A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research

• Published date: 01 May 2016
• Author: CHANDRA KANODIA,HARESH SAPRA
• Date: 01 May 2016
• DOI: http://doi.org/10.1111/1475-679X.12109

DOI: 10.1111/1475-679X.12109

Journal of Accounting Research

Vol. 54 No. 2 May 2016

Printed in U.S.A.

A Real Effects Perspective to

Accounting Measurement and

Disclosure: Implications and

Insights for Future Research

CHANDRA KANODIA

∗AND HARESH SAPRA

†

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 effi-

ciency? (2) How does the measurement and disclosure of a firm’s derivative

transactions affect a firm’s choice of intrinsic risk exposures, risk manage-

ment strategy, and the incentive to speculate? (3) How could marking-to-

market the asset portfolios of financial institutions generate procyclical 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.

JEL codes: D82; D84; G14; G18; G30; M41; M42

Keywords: real effects; disclosure; accounting measurement; accounting

standards; transparency; price efficiency; economic efficiency

∗Carlson School of Management, University of Minnesota; †Booth School of Business, Uni-

versity of Chicago.

Accepted by Christian Leuz. We have benefitted from comments by Philip Bond, Matthias

Breuer,Ron Dye, Rick Lambert, Korok Ray, Doug Skinner, and participants at the 2015 Journal

of Accounting Research Conference. Haresh Sapra is grateful to the University of Chicago, Booth

School of Business, for financial support.

623

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

624 C.KANODIA AND H.SAPRA

1. Introduction

1.1 THE REAL EFFECTS HYPOTHESIS

The real effects hypothesis states that the measurement and disclosure rules

that govern the functioning of accounting systems—which economic trans-

actions 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 fundamen-

tally 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 2008–2009 financial crisis. Many

influential practitioners argued that mark-to-market accounting for the as-

sets of financial institutions significantly exacerbated the downward spiral

in the economy, while defenders of fair value accounting argued that ac-

counting 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. Pro-

viding information that is useful to investors and the principle of “rep-

resentational 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 cor-

relations 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.1Towards this end, the objec-

tives of this paper are as follows: (1) examine some specific accounting

1In a similar vein, Leuz and Wysocki [2016] call for more research on firm behavior, rather

than investor behavior or capital market behavior,in response to new disclosure requirements.

ACCOUNTING MEASUREMENT AND DISCLOSURE 625

measurements from the perspective of understanding the nature of real ef-

fects they could give rise to, (2) analyze the necessary economic forces that

would drive such real effects, and (3) explore the insights that such real

effects provide to guide the development of accounting standards. We syn-

thesize and extend the relevant analytical literature and draw upon related

empirical findings to make our arguments.

1.2 ALTERNATIVE PERSPECTIVES ON THE REAL EFFECTS OF INFORMATION

Accounting measurements could affect real decisions in many ways. In-

formation 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 theo-

retic analysis of information has a long history in economics and account-

ing (see Pratt, Raiffa, and Schlaifer [1965], Feltham [1968], Feltham and

Demski [1970], 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 deci-

sion maker. When a corporate manager is required to disclose, it is pre-

sumed 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 deci-

sions that these corporate managers make on behalf of the firm?

Even this more specialized question has many possible answers. We

sketch some of the more commonly used perspectives in the literature,

before focusing on the particular perspective that we pursue. The exten-

sive literature on agency and contracting provides one intuitively appeal-

ing perspective on how the information available to outsiders would af-

fect corporate decisions. When the incentives of corporate managers are

a priori misaligned with the preferences of shareholders, as they typically

are, or when the preferences of equity holders are misaligned with those

of creditors and other suppliers (Jensen and Meckling [1976]), there is a

need for compensation contracts contingent on performance and on vari-

ous economic events, and a need for covenants that allocate control rights.

Many of the variables on which covenants and contractual contingencies

are written, such as a firm’s earnings, owners equity, and debt-to-asset ra-

tios, are provided by accounting measurements. When such measurements

are carried out in accordance with well-defined measurement rules, they

become verifiable and contractible. Thus, accounting measurements and

disclosure help to alleviate problems of moral hazard and adverse selec-

tion, and thereby affect real decisions and resource allocation. A seminal

result in Holmstrom [1979] asserts that any measurement, no matter how

noisy, that contains incremental information about an agent’s hidden ac-

tions adds value by making contracts more efficient. There is a considerable