Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency

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 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. In addition, under an output-based measure, more accounting noise/manipulation always leads to more inefficient investment choices. Therefore, if an output-based measures is highly noisy and easy to manipulate in practice, the induced investment efficiency can be quite low. On the other hand, an input-based measure, while not as comprehensive, may induce more efficient investment decisions than an output-based measure if some noise is unavoidable in either measure. The reason is two-fold. First, input-based measures may be associated with less noise and limited manipulation in practice. Second and more importantly, we show that under an input-based measure, 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. Two extensions of the basic model are also explored.