The influence of uncertainty on the standard-setting decision between fair value and historical cost accounting under asymmetric information

The design of accounting rules by the international standard-setters takes place by considering a trade-off between relevance and reliability. An example for this trade-off is the standard-setting decision between fair value accounting—associated with more relevant information—and historical cost accounting—associated with more reliable information. This paper examines in which way the decision of a standard-setter between fair value and historical cost accounting is influenced by the uncertainty of the underlying assets, if the standard-setter wants to minimize the social costs of his standard-setting decision. As a first step this paper uses a common signaling model: Good firms—i.e. firms with high expected cash flows in the future—signal their firm type to an analyst by using discretionary accruals to manage earnings. As a second step the resulting signaling costs are compared with the analyst’s costs for determining the firm type by using his own valuation technology. The standard-setter chooses the accounting rule that minimizes the social costs.