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ARTICLE IN PRESS

Journal of Accounting and Economics 46 (2008) 312333

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Journal of Accounting and Economics


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A positive theory of exibility in accounting standards$


Ronald A. Dye, Sri S. Sridhar 
Kellogg School of Management, Northwestern University, Evanston, IL 60208, USA

a r t i c l e i n f o abstract

Article history: We develop a positive theory of accounting standards when standards generate network
Received 24 May 2005 externalities and differ in the amount of reporting discretion, or exibility, they provide
Received in revised form rms. We evaluate expected value-maximizing rms preferences between two
8 September 2008
standards regimes, rigid and exible, as the number of rms subject to each standard
Accepted 12 September 2008
varies, as the organization of the securities market varies, and as the mapping from the
Available online 21 September 2008
underlying economics of the rms transactions to the accounting reports produced
JEL classication: under the two standards vary. We also compare rms preferences between the two
G12 regimes to the preferences of prot-maximizing traders in the rms securities.
G14
& 2008 Elsevier B.V. All rights reserved.
M40
M41

Keywords:
Accounting standards
Network externalities
Reporting biases
Reporting discretion
Investment efciencies

1. Introduction

If there is a feature distinguishing accounting from all other elds of business, it is the emphasis on standards: standards
pervade accounting, whereas standards play a relatively minor role in the elds of economics, nance, organizational
behavior, etc. Given the importance of standards in accounting, one would expect there to be a substantial body of
accounting research describing when standards serve a positive allocational function, as well as what form the standards
will take. Yet there is surprisingly little theoretical work in the contemporary accounting research literature on the
desirability of accounting standards or on rms preferences across standards. In fact, some of the most prominent
contemporary academic accountants seem openly skeptical about the notion that accounting standards and, more
generally, accounting regulation, serve any socially desirable allocational role. For example, Beaver (1998) states that:

The desirability of nancial reporting regulation is still an open question.1

$
We wish to thank seminar participants at the University of Chicago/Minnesota Accounting Theory Conference, the Carnegie Mellon Bosch Accounting
Conference, and the Danish Center for Accounting and Finances Second Interdisciplinary Accounting Conference, along with the referee Robert Bushman
and the editor S.P. Kothari, for helpful comments on previous drafts of the manuscript, and the Accounting Research Center at Northwestern University for
nancial support.
 Corresponding author.
E-mail address: s-sridharan@kellogg.northwestern.edu (S.S. Sridhar).
1
From Beaver (1998, p. 172).

0165-4101/$ - see front matter & 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2008.09.002
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As another example, Leftwich (1980) asserts that:

It is not clear that the net benets of objective accounting measurement rules are positive. . . restricting
managements choice of accounting rules for external reporting can impose costs on stockholders if a rms net
cash ows are affected by managements choice of measurement rules.

The purpose of this paper is to develop a simple formal model in which one of the central issues involving accounting
standards and accounting regulation can be addressed, namely the amount of discretion the standards provide rms
regarding how they report their nancial condition. The paper provides predictions about when value-maximizing rms
and prot-maximizing traders are likely to eschew or embrace expanded reporting discretion. As such, it provides the
beginnings of a positive theory of accounting standards.
We begin by observing that many accounting standards, by imposing uniformity in reporting, suppress some
substantive differences among transactions, and this suppression compromises the information contained in nancial
reports based on the standards. A clear example of this is SFAS 2, the reporting of research and development (R&D)
expenditures: the expenditures outlined in SFAS 2 are expensed regardless of a rms past history of transforming R&D into
commercially viable products, and regardless of the apparent success of its current R&D projects. Another clear example is
the decision by the FASB to disallow any rm affected by the World Trade Center terrorist attacks from reporting the losses
associated with those attacks as extraordinary items.2 The FASBs explanation was that the Board was unable to identify a
criterion that clearly delineated between those rms whose losses were directly related to the terrorists activities, and
those rms whose losses were at most peripherally related to the attacks.3 Though it is clear that the losses of some rms
(e.g., airlines) were more closely connected to the WTC attacks than others (e.g., other rms in the tourism industry), the
FASBs decision had the effect of imposing uniformity in rms reporting that suppressed these differences. These are only
two of myriad examples where accounting standards have suppressed variations in the reporting of transactions.
This uniformity is a cost of rigid accounting standards. Were accounting standards so exible as to allow virtually any
accounting treatment, however, the information contained in nancial reports would also be signicantly compromised. It
is not a priori obvious whether rms, or the investors who follow them, prefer standards that are rigid (in treating
heterogenous transactions homogeneously) or standards that are exible (and are subject to manipulation, but allow rms
reports to capture the heterogeneity in rms transactions). This paper constructs a simple model that predicts rms and
investors preferences for exible standards based on these two distinct methods of constructing standards.
We start the formal analysis by describing an investment setting in which a rms nancial reporting method inuences
its investment choices. We contrast the expected value of a company under two principal accounting standard regimes, one
rigid and one exible. In the exible standards regime, each rm can adopt any report that it wants subject only to the
constraint that it becomes progressively more costly for the rm to adopt reports that depart signicantly from the
economics underlying the rms transactions. In the rigid standards regime, each rm must adhere to essentially the same
reporting procedure as adopted by every other rm, without having the ability to intervene in the nancial reporting
process to inuence opportunistically the report it distributes to investors.
The comparison between the rigid and exible standards regimes is conducted in both a competitive capital market
setting where no investors trades inuence the market prices of rms shares and an imperfectly competitive capital
market setting in which investors trades affect rms share prices. We evaluate the equilibrium expected values of rms
under each setting. In both settings, we show that rigid standards tend to perform better (resp., worse) than exible
standards when there is relatively little (resp., relatively a lot of) cross-sectional variation in transactions that are treated
homogeneously under the rigid standards, and also when there is substantial (resp., little) variation in rms nancial
reports under exible standards due to value-irrelevant variations in rms nancial reporting environments. We also show
that, perhaps surprisingly, when the cost of report manipulation under the exible standards regime is high, rms
preferences between regimes is independent of how competitive the securities market is.
We further show that, often, the attitudes of expected prot-maximizing informed traders are orthogonal to that of
expected value-maximizing rms: that is, when rms prefer rigid standards, traders prefer exible standards, and vice
versa. The explanation for this difference in attitudes is straightforward. Firms benet from having standards that are
maximally informative: the more informative reports produced under a standard are, the more a rms investments in its
productive activities are reected in its accounting reports, and therefore, the greater is the incentive for the rms owners
to invest in the rm. In contrast, informed investorswho know information above and beyond that which can be gleaned
from information in the rms accounting reportsprot from uninformative accounting reports, because such investors
benet from their informational advantage over other less well-informed traders.
Reports produced under all standards regimes have biases in them: there is inevitably a bias in the mapping from the
economics underlying a transaction to what is reported about the transaction in the rms accounting reports. Rigid and
exible standards regimes differ in these biases and in how investors make inferences about these biases. The bias in
reports produced under rigid standards has a (potentially large) component that is common across rms (since reports

2
See the news release by the FASBs Emerging Issues Task Force on 10/01/01.
3
Obviously, while one should not assume that any political bodys formally articulated rationale for its actions accurately describes its real motives,
neither we nor, to the best of our knowledge, anyone else has, in this instance, imputed the FASBs action to some other, unstated motive.
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produced under rigid standards are for the most part common across rms), whereas the bias in reports produced under
exible standards is rm-specic (since reports produced under exible standards are idiosyncratic). As a consequence,
rigid standards have an advantage over exible standards in the rate at which investors learn about the biases embedded in
the standards, since under rigid standards, investors learn about this bias from all rms reports, whereas under exible
standardssince the bias is rm-specicinvestors learn about the bias only one rm at a time. Investors understanding
of the bias under the rigid standard improves as more rms adopt the rigid standard. This cross rm learning under rigid
standards constitutes a network externality (see, e.g., Katz and Shapiro, 1985, 1986). In the text below, we argue that this
network externality, when combined with the previously mentioned observation that rms preferences for standards are
independent of the extent of competition in the securities market, helps to explain the international movement toward
convergence of accounting standards: it becomes progressively easier to compare the performance of rms adopting a
common accounting standard as the number of rms already adhering to the standard increases.4
We wish to point out that in our model, the information rms provide to capital market participants is limited to the
information contained in the nancial reports they produce in accordance with the prevailing accounting standards, and so
the model does not take into account the possibility that rms may supplement their nancial reports through voluntary
disclosures. We justify the lack of incorporating voluntary disclosures into the model on three grounds. First, our primary
focus is on the information content, and allocational roles, of various accounting standards, so we wish to conne attention
to the information imparted by rms compliance with the accounting standards alone. Second, in some situations, capital
market participants may have difculty assessing voluntarily disclosed information because (a) they may not attach a high
level of credibility to that information (as the safe harbor provisions attached to many voluntary disclosures may either
reduce or immunize rms from exposure to liability if the information turns out to be incorrect) and (b) they may have no
means of benchmarking the disclosures with the information supplied by other rms. Neither of these problems exists
with mandatorily supplied information in nancial reports produced in accordance with accounting standards. Third,
despite over 25 years of research on voluntary disclosures, existing theories of disclosure predict that voluntary disclosures
will eliminate more information asymmetry between rms and capital market participants than seems to be the case in
practice. Specically, barring: (1) uncertainty about whether rms have received information, (2) uncertainty about
whether rms make disclosures on the basis of whether the disclosures increase expected rm value, (3) the information
rms receive being proprietary, or (4) anti-fraud statutes being too weak to prevent rms from making false disclosures,
Grossmans (1981) and Milgroms (1981) so-called unravelling result predicts that rms will fully disclose their
information to distinguish themselves from other rms with worse information. Given that, in practice, considerable
information asymmetry between rms and capital markets persists, the unravelling result is not predictive of rms
actual disclosure practices. Consequently, our results can be viewed as indicating the informational and allocational roles of
accounting standards, given the information asymmetry that persists after rms have had the opportunity to make
voluntary disclosures.
Since the present paper concerns the study of the economic impact of alternative accounting standards, the paper is
related to the large literature on the economic consequences of accounting standards (see, e.g., Watts and Zimmerman,
1986; Holthausen and Leftwich, 1983; Lys et al., 2001 for surveys of this literature). Rather than attempting to identify the
linkage between the present paper and this voluminous economic consequences literature, we conne discussion of
references here to the part of the literature dealing with analytical models. Demski (1973, 1974) was the rst to
demonstrate that changing accounting standards has distributional consequences and that it is unlikely that a change from
one accounting standard to another could, even in principle, be uniformly preferred by all participants in the economy.
Beaver and Demski (1979) subsequently observed that, absent complete and perfect markets, developing unassailable
income and/or asset/liability recognition rules is impossible. Kanodia (1980), starting with his dissertation, and
subsequently extending that work in a variety of ways (see, e.g., Kanodia and Mukherji, 1996; Kanodia et al., 2000,
2004), was the rst to study the efciency effects of accounting reports on rms investment decisions. Our approach builds
on Kanodias work by studying the investment effects of alternative accounting standards in a multi-rm context, where
there may be biases in the mapping between a rms reported value of transactions and the economics underlying the
transactions, where the nature of the biases can vary across rms, across standards, across transactions, and across time.
The paper proceeds as follows. Section 2 outlines the base model, and describes the key differences between the rigid
and exible standards regimes. Section 3 presents the rst-best results, a benchmark against which the performance of
actual standards can be compared. Section 4 presents the fundamental distinction between competitive and imperfectly
competitive securities markets. Sections 5 and 6, respectively, present the calculations of equilibrium expected rm value
under rigid standards and exible standards. Sections 7 and 8, respectively, compare the performance of rigid and exible
standards in terms of expected rm value (evaluated at equilibrium investment levels) and expected prots of informed
traders. Section 9 discusses how network externalities in nancial reports affects rms preferences across standards,
and how network externalities may explain the current support toward convergence in accounting standards. Finally,
Section 10 summarizes some of our central ndings. Most proofs in the paper are juxtaposed with the results
corresponding to those proofs. Those results not presented in the text or accompanying footnotes may be found in
the Appendix.

