This paper shows that, in large US companies, founder-CEO and founder-family controlled firms experience about 10% more underpricing relative to non-founder firms during the IPO process. This result holds after controlling for the ownership of founders, and is consistent with the value-destroying behavior of founders. That is, founder-CEOs often consider their firms as their "life's achievement," and thus try to push their IPOs through by bargaining less aggressively with investment banks. Moreover, this paper shows that the partial adjustment phenomenon is weaker for firms that are controlled by founder-CEOs at the time of IPOs, supporting Loughran and Ritter's (2002) prospect theory (behavioral) explanation on this effect. Finally, large US companies controlled by founders' descendants during the IPO process on average experience less underpricing, in contrast to founder-CEO firms. This opposite result on descendant-CEOs is also consistent with the theory that founder-CEOs try to push their IPOs through because they consider their firms as life's achievement.
We first develop the theoretical rationale of the forward exchange rate unbiasedness hypothesis (FUH) for buyers of forward exchange under an assumption of risk neutrality and interest rate parity. Then by using Jensen's Inequality, we show that FUH cannot simultaneously hold true for both the sellers and buyers of the same forward currency contracts. Because of the symmetric nature of relationships among foreign exchange currency pairs, we conjecture that forward rate biases should be small. We introduce a new test statistic that averts unit root problems. This test statistic helps verify our conjectures in the empirical data. We analyze the liquidity effect of the informational content of forward exchange rates using our test statistic. We show that whether unbiasedness holds or not is driven by market conditions of crisis or non-crisis. Introduction Forward exchange rate contracts are used, among other things, to eliminate future spot exchange rate risk. (1) Currency markets are unique in the sense that there are several symmetry features among currency pairs and even among currency triplets. For example, let [S.sub.1] be the number of units of EUR per dollar; if [S.sub.2] is a model for the number of pounds per EUR, then ([S.sub.1])([S.sub.2]) is a model for pounds per dollar. Similarly, [([S.sub.1]).sup.-1] is a model for dollars per EUR, and [([S.sub.2]).sup.-1] is a model for EUR per pound. (2) Forward rates are expected to neutralize future exchange rate risk for both parties (sellers and buyers of the same currency) and, to be fair, unbiased estimators of corresponding future spot rates. (3) However, existing empirical research fails to support FUH, and such a phenomenon is referred to as the forward rate bias puzzle. There have been many attempts to unravel this puzzle, yet to our knowledge, none appears completely satisfactory. Alongside the eguity premium puzzle, the forward rate bias puzzle remains one of the unsolved mysteries of financial economics. The nature of the puzzle is succinctly spelled out by many authors. Not only is the forward rate estimator inefficient, but it predicts the future spot rate in the opposite direction. Of course because the forward rate seems to be systematically biased, it permits the existence of the carry trade. Contrary to interest rate parity theory, future spot exchange rates do not usually depreciate for high interest rate currencies and low interest rate currencies do not appreciate by as much as is expected. (4) However, the empirical evidence varies across countries, by economy type (advanced, developing and emergent economies) and by business cycle conditions. See Bansal and Dahlquist (2000) for a further discussion of these issues. Fama (1984) (5) first popularized this problem even though it had been noted by many authors like Bilson (1981), Hodrick (1987), Hansen and Hodrick(1980), Frenkel (1980), Cornell (1977) and others. (6) Fama (1984), in a study of nine industrialized countries, attributed the existence of the puzzle to the fact that the volatility of the risk premium is greater than the volatility of the realized spot rates. Bilson (1981) analyzed the speculative efficiency hypothesis wherein the null was that there were no profits to be made from pure speculation. The analyzed data led to non-acceptance of the null. Hansen and Hodrick (1980) had also rejected the simple null hypothesis of zero returns to speculation using different modeling technigues. Bansal (1997) deepened the puzzle by postulating that the puzzle was interest rate dependent. It existed only in certain environments where U.S. interest rates exceeded foreign interest rates. He also showed that dependent of the interest rate regime, the volatility of the forward premium could be greater or less than the realized future spot variation in exchange rates. Nevertheless, carry traders have continued to profit in currency markets. Goodhart, McMahon and Ngama (1992) attributed the failure of the unbiasedness hypothesis in their study to the existence of outlier data and structural breaks. …
