28.10.2015

The Uneven Benefits of Improved Accounting Standards

ZHANG, Guochang

Accounting standards matter to investment both at the individual firm and market levels. When accounting standards improve, then the benefits should extend to all economic organizations and agents. But research by Guochang Zhang shows there may be winners and losers among individual firms even as the economic performance of the market as a whole improves.

He came to that conclusion after developing a theoretical model to show how the quality of accounting standards affects real investment and welfare.

The unequal impact among firms arises because changes to accounting standards revise the “hurdle rates” for firms seeking investment. A firm’s hurdle rate depends on the risks stemming from both accounting measurement errors and economic uncertainty. Firms with different combinations of these two sources of risk can have the same hurdle rate, but when accounting standards improve, the balance is tilted; the hurdle rate then changes, but by different amounts for different firms.

As accounting standards improves and hence measurement errors go down, projects offering a return that was somewhat below the previous hurdle rate now become acceptable. This causes the total market portfolio to expand, and consequently triggers a re-ranking of projects in the economy.

So, even as improved accounting standards expand the real economy and reduce the cost of capital for the overall economy, firms in certain risk classes can end up with higher costs of capital and lower values, while others end up better off.

“The reallocation of capital causes some previously rejected projects to enter the real economy and some previously accepted ones to be crowded out,” Professor Zhang said. “Higher accounting standards also lower the cost of capital for some firms and raise it for others. Thus, firms are differentially affected by accounting standard changes, with both winners and losers emerging.”

The findings are particularly significant because whereas previous research has focused mostly on firm-level effects, this study addresses the macro-level impact of improved accounting standards. It has important implications for policymakers.

“The results suggest it may be impossible to implement accounting rules and policies that will receive the unanimous support of all businesses in an economy, even in situations where welfare unambiguously increases. Standard-setters should be aware that a change in standards may actually act as a force to systematically divert resources from some parts of an economy to others,” Professor Zhang said.

This can also happen in different settings than the model used here, which is based on a perfect capital market where investors possess uniform information and fully diversify their investment portfolios.

“For example, in a market with differentially informed investors, the precision of financial reporting information as well as the difference in information possessed by individual investors, have consequences for the cost of capital.

“Idiosyncratic errors can also play a role in the design of compensation and compensation contracts because contracting parties, such as company managers and creditors, typically hold a concentrated stake in a firm and are unable to fully diversify risks.

“Therefore, when it comes to formulating financial reporting standards, standard-setters need to take into account the many effects of accounting quality that are transmitted through different channels to impact financial and real activities, including the effect through investment hurdle rates, and strike a proper balance between them.” And hopefully move closer to standards that are good for every firm, as well as all firms combined.