Academic journal article Accounting Horizons

Knowing What Others Know: Common Knowledge, Accounting, and Capital Markets

Academic journal article Accounting Horizons

Knowing What Others Know: Common Knowledge, Accounting, and Capital Markets

Article excerpt

SYNOPSIS: The concept of common knowledge concerning higher orders of knowledge has seen exciting new developments in the fields of philosophy, game theory, statistics, economics, and cognitive science in the recent decades. Even though information lies at the heart of accounting and capital markets research, these new developments have remained at the periphery of these fields. Common knowledge thinking may significantly advance our understanding of financial reporting, analysis, securities valuation, managerial control, auditing, and information systems. Such accounting and business applications will also make important contributions in the form of concrete, real-life examples and applications to the basic fields where the idea of common knowledge originated. This paper is an overview of common knowledge and its actual and potential applications to accounting and capital markets research.

Keywords: common knowledge; accounting; capital markets; beliefs about others' beliefs.

JEL Classification Codes: D84, G14, M41

INTRODUCTION

In Hans Christian Andersen's fable, "The Emperor's New Clothes," two scoundrels convinced a vain emperor that they could make a magnificent cloth of silk and gold threads invisible only to the incompetent and the stupid. After the emperor gave them money and materials to make the royal garments, they dressed him in nothing at all. Not even the emperor, much less his courtiers, dared admit to not seeing any clothes for the fear of being branded stupid and incompetent. The public applauded as the emperor paraded in the buff to show off his new "clothes." Then a child asked, "Why does the emperor have no clothes?" After a moment of stunned silence, others posed the same question.

If the child's words did not change what the people saw, then why did they change their minds? Are there interesting accounting, capital markets, and business phenomena for which the fable might yield insights?

The Stock Market and the LIFO Inventory Cost Flow Assumption

Before returning to the emperor and his magnificent clothes, consider two stories from the world of business and accounting. First, consider John Maynard Keynes' classic description of the stock market:

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which the average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what the average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees. (Keynes 1936, Chapter 12).

The second business story concerns LIFO (last-in, first-out) accounting for inventories. Since World War II, U.S. tax law permits use of the LIFO method of inventory valuation for tax purposes by firms that use the same method for preparing public financial reports. During periods of inflation, LIFO can conserve cash by postponing tax payments to the government. Many firms that experienced significant inventory inflation during the 40 years following World War II failed to adopt LIFO accounting. When surveyed about their reluctance to adopt LIFO, corporate financial officers stated that the adoption of LIFO, and the consequent rise in cash flows and fall in earnings, might lower their stock price. …

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