The New Palgrave Dictionary of Economics

Living Edition
| Editors: Matias Vernengo, Esteban Perez Caldentey, Barkley J. Rosser Jr

Accounting and Economics

  • Joel S. Demski
Living reference work entry

Latest version View entry history

DOI: https://doi.org/10.1057/978-1-349-95121-5_527-2
  • 715 Downloads

Abstract

Accounting provides an important source of economic measures, yet consistently falls short of the economist’s conceptual ideal. This shortfall is fodder for economic research, is the result of economic forces, and is the key to making the best possible use of these measures.

Keywords

Accounting and economics Auditing regulation Depreciation Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP) Historical-cost accounting Information school of accounting International Accounting Standards Board (IASB) Measurement school of accounting 

JEL Classifications

M4 

Broadly viewed, economics is concerned with the production and allocation of resources, and accounting is concerned with measuring and reporting on the production and allocation of resources. Corporate financial reporting, income tax reporting, and product cost analysis at the firm level are familiar accounting activities. Of course, accounting itself is a production process, and the production and allocation of its output is even regulated; for example, how a firm measures and reports its financial progress and how a firm communicates with outsiders are regulated, and auditing of a firm’s public financial statements is mandatory. This suggests two interrelated themes: accounting is useful in a wide variety of activities, including economics research, and accounting itself is a fascinating and important area of economics research.

Using or researching the accountant’s products, however, rests on an understanding of what those products are and how they are produced. Accounting, in fact, uses the language of economics (for example, value, income and debt) and the algebra of economic valuation (as income is change in value adjusted for dividends and stock issues). But it falls far short of how an economist would approach these matters. For example, the accounting value of a firm is usually well below its market value, as measured by the market price of its outstanding equity securities.

This disparity is related to the institutional setting in which accounting products are produced, and to the economic forces operating on and within those institutions.

Institutional Highlights

Accounting cannot be divorced from its institutional setting. Were firms truly single-product entities, and were markets complete and perfect, economic measurement would be well defined, the nirvana of classical income measurement (for example, Hicks 1946) would be operational. Unfortunately, in such a setting no one would pay for the services of an accountant simply because the underlying fundamentals would be assumed to be common knowledge. But firms are multi-product entities, markets are neither perfect nor complete, and the underlying fundamentals are far from common knowledge. Here we find a demand for accounting services, such as measuring a firm’s periodic income, the performance of the divisions within that firm, and the cost of each of its products. We also find considerable ambiguity over how best to perform those services.

Firms’ published financial reports are the most visible accounting product. They entail a reporting entity (the organization about which the financial reports purport to speak), a listing of resources and obligations in its balance sheet, and a listing of the flow of resources during the reporting period in its income statement. Ambiguity is omnipresent. The reporting entity is not an economically defined firm, as its economic relationships are likely to be more extensive than those identified by its formal reporting; for example, implicit economic arrangements are generally ignored in these reports. Nor is the reporting entity simply a legally defined firm, as it often includes, say, a number of wholly or partially owned though legally free-standing legal entities aggregated into its public reports. Even with an unambiguous reporting entity, that entity’s control of economic resources would be incompletely and inaccurately measured. Some assets, such as proprietary knowledge or capital assets acquired through lease arrangements, would not be included. And among those included we would find a mixture of current prices (for example, cash and some financial instruments) and historical cost (for example, most real assets).

The flow measure is equally ambiguous. It is broadly based on what customers have paid minus the resources that were consumed in the process of satisfying those customers. Such wide-ranging phenomena as product warranties and potential product liabilities, uncollectible accounts, pension plans, advertising, research and development and employee training render precise identification of what customers have paid or what resources were consumed largely the product of art as opposed to science.

