CAPITAL ASSETS AND FINANCIAL STATEMENT DISTORTIONS

This paper investigates distortions in financial statements that arise from employing capital assets. Use of historical cost depreciation tends to overstate earnings because of inflation effects, which in turn misrepresents firms' capacities to expand operations or to distribute dividends. We argue that the financial statement effects of inflation can be traced to two main sources: understated depreciation, and interest expense. Depending on a firm's capital structure choices, the distortion from historical cost depreciation is heightened or mitigated. Measurement errors in accounting numbers obscure the relation between price and earnings. We develop value relevant adjustments that enhance the informativeness of earnings. We also show that the effects of measurement errors from using historical cost depreciation are most pronounced in firms that carry lower levels of debt.