1400000011.pdf Registros

Foundations and Trends R
in
Accounting
Vol. 2, Nos. 1–2 (2007) 1–174

c 2008 G. B. Waymire and S. Basu
DOI: 10.1561/1400000011
Accounting is an Evolved Economic

Institution∗
Gregory B. Waymire1 and Sudipta Basu2
1
Department of Accounting, Goizueta Business School, Emory University,
Atlanta, GA 30322, USA, Gregory Waymire@bus.emory.edu
2
Department of Accounting, Fox School of Business and Mangement,
Temple University, Philadelphia, PA 19122, USA,
Sudipta.Basu@temple.edu
Abstract
We develop our paper by defining “accounting history research” and
posing six big picture questions about historical accounting evolution.
The paper selectively summarizes accounting history over the past ten
thousand years, organized around our six questions. This review pro-
vides useful examples that we draw upon for subsequent sections, but
can also be used as a US accounting history primer. We explain how
accounting history can inform scholars studying modern institutions
by analyzing several exemplary research papers. The paper discusses
numerous empirical studies using archival accounting data and suggests
further questions that can build upon and extend published research.
Finally, we discuss the implications of our evolutionary perspective
for accounting research, and identify numerous research opportunities
* This essay is dedicated to the memory of our colleague, George Benston, who passed away
earlier this year. George was a consummate scholar who believed strongly in the value
of economics-based policy research informed by intelligent data analysis. He also was a
person of remarkable energy and zest for life. We shall miss him.
under each of our six big picture questions that will together help us
build a coherent evolutionary theory of accounting.
Yet, if it is too pessimistic a view that man learns noth-

ing from history, it may well be questioned whether he
always learns the truth. While the events of the past are
the source of the experience of the human race, their
opinions are determined not by the objective facts but
by the records and interpretations to which they have
access. Few men will deny that our views about the
goodness or badness of different institutions are largely
determined by what we believe to have been their effects
in the past. There is scarcely a political ideal or concept
which does not involve opinions about a whole series of
past events, and there are few historical memories which
do not serve as a symbol of some political aim. Yet the
historical beliefs which guide us in the present are not
always in accord with the facts; sometimes they are even
the effects rather than the cause of political beliefs. His-
torical myths have perhaps played nearly as great a role
in shaping opinion as historical facts. Yet we can hardly
hope to profit from past experience unless the facts from
which we draw our conclusions are correct.
— Friedrich Hayek, “History and Politics” (1954, pp. 1–2)
Without a knowledge of history, the accountant may

not be sufficiently aware of the evolutionary nature of
society.
— American Accounting Association (AAA) Committee on the

Future Structure, Content, and Scope of Accounting Education
(1986, p. 181)
1
Introduction: Why Accounting History
Research is Valuable
Accounting is an economic institution whose recordkeeping origins

are at least 10,000 years old (Schmandt-Besserat, 1992). Double-entry
bookkeeping emerged spontaneously in 13th century Italian businesses
and was summarized in Pacioli’s (1494) classic printed text. After the
corporate form was introduced in 16th century Britain (Micklethwait
and Wooldridge, 2003), bookkeeping increased in complexity. Account-
ing, which classifies, aggregates, and summarizes business performance
using a firm’s comprehensive transactional history, is only a few hun-
dred years old (Ijiri, 1975). Even within this relatively short time, mod-
ern corporate accounting largely took shape with little explicit direction
from formal standard-setters.
Accounting, like other economic institutions, has evolved through a
path-dependent historical process over thousands of years wherein cur-
rent practices are influenced by both the recent and distant past. Hence,
accounting scholars need to seriously confront history to understand the
ultimate reasons why accounting institutions take their modern form.
Written conceptual frameworks have guided accounting standards only
in recent decades. Yet, accountants almost exclusively use implicit the-
ories of intentional design to analyze accounting practices, whether
3
4 Introduction: Why Accounting History Research is Valuable
imbedded in regulators’ conceptual frameworks or academics’ compara-

tive static analyses. As a result, we understand virtually nothing about
how the important economic institution of accounting evolves sponta-
neously with the expansion of economic exchange and division of labor
that underlie economic growth (North, 2005; A. Smith, 1776; V. L.
Smith, 2003).
Accounting history research commands little market share in our
most visible research journals. For example, very few empirical papers
published recently in leading US academic accounting journals relied
on historical data for their design and execution.1 Despite the fact
that accounting is one of the oldest economic institutions, account-
ing scholars rarely learn much accounting history.2 The consequence
is that we leave many important questions about accounting unan-
swered, and in some cases, even unstated. Yet, if accounting is largely
an evolved institution, then accounting history research likely is of first-
order importance for a deep scientific understanding of our discipline.
We claim that studying the history of accounting evolution is
socially valuable for several reasons. First, accounting institutional his-
tory can provide useful background knowledge and context for schol-
ars seeking to understand modern institutions, many of which have
deep roots in the past. Historical research provides fodder for thought
experiments that let us envision alternative institutional arrangements
that could have emerged but did not; in the process, these thought
experiments could offer a creative spark for innovative research. In
other words, research that is informed by history allows us to better
1 To illustrate, there were 16 archival papers published in the January 2007 issue of The
Accounting Review, the March 2007 issue of the Journal of Accounting Research, and
the March 2007 issue of the Journal of Accounting and Economics. Of these, only three
studies include any sample data from before 1980 whereas 12 have samples drawn entirely
from the post-1990 period. None of the three studies using data from before 1980 are ones
where historical data is necessary to execute the study (two are asset pricing studies while
one is a methodological analysis of the properties of accounting conservatism measures).
Fleischman and Radcliffe (2005) discuss the lack of historical publications in major US
journals within the broader context of how accounting history research developed in the
1990’s.
2 Human recordkeeping is first evidenced by the tokens of Ancient Mesopotamia that date
back to approximately 8,000 BCE, and humans invented writing to keep better accounting
records (see Basu and Waymire (2006), pp. 213–217, and references therein).
5
understand that which we cannot directly observe or measure rather

than only “what is” (Bastiat, 1848; Hayek, 1989; Smith, 2003).
Second, historical data provide unique opportunities to study issues
of enduring importance. Finance and economics scholars increasingly
use historical data to study important questions such as why people
contribute to charities or whether common law economies always per-
form better than code law economies. Historical data often allow us
to obtain relatively unconfounded evidence on the economic, political,
and social forces at play in major accounting decisions. Examples of this
approach include how corporate disclosure policies are chosen in unreg-
ulated settings (Benston, 1969, 1973; Sivakumar and Waymire, 1993,
1994), the incentives for the use of early audits (Watts and Zimmer-
man, 1983), and the evolution of accounting as a centerpiece of investor
protection mechanisms that underlie corporate governance (Barton and
Waymire, 2004; Bushman and Smith, 2001).
Third, history is the necessary focus of evolutionary theories that
seek an ultimate explanation for how human societies and economic
institutions are shaped over a long period of time. Knowledge of
accounting history allows one to better grasp the deeper function of
accounting, which is to enable humans to cooperate far more broadly
and intensively than any other species (Wilson, 1975). Accounting pro-
motes economic evaluation that provides the foundation for trust upon
which sophisticated economic organizations and markets can develop
(Mises, 1949; Schumpeter, 1950; Sombart, 1919; Weber, 1927, 1956).
We expect that the transactional memory and improved decision-
making facilitated by evolved accounting will ultimately be seen as a
key causal mechanism through which Adam Smith’s “Invisible Hand”
is manifested in economic organizations, markets, and related economic
institutions.
Fourth, a lack of historical knowledge can predispose researchers
to confirmation bias. One reason is that researchers can easily recall
the recent events that prompted their research hypotheses but may
be unaware of prior events that would reveal their hypotheses were
false (one form of overfitting data). For instance, education in the
“fair value” accounting abuses of the 1920s might chasten some of
its advocates today. More importantly, as our opening quote from
6 Introduction: Why Accounting History Research is Valuable
Hayek emphasizes, researchers may develop theories relying on “fac-

toids” or myths about accounting history that are very different from
what actually transpired. As a result, researchers could incorrectly treat
falsifying data as confirmatory. Furthermore, many important account-
ing research questions have been examined many times over using dif-
ferent research methods, and invoking prior answers can make current
answers more persuasive.
Finally, studying accounting history can help develop professional
identity, not just for accounting scholars but also for accounting
students. Current financial accounting textbooks routinely introduce
accounting history with the formation of the SEC in 1934 and its
delegation of accounting rule-making to private standard-setting bod-
ies. Accounting students often get the mistaken impression that the
accounting profession was created recently by government mandate. If
they learned instead that accounting is hypothesized to have enabled
the emergence of capitalism, or that accountants invented reading, writ-
ing and arithmetic, they would be more likely to be proud of their
careers and accomplishments (Hatfield, 1924).
We develop our survey by defining “accounting history research”
and posing six big picture questions about historical accounting evolu-
tion in Section 2. Section 3 selectively summarizes accounting history
over the past ten thousand years, organized around our six questions.
This review provides useful examples that we draw upon for subsequent
sections, but can also be used as a US accounting history primer. In Sec-
tion 4, we explain how accounting history can inform scholars studying
modern institutions by analyzing several exemplary research papers.
Section 5 discusses numerous empirical studies using archival account-
ing data and suggests further questions that can build upon and extend
published research. In Section 6, we discuss the implications of our evo-
lutionary perspective for accounting research, and identify numerous
research opportunities under each of our six big picture questions that
will together help us build a coherent evolutionary theory of account-
ing. Concluding remarks are offered in Section 7.
2
Quantitative Accounting History Research:
Definition and Focus of Paper
We define accounting history research as:
“The careful and distinctive observation and interpreta-

tion of facts related to how humans institutions evolved
to govern the creation of transactional records, and the
ways in which these records are classified, aggregated
and summarized to provide a reconstruction of the past
that aids decision-making.”1
1 This definition derives from separate consideration of what is meant by “accounting,” “his-
tory,” and “research.” Webster’s defines “research” as “to examine anew” and “examine”
as to “observe carefully or critically. To scrutinize.” American Heritage defines “anew”
to mean “in a new and different way, form or manner.” Research is thus defined as sub-
stantive inquiry involving careful and distinctive observation. American Heritage defines
history as “A chronological record of events, as of the life or development of a people or
institution, often including an explanation of or commentary on those events: a history
of the Vikings.” The part of this definition that is most useful for present purposes is
“institution.” Likewise, “development” is a step in the right direction, but still does not
complete the picture. What is lacking here is the issue of context (Previts et al., 1990a,
p. 2). We define history for present purposes as the study of past institutional develop-
ment that encompasses both the gathering of facts as well as their interpretation. Modern
accounting textbooks suggest that accounting includes the recording of transactions and
reporting of summarized totals in financial statements that are potentially useful for mak-
ing economic decisions (Antle and Gartska, 2002, p. G-1; Horngren et al., 2002, p. G1;
7
8 Quantitative Accounting History Research
The research literature on accounting history is large and we do not

attempt a comprehensive review in this survey. Most accounting history
research follows other historical research in using little, if any, formal
statistical analyses to support inferences.2 Nonetheless, this research
provides useful evidence on how social and economic forces have shaped
accounting and its institutions over long periods. Leading studies in
accounting history often have a qualitative character (e.g., Baskin and
Miranti Jr., 1997; Chatfield, 1974; Littleton and Yamey, 1956; Previts
and Merino, 1998; ten Have, 1976). While much of this literature’s
primary focus is on describing the history of accounting institutions,
theory from economics and other social sciences is not entirely lacking
(e.g., Baskin and Miranti Jr., 1997).
A second smaller research area in accounting history relies more on
formal statistical techniques for purposes of analysis. The label Clio-
metrics, which derives from Clio who was “the muse of history and
heroic poetry in Greek mythology, sometimes describes quantitative
research in economic history.”3 Among the most noted economic histo-
rians using Cliometric methods are Robert Fogel and Douglass North,
who shared the Nobel Prize in Economic Science in 1993.4 The first
scholar to use this approach in accounting is George Benston (1969,
1973), and more recent work by Sivakumar and Waymire (1993, 1994,
2003) also falls into this category. Our analysis emphasizes Cliometric
research in accounting, reflecting our training and backgrounds in cap-
ital markets research that relies heavily on econometric analysis and
our own research interests and tastes. This Cliometric emphasis will
be useful when we discuss hypothesis testing in connection with the
history of accounting in later sections.
Libby et al., 2003, p. 846). For present purposes, we define accounting as a process that
involves recording historical data about economic transactions, which are then classified,
aggregated, and summarized in ways that allow re-construction of the past to facilitate
decision-making.
2 A nice review of the use of historical methods in accounting research is available in Previts
et al. (1990a,b).
3 See entry in Wikipedia at http://en.wikipedia.org/wiki/Cliometrics.
4 Examples of their early work include Fogel and Engerman (1974) and North and Thomas
(1973). McCloskey and Hersh (1990) provide a broad listing of cliometric research.
9
We pose six “big picture” evolutionary questions to frame the rest of

the survey, asking why various prominent features of accounting came
to be5 :
(1) Why is the recordkeeping core of accounting important?

Humans had been recording economic exchange for thou-
sands of years before the Italians developed double-entry
bookkeeping. Why does recording economic exchange have
value on a stand-alone basis independent of other account-
ing actions?
(2) How could basic functions like double-entry bookkeeping
enable large-scale capitalism? What is the economic basis for
the assertion by Sombart, Weber, Schumpeter, and Mises
that double-entry accounting provides the foundation upon
which capitalist economies develop?
(3) How can accounting “standards” form spontaneously in the
absence of bodies explicitly charged with standard setting? It
is well known that accounting practice was characterized by
regularities before explicit standard setting was in place. By
what dynamic processes did this state of affairs come to be?
(4) In what ways, both beneficial and detrimental, has account-
ing practice been influenced by law, regulation, and taxation?
We know that law, regulation, and taxation for several thou-
sand years have influenced accounting, but these influences
have intensified over the past 150 years. Can the influence of
law, regulation, and taxation account for complex phenom-
ena such as transaction structuring where the direction of
causality from transaction to accounting is reversed?
(5) Why are broad principles important to accounting but not
other fields like marketing? Why is it that accountants have
adopted broad conventions to guide accounting decisions?
Is this because the fitness consequences of most accounting
5 These questions have been studied and discussed for decades by accounting historians,
although we propose somewhat novel ways of tackling them. For instance, using traditional
historical methods, Macve (2002) analyzes questions very similar to our questions (2) and
(4), Carmona and Ezzamel (2007) analyze issues related to question (1), and McCartney
and Arnold (2002) examine an example of question (6).
10 Quantitative Accounting History Research
choices are not readily apparent for cases where tax and reg-
ulatory effects are absent?
(6) Why is accounting evolution subject to major discontinu-
ities that arise from changes made in response to economic
crises? Do these discontinuities, or punctuated equilibria,
arise because the fitness consequences of poor accounting
choices are revealed only by systemic failures affecting mul-
tiple firms simultaneously?
These questions are posed roughly in chronological order. Record-

keeping is the first manifestation of accounting in human history, and
it dominated accounting practice until the appearance of double-entry
bookkeeping in 13th century Italy. At this time, geographical norms in
accounting practice began to emerge as different regions used local vari-
ations on this basic method. The printing press enabled widespread dif-
fusion of double-entry bookkeeping over several subsequent centuries,
and led to greater geographical homogeneity in accounting practice.
This was in no small way influenced by the development of an account-
ing profession in Britain and the United States in the 19th century.
The influence of regulation and taxation has accelerated over the past
150 years, and the search for principles of accounting dates back a little
over a century. Likewise, a relation between systemic failures, economic
crises, and accounting regulation is a more recent phenomenon that has
become especially pronounced since the mid-19th century.
We will use these questions in Section 3, when we provide examples
from the history of accounting that we seek to explain, and also in
Section 6 to organize our discussion of future research that could lead
to an evolutionary theory of accounting.
3
Overview of Questions that Arise in Accounting
History Research
Our view is that accounting is an important economic institution that

has evolved over a period of at least 10,000 years. In this section, we
use our six big picture questions to organize a chronological descrip-
tion of events in accounting history in Table 3.1, with each panel selec-
tively summarizing accounting history corresponding to one question.
These historical events are cited in subsequent sections when relevant
to a specific discussion. As a caveat, the list in Table 3.1 is far from
comprehensive; it includes primarily English language publications on
American and British accounting events that are most pertinent to the
current undertaking.1
1 More comprehensive reviews of Anglo-American accounting and auditing history are

provided in Littleton (1933), Littleton and Yamey (1956), Hawkins (1963), Chatfield
(1974), Johnson and Kaplan (1987), Edwards (1989), Baskin and Miranti Jr. (1997),
Previts and Merino (1998), Fleischman and Tyson (1998), O’Connor (2004), and Flesher
et al. (2005) among many others. Walker (2005) surveys historical research on account-
ing development around the world including publications in languages other than
English.
11
12 Overview of Questions that Arise in Accounting History Research
Table 3.1 Some important events in accounting history organized around six general themes.
A: The Importance of Recordkeeping (Section 3.1)
A1. 8,000 BCE. Earliest known use of clay tokens as symbolic representations of
transactions (Schmandt-Besserat, 1992).
A2. 3,200 BCE. Tokens begin to be sealed inside baked clay balls with seals impressed
on the outside to improve data integrity regarding complex exchange involving future
promises.
A3. 3,200 BCE. First known invention of writing, which was for the purpose of recording
transactions. Numerals invented around the same time (Nissen et al., 1993).
A4. 1,750 BCE. The legal code of Hammurabi requires transaction records as evidence in
cases of commercial disputes.
A5. 250 BCE. Athens has buildings serving as public archives for financial records,
accounts, lease contracts, and wills that could be used in legal disputes (Sickinger,
1999, pp. 122–134).
A6. 1200 AD. Audits required in English merchant guilds (Watts and Zimmerman, 1983,
p. 616).
A7. 1673. Ordinance of 1673 in France requires that journals be kept documenting
receivables and payables. This was retained in the French Commercial Code of 1807.
Well-kept books could be presented as evidence in legal proceedings over unpaid
obligations (Howard, 1932, pp. 91–102).
A8. 2002. Sarbanes–Oxley Act signed into law by President George W. Bush on July 30.
Section 1102 of the law establishes criminal penalties for tampering with the
transactional records of a company subject to US federal securities laws.
B: Double-Entry Accounting and Economic Complexity (Section 3.2)

B1. 3,200 BCE. Tokens begin to be sealed inside baked clay balls with seals impressed
on the outside to improve data integrity regarding complex exchange involving future
promises.
B2. 1150 AD. Charge–discharge accounting was used for estates (“Historical Dates in
Accounting,” The Accounting Review, July 1954),
B3. 1200. Audits required in English merchant guilds (Watts and Zimmerman, 1983,
p. 616).
B4. 1299. Evidence of a double-entry system of bookkeeping found in records of Farolfi
Company at Florence, Italy (de Roover, 1955, p. 411). The oldest known European
bookkeeping fragments from Florence in 1211 AD show rudiments of double-entry
bookkeeping (Lee, 1973). The earliest undisputed evidence of double-entry
bookkeeping is found in the communal accounts of the City of Genoa in 1340 AD
(Melis, 1950).
B5. 1555. First British joint-stock company (Muscovy Co.) chartered and granted
monopoly rights over trade with Russia (Micklethwait and Wooldridge, 2003).
B6. 1600. East India Company formed and shares in company sold to public, which
evidences early separation of ownership and control (Micklethwait and Wooldridge,
2003 and “Historical Dates in Accounting,” The Accounting Review, July 1954).
B7. 1710-20. South Sea Company organized in 1710 to take over the English national
debt. This company’s shares increased dramatically in 1720 as a result of investor
speculation and subsequently crashed in September and October 1720. An audit by
Charles Snell discovered fraud by the company’s directors. This event is thought to be
the first example where an accountant was hired for purposes of investor protection
(“Historical Dates in Accounting,” The Accounting Review, July 1954, and Parker,
1986, p. 4).
(Continued)
13
Table 3.1 (Continued)

B8. 1838. Boston and Worcester Railroad creates a reserve for deterioration and
depreciation of equipment beyond repair (“Historical Dates in Accounting,” The
Accounting Review, July 1954).
B9. 1860. Pennsylvania Railroad develops renewal/replacement accounting to account
for fixed capital expenditures and this practice diffused through professional network
contacts between railroads (Chandler, 1977, pp. 109–120).
B10. 1902. US Steel becomes the first major American company to issue a consolidated
balance sheet in its first annual report for the 12/31/1902 year (“Historical Dates in
Accounting,” The Accounting Review, July 1954).
B11. 1907. The General Electric Company, one of the first American corporations to
have its own research laboratory in 1900, becomes the first US firm to state its
patents, franchises, and goodwill at a nominal value of $1 with their auditor attesting
that all expenditures for patents and related litigation had been charged against
earnings. This practice was widespread among major publicly traded US firms by the
late 1920s. Montgomery notes that a major impetus was a major revision of the US
income tax code, which had raised rates significantly to finance US involvement in
WWI (Ely and Waymire, 1999b; Montgomery, 1919).
B12. 1919. German economist Werner Sombart hypothesizes that double-entry
bookkeeping was responsible for the emergence of capitalist economies (Werner
Sombart, 1919. Der Moderne Kapitalismus, and Most, 1972). Max Weber (1927,
General Economic History), Ludwig von Mises (1949, Human Action), and Joseph
Schumpeter (1950, Capitalism, Socialism, and Democracy) subsequently advanced
variants of this hypothesis.
C: The Emergence of Accounting Norms and Professional Standards (Section 3.3)

C1. 1494 AD. Publication of Pacioli’s text Summa de Arithmetica, Geometia,
Proportioni et Proportionalita (“Historical Dates in Accounting,” The Accounting
Review, July 1954). The large impact of this publication was not because it reported
an “invention” of double entry nor even that it was the first text on double entry.
Rather its impact was attributable to the fact that it was the first to be printed after
the Gutenberg printing press was introduced in 1454 and it was translated into
several languages (de Roover, 1955, p. 418).
C2. 1645. George Watson of Scotland becomes the first person to earn his livelihood
solely from the practice of accounting (“Historical Dates in Accounting,” The
C3. 1796. William Mitchell writes the first American bookkeeping text (“Historical
Dates in Accounting,” The Accounting Review, July 1954).
C4. 1853. The first professional accountancy society is founded in Edinburgh, Scotland
(Parker, 1986, p. 15 and “Historical Dates in Accounting,” The Accounting Review,
July 1954).
C5. 1860. Price Waterhouse established in London (“Historical Dates in Accounting,”
The Accounting Review, July 1954).
C6. 1867. Scottish societies of Glasgow, Edinburgh, and Aberdeen agree to standardize
examinations and form an examining board for Chartered Accountants (“Historical
C7. 1882. Institute of Accountants and Bookkeepers formed in New York and first exam
required of chartered accountants in England (“Historical Dates in Accounting,” The
C8. 1896. New York regulated public accounting with the title of CPA conferred after
successfully completing an exam (“Historical Dates in Accounting,” The Accounting
Review, July 1954).
(Continued)

C9. 1897. First state society of CPAs formed in New York (“Historical Dates in
C10. 1905. Journal of Accountancy first published in November (“Historical Dates in
C11. 1909. Henry Rand Hatfield’s Modern Accounting published (“Historical Dates in
C12. 1922. Accounting Theory by William Paton is published, which is the first US
textbook to articulate the entity theory of accounting. Littleton (1933, pp. 191–203)
notes that the origins of entity theory date back to at least three centuries before the
publication of Paton’s book (see also Previts and Merino, 1998, pp. 221–223).
C13. 1939. The American Institute of Accountants’ Committee on Accounting
Procedure (CAP) is empowered by the AIA to set accounting principles for the
profession after the SEC delegated its authority to establish accounting rules to the
accounting profession in Accounting Series Release #4 issued in 1938.
C14. 1940. Paton and Littleton’s An Introduction to Corporate Accounting Standards
was published. This book provided the foundation for the Revenue Realization and
Expense Matching principles that had emerged in practice and provided the basis for
historical cost income measurement in financial reporting that was followed through
most of the 20th century in the United States (Previts and Merino, 1998,
pp. 281–283).
C15. 1959. The AICPA replaces the Committee on Accounting Procedure with the
Accounting Principles Board (APB) following criticism that the CAP had no
theoretical foundation for its promulgations. To address the lack of theory, the
AICPA also established an accounting research division within the AICPA. The first
director of this division, appointed in 1960, was Maurice Moonitz.
C16. 1972. AICPA’s Wheat Committee recommends restructuring the standard-setting
process. The APB is replaced the following year with the Financial Accounting
Standards Board (FASB).
C17. 2001. International Accounting Standards Board is established on April 1. It
replaces the International Accounting Standards Committee. In 2002, FASB and
IASB conclude the Norwalk Agreement that commits the boards to work together to
remove differences between IFRSs and US GAAP and to coordinate their future work
program.
D: Accounting and its Relation to Law, Regulation, and Taxation (Section 3.4)
D1. 8,000 BCE. Earliest known use of clay tokens as symbolic representations to signify
the payment of communal tribute (Schmandt-Besserat, 1992).
D2. 1,750 BCE. The legal Code of Hammurabi requires transaction records as evidence
in cases of commercial disputes.
D3. 1433. Bank of Medici regularly produces balance sheets, which at that time were
routinely prepared for both purposes of control as well as property taxation (de
Roover, 1955, p. 414).
D4. 1673. Ordinance of 1673 in France requires that journals be kept documenting
receivables and payables. This was retained in the French Commercial Code of 1807.
Well-kept books could be presented as evidence in legal proceedings over unpaid
obligations (Howard, 1932, pp. 91–102).
D5. 1817. Accountants begin assisting British courts in bankruptcy cases (“Historical
D6. 1844. Joint Stock Companies Act of 1844, the first Companies Act, is written into
British law. Main provisions were to establish principles on differences between
partnerships and corporations, incorporation by registration rather than act of
(Continued)
15

Parliament, and requiring filing information with a new Registrar of Companies.
Limited liability was added in 1855 and the act was updated extensively in 1862
(Parker, 1986, p. 8).
D7. 1845. Companies Clauses Consolidation Act of 1845 was written into British law.
This law dealt with railroads and required “full and true” financial statements
(Parker, 1986, p. 7). This act also mandated shareholder audits (Parker, 1986, p. 23).
D8. 1849. British case of Burnes v. Pennell decided, which is seen as the original source
of the rule that dividends cannot be paid except from profits (Reid, 1988).
D9. 1869. Massachusetts establishes the first permanent state regulatory commission
with power to inspect railroad accounting records and set accounting and disclosure
requirements (Clark, 1891). The law enabling this commission supplanted an 1846 law
limiting earnings to a maximum of 10% with the excess recovered as a tax by the
State of Massachusetts. The excess profits tax explains why Massachusetts railroads
were far more likely to record depreciation than other state railroads even before state
accounting regulation (Boockholdt, 1978, p. 15).
D10. 1887. Act to Regulate Interstate Commerce passed by US Congress. This act set up
federal rate regulation of railroads along with required financial disclosure. The ICC
had significant problems enforcing both the regulation and accounting requirements
until passage of the Hepburn Act of 1906 (Sivakumar and Waymire, 2003).
D11. 1898. The US Supreme Court articulates the principle that a regulated firm is
entitled to earn a “fair return” on the “fair value” of invested capital in Smyth v.
Ames.
D12. 1906. The Hepburn Act of 1906 becomes federal law. This law renders the federal
railroad accounting and disclosure requirements under the 1887 Act enforceable. The
Interstate Commerce Commission writes rules requiring depreciation to be reckoned
and interim reports to be filed (Sivakumar and Waymire, 2003).
D13. 1909. First (post US Civil War) US excise tax based on income is enacted. The
first formal income tax was enacted in 1913, and this law reinforced a shift toward
income measurement and away from the balance sheet (“Historical Dates in
Accounting,” The Accounting Review, July 1954 and Previts and Merino, 1998).
D14. 1929. California regulatory commission requires a utility buying assets in a
corporate acquisition to record those assets at their original cost to the firm that sold
them in an acquisition. Any excess of purchase price over original cost to the seller was
to be written off immediately by the buyer. This represents an early application of
accounting for an acquisition in a fashion similar to “pooling of interests” accounting.
D15. 1933. US Securities Act passed to regulate public offerings of securities. A year
later Congress passes the Securities Exchange Act, which establishes the SEC as an
agency to regulate secondary sales of securities and stock exchanges (“Historical
D16. 2002. Sarbanes–Oxley Act signed into law by President George W. Bush on July
30. Section 1102 of the law establishes criminal penalties for tampering with the
transactional records of a company subject to US federal securities laws.
E: Why Do Broad Accounting Principles Exist? (Section 3.5)

E1. 1299 to 1335. Evidence of a double-entry system that included accruals for interest
and prepaid rent and separate reckoning of profit and loss in books of Farolfi
Company of Florence, Italy (de Roover, 1955, p. 411).
E2. 1406. Conservatism is evident in the application of lower-of-cost-or-market to
inventories of Florentine businessman Francesco di Marco of Prato (Littleton, 1941).
E3. 1849. British case of Burnes v. Pennell decided, which is seen as the original source
of the rule that dividends cannot be paid except from profits (Reid, 1988).
(Continued)

E4. 1898. The US Supreme Court articulates the principle that a regulated firm is
entitled to earn a “fair return” on the “fair value” of invested capital in Smyth v.
Ames.
E5. 1909. First US excise tax based on income is enacted. Regular income tax enacted in
1913 after a constitutional amendment allowing for income taxes. The establishment
of federal income taxation has been seen as further encouraging an already increasing
shift towards income measurement following rapid development of US equity markets
(“Historical Dates in Accounting,” The Accounting Review, July 1954 and Previts
and Merino, 1998).
E6. 1921. Revenue Act of 1921 allows lower-of-cost-or-market for inventory in tax
returns (“Historical Dates in Accounting,” The Accounting Review, July 1954).
E7. 1922. Accounting Theory by William Paton is published, which is the first US
textbook to articulate the entity theory of accounting. Littleton (1933, pp. 191–203)
notes that the origins of entity theory date back to at least three centuries before the
publication of Paton’s book (see also Previts and Merino, 1998, pp. 221–223).
E8. 1939. Kenneth MacNeal’s Truth in Accounting is published. MacNeal was “the first
major accounting writer, at least in the English language literature, to advocate a
market-price system for financial statements” (Zeff, 1982, p. 546). MacNeal’s book
therefore is the first US accounting book to advocate the kind of accounting based on
balance sheet primacy with fair value measurement that the FASB has pursued in
recent years.
E9. 1940. Paton and Littleton’s An Introduction to Corporate Accounting Standards was
published. This book provided the foundation for the Revenue Realization and
Expense Matching principles that had emerged in practice and provided the basis for
historical cost income measurement in financial reporting that was followed through
most of the 20th century in the United States (Previts and Merino, 1998,
pp. 281–283).
E10. 1953. Publication of A.C. Littleton’s book The Structure of Accounting Theory,
which tried to explore the comparative roles of deduction and induction in
establishing broad principles of accounting.
E11. 1962. The AICPA publishes Accounting Research Study #3, written by Robert
Sprouse and Maurice Moonitz, on principles of accounting. This study supported the
use of current values in accounting, but was rejected by the APB as a basis for its
decisions because it was too radical.
E12. 1978. FASB issues its first concepts statement Objectives of Financial Reporting by
Business Enterprises in November.
E13. 2004. In October, FASB and IASB added to their agendas a joint project to develop
an improved, common conceptual framework that builds on their existing frameworks.
F: The Path of Accounting Evolution is Discontinuous (Section 3.6)
F1. 1720. A “bubble” in the stock price of South Sea Company is followed by a “crash”
in September and October 1720. An audit by Charles Snell discovered fraud by the
company’s directors. This event is thought to be the first example where an
accountant was hired for purposes of investor protection. The Bubble Act (passed in
June 1720) forbade joint stock companies not authorized by royal charter. This act
was not repealed until 1825 (“Historical Dates in Accounting,” The Accounting
Review, July 1954, Parker, 1986, p. 4, and Wikipedia on “Bubble Act”).
F2. 1844. Joint Stock Companies Act of 1844, the first Companies Act, is written into
British law. The original British Companies Act, as well as subsequent revisions,
followed after periods of economic crises related to widespread business failures and
bankruptcies. Littleton (1933) suggests that this is the source of the objectivity
(Continued)
3.1 Why is the Recordkeeping Function of Accounting Important? 17

principle in accounting. McCartney and Arnold (2002) document that British
railroads voluntarily switched from cash-basis to accrual accounting and increased
disclosure of balance sheets after the collapse of the railroad “mania” of 1845–1847.
F3. 1909. John Moody publishes his Moody’s Analyses of Railroad Investments, the first
US investor publication to include quantitative ratings of the desirability of bonds
and stocks as investment. Moody’s ratings were devised after the New York State
Armstrong Committee investigation of fiduciary duty breaches by investment banks
and insurance companies in the bank panic and stock market crash of October 1907
(North, 1954; Moen and Tallman, 1992; Carosso, 1970, pp. 110–136) Moody’s service
subsequently expanded over the next decade to provide ratings for industrial
corporations and gas and electric utilities.
F4. 1927. Main Street and Wall Street by William Ripley, a scathing critique of US
corporate reporting practices, is published. Ripley’s book provided much of the basis
for the Securities Acts adopted in the 1930s following the crash in October 1929.
F5. 1929. The New York Stock Exchange crashes in October 1929.
F6. 1932. NYSE requires audits by listed companies (“Historical Dates in Accounting,”
The Accounting Review, July 1954).
F7. 1933. US Securities Act passed to regulate public offerings of securities. A year later
Congress passes the Securities Exchange Act, which establishes the SEC as an agency
to regulate secondary sales of securities and stock exchanges (“Historical Dates in
F8. 2001. Enron files for bankruptcy on December 2.
F9. 2002. WorldCom announces in June that its profits for the prior 15 months were
overstated by $3.85 billion.
F10. 2002. Sarbanes–Oxley Act signed into law by President George W. Bush on July
30. SOX recommended the adoption of principles-based accounting standards.
F11. 2003. The SEC signs off on final NYSE governance requirements. These rules grew
out of NYSE initiatives to improve audit committee independence following a widely
noted 1998 speech by Arthur Levitt, SEC Chairman, on the perceived manipulation
of corporate earnings.
3.1 Why is the Recordkeeping Function of Accounting

