Money Illusion and the Effect of Reporting Components of Accounting Estimates on Financial Statement Users’ Investment Decisions

Abstract

We hypothesize current financial reporting standards contribute to “money illusion,” in which investors overemphasize nominal cash flows and underemphasize effects of discount rates on valuation. We test our predictions in two experiments using a pool of professional and nonprofessional investors. In the first experiment we vary whether a change in the fair value of debt securities is reported in Net Income or Other Comprehensive Income. We find participants knowledgeable about U.S. GAAP are more (less) likely to attribute fair value changes presented in Net Income (Other Comprehensive Income) to changes in expected nominal cash flows. The perception that such changes are attributable to changes in expected nominal cash flows increases investors’ risk assessments, resulting in lower assessments of value. In a second experiment, we confirm money illusion as the mechanism behind our findings in Experiment 1. We find investor valuations are lower when a negative change in fair value is caused by a decrease in expected nominal cash flows relative to an increase in the discount rate, and that this effect is partially mediated through risk perceptions. Overall, our results provide evidence of a structural mechanism in accounting standards that contributes to money illusion, potentially leading financial statement users to lower-quality investment decisions. Our results have implications for accounting standard setters as well as financial statement users.

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

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