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

Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency

Pierre Jinghong Liang
Xiaoyan Wen
Carnegie Mellon University
 

Journal of Accounting Research
Vol. 45, No. 1 (March 2007), pages 155-197.

 
Downloading the paper
2006-Feb Fourth Draft
 
Abstract
In this paper, we investigate how the accounting measurement basis affects the capital market pricing of a firm's shares, which, in turn, affects the efficiency of the firm's investment decisions. We distinguish two broad bases for accounting measurements: input-based and output-based accounting. We argue that the structural difference in the two measurement bases leads to a systematic difference in the efficiency of the investment decisions. In particular, we show that an output-based measure, such as a fair value measure, has a natural advantage in aligning investment incentives because of its comprehensiveness. The (first-) best investment is achieved when the output-based measure is noiseless and manipulation-free. However, in practice, output-based measures may be highly noisy and easy to manipulate, in which case the induced investment efficiency can be quite low. This is because under an output-based measure, investment inefficiency and accounting noise/manipulability are always complements: more accounting noise/manipulation leads to more inefficient investment choices. On the other hand, an input-based measure, such as a historical cost measure, may induce more efficient investment decisions than an output-based measure even though it is not as comprehensive. The reason is two-fold. First, input-based measures are typically associated with less noise and limited manipulation. Second and more importantly, we show that under an input-based measure, investment inefficiency and accounting noise/manipulability may be substitutes: a slight increase in accounting noise/manipulation may lead to more efficient investment choices. In fact, the (first-) best result is achieved when the noise/manipulability is small but positive. In other words, for an input-based measure, being less comprehensive makes small but positive accounting noise/manipulability desirable.
   
   
   
   

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Last updated May 2, 2005
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Last updated January 6, 2004
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