This paper extends prior corporate stock buy back studies by evaluating the effect of stock buybacks on and non-growth industries. Regression results indicate that firms categorized in above average industries contain a higher degree of information content over firms categorized in below average industries, and there appears to be a stronger earnings response among non-buyback firms in the above average industries. When assessing the effects of percent change in stock price correlated with long term investment, results indicate that investors perceive earnings associated with non-buyback firms to be informative and good indicators of stock prices and have a strong correlation with long term investment. However, findings indicate that investors perceive earnings associated with buyback firms to be noisy and unclear indicators of stock prices or possessing a strong correlation with long term investment. Introduction Stock buybacks are typically as straightforward as they sound, with the company buying its own shares on the open market with the help of an institution that specializes in such purchases. Alternatively, a company can tender an offer to existing shareholders to buy some of their shares back. There are several reasons why a company would engage in a stock repurchase program. The most common are: 1) Tax efficiency--In theory, rational investors prefer lower taxes. With that in mind, a company may decide to repurchase its own stock (effect a buyback) rather than pay out cash dividends to shareholders. Dividends are taxed as ordinary income, causing an immediate tax liability. Stock buybacks are not taxable because the shareholder does not receive a distribution (Dittmar 2000). What makes them superior to dividends is the fact that if there are capital gains on the repurchase, the rate at which those gains are taxed is lower than the rate on which dividends are taxed. 2) Management flexibility--Once a firm commits to paying a dividend, it tends to continue doing so since ceasing to pay a dividend sends a negative signal to shareholders (Miller and Modigliani 1961). With buybacks, a firm can announce one and never fulfill or take longer to do so than originally planned without the same negative reaction as cutting or eliminating a dividend. 3) Undervalued stock--What better way to communicate to the market that management thinks their stock is undervalued than by using shareholder money to buy back the stock? This approach has the potential of raising the mid- to long-term price of the stock (Boudry, Kallberg and Lin 2009). 4) Investment--If the company lacks positive net present value investment opportunities, rather than reinvesting the retained earnings into existing businesses, management may be inclined to buy back stock instead (Bayar, Chemmanur and Liu 2015). 5) The earnings game--Companies want to reflect earnings per share (EPS) from one year to the next, but what if they did not actually increase their earnings? Buying back stock reduces the number of shares outstanding, thus making each investor's stake worth a little bit more. If a company can't grow their EPS, they can reduce the denominator (shares outstanding) and get the same effect, which is earnings growth (Ferreira and Rezende 2007). All in all, stock repurchase programs can be considered part of a company's broad policy on distributing retained earnings to shareholders. In general, the market usually favors buybacks as a positive signal sending stock prices higher. That said, there are many reasons for companies to repurchase stock. As long as the motivation to repurchase stock is in line with shareholders' best interests, investors tend to favor them. Over the past three decades U.S. businesses, with the authorization of their boards of directors and encouragement from the Securities and Exchange Commission (SEC), have allocated trillions of dollars to buying back their companies' own stock (Kranish 2015). …
Introduction Commodities very often are added to a diversified market portfolio to protect investors and firms from tail risk events. Recently, this trend is amplified by institutions that hold large positions in commodity futures for hedging purposes and by banks that have to comply with the new liquidity and risk management requirements. This development is known as the financialization of commodity markets. Historically, it has been shown that commodities, like gold, serve as a safe haven in times of market turmoil. (1) When the stock market plummets, gold prices increase, making a diversified investor immune to recession. The hedging feature of gold is reflected in the reduction of a portfolio's Value at Risk (VaR), as well as in a low correlation of gold with the stock market index. Prior research has looked at the ability of gold to act as a safe haven or a hedge in times of extreme market volatility. However, the literature in this area focuses on precious metals and not as much on their Exchange-Traded Funds (ETFs) or on gold mining companies. I extend the analysis to include both ETFs and the stocks of gold mining companies. Investors and hedgers alike will find the results of this paper to be