Accounting for Past and Future Actions

• In Event: Disclosure Regulation

Abstract

Explicitly or not, an accounting measurement system must choose whether or not to exclude, from its scope consideration, any economic activities yet to occur. We provide a model where such a scope distinction between measurements has both accounting and economic meanings. In particular, we represent measurements limited to past actions with an Assets-In-Place (AIP) accounting measurement in contrast to a Full accounting measurement which represents measurements anticipating future actions. We then embed the accounting model into a firm's accounting choice problem in which the firm rationally recognizes that its accounting choice may change its own investment efficiency as well as the risk premium in its share price. We analyze how the optimal choice between the two measurements depends on the investment environment (e.g., growth opportunities) as well as the inherent measurement characteristics (e.g., measurement noise). We show the optimal choice can be subtle if the firm's investment is endogenous to the accounting regime itself. For example, Full accounting may be preferable even if the noise in Full accounting is high. Similarly, AIP accounting may become preferable even if the firm-growth is sizeable. The underlying driving force is that the endogenous investment makes endogenous the total uncertainty of the firm's cash flows as well as the resolution of the uncertainty due to the accounting report. This indirect effect of accounting measurement (i.e., the "real effect" via the investment channel) changes the trade-off the firm faces in choosing a preferred accounting measurement.

Authors

• Wei Li, University of Illinois at Urbana–Champaign

• Jinghong Liang, Carnegie Mellon University

• Xiaoyan Wen, University of Illinois at Chicago