Alternative Accounting Methods, Information Asymmetry and Liquidity:

Theory and Evidence

II
STOR

Eli Bartov; Gordon M. Bodnar

The Accounting Review, Vol. 71, No. 3 (Jul., 1996), 397-418.

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THE ACCOUNTING REVIEW
Vol. 71. Na 3
July 1996
pp. 397-418

AlternativeAccounting Methods,
Information Asymmetry and
Liquidity: Theory and Evidence

Eli Bartov
New York University
Gordon M. Bodnar
University of Pennsylvania

ABSTRACT: Previous research has demonstrated that information asymmetry

translates into higher transaction costs for trading shares of the firm which, in turn,
raise the required rate of return and lower current stock price. The information
asymmetry perspective suggests that, ceteris paribus, managers wishing to maxi
mize the value of their firms have incentives to reduce the degree of information
asymmetry by switching to newly available accounting techniques which make
financial statements more informative to investors. Firms with greater information
asymmetry are predicted to be more likely to switch to more informative
accounting methods when they become available. Tests on the choice of
functional currency among U.S. multinational firms support these predictions
after controlling for variables such as the debt-equity ratio, interest coverage,
size, and the relative size of the foreign currency adjustment in the financial
statement.
Key Words: Accounting choice, Information asymmetry, Liquidity, Share turnover,
Foreign currency translation.
Data Availability:Data can be retrieved from sources identified in the
article.

We would like lo thank Yakov Arnihud, Larry Brown, Paul Healy, Nils Hakansson, Bob Holthausen, April Klein,
Dave Larcker, Fernando Penalva, Steve Penman, Joshua Ronen, Cliff Smith. Robert Verrecchia, and participants in
seminars at Baruch College, UC Berkeley (Haas), SUNY at Buffalo, MIT (Sloan). NYU (Stern), Pennsylvania(Whanon),
Rutgers (Camden), and Tel Aviv University foe helpful comments and insights. We also acknowledge contributions of
an ad hoc associate editor. We thank Barbara Jennings for research assistance. This paper, formerly tided. "Accounting
Choices and the Information Environment: Theory and Evidence," was also presented at the First Internacional
Conference on Conremporary Accounting Issues in Taipei, Taiwan. and at the Pifth Annual Conference on Financial
Economics and Accounting in Ann Arbor, Michigan. Boch authors acknowledge financial support from the John M. Olin
Foundation.
Submitted July 1994.
Accepted November 1995.

397
398 The Accounting Review. July 1996

I. INTRODUCTION

A
fundamental question in accounting research is how accounting choices are made by
managers. While prior research (e.g., Zmijewski and Hagerman 1981; Leftwich 1981)
has demonstrated that variables such as financial leverage and size are important for
explaining cross-sectional variation in accounting choices, one rationale for accounting choice
that has received less attention is the information asymmetry perspective. Loosely stated, this
perspective suggests that value-maximizing managers have incentives to choose more informa
tive accounting techniques co reduce the degree of information asymmetry among market
participants.
Previous studies demonstrate that greater information asymmetry among market participants
translates into higher transaction costs and lower liquidity for trading shares of the firm, thus
raising the required rate of return and lowering current stock prices. In Diamond and Verrecchia
(l 991 ), for example, a credible commitment by managers to improve disclosures (i.e., increase
the precision of public information about firm value) results in higher current stock price due co
reduced information asymmetry and increased liquidity. However, improved disclosure by the
firm is also associated with coses, such as preparation costs and proprietary coses. Thus, srated
more formally, the information asymmetry perspective implies that managers maximizing firm
value will choose accounting techniques, from the set, available, that reduce information
asymmetry to the point where the expected benefit of additional disclosure is offset by the
expected costs of making the disclosure. When this equilibrium is perturbed by the introduction
of a new opportunity for improved disclosure, managers should choose this new technique if the
expected benefit is greater than the expected cost of implementation. However. all firms are not
equally likely co choose the new accounting method that improves disclosure. As explained in
detail below, firms with high information asymmetry are more likely to choose the new
accounting method than firms for which information asymmetry does not represent a serious
problem.1
To rest this implication of the information asymmetry perspective, two problems must be
addressed. The first problem is the identification of a credible new disclosure opportunity
(accounting technique) that would decrease information asymmetry among market participants
by increasing the informativeness of the financial statements coin vestors. We test the information
asymmetry perspective's implications with respect to the choice of the functional currency for
foreign subsidiaries as required by Statement of Financial Accounting Standard No. 52 (Foreign
Currency Translation). This accounting choice provides a suitable framework for three reasons.
First, firms can choose between two different accounting methods=-either the current rate
method (foreign currency as functional currency) orthe temporal method (dollar as the functional
currency)-for measuring and reporting the impact of exchange rate changes on foreign
operations. Although SFAS No. 52 provides guidelines for choosing the functional currency,
these guidelines are broad and it is possible for a firm co justify either choice, providing
managers with some discretion. Second, there is both anecdotal (ex ante) and empirical (ex post)
evidence to suggest that the choice of the foreign currency as functional currency results in
financial

1 While our study is the first to build on prior theoreticat work chat relates information asymmetry to liquidity and firm
value in an effort to enhance understanding of accounting choices. there exists prior research (e.g .. Barnea et al. 1975:
Holthausen and Leftwich 1983; Hohhausen 1990) that has considered the "information perspective," a concept
somewhat related to the information asymmetry perspective. The information perspective suggests that managers
choose accounting methods that provide market participants with better information about the current and future cash
flows of their firms. However. Holthausen ( 1990, 216) notes thac "<he information perspective is admittedly not well
specified," and that ic may be difficult co disrinquish from the contracting perspective of accounting choice.
Bartov and Bodnar-s-Altemative Accounting Methods. Information Asymmetry and Liquidity 399

statements which provide better information about a firm's future cash flows than the choice of
the dollar as functional currency. Third, finally, this choice is required of all U.S. multinationals,
so there is a large sample.
The second problem with testing this perspective is that the degree of information asymmetry
among market participants is not observable; an empirical proxy for this variable must be
identified. We use two measures based upon the volume of trade in the firm's common stock.
While clearly imperfect, these measures reflect the fact that trading volume is relatively low in
stocks where uninformed investors perceive high information asymmetry (e.g., Glosten and
Milgrom 1985: Merton 1987).
Our empirical findings support the predictions of the information asymmetry perspective.
Specifically, measures of information asymmetry are positively related to the likelihood of
choosing the foreign currency as functional currency by the sample firms. This finding holds up
even after controlling for other variables shown by prior research to be important in explaining
cross-sectional accounting choice. Thus, the results are consistent with the prediction chat firms
with high information asymmetry attempt to reduce it through the adoption of more informative
accounting procedures.
The remainder of this article is organized as follows. Section II develops the information
asymmetry perspective in detail. Section III develops testable hypotheses for the information
asymmetry perspective in the context of our empirical framework (i.e., the choice of functional
currency by U.S. multinational firms), and considers the implications of several control variables
for this choice. Section IV outlines the sample selection procedure, defines the variables and
describes the data. Section V reports the results, and the final section summarizes the main
findings.

