Balance Sheet and Accounting

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Ross L. Watts Sloan School Massachusetts Institute of Technology

January 27, 2006

_____________________________ This paper was presented at the Institute of Chartered Accountants in England & Wales Information for Better Capital Markets Conference in London on December 20, 2005. I am grateful to Ryan LaFond, Karthik Ramanna, Sugata Roychowdhury and Joseph Weber for their comments. All remaining errors are mine.

1. INTRODUCTION When I was invited to present at this conference I was asked to address the question: “What has the invisible hand achieved (in financial reporting).” This is a rather broad question and an impossible one to answer using the evidence in the empirical accounting literature in capital markets alone. Accounting is only one mechanism in financial reporting and corporate governance and it evolved to fit in with other mechanisms, to be part of a general reporting, financing and governance equilibrium. The evidence in the international accounting literature is consistent with such an equilibrium (e.g., Ball, Kothari and Robin, 2000). Evaluating the market’s effect on financial reporting requires an understanding of the market’s effects on financing and corporate governance, an understanding of the extent to which mechanisms in those areas substitute for, or compliment, accounting and financial reporting. Thus, evidence on the evolution of corporate finance and governance is crucial to any assessment of the market’s achievements in financial reporting.

Another factor that is crucial in the assessment of the market is the legal and political environment. Markets require property rights in order to function. The nature of those property rights affects financial reporting. For example, the effective limited liability of joint stock companies appears to have influenced debt contracts and the accounting in those contracts and in shareholder reports (see Watts, 2003). When the political process produces changes in property rights, the market adjusts. When shareholders’ rights to bring litigation were changed in the US in the second half of the 20th century the market responded by making accounting and financial reporting more conservative despite the antipathy of the Financial Accounting Standard Board (FASB) towards conservatism in financial reporting (see Basu, 1997, and Holthausen and Watts, 2001). The nature of financial reporting and accounting that evolves in the market is influenced by the political


process and as a result the market demand for financial reporting also influences the political process (see for example Watts and Zimmerman, 1978, and Ramanna , 2005).

The consequence is that the market achievements are a function of economic forces that determine both the private economic arrangements and the outcomes of the political process. If proposed changes in accounting standards and financial reporting ignore those economic forces and generate unverifiable accounting numbers and the market is unable to prevent those changes occurring and/or adjust for them, the market will tend to ignore the resultant financial statements and disclosures and find other ways to meet the demand for financial reporting.1

Understanding the market’s achievements requires an understanding of the market’s responses to the demand for accounting and financial reporting that is generated both from the market and from the political process. My objectives in this paper are to: i) explain the how the market has responded in the past to demands in the market itself and to demands that come through the political process; ii) derive implications for standard-setting bodies and others who want to change the nature of accounting and financial reporting; and iii) predict the effects of current proposed standards

To those ends the next section explains how and why private market forces have influenced accounting and financial reporting. Section 3 explains how and why...
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