The Economic Consequences of Expanding Accounting Recognition

Abstract

This article investigates the economic consequences of including more hard-to-measure future activities in a firm’s accounting measurements. Using a simple model of endogenous investment in which payoffs are measured by either a restrictive or expanded recognition rule, we show that, in the process of expanding accounting recognition, firms’ internal investment efficiency and external share-price risk premium may not necessarily be a trade-off. In particular, we show that the consequences of an accounting scope expansion depend on the investment environment (e.g., growth prospects) and the inherent measurement characteristics (e.g., measurement noise). For example, even with a higher measurement noise, an expanded accounting recognition may generate a lower risk premium in the share price. More surprisingly, it may lead to a higher investment efficiency and a lower risk premium at the same time. The underlying driving force is that different accounting regimes can affect the risk premium indirectly through their impacts on the investment level, beyond directly through the different measurement noise levels they bring.