II. INFORMATION ASYMMETRY PERSPECTIVE

When information asymmetries exist, disclosure decisions made by managers can affect
stock prices because information asymmetries between more informed and less informed
investors raise transaction costs and reduce expected liquidity in the market for a firm's shares.2
These relations among information asymmetry, trading liquidity and stock price have been
developed by prior studies (e.g., Dernsetz 1968; Epps 1976; Copeland and Galai 1983; Glosten
and Milgrom 1985; Diamond and Verrecchia 1991). Diamond and Verrecchia (1991) examine
how the precision of a firm's disclosures impacts the expected liquidity of the market for a firm's
shares. With limited risk-bearing capacity among risk-averse market makers and some degree of
information asymmetry among traders in the market, they demonstrate that the level of
information asymmetry influences the expected liquidity of the market and thereby has a direct
impact on the current market price of the firm. The more liquid the market is expected to be, the
smaller is the expected order imbalance that must be absorbed by the market makers and the
lower is the risk premium they require. Under general conditions, Diamond and Verrecchia(l 991.
1338, Corollary 3) demonstrate that the current long-run price of a firm's shares increases
with a credible commitment for future disclosures that reduces the potential information
asymmetry among market participants.'
The implication of this result is that if managers wish to maximize the market value of their
firms, they should reduce information asymmetry among market participants. The key issue is

2 Of course, managers' disclosure decisions can also affect stock prices if they have contracting or tax implications.
~ This relation between information asymmetry and current stock prices has also been supported empirically by Amihud
and Mendelson ( 1986).
400 Tb.e Accounting Review, July l 996

increasing the expected liquidity in the market, so there must be a credible commitment to
maintaining the level of disclosure in the future (Diamond and Verrecchia 1991, 1330). While
firms could reduce the information asymmetry among market participants by supplementing
mandated reporting with voluntary disclosures, this practice will affect future expected liquidity
if, and only if, there is a credible commitment to the continuation of the disclosures (Amihud and
Mendelson 1988; Baiman and Verrecchia 1993). However, contracts between managers and
investors that guarantee future non-mandated disclosures are generally not observed in practice
(e.g., Dye 1985; Rajan and Sarath 1993).
Given appropriate compensation con traces, it is plausible chatmanagers aceas rational,
value maximizing economic agents and, at a given point in time, choose disclosures from the
available sec based on the expected benefits and coses (e.g., Christie and Zimmerman l 994).
While firms participate in diverse activities with different information environments, the set
of rules for credibly conveying information to the public is rather uniform (particularly within
industries). This mismatch implies chat, in equilibrium, value-maximizing firms have
various levels of information asymmetry. The focus of the information asymmetry
perspective is to ask the following: When this equilibrium is perturbed by the introduction
of a new discretionary opportunity to improve disclosure credibly, which companies are most
likely to choose it?
An interesting implicarion of the Diamond and Verrecchia (1991) model is that the increase
in liquidity from an improvement in disclosure is a concave function of the level of information
precision (the inverse of information asymmetry)." This concavity implies that the increase in
expected liquidity (and therefore price) for a unit improvement in disclosure is greater for higher
initial levels of information asymmetry. Thus, when an opportunity co improve disclosure is
introduced, the benefits of credibly increasing disclosure should be greater for firms with higher
current information asymmetry among market participants. As long as the costs associated with
choosing this new technique are not also an increasing function of the initial level of information
asymmetry, firms with greater information asymmetry should be more likely co switch to the new,
more informative accounting method.
This prediction of the information asymmetry perspective is based upon the assumptions and
findings of the prior research mentioned above. However, under alternative assumptions about
the costs and benefits of increased disclosure, one can get ambiguous or even reversed predictions
for the decision to choose among accounting techniques. Specifically, it may be argued that
communication between managers and market participants is not a concern and that high
information asymmetry represents managements' unwillingness co disclose information because
of severe proprietary costs.! Such arguments imply no relation, or a negative relation, between
the level of information asymmetry and the likelihood of a switch to a more informative
accounting technique. The prediction of chis alternarive hypothesis is the opposite of our
information asymmetry perspective predictions, so the determination as to which set of predic
tions is more descriptively valid is an empirical question.

III. EMPIRICAL FRAMEWORK

Testing these implications requires the identification of a new disclosure opportunity that
could credibly reduce information asymmetry among market participants. The new disclosure
opportunity must be discretionary (at least to some degree) so that individual firms evaluate

This can be seen by taking the second derivative of liquidity with respect to the precision of the information release:
il2( W.. )/o()Je )2<0. (This can be shown from the expression foe the first derivative of iJ'>Joe on p. L 339 o( Diamond and
Verrecchia 1991.) We thank Robert Verrecchia for assistance in discovering rhis point.
.!! However. the fact that information is prcprietary is not sufficient to deter its disclosure (e.g., Verrecchia l 983;
Wagenhofer 1990).
Bartov and Bodnar-Al<emative Accounting Methods, Information Asymmetry and Liquidity 401

whether to accept it. For reasons given in the introduction, we select the choice of functional
currency (and its associated method for foreign currency accounting) under SFAS No. 52 for the
empirical tests.6
The Information Asymmetry Perspective and the Choice of Functional Currency
Prior to the issuance of SFAS No. 52, ir was widely perceived that the existing temporal
method (for reporting the impact of exchange race changes on the assets and liabilities of foreign
operations in consolidated financial statements) did not provide information useful for determin
ing firm value. In discussing the issuance of SFAS No. 52, the Financial Accounting Standards
Board (FASB) stated that the translation technique associated with the temporal method " ... has
produced results that the Board and many of its constituents believe do not reflect the underlying
reality of many foreign operations and thereby produces results that are not relevant" (FASB
l 981, appendix C, para. 63). This conclusion is echoed by Aggarwal ( 1978), who details the
distortions between economic reality and results reported under SF AS No. 8. He also discusses
dimensions of this distortion which could result in real economic costs co the firm.7
Massaro ( l 978) surveyed 117 corporate executives familiar with SFAS No. 8 and found 60
executives favoring repeal ofSFAS No. 8 and 24 executives favoring substantial modification or
amendment. This opposition was due to the fact that the temporal method made income figures
"excessively vulnerable" to changes in foreign exchange races and thus added "excess" noise to
the reported performance of the firm. Although the mean of this added noise was approximately
zero, it was perceived as reducing the precision or informativeness of the earnings numbers and
was not easily accommodated for by investors unless they could obtain information about the
currency and capital structure of the firm's foreign investments (which is not publicly disclosed).
The temporal method also obscured the economic impact of exchange rate changes on the firm's
cash flows, making it difficult for investors to use the financial statements to determine the firm's
exchange rate exposures.
To address these complaints against the temporal method (SFAS No. 8), the FASB released
SFAS No. 52 in Decemberof L 98 L. SFAS No. 52 requires firms to designate a functional currency
(either the U.S. dollar or a foreign currency) for their foreign operations. The choice of functional
currency determines both the method (i.e., temporal or current-rate) and the placement (i.e.,
income statement or balance sheet directly) of the foreign currency adjustment entry in the
consolidated financial statements. Firms using the dollar as functional currency continue to use
(almost exactly) the same accounting technique as they did under SPAS No. 8 (the temporal
method), while firms choosing the foreign currency as functional currency switch to a new
accounting technique (the current-rate method) and a new way of presenting consolidated
information about rhe firm.8
A primary reason for the issuance of SFAS No. 52 was to provide investors with "information
that is generally compatible with the expected effects of exchange rate change on an enterprise's
cash-flows and equity" (FASB 1981 ). After extensive considerations, the FASB concluded that
the method associated with a foreign currency as the functional currency " ... has the
most conceptual merit .... It will result in reports of financial condition and results of operations
that,

