Accounting and the Financial Accelerator

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 financial 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, defined 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 firm value, i.e., the net cash flows to shareholders, may lead to self-fulfilling equilibria with inefficient forced liquidations. The theory offers a stylized paradigm to evaluate accounting policies in the aggregate