Accounting for Owners' Capital

Financial accounting is not merely an information aggregation and distribution mechanism but also controls the withdrawal of equity capital by the owners. In the presence of information asymmetry between owners and outside financiers, this control function implements three necessary and sufficient conditions under which the firm makes efficient, value-maximizing investments, namely, that (i) outside financiers are repaid in full; (ii) optimal investment maximizes owners' equity; and (iii) expected future dividends equal net firm value. There exists a unique accounting system that maximizes distributable equity capital while maintaining these conditions. The solution rationalizes the commonly observed understatement of book value relative to market value as a means to creating incentives for owners to invest optimally under uncertainty. The model implies that the ability to pay dividends is not a byproduct of income measurement but its purpose, and that capital structure neither is irrelevant nor has a single-point optimum but is constrained to a range of equally efficient choices.