of interest. In particular, I show that gold ETFs and gold mining stocks can serve as safe havens during market turmoil. (2) This paper finds that for the period of 2004 to 2012 gold acted both as a safe haven and a diversifier. These two novel findings suggest that gold ETFs and gold mining stocks serve as a safe haven in market turmoil. Gold mining stocks are strongly correlated with the market factor during the normal market conditions, but they do show diversification benefits in the turbulent investment climate. This noteworthy finding is consistent with the notion that gold mining companies stocks act as a call option on the price of gold. The moneyness of this call option changes in periods of market stress, making gold mining stocks act more like gold and less like a typical equity. This paper takes a look at prior research that has been done in relation to gold as a portfolio diversifier and adds a new dimension to the topic. My research contributes to the prior literature in three distinct ways. First, the paper estimates gold price as a function of the Fama-French (1993) benchmark factors and not just a stock index or a bond index, as others have done. Second, this research considers Exchange-Traded Funds that are linked to gold price as an alternative to gold holdings. The results suggest that gold ETFs are independent of the market index, have low betas and can serve as a diversification tool. Third, the paper checks whether the gold mining stocks have the same underlying factors as gold itself. The last hypothesis holds in the events of high market volatility and low equity returns. The results are robust to different model specifications. The current paper touches upon several aspects of the literatures discussed. Section 2 conducts a review of the relevant literature. Section 3 examines the sample and methodology employed in the paper. Section 4 discusses the empirical findings for gold, ETFs and the Gold Mining Index in a normal investment climate. Section 5 analyzes the safe haven quality of gold bullions, ETFs and mining stocks during the periods of high market volatility and low market returns. Section 6 concludes. Literature Review The critical step in evaluating any financial risk management strategy is to correctly measure the underlying risk exposure after the hedge. This research is closely related to prior literature on commodity hedging and portfolio diversification. In particular, gold can be used as a risk management vehicle and as an instrument for capital preservation. First of all, gold increases portfolio diversification through its low correlation, on average 0.1, to other assets (World Gold Council [WGC] 2013). In addition, gold reduces portfolio losses during tail-risk events. …
This study found that changes in current deferred revenues ([DELTA]DRC) are positively associated with sales growth, gross profit margin, profit margin and return on assets of the next two years. The evidence suggests that deferred revenue changes can serve as a valid leading indicator for a firm's future financial performance. It also identified a positive relationship between a firm's [DELTA]DRC and its market valuation, indicating that market participants (at least partially) incorporate the future performance implications of deferred revenue changes into their valuation decisions. While prior research suggested mismatch of revenues and expenses (Prakash and Sinha 2013) as the potential explanation for the abnormal stock returns in reporting firms, the empirical evidence in this study supports an alternative explanation: investors' underreaction to the information content of deferred revenue changes. Introduction Deferred revenues (also called unearned revenues) are normally recorded when a company collects cash from customers before it delivers products and/or services. In recent years, the frequency and amount of deferred revenues reported on company balance sheets have increased significantly (Prakash and Sinha 2013). Despite its growing importance, academic studies on deferred revenue remain few. In a recent study, Prakash and Sinha (2013) found that changes in current deferred revenue ([DELTA]DRC) are negatively associated with the current period's profit margin and positively associated with the future period's profit margin. They attribute this to the mismatching of revenues and expenses that result from a firm's deferred recognition of revenue without deferring the recognition of associated expenses. Due to the mismatching, a large increase in deferred revenues would depress the firm's profit margin in the current period and inflate the firm's profit margin in a future period when the revenues deferred are subsequently recognized. They suggest that income distortion due to this mismatching is a significant contributor to financial analysts' earnings forecast errors of and market mispricing of [DELTA]DRC. They also contend deferred revenue changes can be a useful fundamental signal for predicting a firm's future financial prospects and provide an alternative interpretation for the positive association between a firm's [DELTA]DRC and its future profitability. In