Uniform Versus Discretionary Regimes in Reporting Information with Unverifiable Precision and a Coordination Role

• Published date: 01 March 2017
• Author: TRACY R. LEWIS,KATHERINE SCHIPPER,QI CHEN,YUN ZHANG
• DOI: http://doi.org/10.1111/1475-679X.12130
• Date: 01 March 2017

DOI: 10.1111/1475-679X.12130

Journal of Accounting Research

Vol. 55 No. 1 March 2017

Printed in U.S.A.

Uniform Versus Discretionary

Regimes in Reporting Information

with Unverifiable Precision

and a Coordination Role

QI CHEN,

∗TRACY R. LEWIS,

∗KATHERINE SCHIPPER,

∗

AND YUN ZHANG

†

Received 12 January 2015; accepted 4 April 2016

ABSTRACT

We examine uniform and discretionary regimes for reporting information

about firm performance from the perspective of a standard setter, in a set-

ting where the precision of reported information is difficult to verify and the

reported information can help coordinate decisions by users of the informa-

tion. The standard setter’s task is to choose a reporting regime to maximize

the expected decision value of reported information for all users at all firms.

The uniform regime requires all firms to report using the same set of re-

porting methods regardless of the precision of their information, and the

discretionary regime allows firms to freely condition their sets of reporting

∗Duke University; †George Washington University.

Accepted by Haresh Sapra. The authors acknowledge financial support from the Fuqua

School of Business at Duke University; Yun Zhang acknowledges financial support from

the George Washington University School of Business. We thank three anonymous referees

for their constructive comments. We received helpful comments from Nageeb Ali, Ricardo

Alonso, Scott Baker, Darrel Cohen, Marcello D’Amato, Ron Dye, Paul Fischer, Bjorn Jor-

gensen, Chandra Kanodia, Navin Kartik, Rachel Kranton, David McAdams, Justin McCrary,

Debbie Minehart, Heikki Rantakari, Dan Runbinfeld, Suzanne Scotchmer,Joel Sobel, Eric Tal-

ley, Joel Watson, Michael Woodford, Huseyin Yildirim, and seminar participants at Boalt Law

School, Boston University, the Chicago-Minnesota Accounting Theory Conference, Carnegie

Mellon University, Department of Justice, Duke University, George Washington University,

Marshall School at USC, Shanghai University of Finance and Economics, Tsinghua University,

and UCSD. We thank Zeqiong Huang for excellent research assistance.

153

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

154 Q.CHEN,T.R.LEWIS,K.SCHIPPER,AND Y.ZHANG

methods on the precision of their information. We show that when unver-

ifiable information precision varies across firms and users’ decisions based

on reported information have strong strategic complementarities, a uniform

regime can have a beneficial social effect as compared to a discretionary

reporting regime. Our analysis generates both normative and positive im-

plications for evaluating the necessity and effectiveness of reporting under

standards.

JEL codes: M41; M48; D78; D82; K22

Keywords: accounting standards; discretion; coordination; unverifiability

1. Introduction

An important role of accounting standards is to make firms’ disclosed

information accessible to investors, so that the information can assist

decision-making by the maximum number of users of firms’ financial

reports.1For example, the conceptual framework of the Financial Ac-

counting Standards Board (FASB) states that the objective of standards

is to “seek to provide the information set that will meet the needs of

the maximum number of primary users” (FASB (2010; para OB2-OB5,

OB8; para QC35-QC38)); the conceptual framework of the International

Accounting Standard Board (IASB) states a similar objective. Standards

achieve the objective by restricting how firms report information, for ex-

ample, by defining financial statement elements such as assets, specifying

permissible measurement rules, and standardizing presentation formats

and classifications. The justification for these restrictions rests on two

assumptions. First, only a limited set of reporting choices can achieve

the stated objective; second, absent these restrictions, firms may have

incentives to choose reporting methods (e.g., complicated presentation

formats or complex measurement approaches) that produce disclosures

that can be analyzed, understood, and utilized by only a subset of investors,

even though the disclosures themselves are publicly available to all.

