S.P. Kothari () (MIT Sloan School of Management) Karthik Ramanna () (Harvard Business School, Accounting and Management Unit) Douglas J. Skinner () (University of Chicago Booth School of Business)
Abstract
Based on extant literature, we articulate a positive theory of GAAP under the assumption that the objective is to facilitate the efficient allocation of capital within an economy. The theory predicts that GAAP's principal focus, as shaped by the demand for and supply of financial information, is on the use of the income statement and balance sheet for performance measurement and control (stewardship). This is consistent with efficient contracting considerations guiding financial reporting. Financial reports produced under this model also generate information useful for equity valuation but this is not the primary objective. Thus, artificially imposing equity valuation as the primary objective of financial reporting standards will result in GAAP rules that are unlikely to serve stakeholders' needs. The theory allows us to compare and contrast extant GAAP, as observed in a regulated setting, with GAAP that might arise endogenously as a result of market forces. Building on previous research, we argue that verifiability and conservatism, while detracting from accounting's role in equity valuation, are critical features of GAAP under efficient contracting. We recognize the advantage of using fair values in circumstances where these are based on observable prices in liquid secondary markets but caution against expanding fair values to financial reporting more generally. We conclude that rather than converging U.S. GAAP with IFRS, competition between the FASB and the IASB would allow GAAP to better respond to market forces.
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