A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research 1

Transcription

1 A Real Eects Perspective to Accounting Measurement and Disclosure: Implications and Insights or Future Research 1 Chandra Kanodia Carlson School o Management, University o Minnesota Haresh Sapra Booth School o Business, University o Chicago March Prepared or the 015 Journal o Accounting Research Conerence. We thank Christian Leuz or his insightul comments. 1

2 1. Introduction The accounting literature on real eects postulates that how we measure and report irms business transactions to inancial markets will signiicantly alter irms business strategies. Firms could become myopic in their investment strategies, orego prudent risk management, alter their loan portolios, change how they obtain inancing, and so on. Such a perspective stands in strong contrast to the popular belie that accounting provides inormation on an objective reality that is independent o accounting measurements and disclosure. The presence o real eects has ar reaching implications or standard setting and or uture accounting research. I how accountants measure and disclose a irm s economic transactions changes those transactions, then it may no longer be true that any disclosure that is incrementally inormative to the capital market improves resource allocation. It cannot be presumed that greater price eiciency translates into greater economic eiciency. We must evaluate accounting standards dierently: Providing useul inormation to investors is an insuicient guide to standard setting because the real eects that could be triggered need to be taken into account. The research implication is that it is insuicient and perhaps misleading to merely look or price eects o new disclosure requirements or to examine whether correlations between accounting numbers and security returns are improved. We believe the ocus should shit to the identiication and empirical detection o real eects. Understanding what these real eects are, and how they come about, provides important new insights into how to identiy and test or the economic consequences o alternative accounting standards and disclosure mandates. In the accounting literature, it is commonplace to think o the link rom inancial markets to corporate decisions in terms o a irm s cost o capital. Accounting measurements matter because higher quality accounting, and greater, more precise, or more transparent disclosures reduce a irm s cost o capital. Such reductions in cost o capital occur because public inormation reduces the assessed uncertainty in a irm s cash lows and reduces the adverse selection in capital markets that is caused by inormation asymmetry among traders (e.g.

3 Diamond and Verrecchia [1991], Leuz and Verrecchia [000], Lambert, Leuz and Verrecchia [007]). But, cost o capital cannot be directly measured, and studies that rely on proxies such as the expected rate o return predicted by the Capital Asset Pricing Model (CAPM), bid-ask spreads and trading volume provide only generic insights into the eect o accounting inormation. Although useul, they do little to resolve debates about the speciic measurement and reporting issues that accounting regulators grapple with, such as: What is the appropriate accounting treatment o hedges and other executory transactions; should intangible investments be measured and capitalized; should the loan portolios o inancial institutions be air valued, etc. There is no theory that relates cost o capital to alternative accounting treatments o such speciic transactions. There are two other perspectives on how inancial markets aect corporate decisions. One view stresses the inormation transmission properties o market prices resulting in eedback eects rom inancial markets to the real economy (See Bond, Edmans and Goldstein (BEG) [01] or a comprehensive survey o this literature, and Dye and Sridhar [00]). In this view, individual investors and speculators in the market discover inormation that is relevant to the irm s decisions and trade on that inormation. The inormation signals received by individual traders gets aggregated and impounded in equilibrium security prices in the process o trading. Thus, equilibrium security prices become a statistic o all the relevant inormation that is dispersed among private individuals. Corporate managers extract inormation rom prices and use that inormation to guide the irm s decisions. BEG argue that even though each individual speculator may be less inormed than the irm s manager, speculators collectively may be better inormed. Additionally, there is much inormation external to the irm such as the state o the economy, product demand, etc. that is relevant to the irm s decisions, but which may be better known collectively by outsiders than by the irm s manager. Although there is merit and empirical support or this perspective (see the citations in BEG), this eedback role o inancial markets does not identiy a need or accounting disclosure. 3

4 The other perspective, that is more relevant to accounting, and thereore commonly used in the accounting literature, is that there is much irm speciic inormation that is either consciously collected and analyzed by managers or is learned by managers rom daily conduct o the irm s internal operations and decisions; inormation that individual investors cannot directly access. This kind o inormation asymmetry between internal managers and investors in the capital market is what gives rise to the need or accounting measurement and disclosure to outsiders. We think that most, i not all, FASB standards o measurement and disclosure are concerned with this kind o inormation, and in this paper we will ocus exclusively on it. How does the measurement and disclosure o inormation that is already known to corporate managers aect the decisions that these managers make on behal o the irm? In Section 3, we provide a detailed illustration o how this happens in a simple speciic setting. A general answer to this question was irst ormalized in Kanodia [1980] who showed how corporate decisions and capital market valuations are simultaneously aected, in dynamic general equilibrium, by the inormation in the capital market. Subsequently, Myers and Majlu [1984] and Stein [1989] also studied settings where the market s inormation aects corporate decisions. None o these studies rely on cost o capital eects. Instead, market valuations are derived more directly as market clearing prices with inormation used to update investors belies about the uture cash lows o the irm. The Kanodia [1980] general ramework can be specialized to study the real eects o very speciic accounting measurements and disclosure mandates. Recent studies have done so by constructing and analyzing precisely speciied settings in which the corporate decisions that could be aected by the accounting measurements under study are explicitly modeled and allowed to interact with capital market pricing. In this paper, we synthesize the methodology o real eects studies and illustrate the kind o insights and indings that are obtained rom the consideration o very speciic accounting measurements. Our intent is not that o providing a comprehensive survey o the literature on See Dye [1985, 1986], Verrecchia [1983]. 4