4
We wish to thank the editor for this insight.
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2. Base model

2.1. The description of transactions, accounting standards, and nancial reports

In the model we study, rms produce transactions that are valued by the marketplace. The owners of rms are willing to
produce more or fewer transactions depending on how the marketplace values their transactions. The nancial reports that
rms prepare inuence the markets perceptions of their transactions values. The information in a nancial report about a
transactions value depends on each of: the actual underlying economic value of the transaction, the prevailing nancial
accounting standards, and a rms ability to inuence how its transactions are represented under the prevailing accounting
standards. Accounting standards may differ from each other both in terms of the extent to which they capture
heterogeneity in the values of transactions and the extent to which they are subject to manipulation. There is an inevitable
trade-off in choosing among standards: the standards that permit the heterogeneity in transactions to be expressed in
nancial reports are the very same standards that are most subject to being manipulated by opportunistic managers. In this
setting, accounting standards have real resource allocation effects since: (a) the markets perceptions of a transactions
value inuences the volume of transactions a rm produces; (b) the information contained in a rms nancial report
affects the markets perceptions of a transactions value; and (c) accounting standards affect the information contained in
rms nancial reports.
Formally, we suppose that, in each period t 2 f1; 2; . . .g, there are m rms. To keep the model tractable, we further
suppose that each rm i 2 f1; 2; . . . ; mg produces only one type of transaction in any period. While transactions in principle
could differ from each other in many respects, we emphasize how transactions values differ from each other. We let yit
denote the value of each of rm is period t transactions. This market value, depending on context, could represent the
(common) selling price of the products the rm is producing, the contribution margin on those products, the products
liquidation values, etc. We discuss the appropriateness of this representation further below.

2.2. Firms production technologies

We allow the values of transactions to vary both across rms and across time at a given rm. It is of course natural to
assume that different rms produce transactions of different value, and it is also natural to assume that the value of
transactions at a given rm changes over time, because of shifts in what the rm produces, or in the rms cost of
production, or in the market structure the rm operates in, etc. To model these various changes simply, we suppose that the
value of each of rm is transactions in period t is given by yit Zt eit , where eit is iid across rms, has mean zero, and is
independent of Zt . Here, Zt represents the central tendency in the values of rms transactions in period t, and eit represents
idiosyncratic variations around this central tendency. We take Zt to be iid over time, and also eit to be iid over time, as a way
of reecting possible changes in the values of transactions over time.
The production technology in place at rm i is this: if rm i invests $Iit in its pproduction
technology in period t, it
produces a random number qit of transactions, where the expected value of qit is 2 Iit . Given this production technology, if
the realized value yit of yit were public, then rm is value-maximizing investment in period t would simply consist of the Iit
that would maximize
p
2yit Iit  Iit . (1)
Throughout the following, we assume that yit is not public, and that what investors learn about yit is determined by what
they can glean from reading rms nancial reports. Note that the investment Iit does not have multi-period effectsthat is,
the effect of an investment in period t does not affect rm is cash ows in any period other than period t. In part because of
this feature of the investment problem and in part because of tractability concerns, we posit that each rm in each period
chooses its investment decision on the basis of how that investment affects the value of the rm in that period, rather than
being concerned with longer term, and possibly more complicated, multi-period effects.

2.3. Introduction to the rigid and exible standards regimes

We focus on two principal nancial reporting regimes, a rigid standards regime and a exible standards regime. In
the rigid standards regime, rm is nancial report about each of its transactions consists of the reported value
Rit Zt b rit . Here, b is an unknown, but constant, bias in the rigid standard that is specic to the standard, but not the
rm applying it or the time period in which it is applied. rit is an idiosyncratic bias in the report produced under the rigid
standard specic to both the period and the rm. We take rit to be iid across rms and across time and independent of all
other variables in the model.
The sum b rit is intended to capture the idea that accounting reports of rms produced under a common standard may
have both a common bias, captured by the term b, as well as an idiosyncratic bias specic to the rm and time period,
captured by rit . As just one example of this sort of bias, consider rms who disseminate historical- or acquisition-based
nancial accounting reports in an inationary environment. Since all such rms reports are not adjusted for changes in
current costs, all such rms net incomes are on average overstated, with, roughly, the average overstatement proportional
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to the rate of ination, and with some rms net incomes overstated more or less than the average rate of ination.5 In this
setting, b could reect (in log terms) the average overstatement of income per transaction because the historical cost
statements are not ination indexed, and rit could reect rm and time-period specic variations in this average
overstatement.
In the exible standards regime, rm is nancial report about each of its transactions consists of the reported value y^ it ,
where the relationship between y^ it and the actual value yit of rm is transactions is as follows: rm i incurs the cost
cy^ it  yit  dit 2 =2 per transaction in making the report y^ it . The random variable dit represents some facet of the rms
internal controls and/or reporting environment unknown to outsiders that inuences the cost the rm incurs in adopting
the report y^ it when the realization of yit is yit .6
Note that in the exible standards regime, rm i has the opportunity but not the obligation to report the value of yit
exactly. In this way, the exible standards regime, unlike the rigid standards regime, allows rms to report accurately
idiosyncratic variations in transaction values.
(To avoid introducing too many digressions in the text, in the following we occasionally discuss the motivation
underlying some aspects of the model, or we provide a more expansive discussion of some accounting question that the
model addresses, in the accompanying footnotes. The rst such footnote (at the end of this sentence) discusses alternative
interpretations of our depiction of accounting standards.7 The following footnote discusses the reduced form nature of
our representation of accounting standards and how results with this representation are likely to apply to other, potentially
more realistic, depictions of accounting standards.8)

2.3.1. Additional description of reporting under exible standards


To this specication, we add the following structure on dit : we assume that dit di fit where di is specic to rm i but
constant across time, and fit is iid across rms and across time. The basic reason we adopt this approach is to increase the
parallels between the reports produced under exible standards and the reports produced under rigid standardswhich,
recall, are given by Zt b rit for rm i, and thus have a substantive industry-wide component Zt , a time-series constant
(but not rm-specic) bias component b, and a rm-specic but time varying idiosyncratic component (rit ). Under exible
standards, we will show that rms is preferred reporting choice consists of y^ it yit dit some constant yit di fit
some constant. Consequently, reports produced under exible standards have a rm-specic substantive component yit , a
rm-specic but time-constant bias di , and a rm-specic but time varying idiosyncratic component fit . Additional

5
To apply this illustrative application literally, the amounts b and rit would have to be expressed in logs in the expression Rit Zt b r it .
6 e e
In an alternate interpretation of the model, the initial owners of the rm never observe yit ; they only observe an estimate yit of yit : yit yit dit ,
whereas in the model presented in the textdit is an error term. In this alternate interpretation, in the exible standards regime, rm i can make any
report y^ it it wishes to, but it incurs a cost cy^ it  yit 2 =2 in making the report y^ it when the initial owners estimate of yit is yit .
e e

All of the results that follow hold for both interpretations of the model.
7
Alternative interpretations of the accounting standards depicted in the model: These two alternative reporting procedures might be considered to be
alternative ways of implementing fair value accounting for the products produced by a rm, with the rigid fair value standard requiring rms to prepare
nancial statements by assigning average, industry-wide values to the transactions they generate and the exible fair value standard allowing rms to
develop their own proprietary models for calculating the fair values of their transactions.
But, the idea we are trying to express in this formalism is more general than just alternative ways of implementing fair value reporting methods: we are
trying to capture the idea that (a) some standards allow for more managerial input than others, (b) those standards that do allow for more managerial
input may be able to better capture the idiosyncratic features of transactions, (c) capturing these idiosyncratic elements comes at the potential cost of
being subject to (more) manipulation, and (d) manipulation is costly not because it introduces bias, but rather because it introduces an additional source
of uncertainty: the extent of manipulation, when available, will vary both across rms and across time in ways that are unpredictable by investors.
8
The reduced form nature of the preceding representation of accounting standards and transactions: Clearly, the representation of standards and
transactions in the text is a reduced form setup in several fundamental respects. First, actual standards describe classication, recognition, and valuation
criteria for certain classes of transactions, whereas the approach we adopt just depicts valuation alternatives. Second, actual accounting standards consist
of more or less completely specied algorithms dening the process by which the components of nancial statements are to be constructed, but are silent
about what specic values are to appear in rms nancial statements. Third, transactions differ from each other in more than just the value investors
assign to the transactions: for example, derivative-related transactions are different in both substance and complexity from (operating) sales transactions.
Notwithstanding these simplications, we now argue that this reduced form setup for both standards and transactions captures many of the relevant
complexities of actual standards and actual transactions.
Regarding standards, we claim that even if one were to formally represent standards so that they appeared more like the algorithms or operators that
form the basis of actual GAAP standards, the analysis would be essentially unchanged from the approach we adopt. (A working paper version of this
manuscript, which is available from the authors, provides the details supporting this claim.) Moreover, as was already discussed, our depiction
encompasses the fundamental problem that standard setters face: determining the effects of allowing preparers to distinguish the transactions they
engage in from the transactions of other rms.
Regarding transactions and the various ways in which transactions can differ from each other, we note that, no matter what the structure or
dimensionality of actual transactions, what ultimately matters about the transactions is the value investors assign to them, consistent with our
representation. While calculating contribution margins or fair/market values might seem like a prosaic exercise relative to the calculations involved in
many sophisticated transactions, the practical import of many transactions (and their accounting treatment) is the impact of the transactions on the
contribution margins or market values of the rms performing the transactionse.g., whether a transfer of a bundle of accounts receivable to an SPE
should be treated as a sale or secured borrowing under the terms of FAS 140 is fundamentally a question of what impact, if any, the exchange has on the
contribution margin of the transferor.
So, while we acknowledge that our representations of both transactions and standards are simplications, we believe they capture some fundamental
features of actual transactions and standards.
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justication for the motives underlying this representation of exible standards may be found in the accompanying
footnote.9

3. First-best benchmark

Our main focus of attention will be on how expected rm value under rigid standards compares to expected rm value
under exible standards. As a benchmark, though, we begin by calculating rst-best expected value. Under rst-best, the
2
initial owners maximize expression (1). A simple computation shows that this yields expected value yit when yit 40, and 0
otherwise. To simplify some subsequent calculations, we shall make use of the following pair of assumptions, one a
restriction on the types of distributions of random variables we consider, and one an approximation.