Important?
Accounting originated as a basic recordkeeping function. Symbolic
artifacts were created to signify the consummation of exchange.
Subsequently, recordkeeping was systematized into bookkeeping as
records came to be stored in journals and ledgers to facilitate classifica-
tion and summarization.2 Accounting in its present form with audited
financial statements prepared according to generally accepted methods
is a product of just the past few centuries.
2 Kohler (1952) defines recordkeeping as the collection and maintenance of objective and
verifiable (i.e., legal) evidence of transactions and bookkeeping as the systematic analysis,
classification, and aggregation of transactions.
Accounting history can be divided into two periods, the first being
that before double-entry bookkeeping appeared in Italy in the 1200s
and was summarized in Paciolo’s (1494) printed text (Chatfield, 1974,
p. 4). Throughout this era, accounting was primarily recordkeeping,
although in some places it had been elaborated into single-entry book-
keeping. Recordkeeping is of continuing economic significance since it
forms the core of modern accounting systems based on journalization
using double entry (Ijiri, 1975; Littleton, 1933; Potter, 1952). Thus,
understanding the economic value of recordkeeping, independent of
other steps in the accounting process, is necessary for understanding
the deeper functions of modern accounting. Eight events relevant to
the history of recordkeeping are listed in panel A of Table 3.1.
Archaeologists document that people recorded economic exchange
for at least 10,000 years (Schmandt-Besserat, 1992), although scratches
on stones and bones may have been used to record exchange as far back
as 75,000 BCE (Ifrah, 2001, Chap. 4). The earliest known records of
economic transactions are the tokens of ancient Mesopotamia, which
date back to 8,000 BCE at the time of early human settlements based
on agriculture (event #A1 in Table 3.1). This recordkeeping technology
was improved when multiple tokens for items in a bundled transaction
involving future performance obligations were baked in hollow balls
(“bullae”) after witnesses had affixed their seals (event #A2). This
technology improved the integrity of transactional data by rendering
the data “hard” in the sense that ex post it “will be difficult for people
to disagree” (Ijiri, 1975, p. 36). Further improvements in recordkeeping
resulted from written language and numerals, which were first invented
by the Sumerians around 3,200 BCE for purposes of recordkeeping
(event #A3) (Nissen et al., 1993).3
Transactional records have long served to resolve commercial dis-
putes. The Code of Hammurabi (c. 1750 BCE) specified how receipts
were to be used as evidence in legal proceedings (event #A4) (Saggs,
1989; Versteeg, 2000). By the middle of the third century B.C., the
Athenians maintained public archives of financial records, accounts,
3 Recent claims that writing emerging earlier in Egypt are disputed (Mattessich, 2002),
while similar claims for India (http://www.rediff.com/news/1999/jul/14harap.htm) seem
unfounded.
3.2 How Could Double-entry Bookkeeping Enable Large-scale Capitalism? 19
lease contracts, and wills (Sickinger, 1999, pp. 122–134), which could be
used in legal dispute resolution (event #A5). A continuing paramount
concern over accounting data integrity is evidenced by the use of
manorial audits in Britain around 1200 AD (event #A6) and subse-
quent laws requiring that records be kept in a specific form so that
they can serve as evidence in legal proceedings (event #A7). The
fundamental importance of transactional records characterized by high
integrity continues to be an important issue. Section 1102 of Sarbanes–
Oxley of 2002 establishes criminal penalties for tampering with the
transactional records of a company subject to US federal securities
laws (event #A8).
The economic function of recordkeeping is an issue we will return
to later in this survey, especially in the section on the evolutionary
function of accounting. Specifically, we will explore how hard records
leverage evolved human capabilities for beneficial exchange in building
the kinds of advanced societies seen around the globe today (Basu and
Waymire, 2006).
3.2 How Could Double-entry Bookkeeping Enable

Large-scale Capitalism?
A second broad theme in accounting history is that increasing
complexity in markets and economic organizations is typically asso-
ciated with increased accounting complexity. A relation between
economic development and accounting complexity could arise because
accounting adapts to changing economic environments. Alternatively,
accounting could have feedback effects that alter the economic environ-
ment (e.g., Hopwood, 1987). These views are not mutually exclusive
since bi-directional causality could reflect an underlying process where
accounting and other economic institutions co-evolve.4 Illustrative
events pertaining to the relation between economic and accounting
complexity are shown in panel B of Table 3.1.
4 Werner Sombart is translated in English as asserting: “One cannot say whether capital-
ism created double-entry bookkeeping, as a tool in its expansion, or whether perhaps,
conversely, double-entry bookkeeping created capitalism. . . ” (Lane and Riemersma, 1953,
p. 38).
A relation between economic organization/complexity and account-

ing is apparent in pre-history and at the time when writing and numbers
first appeared in ancient Mesopotamia (Basu and Waymire, 2006; Mat-
tessich, 2000) (event #B1 in panel B of Table 3.1). The use of the
charge–discharge statement of stewardship accounting and its audit in
medieval times are evidence that more sophisticated accounting and
auditing practices developed out of organizational innovations that
required expanded monitoring of agency relationships (events #B2 and
B3). Double-entry bookkeeping emerged in 13th century Italy when
trade was expanding from Italy to all of Europe (event #B4).
The modern large corporation appears in 1555 when the first British
joint stock company was established by Parliament after the Crown’s
grant of monopoly trading rights with Russia (event #B5). Increas-
ing numbers of Britsh corporations were chartered until the passage of
the Bubble Act of 1720 (events #B6 and B7). Many of the specialized
accounting techniques we see today originated as corporate business
expanded in scale and scope. Accounting depreciation became signif-
icant when large 19th century corporations made long-term invest-
ments in tangible assets (events #B8 and B9).5 Consolidated reporting
appeared when large American industrials were created through hori-
zontal mergers in the late 19th century (event #B10). The expensing
of research and development costs became an issue when early US tech-
nology companies like General Electric companies began making large
research and development investments after constructing their own lab-
oratory facilities (event #B11).
Economists and sociologists such as Sombart, Weber, Mises, and
Schumpeter have hypothesized a close connection between account-
ing and the expanded scope and scale of business organization (event
#B12). These scholars conjectured that double-entry bookkeeping was
essential for the development of capitalism. The hypothesized role of
double entry in enabling capitalism suggests that causality between
accounting and economic complexity is bi-directional.
5 Accountingfor wasting assets was clearly recognized before the mid-19th century, but was
not economically significant until large corporations with permanent capital investment
came into being. Mason (1933) lists several examples of the accounting for wasting assets
dating back to the 17th century.
3.3 How Can Accounting “Norms” Form Spontaneously 21
The co-evolution of accounting with economic complexity is central

to constructing an evolutionary theory of accounting. Early accounting,
recordkeeping, emerges spontaneously in response to economic change,
as discussed previously in Section 3.1. This spontaneous emergence
generates subsequent development in accounting beyond recordkeeping
as well as increased economic complexity, as described in this section.6
3.3 How Can Accounting “Norms” Form Spontaneously

in the Absence of Bodies Explicitly Charged with
Standard Setting?
As accounting spontaneously changed in response to changes in markets
and economic organization, accounting practices became increasingly
characterized by regularities despite the lack of institutionalized stan-
dard setting. Accounting knowledge, like other innovations, diffused
gradually through time and space as knowledge built up and spread
(Rogers, 2003). Most of the early accounting knowledge dissemination
occurred through education and professional networks (Carruthers and
Espeland, 1991; Miranti, 1986). Different dynamics appear to underlie
how accounting practices originate and spread under modern standard
setting. For example, standard setters sometimes simply codify norms,
and at other times displace existing norms with new accounting rules
(Ball, 1989; Sunder, 2005; Watts and Zimmerman, 1986). Historical
events associated with the emergence of accounting norms and stan-
dards are listed in panel C of Table 3.1.
Pacioli’s text is a summary of “best practices” for Venetian book-
keeping, as it existed at the end of the 15th century (event #C1 in
panel C of Table 3.1). Pacioli’s text became famous because it was
the first text on accounting to be printed and distributed after Guten-
berg’s development of the printing press. The book’s major impact
occurred because it was translated into five languages before 1600
(Chatfield, 1974; de Roover, 1955, p. 49). Further, Paciolo’s text is not
an isolated example. The printed word in practitioner and scholarly
6 Hopwood’s (1987) three case studies provide a richly textured analysis of the bi-directional
relation between accounting and organizational complexity at the individual firm level that
complements and deepens our description of the broad economy level.
publications has exerted considerable influence on the dissemination

of accounting knowledge. This knowledge dissemination process is
reflected in textbooks (events #C3, C11, C12, and C14) and periodicals
like the Journal of Accountancy (event #C10).
Organized bodies of accounting professionals furthered the spread
of accounting knowledge by enabling professional networks. Full-time
accounting practitioners in Britain date back at least to 1645 (event
#C2) and the major professional accounting firms of today have their
roots in the mid-19th century (event #C5). The first professional
society of accountants was founded in Edinburgh, Scotland in 1853
(event #C4) while the first American national and state societies
were established in 1882 and 1897, respectively (events #C7 and C9).
Modern accountants were first required to pass an exam to attain
professional certification in the last half of the 19th century (events
#C6, C7, and C8).7
Accounting standard setting took explicit shape in the United States
after the SEC was established in 1934. The first formally recognized
United States standard setter was the AIA’s Committee on Accounting
Procedure in 1939 (event #C13), which was replaced by the AICPA’s
Accounting Principles Board in 1959 (event #C15). The FASB began
its operations a year after the recommendation to restructure the stan-
dard setting process by the AICPA’s Wheat Committee (event #C16).
The expansion of FASB into international standard setting occurred
through joint projects with the G4 + 1 accounting standard setters
starting in the early 1990s. The International Accounting Standards
Board (IASB) was created to promote convergence in accounting stan-
dards throughout the world (event #C17).
There is growing recognition that accounting norms form them-
selves by spontaneous processes of cultural evolution that resemble the
evolution of British common law (Sunder, 2005). Hawkins (1963) and
Moonitz (1970) describe several pre-SEC attempts to develop account-
ing and auditing norms in the United States. Understanding the forces
7 The requirement that professional accountants must pass a test to attain professional
status is likely much older. For instance, professional scribes in ancient Mesopotamia were
subject to educational requirements (Pearce, 1995).
3.4 Accounting’s Relation with Law, Regulation, and Taxation 23
that lead to regularities in accounting practice is important for gaining

insight into how the status quo of unregulated accounting practice
comes to exist and could be altered through a formal standard-setting
process (Ball, 1989; Watts and Zimmerman, 1986).
3.4 Accounting’s Relation with Law, Regulation,

and Taxation
Formal government is ubiquitous in large-scale human societies, and
accounting plays an important role in government both directly and
indirectly, and vice versa. Government, like any organization, controls
and expends resources to achieve organizational goals. Thus, budgets
and accounting are directly involved in day-to-day operations of the
government. Accounting helps guide activities of the entities that gov-
ernment deals with, and thus indirectly affects government such as
when firms use accounting to evade taxes. Conversely, government
directly influences accounting practice in the rules it adopts for defin-
ing personal and corporate income to be taxed, especially outside the
United States, and the accounting procedures to be used by firms sub-
ject to government rate regulation or fulfilling government contracts.
Government exerts indirect effects on accounting through regulation of
prices — e.g., Jones (1991) documents attempts to understate earnings
by firms trying to win protection from foreign competition. Govern-
ments have expanded faster than their economies during the 20th cen-
tury (e.g., Lott and Kenny, 1999), and being the largest organizations
in most national economies makes their accounting a natural subject of
study.
Taxes were being collected in the earliest stages of accounting his-
tory. Archaeologists suggest that the first accounting tokens were cre-
ated to signify that “tribute” had been paid (event #D1 in panel D
of Table 3.1) and taxes have shaped accounting practice into the mod-
ern era (events #D3, D12, and D13). Legal dispute resolution also
has a connection with accounting that dates back several thousand
years. The Code of Hammurabi (circa 1,750 BCE) required account-
ing records as evidence in cases of commercial disputes (event #D2).
More recently, 17th century French law required that journals be kept
documenting receivables and payables, which could then be used as

evidence in disputes over unpaid obligations (event #D4).
Accountants began assisting British courts in bankruptcy cases in
1817 (event #D5), a role that grew throughout the 19th century as a
result of a series of Companies Act statutes (event #D6). The British
requirement that financial statements present a full and accurate view
of the firm dates back to railroad regulation enacted in 1845 (event
#D7). US federal regulation of railroads was enacted in 1887 (event
#D10) and extended in 1906 (event #D12), which followed earlier
state attempts to regulate railroad accounting beginning in 1869 (event
#D9). Railroads’ accounting numbers were used extensively in rate
regulation; the principle that a regulated firm was entitled to a “fair
return” on the “fair value” of invested capital was supported by the
US Supreme Court’s 1898 decision in Smyth v. Ames (event #D11).
Regulation, like taxation, has resulted in the creation of account-
ing procedures that eventually found their way into financial reports
to shareholders (event #D14). National governments have increased
regulatory control over the accounting of firms with publicly traded
securities during the 20th century (event #D15).
The influence of law, regulation, and taxation on accounting has
been enormous, and its influence dates back to the very origins of
recordkeeping close to 10,000 years ago. Accordingly, any comprehen-
sive conceptual view of accounting must address how government activ-
ities can alter the evolution of accounting, both for the better and for
the worse.
3.5 The Existence and Development of Broad

Accounting Principles
Accounting is different from other business areas in that it has broad
qualitative principles that guide accounting choice. Our textbooks, both
more recent ones as well as those from early in the 20th century, devote
considerable attention to the conceptual underpinnings of accounting.
Terms like Conservatism, Objectivity, Going Concern, Revenue Real-
ization, and the Matching Concept have long been staples of accounting
language. Accounting in this regard is fundamentally different from an
3.6 The Discontinuous Path of Accounting Evolution 25
area like marketing where marketing policies are evaluated by observing

their actual effects.
Accounting principles have deep roots in history even though they
were not necessarily recognized as principles at the time of their emer-
gence. Examples include the use of accrual accounting (event #E1 in
panel E of Table 3.1) and conservatism (event #E2) in the 13th and
15th centuries. Subsequently, principles of accounting were inferred
through induction applied by the courts, regulators, and accounting
educators (events #E3, E4, E5, E6, E7, E9, and E10). More norma-
tive, deductive approaches that sought to correct perceived deficiencies
in accounting practice accompanied the establishment of formal stan-
dard setting bodies seeking to define the conceptual underpinnings of
accounting (events #E8, E11, E12, and E13).
The conceptual basis for accounting standards has been a central
issue to US accounting policymakers for over a century. The received
view nowadays is that financial reporting practice should be driven
largely by accounting principles formulated under a conceptual frame-
work based on decision usefulness in equity markets. The issue of
accounting principles presents several important puzzles for researchers,
the most important of which is: Why is accounting characterized by
broadly applicable qualitative principles? Developing a clear under-
standing of the origins and evolution of general accounting principles
thus is of considerable importance.
3.6 The Discontinuous Path of Accounting Evolution

The standard view of evolution in biological terms is that it is a slow,
gradual process that plays out over very long periods of time (Darwin,
1859). Human societies and economies are also seen as evolving incre-
mentally, although cultural evolution is clearly far more rapid than
biological evolution (Hayek, 1979; Henrich, 2004; Hodgson, 1993; Rich-
erson and Boyd, 2005). However, recent observations of isolated animal
populations shows that organisms evolve very quickly in response to
local environmental changes, as much as 30,000 times faster than aver-
age speeds calculated by comparing related fossils millions of years
apart (Weiner, 1994). In other words, sun cycles, volcanoes, Ice Ages,
and other climate phenomena change the environment violently in the

short term requiring rapid adaptation, but the earth’s climate has been
relatively stable over very long time scales.8 In particular, more extreme
climate changes exert stronger selection pressures on animal popula-
tions and lead to relatively larger genetic changes. Many archaeologists
argue that the most recent Ice Age that ended about 12,000 years ago
spurred the development of agriculture (Pringle, 1998), while the pre-
vious Ice Age that ended about 40,000 years ago provided the spark
for art and spoken language (Appenzeller, 1998; Holden, 1998).
Similarly, the evolution of accounting is characterized by strong
discontinuities associated with economic crises. Many, but not all,
perceived economic crises are followed by calls for more stringent
accounting regulation. Of course, economic crises provide the spur for
numerous nonaccounting institutional innovations including inflation-
indexed bonds, workmen’s compensation and national social insurance
(e.g., Shiller, 2005), so the connection is considerably broader. The per-
ceived need for quick political action often overcomes conservative resis-
tance to change and enables policy entrepreneurs and rent seekers to
introduce regulations that would not otherwise be considered (Romano,
2005a; Watts and Zimmerman, 1979). The strong relation between cor-
porate governance/accounting regulation and financial market develop-
ment around the world suggests that useful knowledge about effective
accounting practices may be revealed through such crises (Barton and
Waymire, 2004; La Porta et al., 2000).
Accounting practice has been influenced disproportionately by eco-
nomic crises as a result of both regulatory and market responses to
such events. An early example was the crash of markets in South
Sea Company’s equities in 1720 (event #F1 in panel F of Table 3.1).
More recently, revisions of the British Companies Acts in the 19th
century followed on the heels of crises linked to widespread business
failures (Littleton, 1933) (event #F2). The 1930s Securities Acts and
the recent Sarbanes–Oxley Act were enacted following large wealth
8 An analogy is examining a bee’s wing-flapping speed by comparing photographs spaced

milliseconds apart that would show rapid motion versus using photographs spaced several
seconds apart, assuming that its wings flapped only once during that time period, and
thus, estimating slow wing speed.
3.6 The Discontinuous Path of Accounting Evolution 27
losses by US shareholders in economic crises (events #F4, F5, F7, F8,

F9, and F10). Also, private sector market innovations have occurred
after crises, which may be partially caused by the threat of regulation
(events #F3, F6, and F11).
Accounting researchers realize that our discipline has been dispro-
portionately formed by reactions to economic crises. Unfortunately,
there is little research that tries to provide a coherent explanation for
this regularity (Watts and Zimmerman (1979) is a notable exception).
Because crises are “outliers” that cry out for explanation but their
causes are frequently complex and ultimately unfathomable, regula-
tory action is a way to help people make sense of the system failure.
Our lack of understanding of the relation between crises and accounting
change is a major gap in our collective knowledge of how accounting
has evolved to take its modern form.
4
Accounting History Research as a Stimulant
to Thought Experiments
Our focus in this section is on how knowledge of accounting history can

be useful in spurring thought experiments by researchers that could
ultimately improve our world. We begin by describing the importance
of thought experiments in sparking research creativity and then discuss
the role of historical case studies in this process. We next extend these
arguments to consider the role of smaller sample archival studies in
generalizing the findings of case studies. We conclude by offering some
observations about the price we pay for historical ignorance and by
providing some constructive suggestions for how this ignorance can be
lessened.
4.1 The Role of Thought Experiments in Research

Biologist Peter Medawar (1996, p. 71) has written how important sci-
entific research originates from an act of creativity:
“What exactly are the terms of a scientist’s contract

with the truth? This is an important question, for
according to the interpretation of the scientific process
which I myself think the most plausible, a scientist, so
28
4.1 The Role of Thought Experiments in Research 29
far from being a man who never knowingly departs from

the truth, is always telling stories in a sense not very
far removed from that of the nursery euphemism — sto-
ries which might be about real life but which must be
tested very scrupulously to find out if indeed they are
so.” (emphasis in original)
That is, the scholar-scientist often starts by telling a story, which

involves an act of creativity and imagination concerning a world
that does not presently exist but could have under a different set of
antecedent conditions.
Humans can more readily consider counterfactual possibilities that
once were true but no longer are true, which suggests that knowl-
edge of history can facilitate counterfactual thinking (Byrne, 2005,
pp. 35–36). Historical research, like work that uses international data,
exposes researchers to institutions that exist but fall outside of their
immediate experience. This helps the researcher envision counterfactual
worlds that could have developed but did not, as well as contemplate
improvements on current arrangements.1
Appreciation for the ways that institutions develop also is beneficial
since it leads to more informed interpretation of modern data as well as
more critical evaluation of analytical models. The development of eco-
nomic institutions is path dependent and recognizing path dependence
requires that we know something about history. An interpretation of
economic data or a theoretical model that is not assessed against the
history of what occurred and what could have occurred is unlikely to be
useful. Researchers should guard against both ivory tower irrelevance
as well as methodology-obsessed scientism (Hayek, 1952). Economist
Robert Solow (1985, p. 329) articulates this by writing:
“Economic theory can only gain from being taught

something about the range of possibilities in human
societies. Few things should be more interesting to a civ-
ilized economic theorist than the opportunity to observe
1 George Bernard Shaw (1921) eloquently expressed this in Back to Methuselah, “You see
things; and you say ‘Why?’ But I dream things that never were; and I say ‘Why not?’”
See also Dyson (1997).
30 Accounting History Research as a Stimulant to Thought Experiments
the interplay between social institutions and economic

behavior over time and place.”
This suggests a role for historical research to help us in constructing

stories through what Solow (1985, p. 329) describes as “historical nar-
ratives” (see also Bates et al., 1998). We benefit as a discipline when
some scholars are doing “thought experiments” about worlds that dif-
fer from our own and ask why current arrangements are preferable
to these alternative worlds. These thought experiments allow theorists
to model these scenarios and experimental researchers to compare the
structure and performance of alternative institutions under controlled
conditions. But regardless of method used, the starting point must be
a “what if” kind of question. This is most obviously represented in his-
torical research that helps us see the origins and development of those
modern institutions that we wish to study. The historical case study
is useful for this purpose. In addition, these thought experiments also
could spur additional historical research that develops further insights
into why history followed a particular path.
4.2 The Role of Historical Case Studies

In this subsection, we illustrate the role of the historical case study in
understanding the origin of modern accounting practices. The case we
consider is an early predecessor to SFAS 2 in which FASB (1974) man-
dated that firms immediately expense research and development (R&D)
costs. Several empirical studies explore the effects of SFAS2 on firms’
operating decisions (see e.g., Dukes et al., 1980; Horwitz and Kolodny,
1980) and the extent to which R&D information is reflected in security
prices (Lev and Sougiannis, 1996). With few exceptions, little attention
has been paid to the period prior to FASB’s decision to mandate R&D
expensing. Yet, accounting changes, especially those resulting from reg-
ulatory mandate, result from environmental changes coupled with path
dependencies linked to past historical outcomes (Ball, 1980). We show
that the accounting mandated in SFAS2 has a long history among suc-
cessful US technology-based firms that resulted from forces that have
been largely ignored in studies of R&D accounting.
4.2 The Role of Historical Case Studies 31
Prior research documents that 1920s US balance sheets often

included upward revaluations in long-term assets. Subsequently the
Chief Accountant of the US Securities and Exchange Commission
implemented a policy that effectively prohibited asset write-ups
(Walker, 1992). However, many firms in the 1920s reported obviously
“understated” asset values — e.g., intangible assets stated at nominal
values of $1 (Ely and Waymire, 1999b). These companies were among
the more successful and stable firms with common stock listed on the
New York Stock Exchange (Barton and Waymire, 2004).
As far as we know, the first company to ostentatiously understate
intangibles was General Electric in 1907. GE was an early “high tech”
company, having founded the nation’s first industrial research labora-
tory in 1900. General Electric was created in 1892 when Edison General
Electric merged horizontally with Thomson-Houston in an attempt to
reduce inter-firm product market competition.2 Like its competitors,
GE was a capital-intensive business. Edison General and Thomson-
Houston (as well as the Westinghouse Company) had engaged in costly
patent litigation in the 1880s in trying to secure a competitive advan-
tage by limiting others’ patent rights and draining their financial
resources. Because of capital intensity and substantial growth oppor-
tunities, GE required significant financing (its total assets doubled
between 1897 and 1907, with most of this increase occurring between
1904 and 1907).
In 1907, GE reported patents at the nominal value of $1, down from
$1 million a year earlier. Table 4.1 shows General Electric’s 1907 bal-
ance sheet and income statement as reported in the Commercial and
Financial Chronicle of May 11, 1907. GE’s balance sheet, in the British
format with long-term assets listed first, reports “patents, franchises,
etc.” at a carrying value of $1. The asset write down is clearly dis-
closed in the income statement. The full text reports that current period
patent costs (nearly $800,000) were treated as “ordinary expenses,” and
2 Two highly successful scientists, Thomas Edison and Elihu Thomson, led scientific inno-
vation in these firms. Edison’s involvement in the merged entity ended a short time after
GE’s creation. Thomson continued on with GE for the rest of his career, having been
responsible for 696 patents, the third highest in American history as of 1990 (Carlson,
1991). He died in the 1930s.
Table 4.1 General electric income statement and balance sheet for fiscal 1907.
Source: Commercial and Financial Chronicle, May 11, 1907.

the audit report of Price Waterhouse explicitly verified that GE had

fully expensed patent litigation and other related costs (see Commercial
and Financial Chronicle, May 11, 1907, p. 1119).
GE’s 1907 patent write-off was one component of a continuing policy
of accounting conservatism that began well before 1907 and continued
long afterward. GE’s patents were initially reported in the first full
year’s balance sheet at a value of $8.16 million (65% of total assets).
After large writedowns in 1899 and 1900, the patent asset was reported
at $2.0 million (8.9% of total assets). This amount was extinguished
entirely (except for $1) by writedowns in fiscal 1906 and fiscal 1907. GE
continued fully expensing patent-related costs and reporting a nominal
valued asset for patents long after 1907.3
Security analysts have historically been skeptical of intangible asset
values reported on corporate balance sheets (Graham and Meredith,
1937) and have preferred “clean” balance sheets that are free of intan-
gibles (Lough, 1917, pp. 426–480; Lagerquist, 1921, pp. 56–61).4 This
view dates back to at least the early 20th century when many indus-
trial corporations concealed intangibles by aggregating them with fixed
assets (Ely and Waymire, 1999b). Consequently, GE’s innovation of sep-
arately reporting intangibles at nominal carrying values was praised by
contemporary writers, even though such values lacked “representational
faithfulness” in modern parlance. For example, Noone (1910, p. 365)
wrote:
“There is of course no necessary relation between the

book value of a patent and the price which may be
obtained for it. . . . It is believed patents ought not to
be stated upon the books at all, except at a nomi-
nal sum, and especially this is thought to be true in
cases where patents have not been purchased but have
3 Moody’s reports on the firm through the early 1930s consistently reported GE’s patent
asset at $1.
4 Graham and Meredith (1937, p. 23) state this view as: “In general, it may be said that
little if any weight should be given to the figures at which intangibles assets appear on the
balance sheet. Such intangibles may have a very large value indeed, but it is the income
account and not the balance sheet that offers the clue to this value. In other words, it
is the earning power of these intangibles, rather than their balance sheet valuation, that
really counts.”
been developed by the patentee. . . . (I)t is interesting

to note the policy of General Electric Company. The
company has pursued a course at once conservative and
correct. . . The failure of Westinghouse Electric & Man-
ufacturing to write down its patent account is known
to have largely affected its status at the time it passed
into receivership.”
GE’s policy was still praised by writers nearly 20 years later when
Sturgis (1925, p. 122) noted:
“General Electric stood out above all manufacturers of

electrical equipment. As a conservative well managed
industrial, it would be difficult to find its equal any-
where. Its cash assets were enormous. It is known that it
lays away very large reserves, but no one seems to know
just how large they are. Their size was indicated by the
fact that it had spent yearly large sums for patents, but
carried them at only $1, and that over a period of years,
it had spent over $180,000,000 on plants, but carried
them at a value of around $67,000,000. Such conser-
vatism and indicated earning power is hard to match.”
The obvious question about this case is why GE adopted this con-
servative reporting policy. It surely was not to conceal the existence
of economically valuable intangibles — GE’s 1907 annual report made
extensive disclosure of product innovations and sales by product type.
Also, the standard explanations for conservatism as arising from debt
contracting, taxation, and shareholder litigation are implausible. GE’s
outstanding debt as a percentage of total assets was trivial (about 2%
as of 1907); income taxation did not begin until 1909, and even then
only at a rate of 1%; and shareholder litigation over financial reporting
was minimal in this era.5 The threat of anti-trust regulation is more
5 However,in an influential decision in the case of Newton v. Birmingham Small Arms Co.
Ltd. (1906), an English court held, “Assets are often, by reason of prudence, estimated
plausible, but GE had not been targeted like the major railroads and
visible industrials such as Standard Oil.
The most likely explanation for GE’s conservative reporting policy is
that it helped in raising equity capital, which was its primary vehicle of
external financing. Dividend policy was viewed as the primary driver of
value in the early 20th century US equity markets (Graham and Dodd,
1934, pp. 299–306). Because GE was a highly profitable entity and its
conservative reporting policy constrained excessive dividend payouts in
any given year, it could consistently pay annual cash dividends of $8
per common share for at least 25 years after 1900. This allowed the
company to raise considerable equity capital in the two decades after
1907.6 GE’s sales grew from $60.1 million in 1907 to $312.6 million
in fiscal 1927. This suggests that GE was an early growth stock that
secured substantial equity capital to finance its growth. GE’s reporting
and stable dividend policies likely sustained its ability to raise capital,
at least in part.
GE’s policy of maintaining steady high dividends was a challenge
because GE primarily sold equipment to firms and municipalities that
sought to exploit expanding US electrification. GE’s revenues, like those
of other durable goods producers, were highly sensitive to the busi-
ness cycle. GE was financially distressed and almost did not survive
the depression of 1893. Shortly thereafter, GE initiated its conserva-
tive reporting policy with large asset writedowns of patents as well as
securities investments and fixed assets. Lower asset values and immedi-
ate expensing of many investments meant that GE was booking large
“secret reserves.” As a result, the payment of excessive dividends was
and stated to be estimated, at less than their probable real value. The purpose of the
balance-sheet is primarily to shew that the financial position of the company is at least as
good as there stated, not to shew that it is not or may not be better” (Dickerson, 1966).
This precedent may have shaped GE’s expectations regarding any legal proceedings.
6 GE had about 7,000 shareholders when their reported common stock and surplus was $79.5
million in 1907 compared to 50,000 shareholders 20 years later when their total common
stock and surplus was reported to be $295.4 million. The number of shareholders gradually
trended up from 3,000 in 1900 to around 17,000 in 1920, and then surged dramatically
to over 25,000 in 1921. Details of the number of GE shareholders were taken from the
General Electric Annual Report for 1927.
constrained, and GE could initiate high dividend payouts that would

not need to be reduced in a cyclical business downturn.7
Other US firms had different reasons for subsequently reporting
intangibles at nominal values. Income tax law changes in 1916 and 1917
substantially increased corporate tax rates, which led to conservative
balance sheets as managers sought to deduct higher expenses for tax
purposes. Montgomery (1919, p. 3) notes:
“At the end of the year 1917, without the intervention

of bankers or accountants, great numbers of balance
sheets underwent tremendous changes. The assets side
was scrutinized by the boss himself before the books
were closed and, if there was the slightest indication of
overvaluation, ruthless cuts were made in the book fig-
ures. Plant accounts were written down to the lowest
possible point by liberal depreciation charges and by
reductions in amortization and obsolescence. Invento-
ries of raw materials and finished products were reduced
to a cash basis. The most liberal reserves were provided
for possible losses in accounts receivable. All possible
liabilities were set up in the books. This same policy was
continued throughout 1918, so that the average balance
sheet of the most recent date obtainable, speaking from
the point of view of a lender of money or from that of a
public accountant, is a joy to behold. I refer, of course,
to those cases in which there were profits in 1917 and
1918 subject to the higher rates of federal taxes. Where
there were no such profits the procedure outlined was
not followed, nor could it be expected that it would be
followed.”
7 GE’s sales declined sharply during the downturn of 1908 when it reported sales of $44.5
million for the 1/31/09 fiscal year, down from $71.0 million in the prior year. In contrast
to GE’s conservative and transparent reporting policy, one of GE’s primary competitors,
Westinghouse, did not disclose any annual reports and held no shareholder meetings during
the years between 1897 and 1905 (Brief, 1987). Westinghouse was placed in receivership
after the depression of 1907, and George Westinghouse, the company’s founder, lost control
of the company.
Subsequently, increasing numbers of firms began reporting intangi-

ble assets at nominal values around 1920. A search of the Moody’s Anal-
yses of Industrial Investments (1922) yielded a sample of 2,297 firms
with their most recent balance sheet dated between January 1920 and
March 1922. Of these, 750 indicated the presence of intangibles either
reported on a stand-alone basis or as part of an aggregate with other
long-term assets. Of these 750 cases, 93 (12.4%) reported an intangi-
ble asset at a nominal value.8 More firms were reporting intangibles at
nominal values by the end of the 1920s — e.g., 102 (20%) of the 504
NYSE firms in the Barton and Waymire (2004) sample reported nomi-
nal values for intangibles. Firms making this choice tended to be more
profitable, had low tangible assets and high market-to-book ratios, and
had capital structures where the demand for conservative income mea-
surement to avoid dividend distribution conflicts was higher (Ely and
Waymire, 1999b, p. 29; Barton and Waymire, 2004, p. 95).
The trend toward conservative R&D accounting accelerated in the
1930s as firms wrote down previously established carrying values to
nominal amounts (Avery, 1942). No doubt this was partly due to the
recently established SEC and its stated preference for conservative asset
valuation based on historical cost (Dillon, 1979; Walker, 1992; Zeff,
2007). But taxation also contributed when the IRS adopted a confor-
mity policy for R&D expensing that lasted until 1954 (Raby, 1964),
which was similar to the LIFO Conformity Rule that is still in force
today.
Many US firms subject to SFAS2 were already expensing all R&D
before the FASB promulgated the rule (Gellein and Newman, 1973;
Wales, 1962), and early 1970s’ expensing firms were similar to 1920s’
expensing firms in terms of superior profitability and market value
(Elliott et al., 1984). It is also obvious that R&D expensing by US
firms was shaped over a long period of time by forces that had little
to do with the early decision by General Electric or the much later
mandates of accounting standard-setters.
The observation that R&D expensing firms tended to be the most
profitable in both the 1920s and 1970s reflects a broader pattern of
8 We are grateful to Eric Gottlieb for collecting these data for us.
successful firms being more likely to report conservatively. Neither

