Synergy between Accounting Disclosures and

Forward-looking Information in Stock Prices

Anil Arya, Brian Mittendorf, and Ram N.V. Ramanan1

1 Theauthors are from Fisher College of Business, Ohio State University, arya.4@osu.edu; Fisher
College of Business, Ohio State University, mittendorf.3@osu.edu; and Graduate School of Man-
agement, University of California, Davis, ramanan@ucdavis.edu.
 Abstract

It is often noted that accounting information, while faithfully estimating current profitabil-
ity, fails to reflect forward-looking information about new ventures. Stock prices, however,
reflect the prevailing sentiment about both current and future activities. As a result, though
accounting is viewed as an important information source, stock price reactions are the pri-
mary gauge of how new technologies are expected to fare. With this in mind, we develop
a model of accounting disclosures when market prices serve as a useful tool to inform the
use of emerging technologies. We demonstrate that the information in accounting reports
about current activities can indeed prove useful in improving decisions about new activities.
In addition, we also demonstrate a synergy between accounting reports and market prices in
guiding strategiesthe more the forward-looking information that can potentially be gleaned
from price, the more vital accounting information about current activities proves.
1 Introduction

Accounting is primarily geared towards generating information about rms current and
historical activities. An oft-directed criticism of this focus is that such information is not
particularly valuable when it comes to the evaluation and implementation of new business
ventures wherein forward looking information is instrumental. For new ventures, then, it is
the forward-looking market reaction embedded in the rms stock price that is key. This
paper demonstrates that such criticism of accounting information is unwarranted even when
accounting reports provide no direct guidance about the e cacy of future ventures. This
is because public disclosure of a rms current activities makes the rms stock price a
more informative signal of upcoming ventures. That is, public disclosure of a rms current
activities, when coupled with stock prices, proves to be a critical information source for
evaluating new ventures.
To provide a concrete example, consider a rm that has just developed a new product.
The stock markets response contains information, for it conveys prospective userstaste for
and assessment of the new product. An accounting report on the rms existing ventures,
though not directly relevant, helps discern the prospects of the new product from market
reactions. First, disclosure of the accounting report reduces some market level uncertainty
about current ventures. Consequently, any residual volatility in the rms stock price can be
more precisely attributed to the markets assessment of the new ventures e cacy. Second,
as the rm expands its disclosures, we show, the stock price becomes a less noisy aggregator
of rm value. This further improves the ability to read from stock price the markets pulse
for the new product, thus further facilitating future marketing and production decisions.
Formally, we model a rm that develops a new technology whose prospects are uncertain.
The rm issues an accounting report that reects the protability of the rms existing
ventures. The precision of this report is tied to the rms up-front investment in the quality
of its accounting system. We employ a variant of the canonical Kyle (1985) specication of
informed traders to model the rms stock market. The rms underlying value consists of

1
the two uncertain componentsprots from its existing ventures and potential prots from
the newly developed technology. Once the stock market values the rm, a decision on how
to employ the new technology is made after taking into account the stock markets feedback.
Though the setting is one where the accounting report only provides information about
current, not future, ventures (i.e., past, not future, decisions), our main result demonstrates
that a more precise accounting report proves benecial by complementing the usefulness
of stock price in discerning the e cacy of the new technology. In fact, the rms public
disclosure contributes more than just the information contained in it; that is, one learns
more when an accounting report is disclosed publicly than when he observes it privately.
Specically, since the equilibrium stock price is a noisy aggregator of the rms funda-
mental value, the extent to which the price proves decision-relevant to employing the new
technology is aected by (a) the degree of uncertainty or noise in stock price introduced by
the trading process and (b) the volatility in stock price attributable to the existing tech-
nology. In eect, (a) reects the degree to which price contains information pertaining to
the rm and (b) reects confounding information unrelated to the new technology. The
accounting report improves decisions by helping with regard to (b) in that the information
contained in the report about current technologies makes it easier to tease out confounding
information from stock price. The second, more subtle eect, comes from the accounting
report being public. Issuing the report publicly erodes informed tradersprivate information,
giving them less ammunition to distort stock price away from its true value. This helps with
regard to (a) in that it makes stock price a less noisy reection of true rm value. Thus, in
equilibrium, the rm invests resources in its accounting system for improving the precision
of its accounting report.
More generally, we establish that even when the rm does not reap the full benets of
the new technology and shares the benets with a third party, these results prevail (e.g., a
software rm dependent on a hardware partner to implement its new technology and thus
forced to share the benets). As the rm enjoys greater bargaining power with the third

