The Complementarities of Accounting Information and Its Off-equilibrium Role

Abstract

This paper studies the role of financial reporting in enhancing the credibility of other sources of information. We find that an interim accounting report can discipline management's investment behavior and its effectiveness increases with accounting quality. As a consequence, when accounting quality increases, the investment itself becomes a sufficiently credible signal of management's more valuable private information, and therefore induces a dramatic market response. In this sense, the two pieces of information serve as compliments. However, since most information has already been preempted by the investment, the market's response to subsequent earnings announcement declines. Our results are consistent with the confirmatory role by Gigler and Hemmer (1998) in that the value of accounting is off equilibrium. Specifically, it is the threat that accounting will reveal an inefficient investment that prevents it from happening. Nevertheless, the mechanism in our paper is completely different, and the economic magnitude of the off-equilibrium role is first order, rather than a result of improved risk sharing. Therefore, to assess the value of accounting, we cannot simply rely on the equilibrium market responsiveness to earnings.