Market failure fallacies and accounting information

Journal

of Accounting

and Economics

2 (1980) 193-211.

North-Holland

Publishing

Company

MARKET FAILURE FALLACIES AND ACCOUNTING INFORMATION* Richard Uniwrsiry Received

qf Chirugo,

LEFTWICH Chrcugo. IL 606.37. USA

May 1980, final version

received

December

19X0

Proponents of increased regulation of accountmg malntain that there are failures in the probate market for accounting informatmn. In this paper, It is argued that ma&et fadure theories contain a logical fallacy. The optima identified in those theoriey are not optima hecause they arc defined independently of instltutional arrangements necessary to attain them. Existing institutional arrangements, such as markets, should not be condemned until It can be shown that there is an alternative regime which can produce, socially superior output. The paper exammes theories which explicitly allege that there are fnilures in the private market for accountmg Information. In addition, early crttlcisms of accountmg Information are restated in economic terms, and it is revealed that those criticism\ Implvzltly ahsume that private productmn of accounting information suffers from market failures. The paper concludes by suggesting that, of accounting research is to contribute to public pohcy formulatmn. researchers should focus on evaluating the type of tnformation that can bc produced by fcaslble regtmes such as markets or government agencies.

1. Introduction Proponents of increased regulation of accounting argue that there are market failures associated with the private production of accounting information.’ These market failure theories rely explicitly on economic models incorporating public goods, externalities, signaling. or information asymmetry. Government regulation is frequently suggested as a solution to market failure problems. Older theories concerning alleged defects in accounting information seldom relied on an explicit model of accounting information as an economic good.” *This paper is part of my Ph.D. dissertation at the University of Rochester. 1 would hke to thank the members of my committee for their advlce and encouragement: Mlchacl Jensen (Chairman), William Schwert, Ross Watts and Jerry Zimmerman. Robert Holthausen provided valuable comments on earlier drafts. An anonymous referee made suggectlons which clarified my thmkmg on this topic and. hopefully, improved the analysis in the paper. Financial support for the dissertation ‘was provided hy the Ernst and Whmney Foundation and the Managerial Economics Research Center of the Graduate School of Management at the University of Rochester. I am grateful for that financial support. ‘For a summary discussion, see Gonedes and Dopuch t lY74). Beaver (lY76). and May and Sundem (1976). ‘See, for example, Brilo,ff (1967). Myers (1962). Spacek (1969). and Thomas (1969).

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However, a closer examination of those theories reveals that they also depend, to a large extent, on some implied failures in the private market for accounting information. In this paper, I argue that market failure theories are devoid of policy implications because those theories contain a fundamental logical flaw. The social optimum identified in models of market failure is not an optimum because it is not attainable given the existing technology of institutional arrangements such as markets, government regulations, or other regimes. It is of little consequence to show that the output of an actua1 market differs from some abstract norm that we do not know how to attain. Moreover, the emphasis on market failure theories in accounting (and economics) is not only fruitless it is counterproductive because it directs researchers’ attention from the decisions that face policymakers. If policymakers want to maximize social welfare, they must choose the set of institutional arrangements which produces the most highly valued output, given the costs of producing and distributing it. However, that set can be selected only if it is technically feasible. If accounting research is to assist that choice, it must identify and analyze the attributes of information that can be produced by particular feasible regimes such as private markets, regulated markets and government agencies.

Outline oj”the paper Section 2, ‘Explicit Market Failure Theories’, examines economic theories of market failures, especially those which imply that there are failures in the market for accounting information. The examination reveals that those theories identify an optimum which is an optimum in name only. In section 3, ‘Implicit Market Failure Theories’, early criticisms of defects in accounting information are recast in terms of economic models. It is shown that these economic models implicitly assume that the alleged defects persist because the private market for accounting information contains market failures. Section 4 contains a brief summary and some conclusions.

2. Explicit market failure theories This section begins with a critique of models of failures in private markets in general, and goes on to criticize models of failures specific to the market for accounting information.