2
party, not only does it derive a greater share of the surplus from the new technology, but its
preferred disclosure precision also increases.
Broadly speaking, this papers results are tied to the literature on the role of stock market
prices in e ciently aggregating diuse investor information (see, e.g., Fama 1976; Kyle 1985).
Of interest here is how such information embedded in prices is used in subsequent decisions.
Amershi and Sunder (1987), Dow and Gorton (1997), Dye and Sridhar (2002), Langberg and
Sivaramakrishnan (2010), and Kumar, Langberg and Sivaramakrishnan (2012) are notable
theoretical inquiries about such usefulness of market feedback. Empirical examinations of if
and how market information guides decision-making include Luo (2005), Markovitch, Steckel,
and Yeung (2005), Chen, Goldstein, and Jiang (2007), and Kau, Linck, and Rubin (2008).
The literature demonstrates that varied observers make use of stock market reactions to
guide decisions, and that this represents a real eect of price formation.
Given the use of stock prices as an information source relevant to decision making, the
particular interest in the current paper is how accounting disclosures aect such decision-
usefulness. Gao and Liang (2013) and Ramanan (2014) are cases of this line of inquiry. In
Gao and Liang (2013) accounting disclosures are undesirable and thwart decision making.
This is because disclosure discourages information gathering by equity traders and thus limits
new information available through stock prices. In Ramanan (2014), it is timely accounting
disclosures that can undermine the information that is gleaned from stock price. The reason
is that timely disclosures of multiple pieces of information make it di cult to untangle which
disclosure components prompted market reaction; as a result, a rm can nd it optimal to
delay some disclosures. In contrast, we show that betteraccounting disclosure can actually
improve the decision-usefulness of stock prices. In the above mentioned studies, the rms
disclosure and the markets reaction relate to the same aspect of rm value, whereas in our
study the disclosure pertains to one aspect of rm value (existing ventures) and by clearing
the air the rm makes it easier to sift out information in equity price about an unrelated
component of rm value (new ventures). Since the new ventures component is naturally the

3
one that still permits adjustments in decisions, increasing the precision of the accounting
reports actually improves decision-making tied to price.
The rest of the paper is organized as follows. Section 2 describes the economic setting
modeled. Section 3 presents the main analysis, describing the impact of disclosures about
existing activities on learning about the prospects of new ones. Section 4 concludes.

2 Model

A rm has a portfolio of existing business ventures that yields terminal payo (cash ow)
1
of x~, x~ N x ; hx . Also, the rm has recently developed a new technology, e.g., a
touch screen based operating system. This technology can increase rm protability by
1
y~; y~ N y ; hy ; where y~ can be viewed as a measure of consumer taste or demand
for the new technology. Prot from the new technology may reect, for example, product
adoption by existing customers seeking an upgrade. The rm can also further exploit the
new technology by selling the rights to use this technology, e.g., a hardware manufacturer is
given the rights to build and sell tablets around the new operating system. These rights are
transferred to a third-party (manufacturer) for a mutually-agreed price, T . In particular,
this transfer payment is determined based on the familiar (generalized) Nash bargaining
process between the rm and manufacturer with 2 (0; 1] denoting the rms bargaining
power. The manufacturer can make q units by employing the new technology at cost q 2 =2
and receive revenue of ! y~ per unit with ! > 0: Naturally, the payo from this new product
is tied to customerstaste or demand for the underlying technology, as reected in y aecting
the payo. That said, the benets from the new technology may, of course, accrue dierently
to existing and new ventures, as captured by the parameter !.
Although a rms accounting disclosures are not geared to convey if a newly developed
technology will succeed in the future, they typically do provide information pertaining to
protability of existing product lines. In this regard, assume that up-front the rm establishes

4
an accounting system of precision h to generate a publicly observed accounting report of x;
where the report, r; is r = x + ~" with ~" N 0; h1 : To reect the fact that more precise
accounting estimates are costly to generate and credibly convey, let the accounting systems
cost be c (h), which satises standard regularity assumptions c0 (h) 0; c00 (h) > 0; c0 (0) = 0;
and Lim c0 (h) ! 1.
h!1

Of course, accounting reports are not the only source of information about the rm. The
stock market aggregates all information about the rm, including forward looking informa-
tion about the prospects of the newly introduced technology. Formally, we model this aspect
of the stock market by presuming n informed individuals privately observe x and y based on
their ability to be astute evaluators of dierent aspects of rm value. Following Kyle (1985),
the rms equity market consists of these n (risk-neutral) informed traders, some liquidity
traders, and a risk-neutral market maker who sets the price. Based on her private informa-
tion, informed trader i; i 2 f1; 2; ::; ng, places a market order zi zi (x; y; r; h) for the rms
shares. Each informed investors order is designed to maximize her expected trading prots
2
at the expense of liquidity traders. Let u~ N (0; u) denote the quantity demanded by the
liquidity traders with u uncorrelated to all other variables in the model. A market maker
n
observes the aggregate order ow f = zi + u for the rms shares; based on the order
i=1

ow f and the publicly available report r; he sets price P to break even in expectation and
provides the liquidity necessary to clear the market.
The precision h of the information system is chosen to maximize expected rm value
where rm value is given by V = x + y c (h) + T (h). Here the function T (h) recognizes
that the value of the new technology and thus the transfer payment may be aected by the
rms disclosure policy. This completes the description of the model. The sequence of events
is summarized by the timeline in Figure 1.