Assumption 1 (The Distribution Assumption). b, di , eit , Zt , fit , rit are all independent, normally distributed random variables.

In many nancial accounting settings, normality is a conventional distributional assumption and, as Assumption 1 states,
we shall assume that it characterizes the distributions of all the random variables in the model.
Before proceeding, it is helpful for future reference to collect in one place all the notation we use to refer to the
distributions of these normal random variables. We indicate that the distribution of a generic random variable, say x, is
normal with mean x and variance s2x by writing Nx; s2x . Using this convention repeatedly, we posit: the priors on b as of the
start of period t are Nbt ; s2bt (for t 1, this distribution is exogenous; for all other values, this distribution evolves
according to Bayes rule); the initial priors on di as at the start of period 1 are Ndi ; s2d ; Zt NZ; s2Z ; eit N0; s2e ;
fit N0; s2f ; and rit N0; s2r .

Assumption 2 (The Approximation Assumptions). For any normal random variable y with mean Z and density f yjZ, Z is
sufciently large so that
Z Z 1
y2 f yjZ dy  y2 f yjZ dy.
y40 1

The Approximation Assumption is reasonable provided the mean Z is sufciently large. Throughout the following,
Assumptions 1 and 2 will be assumed to hold for every result, and as a consequence, no explicit reference to these
assumptions will be made in the statement of subsequent results.

Our rst result identies the ex ante rst-best expected value of a rm (where ex ante refers to that time preceding
the realization of any of the random variables in the model). This rst-best expected value is obtained by evaluating (1) at
the optimal investment level, and then taking expectations.

Lemma 1. The ex ante rst-best expected value of a rm is given by10


2
Eyit  EZ2t  s2e .

Notice that the ex ante rst best expected value increases in the variance of eit . The reason for this is the same as the reason
why, in microeconomics, prot functions are convex in prices:11 yit is a parameter of the rms investment problem and so
increases in the variance of this parameter give a rms initial owners more opportunities to ne-tune their investment
choice to the realized value of this parameter. Also notice that the ex ante rst-best expected value is a reference point and
is not generally attainable in practice since investors generally cannot see, or infer, the actual value of a rms transactions.
As was noted previously, what investors learn about a rms transactions is restricted to that which can be gleaned from
observing (all) rms nancial reports.

9
Additional motivation for the representation of exible standards: First, we think it is realistic to assume that some facet of each rms reporting
environment has some permanence over time. If a rm has a CFO, or an internal accounting system, etc., that results in the rm adopting aggressive
reporting in one period, then the rm is likely to have a CFO, or an internal accounting system, etc., that is likely to result in reports that are aggressive in
other periods too. The rm-specic, but time constant term di , captures such effects. Second, we think that in any nancial reporting system, there are
features about the reporting system that investors in the rm do not fully understand, but may be able to learn about over time. In the rigid reporting
system, the common bias b serves this role: since it is constant across rms, investors can learn about this bias by observing the reports of multiple rms
in a period. Since it is constant over time, investors also can learn about the bias by comparing how the realized values of rms transactions compare to
their prior reports about the transactions. In the exible standards regime, the time-constant di for rm i serves a similar role: observing a rms reports
over time, and comparing the realized values of a rms transactions to its prior reports about those transactions, allows investors to learn about this rm-
specic time-constant bias too. Third, since virtually any realistic nancial reporting system will have some unknown biases built into it about which
investors can learn over time, it is desirable to understand how investors learn about these biases in different reporting systems. By having time-constant
biases in each of the rigid and exible standards regimes, we can begin such a study. p
10 2
The Proof of Lemma 1 runs as follows: as was already noted in the text, the maximization of 2yit I  I with respect to I yields rm value maxfyit ; 0g.
2 2
So the ex ante value of the rm is Emaxfyit ; 0g. Since yit Zt eit has mean Z, the Approximation Assumption permits us to estimate Emaxfyit ; 0g by
2
Eyit .
11
See, e.g., Jehle and Reny (2001).
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4. Perfectly and imperfectly competitive securities markets

Comparisons of the performance of rigid and exible standards regimes depend on how the securities market is
organized. For example, if the securities market is competitive and populated entirely with informed investors who know
the exact values of rms transactionswith investors learning this exact information from somewhere other than the
rms accounting reportsthen the equilibrium prices of the rms will be the same as rst-best levels, the information
supplied by reports produced in accordance with either standards regime will be irrelevant to investors assessments of
rms values, and the rms owners will be indifferent as to which standards regime is in effect. Clearly, this informed
competitive equilibrium is not an interesting setting in which to study rms or investors preferences toward accounting
standards. But, rms and investors attitudes toward accounting standards, and the allocational effects of accounting
standards, can be studied fruitfully in another competitive equilibrium where the only source of information to investors
about rms is the information derived from the rms accounting reports. (In the following, we sometimes refer to the
latter equilibrium as the uninformed competitive equilibrium.) Between these two competitive equilibria, there are a
host of intermediate cases in which some, but not all, investors trade based on information other than just that which can
be extracted from rms accounting reports.
The performance of accounting standards depends on how securities markets are organized and also on how much
information investors glean about rms nancial conditions from outside the rms nancial reports. So, we study the
performance of accounting standards across both a spectrum of securities markets organizational structure and across a
variety of assumptions about how many traders in a rms securities learn information about the value of the rms
transactions from outside its nancial reports. In the following, we address both sets of issues by using Kyles (1985) model
to represent the securities market. We index the securities market by the number n of informed traders in Kyles (1985)
model, where each informed trader specializes in following the transactions of a single rm i in a period. Each informed
trader is assumed to know the exact value of yit of each of rm is transactions. (Additional justication for this assumption
may be found in the accompanying footnote.12) Uninformed traders know only that which can be inferred from rms
accounting reports; the market maker in rm is transactions knows all rms accounting reports and what can be learned
from the aggregate order ow in rm is transactions.
By adopting this setup, we can study accounting standards in both the informed (n infinity) and uninformed
n 0 competitive equilibrium cases described in the preceding paragraph simultaneously, as well as every intermediate
case. In the footnote at the end of this sentence, we complete the current discussion by commenting briey about a
potential ambiguity in what it means for one securities market to be organized more competitively than another.13

5. Equilibrium expected rm value under rigid standards

The sequence of events in the rigid standards regime in each period is as follows: rst, each rm (or its owners) privately
learns about the value of its own transactions in that period, and then each rm makes an investment decision that maximizes
its perceptions of its expected value net of the cost of the investment. In selecting its investment level, the rm anticipates how
its transactions will be priced by the capital market at the end of the period. Since the market maker prices every rms
transactions based on all rms accounting reports, and since accounting reports are produced only at the end of the
accounting period, at the time a rm makes its investment decision it must forecast both what its own accounting report, and
what other rms accounting reports, will be. Then, all rms generate transactions, and subsequently publicly disclose their
accounting reports about their transactions. After the reports become public, markets open for the transactions produced by all
rms, with the transactions of each rm being priced as in Kyles (1985) model. That is, a market maker in each rm sets a
price for the expected value of each of the rms transactions, based on both the information revealed in all rms nancial

12
An investor who only goes to the trouble of learning how to interpret a rms nancial accounting reports will have no informational advantage
over a market maker in the rms securitiesbecause the market maker is himself certain to evaluate the accounting reports of the rm he specializes in.
Accordingly, such an informed investor will generate zero expected trading prots. So, if an investor expects to generate positive trading prots, he must
acquire additional information from outside the rms nancial reports. Though we do not model this formally, we believe that, often, investors can
generate trading prots by acquiring such outside information only after having rst studied a rms nancial reports, because the ability to intelligently
interpret the outside information frequently requires knowledge of the rms accounting reports. We use this discussion to motivate the assumption that
informed traders who expect to generate trading prots in a rms securities will study the rms accounting reports and, in addition, will learn other
outside information about the rm.
In the following, as was noted in the text, we posit that informed investors learn the exact value of the rms transactions. (This is also consistent with
Kyles (1985) original representation of informed traders.) Assuming that an informed trader merely learns additional, but imperfect, information
beyond that contained in rms accounting reports should yield results similar to those reported here.
13
The most uncompetitive securities market is one in which there is a single n 1 informed trader. That trader has an informational advantage
over all other traders; that trader will recognize that his trades will have an inuence on how the market maker sets the price for the securities of the rm
he trades in; and that trader will take into account how his trades inuence the price of securities when he decides how many securities to trade. Notice
that moving to a situation in which there are either more or less than n 1 traders increases the competitiveness of the securities market, with a move
toward n 0 resulting in an uninformed competitive securities market (as described in the text) and a move toward n infinity resulting in an
informed competitive equilibrium. In the following, absent any qualifying remarks, we will say that a securities market is becoming more competitive
as n increases, recognizing that, based on the present discussion, this is descriptive as long as na0.
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reports and the aggregate volume of market orders placed for the rms shares.14 Every informed trader anticipates the impact
of his trades on the price the market maker sets. Each period ends with the realized values of all transactions for that period
becoming public. Then the next period starts, with investors in the next period learning both the realized values of rms past
transactions and rms previous accounting reports about those transactions.

