Accounting Measurement of Assets and Earnings and Market Valuation of Firm Assets

In this paper we evaluate the quality of accounting reports for valuation purpose from a measurement error based perspective. This perspective views accounting assets and earnings noisy measurements of their underlying economic constructs, economic assets and economic income. We show that the usefulness of accounting report does not depend solely on the absolute amount of errors in either assets or earnings measurement. Instead it depends on how they affect investors inference about firm’s information regarding the rate of return on their decisions. We develop this perspective in a simple analytical framework which generates an empirically implementable measure of accounting quality. Our empirical evidence supports the validity of this measure. The main implication from our analyses is that accounting quality can be high as long as measurement errors satisfy certain time-series properties. We discuss how accrual accounting satisfy these properties.