5
 Figure 1: Timeline

3 Disclosure Policy

The key focus of this analysis is on how disclosures about existing activities can facilitate
learning about a new and independent technology and consequently improve its use and
protability. In order to do so, rst Section 3.1 examines the eects of a given disclosure
on the equity market equilibrium; next, Section 3.2 studies implications of this equilibrium
for the use of the new technology; and Section 3.3 steps back to endogenize the rms
optimal disclosure policy. To further characterize the economic forces at work, Section 3.4
highlights the criticality of the rms public disclosures by contrasting the outcome with that
obtained under private communication; nally, Section 3.5 evaluates the interaction between
the quality of dierent sources of information about the rm and its impact on the rms
choice of disclosure policy.

3.1 Equity Market Equilibrium

The ideal number of units of the new product to manufacture is critically tied to the prospects
of the new technology. For information on this front, the stock markets reaction proves
useful, and can be further facilitated by the rms report r: Recall that report r pertains
to the rms existing technology and not to the new technology. On the face of it such
information is not particularly useful as no decisions are contingent on it. However, before
reaching such a conclusion it is important to recognize that report r and stock price P
interact because of which report r can prove useful to the manufacturer in deciphering the
prospects of the new technology from stock price P . Thus, as a rst step, we simply note

6
how the rms disclosure impacts the equity market equilibrium. (All proofs are detailed in
the Appendix.)

Proposition 1 Given reporting precision h; the equity market equilibrium for a report r is
described by:

+ yx
zi = and P = E [V jr; h] + f; where
[n + 1]
h [x r] + hx [x x]
x = ; y= y y ; and
h + hx
2 n
= var ( x ) + var y with
[n + 1]2 2u
1 1
var ( x ) = and var y = :
h + hx hy

To see how the equity market equilibrium comes about, consider rst the incentives of
the informed traders. Given just the report r under policy h, the market makers best guess
h r+hx
of rm value is E [V jr; h] = h+hx
x
+ y c (h) + T (h). Each informed investor has better
knowledge of the rms underlying value, allowing her to value the rm at x+y c (h)+T (h) :
h r+hx
The dierence in their valuation is x h+hx
x
+y y = x + y; thus x and y

reect informed tradersadvantage in valuing the existing and new technologies of the rm,
respectively. Clearly, the greater the dierence in these valuations, the more the informed
investor benets from trading. What prevents the informed traders from exploiting such
arbitrage by buying (or, when x + y is negative, selling) innitely many shares is that the
market-makers pricing function adjusts price based on order ow, reected in > 0. Thus,
the informed traders seek to balance the number of shares traded at arbitrage pricing with
the per-unit protability from such trades, since greater trading shrinks the wedge between
price and fundamental value. These osetting priorities are reected in the fact that order
ow is increasing in x+ y, the dierence of perceived value between the informed investor
and the market maker, and compressed by ; the sensitivity of stock price to order ow.

7
 The market makers pricing function reects publicly available information E[V jr; h]
adjusted for the order ow f . Given the linear equilibrium and normal distributions, the
optimal weight on the order ow is simply the least squares weight, = cov (V; f ) =var (f ) ;
which simplies to the expression in the proposition. This least square weight eectively
scales the order ow to minimize the losses the market maker suers in trading with informed
traders. Thus: (i) the greater the informed traders advantage in trading, the more the
market maker weights the order ow, i.e., increases in var ( x) + var( y ); (ii) the more
the liquidity trading, the less trade uctuations reect informed trader activity, and the less
2
he needs to protect himself, i.e., decreases in u; and similarly (iii) the larger the number
of competing informed traders, the less the market makers need to protect himself, i.e.,
decreases in n.
Given our focus on extracting forward looking information from an aggregate measure
such as stock price, it is important to identify the dierent pieces of information incorporated
in it. The following proposition helps to do that.

Proposition 2 The stock price can be reexpressed as

n
P = E [V jr; h] + x + y + where
n+1
1
N 0; var ( x) + var y is noise uncorrelated to V; r; x; or y:
n

The stock price consists of two components: E [V jr; h] reects the publicly available in-
n
formation, and n+1 x + y + reects the information uncovered through equity trading.
Trading reveals information about y, the viability of the new technology (via y ). How
much can be learned about y from observing P , in turn, depends on information about other
aspects of the rm ( x)
and noise introduced by the trading process ( ).
var( x )+var( y )
From Proposition 2, n
= var ( ). In eect, although liquidity trading is
independent of informed investors informational advantage, the volatility in stock price
due to liquidity trading, i.e., var ( ), is proportional to informed investors informational

8
advantage. This is because the impact of liquidity trading on stock price is directly tied
to , the sensitivity of stock price to order ow. As already indicated in Proposition 1,
as traders informational advantage increases, increases correspondingly, and this allows
liquidity trading to have a bigger impact on stock price. In contrast, when n goes up,
decreases, and this limits the impact of liquidity trading on stock price.
Having identied how information is ultimately reected in stock price, we next examine
how this information inuences the e cient use of the new technology and how that, in turn,
aects valuation.