Microsoft nor Adobe has capitalized any software development costs
under SFAS 86 (FASB, 1985), even though the standard mandates cap-
italization of costs incurred after technical feasibility. Similarly, large
oil and gas firms preferred to expense most exploration costs under
the successful efforts method rather than follow the full cost method,
whereas small start-ups preferred to capitalize all their exploration
costs. This pervasive pattern of successful firms reporting more con-
servatively likely reflects a counter-signaling strategy (Feltovich et al.,
2002).
Counter-signaling describes behavior where the strongest individu-
als behave like the weakest individuals rather than those in the middle,
and is observed in many settings (Feltovich et al., 2002). In the class-
room, it is usually the case that the mediocre students seek to answer
a teacher’s easy questions, whereas the best students are embarrassed
to show that they know trivial points. Similarly, the newly rich flaunt
their wealth while the old rich consider such gauche displays declasse.
The intuition is that those in the middle signal to indicate that they
are better than the low types; but that those at the top do not signal,
or actually “counter-signal” by behaving like the low types, to show
that they are even better than those in the middle. Counter-signaling
reflects your confidence that you will not be pooled with the low types
even if you use a common signal, likely because you can use other noisy
information to demonstrate that you are not of low quality. Feltovich
et al. (2002) formally show that such counter-signaling behavior can
arise as part of a perfect Bayesian equilibrium in which all players
form rational beliefs and act rationally based on these beliefs. If such
counter-signaling behavior is widespread in accounting practice, it sug-
gests that standard research designs that presume monotonic signals,
such as in the value-relevance literature, are likely misspecified.
We believe that this case contains three lessons for modern
accounting research. The first is that it reminds us that accounting’s
informational role is fulfilled in multiple ways and that mandatory stan-
dardization of accounting practice may result in a material loss of infor-
mation to financial statement users. The obvious way that accounting
transmits information is through the numbers reported directly in
financial statements and supplemental disclosures. A second, more

subtle way that accounting conveys information is through manage-
rial choice of accounting methods and disclosures. The choice of con-
servative reporting by GE provided information that GE’s financial
performance and position were superior to its contemporaries. This
did not occur because financial statement users could literally apply
accounting book values to obtain an estimate of equity intrinsic value;
rather the choice of accounting method itself is an informative signal
of managerial quality and the firm’s superior investment opportunities
(Levine and Hughes, 2005; Lin, 2006; Sunder, 1997, Chap. 7). In this
sense, accounting choice also allows the manager to acquire a reputa-
tion for credibly communicating information indicative of higher mar-
ket values. This suggests that a modern concept like “representational
faithfulness” may be a naı̈ve mirage that impairs a true understand-
ing of how “conservative” accounting information can lead financial
statement users to infer that a higher equity valuation is warranted.9
A second lesson is that accounting policies are often shaped long
before an issue is ever addressed by a standard-setter. From a research
perspective, it is all too tempting to view accounting policy choice solely
through the observable (and hence measurable) actions by standard-
setters. Indeed, changes in agenda, submission of written letters by
constituents, and issuances of exposure drafts and final standards by
FASB itself are identifiable events because FASB operates under trans-
parency requirements. It is useful to remember that accounting issues
often emerged decades before FASB even considered them. For exam-
ple, debate over the initial measurement and subsequent treatment of
goodwill (as in SFAS 141 and 142) extends back over a century (Leake,
1921; Yang, 1927), and the non-amortization of goodwill was a rela-
tively common practice in the 1920s (Hatfield, 1927, pp. 123–125; Ely
and Waymire, 1999b).
9 Investorsevidently were not misled by GE’s conservative reporting policy. GE was one of
only a handful of industrial common stocks quoted above the par value of shares (typically
$100 per share). GE’s market-to-book at 12/31/1908 was 1.27, which was greater than any
other firm in the Sivakumar and Waymire (1993) sample. Similarly, for firms that report
more conservatively, Craig et al. (1987) and Beaver et al. (1989) find higher price-earnings
ratios and higher market-to-book ratios, respectively.
A third lesson illustrated by this example is that the evolution of

accounting practice is characterized by path dependencies that high-
light important forces that fall beyond our immediate view. The his-
tory of R&D accounting suggests that tax rules played a major role
in transforming how American corporations accounted for intangible
assets, but because the tax-book conformity rule for R&D was forgot-
ten, modern researchers are likely to seek other incorrect explanations
for R&D expensing before SFAS2. Common practices can continue long
after the causal regulation is revoked if adverse consequences arise from
reversing longstanding accounting policies — e.g., if security analysts
now view alternative accounting practices with skepticism.
The case study has played an important role in accounting his-
tory research. Another informative example is Previts and Samson’s
(2000) longitudinal study of annual reports by the Baltimore and Ohio
Railroad in the first 30 years of its existence. This case study is inter-
esting because B&O was the first US railroad in the 19th century and
ultimately became one of the significant Eastern trunk line railroads
that dominated rail transportation in the United States. Thus, US
railroads’ reporting history provides an extraordinary glimpse of how
financial accounting developed from the very earliest stages of the first
large scale US industry. The US railroads were the originators of many
accounting practices observed today (Brief, 1966; Chandler, 1977). Case
studies have also been used extensively to study the development of
cost accounting practices in modern corporations (e.g., Johnson, 1972;
McKendrick, 1970).
Historical case studies are important because they remind us that
most theories crystallize their era in their ceteris paribus assumptions
(termed presentmindedness by Barzun and Graff (1977, p. 43)), and do
not generalize to different institutional settings (Previts and Bricker,
1994). Furthermore, unlike in the physical sciences, social science data
are generated by individuals whose tastes, beliefs, preferences and abili-
ties vary (Hayek, 1952; Mises, 1949), making homogeneity assumptions
heroic at best. Case studies allow us to mentally simulate the alleged
decision processes and assess their plausibility much better than sta-
tistical analyses can (Mises, 1957). Statistical analysis of cheaply avail-
able sample data runs the risk of excluding important variables because
4.3 The Role of Small Sample Studies Using Historical Data 41
they are difficult to quantify or collect, resulting in spurious inferences.

Analysis of similar case studies generates “thick associations” that com-
plement the “thin associations” of formal analytical or econometric
models (Arthur, 2000).
One limitation of case studies is that their results may not generalize
more broadly. A useful step would be to investigate how particular
patterns evident in a single case might apply more broadly. We now
turn to this issue.
4.3 The Role of Small Sample Studies Using

Historical Data
Arguably the most important research paper published in accounting
is “The Empirical Evaluation of Accounting Income Numbers” by Ray
Ball and Philip Brown (1968). Ball and Brown asked if the accoun-
tant’s emphasis on computing income was related to how investors
used income information to set stock prices. Ball and Brown’s study
revealed regularities that ran contrary to the perceived wisdom of the
time, and illustrates the dangers inherent to sole reliance on anecdotes
and individual cases.
To illustrate this limitation, consider the case study by Porter et al.
(1995) of the 1908 decision by the American Sugar Refining Company
to reverse its longstanding secrecy policy and begin disclosing annual
income numbers. This decision was associated with modest stock price
increases of approximately 2% of equity value. This result can be inter-
preted in several ways, only one of which is that income reporting
policies have economic value per se. A larger issue is that, even if an
income reporting policy was valuable to American Sugar’s sharehold-
ers, this result may not apply to other firms in the same time period.
American Sugar was an admittedly extreme case; thus, evidence from
a broader sample is required to say anything more generally about the
economic role of voluntary income disclosure by early 20th century US
corporations.
Sivakumar and Waymire (1993, 1994) try to provide such evidence.
These studies are motivated by two empirical regularities in modern
data. The first, as documented by Ball and Brown (1968), is that annual
income changes are positively associated with stock returns in the year
leading up to the annual earnings announcement date. The second is
that managers are less likely to disclose unfavorable news in the absence
of a disclosure mandate or other penalties (Dye, 1983; Patell, 1976;
Penman, 1980; Verrecchia, 1983).
Sivakumar and Waymire (1993, 1994) asked whether early 20th
century disclosures would be skewed toward good news and whether
the minimal accounting and auditing requirements of the era would
lessen or even eliminate the price-informativeness of income numbers.
Accounting income changes were compared to a benchmark of dividend
changes since dividend declarations were a primary information source
in the early 20th century (Graham and Dodd, 1934, pp. 325–338). Div-
idend declarations were credible because directors could be held legally
liable for paying excessive dividends that impaired the firm’s capital
(Berle and Means, 1932, pp. 135–136).
The Sivakumar and Waymire papers study 51 industrial corpora-
tions with common stock traded on the New York Stock Exchange
for at least two years between January 6, 1905 and June 3, 1910, the
latter date coinciding with the NYSE’s formal abolition of trading
in “unlisted” securities. Twenty-three of the 51 firms in the sample
had been traded on unlisted status for at least part of the 1905–
1910 period. These unlisted stocks are interesting because they had
not signed formal listing agreements requiring disclosure of an annual
report to the exchange. Thus, the Sivakumar and Waymire (1993,
1994) sample and time period was well suited to analyzing the impor-
tance of income disclosure in a largely voluntary income-reporting
environment.
There is substantial evidence of income and income component
disclosure although their extent varied considerably. Of the 217 sample
annual reports published in the Commercial and Financial Chronicle,
188 reports (87%) included at least a partial income statement. Of
these 188 reports, 97 (52%) included a sales number and 19 (of 51)
reporting firms always included sales information in their income
statement. Likewise, a majority of firms provided interim earnings
and marketing-production information at least once during the sample
period. Thus, while income and income-related disclosure was neither
4.3 The Role of Small Sample Studies Using Historical Data 43
universal nor uniform, corporate managers did not completely ignore

shareholders and disclose no useful information. Stated differently,
American Sugar Refining’s corporate secrecy policy was the exception
rather than the norm.
In addition, annual income disclosures conveyed information that
was associated with significant contemporaneous stock price and trad-
ing volume changes. The results largely mirrored those attained with
modern data with one noteworthy exception: annual earnings increases
were not accompanied by stock price increases when the firm was
not paying dividends on its common stock.10 This result, along with
much larger price effects for dividend changes in Sivakumar and
Waymire’s sample, supports the view that early 20th century account-
ing income numbers were less important than dividend changes for
valuing equity.11
Finally, the Sivakumar–Waymire sample firms did not show a per-
vasive tendency to disclose only when the information was favorable.
There were only a handful of annual report omissions in the sample,
and firms’ stock price movements coincident with annual and interim
disclosures did not show evidence of systematically positive stock price
changes. This result suggests that reputational or other mechanisms
were sufficient to induce voluntary disclosure.
The Sivakumar and Waymire (1993, 1994) studies shed light on
the development of American financial reporting and analysis prac-
tices in the three decades prior to passage of the 1930s Securities Acts.
Benston (1969, pp. 519, 520) finds that most companies were already
providing extensive disclosure in annual reports before the Securities
Acts and that this had been increasing in the years between 1926 and
1934. These findings are consistent with other studies that document
considerable financial market development in the United States before
1930 (Rajan and Zingales, 2003) and related development of financial
10 About half (n = 26) of the 51 firms examined by Sivakumar and Waymire (1993) paid
dividends at some point in the 1905–1910 period.
11 The pattern of stock price changes coincident with Sivakumar and Waymire’s dividend
change sample is similar to the price behavior accompanying dividend changes in the
modern era when financial reporting policies were far better developed (Aharony and
Swary, 1980; Eades et al., 1985; Healy and Palepu, 1988).
reporting brought about in part by market forces (Hawkins, 1963;

Barton and Waymire, 2004).12
4.4 What Price Do We Pay for Ignorance of Accounting’s

Institutional History?
We suspect that most accounting scholars are largely unaware of the
institutional history of pre-SEC US accounting practice. Further, we
believe this ignorance has exerted a major (and largely negative) impact
on our collective perspective that skews how we select our research
topics. We turn now to a discussion of this issue.
George Stigler (1988, p. 219) wrote 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 per-
vasive facts that have a powerful influence on how a science thinks
and works.” This tendency is strong in accounting, and it shapes
how we teach our subject and the prior beliefs that we bring to our
research.
The SEC propagates a view of benevolent regulation when
describing its mission on its website (http://www.sec.gov/about/
whatwedo.shtml):
“The mission of the US Securities and Exchange Com-

mission is to protect investors, maintain fair, orderly,
and efficient markets, and facilitate capital formation. . .
Only through the steady flow of timely, comprehensive,
and accurate information can people make sound invest-
ment decisions. . . To insure that this objective is always
being met, the SEC continually works with all major
market participants, including especially the investors
in our securities markets, to listen to their concerns and
to learn from their experience.”
12 Thefirst two editions of The Accountant’s Handbook (Paton, 1932; Saliers, 1923) provide
extensive descriptions of the state of accounting practice before the Securities Acts.
4.4 What Price Do We Pay for Ignorance of Accounting’s Institutional History? 45
In reviewing the history of their creation, the SEC also notes on its
website:
“The SEC’s foundation was laid in an era that was ripe

for reform. Before the Great Crash of 1929, there was
little support for federal regulation of the securities
markets. . . Tempted by promises of “rags to riches”
transformations and easy credit, most investors gave
little thought to the dangers inherent in uncontrolled
market operation. During the 1920s, approximately 20
million large and small shareholders took advantage of
post-war prosperity and set out to make their fortunes
in the stock market. It is estimated that of the $50
billion in new securities offered during this period,
half became worthless. . . With the Crash and ensuing
depression, public confidence in the markets plum-
meted. There was a consensus that for the economy
to recover, the public’s faith in the capital markets
needed to be restored. Congress held hearings to
identify the problems and search for solutions. Based
on the findings in these hearings, Congress passed the
Securities Act of 1933 and the Securities Exchange Act
of 1934. These laws were designed to restore investor
confidence in our capital markets by providing more
structure and government oversight.”13
Not surprisingly, similar views are presented in our textbooks. Con-

sider for example Kieso et al. (2006), the largest selling intermediate
accounting textbook. According to its publisher, it is “the standard by
which all other intermediate accounting texts are measured. Through
13 FASB has also stated similar rationales on its website (www.fasb.org/facts): “The mission
of the FASB is to establish and improve standards of financial accounting and reporting
for the guidance and education of the public, including issuers, auditors, and users of
financial information. Accounting standards are essential to the efficient functioning of
the economy because decisions about the allocation of resources rely heavily on credible,
concise, transparent, and understandable financial information.”
thirty years and eleven best-selling editions, the text has built a repu-
tation for accuracy, comprehensiveness, and student success.”14
Similar to the SEC’s statements, Kieso et al. (2006, pp. 6, 7) write:
“(W)hen the stock market crashed in 1929 and the

nation’s economy plunged into the Great Depression,
there were calls for increased government regulation
of business generally, and especially financial institu-
tions and the stock market. As a result of these events,
the federal government established the Securities and
Exchange Commission (SEC) to help develop and stan-
dardize financial information presented to sharehold-
ers. . . . The SEC encouraged the creation of a private
standard-setting body because it believed that the pri-
vate sector had the appropriate resources and talent to
achieve this daunting task. . . . The SEC’s partnership
with the private sector works well. The SEC acts with
remarkable restraint in the area of developing account-
ing standards. Generally, the SEC relies on the FASB
to develop accounting standards.”15
Given that at least two generations of accountants have been edu-

cated using this and similar texts it is not surprising that most aca-
demic accountants view the SEC and FASB as bodies composed of
largely benevolent and diligent professionals who try to “do the right
thing.”16 A standard-setter naturally will be enthusiastic about his job
and believe that he performs a vital public service; otherwise, why
would he do it? It is also likely that a standard-setter will be unable
14 Per website of Wiley (http://he-cda.wiley.com/WileyCDA/HigherEdTitle/productCd-

0471749559.html) as of August 31, 2007.
15 Kieso et al. (2006, p. 17) also take a similar positive view of FASB’s current performance
when they note that the FASB is making “good progress” on their objectives (as stated
by Chairman Bob Herz) and they provide “several examples of where the board has
exerted leadership.” From this, they conclude that improved “financial reporting should
follow.”
16 The statements in Kieso et al. (2006) are not unique; many US accounting textbooks
routinely cite the investor protection rationale for federal regulation through the SEC
(Libby et al., 2003, p. 22; Pratt, 2003, p. 23; Reimers, 2003, pp. 9–11; Soffer and Soffer,
2003, pp. 7–13; Robinson et al. 2004, pp. 10, 11).
or unwilling to recognize any “unfavorable unintended consequences”

that may result from his actions as a result of confirmation bias.
From a research perspective, the big issue is how we form our
prior beliefs about the research questions we explore and how we
tackle these questions. Some have argued that we all too willingly
assume benevolent regulation and then structure our research anal-
yses to provide evidence that can be “relevant” to FASB and the SEC
(e.g., Demski, 2007; Holthausen and Watts, 2001; Waymire, 2004).
If this view is valid, it no doubt arises in part because we have
insufficient skepticism as to whether regulated standard setting can
accomplish the goals articulated by policymakers (Kripke, 1979). Con-
sequently, we are unlikely to see how beneficial effects could arise
from practices that emerge spontaneously in the absence of regula-
tion, Hume (1737) and how regulation designed to produce benefi-
cial outcomes could in fact lead to much worse results than intended
(Hayek, 1967). In addition, researchers routinely ignore the possibil-
ity of over-regulation even though a fundamental law of economics
is that all economic goods, including regulation, have eventually
declining marginal returns that turn negative (Coase, 1975). In other
words, strong prior beliefs lead researchers to avoid searching for
disconfirming evidence and ignore any that they do find (Koehler,
1993). The price we pay is that we will have a woefully incom-
plete understanding of the forces at play in and the broader conse-
quences of regulation and standard setting (Healy and Palepu, 2001,
pp. 415–420).
To illustrate, consider the received wisdom that US federal reg-
ulation of the securities markets originated purely in response to
events of the 1929 crash and the subsequent depression in the 1930s.
A closer look at this history reveals a series of interactions between
academics and policymakers that underlies the genesis of the Securities
Acts.
Harvard economist William Ripley was an early advocate of the
view that regulation was needed to ensure the provision of reliable and
timely accounting data by corporations. In September 1926, he pub-
lished an article in Atlantic Monthly that advocated federal oversight of
industrials’ financial reports, which served as the basis for his oft-cited
book, Main Street and Wall Street (Ripley, 1927). Ripley’s article gen-
erated immediate and vigorous debate among financial news editors,
corporate executives, and professional accountants about the quality of
information available to the shareholders of publicly traded firms, and
Ripley was among a group of activists whose views influenced the pas-
sage of federal securities laws in the 1930’s (Hawkins, 1986, pp. 272–290
and 395, 396).
Ripley argued that, due to separation of ownership and control,
firms were operated more for managers’ self-interest rather than for the
interests of shareholders (Ripley, 1927, pp. 37, 38). Because managers
controlled financial reporting mechanisms, they could mask the effects
of this agency problem by manipulating accounting numbers, delaying
public disclosure, or withholding relevant information altogether. He
asserted that these practices harmed investors in part because equity
prices would not reflect available information, thereby creating an infor-
mational advantage for insiders (Ripley, 1927, pp. 204–207).17
Ripley testified in support of the Securities Acts, and helped shape
the thinking of those drafting these laws (Miranti, 1986, pp. 460, 461).
Foremost among them was lawyer Adolph Berle, who co-authored the
classic study on separation of ownership and control (Berle and Means,
1932). Berle had been Ripley’s student at Harvard, and was heavily
involved in drafting the Securities Exchange Act of 1934 (Parrish, 1970,
pp. 113, 114).18 Brief (1987, p. 147) concludes that Ripley’s impact
lasted beyond the 1930s by shaping perceptions that pre-SEC account-
ing data were routinely distorted and, hence, were largely useless for
equity pricing and investment decisions.
So, what evidence does Ripley provide to support his assertions
in his influential article and book? The 1926 article, which provided
the basis for chapter six of Main Street and Wall Street, only cites a
series of specific cases of alleged reporting weaknesses without providing
17 Ripley had articulated this view for years before his 1926 piece was published — see
Ripley (1911).
18 In the preface to the first edition of Berle and Means (1932), Berle writes: “All students
of these and allied problems, and we among them, owe a debt to Professor William Z.
Ripley of Harvard University, who must be recognized as having pioneered this area” (see
Berle and Means, 1932, liv).
Table 4.2 Summary of criticisms of early 20th century financial reporting practices in 100
cases.
Number of Cases Cited 100
Number of Unique Firms Cited 69
Type of Company
Industrial Corporation 55 (80%)
Other (Interstate Railroad, Utility, Street Railway, etc.) 14 (20%)
Nature of citation
Unfavorable 72 (72%)
Favorable 28 (28%)
Period in which case occurred
After 1920 67 (67%)
Before 1920 33 (33%)
Cases with accounting or disclosure issue raised (n = 95)
Balance Sheet
Surplus/Impaired Capital from Excess Dividends 10
Assets: General 6
Assets: Large Intangible & Overcapitalization 6
Unconsolidated Subsidiaries: Liabilities, etc. 6
Assets: Low Intangibles 4
Disclosure: Balance Sheet &/or Components 4
Fixed Assets & Depreciation Reserve 1
Total Balance Sheet 37
Income Statement
Depreciation Expense 11
Disclosure: Income Stmt &/or Components 10
Interim earnings disclosure 8
Income manipulation & hidden reserves 6
Income manipulation: General 3
Treasury stock transactions 1
Total Income Statement 39
Other
Disclosure: General 19
Grand Total 95
Source: Chapter 6 of Main Street and Wall Street by W. Z. Ripley.
any systematic evidence on the specific cases and their effects on

investor behavior.19 Table 4.2 summarizes basic data on these cases.
These 100 cases (attributable to 69 companies) are largely (but not
entirely) unfavorable. The issues are roughly evenly split between
the income statement and balance sheet. Inspection of these citations
19 Nonetheless,his treatment of institutional details and data is far more cursory in Main
Street and Wall Street than in his earlier academic writings (Ripley, 1905, 1912, 1915).
However, it is likely that his audience was more familiar with the details of these recent
cases than readers almost a hundred years later.
(untabulated) suggests that they are cursory — i.e., they occupy only
a sentence or two and omit overall materiality considerations in most
cases.
To be sure, Ripley cannot be faulted for providing no systematic
quantitative evidence that would directly address the effects of poor
accounting information on managerial and investor behavior in the
periods he considers. Still, it is quite troubling that accounting aca-
demics have been disproportionately influenced by Ripley’s and others’
beliefs about the value of regulation with little evidence to support such
beliefs (Benston, 1969; Sunder, 2005).20 This illustrates the dangers in
over reliance on the case method. Formal hypothesis tests using larger
samples are valuable in historical research because inferences from case
studies may not broadly generalize.
4.5 How Can Researchers Become More Historically

Informed?
The only way to substantively combat ignorance of history is to start
learning, potentially a daunting task for researchers who have no expe-
rience studying history. For example, what resources are available for
the scholar who seeks a better understanding of the historical develop-
ment of accounting practice? Table 4.3 provides references (along with
brief summaries) of helpful resources. These resources are categorized as
follows: books on the general history of accounting (panel A), books on
business, economic, and financial history (panel B), classic accounting
books (panel C), and academic journals that publish or have previously
published accounting history research (panel D).
20 Benston (1969, pp. 517, 518) criticizes the weak evidence presented in the hearings that
led to passage of the Securities Exchange Act of 1934 and was later summarized in a
book by Ferdinand Pecora, the chief counsel of the US Senate Committee on Banking and
Currency (Pecora, 1939). Only recently have scholars skeptically examined the Securities
Acts from a public choice perspective, and Mahoney (2001 Abstract) concludes that the
net effect of the Securities Act of 1933 “was to reduce competition among investment
banks. In particular, the act protected separate wholesale and retail investment banks
from integrated investment banks.” Similarly, O’Connor (2004) argues that accountants
captured the SEC by extending the “best practice” of auditing to a broad mandate,
thus securing a professional monopoly and Partnoy (1999) describes the governmental
oligopolization of the credit rating industry at the same time.
4.5 How Can Researchers Become More Historically Informed? 51
Table 4.3 Alphabetical listing (by Author) of accounting and other historical sources.
A: Books on the General History of Accounting
Baxter, W. and S. Davidson (1962). Studies in Accounting Theory. This book contains
several essays that are classics in accounting. These include Hatfield’s “Historical
Defense of Bookkeeping,” Baxter’s “Recommendations on Accounting Theory,”
Yamey’s “The Case Law Relating to Company Dividends,” and many others.
Chatfield, M. (1974). A History of Accounting Thought. This excellent book provides a
summary of the history of accounting from its origins in ancient recordkeeping
practices up through modern standard-setting institutions.
Hausdorfer, W. (1986). Accounting Bibliography. Hausdorfer compiled several
bibliographies of historical accounting literature including lists of primary sources and
materials in several languages with their locations, lists of previous biographies and
bibliographies, and previous works on accounting history. It is about 50 years out of
date, but still a useful resource.
Littleton, A. C. (1933). Accounting Evolution to 1900. Littleton traces the development
of modern accounting in more depth than Chatfield. His chapters on the origins of
double entry, the appearance of financial statements in going concerns, and the
origins of British accounting regulation are especially informative.
Littleton, A. C. and B. S. Yamey (1956). Studies in the History of Accounting. This
beautiful book of essays includes marvelous pieces on the history of primitive
accounting devices like tally sticks, accounting rules of the British Companies Acts
before 1900, and early railroad accounting.
Mattessich, R. (2000). The Beginnings of Accounting and Accounting Thought.
Mattessich wrote several insightful papers on the development of accounting
technology in ancient Mesopotamia and accounting texts in ancient India that are
collected together in this volume.
Nissen, H. J., P. Damerow, and R. K. Englund (1993). Archaic Bookkeeping: Writing
and Techniques of Economic Administration in the Ancient Near East. This book
chronicles how basic accounting provided the impetus to the first human writing
systems observed in ancient Mesopotamia.
Parker, R. H. (1980). Bibliographies for Accounting Historians. This book reprints 8
bibliographies published during 1903–1977 and one unpublished bibliography.
Previts, G. J. and B. D. Merino (1998). A History of Accountancy in the United States.
This is the standard reference for understanding how accounting was used in colonial
America and then developed into its modern institutional form. The book does an
especially nice job of integrating the appearance of formal institutional structures
with the underlying social forces at play in broader American culture.
Schmandt-Besserat, D. (1992). Before Writing, Volume I: From Counting to Cuneiform.
Schmandt-Besserat’s work describes the archaeological basis for accounting in ancient
Mesopotamia. Her work proceeds from a careful description of the archaeological
evidence to present the hypothesis that ancient tokens were accounting devices that
served as the precursor to writing (also done for purposes of accounting).
ten Have, O. (1976). A History of Accountancy. An interpretive history of accounting
from ancient to modern times that is especially noteworthy in discussing the
transmission of accounting knowledge through time.
Zeff, S. A. (1972). Forging Accounting Principles in Five Countries: A History and
Analysis of Trends. This book is a thorough comparative study of the development of
accounting standards Canada, England, Mexico, Scotland, and the United States.
(Continued)

B: Books — General Business, Economic, and Financial History
Baskin, J. B. and P. J. Miranti (1997). A History of Corporate Finance. This excellent
text begins with a discussion of the problem of information asymmetry within the
modern neoclassical theory of the firm. It then proceeds to chronologically describe
the evolution of the corporate form using this view of the firm as a backdrop.
Discussion of accounting issues is then presented within the broader context of how
accounting fulfills a useful function within the corporate form.
Berle, A. A. and G. C. Means (1932). The Modern Corporation and Private Property.
This is one of those books that is probably cited more often than it is read. The book
consists of two parts. The first part, mostly attributed to Means, provides data on the
relation between corporate size and the diversification of corporate shareholdings.
Berle’s contribution constitutes the second part, which is devoted to an analysis of
corporate law before 1930.
Carosso, V. P. (1970). Investment Banking in America: A History. This book is the
standard reference for understanding the historical origins of investment banking.
Chandler, A. D. (1977). The Visible Hand. This text has deservedly been cited
frequently. It develops a historical story of the role of management in forming the
modern corporation. Like Baskin and Miranti, this book chronicles the development
of the modern corporation from the ground up. It especially is useful for seeing how
these organizations came to exist. Accounting does not form the core of the book, but
it receives significant attention and Chandler illustrates how the corporation needed
accounting information to assume its modern form.
Daggett, S. (1908). Railroad Reorganization. This book chronicles the histories of several
bankrupt railroads in the 1890s. This experience strongly influenced the writing of the
1898 bankruptcy statute that was used during much of the 20th century.
Dewing, A. S. (1922). The Financial Policy of Corporations. This book provides an
excellent and intelligent treatment of early 20th century corporate finance written by
a distinguished initial member of the Harvard Business School faculty.
Graham, B. and D. Dodd (1934). Security Analysis. This is the classic text in securities
analysis. The book holds up well even though its examples are obviously dated.
Jones, E. (1921). The Trust Problem in the United States. This book provides an
extensive review of the history of large corporations that first emerged as trusts in the
1870s and their effects on market competition.
Mokyr, J. (editor) (2007). The Oxford Encyclopedia of Economic History. This
five-volume set is a broad reference source on any economic or business history topic.
Ripley, W. Z. (1912). Railroads: Rates and Regulation. This is a very thoughtful book on
the economics of the US railroad system in terms of operations and the factors that
determined rates, both market and regulatory.
Ripley, W. Z. (1915). Railroads: Finance and Organization. This book gives an overview
of corporate finance applicable to US railroads and their history.
Ripley, W. Z. (editor) (1905). Trusts, Pools, and Corporations. This volume of readings
provides cases descriptions of several early US trust arrangements as well as a couple
of essays on international experience and a more general summary of the literature on
trusts as of 1905.
Sobel, R. (1965). The Big Board. Sobel’s book is the classic history of the development
of the New York Stock Exchange from its humble origins in 1792.
(Continued)

