Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency

45 Pages Posted: 19 Jun 2005

See all articles by Pierre Jinghong Liang

Pierre Jinghong Liang

Tepper School of Business, Carnegie Mellon University

Xiaoyan Wen

Texas Christian University

Multiple version iconThere are 2 versions of this paper

Date Written: February 2006

Abstract

In this paper, we investigate how the accounting measurement basis affects the capital market pricing of a firm's shares, which, in turn, affects the efficiency of the firm's investment decisions. We distinguish two broad bases for accounting measurements: input-based and output-based accounting. We argue that the structural difference in the two measurement bases leads to a systematic difference in the efficiency of the investment decisions. In particular, we show that an output-based measure has a natural advantage in aligning investment incentives because of its comprehensiveness. The (first-) best investment is achieved when the output-based measure is noiseless and manipulation-free. In addition, under an output-based measure, more accounting noise/manipulation always leads to more inefficient investment choices. Therefore, if an output-based measures is highly noisy and easy to manipulate in practice, the induced investment efficiency can be quite low. On the other hand, an input-based measure, while not as comprehensive, may induce more efficient investment decisions than an output-based measure if some noise is unavoidable in either measure. The reason is two-fold. First, input-based measures may be associated with less noise and limited manipulation in practice. Second and more importantly, we show that under an input-based measure, a slight increase in accounting noise/manipulation may lead to more efficient investment choices. In fact, the (first-) best result is achieved when the noise/manipulability is small but positive. In other words, for an input-based measure, being less comprehensive makes small but positive accounting noise/manipulability desirable. Two extensions of the basic model are also explored.

Keywords: Accounting Measurement Basis, Investment Efficiency, Input-based Measures, Output-based Measures

JEL Classification: M41, M43, G31

Suggested Citation

Liang, Pierre Jinghong and Wen, Xiaoyan, Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency (February 2006). Available at SSRN: https://ssrn.com/abstract=744085 or http://dx.doi.org/10.2139/ssrn.744085

Pierre Jinghong Liang (Contact Author)

Tepper School of Business, Carnegie Mellon University ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
412-268-3315 (Phone)
412-268-6837 (Fax)

HOME PAGE: http://www2.tepper.cmu.edu/andrew/liangj

Xiaoyan Wen

Texas Christian University ( email )

M.J. Neeley School of Business
TCU Box 298530
Fort Worth, TX 76129
United States

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