Reasonably Certain Estimates, Recognition, and Communication of Uncertainty

Abstract

of Northwestern University and Anne Beyer of Stanford University for their insights and suggestions. The financial support of the Kellogg School of Management and its Accounting Research Center are gratefully acknowledged. This paper presents a model in which asset/liability recognition is a means for a risk-neutral entrepreneur to communicate with risk-averse investors about the riskiness of investments or the uncertainty of future obligations. The model shows that more conservative accounting may produce less conservative in-vesting and lower expected payoffs for the entrepreneur. While the desired uncertainty-based recognition hurdle is increasing in an asset’s expected payoff, it is decreasing in a liability’s expected magnitude. The impact of further sub-categorization of recognized assets is also considered. While finer classification of assets produces no direct benefit, it may provide a cost-effective means to reduce the entrepreneur’s incentives to engage in costly voluntary disclosure.