Covenant violation concern and investors’ pricing of Level 3 fair value adjustments

We examine the influence of concerns relating to violation of the borrowing covenant on the investors’ valuation of Level 3 fair value adjustments. We reason that managerial bias in Level 3 fair value estimation is greater for firms approaching violation of the borrowing covenant. Based on a sample of Australian real estate firms, we find that managers report upward adjustments to Level 3 investment property values when they approach the threshold where the borrowing covenant is violated; and further find that this deliberate use of discretion is significant for firms closer to the interest coverage thresholds, but not for those approaching the gearing thresholds. We then find that, while fair value adjustments are priced positively, investors apply incremental discounts for firms closer to the violation threshold, or firms which are in technical default of borrowing covenants relative to those that are far from violation. Additionally, we show that the pricing discount on fair value adjustments attributable to the concern over covenant violation is significant only for the weaker governance sub-sample, indicating that effective monitoring mitigates faithful representation concerns about Level 3 fair value estimations.