Properties of Accounting in an Economy with Transaction Costs

Mitchell Farlee, John C. Fellingham and Richard Young

Corporate Finance & Organizations from Ohio State University

Abstract: A simple two-period model with information asymmetry and restriction on transfers is used to induce an inter temporal relationship between a sequence of investment decisions. The owner's reputation for honoring commitments to ex post inefficient production decisions allows her to make efficient use of the manager's private information regarding the first period cost. In particular, she commits to produce more in period two if the manager discloses favorable information regarding period one investment activity. As a result, both the owner and manager benefit from the long-term relationship. Mark-to market accounting is then imposed and a valuation exercise is conducted. The information problem causes the accrual for future economic opportunities to be directly related to prior period cash flows and induces a relationship between period one and period two cash flows that is consistent with empirical regularities found in the literature.

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