addition, the study proposed market underreaction to the information content of [DELTA]DRC as an alternative explanation for the market mispricing of [DELTA]DRC. Prior studies on fundamental signals have documented the incremental predictive ability of changes in balance sheet items, such as accounts receivable and inventory, for future financial performance (Holthausen and Larcker 1992; Lev and Thiagarajan 1993; Abarbanell and Bushee 1997, 1998). To the authors' knowledge, the predictive power of deferred revenue changes has not received much attention in the academic literature. Anecdotal evidence has shown that financial analysts tend to use the change in deferred revenues as a key fundamental signal to predict a firm's growth prospects. For instance, Dennis Byron, a veteran analyst and the principal of IT Investment Research (see Put Up an Umbrella, Red in the June 2009 issue of IT Investment Research newlsetter), and Matthew Aslett, a senior analyst of 451 Research Group (see Keeping an Eye on Red Hat's Deferred Revenue in the 451 CAOS Theory blog datedJune 2009), focused on the minimal growth in deferred revenues of Red Hat Inc. to evaluate the company's financial prospects. Consistent with the analysts' views, the study offered two reasons for the ability of [DELTA]DRC to fundamentally predict future financial performance. First, changes in deferred revenues can indicate changes in a firm's ability to secure new sales contracts in its product/service markets. Second, changes in deferred revenues can signal changes in a firm's bargaining power over customers. …
Introduction Why would anyone consider investing in shares of operationally and/or financially unhealthy firms? Do those investors who invest in the risky shares of evidently distressed and/or bankrupt firms follow Anais Nin's motto Good things happen to those who hustle? (1) Or are these investors blissfully unaware of the brewing troubles and unavoidable destiny of the firms? What about sophisticated and informed investors such as institutions? How do their shareholdings change as the firms approach and then file for Chapter 11 protection, work through reorganization and emerge from bankruptcy proceedings? And do these holdings play a role in the effectiveness of bankrupt firms' restructuring and their speed of returning to profitability? Although it has been shown that, in general, bankrupt firms underperform operationally and in the stock market and investors holding shares of bankrupt firms incur significant capital losses, we may find that institutions are capable of identifying undervalued equity and timing purchases and sales of distressed securities. We investigate whether or not institutional ownership is related to performance of distressed firms as they attempt to reorganize. Another main theme of this paper is to examine whether or not institutional managers who acquire shares of bankrupt firms in the quarter prior to Chapter 11 filings, during bankrupt firms' reorganization or shortly after firms emerge from bankruptcy proceedings possess the ability to strategically trade shares of distressed or bankrupt firms to achieve positive returns. In summary, the purpose of this paper is twofold: to analyze the relationships between institutional holdings and performance of bankrupt firms and to evaluate whether or not institutional investors are capable of identifying undervalued investments that results in future positive returns. The relationship between institutional investment decisions and the operating and market performances of struggling firms before, during and after bankruptcy filings have not been systematically analyzed. We do not know if the operating and stock market performances of failing firms with institutional shareholders differ from that of failing firms without investments from institutions. We do know that higher institutional ownership has a positive effect on stock prices and returns (Brown and Brooke 1993 and Gompers and Metrick 2001). Does this finding apply to special situations, such as institutional investments in bankrupt firms? The existing empirical literature on institutional trading does not provide concrete evidence as to how profitable the investment strategies are that institutions employ in their overall trading. While some researchers argue that institutional investors are capable of picking winners and exhibit fully rational herding behavior that promotes price discovery and predicts stock returns (Nofsinger and Sias 1999 and Sias 2004), others conclude that institutional managers mechanically acquire stocks with certain desirable characteristics and price levels (Falkenstein 1996) and irrationally engage in herding, causing temporary price bubbles (Dreman and Lufkin 2000) and future price correction (Gutierrez and Kelley 2009). Irrespective of that, we can, to this point, find no empirical evidence relevant to profitability of institutional holdings/trading of companies as they approach bankruptcy, proceed through reorganization and emerge from Chapter 11. INVESTING IN SECURITIES OF DISTRESSED FIRMS It is well established that the security returns associated with the immediate period around bankruptcy filings are almost always quite negative and investors in filing firms almost invariably suffer losses. Firms usually start experiencing financial difficulties long before petitioning for reorganization or liquidation in the Federal court by filing Chapter 11 or Chapter 7, respectively, (Altman 1968; Aharony, Jones and Swary 1980; Clark and Weinstein 1983 and Campbell et al. …
