Accounting and the Financial Accelerator

Abstract

We extend the general equilibrium economy of Holmstrom and Tirole (1997) ¨ to optimal reporting of productive assets and examine when the accounting process can contribute to fnancial acceleration. Given a small change in aggregate capital stock, the economy may respond with large readjustments in accounting policies, prices and investment activity. A neutral accounting system, defned as a policy that does not distort decision-making, is optimal when capital is abundant but, after a contraction in aggregate capital, the accounting system becomes initially liberal and then conservative. Surprisingly, accounting policies maximizing frm value, i.e., the net cash flows to shareholders, may lead to self-fulflling equilibria with ineffcient forced liquidations. The theory offers a stylized paradigm to evaluate accounting policies in the aggregate.