2.1. Failures

in markets

in general

In the economics literature, a market failure is said to occur when either the quantity or quality of a good produced in an unregulated market differs

from what is purported to be the social optimum.3 The social optimum is defined as that output which maximizes aggregate social welfare and is attained only if the prices of inputs and outputs are equal to their social marginal costs. In private markets, producers and consumers pursue their individual self-interests. Thus, it is alleged, the output of private markets differs from the social optimum whenever social costs and benefits differ from private costs and benefits. If private costs are lower than social costs for some goods, private markets produce ‘too much’ of those goods. On the other hand, if private benefits are lower than social benefits, private markets produce ‘too little’ of those goods. For example, ‘too few’ consumers purchase tight blue jeans because the purchasers do not capture all of the benefits conferred on society by wearers of those garments. In the extreme, some goods are not produced at all in private markets, i.e., the market for those goods does not exist, even though their social value exceeds their social cost. If a market failure occurs. aggregate social welfare can be improved, in a Pareto sense.4 if producers are costlessly induced to change their output to conform to the social optimum. Frequently. government intervention is suggested as a way of moving the actual output of the private market closer to the supposed social optimum. Many economists recognize the obvious fallacy associated with such policy prescriptions ~- the suggestions commit the ‘grass is always greener fallacy’ by appealing to an unexamined alternative.” Government intervention can increase social welfare only if the value to society of the output of the newly-regulated market. net of the costs of obtaining that output, exceeds the value to society of the output of the private market. It is difficult to predict the output of a newly-regulated market because there are few empirically substantiated theories of bureaucratic behavior.6 A new regime or set of institutional arrangements will produce output which differs from the existing output, but the new output could be even further removed from the apparent social optimum. Thus, ‘government failure’ can be substituted for market failure.7 Government regulation need not move actual output in the direction of the purported social optimum if there are incentives for government regulators to make decisions based on their private costs and benefits, rather than on social costs and benefits. For example, politicians’ chances of reelection and bureaucrats’ chances of retaining their jobs can depend on how well they cater to special interest groups, such as farmers and organized ‘For a rigorous discussion of the economic concept of market failure, see Bator (1958). ‘A Pareto improvement results when at least one member of society is made better off and everyone else is no worse off. ‘Demsetz (1969) identifies and discusses this fallacy. ‘F-or an attempt to develop such a theory, see Niskancn (1971). ‘Wolf (1979) investigates why government intervention to remedy market failure can Itself be a failure.

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labor, rather than how well they serve the public interest. Moreover, it is costly for regulators to identify the socially optimum level of output, let alone determine how that level of output is to be produced, financed and distributed. For example, most of us would agree that an industrial plant discharges ‘too much’ waste into a stream if the owners of the plant do not bear any of the costs of the resulting pollution. However, since it is difficult to determine the social costs and benefits of various levels of pollution, government regulation of waste disposal will not necessarily increase social welfare. Given that pollution control consumes scarce resources, the socially optimum level of pollution need not be zero. Consequently, society’s welfare can suffer if there is too little pollution just as it can suffer if there is too much pollution. There is another fallacy associated with policy pregcriptions based on market failure analyses. That fallacy is related to the grass is always greener fallacy, but it is more subtle and more pernicious. It is a fallacy of not even knowing how to determine whether the grass is greener. I maintain that models of market failure do not identify an attainable social optimum because they define that optimum independently of the set of institutional arrangements that can produce the optimum. The theoretical optima in the models are derived by considering two sets of forces -- preferences and production opportunities. Production opportunities depend upon the economy’s endowment of resources, the structure of property rights,’ the physical laws of nature and man’s knowledge of those laws. To identify market failures, the theoretical optima are compared with the actual outputs produced by existing regimes or sets of institutional arrangements, such as private markets. Then the institutional arrangements are declared a failure if they do not produce the supposedly optimum output. The logic in this final step is fallacious. The existing regime cannot be condemned unless it can be shown that there is a set of institutional arrangements that is capable of producing the purportedly optimal output. If there are to be any allegations of failure, they should be directed at the definition of optimality rather than at a particular set of institutional arrangements. The purported optima they are defined independently of the regimes simply are not optima necessary to attain them. In essence, market failure models assume that it is costless to operate through institutional arrangements such as unregulated markets, regulated markets and collective action. However, actual institutional arrangements are costly. Moreover, alternative arrangements make different demands on society’s resources. Thus, society’s welfare depends on the * choice of institutional arrangements. Unless the costs of alternative institutional *See Jensen and Meckling (1979) for an explanation of why production the structure of property rights and contracting rights within an economy.