C: Accounting Classics
Bliss, J. H. (1923). Financial and Operating Ratios in Management. Bliss provides a
comprehensive early treatment of ratio analysis. Data on the ratios of a large sample
of major firms for about a decade is also provided.
Canning, J. B. (1929). The Economics of Accountancy. This book is likely the first
serious attempt by an economist to make sense out of accounting practice and try to
reconcile it with economic theory of his day.
Chambers, R. J. (1966). Accounting, Evaluation and Economic Behavior. This book
provides the basis for Chambers’ assertion that exit values on balance sheets provide
a superior basis for accounting than historical costs.
Clark, J. M. (1923). Studies in the Economics of Overhead Costs. This book is the first
deep analysis of costs and cost accounting practices in businesses, but also considers
use of cost data in managerial decision-making and government.
Dicksee, L. R. (1892). Auditing. This is an excellent and often-cited source for British
auditing as it existed in the late 19th century after the passage of the Companies Acts.
Edwards, E. O. and P. W. Bell (1961). The Theory and Measurement of Business
Income. An early comprehensive treatment of accounting-based valuation derived
from the residual income approach under clean surplus accounting. This approach
followed from work by Gabriel Preinreich (1936) and was extended subsequently by
James Ohlson (1995) — see Brief and Peasnell (1996).
Gilman, S. (1939). Accounting Concepts of Profit. This book reflects a serious and
comprehensive attempt to address the economics of accounting income measurement
from a perspective that reflects knowledge of the historical development of accounting
practice and principles.
Hatfield, H. R. (1909). Modern Accounting: Its Principles and Some of its Problems.
This is a leading accounting textbook of its time authored by the first full-time
university professor of accounting in US history.
Ijiri, Y. (1975). Theory of Accounting Measurement: Studies in Accounting Research
#10. A classic book that develops a comprehensive theory of accounting working up
from basic recordkeeping through to full-blown financial statements prepared under
historical cost versus other methods.
Leake, P. D. (1921). Commercial Goodwill: Its History, Value, and Treatment in
Accounts. This is a standard text on the history of goodwill and other intangibles in
law and accounting before 1900.
Littleton, A. C. (1953). The Structure of Accounting Theory. This book contrasts
deductive and inductive approaches to the formulation of general accounting
principles. As such, it provides a useful introduction to how accounting principles can
evolve and then be ascertained via induction.
MacNeal, K. (1939). Truth in Accounting. This book is an early attack on historical cost
accounting that resembles much of the concerns raised in the FASB Conceptual
Framework’s recent emphasis on fair-valued balance sheets.
Montgomery, R. H. (1912). Auditing: Theory and Practice. This is the first major
American text on auditing. It was continuously in print in various editions at least
into the 1940s.
Pacioli, L. (1494). Summa de arithmetica, geometrica, proportioni et proportionalita.
The Big Kahuna of texts on bookkeeping; Pacioli’s text summarized the “Venice
Method” of double-entry bookkeeping as it existed in the final decade of the 15th
century.
(Continued)

Paton, W. A. and A. C. Littleton (1940). An Introduction to Corporate Accounting
Standards. This is the classic text that conveys the essence of historical cost
accounting with an income statement emphasis on Revenue Realization and the
Matching Concept.
Pixley, F. W. (1896). Auditors: Their Duties and Responsibilities Under the Companies
Acts and Other Acts of Parliament. This classic text describes the role of auditors in
19th century Britain as this role evolved in practice through legislative actions by
Parliament.
Ripley, W. Z. (1927). Main Street and Wall Street. This text provides an extremely
skeptical view of the quality of US corporate financial reporting in the first quarter of
the 20th century. The book has had enormous influence through how it influenced
perceptions of the general public at the time and when federal securities laws were
enacted in the 1930s.
Sanders T. H., H. R. Hatfield, and U. Moore (1938). A Statement of Accounting
Principles. This book generated considerable controversy when published because the
authors took a non-normative approach to the definition of accounting principles
based on conventions that had evolved from practice.
Sterling, R. R. (1970). Theory of the Measurement of Enterprise Income. Like
Chambers, Sterling is an early proponent of “mark-to-market” accounting. His views
on the subject are articulated in this text.
Vatter, W. J. (1946). The Fund Theory of Accounting and its Implications for Financial
Reports. Vatter introduces the concept of a fund as an area of operation or a center of
interest, and uses it to unify the different branches of financial reporting: profit,
non-profit, governmental, as well as divisional, corporate, consolidated and national
income, without focusing on income or profit determination.
Vatter, W. J. (1950). Management Accounting. Based on his teaching notes, it became
the model for managerial accounting textbooks for at least three decades.
Yang, J. M. (1927). Goodwill and Other Intangibles. This book nicely describes the
accounting for intangible assets and the difficulties associated with their
capitalization. In many ways it presages debates about intangible assets that have
occurred in the last 15 years.
D: Academic Journals
Abacus. A general accounting academic journal that has published historical research
since its founding in 1965 by Professor Raymond Chambers of the University of
Sydney (Australia).
Accounting and Business Research. This British journal was founded in 1970 by
accounting historian Robert Parker. The journal is broad in scope, but occasionally
publishes papers on accounting history. The journal has previously had two special
issues on history, one in 1980 and another in 2002.
Accounting, Business, and Financial History. This British journal founded in 1990 is
entirely historical in content, but it encompasses accounting as well as finance and
more general business subjects.
The Accounting Historians Journal. The pages of this journal are devoted entirely to
subjects in accounting history. Past issues from 1974 to 1992 are available online free
as part of the University of Mississippi Libraries — Digital Accounting Collection of
Mississippi’s website (http://www.olemiss.edu/depts/general library/dac/files/
ahj.html).
(Continued)

Accounting History. This is an accounting history journal published by the Accounting
History Special Interest Group of the Accounting and Finance Association of
Australia and New Zealand. It is an international journal that provides a broad
geographical scope to the subject matter.
Accounting, Organizations and Society. This general accounting journal frequently
publishes articles that have a strong historical bent. It is thus an excellent resource,
particularly for those interested in the interplay between accounting and sociology
over time.
The Accounting Review. While this journal is presently known for mainstream
accounting research articles, it did publish traditional historical research in
accounting in its early years. The journal is thus an excellent source for material on
accounting history published before 1980.
Business History Review. This is a general journal on business history. Several leading
papers on the historical development of accounting and related business issues are
dealt with in the pages of this journal.
The Economic History Review. While accounting history is not the focus of this journal,
occasionally they will publish research dealing with the subject. In this regard, it is a
general journal on history similar to Business History Review.
Journal of Accounting Research. This journal is presently known for the contributions
made in articles on accounting theory as well as empirical and experimental work in
accounting. However, in its early years the journal regularly published traditional
historical research in accounting.
Armed with these resources, the only remaining constraint on

becoming historically better informed is the curiosity to ask basic
questions such as “How did the accounting practice I am studying
originate and spread?” One should exhibit willingness to track through
historical sources, and even possibly hand collect data. Regardless of
the depth of one’s ultimate interest, there are many sources through
which it is possible to become better informed about the institutional
history that lies behind the data that we examine.
5
The Use of Historical Data in Testing
Economic Hypotheses
The British–US history of accounting provides a treasure trove of nat-

urally occurring data that can be exploited by researchers to test
hypotheses that cannot be directly addressed with modern data. These
opportunities arise when societies and their institutions build over time
from simple origins to more complex forms. Several distinct kinds of
opportunities present themselves for investigation. First, it is possible
to explore the forces that shape the origins of accounting institutions in
simpler settings where, unlike modern settings, fewer confounding vari-
ables exist. Second, institutional discontinuities allow for more powerful
research on the conditions that give rise to institutional innovations,
and the effects of these innovations on economic behavior.1
We begin this section by presenting illustrative studies drawn from
the economics literature. In the next two sub-sections, we consider
research on the emergence of accounting institutions and the effect
of regulation on accounting institutions. The final sub-section briefly
1 Changing economic forces could cause significant time-series variation leading to more
powerful tests than in the cross-section (e.g., Basu (1997) tests on effects of litigation
exposure on conservatism in earnings). Relatively unregulated environments also likely
provide more cross-sectional variation, and hence more powerful tests, than the more
regulated environment today.
56
5.1 Using Historical Data to Test Hypotheses: Examples from Economics 57
describes data sources available to researchers who seek to conduct

similar research.
5.1 Using Historical Data to Test Hypotheses: Examples

from Economics
In this sub-section, we illustrate the value of historical research using
two exemplary studies from the economics literature. The first is
a paper entitled “Charity and the Bequest Motive: Evidence from
Seventeenth-Century Wills,” by Leslie McGranahan, published in the
December 2000 issue of the Journal of Political Economy. McGrana-
han (2000) uses historical data to explore whether and how altruistic
motives affect bequests made when someone dies. She predicts that
bequests to the poor are likely higher for more religious people, and
those who are wealthier and unmarried, while such bequests will be
less frequent for those with surviving spouses, children, or other kin
and close friends. McGranahan collects data on bequests to the poor
taken from wills written in Suffolk County, England during the 1620s
and 1630s and documents results that are generally consistent with the
predictions of the altruism hypothesis. McGranahan’s empirical analy-
sis is valuable because she uses historical data to structure a unique test
that is not confounded by today’s favorable tax treatment of charitable
gifts.
The second example, Jonathon Karpoff’s “Public vs. Private Initia-
tive in Arctic Exploration: The Effects of Incentives and Organizational
Structure” (in the February 2001 Journal of Political Economy), pro-
vides a unique and powerful test of the organizational performance
consequences of government versus private financing. Karpoff (2001)
studies Arctic voyages between 1818 and 1909 undertaken to discover
and navigate shipping routes through the Northwest Passage and to
the North Pole. Karpoff’s sample includes 92 different Arctic voyages,
57 of which were mostly financed through private funds while the other
35 were financed primarily by government, partitioned using available
financing data.
Karpoff runs a “horse race” between alternative institutional struc-
tures for financing Arctic voyages. His study is thus applicable to public
58 The Use of Historical Data in Testing Economic Hypotheses
policy issues that center on government financing of services such as

education, transportation, and basic research. Because governments
had not monopolized Arctic exploration, Karpoff’s setting is analogous
to a comparison of space exploration effectiveness by a government
bureaucracy such as NASA, as opposed to possible private sector orga-
nizations. With modern data, the only benchmark to gauge NASA’s
success is that of an alternative government bureaucracy — e.g., that
of the Soviet Union.
Karpoff (2001) documents that public voyages entailed greater total
investment, employed larger crews, and used more experienced cap-
tains. Despite these apparent advantages, publicly financed expeditions
“made fewer major discoveries, introduced fewer technological innova-
tions, and were subject to higher rates of scurvy, lost more ships, and
had more explorers die.” This poorer performance likely arose because
“public expeditions (1) had poorly motivated and prepared leaders;
(2) separated the initiation and implementation functions of executive
leadership; and (3) were slow to exploit new information about cloth-
ing, diet, shelter, modes of Arctic travel, organizational structure, and
optimal party size” (Karpoff, 2001, p. 40).
These studies illustrate how historical data can be used to explore
interesting questions that are difficult to examine with modern data.
There is also growing awareness among economists that historical dif-
ferences in institutions provide fertile ground for testing controversial
hypotheses. Pertinent studies include those on the effects of concealed
handgun laws on crime deterrence (Lott and Mustard, 1997), the inter-
play between state anti-takeover laws, corporate governance, and exec-
utive compensation (Bertrand and Mullainathan, 2000), and the role
of legalized abortion in crime (Donohue III and Levitt, 2001).
Conducting similar research in accounting requires that we con-
sider how to (1) identify interesting institutional settings in account-
ing, and (2) acquire quality data to conduct empirical tests. Accounting
history over the past several centuries provides numerous opportuni-
ties for accounting researchers to identify economic forces that shape
the emergence of modern accounting institutions, and understand how
regulation alters the character of accounting institutions that evolved
spontaneously from private market arrangements.
5.2 Using Historical Data to Study the Emergence of Accounting Institutions 59
5.2 Using Historical Data to Study the Emergence

of Accounting Institutions
Now we describe research questions on what shapes the origins of
accounting institutions and the related evidence. Such institutions
include auditing, external income reporting, voluntary corporate dis-
closure and financial reporting, and information intermediation and
security analysis.
5.2.1 The Origins of Auditing

Audits of corporations listed on US national stock exchanges have
been mandatory under federal securities law since the 1930s. Audits
of British firms have been required since the mid-19th century and
professional accounting firms originated from bankruptcy proceedings
conducted by the British courts in the same era. One might then believe
that regulation was the driving force behind the origins of auditing. On
the other hand, theory suggests that auditing and internal control are
a necessary aspect of accounting and reporting in any setting where
decision-making is delegated and resources are entrusted to another
party. Thus, auditing emerges to mitigate agency costs within any orga-
nization characterized by separation of ownership and control and dele-
gated decision-making (Jensen and Meckling, 1976; Watts, 1977; Watts
and Zimmerman, 1986).
Auditing and internal control procedures have existed for thousands
of years: they were present in ancient Mesopotamia, Greece, Rome, and
India (Stone, 1969; Lee, 1971; Chatfield, 1974, pp. 4–12; Mattessich,
2000). In medieval times, the British crown used elaborate procedures
to audit tax collections by local county sheriffs, who mediated between
the Crown and its subjects (Chatfield, 1974, pp. 20–24). The sheriff
appeared in court at Easter to pay one-half his county’s due, and then
settled up the total, net of expenses, on Michaelmas (September 29)
after collecting the rest from local subjects. Receipts for taxes paid at
Easter by the sheriff to the Exchequer were in the form of a “tally
stick,” which was split down the middle with one notched half given
to the sheriff and the other notched half retained by the Exchequer
(Robert, 1956). At the final settling-up, audit of the total was done by
reference to the original tally stick and the record of remaining obliga-
tions (represented by the tally’s other half held by the Exchequer).
Watts and Zimmerman (1983) test agency cost explanations for
auditing by examining the original charters and by-laws of English
merchant guilds, merchant adventurers/regulated companies, and joint
stock companies from the 15th to the 17th century. Merchant guilds
appeared shortly after the Norman conquest of Britain in 1066 AD
and represent the earliest British incorporated enterprises. Merchant
adventurers and regulated companies that operated as foreign trade
monopolies appeared during the mid-13th century through the 17th
century. The first British joint stock company, the direct forerunner of
the modern corporation, appeared in 1555.
Watts and Zimmerman (1983) show that the charters and by-laws
of these organizations typically include clauses stipulating an audit of
the accounts. This suggests that auditing is an ex ante contracting
choice made when the firm is organized. In addition, teams of directors
and/or shareholders typically conducted the audit, which suggests that
audits were designed with foreknowledge that collusion between the
manager and auditor was possible. Fines and loss of reputation for
non-performance were used to promote independent audits and limit
manager–auditor collusion.
Watts and Zimmerman’s evidence is consistent with the hypothesis
that the origins of auditing result from inherent and powerful economic
forces rather than regulatory action. Their evidence is consistent with
others’ claims that auditing and internal control procedures are ubiq-
uitous to complex economic organizations (Chatfield, 1974).
5.2.2 The Origins of External Income Reporting

Timely public reporting of quarterly income statements is now routine,
and it is thus surprising to realize that major US corporations once did
not even publicly disclose annual net income numbers. Some of the early
US industrial “trusts” were especially secretive. John D. Rockefeller
operated Standard Oil under a strict policy of financial secrecy from its
founding in 1870, and “The Sugar Trust” founded in 1887 (incorporated
as the American Sugar Refining Company in 1891) did not issue a
single annual report until after its founder died in late 1907 (Chernow,
1998, p. 556; Porter et al. 1995). These firms’ common stocks were
actively traded and had large market capitalizations primarily based on
their dividend record. In contrast, many other firms published income
numbers voluntarily during the early 1900s, even though there was no
law requiring this.
Merino and Neimark (1982) argue that regulatory threats — e.g.,
investigations by the Congressional Industrial Commission of 1898–
1902 — provided a strong incentive for industrial firms to publicly
disclose more information about their activities. That is, politicians
clamored for greater publicity of corporate affairs to deter monopolies,
and in response firms increased disclosure to lessen political costs of reg-
ulatory intervention — e.g., prosecutions under the Sherman Antitrust
Act of 1890, one of which dissolved Standard Oil in 1911 (Chernow,
1998, pp. 537–559). Despite this argument’s intuitive appeal, it provides
an incomplete explanation since some firms were reporting extensive
information well before this time.
Another hypothesis is that some firms could not raise enough financ-
ing solely based on a stable dividend history, and hence, chose to dis-
close more information. Large-scale US industrial corporations began
appearing en masse in the 1890s as part of the “Great Merger Wave”
(Navin and Sears, 1955). Hawkins (1963, p. 140) suggests that these
new organizations adopted more transparent reporting policies to help
raise the large amounts of equity financing their expanding operations
needed (e.g., General Electric — see Section 4.2).2 Consistent with this
argument, Hawkins (1963) notes that investment bankers in the pre-
SEC era advocated increasing corporate transparency and disclosure.
But why did some firms voluntarily report income to raise equity
capital whereas others apparently believed that they could raise cap-
ital and sustain investor trust solely through a stable dividend pol-
icy? The answer likely reflects differences in these firms’ operations
and investment opportunities. Trusts like American Sugar Refining
and Standard Oil arose from horizontal mergers aiming to monopolize
2 Hawkins (1963) does not attribute increased disclosure after 1900 solely to the demand for
financing. Indeed, he suggests that regulatory threats exerted a major influence on firms’
willingness to disclose more information about their performance and financial position.
well-established markets for processed consumer items. Lots of informa-

tion was available about these product markets (e.g., commodity prices)
and the production technology was well developed.3 Hence, Standard
Oil’s revenues did not depend, at least in the short run, on significant
product innovation or market development, and internally generated
cash flow could finance all Standard Oil’s investments.
In contrast, General Electric relied on innovating new products
exploiting the emerging technology of electricity and developing new
markets for these products. Because cash flows in these new industries
were fundamentally uncertain, managers had greater opportunity to
pay low dividends and divert cash flows to their own benefit. Thus,
firms like GE may have started extensive external reporting because
stable dividend policies alone could not sustain investor trust. That
is, income reporting reinforces dividends as a credible communication
mechanism when shareholders do not (cannot) know the underlying
distribution of cash flows.
The historical record suggests that dividend policy played a central
role in the origins of corporate income reporting. The first British cor-
porations had finite lives. The East India Company, chartered in 1600
by Elizabeth I, began as a company whose foreign voyages were each
financed separately (Chatfield, 1974, p. 79). Shares were liquidated at
the end of each voyage with a one-time dividend. When corporations
began operating as going concerns, the key issue became whether div-
idends could be paid to shareholders without impairing the corpora-
tion’s permanent capital (Littleton 1933, pp. 245–246; Yamey 1962).
The landmark 1849 British case of Burnes v. Pennell instituted the
rule that dividends could be paid only from accumulated profits.
We have no archival evidence as yet from a “naturally occur-
ring experiment” on whether income reporting is necessary to sustain
investor trust in more uncertain environments in which dividends can
be manipulated. However, Dickhaut et al. (2008a,b) use a laboratory
experiment to test the hypothesis that investor trust is increased by a
communication policy that includes dividend payments and voluntary
3 Forexample, Rockefeller likely increased market share by extracting rents associated with
lower transportation costs rather than lower production costs per se (Granitz and Klein,
1996).
income reporting rather than dividend payments alone. Their results

indicate that investment is greater and managerial fraud is lower when
income reporting supplements dividend policy in a multi-period game
characterized by uncertain payoffs. The experimental evidence in Dick-
haut et al. (2008a,b) is also important because it illustrates a point
that we will return to in Section 6 — namely, the methodological tools
used by the accounting historian need not be confined to qualitative or
Cliometric analyses. Indeed, the systematic study of accounting evo-
lution will likely require an expanded toolkit that includes laboratory
experiments and simulation methods like agent-based modeling.
5.2.3 Expanded Voluntary Reporting and Disclosure

in the Pre-SEC Era
It seems obvious that financial performance and position are measured
to help manage the business. Firms also measure and disclose account-
ing data to outsiders to help enforce contracts. In large developed cap-
ital markets, accounting numbers will likely be disclosed to potential
investors in a firm’s securities. What is less obvious is why major US
industrial corporations voluntarily disclosed extensive financial data
long before Congress enacted a broad disclosure mandate to be enforced
through the SEC.
The first large American corporations to publicly report extensive
data were 19th century transportation companies; first canals and later
railroads (Russ et al., 2006; Samson et al., 2006). Railroad accounting
developed throughout the 19th century. Chandler (1977, pp. 109–120)
chronicles how railroads developed systems for gathering financial data
on income and its revenue and cost components for internal control,
standardized the form of income statements, and created accounting
methods for long-term capital investments (see also Baskin and Miranti
(1997) and Previts and Merino (1998)). While these companies’ report-
ing practices were later influenced strongly by rate regulation, early
railroad accounting evolved by the usual trial and error processes that
characterize all economic institutions.
Financial reporting by American industrial corporations developed
similarly, although regulation affected this evolution indirectly at best.
Large US industrial corporations emerged from the industrial trusts

created in the last quarter of the 19th century (Navin and Sears, 1955).
The corporate form became used more widely after New Jersey revised
its state incorporation laws in 1889 and allowed holding companies to
incorporate. By 1910, markets for industrial preferred and common
stocks had taken root on the New York and other stock exchanges.
These industrial firms’ reporting practices then evolved during the first
three decades of the 20th century.
George Benston (1969, 1973) conducted the first systematic stud-
ies of industrials’ pre-SEC financial reporting practices. Benston (1969,
p. 519) examines the frequency of financial statement component dis-
closure for the years 1926–1934 by firms listed on the NYSE as of June
1935. His data (gathered from Moody’s manuals) indicate that all of
these firms provided a balance sheet with working capital amounts and
virtually all provided a net income number. In 1926, fifty-five percent
of firms reported sales data, and this percentage climbed gradually to
62% by 1934. More firms separately reported depreciation, but fewer
reported cost of goods sold. Over 80% were audited in 1926, increas-
ing to 94% by 1934.4 Benston (1973, p. 136) also shows that the fre-
quency of sales and cost of goods sold disclosure was not materially
lower for firms that were accused of “market manipulation” through
trading pools in this same period. Benston (1973, p. 153) reaches a
skeptical conclusion about the value of SEC disclosure regulation.
Merino and Neimark (1982) question this inference and argue that
financial reporting and disclosure was still weak in the pre-SEC era.
Despite market forces, reporting in the 1920s was still inadequate in
that (1) insiders could (and did) exploit their informational advantage
through stock market manipulation, and (2) accounting information
quality was low, which sustained the informational asymmetries neces-
sary for successful market manipulation (Merino and Neimark, 1982,
pp. 41–45). Only anecdotal evidence is presented in support of these
claims (e.g., government reports or academic work lacking quantitative
hypothesis tests such as Galbraith (1954)).
4 Seligman(2002, p. 48) reports that by 1933, all of the 1157 listed companies provided
annual reports, 60% also provided quarterly reports, and 85% underwent annual audits
by CPAs with the results made publicly available.
Subsequent research has more systematically analyzed the extent

to which insiders could exploit an informational advantage and the
determinants of voluntary financial reporting practices in the pre-SEC
era. Jiang et al. (2005) collect by hand daily stock returns and trad-
ing volume data for 55 NYSE-listed firms in the 1920s, which were
subject to allegedly manipulative trading “pools.”5 These pool market
operations typically lasted from two months to two years (Mahoney,
1999, p. 349). Jiang et al. (2005) document that pool stocks exhibit
positive abnormal stock returns and greater return volatility and trad-
ing activity in the 25 days following the pool formation (Jiang et al.,
2005, p. 159). These returns are positively associated with concurrent
trading volume. The short-run stock returns associated with pool activ-
ity are economically modest and there is no long-run return difference
for pool stocks. Most importantly, their evidence overall is more consis-
tent with informed trading than successful market manipulation (Jiang
et al., 2005, p. 167).
Banerjee and Eckard (2001) test insider-trading effectiveness using
data on 56 corporate mergers during the “Great Merger Wave” of 1897–
1903. The interesting institutional twist is that there were two distinct
types of mergers. In a “fait accompli” merger, disclosure occurred only
after the merger had been agreed upon, whereas in a “prospective”
merger, the intent to merge was disclosed voluntarily before its con-
summation. Banerjee and Eckard (2001) find that all pre-merger stock
price run-ups are fully extracted by insiders in the 19 fait accompli sam-
ple mergers. In contrast, outsiders benefit from modest price increases
following disclosure of intent in the 37 prospective mergers. These find-
ings suggest that even when insiders can exploit inside information for
considerable short-term gain, they usually refrain from doing. Another
intriguing finding is that stock prices fall on average by nearly 5% after
announcement of a fait accompli merger, but prices increase after a
5 The Jiang et al. (2005) sample includes firms with a pool initiating in 1928 or 1929 that
was focused on trading in common stock, that was mentioned in subsequent Congressional
hearings, and where a copy of the pool agreement was available in Congressional investi-
gators’ records stored in the National Archives (Jiang et al., 2005, pp. 152–155; Mahoney
1999). Mahoney (1999) provides an in-depth discussion of the contractual and institutional
arrangements governing 1920’s investment pools.
prospective merger. This suggests that investors penalize insiders who

exploit an informational advantage by reducing stock prices.6
Other papers have also examined pre-SEC accounting quality.
Merino et al. (1994) investigate voluntary audit purchases in 1927 for
a sample of firms with securities traded on NYSE, the Curb Exchange
(forerunner of the American Stock Exchange) and other New York
markets. Two competing hypotheses motivate the tests Merino et al.
(1994) conduct. The first is an economic incentives story; namely
that corporate managers have incentives to buy audits to address
agency/stewardship concerns or to support valuation in secondary secu-
rities markets. The second hypothesis is that the threat of government
regulation led firms to improve financial reporting independently of any
other economic incentives.
Merino et al. (1994) use firm size to measure the extent of manager–
owner agency conflicts, which presumably stimulates greater demand
for audits, all else equal. They find evidence of a weak positive associa-
tion between firm size and audit purchase. For instance, many large
non-NYSE firms were not audited, but this effect was clustered in
the oil industry reflecting a historical aversion to external audits by
Rockefeller-controlled entities. Using a composite variable of finan-
cial reporting practices constructed from summary annual data from
Moody’s manuals, they also find a weak positive association between
auditing and reporting quality.
The Merino et al. (1994) study is an intriguing first attempt to
examine actual reporting choices, but has several inferential prob-
lems. Their biggest challenge is that they do not explicitly test their
alternative hypothesis, but rather attribute all unexplained auditing
variation to attempts to deter government intervention. Additional
challenges include measurement of the dependent variable, financial
reporting quality, as well as the independent variables that proxy for
the hypothesized economic and social forces. Absent more direct tests
6 Banerjeeand Eckard (2001) try to link their findings to differences in firm-specific per-
formance disclosures such as earnings. These attempts are hard to interpret since they
rely on measures of firm visibility rather than direct measures of corporate disclosures or
dividend policies for firms in that era, which vary considerably between firms (Sivakumar
and Waymire, 1993, 1994).
of the regulation hypothesis, their inference “that those who impute

the emergence of audits solely to economic incentives distort, rather
than enhance our understanding, of the complex factors that led to the
emergence of “voluntary” audits in the pre-SEC era” seems premature
(Merino et al., 1994, p. 636).
Barton and Waymire (2004) attempt a more refined analysis of
financial reporting policy determinants for 540 NYSE-listed firms in the
year before the October 1929 market crash.7 They construct a report-
ing quality measure using factor analysis on four measures: income
statement transparency, balance sheet transparency, use of external
auditors, and conservative accounting as reflected in nominal intan-
gible asset values. They test whether financial reporting quality can
be explained by four forces: (1) equity market information costs,
(2) presence of control conflicts associated with potential agency costs,
(3) competitive disclosure costs arising from either government regula-
tion or the actions of competitors, and (4) the availability of alternative
information sources such as regulatory reports or dividend payments.
The results in Barton and Waymire (2004; pp. 89–96) are generally
as predicted. Equity market information cost and contracting/agency
variables explain financial reporting quality. In addition, information
quality is lower when alternative sources of information are avail-
able. However, some variables have significant effects opposite to the
predicted direction. In addition, variables capturing disclosure costs,
including threats of regulation, are significant when considered indi-
vidually. Importantly, their results suggest that firms facing political
threats provided lower quality reporting, which contradicts the Merino
et al. (1994) hypothesis and is more consistent with a political costs
hypothesis (Watts and Zimmerman, 1978, 1986).8
7 They exclude 170 of the 710 NYSE firms in the Center for Research on Security Prices
(CRSP) database at the start of October 1929 that have idiosyncratic industry-specific
reporting practices or missing data.
8 Economic and political forces vary in their influence on different aspects of reporting
policy. The explanatory power of the overall quality model and the components models
is modest — e.g., adjusted R2 of 0.11 for the overall model. This suggests that economic
factors generally explain less than one-fourth of the cross-sectional variation in empirical
measures of financial reporting and disclosure policies, similar to models using modern
data (e.g., Botosan (1997) and Clarkson et al. (1999)).
To summarize, research indicates that insiders profited from an

informational advantage in the pre-SEC era. However, these effects are
similar to those in the SEC era (Banerjee and Eckard, 2001) and it
does not appear that pools successfully manipulated stock markets in
the 1920s (Jiang et al., 2005). Equity market and contracting costs were
important in shaping voluntary reporting policies in the pre-SEC era,
but these factors explain little of the cross-sectional variation in report-
ing policies. Other forces such as regulation (actual and potential) may
have played a significant role in shaping US corporate financial report-
ing in pre-SEC period (Hawkins, 1963), but there is little systematic
evidence to support this claim.
5.2.4 Information Intermediation and Security Analysis