In period t, each Firms generate Each of the m Informed traders Cash flows from The game
firm privately transactions. firms discloses its observe it and transactions are repeats in
observes it and accounting report place market realized publicly. period t+1.
chooses its under a given orders. Market
investment, I it . standard. price, Pit ,forms.
Investors recall the
reports and observed
transactions values
for all periods t<t.
Timeline

In the rigid standards regime, the only inter-temporal link across periods is the bias b. There is no accrual accounting in
so far as overstatements in reports in one period are not followed by understatements in some subsequent period.15
In the Appendix, we establish the following result based on a generic version of Kyle (1985): if, based on publicly
observable accounting reports, the market maker in rm i in period t believes that the value of each of rm is transactions
is given by yit Nyit ; s2y , and there are n informed traders each of whom knows the exact realized value yit of yit , and nally
there are liquidity traders whose aggregate trading volume sums to eit , where eit is the realization of the random variable
eit N0; s2e , then the equilibrium market value of a transaction at rm i in period t is given by (see (27) in the Appendix):

yit nyit
V it yit ; yit ; eit deit , (2)
n1 n1
p
where d s2y n=se n 1.
To adapt this result to the rigid standards regime, we note that, when the market maker in rm is transactions sees all m
rms reports ~
Rt R1t ; R2t ; . . . ; Rmt , then yit Eyit j~
Rt 16 so (2) becomes

Et yit j~
Rt  nyit
V it deit . (3)
n1 n1

The value (3) is determined ex post, after both the volume of liquidity trades and all rms accounting reports realize
their values.17 Since, at the time they make their investment decisions, the owners of rm i know none of: the realized
value Rit of their own rms accounting report, the realized values Rjt , jai, of other rms accounting reports, or the volume
of liquidity trades eit , they must forecast V it . With a  s2Z =s2Z s2bt s2r =m and b  s2Z =s2Z s2e , it is easy to show18 that

Z abyit  Z nyit
Et V it jyit  . (4)
n1 n1

14
It is expositionally convenient in what follows to have the market maker price the individual transactions of a rm, rather than the sum total value
of the rms transactions, because the level of investment made by the owners of rm i depends on how they anticipate the market maker will eventually
price each of rm is transactions. One could, of course, replace this assumption by the alternative assumption that the market maker prices all of a rms
transactions without substantively affecting the subsequent results.
15
We rationalize this assumption, rst, by envisioning an overlapping generations situation in which, when rms are sold from one generation to the
next, a rms accounting slate is wiped clean (and so there is no overlap between accruals recorded over time) and, second, by observing that
introducing reversing accruals would complicate the model without changing its economic substance.
16
The fact that the market-maker and investors following rm i use both rm is reports and the reports of all other rms in estimating the value of
each of rm is transactions illustrates how investors exploit information transfers among rms (see e.g., Foster, 1981; Dietrick and Olsen, 1985).
17
In determining the price (3) of each of rm is transactions in the rigid standards regime (and similarly, in determining the price (6) of each of rm
is transactions in the exible standards regime below), we have assumed that the market maker utilizes the information contained in all rms reports,
but not the volumes of outputs of the various rms. We conne the market makers updating to this information set to emphasize the informational and
allocational roles of the rms accounting reports. (In any event, as the variance in rms outputs grows sufciently large, it can be shown that then the
incremental information contained in the rms outputs about the values of the rms transactions becomes vanishingly small.)
18
Start by letting bt be the expected value of the bias b as of the start of period t. After the reports ~
Rt have been issued, all investors can calculate
Et yit j~
Rt  as

"  # " #
1 P 1P
Rt  Et yit 
Et yit j~ Rjt Et Zt jZt b r jt
m j m j
!
1P
Z a  R  Z  bt :
m j jt
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Given this forecast, rm i chooses its investment to maximize


p
2 Iit  Et V it jyit   Iit ,
which entails, when (4) is positive, setting Iit to equal
 
Z abyit  Z nyit 2
Iit . (5)
n1 n1
Invoking Assumption 1, it follows that the ex ante expected value of rm i is given by
2 !2 3
Z a b yit  Z n yit
Et 4 5.
n1

Performing some algebra,19 this proves:

Lemma 2. When there are n informed traders following rm i, under rigid standards the expected value of rm i is given by
0 12
B s4Z C
B C
Bn   C s2Z s2e
@ s2r A
s2Z s2bt s2Z s2e
m
V rigid  Z2 .
n 12

Note that V rigid is decreasing in s2bt and s2r and increasing in n, m, and Z. As we would expect, increases in the variance of
either the common bias b or the idiosyncratic bias rit reduce ex ante rm value, because increasing either of these variances
adds noise to the information in the accounting reports. The fact that V rigid increases in the number n, along with the
previously observed fact that increasing n (from nX1) is associated with an increasingly competitive securities market,
implies that the initial owners of a rm prefer being listed on more competitive exchanges to being listed on less
competitive exchanges.20 We show below, in Corollary 3(a), that this result is also true in the case where accounting
standards are exible, so the preference for operating in more competitive securities markets is robust with respect to the
accounting standards regime in place.
Within a given period t, increasing m increases expected rm value because it increases what investors learn about the
industry-wide parameter Zt and hence represents a form of information transfer across rms (Foster, 1981; Dietrick and
Olsen, 1985). That is one form of the network externality effect mentioned in the Introduction.21 Further discussion of
this network externality effect, and the multiple ways in which it manifests itself in both the rigid and exible standards
regimes, is deferred until Section 9.
Increasing Z naturally increases rm value, since increasing Z Eyit  increases the average value of the rms
transactions.
It is easy to show that in the uninformed competitive case n 0, a rms expected value under rigid standards declines
in s2e , whereas in all imperfectly competitive cases nX1, the rms expected value increases in s2e . The source of the

(footnote continued)
Then, notice that at the start of period t, just after the owners of rm i have seen yit , the owners will predict the average value of the reports of all rms
to be
" # " #
1P 1P s2Z
Et R jy Et Zt b r jy Z bt 2 y  Z
m j jt it m j jt it sZ s2e it
Z bt byit  Z:
Thus, Et Et yit j~
Rt jyit  is as reported in (4).
19
Observe
2 !2 3
2 2 2 2 2
Z abyit  Z nyit 5 Z 1  ab n ab Eyit  2Z 1  abn ab
Et 4
n1 n 12

Z2 1  ab2 n ab2 s2y Z2 2Z2 1  abn ab



n 12
n ab2 s2y n 12 Z2

n 12
n ab2 s2y
Z2 ;
n 12
and then substitute a and b.
20
Recall footnote 13 that a securities market becomes more competitive by increasing the number n of informed traders when the base level n is
n0 X1.
21
In addition to the present discussion of network externalities, we discuss the relation between network externalities and accounting standards
further in Section 9.
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difference in these two results is clear. In the competitive case, the only information about rm value comes from
accounting reports, which contain no information about the idiosyncratic components of transactions values. Increasing
s2e in that case results in rigid accounting reports being relatively less informative about rm value. But, in the imperfectly
competitive case, informed investors learn the exact value of yit Zt eit before trading, and through their trading, some of
that increased information gets reected in the rms market price. Increasing the variance of eit is valuable in that case, for
the same reason it was in the rst-best case: a rms prots are convex in yit .

6. Equilibrium expected rm value under exible standards

To adapt (2) to the exible standards regime, we suppose that all m rms reports under the exible regime are given by
y^ jt , j 1; . . . ; m, and so, before seeing the aggregate order ow, the market makers beliefs about the expected value of each
of rm is transactions in period t is given by yit Et yit jy^ jt ; all j. So, (2) becomes

Et yit jy^ jt ; all j nyit


V it deit . (6)
n1 n1
In the exible standards regime, the owners of rm i select their accounting report y^ it at the end of the period, at which
time they seek to maximize the value of their rm net of the costs of misreporting. Since misreporting costs are incurred on
a per transaction basis, choosing a report that maximizes expected rm value net of misreporting costs is tantamount to
choosing a report that maximizes the expected value of each transaction net of misreporting costs, so the owners of rm i
choose their report y^ it to maximize

V it  :5cy^ it  yit  dit 2 . (7)


Anticipating this optimal end-of-period reporting at the time they make their investment choice, they choose Iit so as to
maximize
p
2 Iit  Et V it  :5cy^ it  yit  dit 2 jyit   Iit . (8)
The preceding paragraph provides an abbreviated description of the problems the owners of rm i confront under
exible standards. We now expand on this description. If the owners of rm i think that the market maker calculates the
P
conditional expectation Et yit jy^ jt ; all j as the linear function k a y^ it b  1=m  1 jai y^ jt of all m rms reports, for
 
 
some (yet to be specied) constants k , a , and b , it follows from the maximization of (7) that their preferred accounting


report y^ it will be, with yit  yit dit :




a
y^ it yit . (9)
cn 1
In equilibrium, the market maker understands that rm i will adopt the accounting reporting policy (9), because he will
know the coefcients a , b , and k of Et yit jy^ jt ; all j. So, from the market makers perspective, the set of accounting reports
 

^ 
fyjt ; j 1; . . . ; mg is informationally equivalent to the set fyjt ; j 1; . . . ; mg. This informational equivalence, combined with
the symmetry of the problem, implies that

Et yit jy^ jt ; all j Et yit jyjt ; all j  Et yit jyit ; si ,


 
(10)
P 
where si  1=m  1 jai yjt . Standard regression theory then shows that
P !
   jai djt
Et yit jyit ; si  Z a  yit  Z  dit b  si  Z  , (11)
m1

where djt and s2djt denote, respectively, the beginning of period t mean and variance of djt , a  s2e s2dt s2Z =
s2dt s2e ms2Z =s2dt s2e , and b  s2dt s2Z m  1=s2dt s2e s2dt s2e ms2Z .22


Eq. (11) describes how the market maker estimates the value of each of rm is transactions based (just) on observing
all m rms accounting reports. For purposes of selecting rm is preferred investment leveli.e., for purposes of
solving (8)the owners of rm i must calculate the expected value of (11) given their information yit at the time they make

22
Notice that

" #
  1 P 
Et yit jyjt ; all j Et yit jyit ; y
m  1 jai jt
s2dt s2Z
s2e P !
s2dt s2e ms2Z  s2dt s2Z m  1 jai djt
Z  y it  Z  d it  s 
 Z  :
s2dt s2e s2dt s2e s2dt s2e ms2Z i
m1
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that choice, i.e., they must calculate



EEt yit jyit ; si jyit . (12)
23 
Some algebra shows that (12) equals Z a b byit  Z. So (6) equals


Z a b byit  Z

nyit
deit . (13)
n1 n1
Thus, the investment problem (8) amounts to maximizing
( )
p Z a b byit  Z nyit  :5cy^ it  y 2 n 1
it
2 Iit  Iit . (14)
n1

