distressed market. In contrast, some suggest that fair values permit a timely assessment of current market conditions and can alert market participants to potential risks associated with firms’ financial assets and liabilities (Goh et al. 2009).

SFAS 157, Fair Value Measurements, was effective for fiscal years beginning after November 15, 2007 and provides a three-level valuation hierarchy: (1) level 1 (highest priority)—inputs of observable quoted prices in active markets for identical assets or liabilities; (2) level 2—inputs of observable quoted prices, generally for similar assets or liabilities in active markets; (3) level 3 (lowest priority)—inputs that are unobservable for the assets or liabilities.

Non-diversifiable risk refers to the type of risk that cannot be eliminated through diversifying investment portfolios (Easley and O’Hara 2004).

Average precision of investors’ information refers to the “average quality of information that investors have on the expected cash flows of the firm” (Gray et al. 2009).

Differences between the current study and Riedl and Serafeim (2011) are discussed later in this section.

The regression parameter estimates and standard errors in all of our regression models are robust because potential clustering along the two dimensions, firm and year, has been controlled by SAS cluster identifiers (Gow et al. 2010; Petersen 2009).

Altman’s (1968) Z-Score bankruptcy model is constructed as follows: Z = 0.012 * (Working Capital/Total Assets) + 0.014 * (Retained Earnings/Total Assets) + 0.033 * (Earnings before Interest and Taxes/Total Assets) + 0.006 * (Market Value of Equity/Total Liabilities) + 0.009 * (Sales/Total Assets).

Our measures of fair values are similar to those in Song et al. (2010).

Both level 1 and level 2 fair values have observable market prices. See footnote 2.

As in Song et al. (2010), we employ principal component factor analysis (PCA) to capture the common characteristic of the four major corporate governance variables. The governance score is calculated by the estimated factor loading coefficients (developed by PCA-the varimax orthogonal rotation) times the values of these corporate governance variables. The use of an integrated governance score also avoids potential multicollinearity problems among the four corporate governance variables in the regression model. Also, we view the Gscore as a broader measure that captures the aggregate influence of both internal and external governance mechanisms on fair value reporting. The inclusion of auditor industry specialization in deriving Gscore is consistent with the research synthesis on corporate governance by Cohen et al. (2004) where they indicate that the external auditor is considered to be a corporate governance mechanism.

We do not include the frequency of audit committee meetings because the data is unavailable.

Except for fair value measurements, other variables are winsorized at 1 and 99 % to reduce the potential influence of outliers.

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Title: Corporate governance, SFAS 157 and cost of equity capital: evidence from US financial institutions
Authors: Hua-Wei Huang
Mai Dao
James M. Fornaro
Publication date: 01-01-2016
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 1/2016
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-014-0465-1

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