Regulation, to no one’s surprise, now enters the picture. Public financial reports are typically required to be produced according to Generally Accepted Accounting Principles (GAAP). These reports are also typically required to be audited, where the auditor attests to the claim the reports are in compliance with GAAP. One reason for regulations is that the noted ambiguity places a premium on coordinated measurement approaches, a classic example of a network externality (Wilson 1983). A second reason, based on investor protection concerns and again related to the ambiguity, is the potential for opportunism. Absent auditing, the public financial report is simply management’s self-report of its financial results and the unverified claim that those results were measured according to GAAP. Of course the auditor’s verification is statistical and judgemental; to no one’s surprise, the auditor himself is also regulated.

GAAP itself is fluid, varied, contentious and political at the margin. Two major, competing boards, the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) outside the United States, are largely but not entirely responsible for the definition of GAAP. Historically, the two boards have differed (though inter-board coordination has become a priority in recent years), and have tended to lag behind innovations in transaction design. Moreover, firms design transactions with an eye towards how they will be rendered under GAAP. Leases, as noted above, are largely absent from firms’ balance sheets. This reflects careful transaction design so the acquisition and financing of capital assets can be excluded, according to GAAP, from the firm’s balance sheet – in effect lowering the officially measured debt. Similarly, compensating employees with equity options was, until most recently, a form of compensation that, according to GAAP, is absent from firms’ income statements. (While GAAP is defined outside explicit governmental agencies, compliance with GAAP is legally required. The Securities and Exchange Commission in the United States has statutory authority to define GAAP, and has delegated this task, by and large, to the FASB. The European Union, in turn, has delegated this task to the IASB. Auditing regulations, in turn, are more varied, as is enforcement.)

The least visible accounting activity is what transpires inside the firm. Here we again find measures of stocks and flows of resources, aimed now at divisions, plants, departments, product lines, and so forth. The noted ambiguities remain, and extend to such arenas as tracing services from a common provider, such as human resources or cash management, to the consuming units inside a firm or dividing the accounting profit on some particular product line among the various units within the firm whose combined activities produced it. Here we also find less, but far from nil, reliance on GAAP. These measurement activities are not, literally speaking, regulated; but they do rely on the same underlying financial history. We also find a variety of nonfinancial measures, such as customer and employee satisfaction or student course evaluations. We also find occasional wholesale redesign of a firm’s internal accounting activity (Anderson et al. 2002). (Tax accounting is yet another activity, though the measurement rules are often more directly statutory in nature, and diverge from GAAP.)

Importantly, now, the question is: how are we to make sense of these patterns? Two approaches have emerged through the years, the measurement school and the information school.

The Measurement School

The measurement school takes its cue from classical economics. In a fully developed general equilibrium model, with complete and perfect markets (for example, Debreu 1959), value and income are well defined, as is the value of a firm’s assets and obligations. The measurement school takes this as a desideratum and emphasizes the importance of approaching this economic ideal reasonably well.

This is the source of accounting’s intellectual history, its underlying definitions of asset, liability, income, revenue and expense, and the rhetoric used by its regulators. (Important contributors to this school of thought include Paton 1922; Clark 1923; Canning 1929; Edwards and Bell 1961; Solomons 1965; Chambers 1966).

The advantage of the measurement approach is its (Relative) clarity. Foreign currency translation at contemporaneous exchange rates, economic depreciation, and market value of complex financial instruments, for example, all take on a natural conceptual clarity at this point. Indeed, at least in the United States, we find the national income accounts are not mere consolidations of GAAP measures, but are produced with an eye on the economic fundamentals. (See Petrick 2002. More broadly, this leads us to the theory of measurement in general – for example, existence, uniqueness and meaningfulness of a measure – and the axiomatic characterization of additive structures; Krantz et al. 1971; Mock 1976). Unfortunately, adding up the value of a firm’s assets views the firm as the sum of its assets, so to speak, and is inconsistent with synergies among the asset groups. In parallel fashion, marginal cost is the only meaningful product-cost statistic in a multi-product firm, absent separability. Yet accounting requires accounting product costs to sum to the total cost, which implies that the accounting product costs can be reasonably viewed as marginal-cost estimates only under conditions of separability and constant returns. This suggests theoretical limits to the measurement approach).