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arrangements are included in the analysis, there is no guarantee that society would be better off if the so-called optima were produced. Notice the distinction between the grass is greener fallacy and the fallacy of not knowing how to identify the color of the grass. To avoid the former fallacy, we must recognize that, if alternative institutional arrangements are costly, we cannot predict whether government regulation will move the actual output closer to the purported optimum. To avoid the latter fallacy, we must concede that we cannot even idrnr$i the social optimum unless the analysis includes the costs of those alternative institutional arrangements. In the pollution example discussed above, we should recognize that we must account for the resources consumed by various institutional arrangements when we identify the optimal level of pollution. Consider two polar cases. Under one regime. there is a low cost technology to identify, monitor. and enforce pollution compliance. Under the other regime, the only available technology consumes more of society’s resources than are dissipated by the harmful effects of pollution. Clearly. the level of pollution which maximizes social welfare differs under each regime. In summary, market failure theories are devoid of policy implications because those theories do not identify an attainable optimum. Despite the pejorative connotation of inefficiency associated with the term ‘market failure‘, the presence of those so-called failures has no implications for economic efficiency. At best the theories are empty, at worst they involve a seductive use of language. The purported optima identilied in those theories simply are not optima because they are defined independently of the regimes necessary to attain them.

Economists allege that there are failures in the private market for information, leading to either underproduction or overproduction when compared with the unattainable social optimum. Older theories focused on the urltlrrprorluctiorl supposedly resulting from externalities or the public goods aspect of information. It was argued that, because of free rider problems, private producers would not capture all of the benefits of the information they produced. More recently, attention has shifted to the likelihood of o~erl)rc”luc,tion of information. It is alleged that individuals devote resources to producing some information that makes them better off at the expense of others, i.e., the information creates wealth transfers without any attendant increase in social product. Consequently. resources devoted to gathering that information are socially ‘wasteful’.” “lllrshlcfcr (14711 and F’ama and Laffer (lY71) dtscuss the mcentives to ‘overproduce’ infc)rmatlcln III ;~ pnre exchange economy. and Spence (1974) and StlglltL (1075) describe the .o~crproductlon’ ;i\wclated with s~gnahng and screenmg actlwties. Rwzcl (1977) dispute\ the rc\nlt\ de~~lopcd 111thaw studies.

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In the accounting literature, theories of failure in the market for accounting information are based primarily on the public goods problem.” It is argued that accounting information has the distinguishing feature of a public good; that is, the consumption of the good by any individual does not diminish the quantity available for others. In Samuelson’s (1954, 1955) model, the socially optimum quantity of a public good is produced when the marginal cost of the good is equal to the sum of the individual consumers’ marginal valuations of the good. Private production of a public good, it is alleged, falls short of Samuelson’s social optimum for two reasons. First, private producers are unab!e to charge perfectly discriminating prices, i.e., they cannot charge individuals their marginal values of consumption. Second, private producers of public goods cannot, at zero cost, exclude nonpurchasers. However, Samuelson’s optimum is not an optimum because it suffers from the same fallacy that is discussed above - the optimum is defined independently of any institutional arrangements necessary to produce and distribute it. Samuelson’s model does not identify an uttainable optimum for the production of a public good. Unless that attainable optimum is identified, public goods theories have no policy implications because we cannot determine whether the quantity produced in a private market is greater or less than the optimum level that is attainable, given the costs of alternative institutional arrangements. The accounting literature emphasizes the alleged underproduction of accounting information resulting from the problem of excluding nonpurchasers of a public good.” This emphasis is puzzling. Ensuring that only purchasers consume a good is not a problem unique to producers of public goods. For example, relative to the naive optimum which ignores exclusion costs, fertile farm land adjacent to schools is underutilized in the production of apples because of the high cost of excluding students as non-purchasing consumers. It is not that non-purchasers cannot be excluded, merely that it is costly to do so, and the exclusion costs associated with some public goods (such as defense) appear high. However, the presence of exclusion costs is irrelevant for questions of economic efficiency. It is true that social welfare is improved if exclusion costs are lowered, but the same improvement results if any cost of production is lowered. Public goods models do not analyze how those exclusion costs can be lowered. Evidence suggests that the cost of excluding non-purchasers does not preclude private producers from supplying some public goods. Coase (1974) presents evidence of the private supply of one of the most often cited public goods ~- lighthouses. Cheung (1973) offers evidence of market mechanisms “‘See. for example. the discussion in Gonedes (1976), Gonedes and Doplich (1974). and May Dopuch and Penman (1976) and Gonedes (1978) consider and Sundem (1976). Gonedes, signaling behavior in the production of accounting information. “See, for example. Gonedes and Dopuch (1974, pp. 77-78).