In this paper, we take the first assumption as given2and focus on the

second assumption, which speaks to the desirability and consequences of

reporting under standards. On the one hand, reporting under standards is

1We define a disclosure/reported signal as accessible to an investor if, with nonzero prob-

ability, the signal affects the investor’s decision-making, that is, the investor is able to analyze,

interpret, and use the signal.

2Webelieve the first assumption is supported by previous research suggesting that reporting

choices, for example, presentation formats and measurement attributes, affect users’ ability to

comprehend and hence use firms’ disclosures. One posited reason is limited attention (Hir-

shleifer and Teoh [2003], Sims [2006]). For supporting evidence, see, for example, Harper,

Mister, and Strawser [1987, 1991], Hirst and Hopkins [1998], Hodder, Hopkins, and Wood

[2008], Hopkins [1996], Hodge, Hopkins, and Wood [2010], Sami and Schwartz [1992],

and Wilkins and Zimmer [1983]. From the firms’ perspective, Engel, Erickson, and Maydew

[1999], Gramlich, McAnally, and Thomas [2001], and McVay [2006], among others, suggest

that firms are willing to incur the cost of managing the location of information in financial

statements.

UNIFORM AND DISCRETIONARY REPORTING REGIMES 155

costly and possibly even undesirable because standards reduce firms’ discre-

tion to tailor reporting to their specific environments and thereby poten-

tially reduce the usefulness of reported information (e.g., Sunder [2010]).

On the other hand, even when firms have incentives to provide decision-

useful information, market frictions can prevent the market equilibrium

from achieving the desired outcome of assisting the decision-making of the

maximum number of users. Understanding these frictions can help stan-

dard setters, researchers, and others evaluate the necessity and effective-

ness of financial reporting standards, and shed light on the boundary of

standards, meaning what type of information should be reported under

the authoritative guidance of standards and what type of information firms

should be permitted free choice as to how to report.

We contribute to the debate on the desirability and consequences of fi-

nancial reporting standards by studying a setting where we can directly

assess a tradeoff at the center of the debate: the cost of reduced report-

ing discretion and the benefit of improving the accessibility of reported

information so that the maximum number of users can use it for decision-

making. In contrast to certain securities laws that specify whether firms must

reveal certain information, our analysis concerns reporting standards that

govern how, not whether, firms report performance-related information.

We aim to identify conditions under which imposing restrictive reporting

standards for all firms can help achieve higher social welfare than the alter-

native, and to gain insight into the nature of the restrictions that standards

should impose. We focus on standards/rules that restrict how firms report

information in order to maximize information accessibility, and show that

these types of standards can arise as a socially optimal response to the ex-

ternality firms impose on each other when they are permitted to choose

their reporting behaviors in a purely discretionary reporting regime (East-

erbrook and Fischel [1991]). Our analysis identifies two features of the fi-

nancial reporting environment that can give rise to this externality. First,

multiple investors use the reported information to make decisions (e.g.,

whether to invest in securities) and their decisions exhibit strategic com-

plementarities (Morris and Shin [2002]).3Second, the precision of the re-

ported information is unverifiable and is privately observed by firms.

3Investors’ decisions exhibit strategic complementarities when the marginal payoff for an

individual investor’s action is increasing in the average decision of all other investors. For ex-

ample, investors in a secondary market for a firm’s securities will be more willing to invest

if they believe other investors will likely do the same and therefore create a liquid market.

The importance of strategic complementarities in financial markets has long been recog-

nized, both at the firm-level by affecting firms’ liquidity and financial constraints (e.g., He

and Xiong [2012a, b]) or firms’ stock price efficiency (e.g., Allen, Morris, and Shin [2006],

Gao [2008], Chen, Huang, and Zhang [2014]) and at the macro-level by affecting overall fi-

nancial market stabilities (e.g., Diamond and Dybvig [1983], Goldstein and Pauzner [2005],

Amador and Weill [2010], Goldstein, Ozdenoren, and Yuan [2011]). We use the terms “in-

vestors” and “users” interchangeably to refer to current and potential equity investors and

creditors, including possibly providers of trade credit.