Likewise, with the advent of financial engineering it is natural, from the measurement school perspective, that GAAP require fair value (that is, as if market value) estimates of these instruments. In short, with the measurement school we at least know what it is, conceptually, we are trying to measure.

The disadvantage of the measurement approach is that it relies on economics to identify the conceptual ideal, but ignores economics when the time comes to worry about resources devoted to the measurement enterprise. (Audit fees alone exceed $6 billion annually in the United States). It also raises such questions as why international differences persist, why accounting does such a poor job of tracking economic value and why, given this presumptively poor performance, it continues to survive. (Flawed as it is, from this perspective, we also know foreknowledge of firms’ annual reports would allow highly profitable speculation; Ball and Brown 1968). It also fails to capture the accountant’s stock in trade of eschewing economic measurement and embracing historical-cost allocation. Capital assets are not measured at economic value, and no attempt is made to measure economic depreciation. Rather, the historical cost of the capital asset is allocated, is divided among multiple uses in some formula-driven manner. For example, the initial cost of a real asset is divided among periods (accounting depreciation) and from there among products, resulting in an allocated portion hitting the income statement and the net balance being the asset value on the balance sheet. Moreover, when accounting reports the cost of a firm’s product, it is reporting not marginal cost but an allocated accounting cost. Morgenstern (1965, p. 79) is particularly eloquent:

But it is clear that in the absence of a convincing and complete theory there is no unique and objective way of accounting for costs when overhead, amortization and joint costs have to be taken into consideration … ‘Cost’ is merely one aspect of a valuation process of great complexity.

The measurement school, then, focuses on economic measurement as the ideal, but ignores economic forces that impinge on the measurement process.

The Information School

The information school, in contrast, focuses on these economic forces and takes its cue from the economics of uncertainty. It views the accounting product not literally as measures of resources but as information that purports to inform about these resources. Abstractly, then, accounting is a mapping from underlying acts and events into the real numbers. In this view, accounting is one among many sources of information. Analysts, the financial press and trade associations are familiar sources of financial information, as are government statistics themselves. Moreover, firms often engage in voluntary disclosures; for example, new product announcements, major investment announcements, and even so-called earnings warnings where they reveal that a forthcoming earnings measure will be lower than originally anticipated. In addition, the typical financial report reports cash flow, an utterly reliable, unambiguous measure. (Important contributors to this school of thought include Butterworth 1972; Feltham 1972; Ijiri 1975; Beaver 1998; Christensen and Demski 2002).

The advantage of this view is it forces us to think in terms of complements and substitutes when dealing with this vast array of sources, and to look for economic forces that drive the disparity that bedevils the measurement school. And it is here that the comparative advantage of the accounting channel comes into focus: it is purposely designed and managed so that it is difficult to manipulate (Ijiri 1975). This is why it often resorts to historical-cost measurement, as this removes major elements of subjectivity and manipulation potential. It is also why, in organized financial markets, most valuation information arrives before the firm’s financial reports; and in this sense the financial reports provide a veracity check on the earlier reporting sources. In addition, cost allocation now enters as a natural phenomenon, either as a simple scaling device or – to use an analogy with informationally efficient markets – as a cousin to an information-based pricing kernel in a financial market (Christensen and Demski 2002; Ross 2004).

Libraries are organized in coordinated fashion, as are phone books; and the same can be said about accounting. A curiosity is the political side of the regulatory apparatus. It is difficult, for example, for the incumbent government to alter a government-provided statistical series, yet it is routine for the incumbent government to intervene in the accounting regulatory process. A second curiosity is the seemingly episodic nature of financial reporting frauds (Demski 2003), although at the micro level it is well understood that opportunistic reporting is part of the game. For example, an ability to shift income from a later to an earlier period may be an inexpensive signal or, to speak more cynically, less costly to the firm than shifting real resources.