We investigate the short-term market response associated with the announcement of large domestic mergers and acquisitions (M&As) involving public U.S. firms with public targets from 1989 to 2003. We partition the results by industry type, identify the underlying motives for acquiring firms engaging in M&As, and examine potential determinants of abnormal performance. Overall, abnormal returns are significantly negative for acquirers but significantly positive for targets. The wealth effects to acquirers range from significantly positive to significantly negative depending on the industry. Targets earn positive short-run abnormal returns across industries. We find that synergy is the main motive for M&As, but some support exists for hubris. Determinants of acquirers ' returns include the level of financial slack, P/E, relative industry P/E, and being in a heavily regulated industry. For targets, variables influencing their abnormal returns include relative size and whether they are in an industry related to the acquirer.
What are the potential benefits from investing in bonds issued by a province when holding an efficient portfolio of bonds issued by the remaining nine ones? How beneficial is the exposure to additional provincial bond markets from the perspective of investors whose core interests reside in maximizing the return to risk bearing? This paper addresses these and similar questions by evaluating the gains from portfolio diversification in the market for bonds issued by the Canadian provinces.
In Vietnam, we find strong evidence that foreign investors hold higher percentage stakes in firms located in the south of Vietnam, firms listed on the Hochiminh stock exchange, firms with low past returns and firms that are listed longer on the exchanges. The coefficients on firm size and firm age since IPO are consistently positive and robust. Although average firm size is higher for state owned enterprises (SOEs) and foreign investors strongly prefer investing in large firms, they show strong preference for investing in non-SOEs. Risk factors such as government ownership stakes, systematic risk and price volatility negatively influence foreign ownership %. Their effects are less pronounced on the stocks that trade on the more developed stock exchange market, Hochiminh.
Introduction Capital adequacy is desired by regulators and opposed by bankers. Since sufficient capital has the desirable characteristics of preventing excessive asset growth and technical insolvency, why would the banking industry lobby against most recent Basil III, which mandates even more capital than required under Basel I and Basel II? It has to do with competing for placement in institutional equities portfolios. Large banks have need for regular infusions of equity capital not only to meet regulatory minimums and to raise funds for growth but also as a means of keeping a prominent name in securities markets in order to maintain public trust and even make easier the quest for new business. The problem is that banks return little on their assets (perhaps 1%) as compared with non-banking industrial firms. So banks can compete only by using leverage. Bond markets tolerate such extreme financial leverage because of the high quality of bank assets, being mostly in loans receivable and high grade liquid securities. While debt markets tolerate far less leverage for capital-intensive industrial companies because of lower quality assets, manufacturers, which sell products rather than money, earn more return on assets and do not need to be levered. Among the metrics that matter to the stock market is the return on equity (ROE). So, lower return on investments (ROI) at banks is offset by higher debt leverage, resulting in ROE that competes with manufacturers. Since ROE directly affects equity price, bank stocks can now compete with industrial companies for portfolio space. (1) But the requirement for more common equity capital under Basel III reduces ROE. It is possible that ever-enhanced capital requirements (mandated by this and later Basel Agreements (2)) could at some point actually make bank ROE and stock price non-competitive with the rest of those in the market when trying to raise equity capital. A History of Bank Capital Bank capital has gone through dramatic reductions since the 1800s when banks--which then were financed almost entirely with deposits--were required to fund assets with 50% capital (Berger, Herring and Szego 1995). With the advent of the discount window at the Federal Reserve Bank (herein called the Fed) where banks could borrow in an emergency and with deposit insurance, the short term borrowing markets felt that the new collage constituting the new government safety net reduced