The Commitment to Income-Decreasing Accounting Choices as a Credible Signal to Reduce Information Asymmetry: The Case of Asset Revaluations

Abstract

Bagnoli and Watts (2005) propose that a manager could reduce information asymmetry by choosing an income-decreasing accounting choice that signals the firm’s relatively good future prospects. A limitation in testing this theory is that most income-decreasing accounting choices over time reverse such that aggregated earnings would be the same, regardless of the choice. One income-decreasing accounting choice that never reverses is the choice of upward asset revaluation, where the resulting gains are recognized through OCI and reduce future earnings by increasing future depreciation expense. In the UK, prior to FRS15, firms had the option to upwardly revalue on a one-time basis. FRS15, and subsequently IFRS, however, require those firms that upwardly revalue precommit to revalue on a consistent basis. This precommitment sacrifices future reporting discretion, which Bagnoli and Watts (2005) suggest serves as a costly signal of a firm’s relatively good future prospects that reduces information asymmetry. The choice not to upwardly revalue, therefore, serves as a signal of a firm’s relatively poor future prospects and also reduces information asymmetry, but this choice does not require precommitment such that the reduction in information asymmetry would be less than the choice to precommit to upward revaluations. Using a propensity-score matched-pair design on a sample of UK firms to test our predictions during the period requiring precommitment, we find lower forecast dispersion, lower return volatility, and a lower cost of capital for firms that precommit to upward asset revaluations, relative to those firms that choose not to upwardly revalue their operating assets.

Keywords: upward asset revaluations, income-decreasing accounting choice, forecast dispersion, return volatility, cost of capital, precommitment