Formerly Graduate School of Industrial Administration (GSIA)
William Larimer Mellon, Founder
Schenley Park
Pittsburgh, Pennsylvania 15213-3890
United States of America

Pierre Jinghong Liang
Associate Professor of Accounting

Economic Consequences of Expanding Accounting Recognition

Wei Li
University of Illinois at Urbana-Champaign

Pierre Jinghong Liang
Carnegie Mellon University

Xiaoyan Wen
University of Illinois at Chicago
 

October 2013
 
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2013-Oct Draft
 
Abstract
By its recognition rules, traditional accounting system excludes measuring economic events that are hard-to-measure or stemming from future activities. The increasing use of fair value accounting expands the accounting recognition. We investigate the economic consequences to the reporting firm of an expanding recognition scope in accounting measurements. Using a simple model of endogenous investment whose payoffs are measured by either a restrictive (Partial accounting with high precision) or an expanded recognition rule (Full accounting with low precision), we show that, in the process of expanding accounting recognition, firms' internal investment efficiency and external share-price risk premium may not necessarily be a trade-off. In particular, we show that the consequences of moving from Partial to Full accounting depend on the investment environment (e.g., growth prospects) as well as the inherent measurement characteristics (e.g., measurement precision). For example, even with low measurement precision, Full accounting may generate a lower risk-premium in the firm's share price than Partial accounting. More surprisingly, an expanded recognition may lead to a higher investment efficiency and a lower risk-premium at the same time. The underlying driving force is that endogenous investment choices make endogenous the total uncertainty of the firm's cash flows as well as the resolution of the uncertainty due to the accounting report.
   
   
   
   

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