When the optimal investment is positive it is given by


!2
Z a b byit  Z nyit  :5cy^ it  yit 2 n 1
Iit . (15)
n1

Substituting for a, b , and b, invoking Assumption 1, using (9), and taking expectations, we conclude that the expected
value of rm i under the exible standards regime is as reported in Lemma 3(b).24

23
Substitute


Eyit jyit  yit dit
and
"P  # P P
 s2Z
jai yjt  jai djt jai djt
Esi jyit  E y Z 2 y  Z  Z byit  Z
m  1  it m1 sZ s2e it m1
into (12) and take expectations conditional on yit to obtain
" P ! #

   jai djt 
Et Et yit jyit ; si jyit  Et Z a  yit  Z  dit b  si  Z  yit
m1 
P P !
 jai djt jai djt
Z a  yit dit  Z  dit b  Z byit  Z  Z 
m1 m1

Z a b byit  Z:

Observe that, by (9), :5cy^ it  yit 2 n 1 :5a 2 =cn 1 so (14) can be rewritten as
24 

8 9
>
>  a 2 >
>
> >
p<Z a b byit  Z nyit  5cn 1=


2 Iit  Iit .
>
> n 1 >
>
>
: >
;
p
Notice that when x40, the maximization problem maxI 2x I  I x2 , and that the optimal value for I is I x2 . In the present case the latter fact implies

0 12
 a 2
BZ a b byit  Z nyit  5

C
B cn 1C
Iit B C . (16)
@ n1 A

Thus, using (16), invoking Assumption 1, and taking expectations across the realizations of yit , we conclude that the expected value of the rm, net of the
cost of transactions manipulation, when evaluated at the optimal investment policy is given by

0 12 0 12
a 2  a 2 
BZ  :5 a b byit  Z nyit C BZ1 n  :5 a b b nyit  ZC
B cn 1 C B cn 1 C
Et B C Et B C
@ n1 A @ n1 A

 2 !2   
:5 a a b b n 2 2
Z  sZ s2e :
c n1 n1

Substitute for a, b , and b and notice

s2dt s2Z
s2e ! ! !!
s2dt s2e ms2Z s2dt s2Z m  1 s2Z 1 s2dt s2Z m  1s2Z
2 s2 1 2
s2dt s2e s2dt s2e s2dt s2e ms2Z s2Z s2e sdt s2e e s2dt s2e ms2Z sZ s2e
! !!
1 s2dt s2Z ms2Z s2e
s2 :
s s2e e
2
dt
2
s s2e ms2Z
dt
s2Z s2e
The result is the expression appearing in Lemma 3(a).
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Lemma 3. Under exible standards,


2
s sZ 2
s2e dt
 s2 s2 2
e msZ
(a) the rms optimal accounting report is given by y^ it yit ; dit y^ it yit a =cn 1, where a dt
s2dt s2e
; and
(b) the expected value of the rm is given by:
0 ! !! 12
1 s2dt s2Z ms2Z s2e
B 2 s2e nC
Bsdt s2e s2dt s2e ms2Z s2Z s2e C
V flex B
B
C s2 s2
C Z e
@ n1 A

0 0 !12 12
2 2
1 sdt sZ
B
B B 2 s2e 2 C C
B :5 Bs s2 s s2e ms2Z C C
BZ  B
dt e dt C C . (17)
B cB C C
@ @ n 1 A CA

Notice that, according to Lemma 3(a), increasing either the number n of informed investors or the number m of rms
reduces the amount of accounting report manipulation. Increasing the number of informed investors reduces report
manipulation because informed investors assessments of rm value are not affected by the rms accounting
machinations, and so as the number of informed investors increases (and their inuence on the realized price of the
rm expands), the rms returns to manipulation decline. Increasing the number of rms provides additional information
sources which the market maker and investors can use to value any given rm. This reduces the reliance on any given rms
accounting report, and therefore also reduces a rms return to manipulating its accounting report.
Lemma 3(b) contains an explicit expression for the ex ante expected value of each rm under the exible standards
regime. Lemma 3(b) is most naturally discussed when juxtaposed with Lemma 2, which we defer to Section 7.

7. Firms preferences for rigid versus exible standards regimes

Theorem 1 combines Lemmas 2 and 3 to obtain necessary and sufcient conditions for rms to prefer rigid standards to
exible standards.

Theorem 1. A necessary and sufcient condition for rigid standards to be (weakly) better than (i.e. generate higher ex ante
expected rm value than) exible standards is
V rigid XV flex . (18)

One can get a better sense for the implications of this theorem by considering special cases of it. One important special case
involves c being large, in which case the component
0 0 !12 12
1 2
s2dt s2Z
B B 2 s C
B
B :5 Bsdt s2e e s2dt s2e ms2Z C
C CC
BZ  B B C (19)
B C C
@
c@ n1 A CA

of V flex can be approximated by Z2. In that case inequality (18) reduces to


!
s4Z 1 2
s2dt s2Z ms2Z s2e
  X 2 se 2
s2 sdt s2e sdt s2e ms2Z s2Z s2e
s2Z s2bt r s2Z s2e
m
or equivalently rigid standards are preferred to exible standards if and only if

s2dt s2Z ms2Z s2e


4
s2e s2Z s2e
sZ s2dt s2e ms2Z
X . (20)
s2r 2
sdt s2e
s2Z s2bt
m
Corollary 1 shows that this last expression provides the basis for the formal conrmation of several intuitive results
discussed in the Introduction.25

25
No proofs are presented for the following results, as all of the results follow immediately from inequality (20).
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Corollary 1. When c is sufciently large so that (18) is well approximately by (20), then:

1. if s2e is sufciently large, exible standards are better (i.e., generate higher expected rm value) than rigid standards;
2. if s2dt is sufciently large, rigid standards are better than exible standards;
3. as s2e approaches zero, rigid standards are better than exible standards if and only if s2bt s2r =mos2dt =m;
4. as s2dt approaches zero, exible standards are better than rigid standards;
5. even if both s2bt and s2r =m approach zero, exible standards may still be better than rigid standards;
6. when either s2bt or s2r =m is sufciently large, rigid standards are inferior to exible standards;
7. rigid standards are better than exible standards over long enough time periods (in which case investors obtain enough
observations to infer the time-constant bias terms b under rigid standards and di under exible standards) if

s2f s2Z ms2Z s2e


s2e s2Z s2e
4
sZ s2f s2e ms2Z
X ; and (21)
s2r s2f s2e
s2Z
m

8. over long enough time periods if the number m of rms is sufciently large, exible standards are better than rigid standards.

All of these results are intuitive.

1. Large s2e is reective of there being much heterogeneity in transactions values, and since rigid standards do not
capture any of that heterogeneity, expected rm value will be lower under rigid standards than exible
standards.
2. When s2dt is large, reports produced under exible standards exhibit considerable non-substantive variation-
which makes accounting reports under exible standards relatively uninformative, and hence, inferior to
accounting reports produced under rigid standards.
3. As s2e approaches zero, there is not much heterogeneity in transactions values, so the only value-relevant
stochastic component of yit is Zt . Each of the terms b, rjt , and djt introduces noise in the accounting reports
estimates of Zt . Reports produced under the rigid regime will have more noise in them than will reports
produced under the exible standards regime, and hence, rm value based on those reports will be lower, when
the sum of the two noise terms under rigid standards, s2bt s2r =m, is lower than the single noise term under
exible standards, s2dt =m. This also can be seen in the algebra: as s2e ! 0, the expected value of a rm under
exible standards s2e s2Z s2e s2dt s2Z ms2Z s2e =s2dt s2e ms2Z =s2dt s2e approaches s4Z =s2dt =m s2Z .
Contrasting this to the expected value of a rm under rigid standards, s4Z =s2Z s2bt s2r =m, it is clear that the
relative preferability of rigid and exible standards depends on which of s2bt s2r =m or s2dt =m is larger.
4. Reports produced under exible standards are very informative when there is little noise in reports produced
under those standards due to idiosyncratic non-substantive variation in the reports values. s2dt is small in
precisely those circumstances, and so exible standards outperform rigid standards.
5. When s2bt and s2r =m both approach zero, LHS (20) approaches s2Z . RHS (20) can be written as the convex
combination (s2e =s2dt s2e  s2Z s2e s2dt =s2dt s2e  s2Z  s2Z s2e =m=s2Z s2dt s2e =m. It is clear
that the latter expression will exceed s2Z for all sufciently large s2e . This is also intuitive: even if reports
produced under rigid standards perfectly reveal the central tendency Zt in the value of all rms transactions,
exible standards may be better then rigid standards, becauseas we previously notedrigid standards do not
reveal any heterogeneity in the transactions values. When s2e is large, revealing this heterogeneity in
transactions values is important to properly valuing rms, in which case even perfect rigid standards cannot
outperform exible standards.
6. When s2bt or s2r =m is large, the information produced under rigid standards is so noisy as to be almost useless.
7. and 8. After investors have seen enough observations to gure out the time-constant bias terms b (under rigid
standards) and di (under exible standards), s2bt ! 0 and s2dt ! s2f . Since either side of inequality (21) may be
bigger than the other side, there is nothing in general inevitable about the superiority of either rigid or exible
standards even when investors see many accounting reports produced by rms under these standards. But, if the
number m of rms is sufciently large, exible standards dominate rigid standards, as can be seen by observing
that inequality (21) is reversed as m gets large.26 When the time-constant biases in each regime are known and
the number of rms gets large enough, the law of large numbers ensures that, under both standards, investors
can calculate the average realized value Zt of transactions. But, knowledge of Zt is all that investors can learn
under rigid standards, whereas investors can learn morethey can learn something about the idiosyncratic

26 s2e s2Z s2e s2f s2Z


As m gets large (21) converges to s2Z X s2f s2e
; which is clearly false.
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values eit of individual rms transactionsunder exible standards. This fact is responsible for exible
standards dominating rigid standards in part 8 of Corollary 1.

Corollary 1s results are predicated on c being large. The large c case represents the best possible case for exible
standards, as the performance of the exible standards regime improves as c increases. This follows algebraically because
the equilibrium expected cost of report management declines as c increases. This also follows intuitively: one drawback of
the exible standards regime is that the owners of the rm expend costly resources on manipulating a report that results in
no real improvement in the value of its transactions. If the owners could, somehow, bind themselves not to incur such
costs, they would be better off. One way of imperfectly binding themselves to engage in less of this unproductive behavior
is to make the behavior more expensive to engage in, and increasing c is one way to accomplish that.
In the small c case, rigid standards always outperform exible standards. More precisely, if c is sufciently small and
(as is assumed throughout) Z is high, rigid standards will always outperform exible standards because the total costs of
accounting report manipulation becomes excessively high.27
The next corollary places no restrictions on the cost c other than ensuring that the expected output of each rm is non-
negative under exible standards.