6
Another possible example to test the information asymmetry perspective might be the choice of purchase method versus
pooling method for consolidanon of financial statements.
7
Among the costs of accounting data thai do not reflect economic reality are misnllocations and waste of resources, and
an impaired ability lo control and evaluate foreign operations effectively.
8 For details on the accounting rules for foreign currency translation. see Choi and Mueller ( 1992).
 402 The AccountingReview, July 1996

within the constraint of the historical cost model, will most closely reflect economic effects"
(FASB 1981, appendix C, para. 66).9
Bartov and Bodnar ( 1994, L 995) provide evidence that the introduction of SFAS No. 52 has
improved investors' ability to characterize the relation between changes in the dollar and changes
in firm value. More evidence is provided by Collins and Salatka (1993) who study the earnings
response coefficients of firms reporting under the rules associated with the dollar or the foreign
currency as functional currency. They conclude that" ... rhe market perceives the earnings of
firms to be of lower quality if they use the U.S. dollar as the functional currency ... " (Collins and
Salatka
1993, 122). Finally, Bartov (1995) directly evaluates the valuation relevance of alternative
foreign currency translation methods and finds chat, for SFAS No. 8, there is no observed
relation between reported foreign currency adjustments and stock price changes. For SFAS No.
52, there is a significantly positive relation between stock price changes and the foreign
currency adjustments for firms which designate a foreign currency as functional currency, but
no relation for firms choosing the dollar as functional currency.
Collectively, this evidence strongly suggests that the use of the foreign currency as functional
currency improves rhe informativeness of the disclosure of foreign subsidiaries' performance in
consolidated financial statements. In turn, adopting this new method would eliminate some of the
information asymmetry among market participants about the impact of exchange rares on firm
performance. This effect is based upon the assumption (made also by prior research, e.g., Kim and
Verrecchia 1994) that there are differences in the ability of market participants to process a
combination of public and private information that produce different levels of precision about the
value of the firm. 10
To guide managers with the choice of functional currency, SFAS No. 52 provides a List of
economic factors for use in determining the functional currency of foreign operations. However,
these guidelines allow for management interpretations as indicated by the FASB' s statement that
"it is neither possible nor desirable to provide unequivocal criteria to identify the functional
currency of foreign entities under al I possible facesand circumstances ... " (FASB 198 l ,
appendix A, para. 40). Management's judgement on the determination of the functional
currency was important in the Board's eyes, even to the extent that iris referred to as "essential
and paramount" in the determination of the functional currency (FASB L 98 L, appendix A, para.
42).11

'I Griffin and Castanias (!987) survey security analysis and report tl:tat 62.5% of chose interviewed perceived rhat the
quality of earnings was higher under SFAS No. 52 than under SFAS No. 8. This view was expressed by cop management
of many U.S. multinational firms. For example, in its Lener to Shareholders, Nashua Corporation (annual report l 98
L. p.4) management justifies the switch to the foreign currency as the functional currency by saying chat" ... the
adoption of chis change in accounting more clearly demonstrates the basic earning power of the company and
eliminates much of the confusion arising from complex accounting results."
10That
the information provided by the use of the foreign currency as functional currency reduced information asymmerry
rather than provided "new" informarion is also supported by the fact tha: financialresults and exchange rate adjustments
as measured under the foreign currency as functional currency can be reasonably approximated from financial
sraremenrs prepared under SPAS No. 8. Such reverse engineering requires a thorough understanding of the accounting
methods. detailed information about the distribution of foreign sales and assets, and exchange rare information.
Examples of two such reconciliations for firms thar reported results under both merhods in 1981 arc available from the
authors upon request
11
Additional evidence for managerial discretion comes from the business press. Forbes ( !986) quotes a Peat, Marwick,
and Mitchell partner as saying. " ...within rather broad parameters, choosing the functional currency is basically a
management call." Management discrerion is also apparent from different functional currencies designations in
apparenrly similar circumstances within a particular industry. Fo( example, in the oil industry, Texaco, Occidental and
Unocal chose the dollar as che functional currency for their foreign operations while Exxon. Mobil and Amoco chose
the foreign currency as functional currency for their foreign operations (Forbes 1986, 139). One exception co this
discretion is the requirement that subsidiaries in "high inflation" countnes-e-cumulauve inflation of approximately one
hundred percent or more over a three year period- must use the dollar as functional currency. For more on the manager
discretion in choosing a functional currency. sec Choi and Mueller ( 1992).
Bartov and Bodnar-e-Alternative Accounting Methods, Information Asymmetry and Liquidity 403

The costs associated with choosing a foreign currency as functional currency are primarily
costs associated with considering the switch, and calculating and using the new numbers. These
costs are Likely to be roughly uniform across firms. The proprietary costs of choosing a foreign
currency as functional currency are likely to be excremely low.12 Thus, as a first approximation,
the costs associated with choosing the new accouncing method are assumed to be roughly similar
across firms. As developed in section II, the benefits of improved disclosure are increasing in the
initial level of the information asymmetry. When combined with the discretion in choosing the
functional currency, this implies that managers of firms with higher information asymmetries are
more likely to choose the foreign currency as functional currency. Thus, our prediction from the
information asymmetry perspective is:
Firms with higher information asymmetries are more likely co choose the foreign
currency as functional currency.

Other Possible Determinants of the Choice of Functional Currency

To investigate the incremental power of the information asymmetry perspective for explain
ing cross-sectional variation in accouncing choices, we also consider the implications of several
control variables. The control variables serve two roles. First, some of them (firm size, financial
leverage, interest coverage ratio) have been shown to be important in previous work explaining
cross-sectional variation in accounting choices. 13 Second, some of these variables act as controls
for economic differences between firms that chose different functional currencies. Indeed,
appendix Aof SFAS No. 52 lists a series of economic differences that might guide a firm to
choose a particular functional currency. The variables we include to act as possible controls for
some of these economic influences are firm size and the relative size of the currency
adjustment.
Previous research indicates that firm size has proven to be a robust variable for explaining
cross-sectional accouncing choice. One explanation is that large firms seek to choose accounting
practices that reduce the probability of large earnings in order to avoid possible political attention
(regulations and/or taxation). Based upon this view, Large firms should choose the foreign
currency as funccional currency because it removes (virtually) random exchange race
gains/losses from reported earnings, 14 reducing the probability of abnormally large earnings and
the expected costs associated with them.
The roles of leverage and interest coverage in accounting choice research arise from their
common use as covenants in corporate lending contracts to al leviate the bond holder-stock
holder conflict which affects firm value (e.g., Smith L 993).15 These covenants typically place
Iimies on accounting-based ratios which, if violated, result in costs to the firm. With regards to
the choice of functional currency, covenants based upon leverage focus on the differences in the
two choices' impact on the volatility of net assets due to the foreign-currency adjustment. It
is difficult co

llproprietary costs are likely to be low because translation of foreign activities involves enc consolidarion of the effects
o( many different exchange rates upon a variety of undisclosed subsidiary capital structures. Since the information is
aggregated across all foreign operations. ic is unlikely that the translauon disclosures reveal competitive information
about any particular foreign operation, unless the firm has only one foreign operation.
13Papers finding these variables importanr for cross-secnonal differences in accounting choice include Zmijewski and