5 real eects, but rather on distilling a uniying ramework and identiying leads that could stimulate additional work in the uture. 3 Accordingly, we ocus the paper on three broad accounting policy issues that have been diicult to resolve and remain controversial in the practitioner and academic community. In each case we elaborate on the new insights provided by a real eects perspective, insights that have hitherto been missing rom policy debates. The three broad issues are: i. Why is it important to separate a irm s investment rom its operating expenditures? What are the real eects o noise in such measurements? Is there a relevance-reliability tradeo that should be considered in determining whether investment in intangible assets should be measured? ii. Could marking-to-market the loan portolios o inancial institutions trigger pro-cyclical real eects? iii. How does measurement and disclosure o irms derivative transactions aect irms choice o intrinsic risk exposures, risk management strategy, and the incentive to speculate? In the absence o empirical data, the credibility o results obtained in an analytical study depends upon the intuition o readers that important eatures that are salient to the phenomena being studied are captured in the model. Thereore, it is useul to construct a uniying ramework that underlies real eects studies and identiy some o the more important assumptions that occur repeatedly in the models that have been used. We construct such a ramework below and argue why these common assumptions are realistic and essential to study the real eects o accounting 3 Kanodia [006] provides a more comprehensive and detailed survey. 5

6 measurements. We contrast our ramework to models o disclosure in pure exchange settings, where most o the literature is currently ocused.. A Uniying Framework or the Study o Real Eects Prior to the advent o modern capital markets, most group businesses were constituted to engage in speciic ventures o short duration. At the end o the business venture, the proceeds rom the business were distributed to the participants in the orm o liquidating dividends. Such dividends constituted the returns to ownership. The main purpose o accounting was record keeping. Accurate records o assets, obligations, and cash lows helped to insure that the resources o the irm were not misappropriated by those who were actively engaged in the management o the venture. This role o accounting came to be known as the stewardship role. The stewardship role was subsequently enlarged to include reports that were useul in assessing managerial perormance, speciying debt covenants, and making contingent payments. With the advent o modern capital markets these joint ventures o limited duration and scope were replaced by publicly traded irms with indeinite duration and scope. Rather than paying out periodic or terminal dividends, irms retained most o their proits to inance new investment and growth. The owners o irms were no longer a well identiied stable group o shareholders as a shiting and aceless crowd in the capital market could, and did, move readily in and out o ownership in the irm by buying and selling their shares in liquid capital markets. The paradigm o a irm s shareholders providing capital to the irm and holding their ownership shares until the irm liquidates became obsolete. The economic beneits produced by the irm were no longer distributed to the irm s owners via periodic or liquidating dividends. These beneits were transerred to owners via the pricing o the irm in the capital market. The time path o security prices determined the rewards to ownership. In the ace o this radical shit, the principal role o accounting changed rom that o stewardship to inancial reporting to capital markets. 6

7 However, it is misleading to study inancial reporting to capital markets in pure exchange economies where corporate activities and decisions are suppressed. 4 In such an exchange economy, inancial reports are necessarily viewed as providing inormation on exogenously speciied true distributions o uture prices or terminal payos. The eect o such inormation is merely to move prices, generate trading volume and reduce inormation asymmetry between less inormed and more inormed traders. Since or any given distribution o terminal payos the Capital Asset Pricing Model (CAPM), predicts the expected rate o return that determines a securities current price, it is believed that the eect o disclosure can be captured entirely in terms o the CAPM required rate o return. A lower required rate o return is then interpreted as a reduction in the irm s cost o capital. Changes in cost o capital are proxied by changes in irms systematic risk (the beta coeicient in CAPM), bid-ask spreads and trading volume. Even though corporate decisions are not explicitly modeled, it is assumed that reductions in cost o capital can only improve corporate decisions. This view o the world has led to the belie that more inormation is always preerred to less and that price eiciency is synonymous with economic eiciency. In the real eects paradigm, that we wish to portray, we should think o periodic releases o accounting inormation as aecting the evolution o the irm s value over time where values are determined by trades among investors and speculators in the capital market who hold the irm only or short periods o time. The irm is not a passive entity to such valuation. The evolution o value over time is accompanied by the evolution o corporate decisions over time. Valuation and corporate decisions are intertwined because when shareholders derive their payos rom the evolving time path o security prices, irm s must necessarily be concerned with how their decisions are perceived and priced over time in the capital market. This represents a undamental shit in how inormation aects corporate decisions. In a world where a irm s 4 See Beyer, Cohen, Lys, and Walther [010] or a recent comprehensive survey o disclosure in exchange economies. 7

