Evaluation of fair value relevance and the sensitivity to valuation assumptions

Using a sample of real estate investment firms adopting IFRS, we evaluate the value relevance of Level 3 fair values and whether it is impacted by the actual underlying assumptions. This context is unique in that there is generally only one material asset type (investment properties) and they are measured at fair value with the returns (rental income) being reported in the financial statements. This allows investors to easily infer and compare the key valuation assumptions that are captured by the capitalization rate. In contrast to prior research findings on Level 3 fair values, we find that they are value relevant and are generally not considered to be unreliable, hence the values are not generally discounted by investors. However, the value relevance is significantly reduced when the valuation assumptions are identified as being optimistic. Analysis of changes in stock prices and stock return volatility subsequent to the release of financial reports is inconsistent with this result being attributable to mispricing. Rather, investors recognize valuation subjectivity and are not misled by firms’ optimistic estimation. The regulatory implication is that enhanced firm disclosures on assumptions would improve users’ ability to directly assess the reliability of fair values, particularly if the assumptions cannot be inferred from financial reports