Hagerman (198l). Leftwich ( L98L) and Bowen et al. (1981 ).

lThis randomness arises due 10 the unpredictability of exchange rate changes. For a detailed discussion of the
unforecastabiliry of exchange rates, see Frankel and Rose (l995).
15Debt covenants are divided into affirmative covenants and negative covenants. Affirmative covenants require

borrowing firms co maintain specified levels of accounting-based ratios (e.g .. minimum working capital and interest
coverage). Negative covenants restrict (be financing and investing acnvities of borrowing firms (e.g., dividend
payments and issuance o( new debt) unless conditions specified in terms of accounring numbers are satisfied.
404 The AccountingReview,July L996

generalize, but for a broad range of values for leverage and current assets to total assets, the use
of the dollar will result in smaller foreign-currency adjustments to net assets than the use of the
foreign currency, due to a smaller basis for calculating the adjustment.16 As a result, most firms
using the dollar as functional currency should experience smaller currency adjustment-induced
fluctuations in retained earnings (net assets), resulting in a lower probability of triggering a
technical violation of a restriction on the ratio of debt to assets. Thus managers of highly
leveraged firms should be more likely to choose the dollar as their functional currency.
Debt covenants can also influence the choice of functional currency due to interest coverage
considerations. As mentioned above, the foreign currency as functional currency removes a
component of volatility from earnings, so interest coverage ratios should be less volatile under
this method. Firms with interest coverage covenants on existing debt will prefer less volatility in
earnings, so managers of these firms will be more likely to choose the foreign currency as their
functional currency. However, previous studies have shown chat leverage is correlated with the
existence of bond covenants (e.g., Press and Weinrrop L 990), so interest coverage covenants are
more likely to represent a problem for firms with high leverage. Thus, managers with high
leverage and low interest coverage are more likely co choose the foreign currency as their
functional currency than managers of firms with high leverage and high interest coverage.
Appendix A of SFAS No. 52 suggests several economic factors to guide the functional
currency choice-the degree of decentralization, the financing and expense structure of the
foreign operation and the degree of intercompany transactions. Unfortunately, many of these
factors are not readily observable from firm Level disclosures. 17 However, if firm size is positively
correlated with decentralization, chis provides another prediction of a positive relation between
size and the use of the foreign currency. L8
One other control factor is the relative importance of rhe foreign currency adjustment for rhe
firm's financial statements. The relative size of the foreign currency adjustment is likely to be
related to the importance of foreign information in the firm's financial statements. The larger a
firm's foreign currency adjustment (for a given exchange rate change), the more significant is the
choice of the functional currency for the informativeness of the financial statements. Therefore,
we control for this factor in identifying the determinants forthechoiceoffunctionalcurrency. Our
empirical prediction for this variable is based upon the anecdotal evidence in Massaro ( 1978),
that management with large foreign operations most strongly desired removing the volatility
from the

16The basis for calculating the foreign-currency adjustments for firms using the foreign currency is relatively easy to
identify; the basis is the net asset position of the foreign operation (total assets minus total liabilities). For firms using
the dollar. it is more difficult to identify the basis for calculating foreign-currency adjustments because the remeasure
ment of marketable securities and inventories into dollars is ambiguous. The approximation for the basis of the foreign
currency adjustment is net foreign currency monetary assets of the firm. This approximaticn is supported by ernpu'ical
evidence from prior research. which suggests that, for a given change in the exchange rate, the size of the foreign
currency adjustment will be smaller for firms using the dollar. For example, Ayers ( 1986, 144-145) provides evidence
that a majority of her sample firms during 1981 had a larger currency adjustrnenr (in absolute value) when using the
foreign currency as functional currency.
11Among these factors. the degree o( intercompany transactions is the most appealing as it is a clean measure of the
degree of interaction between segments of tbe firm. While some firms report the extent of intercompany sales in the
geographic
disclosure footnote(required by SFAS No. l4). other firms report only 3 segmentaticn of sales co unaffiliated customers,
making it impossible to get a large sample of firms with data on intercompany salcs.(Also. these data are not available
in machine readable form for the period of our study.) It is important to note that while controlling for this additional
factor will increase the predictive ability of our model. inferences about the information asymmetry perspective will
not be changed as there is no reason to believe tbat this factor is linked to share turnover.
&A similar prediccion for the relation between firm size and the choice of functional currency comes directly from the
Diamond and Verrecchia (1991) model. In their model, the impact of improved market liquidity on the current market
price is increasing in the size of the firm. Unless the costs of disclosure are increasing in firm size (asrerthan this
benefit. this also suggests that large firms should be more likely to choose the foreign currency as functional
currency.
Bartov and Bodnar-Alternative Accounting Methods, Information Asymmetry and Liquidity 405

income statement associated with the choice of the dollar as functional currency. As such, we
conjecture that the relative size of the foreign currency adjustment will work in favor of choosing
a foreign currency as the functional currency.

IV. SAMPLE SELECTION, VARIABLE DEFINITIONS

AND DATA DESCRIPTION
Sample Selection
Companies were allowed to switch from SFAS No. 8 to SFAS No. 52 within a three-year
interval. so rhe sample covers the three fiscal years from l98 l to 1983. The sample firms are
identified by a two-step procedure. In the first step, we identify companies that choose a foreign
currency as the functional currency under SFAS No. 52 for (ar lease some) of their foreign
operations by searching the Compustat (Expanded Annual Industrial and OTC Fi le) Database
for companies that report Cumulative Translation Adjustments (CTA) on their balance sheet
for fiscal year 1982 or 1983.'9 Firms reporting CTA for the first time in fiscal year 1983
are considered L 983 switchers. Unfortunately. CTA is not available from Compustat before L
982, so it is impossible to determine from Compustat alone whether the switch co SFAS No. 52
and the choice of local currency as the functional currency occurred in L 98 l or 1982. To
determine the specific year of adoption for these firms, we examine their financial statements.
In the second step, we identify companies that exclusively use the dollar as their functional
currency. These companies report foreign-currency adjustments on their income statements for
at least one year during the eight-year period from 1976 through 1983 (to demonstrate previous
international activity) and report no cumulative translation adjustments on their balance sheets
in years 1982 and 1983. To verify that these currency adjustments contain rerneasurernenrs of
foreign balance sheets (i.e., do not represent only foreign currency transaction effects), evidence
of ownership of foreign subsidiaries by these firms is obtained from the 1983 edition of
Moody's guides. This two-step sample-selection procedure yields a total of 1032 firms.
We classify a firm as using the foreign currency as functional currency (i.e. as a switcher) if
any of its foreign operations use the foreign currency as functional currency. Thus. companies that
select a combination of the dollar and a foreign currency as functional currency (i.e., companies
that use the new translation method for only some of their foreign operations) are considered to
have improved disclosure. This classification is appropriate because an improvement in the
informativeness of the financial statemenrs is expected to occur even in these cases (albeit to a
smaller degree). Of course, this classification may bias the tests chat follow toward the nult.20
Next, we eliminate 181 firms which do not have all the data on Cornpustat required for the
tests described below. We further eliminate 21 finns which have no discretion and are required
to choose the dollar as functional currency (because all of their foreign operations are in highly
inflationary environments) and 18 financial firms because of the difficulty of interpreting some
of the variables tested (e.g., interest coverage). Finally, 24 firms are dropped due to extreme
observations of leverage or interest coverage.21 After removing these firms, our final sample
contains 788 firms: 630 firms (80 percent) which have chosen a foreign currency as the functional
currency and 158 firms (20 percent) which have chosen the dollar as functional currency.

