Accounting for Past and Future Actions

Abstract

This paper investigates the economic consequences of including more hard-to-measure future activities in a firm's accounting measurements. Using a simple model of endogenous investment in which payoffs are measured by either a restrictive or expanded recognition rule, 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) and the inherent measurement characteristics (e.g., measurement noise). For example, even with a higher measurement noise, 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 and the resolution of the uncertainty due to the accounting report.