Now we examine when security analysts first appeared in US securities
markets and the economic forces that promoted their emergence. We
consider the antecedent conditions for security analysts to emerge as
well as analysts’ role in (1) compiling information on alternative invest-
ments, (2) developing analytical techniques, and (3) discovering ways
to communicate credible recommendations to investors.
A useful thought experiment is to imagine the scale and scope
of shareholdings in a world where firms and shareholders interacted
directly without aid of third parties. Firms would identify potential
shareholders themselves, sell their securities directly, and might even
maintain a secondary market for subsequent share liquidations. This
would also imply that firms would supply all ongoing information after
the initial sale and discover means for rendering shareholder commu-
nications credible in order to support the secondary market for shares
(Easterbrook and Fischel, 1984; King et al., 1990). Potential investors
would have to identify and evaluate possible investment opportunities
on their own. While small private firms operate like this, bigger private
firms and publicly traded firms rely on information intermediaries, who
through extensive division of labor reduce the operating costs of the
markets for securities and information. This thought experiment illus-
trates that without division of labor among third party intermediaries
such as investment bankers, stock exchanges, stockbrokers, external
auditors, a financial press, and security analysts, the modern publicly

traded corporation as we know it would not exist.
Since the division of labor is limited by the extent of the market
(Smith, 1776; Stigler, 1951), a large investor base that values analyt-
ical expertise is an obvious demand-side precondition for the emer-
gence of security analysts. Such an investor base emerged in the United
States during the late 19th and early 20th centuries. Huebner’s (1903,
pp. 66–69) data on railroad shareholders around 1900 indicate that,
at least for some railroads, equity ownership was widely dispersed.9
Shortly after 1900, the diffusion of equity ownership accelerated among
major United States industrial firms. Increasing numbers of preferred
and common equity shares of industrial firms were offered for sale from
the early 1890’s through 1903 (Navin and Sears, 1955). United States
shareholders more than tripled in number between 1900 and 1923 with
greater middle-class participation (Warshow, 1924). These ownership
diffusion trends were fueled by an increasing number of employee stock
ownership plans at large companies, share sales programs by some com-
panies (especially large utilities) to their customers, the new income
tax that made the stock market more attractive to those with lower
incomes, and the US government’s investor education efforts in trying
to sell bonds to finance World War I (Warshow, 1924, pp. 31–37).
Well before 1900, increasing numbers of US investors consulted
financial publications and corporate data compilations for information
about the burgeoning financial markets (Sobel, 1965, pp. 175, 176).
The most famous financial publications included Henry Varnum Poor’s
American Railroad Journal and Hunt’s Merchants’ Magazine. In 1868,
Poor began to compile information for his Manual of Railroads of the
United States.10 According to Sobel (1965, p. 175), the Poor’s Man-
ual “analyzed securities as well as providing information, and may be
9 The Pennsylvania Railroad had the most shareholders at 29,000. Three other railroads had
over 10,000 shareholders, nine had between 5,000 and 10,000 shareholders, and another
21 had between 1,000 and 5,000 shareholders. However, railroad ownership was usually
highly concentrated with a few controlling investors owning large numbers of shares. In
fact, some very large railroads were owned by just a few individuals or corporations —
e.g., the Erie Railroad had only 17 shareholders.
10 Loree (1922, pp. 188–200) provides a succinct history of each of the major sources of U.S.
railroad information.
considered the first stock market service in this country.” John Moody
followed suit in 1900 with a similar manual that compiled information
applicable to industrial securities, but provided no investment analysis
and recommendations.
Today’s investment analysis still leans heavily on financial ratios
that arose in this era. Management uses of ratios tended to focus
on operating efficiency and profitability. The mid-19th century rail-
roads developed the “operating ratio,” total operating expenses divided
by revenues, to measure railroad operating efficiency (Mundy, 1912,
pp. 31–34). In 1903, the DuPont Corporation began using the return
on capital invested as its internal measure of financial performance, and
a year later was calculating this measure on a monthly basis for each
of its 13 products (Chandler, 1977, pp. 445, 446). By World War I, the
company had disaggregated this ratio into the product of asset turnover
and profit margin, and further disaggregated these components, initi-
ating the DuPont method (Chandler, 1977, pp. 446–448; Davis, 1950,
p. 7; Horrigan, 1968, p. 286). Credit analysts focused more on balance
sheet measures of liquidity such as the current ratio, which were in
widespread use by 1900 (Horrigan, 1968, p. 285).
Investment recommendations based on financial statement analysis
began on a large scale when John Moody published Moody’s Analyses
of Railroad Investments in 1909. The initial Moody’s manual totaled
nearly 600 pages with the first third of the manual explaining the basis
for the ratings system and the extensive data (both quantitative and
qualitative) used in preparing individual ratings. Unlike current edi-
tions, early Moody’s Manuals rated preferred and common stocks as well
as bonds. Overall ratings (e.g., Aaa, Aa, and so forth) and their compo-
nents (e.g., quantified measures of safety and qualitative descriptions of
salability) were provided. Moody started with railroads because of their
market prominence and because their accounting reports were available
in standardized Interstate Commerce Commission reports and financial
press articles. Such was not the case for major industrial corporations.11
11 Sivakumar and Waymire (1993, 2003) describe evidence that far more accounting infor-
mation was available for railroads than industrials in this era. Differences in the quality
of financial disclosure between railroads and industrials of this era can be seen in the
The overwhelming success of Moody’s first railroad manual sparked

an expansion of the investment analysis market. Moody expanded his
coverage to both industrials and utilities in 1914 and added a man-
ual on government securities in 1918.12 Imitators quickly entered the
investment analysis market — Poor’s in 1916, Standard Statistics in
1922, and Fitch in 1924 (Harold, 1938, p. 13). Moody’s services were
demanded primarily by commercial banks, insurance firms, and trust
companies that managed large portfolios and were legally required to
act as fiduciaries (Harold, 1938, pp. 20–47). Legal requirements for
investment management became much more important after scandals
involving insurance companies in 1905, the New York State Armstrong
Committee investigation of 1905–1906, and the failure of trust compa-
nies in the Panic of 1907 (Moen and Tallman, 1992; North, 1954).
Several factors thus contributed to Moody’s success. One was the
demand for investment evaluation that accompanied expansion of the
financial markets and investor base in the late 19th and early 20th
century. A second was the development of ratio analysis tools that
facilitated direct comparisons of alternative investments. Finally, and
perhaps most important, the increasing availability of accounting data
provided the basic grist for the mill of financial analysis. On this last
point, Moody’s required that firms disclose at least some income data
to obtain a rating, which further encouraged the supply of corporate
accounting information (Archambault and Archambault, 2005).
Basu et al. (2004) document that both income statement and bal-
ance sheet ratios were statistically associated with early Moody’s rat-
ings after controlling for other factors such as contractual provisions.
Their sample includes bonds, preferred stocks, and common stocks of
322 firms with ratings in the Moody’s Industrial Manual for 1922 and
ratio data in Bliss (1923). Their bond results are consistent with bond
ratings models using more recent data (Foster, 1986). Pre-SEC income
statement and balance sheet numbers conveyed useful information for
evaluating debt as well as preferred and common equities. In sum,
Commercial and Financial Chronicle, which printed the full text of corporate annual
reports in some cases.
12 The industrials and utilities were split into separate Moody’s manuals in 1920 and a
Moody’s manual on investment trusts and banks was added in 1928.

the Basu et al. (2004) evidence indicates the existence of a thriving

informational infrastructure before 1930 to support securities market
development.
5.3 Using Historical Data to Study the Effects

of Accounting Regulation
The questions of why accounting regulation originates, how man-
agers respond to accounting regulation, and their implications for the
economic efficiency of financial markets have continually interested
accounting researchers. One motive investigated in this research that we
discuss in this sub-section is investor protection. Accountants partici-
pated in investor protection at least as far back as the early 18th century
South Sea “Bubble” (Parker, 1986). Cross-country research on investor
protection shows that countries with stronger protection of minority
shareholder rights, which includes enforceable reporting requirements,
have more liquid stock markets and better corporate governance (Bush-
man and Smith, 2001; La Porta et al., 2000).
A positive cross-country association between financial reporting
quality and investor protection could occur if: (1) policymakers write
new reporting rules that make information markets more efficient,
(2) policymakers write new rules that codify existing efficient practices
that emerged as market arrangements evolved, or (3) more advanced,
wealthier market economies flourish even if policymakers write rules
that redistribute wealth to promote their political ambitions (Peltz-
man, 1976; Stigler, 1971). In any of these three cases, accounting regu-
lation and the economic efficiency of the information market would be
positively associated. Inferring causality from mere correlation is dan-
gerous without direct historical evidence on the origins of regulatory
mandates and their economic effects (Barton and Waymire, 2004). In
this sub-section, we discuss research on the role of accounting regula-
tion in securities market development.
5.3.1 Early Anglo-American Securities Regulation

and Investor Protection Laws
British investor protection laws and securities regulation have their
genesis in the Bubble Act of 1720. This law was intended to allow
5.3 Using Historical Data to Study the Effects of Accounting Regulation 73
only organizations chartered by Parliament to use the corporate form,

limit speculation in transferable securities, and restrict corporations
to lines of business specified in their original charter (Littleton, 1933,
p. 248; Watzlaff 1971). This law was not a response to the bursting of a
speculative bubble in South Sea Company shares in 1720; the Bubble
Act was conceived and enacted prior to this event (Watzlaff, 1971,
pp. 8–15).13 The Bubble Act was most likely a classic case of special
interest group legislation seeking to benefit the South Sea Company
itself, which was trying to take over England’s national debt (Harris,
1994).
The ultimate effects of the Bubble Act are controversial, but it is
clear that it severely restricted formal incorporations and protected
the British government’s power to confer special monopoly privileges.
It was ultimately repealed in 1825, most plausibly because of strong pri-
vate interests favoring repeal (Harris, 1997). The history of the Bubble
Act’s passage and repeal illustrates the fundamental tension that lies at
the heart of all “investor protection” regulation: while such laws could
in principle benefit investors, their actual effect is often mixed or even
opposite to legislators’ stated intent. Unintended effects occur because
regulatory power attracts rent-seeking constituencies who opportunisti-
cally capture large private benefits even if this imposes high social costs
(North, 2005; Stigler, 1971), although there are many other potential
reasons (Merton, 1936).
English bankruptcy laws started in 1542 and were rarely revised
until a series of repeated revisions in 1825, 1831, 1833, 1842, 1849,
1861, and 1869 followed economic depressions with high business fail-
ure rates (Littleton, 1933, pp. 271–282). Data documenting this regu-
larity (Littleton, 1933, p. 274) are reproduced in panel A of Table 5.1.
The first column labels depression years in bold font and the next two
columns show the number of bankruptcies each year. The fourth and
fifth columns list the year in which a new statute is enacted and briefly
describes its new provisions. These data show that the series of law
revisions followed economic crises and granted increasing control to
creditors in bankruptcy proceedings. As a by-product, these laws also
13 Thislong-held view is a prime example of what Stigler (1988) refers to a widely accepted
“fact” that is incorrect (Harris, 1994, p. 610).
Table 5.1 Historical summaries of 19th century UK bankruptcy statutes, shareholder pro-
tection laws, and the number of practicing accountants.
Year(s)
# New law
Year Bankruptcy # passed
(Crisis commissions Bankruptcy after
in Bold) sealed petitions crisis Description of law(s)
Panel A: Chronological presentation of major 19th century UK bankruptcy laws in rela-
tion to the number of bankruptcies two years before & two years after law enacted
1815 NA 1825 Lord Chancellor to appoint

1816 NA commissioners to direct
1817 2,311 proceedings. Assignees appointed
1818 1,248 by commissioners to dispose of
property and keep accounts with
auditing done by commissioners.
1823 1,250 1831 & 1831 law created court of
1824 1,244 1833 bankruptcy and official assignees
1825 1,475 consisting of “merchants, bankers,
1826 3,307 accountants, or traders.” One
1827 1,688 official assignee (responsible for
disposing of assets) for each case
along with one appointed by
creditors. Modest changes were
enacted in the 1833 law.
1834 1,013 1842 Law extended to jurisdictions
1835 959 outside London with increase in
1836 890 number of official assignees.
1837 1,462
1838 956
1845 1,028 1849 Consolidation of prior laws into one
1846 1,326 statute. Accounting records are to
1847 1,373 be delivered to official assignee &
1848 1,907 financial statements are to be
1849 1,298 reported to the official assignee
and the court. Promoted use of an
accountant to verify the financial
statements.
1855 NA 1861 Creditors granted greater power and
1856 NA the law specified a form for
1857 NA statement of accounts to be used.
1858 NA
1859 2,765
1864 7,224 1869 Creditor power in bankruptcy
1865 8,305 extended to allow expedited
1866 8,126 settlement of claims.
1867 8,994
1868 9,195
(Continued)

Panel B: Timing and description of 19th century British companies acts
1825
The Bubble Act of 1720 is repealed.
1837 Chartered Companies Act
The Crown was granted the right to confer corporate-like features by letters patent for
unincorporated business associations without a corporate charter. Qualifying
businesses could obtain limited liability for owners as well.
1844 Joint Stock Companies Act
Established means for obtaining corporate charter without a Royal act or an act of
Parliament. Required registration of shareholders and provision of an audited “full and
fair” balance sheet. This law did not require provision of an income statement and it
did not specify the form of the balance sheet.
1844 Joint Stock Banking Act
This law dealt with the incorporation and regulation of banks. The law mandated
provision of annual balance sheet and income information to shareholders as well as
required that the accounts be audited. A series of laws throughout the 19th century
extended mandatory reporting and auditing to other public service entities like
railroads and insurance companies.
1845 Companies Clauses Act
Provided more detail on the keeping of accounts and required that auditors hold at least
one share of stock. This law also required the presentation of a half-year’s income and
an income account since the last dividend before an action to declare dividends.
1855 Limited Liability Act
Permitted corporations to register with limited liability. Section 14 required at least one
of the auditors to be approved by the Board of Trade, but did not prescribe any
qualifications.
1856 Joint Stock Companies Act
This law abandoned accounting and auditing requirements enacted in the 1844, 1845 and
1855 laws. Instead, the law contained “model” articles of incorporation. These model
articles also included accounting and auditing clauses far more ambitious and detailed
than the legal requirements of the 1844 and 1845 laws.
1857 Punishment of Frauds Act
Made it a criminal offense for directors, officers, or managers to falsify or tamper with the
books of account for fraudulent purposes.
1862 Companies Act
Retained provision of model balance sheet and income statement with auditing, and that
dividends be paid only from profits. Non-shareholder auditors were now allowed. The
Companies Act underwent further revision in 1879 and 1900, at which point it had
assumed its modern form.
Panel C: Number of accountants listed in city of London occupational directory (by Year)
Year # Accountants Listed
1799 11
1811 24
1820 44
1840 107
1845 210
1860 310
1870 464
significantly increased demand for accountants’ services in resolving

competing claims in bankruptcy.
During the same period, the British Parliament enacted sev-
eral shareholder protection laws (i.e., the Companies Acts) that also
increased the demand for accounting services. We summarize this leg-
islative history in panel B of Table 5.1 (from Edey and Panitpakdi
(1956)). The Bubble Act was repealed in 1825 and restrictions on cor-
porate charters and use of limited shareholder liability were relaxed
beginning with the Chartered Companies Act of 1837. The Joint Stock
Companies Act of 1844 further extended use of the corporate form
and mandated disclosure of an audited “full and fair” balance sheet
as well as providing for the appointment by shareholders of “One or
more Auditors of the Accounts of the Company” annually at a general
meeting. Also in 1844, the Joint Stock Banking Act mandated that
banks disclose an annual balance sheet and income to shareholders.
Statutory accounting and auditing requirements were mandated specif-
ically for railroads and insurance companies in a series of 19th century
laws (Pollins, 1956). The Companies Clauses Act of 1845 introduced
the concepts of auditor independence — by requiring that auditors be
shareholders but have no other interest in the company (e.g., not be
directors or officers of the company) — and auditor competence —
by authorizing the elected auditors to hire professional accountants if
they desired, and charge the expense to the company. The 1845 Act also
required that the company tally and report income before declaring a
dividend.
The 1856 Joint Stock Companies Act represented a major change
in these laws. Far more ambitious “Model” articles of incorporation
and forms of accounting and auditing replaced the 1844 and 1845 reg-
ulatory mandates, although companies could opt out of any default
provisions including mandatory audits via shareholder special resolu-
tions.14 The 1856 Act held that “Auditors need not be Shareholders in
14 Edey and Panitpakdi (1956, pp. 362–367) reproduce these provisions of the 1856 law
and discuss how they differed from prior reporting mandates. Many features of the model
financial statements provided in Table B of the 1856 Act survive in practice today, includ-
ing the reporting of three balance sheets and two income statements as well as the footnote
disclosure of contingent liabilities. The 1856 Act required the auditor to attest that the
Balance Sheet is “full and fair” and exhibits a “true and correct View of the State of the
the Company” (Hein, 1963, p. 509), which led to the rise of the major
accounting firms like Price Waterhouse (Watts and Zimmerman, 1983,
pp. 628, 629), and empowered auditors to “examine” directors and
officers. The Act also introduced minority investor protection by giv-
ing one-fifth of the shareholders, by number and value, the right to
request the government Board of Trade to appoint inspectors to exam-
ine the company’s affairs (O’Connor, 2004, p. 761). The Punishment
of Frauds Act of 1857 criminalized fraud through falsification of or
tampering with books of account. The 1862 Companies Act added an
annual audit to the default provisions and introduced the concept of
an “audit committee” nominated by shareholders but which excluded
directors or officers (O’Connor, 2004, pp. 763, 764). The Companies Act
underwent many minor revisions thereafter until the 1900 Companies
Act mandated many of the “optional” default regulations of prior acts
including reinstating the requirement that an annual audited balance
sheet be disclosed (O’Connor, 2004, p. 764). The 1907 Companies Acts
required companies to submit annual reports to the Registry Office,
which had to include audited balance sheets (O’Connor, 2004, p. 767).
The data in panels A and B of Table 5.1 establishes a relation
between macroeconomic performance and accounting and auditing reg-
ulation that had consequences on the market for audits and financial
information. It also had a major effect on the supply of accounting
services. Panel C of Table 5.1 reproduces data on the number of accoun-
tants listed in London from 1799 and 1870 (Littleton, 1933). Of partic-
ular note is the more than tenfold increase in the number of practicing
accountants in London between 1820 and 1870.
The limited data from Littleton (1933) shown in Table 5.1 cannot
speak to the broader economic consequences of creditor and investor
legislation, but it does suggest that pure “public interest” explana-
tions are likely incomplete. Public interest theories of regulation have
been empirically tested on the first US state laws regulating security
Company’s Affairs.” The 1856 Act also strengthened the auditor independence provision
of the 1845 Act by requiring that (emphasis added) “No Person is eligible as an Auditor
who is interested otherwise than as a Shareholder in any Transaction of the Company;
and no Director or other Officer of the Company is eligible during his Continuance in
Office” (Hein, 1963, p. 509; O’Connor, 2004, p. 761).
sales — i.e., the “Blue Sky” laws.15 The first Blue Sky law was adopted
by Kansas in 1911, and 47 of the 48 states had adopted such laws by
1931. These laws fall into three categories (Mahoney, 2003): (1) merit
review statutes where an appointed official was granted broad discre-
tion in approving all securities sold in the state, (2) ex ante fraud laws
where security sales required state pre-approval but the official had far
less discretion than under a merit review statute, and (3) ex post fraud
statutes that required no government pre-clearance but included anti-
fraud provisions. Kansas enacted a merit review law that was imitated
by eleven states in either 1912 or 1913 (no states enacted such laws after
1913). Twenty-five states enacted ex ante fraud laws between 1913 and
1923, while ten states passed ex post fraud statutes between 1912 and
1931 (Mahoney, 2003, Table 3.1).
Mahoney (2003) treats the Blue Sky laws as a naturally occurring
experiment that allows him to investigate two research questions. First,
why did some firms adopt Blue Sky laws early while others waited?
Second, why did different states adopt different types of Blue Sky laws?
Three hypotheses have been advanced to explain interstate differ-
ences in the timing and type of Blue Sky law adoption. The public
interest hypothesis says that these laws were a response to investor
fraud (Seligman, 1983, pp. 18–33). A second public choice hypothesis
implies that self-interested constituent groups lobbied state regulators
to adopt such laws because their private interests would be favored
(Macey and Miller, 1991). Under the public choice hypothesis, small
local banks actively sought to curtail competition from major corpo-
rations with publicly traded securities and the large investment and
commercial banks that sold these securities. A third political ideology
hypothesis suggests that states with Populist or Progressive movements
would be more likely to adopt certain types of legislation.16 In other
words, Blue Sky laws would be just one component of a broader leg-
islative agenda within such states.
15 Such a law was “popularly known as a ‘blue sky’ law, since it was intended to check stock
swindlers so barefaced they ‘would sell building lots in the blue sky’” (Seligman, 2002,
p. 44).
16 For historical research on the Populist and Progressive movements, see Hofstadter (1955),
Wiebe (1966), Kolko (1963), and Sklar (1988).

Mahoney’s first set of tests examines why some states adopted Blue
Sky laws earlier than others. These tests find no positive association
between fraud incidences and when Blue Sky laws were adopted; indeed,
states with more frauds adopted Blue Sky laws later, which is incon-
sistent with the public interest hypothesis. The best predictor of when
a state passed a Blue Sky law is the extent of its Progressive political
influence. States with a greater securities industry presence tended to
write such laws later. Thus, the results from timing tests are more con-
sistent with the political ideology and public choice hypotheses than
the public interest hypothesis.
Mahoney (2003) examines why states adopted different types of
Blue Sky laws in a second set of tests. These tests indicate that the
public choice hypothesis best explains between-state differences in the
nature of Blue Sky law adopted; states with a large number of small
banks preferred merit review statutes whereas states with greater secu-
rities industry presence did not prefer such laws. Again, there is no evi-
dence that the incidence of fraud is positively associated with the type
of statute enacted, suggesting that either the public choice hypothesis
is invalid or that the fraud incidence measure is noisy.
5.3.2 Early US Attempts to Regulate Railroad Financial

Reporting
The first enforceable federal accounting and disclosure regulations in
US history were those applied to early 20th century railroads (Adams,
1908a; Miranti, 1989). These federal laws followed decades older state
regulations. State railroad commissions, first established in New Eng-
land, regulated railroad rates passively (McCraw, 1984, pp. 17–40).
More aggressive rate regulation supported by agricultural interests
emerged in the Granger states like Illinois, Iowa, and Minnesota around
1870 and state regulation subsequently expanded to the Southern and
Western US (Buck, 1913, pp. 123–237).
State railroad regulation was curtailed in 1886 when the Supreme
Court ruled in Wabash Railway Co. v. Illinois (118 US 557) that state
commissions had no authority to regulate interstate traffic. Congress
then passed the 1887 Act to Regulate Interstate Commerce establishing
federal regulation through the Interstate Commerce Commission (ICC)

(Miranti, 1989, pp. 471–475). The ICC faced legal challenges that ulti-
mately negated its power to regulate railroad rates and accounting poli-
cies in a series of 1890’s decisions by the US Supreme Court (Scharfman,
1931, pp. 25–32; Hoogenboom and Hoogenboom 1976, pp. 21–37).
Congress responded by passing the Hepburn Act of 1906, which
affirmed ICC authority to regulate railroad rates and set uniform
accounting and disclosure rules (Adams, 1908a,b; Dixon, 1906). The
law prohibited railroads from maintaining separate sets of books with-
out explicit ICC approval; the ICC was authorized to inspect railroad
accounting records as needed; and railroad officers could be fined and
imprisoned for noncompliance. The ICC used its power under the Hep-
burn Act to mandate depreciation accruals for equipment, institute
new rules to define specific costs that should be capitalized as asset
betterments, and strengthened interim reporting requirements (ICC,
1907, pp. 140, 141; Young, 1914; Saliers, 1915, pp. 74–77).
Sivakumar and Waymire (2003) test two hypotheses regarding
changes in railroad income measurement practices associated with the
ICC’s new reporting rules in 1907–1908. They first test if the ICC reg-
ulations succeeded in reducing income smoothing by railroads. They
also examine if railroads exploited their flexibility in implementing the
new ICC accounting rules to offset more hostile rate regulation by mea-
suring income more conservatively.
Sivakumar and Waymire (2003) examine 43 major US railroads
during 1903–1912. They compare railroad income measurement in two
sub-periods: 1903–1906 (“Pre-Hepburn” period) and 1909–1912 (“Post-
Hepburn” period). Their results indicate that railroad income was only
weakly less smooth after ICC rules for depreciation were implemented.
More regulated firms had smaller decreases in income smoothing and
increased conservative income reporting. These results are consistent
with firms that face greater wealth expropriation trying to mitigate
these costs by continuing to smooth income and also measure income
more conservatively.
The Sivakumar and Waymire (2003) paper speaks to impor-
tant issues. The first is that regulators and managers often adjust
accounting policies in response to the same exogenous influences, but
in fundamentally different ways (Ball, 1980). In this case, Congress

and the ICC were responding to political pressure for redistributive
rate regulation based on accounting numbers while managers were
likely adjusting income measurement to counteract potential redistribu-
tive regulation through more conservative income measurement. In the
terminology of Watts and Zimmerman (1990), Congress changed the
accepted set of GAAP, and in response, firms changed their choices
within the accepted set. The close coupling of direct rate regulation
with accounting mandates may thus be an inhibiting factor in securing
compliance with mandated accounting rules (Basu, 2003).
Second, the US railroad experience illustrates how earnings “man-
agement” is often more complex than appears initially (Dechow
and Skinner, 2000). Railroads developed the replacement method of
accounting for fixed assets in part because of the political environ-
ment in which they operated. This method capitalized assets when the
initial expenditure was made, and then when the asset was replaced
subsequently, the new costs were expensed (Boockholdt, 1978). Because
capital investments were largely financed from operating cash flow, this
meant prudent operating decisions ended up smoothing income — i.e.,
expenses increased in years when revenues increased, and vice versa.
Thus, railroad income “manipulation” was set in motion by account-
ing policies that had been introduced decades earlier. The replace-
ment method was not abolished until 1983 (Heier and Gurley, 2007),
many decades after the ICC’s original attempt. This history suggests
that mandatorily eliminating longstanding accounting practices is likely
much harder than expected (Basu, 2003).
Third, the setting examined by Sivakumar and Waymire (2003)
illustrates the ubiquitous trade-off involved in empowering a regula-
tory mechanism. Regulation can promote efficiency by setting rules for
economic interaction that promote economic innovation and competi-
tion (North, 2005; North et al., 2006). At the same time, regulation
invokes the power to expropriate and redistribute wealth, which can
encourage rent seeking by third parties and responses from regulatory
targets that take actions to protect wealth from expropriation. As a
result, the case of ICC accounting regulation illustrates how underly-
ing forces unleashed by regulation can produce unanticipated outcomes
that run counter to stated regulatory objectives. Furthermore, other

unanticipated reactions by both the regulated and the parties that
interact with them makes it very difficult to identify let alone assess
the welfare consequences of regulatory interventions, even though such
assessments would likely be essential to evaluating the desirability of
the regulation.
5.3.3 The Impact of the SEC and US Accounting

Standard-Setters
Federal attempts to regulate reporting by US industrial corporations
started shortly before 1900. Congress established an Industrial Com-
mission in 1898 to investigate problems related to large industrial com-
binations (i.e., “trusts”). This body recommended increased publicity
of corporate accounts to encourage competition in product markets that
had been monopolized by the trusts (Jenks, 1907, pp. 261–266). Further
calls for federal regulation of corporate reporting followed investigation
of the “money trust” by Congress’s Pujo Committee in 1912 (Carosso,
1970, pp. 137–155). Both the Industrial Commission and Pujo Com-
mittee investigations had supporters and detractors, and their ultimate
long-run effect is complicated (Previts and Merino, 1998). At the same
time, it is clear that the political forces that led to establishment of the
Securities and Exchange Commission were similar to those at play in
the Industrial Commission, the Pujo Committee, and the various state
Blue Sky laws.
Federal oversight of securities offerings was established in the
Securities Act of 1933. The 1933 Act required registration of new secu-
rities and filing of a detailed prospectus with financial information.
This law was extended to secondary securities transactions on national
exchanges in the Securities Exchange Act of 1934, which also estab-
lished the SEC to monitor and enforce compliance with the 1933 and
1934 laws. Most important for present purposes, the 1934 Act estab-
lished annual reporting mandates along with audit requirements and
granted accounting standard-setting authority to the SEC. These laws
have been described as “disclosure statutes” although they contain
restrictions on insider trading and market manipulation as well as a
series of anti-fraud provisions with both civil and criminal penalties

(Loss and Seligman, 2000).17
The evidence on the effects of the 1933 Act is mixed. Stigler (1964)
compares common stock returns in the 1923–1928 and 1949–1955 peri-
ods and concludes that securities regulation did not add value. However,
his conclusions have proven premature because his work predated major
advances in financial economics over the next two decades. For instance,
Friend and Herman (1964) assert that Stigler’s evidence supported the
hypothesis that the Securities Act lowered the risk of securities offered
for sale, which has been confirmed in subsequent research.
Jarrell (1981) examines the mean and variance of stock returns for
new issues offered between 1926 and 1939. His results indicate lower
mean abnormal stock returns and volatility in the post-Securities Act
period, but these could result from either lower information risk or
different investment opportunities being brought to market. Jarrell also
documents decrease in bond default risks using a longer time series.
Finally, he finds that debt financing became more frequent after the
Securities Act, and that a much higher share of this debt was privately
placed.
In commenting on Jarrell’s paper, Smith (1981) suggests future
research areas that could help identify the benefits of securities regula-
tion. These include expanded tests on experience in the 1960’s when the
new issues market for common stock was characterized by high rates of
activity (more on this below) as well as more analysis of how regulation
altered the performance and risk of securities offered for sale.
Simon’s (1989) analysis focuses on this latter point. Her findings
indicate that unseasoned new issues traded on non-NYSE exchanges
had superior performance after the Securities Act. Simon also
documents a robust effect that the investment risk of new offerings
was lower after the Securities Act. While this effect was stronger for
17 The regulatory scheme in the United States was no doubt strongly influenced by British
securities legislation enacted in the 19th century (see Section 5.1). There are differences in
the objectives of the British and American systems and accounting practice in Britain is
frequently described as principles-based while US practice is labeled as more rules-based.
Differences between the systems are discussed and debated in Bush (2005) and Benston
(2008) (see also Benston (1976)).
non-NYSE issues, it was present for all issues regardless of where the
issue subsequently traded.
Other studies have examined the effects of recurring disclosure
under the 1934 Act. Benston (1973) compared changes in stock return
volatility around 1934 for two sets of NYSE firms: (1) “Disclosers” (i.e.,
those disclosing annual sales prior to 1934), and (2) “Non-disclosers”
(those not disclosing annual sales prior to 1934). Benston (1973) found
no significant differences in return volatility changes between these
firms. This evidence, combined with his review of other academic stud-
ies, court cases, and pre-SEC disclosures, led him to conclude that “the
disclosure requirements of the Securities Exchange Act of 1934 had
no measurable positive effect on the securities traded on the NYSE”
(Benston, 1973, p. 153).
As with Stigler’s (1964) paper, proponents of SEC disclosure
mandates have criticized Benston’s study (e.g., Seligman (1983)).
Not surprisingly, subsequent studies suggest that the SEC’s disclo-
sure mandates may have had more complex effects. Greenstone et al.
(2006) document that market values of over-the-counter (OTC) firms
increased when the SEC mandated new disclosures for them in 1964.
Distinctively, the paper identifies firms that had not previously dis-
closed information meeting the new SEC requirements and shows
that they experienced large stock price increases when they complied.
OTC firms also had a dramatic reduction in stock return volatility
around the SEC’s mandatory disclosure requirements in 1964 (Ferrell,
2007).
Bushee and Leuz (2005) examine the 1999 extension of SEC dis-
closure rules to firms traded on the Over-the-Counter Bulletin Board
(OTCBB). This SEC regulation led over 2,000 noncompliant firms to
leave the OTCBB, reducing their market values. Already compliant
firms experienced increased returns and liquidity when the new SEC
rules were announced. Interestingly, previously noncompliant firms that
improved disclosure to remain on OTCBB experienced increased liq-
uidity but negative stock returns. The Bushee and Leuz results are
provocative because they suggest that while mandating disclosure
improves a market’s liquidity, it also reduces shareholder wealth for
many firms, especially those driven out of the market.
The SEC has materially influenced the development of reporting

and disclosure through informal reviews of filed financial statements,
direct disclosure mandates, and monitoring of the private sector bod-
ies to which they delegated standard-setting responsibility in the late
1930s. The SEC staunchly supported historical cost accounting (Zeff,
2007) largely due to one initial SEC commissioner, Robert Healy, who
was exceptionally averse to asset write-ups (Walker, 1992).
During the 1920s, many firms wrote up assets, typically as “dirty
surplus” items that bypassed net income. Dillon (1979) tracked a sam-
ple of 100 NYSE firms from 1926–1934. He found numerous asset write-
ups during 1926–1929 but none of them increased income. Dillon (1979)
also documented a greater tendency to write down assets during
1930–1934, but some of these reduced income. The SEC essentially
eliminated asset write-ups in the United States by the mid-1940s
through its review of financial statement filings (Walker, 1992; Zeff,
2007).
It is uncertain whether specific SEC disclosure requirements (e.g.,
interim income reporting mandates) make accounting numbers more
informative for securities prices. Butler et al. (2007) examine how much
SEC interim reporting mandates sped up the incorporation of annual
income numbers in common stock prices. Interestingly, they examine
the effects of both voluntary and mandatory increases in interim report-
ing frequency on income timeliness during the period 1950–1973. They
study two timeliness measures: intraperiod timeliness or how quickly
during a given year earnings information is reflected in price, and long-
horizon timeliness or how much current earnings is associated with
current stock returns as in Basu (1997).
Butler et al. (2007) find that increased interim disclosure frequency
is not associated with improved timeliness except in the earliest part
of their sample period (1951–1955). More refined tests compared only
firms that permanently increased interim reporting frequency: 98 vol-
untarily increasing firms and 82 firms that increased interim disclo-
sure due to the SEC mandate. The results indicate that intraperiod
timeliness improved only for voluntary increasers. Long-horizon timeli-
ness seems unaffected by increased interim reporting frequency. In sum,
this paper finds no evidence that SEC disclosure mandates for interim
reporting have strengthened the relation between securities prices and