L 'ILJnder S FAS No. 5 2, fiems were required to designate a functional currency for each of their foreign operations for
fiscal years beginning no later than December 15. 1982.
20we check the sensitivity of our results to this classification by replicating our tests after removing 37 firms for whom
the currency remeasurement adjustments associated with the temporal method ace Iaeger than the translation
adjustment associated with a foreign currency as the functional currency. The results were not sensitive to this
modification of our classification scheme.
21Winsorizing the outliers instead of deleting them yields similar results.
406 The Accounting Review, July 1996

Variable Definitions
One problem with operationalizing the information asymmetry perspective is that the degree
of information asymmetry among market participants is not directly observable. The bid-ask
spread appears to be a natural proxy for information asymmetry, but in practice it suffers from
three deficiencies. First, the spread is associated with order processing costs and inventory
holding costs faced by the specialist (e.g . Stoll 1989. 115). This errors-in-variable problem biases
statistical tests toward the null and is not easily overcome. Second, the observable bid-ask spread
has institurionally imposed discreteness. Since large firms often report spreads of just one tick,
the percentage spread (in terms of stock price) is primarily a function of rhe level of the stock
price.22 Third, and most problematic for the use of bid-ask spreads in our empirical test, previous
studies have shown that bid-ask spreads are not very sensitive to changes in the information
environment (e.g., Morse and Ushman 1983). More recent studies (e.g., Lee et al. 1993) have
demonstrated that a combination of bid-ask spread and market depth (the number of shares
available at each price) data can generate measures that indicate potential information asymmetry
prior to earnings announcements; however. the necessary data are not readily available for our
time period.
Anotherobservable variable shown to be associated with information asymmetries is the
volume of trade in shares of the firm. This variable has been linked to the degree of information
asymmetry in several recent theoretical models (e.g., Glosten and Milgrom 1985; Karpoff l 986)
which examine the volume of trade for different market structures. Increasing information
asymmetries lead to a lower volume of trade because uninformed investors reduce their trade in
these securities. As a real world application of this intuition, Merton (1987, 488) argues that
concerns about information asymmetries could potentially explain why uninformed investors do
not invest at all in certain securities such as small firms with few stockholders. Empirically,
trading volume is significantly negatively correlated with the bid-ask spread, as expected from
theory (e.g .. Barclay and Smith 1988), suggesting that both measures capture a similar phenomenon.
We utilize a trading volume variable based upon annual share turnover as a proxy for
information asymmetry. More specifically, this measure is defined as the annual common shares
traded (adjusted for stock dividends and splits) in the year the selection of the functional currency
was first used in preparing the annual financial statements scaled by the average of common
shares outstanding over the fiscal year, and is denoted INFOASYM. Although less subject to the
problem of discreteness than the bid-ask spread, this trading volume measure still suffers from
an errors-in-variables problem. Ir has been documented that volume is associated with informa
tion events such as earnings surprises (e.g., Beaver 1968; Bamber 1987).Trading volume around
these special information events may be positively related to disagreement among market
participants with respect to the future prospects of a firm (for a theoretical model, see Kim and
Verrecchia 199l , and for empirical evidence, see Atiase and Bamber 1994).23 However, if the
number of information events relative to total trading days is small, then this errors-in-variables

llConsider the following two examples. First, the price of IBM stock has fluctuated between SO and 130 in recent years.
while its bid-ask spread is typically one tick (one-eighth of a dollar). Thus cite percentage bid-ask spread varied from
0.25% to 0.10% solely because of changes in the level of the price. Second. a company with a share price of around 2,
will have a minimum bid-ask spread of about 6% (relative lo the stock price). This high percentage spread is a result
of the Low Level of the stock price.
21Note
the difference between asymmetry and disagreement. Asymmetry occurs from information quality differences that
lead to superior predictive ability of firm performance among some investors, whereas disagreement occurs when
similar information leads to differentiat predictions of firm performance among different investors. Note also that this
difference casts doubt on another possible measure of information asymmetry: dispersion in analysis forecasts of
earnings. As analysts can be thought of as similarly informed, dispersion among analysts is more likely to measure
disagreement than asymmetry. For an excellent discussion of the problems and issues associated with the use of analyst
forecasts as proxies for investor beliefs. see Abarbane II et al. (1995 ).
Bartov and Bodnar-Altemacive Accounting Methods.InformationAsymmetryand Liquidity
407

problem is not very severe. Nevertheless, we attempt to control for this problem by modifying
trading volume by two different methods. For the first method, which has the advantage of wide
coverage, we cross-sectionally regress INFOASYM on the standard deviation of earnings
changes over the previous five years. The residuals from this regression-the annual share
turnover after correcting for the impact of past earnings variability for each firm-represent our
first proxy for information asymmetries. This measure is denoted INFOASYM l and is referred
to as the residual turnover measure. 24
The second method corrects the annual share turnover, INFOASYM, for the influence of
information events in a more direct way by excluding the daily share turnover for a five trading
day window around the reported quarterly earnings announcements days (excludes days -2 to
+2). This measure, available for only a subset of the firms in our sample, is our second proxy for
information asymmetries, and is denoted INFOASYM2.25 Both measures are meant to capture
the extent of general information asymmetry among market participants and not the degree of
disagreement around public announcements which is often the focus of previous research (e.g.,
Kim and Verrecchia 1994).
The tests also involve calculations of firm size, the debt-to-equity ratio, interest coverage and
the relative size of the foreign currency adjustment. Firm size of the ir11 firm (FSIZEi) is the market
value of common equity at the end of the fiscal year in which the switch occurred (the event year).
The debt-to-equity ratio of the i'" firm (DEBTEQi) is the book value of long-term debt scaled by
the book value of shareholders' equity at the end of the year of the switch. Interest coverage of
the jth firm(INTCOVi) is annual pre-tax income plus interest expense.divided by interest expense.
To allow for different effects of interest coverage for high-leverage and low-leverage firms,
the interest-coverage ratio variable is broken into two variables, LLICOV and HLICOV, by
the median value of DEBTEQ. For low-leverage firms (DEBTEQ ~ 0.32), the interest
coverage variable becomes LLICOV and HLICOV is zero, while for high-leverage firms
(DEBTEQ > 0.32), the interest-coverage variable becomes HLICOV and LLICOV is zero. To
consider the importance of the relative size of reported foreign activities for the choice of
functional currency, we calculate the currency adjustment ratio for firm i (CURADJi) as the ratio
of the absolute value of the total foreign currency adjustment reported in the financial statement
(income statement item plus the change in the Cumulative Translation Adjustment) to total assets
for the year 1982.26