3.2 Exploiting the New Technology

The manufacturer of the new product faces a decision about how widely to make use of
the rms technology, particularly given uncertainty about its e cacy. This is a nontrivial
decision because the manufacturer faces convex costs of implementation (be they production
costs or diminishing marginal returns from marketing to consumers). In particular, his
manufacturing decision based on observing the rms disclosures and market price is:

q2
M ax E ! y q r; P ; h T (h) :
q 2

Solving, his implementation choice yields:

h + hx
q (r; P ; h) = ! E [yjr; P ; h] ; or q (r; P ; h) = ! y + (P E [V jr; h]) :
h + hx + hy

Intuitively, when the new technologys prospects are great, the stock price reects such
optimism. Taking his cue from the positive market response, the manufacturer makes more
use of the new technology, as reected in q increasing in P .
In this setting, the question about how useful accounting disclosures are is tied to their
real eects, i.e., how they inuence decision-making. Here, the manufacturers implemen-
tation choice represents such a critical decision. And, while the accounting report itself is

9
not directly relevant to that choice (report r relates to existing technologies x), it can alter
the extent to which market price is relevant to that choice. To see the role of accounting
most clearly, note that the sensitivity of q to stock price P increases in accounting precision,
h i
@
i.e., @h dq(r;P ;h)
dP
= [h+h! h+h
y
]2
> 0: In other words, the more precise the accounting report
x y

on existing technologies, the more precise the manufacturers information about the new
technology, this despite the presumption that the two technologies are independent. This
conclusion is conrmed by the following proposition.

Proposition 3 Greater precision in the accounting report of x results in greater precision

in the manufacturers estimate of y, i.e., var (yjr; P ; h) decreases in h.

Before examining how the connection between accounting precision and decision-usefulness
of stock prices translates to rm value, some explanation for how reporting precision boosts
the usefulness of stock price is in order. Recall, the accounting report does not directly
convey anything about y, the new technology. Rather, it changes the information conveyed
by stock price in two ways. First, since price (imperfectly) reects private information about
x + y, greater disclosures of x make it easier for the manufacturer to extract the y-portion
of such x + y information contained in price. A second, more subtle, eect is that greater
disclosures of x actually enhance the degree to which price reects private information. That
is, as disclosures of x improve, each informed traders information advantage about the value
of the rm is reduced. This reduction means that the market maker is at less risk of being
exploited by the orders of informed investors and so reduces ; the consequences of order ow
for stock price. The ultimate result is that stock price embeds less noise and is, therefore,
more informative. This two-pronged information benet of improving accounting precision
is conrmed in the following corollary.

Corollary Greater precision in the accounting report of x;

(a) reduces the amount of confounding information in price about existing technologies,
i.e., var ( x) decreases in h; and

10
 (b) reduces the amount of noise in stock price introduced by the trading process, i.e.,
var ( ) decreases in h.

Clearly, both forces in the corollary work in concert to improve the manufacturers learn-
ing about the e cacy of the new technology. Given the predictable eect of disclosure
precision on the manufacturers ability to employ the new technology e ciently, the ex-
pected surplus from the new technology, denoted (h) ; can be computed at the negotiation
stage as follows:

q 2 (r; P ; h)
(h) = Er;P Ey ! y q (r; P ; h) r; P ; h
2
!2 2 n h + hx
= y + : (1)
2 [n + 1] hy [h + hx + hy ]

The transfer payment T (h) depends on how the two parties agree to split this expected
surplus. As alluded to in Section 2, we envisage the familiar Nash-bargaining process. In
the event of successful bargaining, the rms expected payo is x + y c (h) + T (h) and
the manufacturers expected payo is (h) T (h). Their status quo payos corresponding
to failed bargaining (the disagreement point) are x + y c (h) and 0, respectively. Thus,
the bargaining process characterized by being the buyers power, maximizes the following
(generalized) Nash-product:

M ax [T (h)] [ (h) T (h)]1 :

T (h)

The above problem yields the following transfer payment:

T (h) = (h) : (2)

As can be expected, an information environment that cultivates more condent and circumstance-
contingent usage of the new technology by the manufacturer translates into a higher willing-

11
ness to pay and, thus, a higher transfer payment.
Having established how accounting precision relates to the transfer payment, we next
consider the rms optimal accounting choice.