Corollary 2. For all those parameter values for which expected rm output is positive, and holding other parameters xed:

1. rigid standards are better than exible standards when each of s2bt; , s2r , and s2e is sufciently small;
2. for sufciently large s2e , exible standards are better than rigid standards;
3. when s2d is sufciently large, rigid standards are better than exible standards;
4. for large enough Z, rigid standards are better than exible standards; and
5. as each of c, s2bt , or s2r gets smaller, rigid standards are more likely to be preferred to exible standards.

The intuition for most of the results in Corollary 2 is similar to that for the results discussed in Corollary 1. The one result
that we expand on here is part 4. Recall that Z Eyit  is the expected value of a transaction. As that expected value
increases, so does a rms equilibrium expected output. As a consequence, the expected cost of report management under
exible standards increases, since the costs of report management are incurred on a per-transaction basis. For large enough
values of the expected value of a transaction, the total cost of report management (summed across transactions) becomes
so large that rigid standardswhich entail no costs of report management because there is no manipulation of rigid
standardsbecome preferred.

While each of Theorem 1, Corollaries 1 and 2 emphasizes conditions under which one standards regime can perform
either better or worse than the other standards regime, Corollary 3 closes this section by highlighting some respects in
which the performance of both standards regimes are similar to each other, insofar as they each respond in similar
qualitative fashion to changes in exogenous parameters of the model.

Corollary 3. Both when accounting standards are rigid and when accounting standards are exible, ex ante expected rm
value is:

(a) increasing in the number n of informed investors, and approaches rst-best as n approaches innity;
(b) bigger when the securities market is imperfectly competitive than when the securities market is perfectly competitive; and
(c) increasing in time t.28

Corollary 3(a) generalizes an observation made following Lemma 2, by showing that value-maximizing rms, regardless
of the accounting standards regime in place, prefer to be listed on exchanges that are more competitive to being listed on
exchanges that are less competitive. Being on a more competitive exchange (with nX1) has two benecial effects: rst, it
increases the likelihood that rms will be accurately priced, and rms initial owners, anticipating this more accurate
pricing, are more willing to invest in their rms because they realize that the capital markets will reward them for their
greater investments. Secondand specic to the exible standards regimeunder exible standards, increasing informed
investor following reduces the amount of report manipulation that rms engage in, which also serves to enhance the rms

27
The smallest sensible value of c is that c for which the expected output of the rm is zero. Given (9) and (15), the unconditional expected output
of the rm is given by
" #
p Z a b byit  Z nyit  :5cy^ it  yit 2 n 1
2 Iit 2E
n1
 2 (22)
^  2 a
Z  :5cyit  yit Z  :5c :
cn 1
Evaluating the performance of exible standards at the value c where the expected output is zero, it is clear from the expressions for V rigid and V flex that
for all large enough Z, exible standards are inferior to rigid standards.
28
The proof of Corollary 3 is straightforward and so is omitted.
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ex ante expected value. Further, the investment distortions resulting from the inability of accounting reports in any
standards regime to accurately reect transactions values become vanishingly small as the number of informed investors
gets large enough. To be explicit, note for example that in the case of rigid standards limn!1 n s4Z =s2Z s2bt
s2r =ms2Z s2e 2 s2Z s2e =n 12 Z2 s2Z s2e Z2 EZ2t  s2e and recall from Lemma 1 that this last expression is
the same as the rst-best. Thus expected rm value approaches rst-best under rigid standards as n increases without
bound, but is below rst-best for any nite n, as long as s2e 40.

Corollary 3(b) is explained by the fact that informed investors in an imperfectly competitive securities market are
endowed with better information than is available to investors in a competitive securities market. Finally, Corollary 3(c)
follows from the market obtaining greater information about time-constant biases under either standards regime over a
greater number of periods.

8. Informed traders preferences for rigid versus exible standards

When the securities market is competitive, no trader has an informational advantage over other traders, all investors
earn zero expected trading prots, and so investors are indifferent between the rigid and exible standards regimes. When
securities markets are imperfectly competitive, informed investors may display a preference between regimes. The
following theorem presents expected prots of informed investors under each standards regime when the securities
market is imperfectly competitive, holding xed the cost of becoming informed across regimes.

Theorem 2. An informed investors gross expected trading prots

(i) under rigid standards are given by


s
s4Z
2se Z s2y  s2
s2Z s2bt mr
p ; and (23)
nn 1

(ii) under exible standards are given by:


v
u s2 s2Z s2Z m s2e
u
! u
u s 2 2
e s y d2t
a 2
t sdt s2e ms2Z
2se Z  :5 2
 s2y 
cn 1 s2dt s2e
p . (24)
nn 1

It is apparent, by comparing Theorems 1 and 2, that prot-maximizing informed traders attitudes toward factors that
affect the performance of accounting standards are very different from the attitudes of expected value-maximizing rms.
These differences are most stark in the case where the cost c of report management is high, as reported in the following
corollary.

Corollary 4. When c is sufciently large so that (18) is well approximately by (20), the preferences of expected value-maximizing
rms and expected prot-maximizing informed investors are strictly opposed. That is, whenever rms strictly prefer rigid
standards, informed traders prefer exible standards and vice versa.

The proof is straightforward: examining (23) and (24), when c approaches 1, it is apparent that informed investors
prefer rigid standards if and only if

s2dt s2Z s2Z m s2e


4
s2e s2y
sZ s2dt s2e ms2Z
p . (25)
s2r s2dt s2e
s2Z s2bt
m
Contrast this to the preferences of expected value-maximizing rms, as described in (21). Clearly, inequality (25) is just the
reverse of inequality (21).
This corollary is also intuitive: as was noted in the Introduction, what makes rms prefer one standard to another is the
information that reporting under the standard conveys to investors. The more informative the standard is, the more rms
investments get reected in the prices of the rms, and so the more willing are the rms owners to invest in their rms.
Informed investors, in contrast, prot when the rms accounting reports are not very informative, as those are the
circumstances in which they have the greatest informational advantage over other investors and the market maker.
Increasing the informativeness of accounting reports thus harms informed investors, but helps value-maximizing rms.
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Theorem 2 leads to other intuitive results. For example, under the rigid standards regime, an informed traders expected
prots are increasing in the heterogeneity in the value of transactions (as measured by s2e ) because the greater the
heterogeneity in transactions the greater the informational advantage informed traders have over a market maker who
knows, apart from the volume of liquidity trades, only what is stated in the rms accounting report. Comparative statics
involving informed investors preferences between accounting standards can be obtained by reversing, as appropriate, the
results in Corollaries in 1 and 2 to reect the orthogonality of rms and investors preferences.
The following corollary provides one set of easily interpretable sufcient conditions for informed traders to prefer rigid
accounting standards to exible accounting standards.

Corollary 5. For sufciently large c, a sufcient condition for rigid standards to generate higher gross expected trading prots for
informed traders than exible standards is se Xsd .29

According to Corollary 5, informed investors prefer rigid standards to exible standards when there is more variation in the
types of transactions eit than there is variation in the idiosyncratic factor dit that inuence rms reporting decision in the
exible standards regime. This is intuitive, since rigid standards fail to capture the idiosyncratic value of rms transactions,
and exible standards are compromised by the noise introduced by non-substantive sources of variation in rms
accounting reports. So, when the variance in the idiosyncratic factor affecting the values of transactions exceeds the
variance in the idiosyncratic noise terms associated with reports prepared according to exible accounting standards,
informed traders informational advantage over other traders is greatest in the rigid standards regime.

9. Network externalities in accounting standards

9.1. Network externalities within a period

Besides explaining rms and traders preferences between accounting standards, we demonstrate in this section that
the model of the preceding sections is also helpful in explaining both the magnitude and sources of network externalities
arising from accounting standards, and is also useful for explaining recent trends toward convergence in accounting
standards. Theorem 3 provides the foundation for the discussion of these issues below.

Theorem 3.

(a) Both when accounting standards are exible and when they are rigid, the ex ante expected rm value is increasing in the
number m of rms, but remains strictly below rst-best even as m approaches innity.
(b) When c is sufciently large so that (18) is well approximately by (20), if rigid standards are better (resp., worse) than exible
standards for some value n 2 f0; 1; 2; . . .g in a given period, then rigid standards are better (resp., worse) than exible
standards for all values of n in that period.

The proof of Theorem 3(a) follows directly from the expressions for V rigid and V flex in Lemmas 2 and 3. The proof for
Theorem 3(b) follows from inequality (20) being independent of n.

There are several economic implications to be drawn from Theorem 3. As was noted briey above following the
statement of Lemma 2, the fact that V rigid increases in the number of rms, m, is a consequence of a network externality
effect arising within an accounting period. This effect can be made more explicit by considering the limiting case m ! 1.30
Pm Pm
In that case, under rigid standards, since i1 Rit =m i1 Zt b rit =m!Zt b within a period investors can
eliminate the idiosyncratic bias rit from their estimate of Zt , but they cannot eliminate the bias b because the latter bias is
common to all rms under the rigid standard.31 Moreover, there is a corresponding, but even stronger, within-period
P ^
network externality effect under exible standards, since the average m i1 yit =m, as m gets large, reveals Zt within period t
32
without error.

29
Proof of Corollary 5. Some simple algebra shows that s4e s2y s2dt s2Z s2Z m s2e =s2dt s2e ms2Z =s2dt s2e Xs2Z as long as s2e Xs2dt (and mX1, the
latter always being true, of course), which implies that (25) holds and hence, (23) X (24) also holds.
30
We wish to thank the referee for clarifying our thinking on this point, and in particular for suggesting studying the limiting case m ! 1 as a way of
making explicit the source and nature of the network externality.
31
Incidentally, comparing Theorem 3 and Corollary 3(a) shows that increasing m does not have the same salutary effect on expected rm value as
does increasing the number n of informed investors. Having the number of rms get large allows investors (in both regimes) to infer precisely the value of
the central tendency in transactions values, Zt ; in contrast, having the number n of informed investors get large results in all the information that
informed investors know about transactions values get reected in rms market values.
32 Pm ^ Pm 
This follows immediately, since i1 yit =m has the same information content as i1 yit =m (see the discussion preceding (10)), and since
Pm  Pm
y
i1 it =m i1 yit dit =m ! Zt .
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9.2. Network externalities across periods

There is a second form of network externality effect under rigid standards that arises across periods. Since, at the end of
the period, the actual realized values of transactions becomes known, investors can compute both the actual average value
P Pm
of transactions and the actual value of the bias b, since as m ! 1, m i1 yit =m i1 Zt eit =m!Zt , and so investors can
Pm Pm
calculate the bias b by computing the difference: limm!1 i1 Rit =m  i1 yit =m. Although this cross-time network
externality effect does not show up in V rigid , it is valuable to future investors, because it will allow those investors to
eliminate the effects of the bias in all periods t 0 4t, and hence allow investors to compute the industry average value of a
transaction, Zt0 , within the period t 0 , because the bias under the rigid standards persists over time.33 Note, in contrast that
there is no corresponding across-period network externality effect under exible standards, since other rms reports
provide no assistance in assessing the biases in a given rms reports produced under exible standards over time.
Whether the within period, or the across period, network externality effect is more important depends on what problem
investors are trying to solve. The within period network externality effect is most important when investors seek to
estimate Zt during an accounting period, but the across period network externality effect is most important, under rigid
standards, when correcting for the bias in estimating b in future accounting periods.34
Remark 1 provides a general result which shows that the across-time network externality effects manifest themselves
independently of whether the number of rms subject to the standard is large or small.