the need for bank capital. With the safety net somewhat supplanting market discipline, capital dropped steadily to single digits where it is today. As Berger et al. point out, the safety net priced at subsidized premiums actually served to allow banks to have the highest allowable leverage of any industrial group. With the new risk-based capital requirements of Basel 1 in 1992, the amount of capital to assets rose since the denominator in the capital ratio became risky assets rather than total assets (Flannery and Rangan 2008). Also, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 requiring prompt correction action by regulators served to impose nontrivial penalties for deficient capital, giving an incentive for banks to voluntarily raise capital above regulatory minimums. As Stiroh (2004) found, the markets required more capital as banks were allowed to get into more aggressive lines of business. The FDICIA and the Omnibus Budget Reconciliation Act of 1993 gave depositors seniority over other short term liabilities, thereby removing the previous implied government coverage of all liabilities and causing the bank borrowing markets to require more capital. As Flannery and Rangan (2008) point out, by 1992 regulatory capital minimums for a time became largely irrelevant as the market itself demanded higher capital ratios. But, regulatory capital requirements remained in place. The Basel agreements allowed subordinated debt to constitute capital under Tier 2 requirements. …
There is a large and growing body of literature on the benefits of established lending relationships with banks, which is an intermediated debt market. We extend that literature by testing for benefits from direct lending relationships in the commercial paper market, which is a public debt market. Diamond (1991) suggests that firms access public debt markets when they have enough reputation to no longer require the close monitoring by banks. Using daily rate data for dealer-placed and directly placed commercial paper, we find that the year-end liquidity squeeze is less pronounced in the directly place commercial paper than in the dealer-placed commercial paper, consistent with the existence of benefits from direct lending relationships in this public debt market.
Introduction Right after the turn of the last century the world was shocked by several substantial cases of accounting fraud, as the Enron and Arthur Anderson debacles, proving, once again, the necessity and requirement for high quality audits. DeAngelo (1981) formulated a two-dimensional definition of audit quality as detecting misstatements and errors in financial statements and then reporting these material misstatements and errors. Due to the lack of direct measurement possibilities for these characteristics, prior literature came up with several surrogates, like audit fees and hours, reputation, litigation risk, auditor size and abnormal accruals. This research will focus on the latter three, formulated in two hypotheses. The first part examines the relation between the audit quality an auditor provides to its clients and the size of the auditor, where audit quality is measured by the client's abnormal accruals and auditor size by a three-tier classification. Prior studies suggest that the main drivers of audit quality are reputational loss and litigation cost. In particular, DeAngelo (1981) states that audit firm size is an important determinant of audit quality. Consistent with her work, Palmrose (1988) and Simunic and Stein (1987) argue that due to deeper pockets and extensive investment in their reputations, large audit firms have higher incentives to minimize litigation risk and protect their reputation by providing high quality audits. DeAngelo (1981) further claims that large auditors possess more financial resources for training and technology enhancement and are less dependent on an individual client. The second part focuses on the association between audit quality and the legal regime by which a firm is governed. According to La Porta, Lopez-De-Silanes, Shleiferand Vishny (1997), Europe accommodates three fundamentally different legal environments: English common law, German civil law and French civil law. Based on their levels of investor protection, and with that the litigation risk for auditors, the audit quality is assumed to differ between these countries (Francis and Wang 2008). Prior studies provide evidence of greater financial transparency in countries with high investor protection (Bhattacharya, Daouk and Welker 2003 and Bushman, Piotroski and Smith 2004). Ball, Robin and Wu (2000) document that in these highly protective countries earnings are less managed and more value relevant. Consistent with prior research, the results of this study suggest that larger audit firms show greater ability in restraining clients' abnormal accruals. According to Jones (1991), abnormal accruals are a valid measure for earnings quality and should therefore give a fair representation of the quality an auditor provides. Additional analysis on firms with positive abnormal accruals fails to find a significant difference between the audit qualities