3.3 Preferred Accounting Precision

Using T (h), the rms benet from the new technology derived in Section 3.2, the rms
expected value at the time accounting precision is chosen is:

E [V ] = x + y c (h) + T (h) : (3)

Using T (h) from (2) and (h) from (1) ; the rst order condition of (3) reveals the unique
value-maximizing accounting precision, as identied in the next proposition.

Proposition 4 The rms optimal choice of accounting precision, h , is the unique positive
h-value that solves:
n !2
[h + hx + hy ]2 c0 (h) = :
2 [n + 1]

Intuitively, the proposition details the trade-os in choosing accounting policy. Greater
precision is costly but can also boost the benets of the new technology and, thus, its prof-
itability to the rm. The nature of this trade-o is governed by how much of the benets of
the new technology the rm can extract ( ), how important technology commercialization is
(!), how much uncertainty there is about the technologys value (hy ), how much uncertainty
there is about the rms other endeavors (hx ), and how much information competitive trad-
ing among informed investors can provide (n). In particular, the more potential information
that can be gleaned from price (lower hx and/or hy ), the better price is at reecting such
information (higher n), and the greater the potential benet from revealing that information
(higher and/or !), the more precise the optimal accounting report. As the next propo-
sition conrms, each of these factors not only inuences accounting policy but also aects

12
rm value in a clear manner. In writing this proposition, we let E [V ] denote the expected
rm value at the optimal accounting precision level, i.e., E [V ] = x + y c (h ) + T (h ) :

Proposition 5
(a) The rms optimal precision level h increases with its bargaining power , the number
of informed individuals n; and with the importance ! of the new technology and decreases
dh
with precisions hx and hy , i.e., d
> 0; dh
dn
> 0; dh
d!
dh
> 0; dhx
< 0; and dh
dhy
< 0.

(b) The expected rm value E [V ] increases with ; n; !; and hx and decreases with hy ,
dE[V ] dE[V ] dE[V ] dE[V ] dE[V ]
i.e., d
> 0; dn
> 0; d!
> 0; dhx
> 0; and dhy
< 0:

From the proposition, notice that not only is the desirability of a more precise accounting
report closely tied to the degree to which disclosure can boost e ciency in the use of the
new technology, but so is the rms value. This value manifests itself along two dimensions.
First, the more the rm stands to benet from the new technologys usefulness, the more
it can gain from information enhancing its eective use. This is reected in value increasing
in bargaining power ( ) and commercialization potential (!). It is also reected in the
fact that rm value is decreasing in hy given the convex payos from the technology, the
manufacturer benets from a high-variance hit-or-miss technology, provided he is able to
judiciously employ the technology with the right information.
This leads to the second dimension, the more potential learning that the manufacturer
can glean from market price, the greater the value of the technology. This second feature is
reected in value increasing in hx the less confounding information in price that pertains
to current ventures, the more the manufacturer can glean decision-relevant information from
stock price. Also, more competition among informed traders drives out fundamental noise
from stock price and boosts the ability to properly employ the new technology, as reected
by value increasing in n.
The analysis in this section considers the disclosure policy that maximizes long term rm
value. Alternately, one could have conducted the same analysis with a manager who xates

13
on stock price P . It is comforting to note that such a managers accounting choice is identical
to the h in Proposition 4. Since the objective of the current disclosure policy is to improve
the informativeness of stock price, the benets of the rms disclosure are fully recognized
in the rms stock price and thus the chosen accounting precision is equally eective in both
the short term and the long term.

3.4 Public Disclosure vs. Private Dissemination

Recall that the emphasis in this study is on how public accounting reports of current business
can help intensify the decision-usefulness of private information embedded in equity prices.
While the analysis thus far focuses on the information content in the accounting report, we
now consider the importance of the report being publicly disseminated.
After all, if the objective of learning r is simply for the manufacturer to tease out infor-
mation pertaining to current technologies from stock price, then can the same objective not
be met by the rm privately communicating the information to the manufacturer?
The following proposition indicates that the public disclosure of report r brings informa-
^
tional value beyond that of just the information contained in it. (We use a to represent
the outcome in the private communication setting to distinguish it from the public commu-
nication modeled thus far.)

Proposition 6 Public disclosure of the accounting report of x results in greater precision in

the manufacturers estimate of y; i.e., var (yjr; P ; h) < var(yjr; P^ ; h).

There are two aspects to the rms report the information contained in it and the public
nature of its dissemination. Each has a role to play. Recall from the corollary to Proposition
3 that the benet of disclosure in boosting the decision-usefulness of equity prices is two-fold:
(i) it allows the manufacturer to tease out confounding information pertaining to the existing
technology from prevailing price; and (ii) it further improves informativeness of stock price
by reducing the noise content.

