Balance Sheet and Accounting

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WHAT HAS THE INVISIBLE HAND ACHIEVED? 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…show more content…
Section 5 predicts the eventual outcomes if the FASB and International Accounting Standards Board (IASB) continue in their apparent resolve to fundamentally change the nature of accounting and financial reporting. Finally section 6 provides a summary and my conclusions. 1 Evidence of the market ignoring unverifiable accounting numbers can be found in Leftwich (1983) who reports that debt contracts exclude goodwill when measuring total assets. 3 2. PRIVATE MARKET FORCES & FINANCIAL REPORTING 2.1 Agency costs and financial reporting. The original development of accounting and financial reporting appears to be driven by control of agency costs. These costs arise when a principal delegates decision-making ability to an agent who maximizes his own welfare rather than that of the principal. There is considerable evidence that writing itself was developed in order to allow for accounting and control of the costs of agency relations such as that between a noble and a steward (de Ste Croix 1956; Yamey, 1962; Chadwick, 1992). Millennia later the wardens of English medieval guilds would prepare and present audited financial accounts as a mechanism to reduce agency costs (Watts and Zimmerman, 1983). The early English companies inherited this mechanism from the guilds. For example, even in its first years the British East India Company prepared annual audited financial statements and presented those statements
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