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Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency




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 accounting measure is highly noisy and easy to manipulate in practice, the induced investment efficiency can be quite low. On the other hand, an input-based accounting 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 twofold. 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. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2007.

Suggested Citation

  • Pierre Jinghong Liang & Xiaoyan Wen, 2007. "Accounting Measurement Basis, Market Mispricing, and Firm Investment Efficiency," Journal of Accounting Research, Wiley Blackwell, vol. 45(1), pages 155-197, March.
  • Handle: RePEc:bla:joares:v:45:y:2007:i:1:p:155-197

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    Cited by:

    1. Guoming Lai & Laurens Debo & Lin Nan, 2011. "Channel Stuffing with Short-Term Interest in Market Value," Management Science, INFORMS, vol. 57(2), pages 332-346, February.
    2. Josep Ma. Argiles (UB) & Josep Garcia Bladon (IQS) & Teresa Monllau (UPF), 2009. "Fair value versus historic cost Valuation for Biological assets: Implications for the quality of financial information," Working Papers in Economics 215, Universitat de Barcelona. Espai de Recerca en Economia.
    3. repec:eee:spacre:v:15:y:2012:i:1:p:109-142 is not listed on IDEAS
    4. Vladu Alina Beattrice, 2013. "FAIR VALUE MEASUREMENT IN AGRICULTURE AND THE POTENTIAL TO MISLEAD Abstract: Applying fair value measurement to tangible and intangible assets in agriculture cannot be risk free. Twofold reasons can b," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 5, pages 95-98, October.
    5. Beatty, Anne & Liao, Scott, 2014. "Financial accounting in the banking industry: A review of the empirical literature," Journal of Accounting and Economics, Elsevier, vol. 58(2), pages 339-383.
    6. Guoming Lai & Wenqiang Xiao & Jun Yang, 2012. "Supply Chain Performance Under Market Valuation: An Operational Approach to Restore Efficiency," Management Science, INFORMS, vol. 58(10), pages 1933-1951, October.

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