Accounting Measurement Rules when Firms and Investors have Bounded Rationality
Abstract
We study the investment efficiency of the historical cost and fair value measurement rules when a reporting firm and its investors have bounded rationality. While all investors are attentive to the firm’s report, the firm is miscalibrated and investors incorrectly believe that only some investors are attentive. We find that the historical cost rule yields greater investment efficiency than the fair value rule if and only if a firm’s profitability is sufficiently negatively correlated with market returns, its production exhibits sufficiently strong returns to scale, the firm is sufficiently well calibrated about its investors’ attentiveness, and investor rationalizability is sufficiently weak. These characteristics offer guidelines for designing fair value accounting standards when market participants suffer bounded rationality.