8 owners contribute capital to the irm in exchange or ownership claims and simply hold these claims long enough to get their rewards by way o terminal dividends, the irm s decisions are governed solely by the inormation possessed by its manager. Benevolent managers would evaluate alternative actions by assessing the risks and expected values o terminal cash lows associated with each action. That assessment would be based solely on the inormation the managers possess. The better is the manager s inormation the better would be the decisions made on behal o the irm s shareholders and the higher would be the expected payo to shareholders. But, when the time path o security prices determines the rewards to ownership, the same benevolent manager s decisions must necessarily be aected by the inormation in the capital market. The price response at any given date to any decision that the irm makes and to any economic event depends only upon what traders in the market observe and upon the inerences they make, and not upon what managers know. In this sense, it is the market s inormation, no matter how determined, that is the key actor aecting the irm s decisions. 5 This is not to say that managers cannot inluence the inormation that is in the capital market, nor do we claim that there is no role or managerial judgment and managerial assessments o uture events. The real eects, that we study, arise rom the interaction between what managers know and what markets iner rom accounting measurements and disclosure. decision d To get a sense o this interaction, consider the ollowing setting. Suppose that some D that a manager needs to make on behal o a publicly traded irm will aect the irm s cash lows over three periods into the uture. Call these uture cash lows x 1, x, and x 3. Assume the manager makes his decision at date zero and there are no later decisions to be made. Let Y describe the inormation available to the manager at the time she chooses the decision on behal o the irm. The irm is priced P 1 in the capital market at date 1 ater realization and observation o the irst period cash low and P at date ater realization and observation o the 5 See Brandenburger and Polak [1996] or a complete model o this type. 8

9 m irst and second period cash lows. Let Y1 and Y be the inormation in the capital market at dates 1 and. The inormation set Y1 m m includes the irst period cash low and any knowledge o m m the decision that the manager made at date zero, and the inormation set Y includes Y 1 and any additional inormation that arrives in the capital market between periods one and two. Now, suppose that the irm s objective unction is to choose d the expected period 1 and period capital market prices, i.e. or some α (0,1). MaxaEP ( Y ) (1 ) EP ( Y ) 1 + a D to maximize a weighted average o Assuming risk neutral pricing and assuming that the irm does not pay interim dividends, m the equilibrium price in the capital market at date 1 will be: P1 = x1+ Ex ( + x 3 Y1 ), and the date capital market price is P = x1+ x + Ex ( 3 Y ). These prices do not depend upon what the manager knows and do not depend upon whether individual traders intend to hold the irm or only one period or until the terminal date. The inormation available in the capital market at dates 1 and is all that matters to the pricing o the irm at these two dates. Now, suppose that all o the inormation available to the irm s manager is also available to traders in the capital market, m m m i.e. Y Y1 Y. Then by the law o iterated expectations, EEx [ ( + x 3 Y1 ) Y ] = m + 3 and 3 Ex ( x Y ) m EEx [ ( Y ) Y ] = Ex ( 3 Y ). Thereore EP ( 1 Y ) = EP ( Y ) and the irm s decision problem is equivalent to Max E( x 1+ x + x 3 Y ) or every value o α. Thus i everything the manager knows is also known to the capital market, the evolution o prices in the capital market is irrelevant to the manager s decisions and the weights assigned to each price is also irrelevant. Maximizing a weighted average o prices is equivalent to maximizing the expectation o terminal cash lows conditional on the inormation set o the manager at the time the decision is made. 9

10 But, i some elements o the manager s inormation is hidden rom the capital market, i.e. m i, in the Blackwell sense, the inormation set o the market Y 1 is not iner than the inormation set o the manager Y, then the law o iterated expectations does not apply and αep ( Y ) + (1 ) EP ( Y ) 1 α Ex ( + x + x Y ). In this case the time path o market 1 3 prices does matter and maximizing some weighted average o expected uture prices is not equivalent to maximizing the expected terminal cash low o the irm. The irm s manager will need to assess the distribution o capital market prices at each uture date conditional on each easible decision. This assessment must depend upon what inormation arrives in the capital market at each date and how market prices respond to that inormation, as well as upon the inormation possessed by the irm s manager. The decision made by the manager will depend in some complex way upon what the manager knows as well as on what the market observes and iners at each date. I the inormation that arrives in the market at uture dates is even partially dependent on accounting measurements and reports, then accounting will have real eects on corporate decisions. The assumption that accounting measurements inorm stock prices is not without controversy in accounting. In the empirical literature in accounting it is oten asserted that capital market prices are independent o accounting because the relevant inormation arrives in the market much earlier rom alternative sources. For example, voluntary disclosures, earnings guidance, and orecasts provided by managers and inancial analysts provide more timely and more orward looking inormation (See Ball and Shivakumar [008], and Ball [013]). The assertion rests on the empirical inding that the inormation contained in accounting statements is impounded in stock prices much earlier than the date on which these statements are ormally released to the public. We do not dispute such empirical results, but we eel that the measurement rules that are mandated by FASB color all o the disclosures to the capital market regardless o who is actually doing the disclosing and regardless o when the inormation enters 10

