Volume 9, Issue 1 - On the Evolutionary Advantage of Cost Accounting and Conservatism

The principles characterizing the traditional revenue-expense approach to accounting cannot be traced back to a distinct event. I argue that they are ecologically rational . Their functionality is the result of cultural evolution, not of unitary human design. This is the reason why the efforts to defend them against the balance-sheet approach endorsed by standard-setters have encountered severe difficulties. Only the latter is clearly based on a coherent model of the economy, namely neoclassical economics. I further argue that a solid basis for explaining the rationale of the culturally evolved accounting principles can be found in behavioral economics. These principles are in line with human behavior as found in numerous laboratory and field experiments. It is especially with respect to Prospect Theory that a close parallel can be identified. I combine this observation with a market process view of the economy. Financial accounting according to the balance-sheet approach does not add new information to the market process; it only summarizes on the firm level information provided by the market. In contrast, the revenue-expense approach provides private information to the market à la Hayek (1945). The revenue-expense approach thus turns out to be congenial to the organization of the market economy.

Braun (The ecological rationality of historical costs and conservatism. Accounting, Economics and Law: A Convivium , this issue) argues that the traditional accounting principles underlying the revenue-expense approach such as Historical Cost and Conservatism are ecologically rational in that they help organizations survive better in uncertain economic environments. More importantly, Braun argues that the revenue-expense approach generates new private information, which informs markets and makes them more effective (Hayek, 1945, The use of knowledge in society. The American Economic Review, 35 (4), 519–530), as opposed to merely reflecting back market data under the asset-liability approach (e.g. Sunder, 2011, IFRS monopoly: The Pied Piper of financial reporting. Accounting and Business Research, 41 (3), 291–306). We try to explicate the nature of the new private information generated jointly by Historical Cost and Conservatism, and how this information facilitates the survival of individual entrepreneurs and organizations in market competition.

Since the 1970s, the decision-usefulness has taken center stage and our attention has been concentrated on valuation of assets and liabilities instead of income measurement. The concept of income, once considered the gravitational center of accounting has lost its primacy and become a byproduct of the balance sheet derived from the measurement of assets and liabilities. However, we have not been equipped with robust conceptual foundation supporting theoretically reasoned accounting measurement. It is not only theoretically but also practically important to renew our seemingly waned interest in the concept of income because ongoing reforms of accounting standards cannot be successfully implemented without a sound understanding of the concept of income.

This article argues that the debate between historical cost basis and fair value basis of accounting also rests upon one central question: what kinds of output do users want out of the accounting system: metrics to measure the long-run profit-generating ability or metrics to capture the short-run fluctuation in the estimated values of net assets?

Eduard Braun’s paper entitled “The Ecological Rationality of Historical Costs and Conservatism” has many elements which recommend it. Professor Braun has done an excellent job of summarizing several key topics in accounting theory, in particular those related to the issue of the revenue-expense versus the asset-liability approach to income determination and the historical cost versus fair value debate. In his paper, Braun argues that the revenue-expense approach to accounting cannot be traced to a distinct event. He also maintains that the revenue-expense approach is ecologically rational; that is, it results from “social evolution”, not human design. He goes on to argue that this ecological rationality is the reason why the efforts to impose the asset-liability approach favored by accounting standard-setters has encountered difficulties. He further argues that a solid basis for explaining the ecological rationality of the revenue-expense approach can be found in behavioral economics especially in Prospect Theory. He concludes that the revenue-expense approach is ecological rational and that it provides a basis for the organization of a market economy. The author supports his arguments with citations to well-respected accounting research which provides arguments against abandoning the revenue-expense approach (Waymire & Basu, 2007, Accounting is an evolved economic institution. Foundations and Trends in Accounting, 2 (1–2), 1–173; Dickhaut, Basu, McCabe, & Waymire, 2009, Neuroaccounting II: Consilience between accounting principles and the primate brain. Retrieved January 30, 2009 from http://ssrn.com/abstract=1336517 or http://dx.doi.org/10.2139/ssrn.1336517;Dickhaut, 2009, The brain as the original accounting institution. The Accounting Review, 84 (6), 1703–1712). This commentary will focus on two themes in Braun’s paper. First, the question of ecological rationality and whether this concept implies evolutionary progress. Second, the historical evolution of the revenue-expense approach, and why this approach can traced to several distinct events.