24Firm
size is not included in the regression as it is ccnrrolled for directly in the tests that follow. Firms with standard
deviations o( earnings changes, a(~EPS), which are more than fifteen standard deviations away from the mean are
dropped (3 firms). The results of the regression are (standard errors in parentheses):
INFOASYM, 0.507 + 0.265 a('1EPS); + e i
(.018) (.l23)
The regression is run on 717 observanons (due 10 data availability 10 calculate the standard error o( earnings), and it is
significant at the 5 percent level. Indeed, the regression s explanatory power is stronger than ic appears as the dependent
variable is measured with error. Still, this problem is not serious for our purpose as the parameter estimates are unbiased.
The residual, e ;represents our first adjusted measure of information asymmetry for firm i (INFOASYM 1,). We do not
use this residual annual share turnover measure for our univariare tests since <he assumption necessary for the univariate
ceses that the observations are independent is violated. tnsread, we use 1he unadjusted annual share turnover,
INFOASYM.
250bservations with fewer than ten days of daily share turnover darn within the four windows around earnings
announcements are excluded.
26The numberof observations for this variable(727) is less than the full sample(788)as some firms do not separately
report foreign currency adjustment in <he income statement if it was noe material. Also, we choose 1982 as opposed to
the year
o( the switch so that all firms' foreign currency adjustments are based upon similar exchange rate changes.
408 The Accounting Review, July 1996

Data Description
For the sample firms and for all other Compustat firms, table L reports a comparison of the
first, second, and chi rd quartiles for five descriptive statistics: firm size, total sales, debt-equity
ratio, dividend yield and sales growth. (Descriptive statistics are for 1983, arbitrarily chosen.)
Boch firm size and coca) sales for the sample firms exceed chose for Compustat firms chat are not
in che sample. This finding is consistent with prior research (e.g., Bartov and Bodnar 1994) and
reflects the fact that multinational companies are Larger than other publicly traded companies.
Table l also shows that the sample firms have a higher dividend yield and lower leverage than
Compuscac firms that are not in the sample. These findings are expected because larger firms tend
co be less leveraged and to pay higher dividends. Finally, the five-year average growth rate of sales
does not differ substantially between the sample firms and the remaining Compustat firms.
Based on major Standard Industrial Classification (SIC) groups, the proportion of firms
choosing the dollar as functional currency and firms choosing the foreign currency is roughly
similar (see discussion of Table 5 below). The 630 (158) firms that have chosen the foreign
currency (dollar) as their functional currency are from 50 (36) two-digit SIC industries. A broad
cross-section of industries is represenced in both sub-samples.
V. EMPIRICAL EVIDENCE
Univariate Tests
Results of univariate tescs for our prediction based upon the information asymmetry
perspective, along with each of the control variables are shown in table 2.27 The differences in
the means of the variables between the two groups of firms are always in the direction
predicced above. A two-sample t-test is carried out to determine whether the differences in
means are statistically significanc. Each hypothesis is supported at standard levels of
significance. 28
Our proxies for informacion asymmetry are both different between firms choosing the foreign
currency as functional currency and firms choosing the dollar. For the uni variate tests, the
residual cu mover measure is replaced by the raw share turnover variable, INFOASYM. 29 The
mean of INFOASYM is significantly higher for firms choosing the dollar, 0.68 versus 0.50.
The results are simi tar for the daily turnover measure of information asymmetry, despite fewer
observations. The mean oflNFOASYM2 is significantly higher for firms choosing the dollar,
0.72 versus 0.49. Given the market percepcion that the choice of foreign currency is more
informative about the true economic performance of the firm, these results are supportive of
the information asymmetry perspective as a hypothesis for explaining accounting choices.
The results forchecontrol variables are also in agreement with the predictions outlined above.
Finns choosing the foreign currency as functional currency are larger on average than firms
choosing the dollar. The former have a mean market value of 5.36 (measured as the natural log
of firm size in millions of dollars), whereas che latter have a mean market value of 4.95. Debt-to
equity racios are also significantly different between these two types of firms; firms choosing the
foreign currency as functional currency are Less leveraged. The mean debt-to-equity ratio for

27Significance
levels for all tests are based upon one-tailed tests.
28Mann-Whitney
U-tests are also conducted as non-parametric univariate tests of the hypotheses. The results of the Mann
Whitney U-tests are similar 10 the parametric tests wilh rhe excepuon tharrhe interest coverage ratio for firms with high
leverage is not significant.
2':1
As mentioned, we do not use the residual annual share turnover measure. INFOAS YM I. for our univariate tests, as
the assumption of independence among the observations is violated; they all will suffer from the same esrimarion error.
We therefore use the raw annual share turnover variable. denoted INFOASYM, in its place for our univariate test.
Bartov and Bodnar-Allemative Accounting Methods, Information Asymmetry and Liquidity 409

8888~
00000
410 The Accounting Review, July 1996

0 8
V')

0

0 0 0

Al
,-...
e.

0
-o

V')
00
0
0

h
0

8 0 0
V')

0 s0r -

00
V')

80

00
00
0

N
00 <::t
r- 0
0 0

N'
M
0
VI
>Cl
8~
~
z e.
tlJ
Bartov and Bodnar-Alternative Accounting Methods, Information Asymmetry and Liquidity 4ll

firms choosing the dollar as functional currency is 0. 73; for firms choosing the foreign
currency as functional currency, it is 0.47.
For the interest coverage variables, there are two points to notice. First, interest coverage is
much smaller for firms with high Leverage,HLICOV, than for firms with low leverage, LLICOV.
Low leverage firms have a combined mean interest coverage ratio of approximately ten, while
high leverage firms have a combined mean interest coverage ratio of approximately three.
Second, as predicted, the difference in the means of the interest coverage ratios is significant only
for firms with high leverage. Among firms with high Leverage, those choosing the foreign
currency as functional currency have significantly Lower interest coverage ratios, although the
difference is (weakly) significant at the ten percent level.t? Also, as expected, the difference in
interest coverage ratios between firms with Low Leverage is not statistically significant.
Tests of the difference in the relative size of the foreign currency adjustment between the two
groups of firms reported in the last row of table 2 support the claim of Massaro ( 1978) about the
relation between the size of the foreign currency adjustment on the financial statement and the
desire to change to a new accounting method. The mean of CURADJ for firms choosing the
foreign currency as the functional currency is Larger than for firms choosing the dollar as the
functional currency, 0.024 versus 0.013.
MultivariateTests
While the univariate tests support the information asymmetry perspective, these results may
be due co correlations among the explanatory variables. Table 3 shows correlations among the
variables and indicates that, while there are several statistically significant correlations between
some of the explanatory variables, only the two information asymmetry variables are highly
correlated. A multivariate test allows for correlations among the explanatory variables and
provides a method for determining the incremental effect of each variable and the overall
explanatory power of all variables. The dependent variable is an indicator variable (set to one for
firms choosing the foreign currency as functional currency and set to zero for firms choosing the
dollar), so we employ a multivariate logistic model to simultaneously test our hypotheses. This
model is based upon the assumption that the dependent variable represents the probability that an
observation belongs in one of two groups. The model assumes that this probability function has
a logistic distribution; such models are commonly used in cross sectional studies of accounting
choice(e.g., Ayers 1986; Bowen et al. 1981).3'
Table 4 presents the results of the logistic model using all variables. Panel A presents the
results using the residual turnover measure, INFOASYM I, while panel B presents the results for
the sub-sampleoffirms for which wecouldconstruct the daily turnover measure. INFO AS YM2.
32
The results in the two panels differ only slightly because the measures of information asymmetry
are highly correlated. 33 The similarity of the results also provides some measure of robustness and
suggests that our broad measure of information asymmetry, INFOASYMI, is appropriately
corrected for information events.

