Market exit through divestment - the effect of accounting bias on competition

Abstract

We analyze the effect of accounting bias on the competition and market structure of an industry. In our model, firms’ interim accounting reports on investment projectsmay contain bias introduced by the mandatory accounting system. We find that this biasstrictly decreases firms’ profits when investors do not have an abandonment option, butdifferent results emerge when we allow the investors to divest in the interim. Specifically,a conservative accounting regime may increase the likelihood of projects being discontin-ued, inducing some firms to exit from the product market and leaving rivals to capturetheir market share. A conservative regime can thus soften market competition and resultin ex ante higher investment payoff, higher consumer surplus, and higher total socialwelfare. Since industries often have common reporting standards, we also identify thedegrees of industry-wide accounting bias that maximize the expected investor payoffs.Finally, we allow for investors to coordinate their divestment decisions when both firmsreport unfavorable costs and show an improvement to both firm profits and consumer surplus.