Remark 1. Under the rigid standards regime, at the start of period t, tX1, the priors on b are normally distributed with
variance
2 2 2 2 2 2
s s s s s
b1 Z m r e Z m r s
s2bt 2 m 2 2 m 2 m 2 2 2 m
. (26)
t  1sb1 es Z s Z s s
r e Z s s s2r

It is clear from this expression that limt!1 s2bt 0 and, consistent with the discussion above, limm!1 s2bt 0. Thus, there
are multiple ways in which investors can learn bs realization: see the reports, and subsequent realized values, of multiple
rms at once, or see the reports of a few rms over several periods, or both.

Even though, as previously noted, there is no across period network externality effect in the exible standards regime,
learning about biases under exible standards does occur over time, one rm at a time, as Remark 2 reports. Remark 2
shows exactly how fast investors learn about the time-constant (and rm-specic) bias di in the exible standards regime.

Remark 2. Under the exible standards regime, at the start of period t, tX1, the priors on di are normally distributed with
variance 1=1=s2d t  1=s2f .

From this remark it is clear that investors perception of the variance di decreases at rate t in time. This rate of learning is
necessarily independent of the number m of other rms in the economy because the bias is rm-specic.

9.3. Network externalities and the movement toward convergence of accounting standards

Theorem 3(a) helps explain the tendency for convergence in accounting standards regardless of whether rms make
their choices of accounting standards myopicallyi.e., only based on which standard results in a higher expected rm value
for the current periodor whether they make their choices with foresight and take into account how their expected values
will change over time as additional rms enter the capital market and also make accounting standard choices.35 Consider
the case where rms are myopic rst. Supposefor the sake of expositionthat periods are sufciently short so that only
one new rm makes a choice between accounting regimes in a single period, and that rms standard choices are
irrevocable (meaning that, once a standards choice is made, it cannot be reversed). If a rm makes its standards choice
myopically, its decision would be based simply on a comparison of its expected value under each regime in the current
period. Let V flex mtflex denote the expected value of a rm in period t under exible standards when there are currently in

33
Which network externality is more important depends on what problem investors are trying to solve. Estimating Zt is valuable to investors during
the accounting period, but estimating b is valuable to investors in future accounting periods, since the bias b persists over time, whereas the industry
parameter Zt changes over time (recall Zt is posited to be iid).
34
In this footnote, we argue that rigid standards have much in common with (in the current vernacular) a rules-based regime, and exible
standards have much in common with a principles-based regime and so, based on the previous discussion in the text, we assert that the within period
network externality effect is likely to be more powerful under principles based standards, whereas the across period network externality effect is likely to
be more powerful for rules-based standards.
Under a principles-based regime, the source of bias in the mapping between a rms reports about its transactions and the underlying values of its
transactions is in how rms interpret the principles. As different rms may be inclined to interpret a given principle differently, there may not be much
common uncertainty across rms in the bias under a principles-based regime. This lack of a common source of reporting bias is characteristic of reports
produced under exible standards.
Under a rules-based regime, the bias in the mapping between a rms reports about its transactions and the underlying value of those transactions is
likely to be in the rigidity of the rule itself. This common source of reporting bias is characteristic of reports produced under rigid standards.
35
The discussion that follows is suggestive and informal as, for example, it does not completely specify the dynamics of rms decision processes.
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total mtflex rms who have adopted the exible standard in period t, and let V rigid mtrigid denote the value of a rm under
rigid standards when there are currently in total mtrigid rms who have adopted the rigid standard in period t. Barring knife-
edge cases, one of the two values V flex mtflex or V rigid mtrigid will be strictly higher than the other, of course. Suppose, to be
explicit, V rigid mtrigid is higher, so the rm making its accounting standards choice in period t chooses the rigid standards
regime. Then, at the start of period t 1, mt1
flex
mtflex and mt1
rigid
mtrigid 1. Since, as Theorem 3 observes, V rigid is an
increasing function in mtrigid , it follows that the rm making its accounting standards choice in period t 1 is more likely to
also nd the rigid standards regime preferable to the exible standards regime. This forms the basis of a virtuous circle,
with rigid standards becoming more and more attractive to rms over time.
It is worth noting that this phenomenon is not an informational cascade in the sense of Bikhchandani et al. (1992) or
others: rms are not learning from, or piggy-backing on, the decisions made by other rms. Rather, it is simply a classic
case of a network externality, where the value to a rm of being on a standard is an increasing function of the number of
other rms also on the same standard (Katz and Shapiro, 1985, 1986).
If accounting standards choices were made non-myopically, then the self-reinforcing behavior exhibited in the myopic
case can become even more compelling. If the rm making its accounting standards choice in period t anticipates the
accounting standards choices made by rms in periods t 0 4t, then such a rm can anticipate the long run, call it m1 flex ,
number of rms who will choose the exible standards regime as well as the long run, call it m1 rigid , number of rms who
choose the rigid standards regime. Suppose, to consider a simple case, rms are homogenous and they make their
accounting standards choice based on which of V flex m1 1
flex or V rigid mrigid is larger. Then since in every period t rms
choices are made based on the same long run comparison between V flex m1 1
flex and V rigid mrigid , all rms will make the
same choice (by homogeneity), and so consistency will demand that one of m1 1
flex or mrigid will be innite and the other of
m1 1
flex or mrigid will be zero. That is all rms elect the same standards regime.
While these observations are not intended as a complete explanation for recent trends in convergence among
accounting standards, they do seem to point to the usefulness of network externalities in explaining convergence.
That the extent of competition in the securities market does not affect rms preferences between standards under the
hypotheses of Theorem 3(b) follows because what determines the performance, and preferability, of one accounting
standards regime over another in the large c case is only the amount of information generated by reports under the two
standards regimes. (In particular, the expected cost of manipulation is not a factor that affects the performance of the
exible standards regime in the large c case.) While the extent of competition in the securities market affects the amount
of information generated outside the accounting reporting systemand hence affects the total expected rm value under
both standards regimesthe extent of competition does not differentially affect expected rm value across the two
regimes, because the extent of competition does not in any way affect the informativeness of the reports produced under
the standards.
Notice that Theorem 3(b) provides an additional explanation for the worldwide movement toward convergence in
accounting standards. To see this, suppose two rms, A and B, are similar to each other except for the level of
competitiveness in capital markets in which their shares are traded. Where rm As shares are traded, the securities market
is competitive; where rm Bs shares are traded the securities market is not competitive. According to Theorem 3(b) if rm
A prefers rigid standards to exible standards, then so will rm B. Thus, cross-country differences in the competitiveness of
securities markets do not predispose rms domiciled and listed on different countries exchanges to have distinct
preferences among accounting standards.36

10. Summary

Among our central results are the following: expected value-maximizing rms will choose rigid standards over exible
standards when transactions are relatively homogenous or when there is substantial variation in how transactions are
reported under exible standards for reasons unrelated to the economic value of the transactions. Symmetrically, expected
value-maximizing rms will choose exible standards over rigid standards when transactions are relatively heterogenous
or when there is little non-substantive variation in how transactions are reported under exible standards. Also, informed
traders view of rigid standards versus exible standards tend to be orthogonal to that of expected value-maximizing rms,
since informed traders benet from relatively uninformative accounting reports, whereas value-maximizing rms benet
from informative accounting reports. Flexible standards regimes perform best when the cost of accounting report
manipulation is high, since high costs of report manipulation effectively commit rms not to engage in much report
manipulation. All standards regimes tend to introduce biases in the mapping from the underlying economics of

36
When the level of competition among traders in the capital market is endogenous, and determined by letting traders decide whether to incur the
cost of learning the value of a rms transactions, we have shown in a working paper version of the manuscript that more traders will choose to become
informed as the prevailing accounting standard becomes less informative. In this setting, the informativeness of capital market prices is inuenced by
both the informativeness of extant accounting standards and the information acquisition decisions of traders. Consequently, rms preferences among
accounting standards also may be inuenced by the level of the competition in the capital markets too.
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transactions to accounting reports about the transactions. Rigid standards regimes tend to have an advantage over exible
standards regimes in eliminating the effects of such biases, since investors learn the value of the rigid bias more quickly
than they learn the exible bias (because the bias under rigid standards is common across rms, whereas the bias under
exible standards is rm-specic). When the cost of report manipulation under exible standards is incurred on a per-
transaction basis, rigid standards tend to perform better than exible standards when rms expected outputs are high
(because the cost of report manipulation under exible standards then will be high). These costs often outweigh any
informational advantage that reports produced under the exible standards regime may possess.
Since expected rm value under both standards regimes increases with the number of rms that adopt the standard, a
standard adopted by many rms becomes relatively more attractive to rms that have yet to choose a standards regime.
This network externality may help to explain the recent trend towards convergence in accounting standards. Another factor
reinforcing the trend toward convergence is that, when the cost of report manipulation is high under the exible standards
regime, cross-country differences in the competitiveness of securities markets do not affect rms relative preference for
exible or rigid standards.
In the model we study, capital market participants obtain information about rms through the accounting reports they
produce under prevailing accounting standards. Firms do not supplement the information provided in their nancial
reports through voluntary disclosures. While, as we noted in the Introduction, there are a variety of reasons for studying
the informational and allocational roles of accounting standards absent the possibility of voluntary disclosures by rms, an
interesting area for future study is how accounting standards differ from each other in terms of the incentives they give
rms to supplement the mandatory disclosures they produce with voluntary disclosures.

