REVISION: Where Does the Information in Mark-to-Market Come From?
We study the effects of mark-to-market accounting (MTM) on banks’ loan origination and retention decisions. We point out a conceptual shortcoming of MTM. Loan prices are informative in equilibrium but this price discovery is sustained by the good banks’ costly retention. The attempt to exploit the information in equilibrium prices through MTM makes price discovery more costly or even impossible. We show that, relative to historic cost accounting (HC), MTM has three consequences. First, it improves the accuracy of loan valuation ex post. Second, it forces the good banks to retain even more risk exposure on their balance sheet. Finally, it can reduce ex-ante origination efforts. To the extent that a lower loan quality and banks’ excessive risk exposure are two important ingredients for financial crises, we identify one mechanism through which MTM could contribute to financial crises.
REVISION: Accounting Manipulation, Peer Pressure, and Internal Control
We study firms' investment in internal control to reduce accounting manipulation. We first show the peer pressure for manipulation: one manager manipulates more if he suspects reports of peer firms are more likely to be manipulated. As a result, one firm's investment in internal control has a positive externality on peer firms. It reduces its own manager's manipulation, which in turn mitigates the manipulation pressure on managers in peer firms. Firms don't internalize this positive externality and thus under-invest in their internal control over financial reporting. The under-investment problem provides one justification for regulatory intervention in firms' internal control choices.
New: Reporting Discretion, Market Discipline, and Panic Runs
This paper investigates the economic consequences of a financial institution’s reporting discretion in the context of bank runs. A fundamental-based run imposes market discipline on insolvent institutions, but a panic-based run shuts down institutions that could have survived with better coordination among investors. We augment a bank-run model with the financial institution’s discretion over reporting to investors. We show that reporting discretion reduces panic runs, but excessive reporting discretion weakens the market discipline. Moreover, one institution’s opportunistic use of reporting discretion exerts a negative externality on others.
New: Optimal Thresholds in Accounting Recognition Standards
This paper investigates the design of recognition thresholds in accounting standards. In statistics, a threshold classi.es evidence to balance two types of recognition errors weighted by their respective costs to a decision maker. In accounting recognition standards, a threshold induces firms to respond strategically and thus affects the very distribution of evidence the threshold classi.es. With this strategic effect, the optimal recognition threshold is determined by not only the decision maker’s loss function but also the transaction’s features. We compare the optimal threshold’s properties under the statistical and strategic approaches, provide their respective empirical predictions, and discuss the limitations of using a statistical approach to guide accounting standard setting.
REVISION: A Measurement Approach to Conservatism and Earnings Management
This paper develops a model of accounting measurement to study the design of the optimal measurement rule. The core of the model is a representation of accounting measurement process that features the manager’s opportunistic influence and the use of verification as a response. To safeguard against the manager’s ex post opportunism, the optimal measurement rule is conservative in the sense that it requires more verification of the transaction characteristics favorable to the manager. The ...
REVISION: Informational Feedback Effect, Adverse Selection, and the Optimal Disclosure Policy
Trading in a secondary stock market not only redistributes wealth among investors but also generates information that guides subsequent investment. We provide a positive theory of disclosure that reflects both functions of a secondary market. By making private information public, disclosure reduces private information acquisition and levels the playing field. However, a leveled playing field has two opposite effects on firm value. On one hand, it ameliorates adverse selection among investors ...
New: Economic Consequences of Idiosyncratic Information in Diversified Markets
While most accounting information is idiosyncratic in nature, economy-wide factors such as accounting standards affect the quality of idiosyncratic accounting information of many firms simultaneously. We study idiosyncratic and systematic features of accounting information by embedding a parsimonious, moral hazard problem into the framework of a multi-firm economy. Our model yields the insight that moral hazard distorts the sharing of idiosyncratic risk but does not affect the sharing of ...
REVISION: Disclosure Quality, Cost of Capital, and Investors' Welfare
One might expect that disclosure quality improves investor welfare by reducing cost of capital. This study shows that the argument is valid only in limited circumstances. Based on a production economy with perfect competition among investors, the analysis demonstrates three points. First, cost of capital could increase with disclosure quality when new investment is sufficiently elastic. Second, there are plausible conditions under which disclosure quality reduces the welfare of current and/or ...
New: Keynesian Beauty Contest, Accounting Disclosure, and Market Efficiency
This paper examines the market efficiency consequences of accounting disclosure in the context of stock markets as a Keynesian beauty contest, an influential metaphor originally proposed by Keynes (1936) and recently formalized by Allen, Morris, and Shin (2006). In such markets, public information plays an additional commonality role, biasing stock prices away from the consensus fundamental value toward public information. Despite this bias, I demonstrate that provisions of public ...
REVISION: Keynesian Beauty Contest, Accounting Disclosure, and Market Efficiency
This paper examines the market efficiency consequences of accounting disclosure in the context of stock markets as a Keynesian beauty contest, an influential metaphor originally proposed by Keynes (1936) and recently formalized by Allen, Morris, and Shin (2006). In such markets, public information plays an additional coordination role, biasing stock prices away from the consensus fundamental value toward public information. Despite this bias, I demonstrate that provisions of public ...