Accounting Standard Setting and Investor's Learning

Abstract

This paper examines how the investor's belief about the project's ability of generating cash flow affects accounting standard setting. It proves analytically that the accounting standard in the Stackelberg equilibrium of the static model increases with the increase in the investor's belief about the upper bound of the project's ability of generating cash flow. In addition, assuming that the investor revises his belief upwards about the upper bound of the project's ability of generating cash flow based on the past realizations of the project's ability of generating cash flow, and assuming that the standard setters revise the accounting standard accordingly with a cost, this paper proves that with probability one, as time goes to infinity, the investor's belief about the upper bound of the project's ability of generating cash flow converges to the true one and the accounting standard in the Stackelberg equilibrium converges to a number smaller than the one in the static model. In the limit, the investor becomes informed about the upper bound of the project's ability of generating cash flow and a higher expected value of the investment project is achieved.