Balance Sheet and Accounting
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 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
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
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