Asset Revaluation Regulations*

Abstract

Generally accepted accounting principles (GAAP) provide a vast array of revaluation requirements, including lower of cost or market for inventory, net realizable value for receivables, a less restrictive variant of lower of cost or market for longlived assets, and fair value for a variety of financial instruments. We examine a simple model with endogenous investment in which any one of these revaluation policies can maximize welfare, depending on regulatory objectives and model parameters. Thus, standard economic considerations can produce GAAP with a wide variety of revaluation requirements. The central feature of the model is a lemons problem (Akerlof 1970) where an entrepreneur acquires an asset and then privately observes value-relevant information before the asset resale market opens. Some entrepreneurs are forced by liquidity concerns to liquidate their holdings, while others may opportunistically impersonate those who are liquidity-constrained. This potential impersonation and private valuation information together create a lemons problem in the resale market. The prospect of this lemons problem can affect investment incentives, as entrepreneurs anticipate mispricing of assets and recognize that if they ultimately become liquidityconstrained they may be unable to earn a reasonable return on their investment.1 In principle, mandated revaluation of assets (in effect, movement away from historical cost) can lead to more accurate pricing, protect distressed entrepreneurs, and enhance incentives for investment. However, revaluation regulations also can impose costs on affected entrepreneurs and can induce investment distortions. The optimal design of revaluation regulations requires a careful balancing of these benefits and costs. Our model provides three primary qualitative conclusions in a setting where risk-neutral entrepreneurs face identical stochastic investment opportunities. First, when the level of initial investment is readily observed, the revaluation policy that maximizes aggregate expected surplus imposes no revaluation requirement whatsoever. This is the case because the losses that the lemons problem imposes on distressed entrepreneurs are exactly offset by the opportunistic gains that it affords