1. Stability of Monetary Unit and Corporate Financial Reporting
Shyam Sunder, Yale University
International Workshop on
Monetary Unit Stability in Holistic Approach
Leon Kozminski Academy of Entrepreneurship and Management, Warsaw, Poland
April 12, 2002
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Monetary Unit Stability

2. Stability of Monetary Unit
Sovereign power controls money in most societies
Goals sought by monetary policy may, variously, cover
Macroeconomic management (inflation, employment, output, investment)
Transfer of wealth
Creation and maintenance of power
Monetary stability may influence all these goals
Perspective of this paper is different
Analysis of the consequences of monetary instability for economic efficiency of investments through its effect on informativeness of corporate financial reports
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Monetary Unit Stability

3. Monetary Unit Stability
Money as a Yardstick
Firm and household consumption-investment decision based on specific prices
Reliable yardstick: changes in preferences , technological innovation translated into changes in individual prices
Firms use changes in relative prices to adjust their business strategy
Stable prices facilitate smooth reallocation of resources to production and innovation for growth
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4. Reliability of Yardstick
Unstable prices  unreliable yardstick
Signaling function of prices weakened
Transfer of labor and capital to growth industries less certain
Possibility of business unstable cycles
Impaired ability of business and households to make plans
Decline in long term growth
Empirical evidence: monetary instability poorer investment allocation
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5. Economic Efficiency and Unit of Accounts
Examine the effects of monetary policy on economic efficiency through role of money as unit of accounts
Overall, monetary instability increases noise in accounting data less efficient business decisions
Magnitude of effect not yet available
May deserve attention in choosing monetary policy
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Monetary Unit Stability

6. Accounting in Units of Money
Most, though not all, accounting is done in units of money
Commercialization: opportunities to exchange resources
Monetization: exchange for units of money
Opportunity costs of resources in money available
Then, resource bundles easily, transparently and usefully represented in units of money
Unit of money becomes a basis element of accounting
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Monetary Unit Stability

7. Welfare Consequences of Instability from Poor Decisions
Money is not perfect for all accounting
Becomes less perfect with value instability
Monetary instability in statistical forms
Changes in specific rates of exchange
Changes in average rate of exchange
Imprecision, absence of prices in thin markets
Change in composition of relevant resource bundles
Instability implies noisier information and therefore less effective business decisions
Reduction in welfare from poorer decisions
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Monetary Unit Stability

8. Non-Money Unit Accounts
Use of money, or some other single resource, as a unit of accounts helps
But it is not absolutely necessary
See Table 1 for an example of accounts without a common unit
Awkward collection of incommensurables
Informativeness depends on reader’s familiarity with the specific resources
May be better to those familiar with resources
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9. Original Unit Balance Sheet
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10. Original Unit Income Statement
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11. Conversion to Common Unit Accounts
Common unit accounts are simpler
Value of simplicity and commensurability depends on the information and goals of the reader
Conversion to money unit accounts is subject to ambiguities due to imperfect and incomplete markets
Introduction of agency problem due to opportunistic behavior of managers who resolve the ambiguities
Management and control accounts used by people with intimate knowledge of resources may not use money units
Financial reports used by others use money units
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12. Single Unit Balance Sheet
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13. Single Unit Income Statement
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14. Monetary Instability Relevant to Accounting
Change in specific prices: sensitivity to
Timing of prices used in accounts
Timing when accounts information used
Uncertainty about future price changes
Difficult to project future results, NPV
General price level change
Specific price changes
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Monetary Unit Stability

15. Statistical Measures of Price Instability
Average (expected) general price change
Variance of general price change
Average (expected) specific price changes
Variance of specific price changes
We also consider another related measure
Error of measurement in prices due to incompleteness and imperfection of resource markets
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Monetary Unit Stability

16. Assessing Consequences of Monetary Instability
Sunder (1978) and Lim and Sunder (1991) framework
Use mean squared error in estimated and actual change in the accounting value of a basket assets as an inverse measure of informativeness of accounting valuation
Consistent with econometric practice
Use various linear accounting valuation rules
Historical cost
General price level
Specific price index
Current valuation
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Monetary Unit Stability

17. Sensitivity of Valuation Errors to Monetary Instability Parameters
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18. Results: Historical Cost Valuation
Historical valuation becomes less informative as
Increase in expected change in specific price
Increase in general inflation
Increase in variance of changes in specific prices
Increase in covariance of changes in specific prices
Increase in the variance of measurement errors in specific prices has no effect on informativeness of historical valuation
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Monetary Unit Stability

19. Empirical Implications of the Model
Investors use multiple imperfect sources of information to support their decisions
Financial reports are an important source of information
More noise in financial information should cause a decrease in association between reports and stock prices for two reasons:
More noise per se
Substitution of reports by alternative sources of information
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Monetary Unit Stability

20. Empirical Implications…
Model suggests that monetary instability causes financial reports to be noisier
Empirically, monetary instability should be associated with weaker association between financial reports and stock prices (levels and returns)
Theory is testable because monetary instability parameters, financial reports and stock prices are all observable
Time trends in association between financial information and stock prices have been analyzed but no studies yet of the effects of monetary instability
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Monetary Unit Stability

21. Monetary Unit Stability
Policy Implications
Monetary instability introduces noise into accounting reports because:
Historical costs deviate from opportunity costs
Even if adjustment is made for general price changes, variances introduce additional noise
Decisions based on noisier information are less efficient
Agents may wish to use alternative sources of information but they are not free of cost
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Monetary Unit Stability

22. Monetary Unit Stability
Policy Implications
In 2002, price instability in U.S. is low and accounting rules do not require adjustment of financial reports for monetary instability
However, rule makers should be ready to make a change when instability increases (Lim and Sunder, 1991)
Monetary policy driven by inflation, employment and output; perhaps should include decision efficiency consequences also
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Monetary Unit Stability

23. Monetary Unit Stability
Thank You
The paperand slides will be available at
Please comments to
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Monetary Unit Stability