11 the market. For example, it is diicult to see how inormation about sales, manuacturing costs, marketing costs, proits, R&D expenditures, investment expenditures etc. can be provided by any source without relying on some systematic recording and aggregation process that operates in accordance with pre-speciied and well understood measurement rules. Dierent measurement rules (and thereore dierent accounting standards) have dierent inormation content and will, thereore, dierently aect the time path o security prices. Managerial decisions are typically modeled as driven by incentive arrangements and compensation contracts. Yet, it is commonly assumed in the real eects literature that corporate decisions are driven by how prices in the capital market respond to those decisions. Managerial compensation contracts are not explicitly modeled and it is assumed that managers benevolently adopt whatever preerences shareholders have over the time path o security prices. This is not a atal law because surely managerial compensation contracts will be structured in such a way that managers become ocused on whatever price perormance shareholders demand. So, ultimately it is the preerences o shareholders, not the preerences o managers that determine managerial actions. 3. Real Eects o Measuring a Firm s Investment 3.1 A Canonical Model o How Measurement Noise Aects a Firm s Investment. The measurement and reporting o a irm s periodic earnings is central to accounting, but the separation o investment expenditures rom operating expenditures is essential to such measurement. Investment expenditures are recorded on the Balance Sheet as assets and expensed against uture revenues, while operating expenses are believed to have expired and are matched with current revenues to determine a irm s current period earnings. A irm s investment cannot be directly observed by outsiders and, in practice, it is diicult to measure. What is readily observable to the accountant is the irm s cash outlows, but how much o this outlow is investment and how much is operating expenditure is not obvious. The distinction between the 11

12 two requires diicult judgments o how the uture will unold. Thus accounting measurements o investment are inevitably noisy and contentious. Managers are much better inormed than outsiders regarding a irm s investment outlays, but their opinion cannot be readily accepted because managers are strongly tempted to disguise operating expenses as investments and so report both higher assets and higher earnings. In recognition o these acts, the measurement o various kinds o investment is governed by numerous accounting conventions and standards, but these standards do not perectly it the acts and usually require judgment in their application. Understanding the real eects o measuring a irm s investment provides rich insights into how accounting measurement and disclosure aect corporate decisions generally. Thereore we construct a somewhat detailed model o how measurement noise aects a irm s choice o investment. The oundations o the model presented here is due to Stein [1989] and its augmentation in Kanodia and Mukherji [1996]. New insights are derived here that are not present in the earlier work. Consider a three date model o a publicly traded irm that is choosing how much to invest. The irm chooses its investment at date zero and the uncertain returns to investment, in the orm o operating proits, are realized at dates one and two. The irm s accounting system produces a report at date one ater the irst period operating proit has been realized. 6 Let x 1, x be the operating proits at dates one and two that result rom the investment. We assume that cov( x, x ) > 0, so that knowledge o the irst period s operating proit is useul or predicting 1 the next period s operating proit. More speciically, x 1 is distributed Normal with mean µ and precision α and x = gx 1+ ω where ω is independent o x 1 and distributed Normal with mean zero and precision τ, and g > 0 is a growth or persistence actor. Thus, rom the perspective o 6 For reporting purposes, we merge dates 0 and 1 into a single reporting period. This is done to allow possible conounding o investment expenditures with operating proits without making the model needlessly complex. The same economic orces are present in a more realistic model with date zero reporting where the conounding occurs between new investment and operating cash lows rom assets already in place. See Kanodia and Mukherji [1996] or a model o this type. 1

13 date zero, Ex ( 1) = µ, Ex ( ) = gµ and cov( x 1, x ) = g var( x 1) = g > 0. We assume that these a expected returns are strictly increasing in the scale o the investment project, so the irm eectively chooses µ by choosing how much to invest. Let c ( µ ) be the intended investment expenditure required to produce these expected returns. The actual investment expenditure o the irm deviates rom the intended expenditure by a non-controllable random component so that the irm s actual investment expenditure is c ( µ ) + γ. We assume that c (.) is increasing and strictly convex with c (0) = 0 and γ is distributed Normal with zero mean and precisionδ. The irm s realized net cash low, at the end o the irst period is: z1 = x1 c ( µ ) γ (3.1) We assume that none o the variables that are typically measured by accounting systems, such as realized cash lows, operating proits, or investment expenditures is directly observed by outsiders in the capital market. Inormation about these quantities is provided by the irm s accounting system. Since cash can be counted with perect precision, we assume that the accounting system reports z 1 without error. However, as speciied in (3.1), net cash low conounds investment expenditures and operating proits. The accounting system measures the irm s investment by trying to separate these two components but cannot do so perectly. So measured investment, reported by the accounting system is: K = c ( µ ) + γ + ε, (3.) where ε is measurement error, independent o γ, and is distributed Normal with mean zero and precision β. The irm s measured income in the irst period is its cash low adjusted or accruals. The only accrual here is the irm s measured investment. Thereore, the irm s income as measured by the accounting system is y1 = z1+ K. Substituting rom (3.1) and (3.), yields: y = x c( µ ) γ + [ c( µ ) + γ + ε] = x + ε (3.3)