accounting earnings.
Academic accountants are likely most interested in the effect of regu-
lated accounting standards. The SEC delegated this function to private
sector bodies in April 1938’s Accounting Series Release #4 (Cooper
and Robinson, 1987). These bodies, the Committee on Accounting
Procedure (CAP: 1939–1959), the Accounting Principles Board (APB:
1959–1973), and the Financial Accounting Standards Board (FASB:
1973-Present), have collectively written hundreds of accounting rules
that have influenced the developmental path of modern US accounting.
Accounting “standards” actually predate the establishment of the
SEC and formal standard setting bodies. Before 1930, these took
the form of reporting norms (Sunder, 2005). These were typically
established through less formal means to provide guidance as to “best
practices” rather than binding rules and mandates. The American Insti-
tute of Accountants (AIA) (forerunner of the AICPA) issued “special
bulletins” in the 1920s that summarized extant practice and provided
guidance to practitioners; a similar function was fulfilled by the Journal
of Accountancy’s Student’s Department as well as the numerous articles
in that publication (Moonitz, 1970).18 The AIA, working in conjunc-
tion with the New York Stock Exchange, developed a set of five basic
accounting principles in the early 1930s (Carey, 1969, p. 176), and six
basic accounting principles were approved by the AIA membership in
1934 (Zeff, 1984, pp. 450–452). In 1935, the AIA reorganized an existing
committee to form the CAP and empowered it to develop accounting
policy pronouncements (see Zeff (1984, pp. 453–458)). The CAP was
formally authorized to recommend accounting standards on behalf of
the AIA in 1939 (Zeff, 2003).
The CAP, APB, and FASB differed in their approaches to setting
standards. The CAP largely wrote standards that codified existing
practice or addressed specific problems arising in practice, and their
standards were not binding or based on an overarching conceptual view
18 In1917, the AIA worked with the Federal Trade Commission to develop a set of account-
ing and auditing guidelines that was published by the Federal Reserve Board (1917), but
firms were not required to follow these guidelines (see Moonitz (1970)). A revision was
published in 1929.
of accounting. Before 1939, two routes to improving accounting prac-

tice through standard setting were debated (see AIA (1934, p. 7)).
The first does not alter existing practice, but provides information
on alternative methods employed in practice and requires disclosure
of the methods used by a firm. Since evolution usually results in
good outcomes, codification of “best practices” is often good policy-
making (Keynes, 1913). The CAP’s approach to standard setting was
similar in intent and thus represents a continuation of pre-1930 prac-
tice in many ways (Zeff, 1984, pp. 453–458). The second approach to
standards was one where the standard setter selects a single method
(or fewer methods) to be used by all companies. The APB moved
closer to the uniformity approach and the FASB has extended it even
further.
The standard setting process was reorganized in the late 1950s and
again in the early 1970s. Both reorganizations were seen as attempts
to address three problems with the standard setting process as pur-
sued by the CAP (Zeff, 1984, pp. 458–462). First, the CAP did not
adopt accounting principles that could enhance comparability by reduc-
ing diversity in accounting practice. Second, they did not develop a
broad theoretical framework to direct the selection among alternative
accounting methods. Third, the CAP failed to win corporate support
for their pronouncements while maintaining independence.
The APB adopted a more normative approach to standard setting
than the CAP and succeeded in reducing the diversity of practice in
some areas. This was accomplished, in part, by making it more difficult
for firms to use methods of accounting other than those sanctioned by
the standard-setter. In the mid-1960s, the AICPA began requiring that
auditors disclose departures from APB Opinions in their reports or
in the footnotes to the financial statements (Davidson and Anderson,
1987, p. 118). However, the APB was ultimately seen as an organi-
zation that had failed to successfully implement a conceptual frame-
work (Davidson and Anderson, 1987, p. 117). Also, delays in writing
accounting rules for business combinations (APB Opinions 16 and 17)
combined with intense pressure from industry groups led some to ques-
tion whether the APB could remain independent of political influence
while reaching consensus on new standards (e.g., Horngren (1973)).
The FASB’s creation was guided by the work of two AICPA

committees: the Trueblood Committee that examined the conceptual
underpinnings of accounting and the Wheat Committee that con-
sidered the organization of the standard-setting process. The FASB
built on the final report of the Trueblood Committee (AICPA Study
Group, 1973) by adopting a user primacy objective for standards in
its Conceptual Framework (FASB, 1978). FASB was legitimized and
empowered in 1973 when the SEC required compliance with FASB
standards in SEC filings (SEC, 1973). The Wheat Committee’s report
led to the FASB being established independently of the AICPA (both
the CAP and APB had been AICPA committees), its fewer members
represented a broader set of constituencies and these members serve
full-time.
Two studies examine how the relation between accounting earnings
and stock prices have changed during the decades that formal standard
setting bodies have existed. The first is a paper by Ely and Waymire
(1999a) that examines the association between income numbers and
annual stock returns. This paper is relevant given that the standard
setting process has evolved to one focused primarily on investor use-
fulness, and earnings measurement emerged as the primary focus for
capital markets, accounting theorists, and standard setters during the
20th century (AIA, 1934; Buckmaster and Jones, 1997; Hawkins, 1963;
FASB, 1978; Paton and Littleton, 1940). A second paper by Holthausen
and Watts (2001) provides evidence on changes in income conservatism
over the time that formal standard setting has been in place. Account-
ing conservatism is among the oldest of basic accounting principles
and remains important in present day accounting measurement (Basu,
1997; Sterling, 1967).
Ely and Waymire (1999a) select a random sample of 100 NYSE-
listed firms for each of the 67 years between 1927 and 1993 to examine
longitudinal changes in how strongly annual income numbers corre-
late with annual common stock returns. The correlation test is based
on the longstanding view that accounting numbers are critical inputs
for estimating the underlying “intrinsic value” of a security (Graham
and Dodd, 1934; Penman, 1992; Palepu and Healy, 2007). Presumably,
accounting numbers that correlate more strongly with how the market
prices firms’ securities are more useful in this regard (Ball and Brown,
1968).
Ely and Waymire (1999a) estimate the following cross-sectional
model for each of their 67 annual samples:
ri = γ0 + γ1 ∆Ei + γ2 Ei + εi , (5.1)
where ri is the 16-month market-adjusted stock return for firm i mea-

sured from the first month of the fiscal year through the end of the
fourth month after the fiscal year end, ∆Ei (Ei ) equals the change in
(level of) annual earnings for firm i scaled by the beginning of period
market value, and εi is a residual. Their primary measure of earnings
usefulness is the explanatory power (adjusted R2 ) of this model (Lev,
1989). Other concurrent studies that examined the relevance of income
numbers also employed this measure, imperfect as it may be (Collins
et al., 1997; Francis and Schipper, 1999; Lev and Zarowin, 1999).
Table 5.2 briefly summarizes some of the primary measures of
earnings relevance from the 67 annual samples examined by Ely and
Waymire (1999a) study. The first line shows the median adjusted R2
from annual estimates of Equation (5.1). These numbers indicate that
earnings relevance as measured by the adjusted R2 has not been increas-
ing monotonically through time. Indeed the median is highest in the
CAP period and the other three periods do not materially differ.
Table 5.2 Summary of estimation results for yearly models (ri = γ0 + γ1 ∆Ei + γ2 Ei + ε∗i )
of the earnings-return relation across different accounting standard setting regimes for yearly
NYSE samples, 1927–1993 from Ely and Waymire (1999a).
Pre-CAP CAP APB FASB
(1927–1938) (1939–1959) (1960–1973) (1974–1993)
Median of annual 15.7% 23.1% 13.3% 13.9%
adjusted R2
Median of annual sum 0.81 1.25 2.37 0.86
of coefficients
(γ1 + γ2 )
Median of annual % of 22.3% 8.0% 7.0% 14.6%
losses
∗ r equals the 16-month market adjusted return on security i, ∆E equals the change in
i i
annual earnings scaled by beginning of period price for security i, and Ei equals the level
of annual earnings scaled by beginning of period price for security i. The regression model
is estimated using cross-sectional data for yearly samples of NYSE common stocks for each
of the 67 years between 1927 and 1993, inclusive.
The evidence for the pre-CAP period is interesting in that it shows

a positive earnings-return relation even before formal standard set-
ting. A similar non-monotonic pattern emerges when using the sum of
the coefficients as the measure of earnings relevance (the median for
the APB period is highest in this case). The non-monotonic pattern of
the median adjusted R2 measures across time is not altered fundamen-
tally by the exclusion of losses from the annual sample, the frequency
of which is especially pronounced in the pre-CAP era.19
Holthausen and Watts (2001) review the literature on value rele-
vance studies. As part of their review, they use the 67 annual samples
collected by Ely and Waymire (1999a) to obtain yearly estimates of
accounting conservatism from the Basu (1997) asymmetric timeliness
model:
Ei = α0 + α1 Di + β0 Ri + β1 Ri Di + ei . (5.2)
Ei equals annual earnings available to common shareholders scaled by

beginning market value of common equity, Ri is the firm’s common
stock return, Di equals one if Ri is negative, and ei is a residual. Based
on Basu (1997), earnings are asymmetrically timely (i.e., conservative)
when they respond more strongly to negative news. Thus, conservatism
implies that β1 will be positive.
Table 5.3 summarizes some of the findings reported in Holthausen
and Watts (2001, Table 2, pp. 44–46). Because Holthausen and Watts
also examine the influence of shareholder class-action lawsuits, their
partition of time periods differs from that in Ely and Waymire (1999a).
The first two columns show the time periods used in Holthausen and
Watts (2001, Table 5.2) and their description of the time period.
The third column shows the mean Basu asymmetric timeliness coef-
ficient (β1 ) for the time period. The fourth column shows the mean of
the annual median market-to-book ratio for the periods examined by
Holthausen and Watts (2001). The market-to-book ratio is a common
measure of accounting conservatism (Givoly and Hayn, 2000) and we
19 TheGreat Depression causes the higher loss frequency. For instance, the percentage of
firms with negative net income in the 1931, 1932, and 1933 samples equals 39%, 63.6%,
and 47.5% respectively.
Table 5.3 Summary of estimation results for yearly models (Ei = α0 + α1 ∆Di + β0 Ri +
β1 Ri Di + e∗i ) of Basu (1997) asymmetric timeliness regression model reported in
Holthausen and Watts (2001, Table 2).
Mean Basu Mean of annual
Reporting regime as described timeliness median market
Period by Holthausen and Watts measure (β1 ) to book ratio
1927–1941 Prestandard-setting, low 0.09∗∗ 0.77
litigation
1942–1946 Price controls, standard-setting, −0.32 1.03
low litigation
1947–1950 Standard-setting, low litigation 0.01 0.90
1951–1953 Price controls, standard-setting, 0.07 0.93
low litigation
1954–1966 Standard-setting, low litigation 0.06∗∗ 1.31
1967–1975 Standard-setting, high litigation 0.05∗∗ 1.30
1976–1982 Standard-setting, litigation 0.16∗∗ 1.01
1983–1993 Standard-setting, high litigation 0.43∗∗ 1.67
∗ E equals the 16-month market adjusted return on security i, ∆D equals the level of
i i
annual earnings scaled by beginning of period price for security i, Di equals one if Ri is
negative, and ei is a residual. The regression model is estimated using cross-sectional data
for yearly samples of 100 NYSE common stocks for each of the 67 years between 1927 and
1993, inclusive. Ely and Waymire (1999a) collected the regression data originally.
∗∗ Significantly different from zero at .05 level or better with one-tailed test.
have computed annual median market-to-book ratios from the Ely and
Waymire (1999a) samples in constructing this column.
Two aspects of these findings are relevant for present purposes. The
first is that significant conservatism is present for the earliest period
they examine (1927–1941). This is consistent with the hypothesis that
accounting practice reflected longstanding principles even before the
advent of modern standard setting. The second is the presence of con-
servatism in all periods after 1954. This is also evident in the levels of
market-to-book ratios, which reach their maximum value in the 1983–
1993 sub-period.20 This is consistent with conservatism being a deeply
ingrained feature of practice that is difficult for standard setters to
eliminate (Watts, 2003).
20 The significantly higher conservatism in the most recent period also helps explain the
lower R2 s that Ely and Waymire (1999a) find for the FASB era because their linear
regression model is less well specified for this period. Ryan and Zarowin (2003) show
that the apparent secular decline in R2 after 1950 is completely explained by increasing
conservatism and greater market efficiency (increase in prices leading earnings).
5.4 Data Availability for Economic History Research in

Accounting
The studies described in this section are ones that rely primarily,
though not exclusively on hand-collected data. The initial problem
in conducting an historical study with a Cliometric focus is gaining
familiarity with the available data. Table 5.4 provides a brief summary
of data sources for stock price and annual reports. The Accountant’s
Handbook provides excellent summaries of prevailing accounting prac-
tices. This volume was first published in 1923 and subsequently in
1932. It is available today in its 11th edition (Carmichael et al., 2007).
A good mid-century compilation of additional accounting reference
Table 5.4 Publications with useful historical data.

Accounting Practices and Data:
These Accountants Handbook. These volumes provide extensive summaries of the state
of accounting practice at the time of their publication. A respected academic edited
each volume and several contributors wrote the individual chapters. The first edition
was published in 1923 and was edited by Earl Saliers. The second edition was edited
by William Paton and published in 1932. D. R. Carmichael, O. Ray Whittington, and
Lynford Graham edit the eleventh edition, published in 2007.
Commercial and Financial Chronicle. This publication provided a publication of record
for American business. It was established in 1839 as the monthly Hunt’s Merchants’
Magazine and Commercial Review and in 1865 became the weekly Commercial and
Financial Chronicle. This publication provided summaries (and in some cases the full
text) of corporate annual reports. This publication survived into the latter part of the
1980s.
Moody’s Investment Manuals. Moody’s Manuals contain extraordinary amounts of
financial statement data and other corporate information in annual volumes dating
back to 1909. The first manual covered railroads (Moody, 1909), but coverage was
later extended to industrials and utilities in 1914 and government securities in 1918.
Stock Price and Returns Data:
Center for Research in Security Prices (CRSP) at the University of Chicago. CRSP
provides daily and monthly return data in machine-readable form from 1926 to the
present for stocks listed on the New York Stock Exchange. Similar data are available
for AMEX and NASDAQ stocks for shorter time intervals.
Commercial and Financial Chronicle. This publication provided daily and weekly stock
market statistics and prices for the leading stocks of the era.
The New York Times. Daily quotes and volume data are available since the founding of
the newspaper in the mid-19th century.
The Wall Street Journal. Daily price quotes and volume data are available since the
late-19th century.
Yale Center for International Finance. Monthly stock returns data on NYSE stocks from
1815 to 1925 are downloadable online at http://icf.som.yale.edu/nyse/. The
properties of these data are described in Goetzmann et al. (2001).
5.4 Data Availability for Economic History Research in Accounting 93
sources is Cannon (1950). The contents of specific annual reports are

available in the Commercial and Financial Chronicle, a weekly publi-
cation established in the mid-19th century. This newspaper published
summary annual report information and other disclosures. In some
cases, the full text of annual reports is available. Moody’s Investment
Manuals, dating back to 1909, provide extensive financial statement
data and other corporate information in annual volumes.
Monthly and daily stock returns data for NYSE stocks are avail-
able in machine-readable form on the files of the Center for Research
in Security Prices (CRSP) at the University of Chicago starting from
January 1926. Monthly stock returns data on NYSE stocks from 1815
to 1925 are downloadable online at http://icf.som.yale.edu/nyse. These
data are described in greater detail in Goetzmann et al. (2001). Daily
and weekly stock prices and trading volume for NYSE and other stocks
can also be collected by hand from back issues of the Commercial and
Financial Chronicle. Daily issues of The New York Times provide an
additional source of stock market data, and The New York Times also
published summaries of yearly activity in individual securities at the
beginning of the following calendar year.
6
Future Research: Toward an Evolutionary
Theory of Accounting
In this section, we first provide an evolutionary story of accounting.

We then return to our six “big picture” questions in the second sub-
section to describe how future research can quantitatively investigate
important hypotheses related to accounting evolution.
6.1 An Evolutionary Story of Accounting

Our purpose in this sub-section is to provide some conceptual
perspective on what we mean by an evolutionary theory of accounting.
Understanding accounting evolution requires that we reconcile the basic
functions of accounting with their historical emergence. The distin-
guishing feature of an analysis of institutional evolution centers on the
distinction between ecological rationality and constructivist rationality
(Smith, 2003). Ecological rationality focuses on how and why institu-
tions like accounting “grow” spontaneously to perform some underlying
function in enabling economic exchange and cooperation. In contrast,
constructivist rationality largely takes the existence of specific institu-
tions whose effects we seek to understand as a given. Sargent (2008)
94
6.1 An Evolutionary Story of Accounting 95
in his analysis of monetary policy theories dubs these two approaches

“evolution” and “intelligent design,” respectively.
For purposes of illustration, consider why human housing varies
across societies around the world. A scholar seeking to explain cross-
country housing variation from a constructivist perspective might pose
a static problem in which a person tries to satisfy her preferences
for shelter from bad weather and predators subject to the costs of
building materials and labor as well as a production function that
depends on “know-how” for homebuilding in a given climate and geog-
raphy. This analysis, however, would not speak to why humans came to
acquire “know-how” for homebuilding, how they came to learn about
climate and geography, and how this knowledge was transmitted across
generations.
An ecological scholar might begin by imagining a small group of
hunter-gatherers who sleep outdoors and face bad weather and preda-
tors on a recurring basis. His analysis might then characterize how an
individual sought better housing that enhanced his survival prospects
and those of other group members. This could originate from histor-
ical accidents — e.g., when someone wanders into a cave to escape a
predator and realized that caves could be useful for other things. The
formation of causal beliefs and reasoning, akin to that which compels
human tool making and use (Wolpert, 2003), could then have generated
the impetus to build more secure and comfortable forms of housing.
Knowledge about how to construct “better” housing would have ini-
tially been stored in the brain and communicated verbally to the next
generation, but this knowledge might eventually be stored in external
media (Tomasello, 1999).1 Throughout, the analysis would be focused
on the function of housing in terms of its ability to improve survival
prospects.
1 Human cultures that develop better capabilities to adapt their behavior through routines
and rituals will more likely survive and procreate (Donald, 1991). Thus, human ability to
perform complex tasks is enhanced if somebody learns how to store information external
to the brain so as not to be forgotten. For example, knowledge stored in a book (e.g.,
The Idiot’s Guide to Finding and Decorating a Bigger and Better Cave) can be passed
on to the future generations or other cultures, even if that was not the author’s original
intent.
96 Future Research: Toward an Evolutionary Theory of Accounting
Thus, an ecological theory of human housing would focus on how

housing evolves in complexity along with changes in environment and
technologies for efficiently transferring accumulated knowledge across
time and space. By tracking changes in this knowledge and the obser-
vation of housing through time (either by archaeological or contempo-
rary observation), one could identify how and why distinctive features
of homebuilding originate. The research agenda we describe in this sec-
tion is an ecological attempt to understand the foundations of modern
accounting.
Our working hypothesis is that accounting as an institution has
been shaped by cultural evolution dependent on evolved functions of
the human brain and related psychological adaptations. The human
brain has evolved over millions of years in a manner that promotes
social exchange and cooperation in large social groups. Particularly
important functions of the brain include evolved modules for cheater
detection, memory of past interactions, and the ability to read complex
signals of others’ intentions that promote reciprocal social exchange
(Cosmides and Tooby, 1992, 2005; Klein et al., 2002; McCabe et al.,
2001).
Accounting evolution is thus largely a story about how the human
brain orders its world, which in turn produces institutions with
the features we typically associate with the activity we refer to as
“accounting.” These features include the recording of transactions in
memory, the use of manipulated and summarized data to order more
extensive interactions, and the spontaneous emergence of accounting
conventions that guide how accounting is structured to best guide
economic decisions. Simultaneously, accounting promotes extended
economic exchange that results in what has been termed a “complex
adaptive system” of economic interaction. The human mind naturally
seeks to shape the direction of such interactions resulting in both favor-
able and unfavorable consequences.
Economic institutions are culturally evolved products of the human
brain (North, 2005). The brain allows an economic actor to gather and
process information and learn from interactions with its environment
and other strategic actors in that environment. Based on this expe-
rience, adaptive rules emerge that provide behavioral guidance and
mitigate the effects of environmental uncertainty. North (1990) refers

to these rules as “institutions” and emphasizes their gradual emergence
throughout the history of human interaction:
“Institutions are the humanly devised constraints that

structure political, economic and social interaction.
They consist of both informal constraints (sanctions,
taboos, customs, traditions, and codes of conduct)
and formal rules (constitutions, laws, property rights).
Throughout history, human beings to create order and
reduce uncertainty in exchange have devised institu-
tions. . . They evolve incrementally, connecting the past
with the present and the future; history in consequence
is largely a story of institutional evolution in which the
historical performance of economies can only be under-
stood as part of a sequential story.”
Archaeological research documents that humans have engaged in

recordkeeping for economic transactions for at least 10,000 years
(Schmandt-Besserat, 1992). Basu and Waymire (2006) hypothesize
that the act of recording exchange is a means for creating “transac-
tional memory” external to the brains of the parties to an exchange.
Recordkeeping enables the trust and cooperation that is necessary for
large-scale exchange and coordination between strangers across time.
Recordkeeping, along with other exchange supporting institutions like
law, weights and measures, and language, promotes the emergence of
modern markets and economic organizations.
The benefits of transaction records as memory aids have been rec-
ognized for centuries. In a section describing double-entry bookkeeping,
Bennedetto Cotrugli (1458) advises merchants (quoted by Carruthers
and Espeland (1991, p. 44)):
“We shall turn to the practice of [keeping] records.

These not only preserve and keep in memory [all] trans-
action, but they are also a means to avoid many lit-
igations, quarrels and scandals. And they also cause
literate men to live thousands upon thousands of

years. . . . Mercantile records are the means to remem-
ber all that a man does, and from whom he must have,
and to whom he must give, and the costs of wares,
and the profits, and the losses, and every transaction
on which the merchant is all dependent. And it should
be noted that knowing how to keep good and orderly
records teaches one to draw contracts, how to do busi-
ness, and how to obtain a profit. And undoubtedly, a
merchant must not rely upon memory, for such reliance
has caused many persons to err.”
The Basu–Waymire hypothesis complements arguments made by

Sombart (1919), who asserted that double-entry bookkeeping enabled
large-scale capitalism. The double-entry bookkeeping system originated
in 13th century Italy (de Roover, 1955), and was summarized in the
classic text of Luca Pacioli (1494) published shortly after Columbus’
voyage to the New World. Double-entry bookkeeping spread in use as
Italian businesses found it useful for evaluating performance as they
entered new markets. The double-entry bookkeeping system provides
a comprehensive record of the firm’s transactional history (Ijiri, 1975).
This, in combination with Sombart’s hypothesis, naturally leads to con-
sideration of how comprehensive information derived from an organi-
zation’s transactional history promotes scale and scope expansions in
economic organizations.
A firm exists because an entrepreneur believes the expected cost
of organizing production and exchange within a firm is lower than
the cost of transactions between sub-contractors on a market (Coase,
1937). A firm’s survival depends on successfully locating customers,
convincing these customers to transact with the firm, and then pro-
ducing and delivering a product for a price that both invites purchase
and covers the firm’s costs. The entrepreneur uses accounting data
to evaluate whether the expected economies that justify the firm’s
existence have in fact materialized. There is an inherent demand for
accounting information to manage the business even in the absence of
any stewardship or valuation demand for accounting (Littleton, 1928).
Accounting provides information on how a firm is doing relative to its

competitors and guides decisions that determine the firm’s survival
within the ecology of its industry (Alchian, 1950).
Uncertainty exists because the firm’s experience is limited, and
its survival is affected by unknowable technology changes or strategic
behavior by competitors that directly affect production or the avail-
ability of substitute products. The key point here is not that the firm
can be characterized by random cash flows drawn from a known proba-
bility distribution. Rather, the dynamic nature of technological change
and strategic behavior in product and factor markets leads to an envi-
ronment of fundamental uncertainty in the sense that the distribution
of a firm’s eventual payoffs may not be known or even be knowable, at
least in the short run (Knight, 1921).
As a result, competition is a “discovery process” wherein the success
of any firm is unknown in advance and depends on its ability to suc-
cessfully navigate uncertain product and factor markets (Hayek, 1968).
This stands in contrast to standard neo-classical definition of compe-
tition where the firm is a “price taker,” and the equilibrium outcome
of the competitive process is known in advance. In a Hayekian world,
adaptation requires that information be gathered and evaluated, and
the most relevant information in a decentralized market economy is that
which is pertinent to the firm’s local circumstances (Hayek, 1945). An
historical cost double-entry accounting system based on a comprehen-
sive record of the firm’s actual transactions is likely valuable because
it stores data efficiently, and these data allow the entrepreneur to plan
future actions based in part on the results of successful past actions
(Littleton, 1937; Mises, 1949, pp. 210–232; Ijiri, 1975; Demski, 1993).
More broadly, it allows the entrepreneur to “simulate” various decisions
and their effects on operating performance before taking action.
The origins of the modern corporation date to charters granted by
the British Crown that conferred monopoly rights on private citizens in
the 16th century — i.e., the corporation was an “outsource” of prop-
erty rights from the monarch (Micklethwait and Wooldridge, 2003).
Changes in accounting and auditing practice resulted from interdepen-
dence between organizational structure and the demand for verifiable
information to evaluate performance (Watts and Zimmerman, 1983).
Later changes in British accounting practice during the 19th century

were driven by a demand for reliable audits of the accounts with the
result being that some accounting principles have their roots in 19th
century Britain (Chatfield, 1974; Littleton, 1933).
The demand for new accounting methods arises from new business
transactions and organizational forms. Depreciation and consolidated
reporting first surfaced in canals and railroads with large fixed capital
investment and industrial organizations created by mergers in the 19th
century, respectively (Previts and Merino, 1998). Nineteenth century
accounting practice displayed commonalities, or “norms,” as knowledge
of best practices spread through shared links in a social network such as
interlocked directors and external auditors (Lee, 2000; Sunder, 2005).
Emergent practices can crystallize as social norms of reporting when
these practices spread through imitation or are reinforced through pro-
fessional education and knowledge sharing.2
Accounting norms that take hold through imitative behavior need
not be “optimal” in the sense of maximizing the imitating firm’s sur-
vival prospects. Accounting methods that enhance organizational “fit-
ness” cannot be easily identified because the marginal impact of a
given accounting practice on a firm’s survival is often very small rela-
tive to the effects of other factors. For instance, some methods have
no direct consequences on a firm’s cash flows absent tax or regu-
latory effects (e.g., the choice between straight line and accelerated
depreciation).3
Instead, whether an accounting method is “good” is often deter-
mined by whether that method is consistent with long established
principles. The demand for accounting principles was first addressed
2 In the United States, these processes became far more important around 1900 when an
accountancy profession gained increasing social acceptance (Miranti, 1986; Previts and
Merino, 1998).
3 Accounting has no analogue to marketing research that allows for the ex ante evaluation
of the consequences of a specific policy. This is likely one reason that empirical models of
accounting choice have such low explanatory power; see Fields et al. (2001) for a review of
accounting choice research. Similarly, the lack of direct ex post feedback allows standard-
setters to use inaccurate subjective models as the basis for “intelligent design” attempts for
long periods of time, and only large crises cause regulators to attempt to learn and improve
their models (see Sargent (2008) for an insightful historical and theoretical analysis of
learning by monetary authorities).
in the United States by 20th century writers seeking to understand the

basis for spontaneously evolved accounting conventions through pro-
cesses of induction (Littleton, 1953, Chaps. 10 and 11). Early account-
ing principles were analogous to common law doctrines, which are
refined iteratively through precedents that the courts establish as they
resolve challenges to the doctrine. It is thus not surprising that many
accounting scholars in the early and mid-20th century understood the
close connection between court decisions and how accounting conven-
tions took hold in practice (e.g., Hatfield, 1909). Indeed, Berle (1938)
and Spacek (1958) argued that an “accounting court” should determine
accounting policies.
The impact of regulation and taxation on US accounting has
increased dramatically since the late 19th century. Regulation of rail-
roads and utilities based on accounting measures of profitability was
one such influence and the advent of federal income tax was another.
Tax and regulatory consequences on accounting are more readily iden-
tifiable since these have direct cash flows effects. Thus, the possibility of
wealth expropriation (i.e., political costs) tied to accounting numbers
creates strong incentives to manage accounting numbers so as to reduce
such effects (Watts and Zimmerman, 1978). Spillover effects from reg-
ulatory and tax accounting to financial reporting can result because
inconsistencies between accounting reports to shareholders and reports
to regulatory authorities can adversely affect the outcome of regulatory
processes.
The long-run effect of regulation and taxation on accounting can
be to alter the causal relation between a transaction and its account-
ing treatment. As accounting becomes progressively more regulated,
transactions become increasingly structured in anticipation of their
subsequent accounting treatment. In addition, profitable transactions
may be delayed or not undertaken if there is sufficient uncertainty
about their current or future accounting treatment. The causality from
transaction to accounting can thus reverse so that the relation now
runs from accounting to transaction. This reversal of causality can be
further magnified by rigid accounting standards that seek a uniform
“correct” accounting for transactions that are themselves endogenous
responses to current and anticipated accounting standards.4 The

ultimate consequence is that regulated, inflexible accounting standards
may discourage innovation in measurement when standards become
binding constraints to be circumvented rather than measurement rules
that enable economically beneficial transactions (Sunder, 2005).
The relation between transactions and their accounting treatment
can be fundamentally changed by economic crises. As noted in Sec-
tion 5, change in the nature of accounting occurs disproportionately
after such crises. One possibility is that such crises convey considerable
information about either the character of effective accounting measure-
ment, or the ineffectiveness of current accounting models, which can
be used to improve accounting practice. Updating can occur sponta-
neously through both market and political forces, and is needed because
the fitness consequences of poor accounting may not readily observable
in periods of economic growth. At the same time, learning can be dis-
couraged if regulation is rigid and ideological or provides rent-seeking
opportunities (North, 2005). Indeed it is possible that learning from
crises can lead to a self-confirming equilibrium where the standard-
setter continues to choose optimal policies from a wrong model (Sar-
gent, 2008), especially if policymakers are prone to discount past history
because “times have changed.” Whether the character of accounting
measurement becomes more or less adaptive after an economic crisis is
therefore unclear.
At the most general level, biological and cultural forces determine
the evolutionary path of accounting institutional development. Biologi-
cal evolution refers to the standard Darwinian account whereby contin-
gency plays a role through natural selection, beginning with variation in
traits that are genetically based, are inheritable, and have different fit-
ness consequences depending on the organism’s environment (i.e., affect
life expectancy and related procreation opportunities). Thus, the same
4A parallel can be drawn to the costs of excessive traffic signals and uniform speed limits,
whose often arbitrary enforcement can cause drivers to watch out for signs rather than
monitor traffic conditions when they drive (Staddon, 2008). Several European cities have
removed all traffic signs from their roads and report fewer fatal traffic accidents and better
traffic flow as a result (e.g., Schulz (2006) and Neate (2008)).
genetic endowment can have fundamentally different consequences in

different environments.
Cultural evolution refers to how human institutions evolve via selec-
tion pressures applied through human culture. Richerson and Boyd
(2005, p. 5) define culture as “information capable of affecting individ-
uals’ behavior that they acquire from other members of their species
through teaching, imitation, and other forms of social transmission.”
Culturally evolved economic institutions thus result from a social pro-
cess rooted in learning through imitation or knowledge transfer via
education (Hayek, 1979; North, 2005). Culture alters an organism’s
environment through specific cultural variants (ideas, concepts, or insti-
tutions) that have average fitness consequences for all members of the
group that adopts such practices (Henrich, 2004).
Gene-culture co-evolution occurs because natural selection affects
genetic fitness conditional on the organism’s environment, which itself is
altered by culture. Thus, evolutionary processes reflect both biological
processes acting directly on genes as well as cultural evolution that acts
on genes indirectly through cultural practices that affect the fitness
of groups that adopt them — i.e., human genes and culture change
through time in a process where causality flows in both directions.
The distinguishing feature of Homo sapiens sapiens (relative to
other primates) is that our species evolves rapidly through cul-
ture (Bowles et al., 2003; Henrich, 2004; Richerson and Boyd, 2005,
pp. 199–236). These cultural processes increase between-group varia-
tion in fitness-related traits, but diminish within-group variation. In
other words, individuals within a society can adopt and imitate the
cultural adaptations they observe. However, geographical, linguistic,
or other barriers limit the diffusion of cultural adaptations across soci-
eties, resulting in differences in economic institutions and economic
development between societies.
Culture is a mechanism through which humans have leveraged
innate abilities to scale up levels of cooperation through increasingly
larger networks (Wilson, 1975, Chaps. 2, 3, and 26 in particular). In this
sense, culturally evolved institutions allow human economic interaction
to scale up from small communities characterized by dense social net-
works to the extended order of the marketplace that allows cooperative
interaction between complete strangers in highly complex forms of eco-

nomic exchange (Demsetz, 2002; North, 2005; Seabright, 2004). The
key point here is that institutions allow us to better accomplish what
we desire — e.g., mutual benefits from exchange and division of labor
(Smith, 1776). Accounting is such an economic institution; for example,
accounting promotes extended economic organization in part because
it facilitates the formation and enforcement of contracts (Watts and
Zimmerman, 1986).5
North (2005, pp. 49, 50) asserts that economic institutions likely
have their origins in the human brain:
“There is an intimate relationship between belief sys-

tems and the institutional framework. Belief systems
embody the internal representation of the human
landscape. Institutions are the structure that humans
impose on that landscape in order to produce the
desired outcome. Belief systems therefore are the inter-
nal representation and institutions are the external
manifestation of that representation. . . . The intimate
interrelationship of beliefs and institutions, while evi-
dent in the formal rules of a society, is most clearly
articulated in the informal institutions — norms, con-
ventions, and internally held codes of conduct. . . . While
formal institutions may be changed by fiat, infor-
mal institutions evolve in ways that are still far from
completely understood and therefore are not typically
amenable to deliberate human manipulation.”
We presently know little about the forces that have shaped account-
ing’s evolution. Thus, our focus in the next sub-section will be to iden-
tify areas for future research using the six “big picture” questions that
we posed earlier in the survey.
5 The ability of humans to form contracts is unique relative to other species (Wilson, 1998,
pp. 186, 187).
6.2 Future Research on Accounting Evolution 105
6.2 Future Research on Accounting Evolution

Our comments on areas of future research correspond to the six “big
picture” questions we introduced in Section 1. To set the stage for our
present discussion, we restate these questions:
(1) Why is the recordkeeping function of accounting important?