provided by first, second and third tier auditors. The analysis of audit quality in different legal environments reveals no significant difference between the assessed common and civil law countries. This contradicts the argument of La Porta et al. (1997) on diverging investor protectionism in European legal regimes. The additional test for the positive abnormal accruals subsample reveals similar results to those for the entire sample. This research contributes to extant academic literature in several ways. First, audit firm size has proved itself to be a valid measure for audit quality. However, nearly all previous studies on this topic focus on the Big N/non-Big N dichotomy. This study uses a three-tier classification, which gives better insight in the audit quality distribution over different sized auditors. Unlike Francis, Maydew and Sparks (1999) who proxy for a three-tier classification by the level of operations (Big 6/national/local), this research bases the distinction on net income from audit practices. According to DeAngelo's (1981) argument that the value of an audit firm is determined by the present value of its future quasi rents, we believe this classification is more consistent with the established theory on audit quality and should give a better representation of the auditors' incentives. …
Introduction The objective of paper is to examine discretionary effect of fair value under SFAS 157, entitled Fair Value Measurements, first, on earnings management and, second, on capital management behavior by banks during a financial crisis. In essence, do banks use discretionary fair value asset classification as another tool to manage earnings and capital? SFAS 157 was released in 2006 and is effective from fiscal year beginning after November 15, 2007. (1) The standard defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at measurement date (SFAS 157). In addition, standard establishes a three-level fair value hierarchy that ranks inputs used in measurement of fair value based on their reliability. SFAS 157 does not mandate new fair value measurements; rather, it provides a coherent framework for applying fair value and enhances disclosures about nature and source of fair value measurements (SFAS 157). According to SFAS 157, Level One inputs (hereafter L1) are quoted prices in active markets for assets and liabilities identical to those of firm. These inputs can be observed directly from liquid markets and used to measure fair value of assets and liabilities. Therefore Level One fair value may not be subject to management discretion or manipulation. However, active markets do not always exist for certain assets and liabilities, and even if they exist, they might be too thin to provide relevant and reliable information to measure fair value (Song et al. 2010). Level Two inputs (hereafter L2) are categorized into three subgroups: quoted market prices for similar assets and liabilities traded in active markets, quoted market prices for identical assets and liabilities in inactive markets and prices corroborated by market-based measures that are sufficient to allow fair values to be estimated. Level Three inputs (hereafter L3) require significant unobservable inputs, which are computed by using price models or discounted cash flow methodologies or other information reflecting management's assumptions and discretion (SFAS 157 and Song et al. 2010). (2) Dechow et al. (2010) indicate that measurement of fair values can be very complex because in absence of quoted market prices in active markets, fair value are based on subjective assumptions and may be subject to manipulation. FASB limits use of Level Three inputs to cases where inputs from Level One and Level Two are not available (SFAS 157 and Song et al. 2010). However, Level Two also requires discretion in identifying similar assets and liabilities, especially when market is inactive. Therefore, Level One is least subjective, while discretion or latitude to manipulate increases when we progress from Level One to Levels Two and Three fair value measurements. (3) In this study, we examine role of fair value classification (the L1, L2 and L3 categories) on use of LLP to manage earnings and capital. Prior research, in pre-SFAS 157 period, documents that loan loss provisions (LLP) are primarily used as a tool by banks to manage earnings (Beatty et al. 1995, Kanagaretnam et al. 2003 and Ryan 2008) and capital (Ahmed et al. 1999). Hence, in this study, we measure earnings management and capital management by using loan loss provisions (LLP). (4) We then examine effect of L1, L2 and L3 fair value measurements' classification on discretionary use of LLP to manage earnings and capital. We use a sample of public commercial banks' quarterly data covering period 2009-2013. We find that in large banks sample Level Three fair value measurement attenuates use of LLP to manage earnings, while Level Two accentuates use of LLP to manage earnings. We find that results of Level Three fair value measurement are driven by financial crisis period while, Level Two fair value measurement is driven in subsequent economic recession period. …