30
A Mann- Whitney U -test for the difference in this variable is not significant.
31
All of the tests in this section were replicated using a probit model. The signs of all of the coefficients were the same
and 1heirstarisncat significance was nearly identical. This is to be expected as for most problems there is liule
difference
between probit and logit specifications of the model-both rely on distribunons 1ha1 are symmetric around zero.
However. under certain circumstances. a logtt specification is more robust than probit and therefore is preferable (e.g.,
Maddala 1983).
32The
number of observations {or panel A is 666 due 10 the missing observations for CUR ADJ and INFO AS YM 1. For
panel B lhe number of observations drops 10 384 due co the lack of data to calculate the modified share turnover vari
able. INFOASYM2. for some firms .
.l3The primary difference between the results in the two panels is that the size variable is not significant in panel B.
Bartov and Bodnar-Alternative
4l2 Accounting Merbods, Information Asymmetry and Liquidity
The Accounting Review, July 413
1996

TABLE3
Pairwise Correlation among Explanatory Variables
Variable FSIZE DEBTEQ INTCOV INFOASYML INFOASYM2 CURADJ
FSIZE 1.000
n=788
DEBTEQ -0.09Lb 1.000
0=788 n=788
INTCOV 0.181" --0.201" l.000
n=788 n=788 n=-788
INFOASYMI 0.109" 0.085h -0.063 l.000
n=7L7 n=7l7 n=717 n=717
INFOASYM2 0.L04b 0.146a -0. l t 9 0.9963 l.000
n=40L n=40L n=401 n=401 n=401
CURA DJ -0.087b --0.090' 0.007 --0.126' --0.131 L.000
n=727 n=727 n=727 n=666 n=384 n=727

Table Notes: INFOASYM I is the residual from a cross-sectional regression of annual share turnover on the standard
deviation of earnings over a five year interval; all ocher variables ace defined in table 2. The reported numbers ace Pearson
correlation coefficients.
Significant at the I percent level for two-tailed tests.
t> Significant at the 5 percent level for two-tailed tests.

The multi variate regression results are fully supportive of the uni variate results. In
particular, the coefficienc estimates of both share turnover variables (i.e . the proxies for
information asymmetry) are negative and significant al the one percent level. Since share turnover
is inversely correlated with the level of information asymmetry, these negative estimates suggest
that information asymmetry is associated with the choice of functional currency in the
predicted direction. Therefore, information asymmetry appears to be an important variable in
explaining the use of functional currency. even after concrolling for all the other variables
discussed above. J4
The coefficients on the control variables are also consistent with their uni variate results, with the
exception of firm size in panel B which is not significantly different from zero.
Sensitivity Tests
One concern in interpreting the results shown in table 4 is a possible confounding effect due
to industry. Table 5 displays the distribution of firms within each industry group according to their
choice of functional currency. In every industry group. a minority of firms chose the dollar as the
functional currency. 35 An industry effect appears unlikely because of the broad cross-section of
industries represented in the sample and the similar proportion of firms choosing each functional
currency within each industry group. Nevertheless, we test for the presence of an industry effect

HSince NASDAQ-repo11ed volume may double or even triple count the trades from the seller to the purchaser tdue co the
inclusion of inter-dealer transactions), we replicate the analysis reported in panels A and B afrer delering all NASDAQ
firms, While this resulted in a Joss of 125 (8) observations for panel A (B}, the results (not reported here for
parsimony) were similar.
Hour tests cover only l56 dollar firms and 626 foreign currency firms because two firms o( each type are dropped due
co no reported SLC code and two foreign currency firms with SIC codes beeween 100-999 (Agriculture) are dropped as
there are no companies that selected the dollar as the functional currency in this group.
Bartov and Bodnar-Alternative
4l2 Accounting Merbods, Information Asymmetry and Liquidity
The Accounting Review, July 413
1996

TABLE4
Logistic Model of Decision to Choose Foreign Currency as Functional Currency

Panel A: Multivariate Logistic Regression with /NFOASYM I

Number of Observations 666

Dependent Variable = I, if firm chooses foreign currency as functional currency (n = 547)
= 0, if firm chooses dollar as functional currency (n = 119)

Intercept INFOASYMI FS/ZE DEBTEQ UICOV HLICOV CURA DJ

Expected Sign ? + -/? +
Coefficient 0.584 -0.7l3 0.116 -0.300 0.002 -0.058 0.031
Std Error (0.353) (0.236) (0.058) (0.126) (0.009) (0.036) (0.007)
Significance 0.050 0.001 0.023 0.009 0.927 0.053 0.000
(one-tailed)

Chi-Squared statistic (H0: all model parameters (expect the intercept) are zero): 59.74 (p=0.000)

Panel B: Multivariate Logistic Regression with INFOASYM2

Number of Observations 384
Dependent Variable I. if firm chooses foreign currency as functional currency (n = 326)
0, if firm chooses dollar as functional currency (n = 58)

Intercept INFOASYM2 FSIZE DEBTEQ LUCOV HLICOV CURADJ

Expected Sign ? + -!? +
Coefficient 2.575 -l.028 -0.045 -0.407 -0.015 -0.095 0.028
Std Error (0.624) (0.340) (0.086) (0.223) (0.0LO) (0.050) (0.009)
Significance 0.000 0.001 0.801 0.035 0.084 0.028 0.004
(one-tailed)

Chi-Squared statistic (H0: all model parameters (expect the intercept) are zero): 30.89 (p=0.001)

Table Notes: Variables aceas defined in cables 2 and 3. There are 122 fewer observanons than the full sample (n = 788) in
panel A because of missing values for INFOASYMl (7 l) and CURADJ (51). Panel B has fewer observations because
INFOASYM2 could be constructed for only 401 firms o( our sample, and some of these firms did not have data 10 calculate
CUR ADJ. Tests for LLICOV are based upon the prediction of a negative coefficient.

directly by replicating the univariate tests for the information asymmetry perspective by major
industry groups.
These results are presented in table 5 and show that both the cross-industry mean (0.669) and
the median (0.731) of INFOASYM are substantially higher for firms using the dollar as the
functional currency than for those firms using the foreign currency as the functional currency
(mean = 0.492, median = 0.488). The differences in means and medians are both statistically
significant at the one percent level. In addition, the difference has the correct sign for l4 out of
the l 7 industry groups, and a signs test indicates that this ratio is significant at the two percent
414 and Bodnar-Alternative Accounting Methods. Information Asymmetry
Bartov The Accounting Review, July L415
and Liquidity 996

