The impact of audit quality on the pricing of fair value estimates in the banking industry
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In recent years, the Public Company Accounting Oversight Board’s (PCAOB) inspections have frequently reported audit deficiencies related to fair value measurements. Motivated by PCAOB’s concern, this paper examines investors’ perceptions on audit quality of fair value measurements. Using a sample of U.S. public banks from 2008 through 2013, I document a significant positive (negative) association between stock prices (bid-ask spreads) and audit quality of fair value measurements. This finding indicates that audit quality adds incremental value to investors as it mitigates reliability concerns relating to fair value estimates. Furthermore, using the fair value hierarchy mandated by Statement of Financial Accounting Standards (FAS) 157, I find the audit quality effect is stronger for Level 3 fair value estimates; suggesting high audit quality mitigates the reliability concerns relating to the substantial estimation uncertainties and management bias inherent in the more opaque Level 3 financial assets. Additional cross-sectional evidence shows that the effect of audit quality on the pricing of fair value estimates is greater for smaller banks and banks with a declining regulatory capital.