A Real Effects Perspective To Accounting Measurement And Disclosure: Implications And Insights For Future Research

Chandra Kanodia

University of Minnesota – Carlson School of Management

Haresh Sapra

University of Chicago – Booth School of Business

January 2016

Journal of Accounting Research, Forthcoming

Abstract:

Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm’s investment efficiency? (2) How does the measurement and disclosure of a firm’s derivative transactions affect a firm’s choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How marking-to-market the asset portfolios of financial institutions could generate pro-cyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards but also for guiding future empirical research.

A Real Effects Perspective To Accounting Measurement And Disclosure: Implications And Insights For Future Research – Introduction

The Real Effects Hypothesis

The real effects hypothesis states that the measurement and disclosure rules that govern the functioning of accounting systems–which economic transactions are measured and which are not measured, how they are measured and aggregated, what is disclosed to capital markets and how frequently such disclosures are made–have significant effects on the real decisions that firms make. Firms could become myopic in their investment strategies, forego prudent risk management, change their asset portfolios, change how financing is obtained, etc. The accounting regime is an integral and important component of the economic environment that determines how firms allocate resources. A change in the accounting regime, just like other changes in the economic environment, will result in a new equilibrium with different decisions and prices. Such a real effects perspective is fundamentally at odds with the common assumption that the accounting process is like a neutral onlooker that observes and reports on an objective external reality that exists independently of accounting. A graphic example of such conflicting opinions occurred during the 2008-09 financial crisis. Many influential practitioners argued that mark-to-market accounting for the assets of financial institutions significantly exacerbated the downward spiral in the economy, while defenders of fair value accounting argued that accounting signals served only as messengers of an unpleasant reality that was independent of accounting.

The presence of real effects has far reaching implications for standard setting and for future accounting research. If how accountants measure and disclose a firm’s economic transactions changes those transactions, then it is not necessarily true that any disclosure that is incrementally informative to the capital market improves resource allocation. It cannot be presumed that greater price efficiency translates into greater economic efficiency. Providing information that is useful to investors, and the principle of “representational faithfulness,” as enunciated by standard setters such as the Financial Accounting Standards Board (FASB) are insufficient guides to standard setting because the real effects that could be triggered will also affect the welfare of investors and must therefore be taken into  account. As a research strategy, it is insufficient and perhaps misleading to merely look for price effects of new disclosure requirements or to examine whether correlations between accounting numbers and security returns are improved. We believe that more relevant insights are obtained by predicting and testing directly for changes in specific corporate decisions in response to changes in specific accounting mandates.1 Towards this end, the objectives of this paper are: (i) Examine some specific accounting measurements from the perspective of understanding the nature of real effects they could give rise to, (ii) Analyze the necessary economic forces that would drive such real effects, and (iii) Explore the insights that such real effects provide to guide the development of accounting standards. We synthesize and extend the relevant analytical literature and draw upon related empirical findings to make our arguments.

Alternative Perspectives On The Real Effects Of Information

Accounting measurement could affect real decisions in many ways. Information provided to a decision maker obviously has the potential to alter his/her decisions. For example, information about the quantity of rainfall will affect the decisions of a farmer who must choose between planting wheat and rice. Information about the profitability of firms will alter the portfolio decisions of investors in the capital market. This decision theoretic analysis of information has a long history in economics and accounting (see Pratt, Raiffa and Schlaifer [1965], Feltham [1968], Feltham and Demski [1970], and Demski [1972]). We do not discuss real effects nor do we evaluate information systems from such a perspective. We are concerned here exclusively with the real effects of information disclosure by a decision maker rather than the real effects of information produced for that decision maker. When a corporate manager is required to disclose, it is presumed that he/she already has access to the information. So the issue we are concerned with is this: How does the disclosure of information already possessed by corporate managers to agents outside the firm affect the decisions that these corporate managers make on behalf of the firm?

A Real Effects Perspective To Accounting Measurement And Disclosure

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