TABLES
Univariate Tests of the Information Hypothesis by Industry

Mean INFOASYM for Mean /NFOASYM for

firms using the Dollar firms using the Foreign
as the Functional Currency as the Functional
industry Currency N Currency N Difference

Mining 0.591 IS 0.497 29 0.094

Construction 0.361 6 0.467 7 --0. 106
Food and Tobacco 0.732 5 0.445 28 0.287
Textiles 0.764 2 0.515 12 0.249
Wood and Furniture 0.337 2 0.352 II -O.Ol5
Paper and Books 0.475 9 0.394 26 0.081
Chemicals and Petroleum 0.325 14 0.484 86 -0.159
Plastic and Cement 0.639 4 0.434 20 0.205
Steel and Machinery 0.472 23 0.470 LS8 0.002
Electronic Equipment L.072 18 0.541 52 0.531
Transport Equipment 0.753 6 0.512 32 0.241
Medical Equipment 0.785 17 0.599 45 0.186
Jewelry and Toys 0.835 3 0.488 12 0.347
Transportation and Utilities 0.928 10 0.613 18 0.315
Wholesale Trade 0.748 7 0.320 23 0.428
Retail Trade 0.857 6 0.626 17 0.23L
Services 0.709 9 0.606 50 0.103

Cross-Industry Mean 0.669 0.492 0.178

Std Error of tbe Mean (0.0447)
p-value (0.001)
Cross-Industry Median 0.731 0.488 0.205
p-value (0.007)

Table Notes: The variable INFOASYM is as defined in table 2. Agriculture is omitted from this industry analysis as botb of
the sample firms in this industry chose the foreigncurrency as a foreigncurrency. In addition. two firmsof eachtype
are.dropped due to missing SIC codes. Thus, total dollar as functional currency firms number 156and total foreign currency
as functional currency fi(lllS number 626. P-values are for one-tailed tests.

level. Similar results (not reported) are obtained for the daily turnover measure of information
asymmetry (1NFOASYM2), despite the smaller number of observations. These results increase
the confidence that industry effects are not influencing the results.36
A second type of corroborating evidence examines the change in share turnover following
the selection of a foreign currency as the functional currency, i.e., a switch to the new more
informative accounting method. If this switch reduces information asymmetry as hypothesized,
then theory (Diamond and Verrecchia l 99 l) implies chatliquidity (trading volume) should go up.

36Auempts
to add industry control dummies lo the rnuluvariare logi; regressions resulted in a failure of the estimation to
converge.
415 and Bodnar-Alternative Accounting Methods. Information Asymmetry
Bartov The Accounting Review, July L415
and Liquidity 996

We test for chis implication by comparing the change in annual trading volume in the year
following the selection of the functional currency. The change in annual trading volume for the
i'h firm (LlVOLi) is measured as the share turnover ratio (INFOASYM) of the i'n firm in the year
following the selection of the functional currency (year L) minus the share cu mover ratio in the
year the selection was made (year 0), scaled by the share turnover ratio in year 0. Table 6 shows
that, as expected, the mean of LlVOL for firms selecting a foreign currency as the functional
currency is positive (0.259) and significant at the one percent level; the mean of Li VOL for firms
selecting the dollar as the functional currency is negative (-0.09 l) but insignificant at conven
tional levels. The difference in means is highly significant, indicating thar the trading volume of
firms selecting a foreign currency as the functional currency increased relative to the trading
volume of firms selecting the dollar as the functional currency.37 Similar results hold for the
median Ll VOL.

VI. CONCLUSION
This paper explores the relevance of information asymmetries for explaining accounting
policy by focusing on the informational effects of alternative financial reporting methods on firm
value. Finns operating in environments of varying complexity have differenc degrees of
information asymmetry due to the limited flexibility of the required reporting technology. This
information asymmetry among market participants translates into higher transaction costs for
trading shares of the firm; these higher transaction costs raise the required race of return and, thus,
lower current stock prices. Ceteris paribus, managers wishing to maximize the value of their firm

37 Apotemiat problem wirh this test is thar the definition oi tVOL assumes that the influence of the selection of the
functional currency on trading volume occurs in the year following the selecrion rather than in the year o( the switch
itself. To rest the sensitiviry of the result to this definition, we replicate the test redefining the change in trading volume
as the share turnover of the firm in the year following the selection of the functional currency minus the share turnover
in the year prior to the year the selection was made (year -1 ). scaled by the share turnover in year -1. Results using this
measure (not reported) are similar to those reported in roble 6 suggesting thac our findings are not sensitive 10 the
choice of the base year when calculating the change in leading volume.

TABLE6
Tests for Changes in Trading Volume Following the Selection of the Functional Currency

N Mean L1VOL Median LlVOL

Finns choosing a foreign currency

as the functional currency 592 0.259 0.067

Finns using only the dollar

as the functional currency 144 -().091 -().267

p-values for two-sample tests or the null

hypothesis that VOLdollu ~a VOLforc~ 0.00 0.00

Table Notes: The change in share turnover for the ilh finn(~VOL;) is measured as the share turnover ratio of the i~' firm in
the year following the selecrion of the functional currency minus the share turnover in the year the selection was first
reported in the annual financial sraeements (year 0), scaled by the share turnover in year 0. N is rhe number of observations.
416 The Accounting Review, July 1996

will have incentives to reduce the degree of information asymmetry among market participants
by switching to new accounting techniques that make financial statements more informative to
investors.
We test the information asymmetry perspective on the choice of the functional currency as
required by SFAS No. 52. Results from both univariate and multivariate tests support the
implications of the information asymmetry perspective. Measures of information asymmetry
based upon trading volume are significantly related to firms' probabilities of choosing the foreign
currency as their functional currency in the predicted direction. This finding is consistent with
high information asymmetry firms reducing informational asymmetries and increasing liquidity
through improved disclosure by switching to more informative accounting methods. This relation
holds even after controlling for economic characteristics of the firms, other variables common I
y used in prior research to explain accounting choice, and anecdotal explanations for the choice
of functional currency.
le is important to note that, while the empirical implications of the information asymmetry
perspective are borne out by the data, there may be ocher theories with similar implications. As
Friedman ( l 953, 9) states, "if there is one hypothesis that is consistent with the a vai table
evidence, there are always an infinite nurnberthat are." Our assumptions-which include ( l) the
current rate method is more informative than the temporal method and thus reduces information
asymmetry, (2) managers are firm-value maximizers, and (3) the choice of the functional
currency is discretionary-appear reasonable, but they represent generalizations that are not
likely to be true in every case. 38 Thus, the interpretation of the results should be viewed
cautiously at this point. We expect fucure research to develop methods and identify settings
which allow further examination of the information asymmetry perspective and other theories
of accounting choice.

3 8forexample. under an alternative hypothesis there may have been no discretion for managers in selecting the functional
currency. and the guidelines provided by the regulators (based upon other economic factors) result in firms with high
information asymmerry choosing the foreign currency as funcnonal currency. Under such an interpretation, the results
in table 4 are of less economic interest than the results in cable 6, and the "credit" for the improved liquidity resulting
from the switch to the foreign currency as the functional currency goes to regulators, not co value -rnaximizing
managers. Still, our main result holds: selecting a more informative accounting method leads to improved liquidity.

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