Accounting, Finance and Adverse Selection: Illustrations and Applications

Abstract

Accounting is often viewed from a legalistic rather than economic perspective. Finance, on the other hand, is deeply rooted in economic theory, but at its heart is built on assumptions of frictionless markets. Neither perspective fully incorporates the rich economic environment in which we find the practice of accounting and finance; a market setting rife with information inefficiencies. We illustrate and review one such inefficiency, adverse selection. Adverse selection results when market participants have different levels of information about an attribute of payoff relevance. In such cases, less informed parties transact in a market where the profile of assets for sale or employees for hire is worse than the population as a whole. In general, adverse selection causes a loss of social welfare and, in extreme cases, may cause the breakdown of an entire market. Each illustration is based on one of the seminal papers written by the Nobel Laureates of 2001, recognized for their work on adverse selection. We then trace the insights into the accounting and finance literatures. We consider both disciplines jointly, because accounting information is often useful in mitigating the market inefficiencies studied in finance.

Keywords: Adverse Selection, Information Asymmetry, Auditing

JEL Classification: D82