Economic crisis and accounting evolution

Abstract

We study changes in financial reporting around economic crises from a historical perspective through the lens of punctuated equilibrium evolution. Historical evidence and contemporary economic analyses indicate that corporate financial reporting plays a minor role in precipitating economic crises but might amplify them. Economic crises likely play a role similar to major shocks in biological environments by selecting accounting practices, accounting principles, firms and regulatory institutions for survival based on how well they adapt to post-crisis environments. Conscious attempts to improve accounting in the wake of crises, whether through market or political forces, may not prove as beneficial as hoped because we currently know far too little about the causes of economic crises or the consequences of abrupt changes to complex adaptive systems such as accounting. We outline several questions for future research that would increase our knowledge about these fundamental issues.

Keywords:

• selection
• transformation
• migration
• unintended consequences
• pretence of knowledge

Acknowledgements

This paper is adapted from the P.D. Leake Lecture delivered by Waymire at the Institute of Chartered Accountants in England and Wales on 21 October 2010 entitled ‘Financial Reporting and Financial Stability: What Can We Learn from History?’ We thank an anonymous reviewer, Robert Hodgkinson, Richard Macve, Brian Singleton-Green and audience members at the 2010 P.D. Leake Lecture for helpful conversations and suggestions.

Notes

This is partly because neo-classical economics primarily analyses equilibrium conditions during which stable behaviour is optimal for all parties. In contrast, crises are periods of severe economic discontinuity, and agents may have to drastically alter their behaviours even to survive. While beneficial in many ways, economists' tendency to rely on equilibrium analyses has limited the study and understanding of disequilibrium phenomena (Robinson 1962/2008, pp. 79–83, Colander et al. 2009).

Jacobellis v. Ohio 378 US 184 (1964).

Government defaults and currency degradation might also be relevant to accounting, but this relation does not primarily concern corporate reporting. For example, government off-balance sheet liabilities and a lack of accrual accounting by the US government are frequently criticised. In addition, calls for inflation accounting frequently follow large and persistent currency degradation.

We view managerial accounting as necessary not only for profit-seeking businesses but also temples and organised religions, clans, governments, armies, cooperatives, charities and various other organisations that control lots of resources. Similarly, we view entrepreneurs more broadly as organisation founders.

Allen and Carletti (2008) and Plantin et al. (2008) provide theoretical models showing how fair value accounting can lead to inefficiencies in the real decisions by managers of banks and insurance firms. However, Ryan (2008) argues that feedback effects from fair value accounting could have contributed only slightly to market illiquidity during the crisis. In response to political pressure, FASB relaxed application of its fair value rules in April 2010.

Another possibility is that lenders made insufficient provisions ex ante for potential loan losses during the real estate bubble and that more conservative estimates might have reined in some of the excessive lending. However, the human tendency to over-extrapolate from a short sequence of observations (e.g. Bloomfield and Hales 2002) as well as direct and indirect government subsidies likely swamped more conservative tendencies.

George Stigler (1988, p. 218), writing on the value of historical scholarship, remarks that a ‘useful and somewhat surprising lesson of historical scholarship is that widely accepted facts are often wrong. Not minor facts suitable for a game of trivia, but pervasive facts that have a powerful influence on how a science thinks and works.’ See also Hayek (1954, pp. 1–2).

Arnold and McCartney (2003, fn. 5) point out that Adams (1886, p. 85) portrays the UK Railway Regulation Act of 1844 as a consequence of the UK ‘Railway Mania’ by incorrectly dating the mania in 1844 before the act instead of the correct dates 1845–47, which inconveniently followed the act.

Maximising profit in a world of uncertainty is not necessarily synonymous with acting to improve survival prospects (Alchian 1950, Radner 1996). The idea that accounting can facilitate improved firm performance is at the heart of the hypothesis that double-entry accounting was responsible for the rise of capitalist organisations (Sombart 1919, Weber 1927, Schumpeter 1942, Mises 1949, Ijiri 1975, pp. 81–84).

Heads and Leuzinger (2011) recently reported the discovery of a 100 million-year-old fossil that appears anatomically identical to living splay-footed crickets, revealing that the genus has been in a period of ‘evolutionary stasis’ in a stable arid or semi-arid monsoonal habitat for at least the last 100 million years.

At this point, we assume a competitive environment and disregard the ‘bright-line’ use of accounting numbers for tax and regulatory purposes (e.g. Watts and Zimmerman 1986), which may have a sizable and direct impact on firm prospects. Such effects are clearly very important in some countries, industries and time periods than others, but less relevant to a general theory of accounting evolution.

Dickhaut et al. (2010a) survey recent neuroeconomics research showing that modern primates' brains operate in ways consistent with culturally evolved accounting principles. Thus, some modern accounting principles have links with neurological behaviours evolved over millions of years.

Pagel et al. (2006) estimate that about 22% of genetic changes among biological species occurs in punctuated bursts, which suggests that punctuated equilibrium accounts for a significant proportion of evolution in multiple domains.

Another prominent historical example is the practice of fully expensing research and development costs and leaving an intangible asset at nominal value on the balance sheet. Waymire and Basu (2007, pp. 31–40) describe the origins and subsequent spread of this practice in the USA after 1900.

Asset write-ups on the books of utilities in the 1920s occurred as a result of mergers, reorganisations and write-ups following asset appraisals (Barnes 1942, pp. 91–101, Twentieth Century Fund 1948, pp. 260–272, Bauer 1950, p. 102, Foster and Rodey 1951, p. 317). In response, a California regulatory commission required a utility to record assets bought in an acquisition to be recorded at ‘original cost’ to the seller with the excess of price over original cost written off to surplus or earnings (Twentieth Century Fund 1948, p. 261), a 1931 Wisconsin law required that subsequent acquisitions be recorded at ‘original cost’ and a 1933 New York law required that ‘original cost’ be applied retroactively to prior transactions (Foster and Rodey 1951, p. 293). However, Foster and Rodey (1951, p. 297) note ‘As late as 1933 it apparently had not occurred to accounting authorities generally that original cost might be defined to mean cost to a predecessor company.’

Rayburn and Powers (1991) provide a history of the use of pooling of interests accounting in the USA. FASB (2001) banned usage of the pooling-of-interests method in the financial statements of publicly-traded US companies starting from July 2001.