Appendix A. Generic results regarding the Kyle model

Eq. (2) in the text makes reference to generic results from the Kyle model. This section describes these results.
The value of a transaction is given by the random variable yit . After a report concerning the transaction is made, the
common public priors regarding yit are that yit Nyit ; s2y . The market maker and all uninformed investors know these
priors, but they have no direct knowledge about the realized value of yit . There are n informed risk-neutral traders, all of
whom know the realized value yit of yit . Each informed trader places a market order for Dyit g hyit units of the
transaction (these units can be fractional). All informed traders use the same function Dyit , though each trader
constructs his own demand function Dyit without coordinating with other traders. There are, in addition, a collection of
noise traders who have aggregate demand for the transaction summarized by eit N0; s2e . The market maker observes the
aggregate order ow a nDyit eit . The market maker then establishes the price Va, at which these market orders are
executed.

Denition. An equilibrium in the multi-informed investor Kyle model consists of a pricing function Va l ma and
market orders Dyit g hyit such that

(i) given D
and V
, for each yit ,
Dyit 2 arg max x  yit  EVn  1Dyit x eit ;
x

(ii) given D
, Va Eyit jnDyit eit a.

The following lemma characterizes several features of this equilibrium.

Lemma A. There is an equilibrium characterized as follows:

(i) given Va l ma, then Dyit yit  l=mn 1, i.e., g l=mn 1 and h 1=mn 1;
p
(ii) l yit and m sy n=se n 1;
p
(iii) an informed traders expected trading prots are given by sy se =n 1 n;
(iv) the equilibrium pricing function can be written as, when a nDyit eit :

yit nyit
V meit . (27)
n1 n1
Proof of Lemma A. The proof is omitted, as this is just Kyle (1985) extended to n informed investors. See also Fishman and
Hagerty (1992). &
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Below, we use the following pair of facts concerning multivariate normal distributions. Given any normal random
variable x and any vector of normal random variables Y , if S12 covxY and S22 varY , then

ExjY Ex S12 S1


22 Y  EY , (28)

VarxjY s2x  S12 S1


22 S21 . (29)

Proof of Corollary 2.

1. Take the limits of inequality in Theorem 1 as each of s2bt , s2r , and s2e approaches zero. Inequality (18) becomes
0 12 0 0 !12 12
ms2Z 1 s2dt s2Z
!2 Bn 2 B C
n s2Z B sdt ms2Z C
C B
B
B 2
:5 Bsdt s2dt ms2Z CC CC
 s2Z Z2 4B
B
C
C
2
sZ BZ  B B C
C C
n1 @ n 1 A B c@ n1 A C
@ A

which is true since ms2Z =s2dt ms2Z os2Z and since expected rm output is positive only if Z  :5=c1=s2dt s2e s2e
s2dt s2Z =s2dt s2e ms2Z =n 1 is positive (so Z2 4Z  :5=c1=s2dt s2dt s2Z =s2dt ms2Z =n 12 2 ). The result then
follows by appeal to continuity.
2. Divide both sides of (18) by s2Z s2e to get
0 12
s4Z 0 ! !!12
Bn   C 1 s2dt s2Z ms2Z s2e
B s2r C s2
B 2 2
sZ sbt sZ se C
2 2 Bn 2 C
B m C Z2 B sdt s2e e 2
sdt s2e ms2Z s2Z s2e C
B C 4B C
B n1 C s2Z s2e B n1 C
B C @ A
B C
@ A

0 0 !12 12
1 2
s2dt s2Z
B B 2 s C
B
B :5B sdt s2e e s2dt s2e ms2Z C
C CC
BZ  BB C
B C C
@
c@ n1 A CA

.
s2Z s2e

Then take limits as s2e goes to innity to get


 2  
n n1 2
4 ,
n1 n1
which is false.
3. Taking limits of (18) as sd ! 1:
0 12
s4Z
Bn   C
B s2 C
2 s2 r s2 s2 C
B sZ Z e  2
B bt m C n
B C s2 s2 Z2 4 s2Z s2e Z2
B n1 C Z e n1
B C
B C
@ A

which is true.
4. This is clear.
5. Follows immediately upon differentiation of both sides of inequality (18). &

Proof of Theorem 2. Begin by noting that, in either regime if the standard deviation in the distribution of the value of a
transaction given all rms accounting reports in period t is denoted by std, it follows that from Lemma A that the expected
p
prots of an informed trader from trading in a market for one of rm is transactions is given by std  se =n 1 n, and
p 37
so, if rm i produced qit transactions, its expected trading prots are qit  std  se =n 1 n. Thus, if ex ante, i.e., before

37 p
The total expected trading prots qit  std  se =n 1 n of each of the informed traders can arise either from assuming that each of the
informed traders participates on one market where all qit of the transactions of rm i are sold, and what all of the traders (either informed or uninformed)
do is place an order to purchase some fraction of all qit transactions. Alternatively, all the informed traders can be considered to be trading on qit Kyle
markets, where there is a separate market for each of the qit transactions, and what each trader (informed or uninformed) does is place an order to
ARTICLE IN PRESS
332 R.A. Dye, S.S. Sridhar / Journal of Accounting and Economics 46 (2008) 312333

rm is prots in period t are known, the rm is expected to produce Et qit , transactions, then an informed traders
p
expected prots are given by: Et qit   std  se =n 1 n.
P
Now apply this result to the rigid standards regime. Using (29) in period t, since 1=m i Rit is a sufcient statistic for ~ Rt
with respect to yit , the variance in the value of one unit of output, given the vector of nancial reports ~ Rt under the rigid
standard, is s2y  s4Z =s2Z s2bt s2r =m. From (5) in the text, we known rm is expected output in period t, given yit , is
given by 2Z abyit  Z=n 1 nyit =n 1; thus, invoking Assumption 1, its ex ante (before yit is known) output is 2Z.
So the ex ante expected prots of an informed trader are
v
u s4Z
u 2
2se Zu
tsy  s2
s2Z s2bt r
p m. (30)
nn 1
Next, consider an informed investors expected prots in the exible standards regime in period t. Using (29), conditional
on the set of accounting reports y^ it , i 1; . . . ; m, the conditional variance of yit is s2y  s2e s2y s2dt s2Z s2Z m s2e =
s2dt s2e ms2Z =s2dt s2e . Referring to (16), we know that the rms ex ante expected output is given by
2Et Z a b byit  Z nyit  5a 2 =cn 1=n 1 2Z  :5a 2 =cn 12 . It follows, invoking, Lemma A again,


that the ex ante expected prots of an informed trader are given by


v
u s2 s2Z s2Z m s2e
u
!u
u s 2 2
e s y d2t
a 2
t 2 sdt s2e ms2Z
2se Z  :5 2
sy 
cn 1 s2dt s2e
p . (31)
nn 1
This proves Theorem 2. &

Proof of Remark 1. In the following, we let s2b1 be denoted by simply s2b . Appealing to (29), at the end of period 1, after the
realizations yi1 , Ri1 , i 1; . . . ; m have been observed it follows that the posterior variance of b is determined by
 
1 1
Varbjyi1 ; Ri1 ; i 1; . . . ; m Var bj Syi1 ; SRi1
m m
 
Sj rj1 Sj ej1
Var bjZ1 b ; Z1
m m
s2b  S12 S1
22 S21 , (32)
2
where, here, s is the initial (beginning of period 1) variance for b, S12 covb; Z1 b Sj r j1 =m; covb; Z1 Sj ej1 =m
b
s2b ; 0 and
2 3
2 2 r s2
6 sZ sb s2Z 7
6 m 7
S22 6 7.
4 2 s2e 5
sZ s2Z
m
The reason for this is that we can compress all the data about b obtained during period 1 from observing the realizations yi1
and Ri1 , i 1; . . . ; m into the two averages Si Ri1 =m Z1 b Sj r j1 =m and Si yi1 =m Z1 Sj ej1 =m.
Multiplying out the various matrices that appear in (32) and simplifying shows that (32) equals

s2b s2Z ms2r s2e s2Z m s2r


. (33)
s2b ms2e s2Z m s2Z ms2r s2e s2Z m s2r
Now move to the end of period t  1 and suppose that investors have observed the averages Si Rit0 =m Zt0 b Sj r jt0 =m
and Si yit0 =m Zt0 Sj ejt0 =m for all t 0 pt  1. We claim the posterior variance of b at that time is given by
2 2 2 2 2 2
s s s s s
b Z m r e Z m r s
s2bt 2 m 2 2 m 2 m 2 2 2 m
. (34)
t  1sb
s s
e Z Z s s
r e Z s s s2r

(footnote continued)
purchase some fraction of one of these transactions on each market. The expected prots of an informed trader are identical in either of these two
situations, as long as (a) in the case where there are separate markets for each transaction, the markets run concurrently and (b) the standard deviation in
the volume of noise traders is the same in the individual markets as in single aggregate market. Moreover, when these two conditions hold, the expected
prots of an informed trader are unaffected by the presence or absence of correlations among the volume of noise traders on the various markets in the
multi-market interpretation.
These statements follow immediately from the easily veriable fact that the expected prots from trading in a sum of transactions is equal to the sum of
the expected prots from trading in the individual transactions.
ARTICLE IN PRESS
R.A. Dye, S.S. Sridhar / Journal of Accounting and Economics 46 (2008) 312333 333

We can see that (26) is true for both t 1 and 2 by evaluating (34) at t 1 and t 2 and comparing the result to (33).
Suppose (26) is true for t. (This is the induction hypothesis.) Then, s2bt is the beginning of period t prior variance for b. Thus,
substituting s2bt for s2b into (33) gives the end of period t variance for b, after observing the period t reports and period t
actual realizations of yit . Some simple algebra shows that this equals

s2b s2Z ms2r s2e s2Z m s2r


.
t s2b ms2e s2Z m s2Z ms2r s2e s2Z m s2r

Since this coincides with the expression s2bt1 in (26), the proof is complete. &

Proof of Remark 2. The beginning of period 1 priors on di have exogenous variance s2d . By the end of period t  1, investors
see both rm is report y^ it1 and the realized value yit1 . Since investors know that the relation between y^ it1 and yit1 is
given by y^ it1 yit1 dit1 at1 =c (for some constant at1 in period t  1 analogous to the constant a in period t), and
since investors can infer the value at1 =c, they can deduce dit1 , which is an unbiased estimate of di . Moreover, since no
other information in period t  1 is useful to investors in updating their assessment of di , they can apply normal Bayesian
updating formulas to conclude that, as of the beginning of period t, investors priors about the distribution of di , is that it
has variance 1=1=s2d t  1=s2f . &

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