14
 The information revealed in the report leads to (i), and thus private communication of
the accounting information achieves (i). However, it is the public nature of the reports
dissemination that leads to (ii). To get a feel for why this is the case, note that disclosing
the report publicly curtails the informed investorsinformational advantage. Consequently,
and as already discussed in Proposition 2, noise content in stock price goes down. This
important eect on stock price cannot be achieved when the report is privately observed by
the manufacturer.
That the report is less valuable when communicated privately than when disseminated
publicly has wider ramications on the rms accounting policy choice. To examine these
additional consequences, we repeat the main analysis as before, assuming that the account-
ing report is privately disseminated (only to the manufacturer) in time for the production
decision q. The following proposition summarizes the results.

Proposition 7 In the private communication setting:

^ < h ; where h
(a) the rm acquires and communicates less information, i.e., h ^ is the

unique h-value that solves:

2
n+1 h hy n !2
h + hx + hy + c0 (h) = :
n [n + 1] hx 2 [n + 1]

(b) Expected rm value is lower relative to the public disclosure setting, i.e., E[V^ ] <
E [V ], where:

2 3
! 2
n ^ + hx
h
E[V^ ] = x + y
^ )+
c(h 4 2
y + h i5 .
2 [n + 1] h h ^ hy
y
^ + hx + hy + h
[n+1]hx

Not only does private dissemination aect the informational value of a given accounting
report, but also inuences the precision of the report in the rst place. The smaller benet
from the private report adversely inuences the rms investment in its accounting system.
^ , which in turn depresses both the value of
This manifests as a report of lower precision h

15
the technology and the benets the rm can derive from it.

3.5 Quality of Private Information

To present the main ideas lucidly, the analysis presumes that the manufacturer has no
information about the prospects of the new technology and that the stock market has perfect
knowledge of it. However, in practice, neither will the market know perfectly about the
prospects of the new technology nor will the manufacturer be completely in the dark about
it. To examine this more realistic situation where both the manufacturer and informed
individuals in the stock market each have some information about the technologys prospects,
consider the main setup with hx = hy = n = 1 for simplicity. Let the informed trader
observe a noisy signal s = y + e~ with e~ N 0; k1 , and the manufacturer observe another
noisy signal = y + ~ with ~ N 0; 1t ; where e and are independent of each other. The
next proposition evaluates the outcome for this case with equilibrium outcomes expressed as
functions of (k; t).

Proposition 8
(a)The rms optimal choice of reporting precision, h (k; t), increases in k and decreases
dh (k;t) dh (k;t)
in t, i.e., dk
> 0 and dt
< 0; where h (k; t) is the unique positive h-value that solves:

h i2
2 [1 + k] 1 + k [2 + h] + t 2 + k [3 + h] [2 + k]
2 c0 (h) = !2:
k2 [1 + k]

dE[V (k;t)]
(b) Expected rm value E [V (k; t)] increases with k and t, i.e., dk
> 0 and
dE[V (k;t)]
dt
> 0 where:

E [V (k; t)] = x + y c (h (k; t)) +

" #
!2 2 k 2 [1 + h (k; t)] + t 2 + k [3 + h (k; t)] [2 + k]
y + :
2 2 [1 + k] 1 + k [2 + h (k; t)] + t 2 + k [3 + h (k; t)] [2 + k]

16
 From the proposition it follows that both the primary results about optimal accounting
precision choice and rm value generalize to the case of imperfectly informed decision maker
and market traders (the main setup corresponds to the case of t ! 0 and k ! 1). Thus,
the key is that equity market participants have some private information useful to decision
makers that can be extracted from prevailing equity prices, not that such information be
a perfect reection of the prospects of the new technology or that decision makers have no
information of their own.
Intuitively, the more the information available to guide the manufacturers choice, the
greater the technologys value and, thus, the greater rm value: rm value increases in
both k and t. Interestingly, the proposition also shows that the more information equity
traders possess (higher k), the greater the precision of the optimal accounting report, whereas
more information possessed by the manufacturer (higher t) favors a less precise accounting
report. This result again underscores a key conclusion of the paperaccounting information
about existing technologies and forward-looking private information about newly developed
technology are complements. The synergy between accounting information and stock prices
is seen by noting that the more the informed traders know, the more precise the optimal
accounting system. After all, the better informed the traders are about y, the more there
is to learn from stock price and greater the benet to the rm of investing in h to make
price a better measure of y. In contrast, and as expected, the manufacturers information
and the rms accounting precision are substitutes. If the manufacturer knows more about
y from another source, there is less compelling reason for the rm to make investments in h
to make stock price more informative of y. Thus, the key complementarity is not between
accounting reports and any other information source, but rather between accounting reports
and a particular information source, stock price.

