Historical Accounting and the Endogenous Credibility of Current Disclosures

Abstract

In this paper I examine how an untimely mandatory accounting system -- one that gives an accurate report of past value -- can enhance the credibility of a firm's more timely discretionary disclosures. I develop a model of firm disclosure in a simple setting with information asymmetry and adverse selection. The communication of the firm's current private information about value, if possible, enables the firm to issue equity at a "fair" price and adverse selection does not occur. However, the mandatory accounting system can only report the firm's value with a significant time lag, and there is no other exogenous mechanism that would make a firm's more timely disclosures credible. Nonetheless, I show that the existence of an accurate mandatory report of the firm's historical value is sufficient to make the firm's current disclosures credible most of the time. It does this by providing a lagged ex post check on the firm's more timely disclosures. Thus, while the capital market participants can be fooled by a dishonest disclosure, in time the mandatory accounting system will reveal this. The result is that firms will typically disclose their private information truthfully, capital market participants will rationally believe the disclosures, and adverse selection will be greatly reduced.

The model also allows for the possibility that, in some periods, the firm may not be able to resist the temptation to lie, such as when management is selling shares or needs to raise capital quickly on favorable terms. When the accounting system later reveals the false prior disclosure, the model describes how market participants ignore the firm's subsequent disclosures for a period of time, causing adverse selection and the loss of profitable capital market transactions. But, after a sufficient number of periods, the market believes the firm's disclosures again and efficient trade resumes. The paper studies how the timeliness of the mandatory accounting measure affects the frequency of cycling in and out of the efficient state where communication is truthful and adverse selection is held at bay. Financial reporting has recently come under considerable criticism. SEC Chairman Arthur Levitt recently spoke out strongly against perceived abuses of the flexibility in financial reporting, and has undertaken an initiative to reduce the amount of discretion in restructuring charges, acquisition accounting, and the unfettered use of reserves. But the results of this paper suggest that eliminating the discretion in GAAP indiscriminately would eliminate a powerful source of communication between the firm and the market. An alternative solution would be to modify the system to more clearly identify firms who have abused the discretion in the past.

JEL Classification: D82, G10, M41, M43, M44