Confused by Unclear Accounting Information

In the grand scheme of the economy, the accounting information that individual firms report can have big impacts. Here’s why. 

Lots of economic forces keep underdogs in industries alongside top-producers – think the retail dichotomy of Kmart and Walmart. Competition, taxes, regulations and government subsidies are just some of the forces that prevent markets from simply weeding out underperforming firms within industries. Information is another force, says Rebecca Hann, an accounting professor at the University of Maryland’s Robert H. Smith School of Business.

Hann and her co-authors (Heedong Kim, Wenfeng Wang, and Yue Zheng, who are current and former Maryland Smith PhD students) for the first time explore how accounting numbers can explain productivity dispersion within an industry. In capital markets, investors want to put their money into productive firms. But productivity is not something that one can easily observe or measure, so outside investors have to use other information signals, like accounting earnings, to surmise productivity. And investors look at the picture of the whole industry. They need to know where each firm is in relation to others in the industry to decide where to invest. 

“‘Bad’ quality financial statements can reduce investors’ ability to gauge firm productivity,” Hann says. “A low productivity firm may exploit its reporting discretion to inflate earnings — there are many accounting cookie jars that firms can use to save for the rainy days. This can make it difficult for investors to make efficient investment decisions. As a result, resources may not always be allocated to the more productive firms, and low productivity firms may continue to exist. That’s when we observe large productivity dispersion.”

Industries with more transparent financial reporting and higher quality financial statements have less productivity dispersion, Hann says. Those industries are like open books so investors know where to put their money and the market can work as it should. 

The bottom line, Hann says, is that accounting information can have a significant effect on the macroeconomy. 

“In an economy where much of the growth is driven by reallocation of resources, anything that can help improve efficiency is worth looking at. When resources are allocated across firms more efficiently, the whole economy can grow faster.”

Read more: Information Frictions and Productivity Dispersion: The Role of Accounting Information, by Rebecca Hann with Heedong Kim, Wenfeng Wang, and Yue Zheng, is featured in The Accounting Review.