Disclosure and Recognition Requirements: Corporate Investment Decisions with Externalities

This paper examines the effects of disclosure and recognition requirements on investment decisions when shareholders have limited liability. Firms' investment projects have either high initial pollution prevention costs or high subsequent clean-up costs, and their liability for clean-up costs may be either individual or joint and several. Even with individual liability for clean-up costs, shareholders' limited liability creates an incentive to select the latter project type and to impose costs on the rest of the economy. This tendency is exacerbated when clean-up liability is joint and several. We show that a disclosure requirement cannot have an unambiguous effect on the selection of the "cleaner" project. However, an accrual requirement, together with an accounting-based dividend restriction, is shown to promote choice of the project that imposes lower expected costs on the rest of the economy. Moreover, we find that it is possible for a recognition requirement to have a greater impact in a joint-and-several liability regime than in an individual liability regime.