17
4 Conclusion

The relationship between accounting reports and stock market participants reects a strange
paradox. On one hand, accounting is painted as an inferior information source for failing to
incorporate critical pieces of information about rmsfuture prospects; on the other hand,
market participants eagerly await earnings releases to see if and how they comport with the
seemingly more useful market measures. This dichotomy is also seen in empirical studies
of accounting information, where value relevance is often measured by an ability to reect
price movements, while usefulness is often measured by the degree to which prices change
subsequent to information release. The tensions underlying each of these circumstances
reect an oft-expressed, but hard to formalize, view that accounting reports are best viewed
as complements to, rather than alternatives of, market indicators.
Our study formalizes this complementarity. In particular, we show that by reducing un-
certainty about the protability of a companys current technologies, accounting disclosures
make it easier to sift out the information embedded in equity prices that can help guide
decisions about newly developed technologies. Besides demonstrating a natural complemen-
tarity between accounting reports and market feedback as it pertains to decision-making,
the model also develops clear predictions about the determinants and consequences of more
precise accounting reports.

18
5 Appendix

Proof of Proposition 1:
Conjecture a linear pricing rule of the form P = E [V jr; h] + f and a linear trading
strategy of the form zi = b0 + bx x + by y.

The ith informed traders maximization problem is:

M ax E [fV P g zi jr; x; y; h] :
zi

Taking the conjectured pricing rule P and each of the other n 1 informed traders
conjectured orders, and noting that E [u] = 0, the prot maximization condition is:

M ax V E [V jr; h] [n 1] b0 + bx x + by y + zi zi :
zi

Noting that V E [V jr; h] = x + y and solving the informed investorsproblem yields:

x + y [n 1] b0 + bx x + by y
zi = :
2

Consider the proposed linear pricing rule zi = b0 + bx x + by y; comparing coe cients with
the above and simplifying, we obtain:

1
b0 = 0 and bx = by = : (4)
[n + 1]

Next consider the market maker. His pricing rule is chosen to ensure zero expected prot as
follows:
P = E [V jr; f ; h] :

19
Expanding given normal distributions and simplifying:

P = E [V jr; h] + f where
cov (V; f )
= :
var (f )

Substituting for the conjectured trades:

n bx cov (x; x ) + by cov y; y

= . (5)
n2 b2x var ( x ) + n2 b2y var y + 2
u

Jointly solving (4) and (5) after noting cov (x; x) = var ( x) and cov y; y = var y

yields:

2 n
= var ( x) + var y where (6)
[n + 1]2 2
u
1 1
var ( x) = and var y = ;
h + hx hy

and s
1 2hx hy
u
b x = by = = :
[n + 1] n [hx + hy ]

Proof of Proposition 2:
Using the equilibrium trading strategies zi in the pricing function derived in Proposition
1, we get: " #
n x+ y
P = E [V jr; h] + +u :
[n + 1]
n+1
Denoting n
u= and noting that is uncorrelated to all other variables (follows from
n
properties of u) the above can be rewritten as P = E [V jr; h] + [n+1] x + y + : Using
(6) ; the variance of is given by:

[n + 1]2 2 2
u var ( x) + var y
var ( ) = = : (7)
n2 n

20
 Proof of Proposition 3:
From Proposition 2:

1 n h + hx
var (yjr; P ; h) = var yjr; x + y + ;h = : (8)
hy n + 1 hy [h + hx + hy ]

Dierentiating with respect to h :

d var (yjr; P ; h) n 1
= < 0:
dh n + 1 [h + hx + hy ]2

Proof of Corollary:
1
(i) From (6) ; var ( x) = h+hx
: Dierentiating with respect to h yields:

d [var ( x )] 1
= < 0.
dh [h + hx ]2

(ii) Using var ( ) from (7) ; substituting for var ( x) and var y from (6) ; and then
dierentiating with respect to h :

d [var ( )] 1
= < 0:
dh n [h + hx ]2

Proof of Proposition 4:
Substituting from (1) into (2) :

!2 2 n h + hx
T (h) = y + :
2 [n + 1] hy [h + hx + hy ]

Using the above we compute E [V ] as follows:

!2 2 n h + hx
E [V ] = x + y c (h) + y + : (9)
2 [n + 1] hy [h + hx + hy ]

21
 Dierentiating the above expression twice with respect to h; we obtain:

d2 E [V ] n !2 1
= c00 (h) < 0:
dh2 [n + 1] [h + hx + hy ]3

The sign of the second derivative indicates that the solution to the maximization problem
dE[V ]
M ax E [V ] is unique and that it satises dh
= 0: Solving we obtain:
h

n !2
[h + hx + hy ]2 c0 (h) = : (10)
2 [n + 1]

Denoting the optimal h derived above by h establishes the proof.

