Output & Impact: Accounting

Monday, May 23, 2016

In the nearly 100 years of the Carlson School's existence, its faculty has produced an unending stream of groundbreaking research, pushing against boundaries in both academia and in the business world at large. Discover notable examples from the Accounting Department. 

Accounting’s ‘real effects’

To the general public, accounting is often viewed as a perplexing—and boring—tangle of record keeping rules. But it is much more than that. Accounting is the yardstick by which business transactions are measured, aggregated, and reported to the capital market, and the Carlson Accounting Department proves that every day. 

“These accounting measurements and disclosures matter in a very real sense, because how we measure and report on firms’ business transactions will alter those transactions,” says Professor Chandra Kanodia, the Arthur Andersen & Co./Kullberg Chair in Accounting and Information Systems. “Many instances of these phenomena have been studied. Mark-to-market accounting is believed to have significantly exacerbated the 2008-09 financial crises. Deficiencies in measuring investment induce firms to adopt myopic investment strategies, and accounting policy for derivatives affects firms’ risk-management strategies. The main reason for these accounting-induced real effects is that corporate managers are deeply concerned about how their decisions will ‘play’ on the capital market.”

The theory of how accounting measurements and disclosure has real effects was first developed by Kanodia more than 35 years ago in his doctoral dissertation, “Effects of Shareholder Information on Corporate Decisions and Capital Market Equilibrium” (Econometrica, 1980). Over the subsequent years, Kanodia and his students have continued to develop the real effects perspective and have applied it to numerous accounting debates.

The presence of real effects has major implications for the setting of accounting standards by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). Historically, these agencies have established accounting standards as if accountants were mere observers of an objective reality independent of accounting. “The key guiding principle has been that any financial information that is relevant to investors and that can be provided with sufficient reliability should be provided,” Kanodia says. “The principle is due to the belief that more information can only be better than less, and that any disclosure that moves stock prices must necessarily improve resource allocation.”

The literature on real effects actually shows much more complexity. While more transparency does give more accurate information and improves investors’ portfolio decisions, if the information causes change to firms’ fundamentals, returns to portfolios will also change and investors could be worse off.

How we measure and report business transactions alters those same transactions.

Consistent with Kanodia’s arguments, corporations, which have lobbied against proposed changes in accounting standards, have said they would change their business strategies in response to new standards.

“But FASB has been skeptical. In academic circles, while the real effects literature was respected for its logical consistency and precision, it was considered a cry in the wilderness,” he says. “But all that has changed after the recent financial crisis. There is now a surge of interest in studying accounting-induced real effects that spans virtually all of the leading business schools.”

In addition, empirical researchers have been examining field data and finding the real effects predicted by theory. In recognition of its growing presence, the Journal of Accounting Research recently commissioned Kanodia to publish a survey of the real effects literature and its policy implications.

The value of voluntary disclosures

In 1968, Professors Ray Ball and Philip Brown at the University of Chicago wrote what became the most influential paper in accounting research. “An Empirical Evaluation of Accounting Numbers” (Journal of Accounting, 1968) was the first paper in accounting to assess the usefulness of accounting information using newly developed methods in finance of looking at whether that information is impounded in stock prices.

“They found that the information in accounting net income is indeed impounded in the stock price, meaning that it is useful,” says Professor Frank Gigler. “But the information in accounting income is impounded in stock prices before the financial statements are made public, bringing into question whether providing public financial statements is really useful and suggesting that it may in fact be entirely redundant.”

Thirty years later, Gigler, Accounting Department chair and Curtis L. Carlson Chair of Accounting, and co-author, Professor Thomas Hemmer, published their first in a series of papers developing a theory that explained why the results found in Ball and Brown are exactly what one would expect when accounting is playing a “confirmatory role.” Gigler and Hemmer’s “On the Frequency, Quality, and Informational Role of Financial Reports” (Journal of Accounting Research, 1998) argued that if the accounting information in financial statements provides the discipline that makes firms’ voluntary disclosures credible, then a muted stock price reaction to the financial statements may be evidence that the financial statements are doing a good job of disciplining the voluntary disclosures.

“When markets believe what firms disclose on their own volition, the reaction to the information they are required to have audited and are mandated to disclose may be muted,” Gigler says. “But this doesn’t mean that publishing financial statements is of no value, because if it wasn’t for the threat of being caught lying that disclosing audited financial statements creates, the information that firms voluntarily disclose might not be viewed as credible.”

Gigler says that the most meaningful measure of the impact of this work came when Professor Ball wrote “The Complementary Roles of Audited Financial Statements and Voluntary Disclosure: A Test of the Confirmation Hypothesis” (Journal of Accounting and Economics, 2012), in which Gigler’s work with Hemmer provides the underlying hypothesis. “Imagine how it feels to see one of the absolute pioneers in your field adopting your thoughts more than 40 years after he wrote the paper that inspired your thinking,” he says. “Let alone seeing that his results confirm your theory!”

Discover the impact of research taking place across the Carlson School:

Output & Impact: Finance
Output & Impact: Information and Decision Sciences 
Output & Impact: Marketing 
Output & Impact: Strategic Management and Entrepreneurship
Output & Impact: Supply Chain and Operations
Output & Impact: Work and Organizations