The disadvantage of the information school is its sheer breadth. The institutional context includes a vast array of information sources and actors, and sorting out first-order effects remains problematic.

Conclusion

Accounting, then, is simultaneously an important source of economic data and a collection of institutional regularities that provide research economists with yet another venue for documentation and exploration of economic forces. Why do we see episodic regulatory interventions? Why do we see forecasts of forthcoming accounting measures? Why do we not see supplementary estimation of economic depreciation? Why do we see the mix of historical-cost and market values that characterize modern financial reporting? Questions of this sort motivate much of the current research in accounting and finance.

See Also

Notes

Acknowledgments

Helpful comments by Haijin Lin and David Sappington are gratefully acknowledged.

Bibliography

  1. Anderson, S., J. Hesford, and M. Young. 2002. Factors influencing the performance of activity based costing teams: A field study of ABC model development time in the automobile industry. Accounting, Organizations and Society 27: 195–211.CrossRefGoogle Scholar
  2. Ball, R., and P. Brown. 1968. An empirical evaluation of accounting income numbers. Journal of Accounting Research 6: 159–178.CrossRefGoogle Scholar
  3. Beaver, W. 1998. Financial reporting: An accounting revolution. Englewood Cliffs: Prentice-Hall.Google Scholar
  4. Butterworth, J. 1972. The accounting system as an information function. Journal of Accounting Research 10: 1–27.CrossRefGoogle Scholar
  5. Canning, J. 1929. The economics of accountancy. New York: Ronald Press.Google Scholar
  6. Chambers, R. 1966. Accounting, evaluation and economic behavior. Englewood Cliffs: Prentice-Hall.Google Scholar
  7. Christensen, J., and J. Demski. 2002. Accounting theory: An information content perspective. New York: McGraw-Hill/Irwin.Google Scholar
  8. Clark, J. 1923. Studies in the economics of overhead costs. Chicago: University of Chicago Press.Google Scholar
  9. Debreu, G. 1959. Theory of value: An axiomatic analysis of economic equilibrium. New Haven: Yale University Press.Google Scholar
  10. Demski, J. 2003. Corporate conflicts of interest. The Journal of Economic Perspectives 17 (2): 51–72.CrossRefGoogle Scholar
  11. Edwards, E., and P. Bell. 1961. The theory and measurement of business income. Berkeley: University of California Press.Google Scholar
  12. Feltham, G. 1972. Information evaluation. Sarasota: American Accounting Association.Google Scholar
  13. Hicks, J. 1946. Value and capital. Oxford: Clarendon Press.Google Scholar
  14. Ijiri, Y. 1975. Theory of accounting measurement. Sarasota: American Accounting Association.Google Scholar
  15. Krantz, D., R. Luce, P. Suppes, and A. Tversky. 1971. Foundations of measurement. New York: Academic.Google Scholar
  16. Mock, T. 1976. Measurement and accounting information criteria. Sarasota: American Accounting Association.Google Scholar
  17. Morgenstern, O. 1965. On the accuracy of economic observations. Princeton: Princeton University Press.Google Scholar
  18. Paton, W. 1922. Accounting theory. New York: Ronald Press.Google Scholar
  19. Petrick, K. 2002. Corporate profits: Profits before tax, profits tax liability, and dividends, Methodology paper. Washington, DC: Bureau of Economic Analysis. Online. Available at http://www.bea.gov///bea/ARTICLES/NATIONAL/NIPA/ Methpap/methpap2.pdf. Accessed 18 Nov 2005.
  20. Ross, S. 2004. Neoclassical finance. Princeton: Princeton University Press.Google Scholar
  21. Solomons, D. 1965. Divisional performance: Measurement and control, 1965. New York: Financial Executives Research Foundation.Google Scholar
  22. Wilson, R. 1983. Auditing: Perspectives from multiperson decision theory. The Accounting Review 58: 305–318.Google Scholar

Copyright information

© The Author(s) 2008

Authors and Affiliations

  • Joel S. Demski
    • 1
  1. 1.