Inflation and the Effect of Reporting Nominal Components of Accounting Estimates on Financial Statement Users' Valuation Judgments

Abstract

Financial reports help investors make capital allocations by providing information about the amount, timing, and uncertainty of future cash flows. However, inflation adjustments are largely absent from published financial statements, and prior research suggests investors underweight inflation risk in their valuations. We examine the extent to which characteristics common to financial reporting influence the likelihood financial statement users underweight effects of inflation in their valuation judgments. In a stylized experiment, we find that increasing the prominence of separately labeled changes in the cash flow and discount rate components of fair values increases investors’ underweighting of the inflation-affected discount rate component. In a second experiment, we provide evidence that accounting rules requiring separation of cash flow and discount rate components of accounting estimates diminish the quality of investors’ valuation judgments with respect to inflation. Collectively, our results suggest deemphasizing disaggregation of fair value components can help investors more properly incorporate inflation into their valuation judgments.

Keywords: Fair Values, Money Illusion, Inflation, Financial Securities, Cash Flow, Discount Rate

JEL Classification: M40, M41, E03, G11, G02