14 The irm s accounting system reports { z1, y1, K } at date 1. What inormation is contained in the accounting report? Even though the accounting system seeks to measure and report the irm s investment, the reported amount K cannot be used to make any Bayesian inerence about the irm s true investment. This is because the irm s true investment c ( µ ) is not a random variable and has no prior distribution 7. The scale o investment implied by µ is a choice variable or the irm and this act, together with the structure o the irm s decision problem, is common knowledge. Thereore, investors in the capital market will rationally conjecture µ rom their understanding o the irm s decision problem. Let ˆµ be this conjectured value o µ. Given this conjecture, the capital market must perceive the irm s reported cash low z 1 as being generated by the equation: z = x c ( µ ) γ (3.4) 1 1 ˆ Thus the quantity z ˆ 1 + c ( µ ), where c ( ˆ µ ) is a known constant, is perceived as representing the quantity x1 γ. This implies that the irst period reported cash low conveys inormation about the irst period operating proit and because cov( z1, x1) = var( x1) > 0 higher cash low will be interpreted as good news. The above analysis does not mean that imprecise measurements o investment are completely ignored. Measured investment eeds into the income report: y1 = z1+ K. As shown in (3.3) the income report also conveys inormation about the irst period operating proit o the irm and, given that γ and ε are uncorrelated, the two reports contain inormation that is incremental to each other. The noise in measuring investment translates into noise in the income 7 In general, noisy measurements o endogenous choices contain no inormation about that choice. This subtle truism was irst pointed out by Bebchuk and Stole (1993) and Bagwell (1995). 14

15 report. The less precise is the measurement o investment, the less inormative is the irm s income report. The above description o the inormation contained in accounting measurements o net cash low, investment, and income is quite general. Cash low is ree o accrual noise, so will acquire inormation content whenever accruals are noisy. Similarly, accruals acquire inormation content when cash lows are noisy and accruals ilter out the noise in cash lows. This implies that both reports; cash low and accounting income will be used to update investor assessments o irms uture cash lows. This claim is consistent with the empirical indings in Bowen, Burgstahler and Daley [1987], Rayburn [1986], and Wilson [1986, 1987]. We now turn to the decision problem aced by the irm. As argued in Section, a irm s objective unction is determined by the preerences o its shareholders, not by the preerences o its manager. This being the case, we do not explicitly model managerial incentive contracts but simply assume that the manager is benevolent and does whatever shareholders would want her to do. We also assume that all agents in the economy are risk neutral and uture cash lows are not discounted. 8 Now, i the irm s shareholders held the irm until liquidation (i.e. until the end o period two) the shareholders would want the manager to maximize the manager s expectation o cumulative net cash lows: Max E [ x + x c( ) ] (3.5) µ 1 µ γ where E (.) denotes the expectation conditional on the irm s or its manager s inormation. Since the manager knows the precise µ that she chooses, (3.5) is equivalent to: Maxµ [ µ + gµ c( µ )], which yields the irst order condition: c ( µ ) = 1+ g (3.6) 8 Adding risk aversion and discounting produces no new insights into the phenomena we are seeking to study. 15

16 Equation (3.6) describes the irm s irst best level o investment. Notice that when shareholders hold the irm until the terminal date there is no role or accounting measurements and disclosure even though the shareholders are missing some inormation that the manager possesses. There is not even any reason or the market to price the irm. The economy unctions perectly well without accounting. 9 However, we argued in Section that a model where the irm s shareholders hold the irm till liquidation is unrealistic and the concept o liquidating dividends is obsolete. Firms continue their operations indeinitely and shareholders derive their return rom the valuation o the irm in the capital market. We capture the spirit o these realistic eatures in our model by simply assuming that the irm s current shareholders sell their holdings in the capital market at the end o period one ater the release o accounting reports. The price in the capital market at date 1 depends upon the inormation in the market at that date and thereore upon the inormation contained in accounting measurements and reports. Given risk neutrality and the absence o discounting, in equilibrium this price must equal the observed cash accumulation in the irm at date 1 plus the conditional expectation o uture cash lows: P( z, y ) = z + E( x z, y ) (3.7) The objective unction o a benevolent manager would then be: Max E [ P( z, y )] µ 1 1, (3.8) 9 As indicated in the Framework described in Section, a role or accounting would emerge i there are conlicts between managers and shareholders thus creating a need or stewardship reports and contingent managerial compensation. 16

17 i.e., the manager would seek to maximize her expectation o the equilibrium price that will prevail in the capital market at the date that current shareholders liquidate their share holdings. Ex ( z, y) = gex ( z, y), and rom Bayes Theorem or Normally distributed Now, random variables Ex ( 1 z1, y 1) is a precision weighted average o the three estimates o x 1 that are available to the capital market, the prior conjectured mean ˆµ, z ˆ 1+ c( µ ), and y1. Speciically: ˆ ( z1 c( ˆ)) y1 Ex ( z1, y1) g αµ + δ + µ + β = α + β + δ (3.9) Inserting (3.9) into (3.7) yields the capital market s pricing rule as a unction o accounting reports: δg βg α g ˆ µ + δ gc( ˆ µ ) Pz ( 1, y1) = z1 + z1 + y1 + α + β + δ α + β + δ α + β + δ (3.10) From the irm s perspective ˆµ is a constant that it must accept as a given. The irm s decisions aect its price in the capital market, but not the pricing rule, and the market s conjecture ˆµ is a parameter in this pricing rule. Inserting (3.10) into (3.8) and eliminating constants over which the irm has no control, yields the objective unction as perceived by the irm s manager: µ 1 + z 1 + y 1 Max E z b z b y (3.11) where, the coeicients b z and b are pricing parameters deined by: y 17

