Manipulability vs. Information Asymmetries about the Manipulability of Accounting Numbers

Many of the Financial Accounting Standards Board's (FASB's) recent standards and ongoing projects emphasize fair value measurement in an attempt to increase the relevance of financial statements. This can be seen as part of the FASB's broader emphasis on decision usefulness. Arguably, these same standards and projects have reduced or have the potential to reduce the reliability of accounting, as is to be expected in the familiar tradeoff between relevance and reliability. Ijiri (1975) and Christensen and Demski (2003) emphasize the stewardship and information content roles of accounting. Both recognize the hidden (out-of-equilibrium) role of accounting in ensuring managerial actions and reports are held in check. Ijiri (1975) studies the axiomatic structure of historical cost accounting and compares historical cost accounting to other valuation methods along three dimensions: accountability, performance measurement, and economic decisions in general. In Paton and Littleton (1940), a focus on measuring effort and accomplishment leads to their advocating " verifiable, objective evidence " and historical cost-based valuation. Paton and Littleton write (p. 7) " [i]n general, the only definite facts available to represent exchange transactions objectively and to express them homogenously are the price-aggregates involved in the exchanges; hence such data constitute the basic subject matter of accounting. " Ijiri and Jaedicke (1966) view reliability as having two components: objectivity and bias. Objectivity is defined as the variance in observed measurements produced by independent (and truthful) measurers/accountants. (The FASB's definition of verifiability corresponds to Ijiri and Jaedicke's definition of objectivity.) Ijiri (1975) 2 goes on to develop the idea of " hardness, " which asks how far apart measurers can push the measures if they have incentives to take extreme positions. That is, hardness encompasses both objectivity and a lack of manipulability. This paper studies a principal-agent (both are risk neutral) model of moral hazard with two performance measures: one perfectly hard (not manipulable) and one soft (partially manipulable). Our basic premise is that soft performance measures are not only subject to manipulation but also that there is often an information asymmetry between managers and investors about the degree of manipulability. Such an information asymmetry arises because of previous accounting choices (e.g., the creation of a hidden/secret reserve) or a better understanding of: the inherent objectivity of a specific firm's estimates, opportunities for structuring transactions to achieve accounting objectives, the toughness of the particular audit engagement partner, etc. We derive conditions under which it is optimal …