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Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency

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  • PIERRE JINGHONG LIANG
  • XIAOYAN WEN

Abstract

In this paper, we investigate how the accounting measurement basis affects the capital market pricing of a firm's shares, which, in turn, affects the efficiency of the firm's investment decisions. We distinguish two broad bases for accounting measurements: input‐based and output‐based accounting. We argue that the structural difference in the two measurement bases leads to a systematic difference in the efficiency of the investment decisions. In particular, we show that an output‐based measure has a natural advantage in aligning investment incentives because of its comprehensiveness. The (first‐)best investment is achieved when the output‐based measure is noiseless and manipulation free. In addition, under an output‐based measure, more accounting noise/manipulation always leads to more inefficient investment choices. Therefore, if an output‐based accounting measure is highly noisy and easy to manipulate in practice, the induced investment efficiency can be quite low. On the other hand, an input‐based accounting measure, while not as comprehensive, may induce more efficient investment decisions than an output‐based measure if some noise is unavoidable in either measure. The reason is twofold. First, input‐based measures may be associated with less noise and limited manipulation in practice. Second, and more importantly, we show that under an input‐based measure, a slight increase in accounting noise/manipulation may lead to more efficient investment choices. In fact, the (first‐)best result is achieved when the noise/manipulability is small but positive. In other words, for an input‐based measure, being less comprehensive makes small but positive accounting noise/manipulability desirable. Two extensions of the basic model are also explored.

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  • Pierre Jinghong Liang & Xiaoyan Wen, 2007. "Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency," Journal of Accounting Research, Wiley Blackwell, vol. 45(1), pages 155-197, March.
    • Handle: RePEc:bla:joares:v:45:y:2007:i:1:p:155-197
    DOI: 10.1111/j.1475-679X.2007.00227.x
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    1. Jeremy C. Stein, 1989. "Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 104(4), pages 655-669.
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    3. Ronald A. Dye, 2002. "Classifications Manipulation and Nash Accounting Standards," Journal of Accounting Research, Wiley Blackwell, vol. 40(4), pages 1125-1162, September.
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    5. Guoming Lai & Wenqiang Xiao, 2018. "Inventory Decisions and Signals of Demand Uncertainty to Investors," Manufacturing & Service Operations Management, INFORMS, vol. 20(1), pages 113-129, February.
    6. William Bradford & Chao Chen & Song Zhu, 2017. "Conservative Accounting, IFRS Convergence and Cash Dividend Payments: Evidence from China," European Financial Management, European Financial Management Association, vol. 23(3), pages 376-414, June.
    7. Vladu Alina Beattrice, 2013. "FAIR VALUE MEASUREMENT IN AGRICULTURE AND THE POTENTIAL TO MISLEAD Abstract: Applying fair value measurement to tangible and intangible assets in agriculture cannot be risk free. Twofold reasons can b," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 5, pages 95-98, October.
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    13. Shen, Huayu & Zheng, Shaofeng & Xiong, Hao & Tang, Wenjie & Dou, Jiachun & Silverman, Henry, 2021. "Stock market mispricing and firm innovation based on path analysis," Economic Modelling, Elsevier, vol. 95(C), pages 330-343.
    14. Malgorzata Wegrzynska & Alina Nowotarska, 2021. "Measuring and Valuation of Biological Assets: A Research Study," European Research Studies Journal, European Research Studies Journal, vol. 0(2), pages 331-345.
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