18 b z δ g, and (3.1) α + b + δ b y b g α + b + δ (3.13) Remarkably, the irm s objective unction reduces to maximizing an expectation o a weighted sum o the date 1 accounting reports. But, this ocus on accounting reports is not due to the unctional ixation described by Ijiri, Jaedicke and Knight [1966] or the projected earnings ixation described by Verrecchia [013]. The irm s objective unction is entirely consistent with Bayesian updating and rational inerences made by traders in the capital market. Using E ( z1) = µ c( µ ) and E ( y 1) = µ yields the irst order condition that characterizes the equilibrium investment o the irm: by c ( µ ) = 1+ (3.14) 1+ b z Because everything in (3.14) is known by traders in the capital market, the market can correctly conjecture the irm s equilibrium investment. Thus, i traders orm their belies rationally the conjectured level o investment c ( ˆ µ ) that is used to price the irm will coincide with the irm s true investment described by (3.14). Notice that, regardless o the precision with which the irm s investment is measured, in equilibrium, the irm is always priced consistent with its undamentals. It is not the case that accounting inormation makes markets more eicient. The eect o accounting measurement is to change the irm s undamentals. The equilibrium price in the capital market adjusts to it the new undamentals. Additionally, price eiciency and economic eiciency are not synonymous. Even when market prices are eicient in the sense that 18

19 they relect the true undamentals o the irm, the irm underinvests. This can be seen by comparing (3.14) to (3.6) and rom the act that: by b g = < 1 + bz α + b + δ(1 + g) g Let us examine how the precision o accounting reports aects the equilibrium investment o the irm. The optimality condition (3.14) indicates that the irm s investment strictly increases in the weight b y on the income report and strictly decreases in the weight b z on the cash low report. Thus, market inerences based on a irm s earnings report have a beneicial eect on the irm s investment while market inerences based on a irm s net cash low detract rom investment eiciency. The weight b y on the earnings report is strictly increasing in the precision β with which the irm s investment is measured as can be seen rom (3.13), and the weight b z on the cash low report is strictly decreasing in β as can be seen rom (3.1). So, the more precise is the measurement o investment the closer is the irm s investment to irst best. It is interesting to examine two extremes, one where there is no attempt at all to separate investment rom operating expenditures and the second where the separation is perect. The ormer case is described by β = 0 and the latter case is equivalent to β =. When β = 0 it can be seen rom (3.13) that b y = 0, in which case (3.14) indicates that the irm s equilibrium investment shrinks to the level described by c ( µ ) = 1. This implies that the non-measurement o investment results in extreme myopia in the sense that investment is determined solely by its eect on short term returns and all eects o investment on uture cash lows are ignored. This explains why it is so important to separate a irm s investment expenditures rom its operating expenditures. The importance o this accounting procedure is not due to concerns about market 19

20 eiciency, but due to the result that in the absence o such measurement, eicient market prices cannot sustain anything better than myopic investment policies. At the other extreme, ininitely precise measurement o investment results in irst best investment since: by b g = g as b 1 + bz a + b + δ(1 + g) When the irm s investment is perectly measured, the maximization o the expected short-term price in the capital market is equivalent to the maximization o the expected long-term accumulation o cash lows. Thus, the short-termism orced on the irm by short-term shareholders does nothing to detract rom economic eiciency. But this happy result is not automatically true. It cannot be achieved without perect accounting measurement. The inormation content o the cash low report strictly increases in δ which describes both the precision o cash low and the degree o uncertainty in the irm s capital expenditure. What happens when the uncertainty in the irm s capital expenditure vanishes, so that δ becomes arbitrarily large. It can be seen rom (3.13) and (3.1) that as δ, by 0 and (3.14) becomes c ( µ ) = 1. Once again there is extreme myopia. The reason or this strange behavior is that as the variance o γ vanishes, the market perceives the irm s cash lows as z ˆ 1 = x1 c ( µ ), so the market believes it can perectly iner the irm s operating income rom the irm s reported cash low. Given such a belie, the inormation content o any noisy measure o income vanishes causing b y = 0. Since higher values o cash low lead to the inerence that the irm s operating income is higher the irm reduces its investment to increase its reported cash low. The irm is not penalized or such actions because its actual investment is unobservable and thereore, o equilibrium, the market s belie c ( ˆ µ ) does not vary with the irm s actual investment. At the 0

