Download this Paper Open PDF in Browser

Accounting, Finance and Adverse Selection: Illustrations and Applications

37 Pages Posted: 11 Sep 2010  

Murali Jagannathan

State University of New York (SUNY) at Binghamton

Steven Schwartz

SUNY at Binghamton - School of Management

Joshua D. Spizman

Loyola Marymount University - Department of Finance and Computer Information Systems

Richard A. Young

Ohio State University (OSU) - Department of Accounting & Management Information Systems

Date Written: September 9, 2010

Abstract

Accounting is often viewed from a legalistic rather than economic perspective. Finance, on the other hand, is deeply rooted in economic theory, but at its heart is built on assumptions of frictionless markets. Neither perspective fully incorporates the rich economic environment in which we find the practice of accounting and finance; a market setting rife with information inefficiencies. We illustrate and review one such inefficiency, adverse selection. Adverse selection results when market participants have different levels of information about an attribute of payoff relevance. In such cases, less informed parties transact in a market where the profile of assets for sale or employees for hire is worse than the population as a whole. In general, adverse selection causes a loss of social welfare and, in extreme cases, may cause the breakdown of an entire market. Each illustration is based on one of the seminal papers written by the Nobel Laureates of 2001, recognized for their work on adverse selection. We then trace the insights into the accounting and finance literatures. We consider both disciplines jointly, because accounting information is often useful in mitigating the market inefficiencies studied in finance.

Keywords: Adverse Selection, Information Asymmetry, Auditing

JEL Classification: D82

Suggested Citation

Jagannathan, Murali and Schwartz, Steven and Spizman, Joshua D. and Young, Richard A., Accounting, Finance and Adverse Selection: Illustrations and Applications (September 9, 2010). Available at SSRN: https://ssrn.com/abstract=1674597 or http://dx.doi.org/10.2139/ssrn.1674597

Murali Jagannathan

State University of New York (SUNY) at Binghamton ( email )

P.O. Box 6015
Binghamton, NY 13902-6015
United States
607-777-4639 (Phone)

Steven Schwartz (Contact Author)

SUNY at Binghamton - School of Management ( email )

P.O. Box 6015
Binghamton, NY 13902-6015
United States

Joshua D. Spizman

Loyola Marymount University - Department of Finance and Computer Information Systems ( email )

Los Angeles, CA 90045
United States
(310) 338-2902 (Phone)

Richard A. Young

Ohio State University (OSU) - Department of Accounting & Management Information Systems ( email )

2100 Neil Avenue
Columbus, OH 43210
United States
614-292-0889 (Phone)
614-292-2118 (Fax)

Paper statistics

Downloads
659
Rank
32,051
Abstract Views
3,137