Optimal Comparability, Relative Accounting Performance, and Real Effects

Abstract

This paper examines how accounting comparability affects investment efficiency and risk-allocation in the economy. We develop the statistical and informational properties of accounting reports under varying degrees of comparability. In our information economics framework, a perfectly comparable accounting measurement system enables investors to perfectly infer the difference between any two firms future cash flows although investors remain uncertain about either firm s cash flow. Because of the increased informativeness of the relative accounting performance, comparability alleviates the underinvestment problem by strengthening the price response to accounting earnings. However, perfect comparability is not socially optimal as it induces excessive price risk as well as systematic cash flow risk.