Ex Ante Testing of Accounting Standards Using Stochastic Models

Most previous studies of the effects of accounting standards have been conducted on an ex post basis. This paper explores a methodology for studying the implications of accounting standards prior to their introduction. As an illustration, the effects of alternative earnings recognition methods for long-term contracts were examined (SSAP 9). A stochastic model of a representative firm was constructed, where the underlying stochastic process was mean reverting. This model was then used to derive mathematical expressions for the earnings figures produced by different accounting procedures. The performance of these alternative accounting procedures was examined using the general criteria of prediction and closeness to economic income. The accounting procedures required by SSAP 9 emerged relatively well from these tests, and the methodology appears to offer the potential for development.