The observer effect in accounting

by Chicago Booth

3rd December 2015

In physics, the observer effect describes how the act of measurement changes what’s being measured. An electron can’t be detected without interacting with a photon, yet that interaction changes the path of the electron.

Similarly, in accounting, previous research suggests that the way we measure and report companies’ business transactions significantly changes those companies’ strategies, write Chandra Kanodia of the University of Minnesota and Chicago Booth’s Haresh Sapra. One consequence, they argue, is that accounting disclosures that incrementally inform investors may not necessarily help companies make better decisions in allocating resources.

The researchers synthesize the methodology of recent “real effects” studies. They say that accounting standard-setters should question the popular belief that accounting provides information on an objective reality, independent of accounting measurements and disclosure. Also, they argue that researchers and policy-
makers should shift away from seeking correlations between increased disclosure and improved security returns, and instead focus on the “identification and empirical detection of real effects.”

In the traditional view, corporate managers make decisions based solely on the information they possess. Better information means the managers make better decisions, and shareholders get a higher payoff. But this one-way model doesn’t incorporate how an awareness of shareholders’ desire for larger returns affects managers’ choices. Managers’ decisions “must necessarily be affected by the information in the capital market,” the researchers write.

Consider, for example, how accounting disclosures about a company’s expenses can affect shareholders. Currently, investment expenditures are generally recorded on the balance sheet as assets, and are expensed against future revenue through depreciation and amortization. Operating expenses, meanwhile, are matched with current revenue to determine the current-period profit or loss for a firm. But a company’s investment cannot be directly observed by outsiders and, in practice, that investment is difficult to measure. Further, although a firm’s cash outflows are readily visible, those aggregate outflows do not make it clear how much is investment and how much is operating expense. This “measurement noise” affects investors’ views on the company, which in turn influence managers’ decision-making.

Building on previous research, Kanodia and Sapra construct a detailed model of how measurement noise affects firms’ investment choices. The authors note that when accruals are particularly noisy, cash flow can be more informative to investors. Conversely, accrual accounting can be more informative when cash flows are noisy. The implication is that cash flow and accounting income will be used to update investor assessments of the firms’ future cash flows, the researchers add, noting that this claim is consistent with previous findings. This is significant, since research implies that the market’s feedback about performance influences firms’ investment strategies.

Kanodia and Sapra note that market inferences based on a firm’s earnings report tend to have a beneficial effect on the firm’s investment, while market inferences based on a firm’s net cash flow detract from investment efficiency. So when investment is measured more accurately, the firm’s investment is likely to
be better.

The researchers aren’t about to throw accounting standards overboard, but they believe that for stewardship purposes, measurement and reporting systems are best left to the discretion of corporate boards.

Work cited

Chandra Kanodia and Haresh Sapra, “A Real Effects Perspective to Accounting Measurement: Implications and Insights for Future Research,” Working paper, March 2015.

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This article originally appeared in Capital Ideas, a publication of the University of Chicago (http://www.chicagobooth.edu/capideas)