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Principles-Based Accounting, Legal Liability, and Asymmetric Information Problems
Mingcherng Deng,
Columbia University
ABSTRACT. This paper analyzes how principles-based accounting may alleviate the asymmetric information problem between investors and managers. In my model, a privately-informed entrepreneur seeks to raise capital from an investor. The investor observes a noisy accounting signal that may help mitigate asymmetric information problem. However, the entrepreneur may be subject to a litigation penalty because of the errors in the accounting signal. Due to inefficiencies in the legal system this penalty will not be entirely collected by the investor. The ensuing deadweight loss reduces the investment efficiency. When the entrepreneur is granted more discretion over the accounting signal, the informativeness of the accounting signal is reduced, but the costs of the penalty indirectly borne by the investor are also lower. I show that weighing the benefits of the accounting signal to the investor against the costs, a regulator may adopt a principles-based system.
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