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Research Focus

The Impacts of Accounting Information on Investments and the Economy

By Judson Caskey

My current research examines accounting information in the context of the broader economy. Many ideas about the effects of accounting information rely on intuition that applies to individual companies. This approach has some merit, but can be misleading when applied to companies in a large, developed economy like the United States. Also, some questions cannot be examined at all without considering the overall economy.

For an example of a failure of intuition developed in the context of a single company, conventional wisdom suggests that high quality accounting can lower the cost of capital. The rationale behind this idea is that typical investors can rely on price protection when facing the prospect of trading against a privately informed speculator, which lowers the prices they pay for stocks and raises the cost of capital. Privately informed speculators exacerbate this effect by deliberately structuring their trades to limit the amount of information revealed in prices and further increasing the uncertainty faced by typical investors. High accounting quality can reduce the cost of capital by both mitigating the uncertainty faced by typical investors and leveling the playing field between them and speculators.

One of my recent coauthored studies shows that this conventional wisdom does not hold in a large economy where investors hold diversified portfolios. Poor accounting quality may cause investors to overvalue some companies, and undervalue others, but, on average, investors can rely on diversification to protect their portfolios from any effects of poor quality accounting. Because poor quality accounting does not impact diversified investors’ payoffs, it does not affect the cost of capital. This does not imply that accounting does not ‘matter’ in a large economy; rather, it suggests that accounting matters for reasons other than cost of capital, such as the allocation of capital or monitoring managers.

I recently coauthored a study on how trade linkages between companies affect the propagation of shocks to company performance, a question that can only be examined in the context of the overall economy. We identify some industries as hubs in the sense that they serve as conduits for a large amount of trade in goods and services. We provide empirical evidence that these industries play a special role in propagating macroeconomic shocks. For example, because hub industries interact with large portions of the overall economy, shocks to their earnings tend to have ripple effects on the broader economy.

Judson Caskey, Assistant Professor of Accounting, received his BS in Accounting from Michigan State university and received both his MBA and Ph.D. from the University of Michigan. His research and teaching interests include capital markets, financial reporting, informational asymmetry, and security market valuation.

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