Why does basic function of recording exchange have value
on a stand-alone basis independent of other stages in the
accounting process?
(2) How could basic functions like double-entry bookkeeping
enable large-scale capitalism? What is the economic basis for
the assertion by Sombart, Weber, Schumpeter, and Mises
that double-entry accounting provides the foundation for
capitalist economies?
(3) How can accounting “standards” form spontaneously in the
absence of bodies explicitly charged with standard setting? By
what dynamic processes did accounting practice come to be
characterized by norms before explicit standard setting was
in place?
(4) In what ways, both beneficial and detrimental, has account-
ing practice been influenced by law, regulation, and taxation?
How can law, regulation, and taxation account simultane-
ously for favorable effects on economic interaction while also
allowing for complex phenomena such as transaction struc-
turing where the direction of causality from transaction to
accounting is reversed?
(5) Why are broad principles important to accounting but not
other fields like marketing? Why is it that accountants have
adopted broad conventions to guide accounting decisions?
(6) Why is accounting evolution subject to major discontinuities
that arise from changes made in response to economic crises?
Do these discontinuities, or punctuated “equilibria,” arise
because the fitness consequences of poor accounting choices
are revealed only by systemic failures affecting multiple firms
simultaneously?
6.2.1 The Importance of Recordkeeping

Basu and Waymire (2006) hypothesize that recordkeeping sustains and
expands economic exchange by providing effective memory of past
exchange outside the individual brain. Basu and Waymire’s story has
four components. First, records are created external to the brain as
exchange complexity increases. Second, recordkeeping, law, and other
exchange supporting institutions co-evolve to replace unaided human
memory and informal sanctions for noncooperative behavior used in
small groups. Third, the larger networked groups enabled by record-
keeping and related institutions enable complex exchange that pro-
motes welfare-enhancing division of labor. Fourth, groups that evolve
markets with effective supporting institutions and organizations will,
all else equal, more likely flourish.
Basu and Waymire (2006) state two hypotheses. First, recordkeep-
ing emerges as a mnemonic aid as the complexity of exchange increases.
Recordkeeping sophistication will thus be a function of: (a) exchange
complexity and scale, and (b) the extent to which a given culture relies
on markets and a specialized division of labor. Second, evolved record-
keeping promotes (a) more complex and advantageous exchange, and
(b) the co-evolution of exchange-supporting institutions including lan-
guage, standardized weights and measures and law. Basu and Waymire
review the archaeological evidence on ancient recordkeeping practices,
and conclude that this evidence is supportive of their predictions.
More direct evidence on these hypotheses is provided in Basu et al.
(2008a,b). These studies are complementary in that they approach the
same issue using different methods. Basu et al. (2008a) conduct an
experiment that directly examines the causal relation between mem-
ory constraints, the endogenous use of recordkeeping, and the resul-
tant changes in the extent and nature of economic exchange between
strangers. Basu et al. (2008b) use naturally occurring data collected by
ethnographers to investigate the use of recordkeeping in less advanced
economies.
The experiment in Basu et al. (2008a) is a networked trust game
experiment extending the original Berg et al. (1995) design. In a stan-
dard trust game (a.k.a. “investment game”) experiment, two subjects
are paired to play the role of “investor” and “trustee,” respectively.

In the one-shot version (Berg et al., 1995), the investor is endowed
with 10 units of experimental currency and the trustee with none.
The investor then decides how much of his endowment to send to the
trustee, and how much to retain. Any amount sent to the trustee is
tripled en route thereby generating gains from trade. After receipt of
the tripled amount, the trustee then decides how much of the amount
received to send back to the investor. Gains from trade are maximized
when the investor sends his entire endowment to the trustee, but this
is entirely conditional on whether the investor believes the trustee will
send back an amount that at least covers the investor’s investment.
The standard economic intuition is that investors will send nothing
because they do not expect the trustee to reciprocate a positive invest-
ment when this is costly to the trustee. The surprising result in Berg
et al. (1995) is that investors on average invest half their endowments
and trustees provide positive net returns even in one-shot interactions
characterized by complete anonymity.
When subjects play the trust game one-on-one in a multi-period
setting, it is possible that subjects can establish reputations and pos-
itive investment can be sustained (King-Casas et al., 2005). However,
reputation can be sustained only when subjects have effective mem-
ory of trading partners’ past actions (Axelrod and Hamilton, 1981).
The experimental design in Basu et al. (2008a) includes two manipu-
lations that allow them to directly address the effect of recordkeeping
on memory in the repeated trust game. First, instead of playing the
game with one partner, each subject plays the game with five partners
simultaneously. Playing with multiple partners places an implicit tax
on memory since it becomes more difficult to track a specific partner’s
past behavior as the number of trading partners increases. Second, sub-
jects in half of their experimental sessions are provided a software pro-
gram that allows them to keep records. Basu et al. (2008a) document
that subjects use recordkeeping to a greater degree in a multi-partner
setting. They also document that subject decisions are better coordi-
nated, more closely track constructed measures of partner reputation,
and incorporate a longer history of past interactions in multi-person
exchange when recordkeeping is possible.
One limitation of laboratory experiments is they may not describe

well what occurs outside the laboratory. Basu et al. (2008b) examine
the role of recordkeeping using the Standard Cross-Cultural Sample
(SCCS). The SCCS is an ethnographic database constructed from a
large number of studies by anthropologists and archaeologists for a
range of societies. The SCCS provides extensive coded data for over
2,000 cultural variables for 186 societies chosen by Murdock and White
(1969) to maximize the cross-society independence of observations. The
SCCS societies include early historical states as well as contemporary
hunter-gatherers, agriculturalists, and industrial societies. The SCCS
includes a variable for recordkeeping and a number of demographic,
social, and economic measures of group size and complexity, the use of
markets, the extent of division of labor, and the extent of hierarchical
organization.
The SCCS data are well suited to examining how recordkeeping use
varies as a function of social group size. Group size is important because
anthropological research suggests that the unaided human brain can
sustain stable cooperative groups to an upper limit of about 150 mem-
bers. Dunbar (2001, p. 181) writes:
“(T)here is indeed a characteristic group size of around

125–200 that reappears with surprising frequency in
a wide range of contemporary and Neolithic horticul-
tural societies. These groups . . . all share one crucial
characteristic: they consist of a set of individuals who
know one another intimately and interact on a regular
basis. . . . Thus there seems to be quite strong evidence
that at least one component of human grouping pat-
terns is as much determined by relative neocortex size
as are groups of other primates. We have bigger, more
complexly organized groups than other species simply
because we have a larger onboard computer (the neo-
cortex) to allow us to do the calculations necessary to
keep track of and manipulate the ever-changing world
of social relationships within which we live.”
Dunbar’s Number is the estimated limit to human group size in

the absence of institutions that store data on past exchange outside
individual human brains. Relying on this estimate, Basu et al. (2008b)
hypothesize that recordkeeping should become increasingly prevalent
in groups of more than 200 persons. More generally, if group size is a
measure of social and economic development, then the relation between
group size and the presence of various institutions ought to indicate
which institutions are necessary at differing development stages.
The major result reported by Basu et al. (2008b) is that record-
keeping appears very early in the course of an economy’s develop-
ment. Figure 6.1 reproduces Figure 4b from Basu et al. (2008b), which
represents a “horse race” between various institutions to see which
institutions emerge earliest as a society grows in size. Plotted on the
horizontal axis are eight different categorical values for the SCCS vari-
able Community Size ranging from societies where the typical com-
munity is less than 50 persons up to societies with communities of
over 50,000 persons. The vertical axis shows the cumulative percent-
age of SCCS societies where that institution is present as we include
larger societies. For example, the institutions in cluster A are present
in slightly less than 80% of the societies whereas cluster D signifies an
institution is present in only one-third of the SCCS societies.
100%
80% A: Agriculture 79.5%

Tech Specialization 78.9%
B: Food Storage 62.7%

60% Land Inheritance 61.7%
Recordkeeping 60.5%
Money 58.4%
C: Admin Hierarchies 46.5%

40%
Judiciary 43.7%
D: Credit 32.5%
20%
0%
Community Size
Fig. 6.1 Cumulative percentage of SCCS Societies where a particular economic institution
is present plotted against community size (from Basu et al. (2008b), Figure 4a).
The two variables in the cluster labeled A indicate whether basic

agriculture or simple division of labor is present in the society. Not
surprisingly, both these very basic institutions are highly prevalent in
the SCCS database. Indeed, the SCCS societies without agriculture
and primitive division of labor are hunter-gatherer groups that forage
and hunt for food.
The next cluster (labeled B) is present in about 60% of SCCS soci-
eties and includes the SCCS variable indicating that the society keeps
records. The other three variables in this cluster indicate the presence
of (1) basic food storage technology, (2) a property rights system that
allows the inheritance of land, and (3) primitive forms of money. Dem-
setz (1967) argues that private property rights emerge to “internalize”
the externalities created by a new technology, so we should expect prop-
erty rights in land to lag behind agriculture. Money and transaction
records are likely to appear after individuals specialize in production
and routinely trade goods and services for their other needs. Similarly,
community granaries necessitate tracking of individual deposits and
withdrawals, which are likely facilitated by recordkeeping. The early
emergence of records suggests that they play a fundamental role in
economic development.
The two variables in the third cluster (labeled C) capture whether
administrative hierarchies and a judiciary are present and the one
variable in the cluster labeled D measures whether credit outside
the family is available. These patterns in the data suggest that
recordkeeping usually appears earlier than complex organizations,
judicial review, and the availability of credit beyond one’s family or an
immediate circle of friends. This is consistent with Basu and Waymire’s
(2006) prediction that the basic accounting function of recordkeeping
is necessary for an economy to develop beyond the primitive types of
economic interaction found in small hunter-gatherer groups. Further
analyses in Basu et al. (2008b) indicate that recordkeeping enables the
development of markets, division of labor, hierarchical organization,
and increased scale in network size, and through these institutions
is positively associated with better societal outcomes such as fewer
famines and educational investment.
Basu et al. (2008a,b) provide fairly strong support for Basu and
Waymire’s (2006) prediction that the basic accounting institution of
recordkeeping fundamentally alters the nature of an economy and pro-
motes its further expansion. There are of course a number of other
empirical analyses that could be conducted (see Basu and Waymire
(2006, pp. 218–223)). We regard the agent-based simulations and neu-
roscientific experiments as being especially promising because they rep-
resent new research techniques and data that enable investigation of
other aspects of the same research question. Because these methods
can also be used to analyze the effects of double-entry bookkeeping and
evolved accounting principles, we defer discussion of these approaches
to subsequent sub-sections.
6.2.2 Double-Entry Bookkeeping and Expansion in the

Scale and Scope of Economic Organizations
Typical financial accounting texts stress the stewardship and valuation
roles of accounting, but a more fundamental function of accounting
is to aid in management decision-making (Littleton, 1937, pp. 17–22;
1952, pp. 168–172; Vatter, 1950, pp. 97–107, 505–510; Johnson and
Kaplan, 1987). We see this role as more fundamental since a system for
recording past exchange transactions and summarizing their financial
implications would still be useful to an entrepreneur-manager operat-
ing a self-financed business in a world of zero taxes where only family
members were employees of the business. Stated differently, accounting
fulfills a decision-making and planning function within the firm and
this function provides the basis for the hypothesis that double-entry
accounting enabled modern capitalism (Most, 1972, 1973).
This hypothesis has deep historical roots; German philosopher and
scientist Goethe (1824) observed: “What advantages does the Merchant
derive from book-keeping by double-entry? It is among the finest inven-
tions of the human mind.” Yamey (1964, p. 117) assigns the first source
of the hypothesis that double-entry bookkeeping enabled capitalism to
Sombart (1919). Joseph Schumpeter (1950), Ludwig von Mises (1949),
and Max Weber (1927; 1956) subsequently proposed variants of this
hypothesis (Carruthers and Espeland, 1991).
Testing the hypothesis that accounting plays a critical role in man-

agement decision-making that in turn enhances capitalist economic
development is no straightforward matter. The reason is that the
hypothesis is stated in terms of fundamental cognitive changes induced
by double entry, which in turn enable developments in the nature and
scale of resultant economic interaction. Schumpeter (1950, p. 123) notes
this explicitly when he writes:
“But capitalism develops rationality and adds a new

edge to it in two interconnected ways. First it exalts
the monetary unit — not itself a creation of capital-
ism — into a unit of account. That is to say, capitalist
practice turns the unit of money into a tool of rational
cost-profit calculations, of which the towering monu-
ment is double-entry bookkeeping. Without going into
this, we will notice that, primarily a product of the evo-
lution of economic rationality, the cost-profit calculus in
turn reacts upon that rationality; by crystallizing and
defining numerically, it powerfully propels the logic of
enterprise.”
Mises (1949, p. 231) states the hypothesis more broadly as follows:
“Monetary calculation is the main vehicle of planning

and acting in the social setting of a society of free
enterprise directed and controlled by the market and its
prices. It developed in this frame and was gradually per-
fected with the improvement of the market mechanism
and with the expansion of the scope of things which are
negotiated on markets against money. It was economic
calculation that assigned to measurement, number, and
reckoning the role they play in our quantitative and
computing civilization. . . . Monetary calculation reaches
its full perfection in capital accounting. It establishes
the money prices of available means and confronts this
total with the changes brought about by action and by
the operation of other factors. This confrontation shows
what changes occurred in the state of acting men’s

affairs, and the magnitude of those changes; it makes
success and failure, profit and loss ascertainable. . . . Our
civilization is inseparably linked with our methods of
economic calculation. It would perish if we were to
abandon this most precious intellectual tool of acting.
Goethe was right in calling bookkeeping by double entry
‘one of the finest inventions of the human mind.’ ”
Because of the hypothesized but weakly specified links between

double-entry accounting, human cognition, and organizational form
and performance, gathering evidence on Sombart’s hypothesis requires
indirect tests (Most (1972) provides a nice discussion of this issue). For
example, is organizational performance and survival, and by implica-
tion macroeconomic performance, improved once the better accounting
technology of double entry is integrated into the information systems
that support managerial decision-making?
Some historians conclude that large-scale enterprises could not be
managed without extensive accounting information systems based on
double-entry bookkeeping. For example, de Roover (1938) describes
how extensive cost data were collected and used by managers of the
cloth-making operations of the Medici family in 16th century Florence.
As already noted, there is evidence for cost records by Italian cloth mak-
ers before 1400 (see Melis (1950) as cited by de Roover (1955, p. 16)).
The subsequent adaptation of double entry to measure product costs
from complex manufacturing processes has been argued to improve the
efficiency of 19th century New England cotton mills (Johnson, 1972).
Double-entry bookkeeping may have been especially useful in moni-
toring agents located in distant towns as trade began spanning all of
Europe and banks opened branches in major trade centers (Robson,
1992).
The historian who is most skeptical of Sombart’s hypothesis is Basil
Yamey (1949, 1964, 2005). The essence of Yamey’s argument is that
(1) double entry is not necessary for calculations of profit and loss (these
could be done with single-entry systems), (2) the evidence suggests that
some capitalist firms functioned for long periods without double entry,
and (3) there is little a priori reason that accounts would be useful
for deciding whether to start a new organization, enter a new market,
or expand within an existing market (see Yamey (1964, pp. 119–133)).
Most (1972) agrees with many of the specifics of Yamey’s argument, but
reaches an overall different conclusion after reformulating Sombart’s
hypothesis in light of assertions by Schumpeter that double entry was
a device to deal with cognitive constraints inherent to fundamentally
uncertain economic environments (Most, 1972, pp. 731–733).6 Most
(1972) takes the position that Sombart’s hypothesis asserts that double-
entry bookkeeping fulfills a planning function that is more fundamental
than other functions it came to serve (e.g., stewardship and valuation).
Most’s (1972, p. 734) restatement of Sombart’s hypothesis is
(emphasis in original):
“The essential fact is that men are acting and competing

on the basis of what they think of the future. . . . Deci-
sion involves comparing a subjective judgment of the
significance of a commodity to the decision-maker with
an estimated future price, and it is in the elaboration
of the subjective evaluation that accounting serves the
planning function. Its use as a control mechanism fol-
lows from its planning function, since we define control
as the systematic measurement of performance against
predetermined standards, with the objects of evaluation
and prediction linking it up again with planning.”
Carruthers and Espeland (1991, p. 34) “analyze the development

of accounting and examine why various audiences have found account-
ing persuasive and how much the technical superiority of double-entry
bookkeeping explains its diffusion.” They study the rhetorical and
cognitive effects of accounting texts published in Italy and England
from before Pacioli through the 19th century. They identify Sombart’s
hypothesis with the broader issue of how double-entry bookkeeping
changed how people came to rationalize economic action and perceive
6 In
constructing this argument, Most (1972) relies on arguments by Frank Knight (1921)
and John Maynard Keynes (1936) about the economics of fundamental uncertainty.
action differently. That is, “double-entry bookkeeping was devised to

account for business transactions, but once established it altered those
transactions by changing the way businessmen interpreted and under-
stood them” (Carruthers and Espeland, 1991, p. 36).
While accounting theory per se showed little change in the 200
years after Pacioli’s book in 1494, the message of double entry was
linked early on with developing individual moral character and self-
discipline (Carruthers and Espeland, 1991, pp. 39–44). This was due in
part to the emphasis on duality in exchange based on symmetric deal-
ings (Aho, 1985). It was also due in part to links between religion and
accounting, which could show up in exhortations to God being explic-
itly entered into the books of account and charitable contributions
posted in the ledgers under “God’s account” (D’Epiro and Pinkow-
ish, 2001, pp. 110, 150). The newly instituted sacrament of confession,
which taught that commerce was morally suspect, drove businessmen to
justify their affairs to their community and themselves through scrupu-
lous recordkeeping (Aho, 2005). Human virtues of honesty and fairness
thus came to be linked inextricably with accurate accounting, which
presumably affected an individual’s reputation as a trustworthy agent
(Carruthers and Espeland, 1991, pp. 41, 42).
The diffusion of double-entry bookkeeping as well as related skills
and ethical values occurred through education and mercantile networks
(Carruthers and Espeland, 1991, pp. 48–52). The rhetorical importance
of double entry arose because it was taught in commercial schools of
training with textbooks that furthered this process (Hoskin and Macve,
1986). Businessmen and students faced ongoing reminders that the need
for keeping accurate books was to protect one’s reputation for honest
dealing. In the end, Carruthers and Espeland (1991, pp. 47–48, 56–60)
conclude that much of double-entry bookkeeping’s importance came
from its flexibility in promoting accurate bookkeeping and improved
decision-making for businesses that ranged widely in size and industry.7
7 Yamey (1964, p. 127) also recognized the flexibility of double entry but significantly down-
played its importance. Yamey (2005) critiques the arguments and evidence in Aho (1985)
and Carruthers and Espeland (1991), and remains steadfastly immune to any “Sombartian
intoxication.”
Sombart’s hypothesis is exceptionally important from the stand-

point of accounting research. The hypothesis basically says that
accounting systems construct the information (from raw transactional
data) that fuels the search for comparative advantage by the modern
corporation operating in product markets. Alchian (1950) interprets
economic competition in Darwinian selection terms, wherein a highly
uncertain environment “adopts” some exploratory actions over others.
An environment of Knightian uncertainty with incomplete information
is likely to elicit adaptive imitative and “trial and error” behaviors
by entrepreneurs in a search for positive profits. Alchian (1950, p. 23)
explicitly discusses how profits signal fitness in this evolutionary selec-
tion process (emphasis in original):
“Realized positive profits, not maximum profits, are
the mark of success and viability. It does not matter
through what process of reasoning or motivation such
success was achieved. The fact of its accomplishment is
sufficient. This is the criterion by which the economic
system selects survivors: those who realize positive prof-
its are the survivors; those who suffer losses disappear.”
Thus Sombart’s hypothesis is consistent with an interpretation that
accounting plays an important role in the discovery process that Hayek
(1968) argues is the essence of competition. Indeed it suggests that
accounting information gathered for management purposes may be a
key ingredient of the “invisible hand” that promotes the spontaneous
order of the market (Smith, 1776). Sombart’s hypothesis also suggests,
if valid, that the fundamental decision-making role of accounting (inde-
pendent of its stewardship and valuation functions) has been given
short shrift in our research and teaching efforts.
It is important to test Sombart’s hypothesis more directly than has
been tried so far. Two methods seem well suited to this purpose. The
first is the neuroscientific methods applied in the emerging literature on
neuro-economics (e.g., Chorvat and McCabe, 2004; Glimcher and Rus-
tichini, 2004). The thrust of Sombart’s hypothesis is a cognitive change
associated with modern accounting relative to its predecessors. It is
instructive to recall the earlier quotes from Schumpeter (1950, p. 123)
that double-entry accounting promotes “rational cost-profit calcula-

tions” and Mises (1949, p. 231) that “Our civilization is inseparably
linked with our methods of economic calculation. It would perish if
we were to abandon this most precious intellectual tool of acting.”
Thus, accounting is hypothesized to fundamentally change the manner
in which people approach economic exchange with strangers relative to
family members or friends.
It may be possible to detect this effect with a well-designed neuro-
science experiment. Research suggests that human emotions play a role
in evaluating the results of exchange — e.g., humans have an inherent
desire to punish cheaters that is manifested in certain brain activation
patterns in trust game experiments (de Quervain et al., 2003). One
question raised by this research is whether the human brain processes
cheating in exchange differently when it comes to be seen as a busi-
ness risk by how accounting processes the results of a large number
of economic transactions with strangers. That is, the scale expansion
enabled by accounting may have transformed dishonest behavior from
a personal affront into a cost associated with doing business. If so, then
basing action on recorded exchange results may implicate areas of the
brain associated with rational decision-making rather than brain areas
associated with more basic emotion.
Another useful way to test Sombart’s hypothesis is using simu-
lation techniques such as agent-based modeling (see e.g., Dickhaut
and Xin (2007), and Epstein and Axtell (1996)). The idea here is
to test more directly the evolutionary hypothesis that more effective
accounting measurement provides a competitive advantage to firms
that operate in a world of large scale exchange and production char-
acterized by heterogeneity of exchange transactions. This would be an
especially effective way to test Sombart’s hypothesis if double-entry
bookkeeping’s spread occurred primarily because new firms adopted
this method while existing firms stayed with older technologies. If
this is valid, an inspection of the time series of a small number of
firms’ use of double entry could not provide evidence supporting the
hypothesis. That is, inspecting historical accounting records would
be akin to the paleontologist looking for the “missing link” to verify
Darwin’s hypothesis of natural selection. The advantage of a technique
like agent-based modeling is that it would allow one to identify the

conditions under which more accurate knowledge of opportunities and
risks in a stochastic economic environment could exert a first-order
effect on firm survival and resource acquisition.8
6.2.3 Do Accounting “Standards” Form Spontaneously

in the Absence of Standard-Setting Bodies?
Accounting norms existed before formal standard-setting institutions
were created in the United States and Britain (Sunder, 2005). Con-
ventions can emerge spontaneously (i.e., in the absence of explicit
planning) as a result of the common tendency to imitate “best prac-
tices.” Two forces contribute to this. One is mimicking of behaviors
by industry leaders or the majority of one’s peers. The other is profes-
sional knowledge accumulation that is transmitted across firms through
knowledge sharing. This, for example, is the role of established profes-
sions. In the United States, the emergence of an accounting profession
near 1900 contributed considerably to the development of reporting
norms. In consequence, there are three likely sources of accounting
innovation and diffusion: (1) the development of professional expertise
lodged in major accounting firms and reflected in the experience of its
personnel, (2) the building of professional networks involving knowledge
sharing between professionals, and (3) informal diffusion that involves
mimicking behavior by some firms of others’ choices.
In considering accounting method choice, it is appealing to revert
to a static view of the problem. In some cases, the “optimal” choice
is obvious. LIFO is advantageous in a setting of rising inventory costs
because its use for US tax purposes requires it also be used for financial
reporting (a.k.a. the LIFO Conformity Rule). Likewise, when explicit
price or rate regulation determines the firm’s selling price, the most
preferred accounting method becomes clearer. But what about settings
8 Ofcourse, Sombart’s hypothesis implies more generally that accounting provides informa-
tion useful to any economic actor besides management in “making sense” of an organi-
zation’s performance within its local environment. An implication of this “sense-making”
view would be that accounting data could be useful to a security analyst drawing infer-
ences based on qualitative analysis, which would provide the basis for forecasting earnings
necessary for equity valuation tasks (Palepu and Healy, 2007).
where tax and regulatory factors are absent? In this case, it is harder to
evaluate how a specific accounting method affects the firm’s prospects
for survival and resource acquisition. Clearly the portfolio of account-
ing methods and judgments must matter, but how much a particular
method is preferred is less obvious. Absent tax or regulatory forces, it
seems that the choice of straight-line or accelerated depreciation just
does not matter as much as say how the firm prices its products or
invests in research and development or whether or not it closes an
existing production facility. Stated differently, the signal-to-noise ratio
regarding the effect of a specific accounting method is very low in the
absence of regulatory or tax effects.
The obvious retort to this line of thinking is that it must matter to
some degree, and if we could only figure it out, we could understand
better why firms choose specific accounting methods. Stated differently,
if the net benefits of an accounting method were more obvious to deci-
sion makers, then researchers would be able to empirically identify such
effects. Or, even if decision makers were not very well informed, mar-
ket forces would render organizations that make inferior choices extinct.
Fields et al. (2001) report that our empirical models of specific account-
ing method choices perform poorly. One possible explanation is that
the typical rational choice theories are not descriptive because deci-
sion makers cannot identify which methods will produce better results.
Instead decision makers adopt mental models that help rationalize prior
successes and failures but that will only be revealed to be inaccurate
in novel states of the world. Shared subjective models produce self-
confirming equilibria that generate “rational” actions in normal states
but generate dysfunctional actions in unusual situations.9
The question thus becomes: how do “new” accounting methods orig-
inate and then subsequently spread in use? The most likely answer lies
in new forms of transactions. For example, consolidated reporting in
the United States grew out of the experience with the creation of new
large entities created by mergers in the latter part of the 19th century.
9 deFigueireda et al. (2006) use inaccurate mental models and self-confirming equilibria to
explain several historical puzzles regarding the American Revolution. Sargent (2008) uses
a similar framework to understand recurrent failures in monetary policy over hundreds of
years.
Similarly, the use of depreciation became widespread when permanent

organizations with fixed capital became widespread. The spread of
these practices likely occurs when other organizations confront similar
issues and sought knowledge of extant “best practices.”10 In this sense,
the accounting method choice “hitchhikes” off the underlying choice of
transaction.11 Thus, an accounting procedure may not be globally opti-
mal, but its initial design is “good enough” and gets copied along with
the transaction to the extent that mechanisms exist for the social trans-
mission of accounting choices and differential selection of organizations
based on the underlying transaction.12 In this sense, the accounting
procedure becomes a “norm” for others that engage in similar types of
transactions.
Two other issues are also pertinent. One is the means through which
knowledge of accounting innovations spreads. This possibly is governed
by the same forms of social mechanisms responsible for the transmission
of any norm (Coleman, 1990; Rogers, 2003). It obviously can come from
knowledge of the behaviors of other firms in the industry. For example,
firms could mimic the behaviors of industry leaders or the “average
firm” in the industry. These mimicking behaviors are consistent with
more general forms of prestige-biased and conformist forms of transmis-
sion (Richerson and Boyd, 2005). A second issue is the type of social
institutions that fuel these imitative processes. These likely include
the emergence of auditors with industry-specific expertise, an account-
ing profession based on extensive knowledge sharing (e.g., through
publications) and education requirements, and network links between
organizations within an industry such as trade associations, interlocked
directorates, and auditor links (Miranti, 1986; Lee, 1995, 2000).13
10 This search could be internal rather than external. Early railroad depreciation methods
such as retirement and replacement accounting are similar to FIFO and LIFO inventory
accounting, and were only gradually replaced by systematic depreciation methods.
11 Within the context of genetic transmission and natural selection, some have argued that
docile and altruistic behaviors essentially “hitchhike” off other genes that enhance per-
sonal fitness (Gintis, 2003; Simon, 1990).
12 In conversations at the 2007 AAA annual meeting, archaeologist Denise Schmandt-
Besserat indicated that recordkeeping and agriculture spread as a bundle throughout

the Middle East starting from Sumer.
13 Incentives to copy behaviors of other firms likely increase when taxes and regulation affect
payoffs. We discuss this issue in more depth in the next sub-section.