21 other extreme, as the uncertainty in cash low becomes arbitrarily large (i.e., var( γ ) ) the irm s cash low report becomes completely uninormative. So d 0 and b z 0. The irm s g investment is then described by c β ( µ ) = 1 + α + β. Investment remains below irst best as long as there is noise in the measurement o investment, even though the negative eect o cash low inormation is no longer present. 3. Insights rom the Noisy Measurement o Investment The simple model o investment that we have studied provides a rich array o insights into accounting issues. We develop these insights below. (i) Price eiciency versus economic eiciency: I we think o signals as providing inormation about the state o Nature, then it is certainly true that more precise signals will enhance economic eiciency and result in decisions that are more consistent with the true state o Nature. The study o accounting inormation in exchange economies treats the irm as i it were a state o Nature. Such a perspective leads naturally to the view that inormation increases price eiciency in the sense that prices become more consistent with the true undamentals o the irm. In turn, greater price eiciency results in greater economic eiciency because prices guide the allocation o capital in the economy. Such thinking would be correct i the irm s undamentals are independent o the inormation in the capital market. However, our simple model o the irm s investment decision indicates that the irm s undamentals are not independent o what investors in the capital market know. The more imprecise is the measurement and reporting o investment the lower is the irm s investment. When investment is not measured at all, the irm invests in an extremely myopic ashion. But, in all cases the price in the capital market is ully consistent with the equilibrium investment o the 1

22 irm, so price eiciency is always attained. What suers due to lack o inormation is the sustainability o the investment that should occur given the long-term prospects o the irm. Thus, economic eiciency is aected even though price eiciency is not. This is the central message in Stein [1989] and is also argued in Bond, et al [01]. We should be studying economic eiciency rather than price eiciency and the two concepts are not equivalent. (ii) Measures o the total inormation content o accounting reports are misleading: The previous literature has only identiied the empirical regularity that both cash lows and earnings are priced by the capital market without any insight into whether this is good or bad or economic eiciency. In act, i we theorize about accounting in the context o a pure exchange economy, only the total inormation content o accounting reports matters; how much o the inormation is contained in cash low and how much is contained in reported earnings is o no consequence. But, a real eects perspective indicates that the source o the inormation is highly relevant. When investors in the capital market condition their belies strongly on the cash lows produced by the irm, economic eiciency suers. Because higher cash lows are rationally interpreted as good news, a relatively greater weight on cash low incrementally penalizes any unobservable action that decreases cash lows in the short-term regardless o how beneicial that action may be in the long-term. Greater reliance on the earnings report promotes economic eiciency. (iii) A new measure o accounting quality: Our results provide a distinctly dierent perspective on the concept o accounting quality and its measurement, a perspective that is based on real eects. We have argued that it is the noise in accruals that gives cash low its inormation content. Additionally, we have shown that greater weight on cash low decreases economic eiciency. I accruals were noise ree, observed cash lows would have no inormation content and prices in the capital market would sustain ull

23 economic eiciency. Thereore, our results indicate that the observed relative weight on cash low in regressions o stock price on cash low and earnings can be used as a proxy or the quality o accounting. The higher the relative weight on cash low, the lower is the quality o accounting. It would be interesting to empirically determine how this measure o accounting quality has varied over time and how it varies cross-sectionally across industries. (iv) An important beneit to accrual accounting is that it deters corporate myopia: Our analysis provides new insight into the rationale or accrual accounting. A well unctioning system o accruals deters the corporate myopia that would otherwise be induced by short-term traders in the capital market. An accounting system without accruals is equivalent to merely reporting a irm s cash lows. We have shown that such accounting induces extreme myopia. On the other hand, perectly precise measurement o investment, and thereore a perect accrual system, makes a ocus on short-term prices equivalent to a ocus on long-term cash lows and thereore eliminates the myopia. The principle that guides the design o accruals is the matching o costs and beneits. Such matching does not require accounting reports to be orward looking in the sense o pulling uture beneits into current period perormance reports. Our analysis indicates that an appropriate deerral o cash expenditures achieves the same goal. When the reporting o costs is deerred to the periods in which the corresponding beneits are realized and recorded, those actions that produce greater value in the long-term do not look like inerior actions in the short-term, thus decreasing the incentive or myopic actions. Rogerson [1997] and Reichelstein [1997] study inter-temporal allocations o capital expenditures in order to align the incentives o managers with the preerences o shareholders and show that a depreciation schedule based on relative beneits provides robust incentives. None o these insights hold in exchange economies where real eects are suppressed. FASB has consistently argued that accrual accounting provides a better measure o a irm s 3

24 perormance than a mere listing o cash inlows and outlows. But FASB has not indicated how this better perormance measure provides better resource allocation or otherwise provides beneits to any agent in the economy. In empirical research better perormance measure and higher accounting quality have been operationalized as better prediction o the irm s uture cash lows. A real eects perspective indicates that higher accounting quality not only leads to better prediction o irms uture cash lows but also avorably alters those cash lows. 3.3 Should Investment in Intangibles be Measured? A irm s investment in intangible assets such as research and development, human capital, inormation technology, brand equity, etc. are currently not treated as assets and are not capitalized on the irm s balance sheet. R&D expenditures are measured and line itemized in the earnings report, but all other kinds o intangible investments are unmeasured and remain commingled with operating expenditures. During the 1990 s there was much debate about the accounting treatment o intangible investments. Advocates or the measurement and capitalization o intangible investments argued that intangible assets are highly relevant to a irm s value in the new economy and that such disclosures can only increase the amount o inormation in the capital market, thus enhancing price eiciency and improving resource allocation. The value relevance studies o Aboody and Lev [1988], Lev and Sougiannis [1996] and Healy, Myers and Howe [00] seemed to support such claims. But, FASB opposed the capitalization o intangibles arguing that intangibles cannot be measured with suicient precision and that attempts to do so would decrease the reliability o inancial statements and open the door to earnings management. FASB s argument stems directly rom the diiculty o separating operating expenditures rom investment expenditures. Although FASB expresses its concerns solely in terms o the reliability o accounting numbers, we have shown in the investment model o section 3.1 that non-measurement is worse than noisy measurement, when real eects are taken into account. 4

