Signaling Private Information via Accounting System Design

45 Pages Posted: 2 Apr 2020 Last revised: 18 Oct 2022

See all articles by Aysa Dordzhieva

Aysa Dordzhieva

University of Texas at Austin

Volker Laux

University of Texas at Austin - McCombs School of Business

Ronghuo Zheng

University of Texas at Austin - McCombs School of Business

Date Written: March 21, 2022

Abstract

This paper shows that firms that wish to raise capital from external investors can signal favorable private information about their long-term prospects by publicly adopting a liberal accounting system that increases the probability of an overstated financial report. All else equal, the liberal bias deteriorates investors' ability to make efficient investment decisions, which increases the firm's cost of raising capital as investors price protect. But the very fact that the firm is willing to adopt such a bias signals booming long-term prospects, which ultimately allows the firm to raise capital at more favorable terms. We also study the effects of accounting standards that require firms to generate unbiased financial reports. Unbiased reporting leads to efficient investment decisions but prevents firms from signaling their private information, which reduces their ex ante incentive to take costly actions that improve long-term prospects. We find that giving firms discretion over reporting choices is optimal in innovative industries, whereas enforcing unbiased reporting is optimal in traditional industries.

Keywords: Information System Design; Accounting Bias; Signaling

JEL Classification: D82; G30; M41

Suggested Citation

Dordzhieva, Aysa and Laux, Volker and Zheng, Ronghuo, Signaling Private Information via Accounting System Design (March 21, 2022). Journal of Accounting & Economics (JAE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=3551562 or http://dx.doi.org/10.2139/ssrn.3551562

Aysa Dordzhieva

University of Texas at Austin ( email )

2317 Speedway
Austin, TX Texas 78712
United States

Volker Laux (Contact Author)

University of Texas at Austin - McCombs School of Business ( email )

2317 Speedway
Austin, TX Texas 78712
United States

Ronghuo Zheng

University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

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