The Observer Effect in Accounting

In physics, the well-known 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, recent research suggests that the way we measure and report companies’ business transactions will significantly change those companies’ strategies, argue Chandra Kanodia of the University of Minnesota and Haresh Sapra of Chicago Booth. If that’s true, they suggest, then accounting disclosures that incrementally inform investors may not necessarily help companies make better decisions in allocating resources.

In a paper to be presented this week at the Journal of Accounting Research conference, the researchers synthesize the methodology of some of these recent “real effects” studies. They suggest that accounting standard-setters should question the popular belief that accounting provides information on an objective reality, independent of accounting measurements and disclosure. They argue that researchers and policymakers 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 solely based 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 argue.

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, it 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 a firm’s investment choices. They note that cash-flow accounting methods filter out the noise in accrual accounting measurements, so cash flow becomes more informative to investors whenever accruals are noisy. Conversely, accrual accounting becomes 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 regarding firm performance will influence the firm's investment strategy, for better or for worse. For example, note Kanodia and Sapra, 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 in fact be better.

The researchers aren’t about to completely throw accounting standards overboard, but they argue that measurement and reporting systems for stewardship purposes are best left to the discretion of the boards of individual firms. “Accounting standards are intended to govern only the mandatory disclosures that are made to the public at large, including the firm’s current stakeholders and also all potential stakeholders,” Kanodia and Sapra note. “The value of such large scale public disclosure depends upon having a ‘shared’ language, which in turn requires the kind of uniform measurements that are enshrined in accounting standards.” But they suggest that accounting standard-setters who ignore the real effects being studied will likely produce many unintended consequences.