25 This would suggest unambiguously that intangible investments should always be measured regardless o reliability concerns. Kanodia, Sapra and Venugopalan (KSV) [004] showed that when the irm invests in both tangible and intangible investments and there is a need to measure and report each separately, there is actually a relevance-reliability tradeo that determines whether intangibles should be measured or let commingled with operating expenses. 10 The tradeo depends upon an assumed complementarity between the two kinds o investment and the assumption that measurement o intangible assets is much noisier than the measurement o tangible assets. Both assumptions seem realistic. KSV use a Cobb Douglas like production technology to capture the complementarity between tangible and intangible assets: Q = K α N β, α > 0, β > 0, α + β < 1 (3.15) where Q is the irm s aggregate capital stock, and K and N are its investments in tangible and intangible assets, respectively. Investments are made at date 0 and the returns to investment, x, x, occur at dates 1 and. KSV assume that the mean returns to investment are strictly 1 increasing in the irm s capital stock: Ex ( ) = Ex ( ) = Qµ, 1 where µ > 0 captures the known proitability o investment. Also cov( x 1, x ) = ρ > 0, and the prior variance o x 1 = σ x. As in our canonical model o investment described in section 3.1, the actual expenditure on intangibles is N + γ where γ is a random non-controllable perturbation o intended investment and is distributed Normal with mean zero and variance and intended expenditure on tangibles is K. σ γ while the actual 10 Dye and Sridhar [004] also study a relevance-reliability tradeo, but the context and the nature o the tradeo is quite dierent rom that developed by us. 5

26 KSV contrast two accounting regimes, one where intangibles are not measured and are let commingled with operating expenditures ( the expensing regime) and the second where intangibles are measured (the capitalization regime), but the measurement gives rise to several kinds o noise. Additionally, both regimes measure and report the irm s investment in tangible assets, the irm s net cash balance at date 1, and the irm s earnings at date 1. When intangibles are measured there are random classiication errors between tangible and intangible assets and also between intangible assets and operating expenditures. These sources o noise are absent when intangibles are let commingled with operating expenses. The date 1 accounting reports that are produced in the two regimes are. Expensing regime: e IK = K.measured tangible assets, z = x K N γ.measured cash balance, and (3.16) 1 = + =..measured earnings. e e y z IK x1 N γ Capitalization regime: I = K + η,..measured tangible assets, m K I = N + γ η+ ω,..measured intangible assets, m N z = x K N γ,.measured cash balance, and 1 y = z+ I + I = x + ω..measured earnings. m m m K N 1 The random variables γη,, and ωare independently distributed and Normal with zero means and variances σ, σ and σ respectively. The random variable η represents classiication γ η ω error between tangible and intangible assets while ω represents classiication error between 6

27 intangible assets and operating expenditures. Notice that the misclassiication between tangible and intangible assets is osetting and so does not aect measured earnings, but the misclassiication between intangible assets and operating expenditures lingers and introduces noise in the earnings report. The key inormational dierence between the two regimes is as ollows. The capitalization o intangibles results in strictly greater inormation about the irm s irst period operating proits because reported cash low communicates x 1 γ and reported earnings provide an additional conditionally independent signal x 1 + ω. When intangible investments are expensed the latter signal is lost and the only inormation about the irm s irst period operating earnings is x 1 γ. However, in the capitalization regime inormation about the irm s tangible investment is lost because o the presence o random misclassiications between tangible and intangible investments. As in our canonical model o investment, the objective unction o the irm is to maximize the manager s date zero expectation o the date one price that prevails in the capital market. KSV establish that in both regimes the irm underinvests in both tangible and intangible assets, but or dierent reasons. The underinvestment in the capitalization regime is due to orces similar to that in our canonical model o investment with measurement noise. Since, in this regime, both cash lows and earnings are inormative about uture cash lows, the date 1 price in the capital market prices both variables. The weight on cash low is a deterrent to both kinds o investment. In the expensing regime, there is no noise in the measurement o tangible investments, but because o the complementarity between tangible and intangible assets, the underinvestment in intangible assets drags down the investment in tangible assets also. In the capitalization regime, the two kinds o assets are combined in an eicient manner to produce the irm s capital stock, but in the expensing regime the irm increases its reliance on tangible assets and decreases its reliance on intangible assets resulting in an ineicient mix o the two kinds o 7