ACCOUNTING and ECONOMICS by Joel S. Demski University of Florida

ACCOUNTING AND ECONOMICS by Joel S. Demski University of Florida prepared for The New Palgrave Dictionary of Economics, 2nd edition August, 2005 Helpful comments by Haijin Lin and David Sappington are gratefully acknowl- edged. ACCOUNTING AND ECONOMICS 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. Broadly viewed, economics is concerned with 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, e.g., how a firm measures and reports its financial progress, how a firm communicates with outsiders, and mandatory auditing of a firm’s public financial statements. 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 un- derstanding of what those products are and how they are produced. Ac- counting, in fact, uses the language of economics (e.g., 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. 1 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 1 measurement (e.g., Hicks) would be operational. Unfortunately, in such a setting no one would pay for the services of an accountant simply because the underlying fundamentals are assumed to be common knowledge. But firms are multiproduct 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 whom 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 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 le- gal entities aggregated into its public reports. Even with an unambiguous reporting entity, that entity’s control of economic resources would be in- completely 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 (e.g., cash and some financialinstruments)aswellashistoricalcost (e.g., most real assets). The flow measure is equally ambiguous. It is broadly based on what customers have paid less what resources were consumed in the process of satis- fying those customers. Such wide ranging phenomena as product warranties and potential product liabilities, uncollectible accounts, pension plans, ad- vertising, 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 surprise, now enters the picture. Public financial reports are typically required to be produced according to Generally Accepted Accounting Principles, or GAAP. These reports are also typically required to be audited, where the auditor attests to the claim the reports are in com- pliance with GAAP. One reason for regulations is the noted ambiguity places 2 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 those results were measured according to GAAP. Of course the auditor’s verifica- tion is statistical and judgmental; to no surprise, the auditor himself is also regulated. GAAP itself is fluid, varied, contentious and political at the margin. Two competing boards, the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) outside the U.S. are largely responsible for the definition of GAAP. Historically, their requirements 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 toward 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.1 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, etc. The noted ambigui- ties 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 the product. 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 non-financial measures, such as customer and employee satisfaction 1 While GAAP is defined outside explicit governmental agencies, complaince with GAAP is legally required. The SEC in the U.S. has statuatory 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. 3 orstudentcourseevaluations. Wealsofind occasional wholesale redesign of a firm’s internal accounting activity (Anderson et al, 1997).2 Importantly,now,thequestionishowarewetomakesenseofthesepat- terns? Two approaches have emerged through the years, the measurement school and the information school. 2 measurement school The measurement school takes its cue from classical economics. In a fully developed general equilibrium model, with complete and perfect markets (e.g., 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 reasonably well approaching this economic ideal. This is the source of accounting’s intellectual history, its underlying defi- nitions 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, and Chambers 1966.) The advantage of the measurement approach is its (relative) clarity. For- eign currency translation at contemporaneous exchange rates, economic de- preciation,and market value of complex financial instruments, for example, all take on a natural conceptual clarity at this point. Indeed, at least in the U.S., we find the national income accounts are not mere consolidations of GAAP measures, but are produced with an eye toward the economic fundamentals.3 Likewise, with the advent of financial engineering it is natural, 2 Tax accounting is yet another activity, though the measurement rules are often more directly statuatory in nature, and diverge from GAAP. 3 See Petrick (2002). More broadly, this leads us to measure theory in general (e.g., existence, uniqueness and meaningfulness of a measure), and the axiomatic characteriza- tion of additive

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