Proof of Proposition 5:
(a) The left-hand-side of (10) is increasing in h while the right-hand-side is free of h. The
result then follows from the fact that the left-hand-side increases with hx and hy while the
right-hand-side increases with ; n; and !.
(b) Applying the envelope theorem:

dE [V ] @E [V (h)]
= = (h ) > 0;
d @ h=h
dE [V ] @E [V (h)] ! 2 [h + hx ]
= = > 0;
dn @n h=h 2hy [n + 1]2 [h + hx + hy ]
dE [V ] @E [V (h)] 2 (h )
= = > 0;
d! @! h=h !
dE [V ] @E [V (h)]
= = c0 (h ) > 0; and
dhx @hx h=h
dE [V ] @E [V (h)] [h + hx ] [h + hx + 2hy ] c0 (h )
= = < 0:
dhy @hy h=h h2y

Proof of Proposition 6:
Following the same arguments as the proof in Proposition 1, the trading equilibrium in

22
the private information dissemination setting is as follows:

^ +^
x y
z^i = and P^ = E [V ] + ^ f^ where
^ [n + 1]
^x = x x;
^ y = y and
n h i
^2 = var( ^ x ) + var( ^ y ) with
[n + 1]2 2u
1 1
var( ^ x ) = and var( ^ y ) = :
hx hy

Consider:
1 n hx
var yjr; P^ ; h = :
hy n + 1 hy [hx + hy ]

Comparing with var (yjr; P ; h) from (8):

n h
var(yjr; P^ ; h) var (yjr; P ; h) = > 0:
n + 1 [hx + hy ] [h + hx + hy ]

Proof of Proposition 7:
(a) The production quantity q^ in this setting is given by:

hi
^
q^ = ! E yjr; P ; h :

In a manner analogous to that in Section 3.2, we rst determine the value of the new
technology; then we evaluate the rms fraction from it; and nally, we derive the expected
rm value given precision h:
2 3
2
! 4 n h + hx
E[V^ ] = x + y c (h) + 2
y + h i5 : (11)
2 [n + 1] h h + h + h + h hy
y x y [n+1]hx

23
 dE [V^ ]
The optimal information precision is the h-value that solves dh
= 0. This yields:

2
h hy n2 ! 2
h + hx + hy + c0 (h) = :
[n + 1] hx 2 [n + 1]2

^ and comparing with h in (10) establishes h

Denoting the optimal h by h ^ <h :

(b) E [V ] in (9) is maximized at h = h , so E [V ] jh=h > E [V ] jh=h^ . Further, comparing

(9) and (11) ; E [V ] jh=h^ > E[V^ ]jh=h^ , since the right-hand-side of expression E[V^ ] has an
extra term in the denominator. Thus result, E [V ] jh=h > E[V^ ]jh=h^ ; follows.

Proof of Proposition 8:
(a) Deriving the trading equilibrium in a manner analogous to Proposition 1:

(h; t) + y (k; t)
x
z (k; t) = and P (k; t) = E [V jr; h] + (k; t) f (k; t) ; where
2 (k; t)
h [x r] + [x x] k s y
x (k; t) = ; y= and
h+1 k+1
2 1
(k; t) = 2 var ( x (k; t)) + var y (k; t) with
4 u
1 k
var ( x (k; t)) = and var y (k; t) = :
h+1 k+1

The production quantity in this setting is:

q (k; t) = ! E [yjr; P (k; t) ; h] :

In a manner analogous to that in Section 3.2, we rst determine the value of the new
technology; then we evaluate the rms fraction from it; and nally, we derive the expected
rm value given precision h:
h i
k 2 [1 + h] + t 2 + k [3 + h] [2 + k]
E [V (k; t)] = x + y c (h) + :
2 [1 + k] 1 + k [2 + h] + t 2 + k [3 + h] [2 + k]

dE[V (k;t)]
As before, the optimal information precision is the h-value that solves dh
= 0. This

24
yields: h i2
2 [1 + k] 1 + [2 + h] k + t 2 + k [3 + h] [2 + k]
2 c0 (h) = !2 . (12)
k2 [1 + k]

Denoting the solution for h by h (k; t) establishes the preferred disclosure precision.
The left-hand-side of (12) is increasing in h while the right-hand-side is free of h: The
comparative statics results follow from the fact that the left-hand-side increases in t and
decreases in k.
(b) Noting that E [V (k; t)] = E [V (k; t)] jh=h (k;t) and applying the envelope theorem:

dE [V (k; t)] ! 2 k [1 + h (k; t)] 2 + k [3 + h (k; t)]

= h i2 > 0 and
dk
2 [1 + k] 1 + k [2 + h (k; t)] + t 2 + k [3 + h (k; t)] [2 + k]
2
dE [V (k; t)] ! 2 2 + k [3 + h (k; t)] [2 + k]
= h i2 > 0:
dt
2 2 [1 + k] 1 + k [2 + h (k; t)] + t 2 + k [3 + h (k; t)] [2 + k]

25
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