Industry publications are an arrangement for knowledge sharing

that had a substantial influence on the development of US practice.
The Journal of Accountancy published its first issue in November 1905
with the stated goal of providing “the best thought of the profession
on the intricate problems which they are called upon to solve, and
will also present the literary work of men eminent in their various
branches of business on accountancy subjects. These leading articles
will crystallize professional thought and broaden professional interest,
while at the same time enforcing upon the business world the neces-
sity of placing the solution of difficult problems in the hands of the
professional expert accountant.” (Editorial, Journal of Accountancy,
November 1905, pp. 57–59). Through this publication, the accounting
profession provided a repository for knowledge and a vehicle promoting
conversation about accounting conventions used in practice (Moonitz,
1970).
A promising line of research in this area is the work by Jamal et al.
(2003, 2005), which uses the development of Internet privacy norms to
compare the effectiveness of spontaneous norms relative to regulated
standards. Internet privacy standards in Britain are legislated while
US standards are market driven. The results of this direct comparison
do not support the hypothesis that Britain’s regulated standards for
Internet privacy are more effective than the spontaneous norms in the
United States (Jamal et al., 2005). Moreover, a market for private cer-
tification of Internet privacy developed in the United States but not in
Britain, which suggests that regulation can crowd out private institu-
tional development. Related research by Jamal and Sunder (2007a,b)
evaluates the historical effectiveness of government sponsored account-
ing standard-setters in the United States against private standard-
setters in a variety of industries. Mahoney and Sanchirico (2001) use
evolutionary game-theoretic analyses to identify games or situations
in which efficient norms will emerge as well as identify games where
efficient norms will not emerge and a benevolent regulator can create
efficiency-enhancing law.
Three areas for future research present themselves. One is to inves-
tigate how accounting policies emerge in the absence of regulation. For
example, how are accounting practices shaped before they are added to
a standard-setter’s agenda? Second, how does knowledge of accounting

ideas and practices enter accounting education and research through
textbooks and journals? How, if at all, have accounting textbooks been
changed by standard setting? Finally, do accounting policies ever dis-
appear without regulatory action? For example, the pooling of interests
method was eliminated in the United States by a superseding FASB
standard (FASB, 2001). Is this case atypical, or have standards been
eliminated from practice previously by market forces?
6.2.4 How do Regulation and Taxation Alter the

Developmental Path of Accounting Practice?
The story in Section 6.2.3 was that reporting norms could develop
as firms mimicked other firms as accounting innovations diffused along
with new transactions. This occurs mainly because a specific accounting
procedure’s effects on the firm’s future survival prospects are hard to
identify — i.e., the primary cause is a low signal-to-noise ratio.
The signal-to-noise properties of specific accounting procedures
changes dramatically once real effects attach to specific accounting
methods through regulation and taxation. One immediate consequence
of income taxation is that managers will tend to choose those account-
ing methods that minimize the present value of future tax payments.
A longer-term consequence is that managers’ choices of accounting
methods for tax purposes come to be linked with financial reporting
choices when the behavior of those who write or enforce tax law is
conditioned on reports provided by managers to shareholders. The ulti-
mate effect may be to reverse the causation between transaction and its
accounting treatment. In other words, the consummation of exchange
normally precedes accounting for the transaction. The effect of taxes
and regulation is that transactions become increasingly structured or
abandoned in anticipation of their accounting.
Increasing regulation and taxation tied to accounting numbers has
important implications for accounting evolution. Specifically, account-
ing and reporting practice will be increasingly driven by forces other
than measurement for managing the firm’s interactions with markets
for output, factors of production, and capital. The impact of this shift
will be that the evolution of financial reporting begins to lag changes

in regulatory and tax laws, and even the origins of financial reporting
practices will have their genesis in taxation and regulation. This was
the case for R&D expensing and pooling of interests accounting (see
Table 3.1) as well as others such as LIFO inventory costing (see Davis
(1982) and Pincus (1997)).
Two areas for future research are particularly important under an
evolutionary perspective articulated here. As noted earlier, our abil-
ity to explain accounting choice is limited (Fields et al., 2001). If the
evolutionary hypothesis is valid, this suggests that accounting choices
that have direct cash flow effects due to regulation and taxation will
be much better “explained” by empirical models of accounting choice.
Thus, a direct comparison of empirical models estimated for method
choices with and without tax and regulatory consequences is war-
ranted. In addition, the path by which such accounting choices are
diffused within an economy should be explored. Methods with such
consequences should be subject to more intense clustering in time peri-
ods where tax and regulatory legal changes occur or when such incen-
tives become more pronounced in periods of exogenous macroeconomic
changes (e.g., changes in inflation and inventory method changes in the
mid-1970s).
A second area for future research concerns the relation between
transaction structuring and accounting standards. If accounting evolves
to promote beneficial economic exchange, then changes in accounting
practice should follow from expansion in the set of exchange opportuni-
ties. The key point here is that accounting does minimal disturbance to
the underlying transaction. However, if standards become too rigid and
intrusive or if tax and regulatory effects loom large, it is more likely that
transactions will be structured in anticipation of their accounting treat-
ment. The consequence is that exchange transactions that would have
been disadvantageous otherwise are executed under a regulated regime,
and conversely previously advantageous transactions may no longer be
consummated. The testable prediction is that we expect more transac-
tion structuring when the costs of taxation or regulation are higher and
when rigid accounting standards are promulgated that actually inhibit
business innovation aimed at discovering new exchange opportunities.
Nelson et al. (2002) report survey evidence from auditors that earn-
ings management through transaction structuring is more prevalent for
bright-line accounting standards. This research can be extended using
experiments that examine how transaction structuring to avoid rigid
standards and regulation lead to economic inefficiencies.14 For instance,
trust game experiments that allow for interaction between actors but
require standardized financial reporting might be designed to evalu-
ate the effects of historical cost accounting (representation based on
the firm’s local conditions) versus fair value accounting (representation
based on more global conditions presumed to be applicable to all firms).
6.2.5 Why are Broad Principles Important to Accounting

but not Other Fields Like Marketing?
Two competing approaches are available for establishing accounting
principles (Littleton, 1953). One, based on induction, infers principles
from evolved practices. An example of this approach is the income
measurement rationalization of historical cost accounting by Paton
and Littleton (1940). A second deductive approach is one where a
designer of principles asserts that specific principles follow from var-
ious assumptions about the objectives of accounting.15 An example of
a deductive approach is the FASB’s move toward fair value account-
ing with primacy placed on balance sheet measurement. Forerunners of
this approach include the asset valuation approaches based on “current
values” (Chambers, 1966; MacNeal, 1939; Sterling, 1970).
The genesis of many modern accounting principles dates back sev-
eral centuries. Even before Pacioli wrote his famous text, Italian orga-
nizations were using accruals, recognizing depreciation, writing down
inventories under lower of cost or market, and were making foreign
exchange adjustments to the accounts (Littleton, 1941; Chatfield, 1974,
14 Lys and Vincent (1995) estimate that AT&T spent between $50 million and $500 million
to satisfy pooling accounting requirements when it acquired NCR in 1991, and conclude
that this value-destroying merger was at least partially related to the 1984 consent decree
with the Department of Justice that led to the breakup of AT&T. Case studies can also
shed light considerable light on these questions.
15 Easterly (2008) labels these approaches as “bottom-up” and “top-down” in distinguishing
between attempts at institutional reform in economic development policy.

p. 42). By 1900, elements of modern principles were grounded in long-

standing conventions characterizing practice in both Britain and the
United States. These conventions included the entity concept, going
concern, periodicity, revenue realization, historical cost, and conser-
vatism, all of which had been fostered by the combined forces of corpo-
rate expansion, legal precedents, and economic crises (Gilman, 1939,
pp. 147–249; Paton and Littleton, 1940, pp. 7–23; Littleton, 1953,
pp. 185–208; Hendriksen, 1970, pp. 22–56; Chatfield, 1974, pp. 79–84,
89–99). The discussion of accounting principles became especially active
in the United States in the 1930s after the Market Crash of 1929 and
enactment of federal securities laws in 1933 and 1934 (Storey, 1964;
Chatfield, 1974, pp. 234–239, 284–239).
Accounting principles operate at the highest level of a hierar-
chy of measurement rules. Principles inferred from practice are broad
statements gleaned from specific norms and conventions evolved in
accounting practices. Principles inferred via induction are thus like
common law in that they are discovered but not made (Hayek, 1967,
1979). An accounting principle likely has economic value because it
provides measurement guidance in settings when the selection pres-
sures acting on specific accounting policies are weak. In other words,
accounting principles are useful because, unlike effective marketing poli-
cies identified through marketing research, they guide action in deter-
mining how to best measure performance when a single most effective
method of measurement cannot be clearly identified.16 Thus, broad
accounting principles lead to accounting measurements that guide
survival-enhancing business decisions (Byrne, 1937).17
What explains the longstanding skepticism toward principles
inferred by induction from evolved practice? We suggest that two
related forces are likely at play here. One is that humans have inherent
difficulties understanding phenomena subject to evolution. That is,
16 The problem here is one of a low signal-to-noise ratio independent of tax and regulatory
effects. This is generally consistent with the weak pattern of association that emerges in
the empirical literature on accounting method choices (Fields et al., 2001).
17 Radner (1995) demonstrates that action based on a survival motive can have very differ-
ent implications for aggregate economic outcomes in a world of uncertainty than profit
maximizing actions.
humans feel naturally more comfortable with theories of intelligent

design where outcomes result from conscious planning. This construc-
tionist perspective dates back at least to the writings of Aristotle
(Hayek, 1988, pp. 45–47). Second, humans inherently believe they can
design tools to favorably alter their environment. Tool use has been
hypothesized as providing the evolutionary origin of causal human
beliefs (Wolpert, 2006). Regardless of the ultimate cause of such
beliefs, the design of accounting through human deductive reasoning
has exerted a strong influence on recent accounting practice. This is evi-
dent in the work of early valuation scholars such as Chambers and Ster-
ling, and is present wholesale in the FASB’s Conceptual Framework.
The big questions at the heart of this discussion are the forces at
play in the spontaneous evolution of accounting conventions, and the
ultimate performance of principles inferred through induction versus
ones deduced from assumptions about the objectives of accounting.
We believe future research in three areas is needed.
First, what is the historical path that led to the “bottom up”
development of accounting principles? Presumably, induction-based
principles will be evident in commonalities that exist independently
of cultural diffusion patterns, and these principles will be “robust”
in that they will work well in a broad range of circumstances.
Is there any basis for this view in the historical record? How exactly
were very basic principles such as Historical Cost, Conservatism, and
Objectivity identified — i.e., what was the nature of academic and
practitioner (both in accounting and law) interchange that led to
such principles? Some early writers note that accounting conventions
such as revenue realization emerged from British legal cases in the
19th century (Hatfield, 1909, pp. 195–213).18 Additional research that
traced through the emergence of accounting conventions would greatly
improve our present understanding.
Second, principles that have deep roots in experience and that have
been identified through induction are suggested to be robust and work
better across a range of conditions. Is this a valid view? If so, then
18 Others note much earlier links between accounting practices and subsequent principles
such as the entity theory (Littleton, 1933, pp. 183–204).
the performance and survival properties of organizations with account-

ing systems guided by evolved principles will be superior to systems
based on designed accounting principles. One method to investigate
this hypothesis is agent-based modeling. This methodology (discussed
earlier in Section 6.4.2) allows the researcher to manipulate the nature
of information used by an agent in making economic decisions and
directly identify via simulation methods the nature of information that
best promotes the agent’s resource acquisition and survival.
Third, if the contention of Douglass North (2005) that economic
institutions have their genesis in the human brain’s attempt to order
its environment is valid, then there should be a relation between the
human brain and evolved accounting principles. That is, conventions
and principles will “stick” to the extent they are consonant with how
the human brain orders its environment.
Dickhaut et al. (2008a,b) review neuroscientific evidence indicating
that several areas of the brain that have been implicated in economic
decisions and these fundamental decision-making processes resemble
important features of evolved accounting conventions. For instance,
Conservatism advises the accountant to anticipate no profits, but recog-
nize all losses (Basu, 1997). Neuroscientific experiments where subjects’
brains are scanned while making decisions demonstrate differential pat-
terns of brain activation associated with monetary losses and gains. In
particular, gains produce neural rewards in the right hemisphere while
losses provoked emotional responses associated with fear or regret in
the left hemisphere (Breiter et al., 2001), and areas of the brain asso-
ciated with memory such as the hippocampus show greater activity
for losses than gains (Knutson et al., 2003). Future research that more
directly explores the relation between accounting and the human brain
is likely to be an especially important area for future research.
6.2.6 Why has Accounting Evolution Been Subject to

Discontinuities Associated With Economic Crises?
As discussed earlier in Sections 3.6 and 5.3, British–American account-
ing practice and regulation exhibit strong discontinuities following
economic crises (see panel F of Table 3.1). Littleton (1933) describes
the extensive changes made to British bankruptcy statutes and the

Companies Act throughout the 19th century (see Table 5.1). In the
United States, similar major changes occurred following the market
crashes in 1907 and 1929. The bursting of the technology bubble in 2000
and the scandals involving Enron and WorldCom led to enactment of
the Sarbanes–Oxley Act of 2002. These episodes of rapid change are
consistent with the notion of “punctuated equilibrium” in accounting
evolution.19 That is, the cultural evolution of accounting is in most
cases gradual, but shows relatively rapid change following episodes
of economic crisis. Atkinson et al. (2008) estimate that 10%–33% of
evolution in major language families occurred in punctuated bursts
when languages split from one another.20 If accounting, the language
of business, evolves like other languages, then one-tenth to one-third of
changes are likely to occur in short bursts.
The notion that accounting has been shaped strongly by crises and
stock market crashes raises two questions. First, what is the role of
accounting information during these events? Second, do the account-
ing regulations adopted after these events provide increased economic
stability?
Bowen et al. (1989) and Keating et al. (2003) provide evidence on
the extent to which common stock returns during the market crashes
of 1987 and 2000 are associated with accounting earnings and other
related disclosures. These studies evidence provide little support for an
association between the content of firm-specific disclosures and crash
period returns. Thus, it does not appear that firm-specific disclosures
provide the spark that ignites a market crash.
Three studies examine whether firms with “better” accounting and
reporting policies suffer lower losses in the event of a market crash
19 According to Wikipedia, “Punctuated equilibrium is a theory in evolutionary biology. It

states that most sexually reproducing populations will show little change for most of their
geological history, and that when phenotypic evolution does occur, it is localized in rare,
rapid events of branching speciation (called cladogenesis).” The concept of punctuated
equilibrium derives from work by Mayr (1954) on the evolution of species. The idea
received greater attention as the result of work by Eldredge and Gould (1972). Eldredge
and Gould (1993) review the research on this subject.
20 These estimates are similar to the 22% estimate for genetic change via speciation (Pagel
et al., 2006).
(Barton and Waymire, 2004; Johnson et al., 2000; Mitton, 2002). John-
son et al. (2000) and Mitton (2002) investigate the East Asian crisis of
1997–1998 and Barton and Waymire (2004) examine the stock market
crash of 1929.
The 1997–1998 East Asian crisis affected equity securities in Asian
emerging markets. The primary issue associated with this crisis was
a loss of investor confidence that triggered a large net capital outflow
from these economies. This, in turn, created strong incentives for man-
agers of firms in these economies to expropriate shareholder wealth by
diverting corporate assets for their personal use. Johnson et al. (2000,
pp. 145–151) use a static model to hypothesize that a loss of investor
confidence is associated with a lower expected return from investment
in a particular firm, which in turn increases incentives for expropri-
ation by the manager. Thus, their hypothesis is that the effect of a
crisis will be greater when shareholder protection from expropriation
through governance institutions is weaker. They use several variables as
empirical proxies for governance, one of which is the presence of more
stringent accounting standards in the economy.
Johnson et al. (2000) estimate a series of regression models using
the country level measures employed previously by La Porta et al.
(1998). They find evidence that several of the governance variables
help explain cross-country differences in the 1997–1998 exchange rate
depreciation and stock market decline in 25 emerging market coun-
tries. Their results, however, provide no support for the hypothesis that
stronger accounting standards are associated with these cross-country
differences.
Mitton (2002) extends the Johnson et al. (2000) study to more
closely examine the relation between accounting policies and stock price
performance during the East Asian crisis at the individual firm level.
Mitton’s sample includes 398 firms in five specific countries affected by
the East Asian crisis: Indonesia, Korea, Malaysia, the Philippines, and
Thailand. Mitton’s empirical proxies for disclosure quality are based
on whether the firm (1) has an ADR listed in the United States at
the start of the crisis (10.3% of firms; N = 41), or (2) is audited by a
Big Six auditor (29.6% of firms; N = 118). The motivation for these
proxies is that firms with an ADR comply with the more stringent US
reporting requirements and firms with higher quality auditors likely

must have better reporting in order to obtain a clean audit opinion.
Mitton’s results support the hypothesis that higher disclosure quality
is associated with lower shareholder wealth losses during the East Asian
crisis. These effects are economically large: firms with an ADR traded
in the United States (Big Six auditor) earn a return that is less negative
by 10.8% (8.1%).21
The 1929 stock market crash in the United States is suggested to
have resulted from the bursting of a speculative “bubble” primarily
related to fundamental uncertainty about the eventual payoffs asso-
ciated with particular technological innovations (Kindleberger, 2000;
Shiller, 2000; White, 1990). Speculative bubbles have a long history
of being attributed to speculative excesses that accelerate as a bubble
grows in intensity and crowd psychology takes hold (Mackay, 1841;
Chancellor, 1999). Others offer rational explanations for escalating
stock prices that depart from fundamental values (Blanchard and Wat-
son, 1982; Garber, 2000). The truth may lie somewhere in the middle if
investors with short-term horizons begin to trade on anticipated price
increases in markets where prices have departed from fundamental val-
ues (Keynes, 1936, Chap. 12).
The empirical question addressed by Barton and Waymire (2004)
was whether firms with better accounting and disclosure experienced
less severe price declines in October 1929. Addressing this “simple”
question proved to be a difficult matter. Basic OLS regressions that
sought to explain cross-sectional variation were characterized by severe
endogeneity problems. This endogeneity led to their attempt to sta-
tistically model determinants of corporate reporting in the 1920s (see
discussion in Section 5.2.3). As a result, Barton and Waymire (2004)
employ econometric methods whose effectiveness in dealing with the
endogeneity issue is difficult to assess (Chenhall and Moers, 2007; Lar-
cker and Rusticus, 2007; van Lent, 2007).
The intuition underlying Barton and Waymire’s design is that, in
the presence of noisy fundamental values, higher quality accounting
information can (all else equal) lessen the effects of noise in price.
21 Theaverage market decline of the firms in Mitton’s sample over the entire crisis was
−68.7% (Mitton, 2002, p. 220).
Thus, firms with higher quality financial disclosure are expected to

experience less negative stock returns during October 1929. As dis-
cussed in Section 5.2.3, Barton and Waymire (2004) develop a measure
of reporting quality based on income statement transparency, balance
sheet transparency, auditor identity, and conservatism. After correcting
for endogeneity, this single factor variable shows a significant positive
association with October 1929 returns — i.e., firms with higher lev-
els of reporting quality experience less negative returns. As with the
Mitton (2002) study, this effect is economically large; firms in the high-
est quartile on the reporting quality measure suffer shareholder losses
that are lower than others by about 11%.22 At the same time, these
results should be interpreted with some degree of caution since they
are highly sensitive to the correction for endogeneity (see also Leftwich
(2004, pp. 124–127)).
One concern with these studies is that they are basically case stud-
ies; each examines a single extreme event. One methodology for assess-
ing the replicability of these findings is to extend them with economic
experiments. A series of experiments dating back to the 1980s demon-
strate price bubbles in laboratory asset markets (Smith et al., 1988).
Hirota and Sunder (2007) document that asset price bubbles in labora-
tory markets emerge in part because short-horizon investors lacking a
dividend anchor cannot backward induct to fundamental values. This
behavior is consistent with subjects basing their trading decisions on
anticipation of future prices rather than the difference between current
price and fundamental value suggested by dividends.
The only study of which we are aware that tries to link account-
ing with bubbles in experimental markets is a recent working paper by
Hobson (2007). Hobson runs an experimental market similar to that
used in the experimental economics literature with a manipulation as
to the form in which information is provided to subjects. Hobson doc-
uments that information about future dividends given to subjects in
hard-to-process form leads them to suffer trading losses at the hands
22 Barton and Waymire (2004, Table 12) find a statistically significant relation between
October 1929 returns and proxies for noisy fundamentals and the availability of divi-
dends as an anchor for valuation, providing additional evidence consistent with their
predictions.
of subjects receiving easy-to-process information. A useful extension

would be to evaluate whether the emergence of price bubbles and their
persistence is associated with the quality of accounting information
made available to all subjects, which the Internet bubble of the late
1990s suggests is a plausible outcome.
Overall, the evidence summarized above does not support the
hypothesis that accounting data carries information related to market
crashes, but there is some evidence that firms with better account-
ing policies fare better during such events. However, it is important to
note that the evidence in these studies is based on voluntary reporting
choices that emerged largely from market incentives. Thus, it is unclear
whether regulatory mandates for more extensive disclosure are effective
in promoting economic stability.
Disclosure and accounting mandates could promote stability if eco-
nomic crises provide information on the fitness consequences of weak
accounting systems and conceptual frameworks and if regulators can
successfully implement changes in their conceptual frameworks that
lead to widespread use of better accounting systems. Clearly, the
major conventions that define modern accounting have been identi-
fied mostly as a result of business failures (see Section 5.3.1). The
conventions of Objectivity and Historical Cost are among these —
for example, supporting evidence for transactions and recording at
cost allow for a more accurate reconstruction of a firm’s financial his-
tory that is useful in the event of bankruptcy or liquidation (Briggs,
1931; Hoffman, 1952; Shannon, 1951). Income measurement that clearly
separates income from capital likewise is necessary to insure that
excessive dividends are not paid in a firm operating as a going
concern (Littleton, 1933, pp. 245–246). The courts worked through
these issues gradually in a number of court precedents established
in 19th century Britain (Kehl, 1941; Parker, 1986; Yamey, 1962).
Auditors and practicing accountants institutionalized these broad
conventions in practice through adherence to these legal precedents
(Pixley, 1896).23
23 Pixley(1896) is instructive in this regard. After two brief chapters (35 pages) that provide
introductory remarks and describe the appointment and payment of auditors, the third
chapter (comprising 119 pages) deals with the law of auditing and accounting.
A similar experience occurred in the United States in the 1930s when

both the AICPA and AAA instituted programs to determine what is
meant by the term “accounting principles” (Zeff, 1972, pp. 119–139).24
These efforts were no doubt the artifact of the 1929 market crash, the
highly visible failure of Krueger Toll in March 1932, and the passage
of the Securities Act in 1933 and the Securities Exchange Act in 1934
(Flesher and Flesher, 1986). Both the AICPA and the AAA agreed
that broad principles should be identified based on evolved account-
ing practices, but they disagreed on the means to proceed with the
AAA favoring more aggressive change to move practice in the direction
of principles and the AICPA preferring a more incremental approach
(Storey, 1964).
The effects of regulation on accounting evolution are complex for
several reasons. First, it likely depends on the character of regula-
tion. For instance, regulation that creates incentives for firms to adopt
“best practices” in reporting is more likely to have a favorable influ-
ence because the regulator adopts incremental policies that allow for
flexibility in implementation that varies with specific circumstances.
The success of the 1856 Joint Stock Companies Act in Britain that
rescinded mandatory disclosure and instead provided illustrations of
“model” financial reporting suggests this is plausible. When reporting
is more flexible, but best practices are known, then non-compliance
can be enforced by market arrangements. US securities market devel-
opment and improved reporting before 1930 has this general character
(Hawkins, 1963).
Stringent and inflexible accounting regulation may ultimately
produce very different long-run effects. First, the establishment of a
regulatory apparatus with broad powers creates incentives for rent
seeking by those who could benefit from regulation. For instance, it
is common for major auditing firms to lobby the SEC and FASB
in favor of positions they support and from which they derive eco-
nomic benefits (Puro, 1984; Watts and Zimmerman, 1978). Sec-
ond, stringent regulation creates strong incentives for firms to avoid
24 Similar
kinds of concerns were voiced after the market crash in October 1907 when stock
market values plummeted and several banks and trust companies failed (Sobel, 1968,
Chap. 9; Previts and Merino, 1998, Chap. 5).
the negative consequences associated with regulation. For example,

transaction structuring is seen as a common artifact of modern stan-
dard setting and firms have avoided the effects of new securities regula-
tion by going private or switching exchanges (Bushee and Leuz, 2005;
Engel et al., 2007; Leuz et al., 2008; Piotroski and Srinivasan, 2008).
The big issue with stringent regulation concerns its long-run effects.
The political demand for a quick legislative response allows pol-
icy entrepreneurs to get enacted otherwise unpopular or undesirable
statutes (Romano, 2005b,a). This is particularly true if special inter-
ests can advance their agendas by sponsoring more politically appealing
groups with similar proposals (Yandle, 1983). The cumulative effects
of a strict regulatory posture, the adoption of new regulations, and the
associated responses of rent seeking and avoidance strategies create a
complex adaptive economic system (Arthur, 1999; Rosser, 1999; Simon,
1962). This has the effect that causation between regulatory behavior
and the structure of economic interaction becomes impossible to iden-
tify (Lott and Fremling, 1989). More importantly, the cumulative effect
of regulation could be an increase in the number and severity of crises
and scandals that regulation was presumably designed to avoid. That
is, crises and the like are endogenous outcomes of complex systems
that have evolved as a result of human action. Gawande (2002, p. 55)
summarizes this view with a medical example:
“(D)isasters do not simply occur; they evolve. In com-
plex systems, a single failure rarely leads to harm.
Human beings are impressively good at adjusting when
an error becomes apparent, and systems often have
built-in defenses. For example, pharmacists and nurses
routinely check and countercheck physicians’ orders.
But errors do not always become apparent, and backup
systems themselves often fail as a result of latent
errors. A pharmacist fails to check one of a thousand
prescriptions. A machine’s alarm bell malfunctions. The
one attending trauma surgeon available gets stuck in
the operating room. When things go wrong, it is usu-
ally because a series of failures conspires to produce
disaster.”
Unfortunately, there is little research in accounting that goes beyond

fairly simple treatments of the link between economic crises and the
promulgation and effects of accounting regulation. Perhaps ultimately
it will be impossible to produce such research, but we suggest that
academic accountants could better understand this issue by exploring
the extensive research on complex adaptive systems (Holland, 1995;
Miller and Page, 2007; Rosser, 1999; Simon, 1962). Such research would,
at a minimum, yield a better understanding of why “less may often be
more” when it comes to regulatory action.25
25 The propensity of humans to believe they can control complex systems has been termed a
“fatal conceit” by Frederich Hayek (1988) that often produces “unintended consequences”
(Merton, 1936). This suggests that accounting research on regulating a complex system
will likely be interdisciplinary and involve research on how policymakers write rules, the
effects of such rules, and how policymakers alter the very language of discourse that affects
the academic research produced to evaluate the consequences of regulation (White, 2005).
7
Concluding Remarks
We posit several reasons why accounting history research is socially

valuable in this essay. The first is that historical knowledge is important
to researchers investigating modern accounting issues. Many issues of
interest to accounting researchers have deep historical roots. Awareness
of accounting history can thus complement more traditional research
approaches used in accounting. The second claim is that history pro-
vides a wealth of data to explore the origins of accounting institutions
and the effects of regulation on accounting institutions. Considerable
opportunity exists in this domain, and offers the prospect to build a
deeper understanding of the phenomena we study. Economists have
seized the opportunities afforded by historical data, and there is no
reason why similar gains cannot accrue for academic accounting. Our
third claim is that accounting is at its core an evolved economic insti-
tution whose origins extend back at least 10,000 years. Future research
on the evolutionary foundations of accounting offers the prospect of
furthering our understanding of how accounting has developed as an
institution to fulfill a vital role in economic development. A fourth
claim is that a good knowledge of accounting history will help insu-
late researchers and regulators from reliance on convenient myths and
136
137
incorrect factoids about past experience. This is especially important if

conceptual frameworks guiding future accounting principles and prac-
tices are based on inaccurate mental models that could be easily falsified
by reference to historical events and data. Last but not least, we claim
that a shared appreciation of the fundamental importance of account-
ing in promoting economic development, partly responsible for moving
humans beyond the hunter-gatherer life of the great apes, would pro-
mote professional identity amongst accounting students and scholars.
Although we devote separate sections to document evidence only for
the first three claims, we hope that our discussion within these sections
is persuasive regarding the other claims as well.
We propose that accounting historians invite scientific quanti-
tative (Cliometric) analyses of historical data to complement the
more humanistic qualitative analyses of traditional accounting history
research. Theories from economics, anthropology, and biology can also
enrich the sociology and literary theories used in traditional account-
ing research. This will hopefully cross-fertilize ideas between account-
ing research domains that are becoming increasingly walled off from
one another (Hopwood, 2007). Furthermore, this should help attract
junior accounting scholars, who are overwhelmingly being trained in
quantitative methods in their PhD programs, to explore fundamental
accounting issues with quasi-experimental historical data (Ball, 2008).
We conjecture that an evolutionary perspective on accounting can
offer fresh insights on several fundamental issues that accounting his-
torians have grappled with for decades:
— How accounting endogenously develops as an economic insti-

tution through ecological rationality rather than by con-
structivist design to facilitate economic exchange (Kohn,
2004; North, 2005; Smith, 2003).
— The process of how basic accounting functions promotes
the economic development of market exchange and eco-
nomic organization. In this regard, we expect that the role
of accounting as a guide to decision making will be seen
as equally, if not more, important than the stewardship
and valuation roles of accounting. Indeed, accounting may
138 Concluding Remarks
ultimately be identified as an essential ingredient of the eco-

nomic dynamics referred to in metaphors such as the “invis-
ible hand” of the market (Smith, 1776), “visible hand” of
the firm (Chandler, 1977) and “visible boot” of the state
(Buchanan and Tullock, 1962).
— How accounting practices take shape and spread sponta-
neously through interaction independent of formal standard
setting. It will help us understand why the fitness conse-
quences of highly specific methods are difficult to identify.
— Why broad accounting principles to guide choice across a
broad range of circumstances are ultimately valuable. In the
process, it may provide an understanding of why accounting
conventions evolved from practice can be more effective than
those principles resulting from designed conceptual frame-
works.
— The role of accounting within a complex economic system,
and why, if at all, weak accounting can destabilize an eco-
nomic system. It also can help us better understand the
“unintended consequences” of accounting regulation.
Acknowledgments
We have benefited from the comments of Ilia Dichev, John Dickhaut,

and an anonymous reviewer as well as data collection by Eric Gottlieb
and editorial assistance by Michelle Waymire.
139
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Foundations and Trends R

Accounting is an Evolved Economic

Gregory B. Waymire1 and Sudipta Basu2

Yet, if it is too pessimistic a view that man learns noth-

— Friedrich Hayek, “History and Politics” (1954, pp. 1–2)

Without a knowledge of history, the accountant may

— American Accounting Association (AAA) Committee on the

Accounting is an economic institution whose recordkeeping origins

imbedded in regulators’ conceptual frameworks or academics’ compara-

understand that which we cannot directly observe or measure rather

Hayek emphasizes, researchers may develop theories relying on “fac-

We deﬁne accounting history research as:

“The careful and distinctive observation and interpreta-

The research literature on accounting history is large and we do not

We pose six “big picture” evolutionary questions to frame the rest of

(1) Why is the recordkeeping core of accounting important?

These questions are posed roughly in chronological order. Record-

Our view is that accounting is an important economic institution that

1 More comprehensive reviews of Anglo-American accounting and auditing history are

B: Double-Entry Accounting and Economic Complexity (Section 3.2)

Table 3.1 (Continued)

C: The Emergence of Accounting Norms and Professional Standards (Section 3.3)

Table 3.1 (Continued)

Table 3.1 (Continued)

E: Why Do Broad Accounting Principles Exist? (Section 3.5)

Table 3.1 (Continued)

Table 3.1 (Continued)

3.1 Why is the Recordkeeping Function of Accounting

3.2 How Could Double-entry Bookkeeping Enable

A relation between economic organization/complexity and account-

The co-evolution of accounting with economic complexity is central

3.3 How Can Accounting “Norms” Form Spontaneously

publications has exerted considerable inﬂuence on the dissemination

that lead to regularities in accounting practice is important for gaining

3.4 Accounting’s Relation with Law, Regulation,

documenting receivables and payables, which could then be used as

3.5 The Existence and Development of Broad

area like marketing where marketing policies are evaluated by observing

3.6 The Discontinuous Path of Accounting Evolution

and other climate phenomena change the environment violently in the

8 An analogy is examining a bee’s wing-ﬂapping speed by comparing photographs spaced

losses by US shareholders in economic crises (events #F4, F5, F7, F8,

Our focus in this section is on how knowledge of accounting history can

4.1 The Role of Thought Experiments in Research

“What exactly are the terms of a scientist’s contract

far from being a man who never knowingly departs from

That is, the scholar-scientist often starts by telling a story, which

“Economic theory can only gain from being taught

the interplay between social institutions and economic

This suggests a role for historical research to help us in constructing

4.2 The Role of Historical Case Studies

Prior research documents that 1920s US balance sheets often

Source: Commercial and Financial Chronicle, May 11, 1907.

the audit report of Price Waterhouse explicitly veriﬁed that GE had

“There is of course no necessary relation between the

been developed by the patentee. . . . (I)t is interesting

“General Electric stood out above all manufacturers of

constrained, and GE could initiate high dividend payouts that would

“At the end of the year 1917, without the intervention

Subsequently, increasing numbers of ﬁrms began reporting intangi-

successful ﬁrms being more likely to report conservatively. Neither

ﬁnancial statements and supplemental disclosures. A second, more

A third lesson illustrated by this example is that the evolution of