which overcome the classic bees-and-honey externality problem. Benston (1969), Watts (1977), and Watts and Zimmerman (1979) discuss evidence of firms voluntarily providing investors with accounting information (some of which was audited) long before disclosure laws were enacted. It is paradoxical that, just as there is concern in the accounting literature that non-purchasers of information ~ur~~ot be excluded from purchasing it, there is concern in the economics literature that non-purchasers of a public good should not be excluded from purchasing it. Some welfare economists argue that, even if exclusion is costless, it is inefficient to exclude nonpurchasers of a public good if the marginal cost of their consumption is zero. For example, suppose there is a device that can scramble television signals so that only those who pay fees to the broadcaster can view the signal. Such a device can exclude non-purchasers, even though the marginal cost of their viewing is zero. In the Samuelson sense of efficiency, use of that device reduces social welfare because the resources devoted to excluding nonpurchasers are dissipated, i.e.. it is not socially optimal to allow public goods to be marketed as private goods.” The issue of excluding or not excluding non-purchasers ignores the fundamental policy issue of identifying the optimum output. The Samuelson notion of efficiency requires that non-purchasers be allowed to consume a given output, but it says nothing about how the quantity and quality of the optimum attainable output can be ascertained. As Minasian (1964) observes, in addition to deciding how to (or whether to) ration the output, policymakers are concerned with determining the quality and quantity of output to produce, and the production and rationing decisions are not independent. For example, consider the production and distribution of movies. To a first approximation. suppose that, once a movie has been produced, additional prints of the movie can be made and screened at zero cost. Naive public goods analysis reveals that, under those circumstances, social welfare is maximized if movies are duplicated and shown to anyone who values the viewing experience at greater than zero. Duplicating the films consumes none of society’s scarce resources, but it provides consumption value to some members of society. The fallacy is obvious. The quantity and quality of movies produced under the new ‘rules of the game’ will differ from those produced under the old rules, unless a scheme is devised to provide incentives for producers to maintain the previous quantity and quality levels. Of course. the example is virtually a parody. but it illustrates the dependence between the rationing and the production decisions. Even the simple presumption that accounting information is a public good is questionable. It can be argued that accounting is a private good because the consumption (use) of that good by one investor reduces the quantity ‘2S~e the debate betueen IS dlacusscd m detail.

Mmasi~~

(1964) and Samuelson

(1964) where the televlslon

example

available for others.13 Suppose that a particular piece of accounting information, e.g., the annual income number, has value to an investor, i.e., prior to the release of the accounting information, the market value of the firm does not incorporate that information. To the extent that the investor’s use of the information impounds some or all of it in the prices of the firm’s securities, the value of the information to other investors is reduced. In any event, the issue is not whether accounting information is a public good or a private good. The public--private dichotomy is an artificial one, useful for economic model building because it enables both ends of a Virtually all goods have both public and spectrum to be represented.” private attributes, e.g., brief swimsuits. If public policy is governed by efficiency considerations, the issue involves choosing, from among. the institutiond urrangements that urr currently> feasible, that set which produces the most highly valued output, net of the costs of obtaining that output. Public goods models cannot resolve the efficiency issue because they do not identify attainable solutions. Instead, they reject ‘a particular system not on the basis of its merit relative to other alternative approaches to a particular problem, but merely because it does not fulfill the conditions of an “ideal” world’. 1’ Policy prescriptions based on alleged market failures are comparatively However. a re-examination of some recent in the accounting literature. earlier criticisms of accounting information produced by unregulated markets reveals that those criticisms were based on implicit failures in the market for accounting information. Logical fallacies associated with those implicit market failure arguments are discussed in the next section of the paper.

3. Implicit market failure theories Early criticisms of accounting information in the accounting literature and in the popular press characteristically focus on one or more of the following claimed defects of the private market for accounting information:‘6 (i) (ii) (iii) (iv) (v) (vi)

monopoly control over information naive investors, functional fixation, misleading numbers, diversity of procedures, and lack of objectivity.

by management,

‘“Watts and M~lne (1977) made this argument. Lev (1976) discusses the private good aspects of accounting information. 14Pubhc goods theories are, of course, useful to advocates of increased regulation because those theories provide a justrfication, albeit superficial, for regulation. See Stigler (1976) and Watts and Zimmerman (1979). ‘5Minaslan (1964, p. 78). ‘“See.

for

exampk

Chambers (1965),Ijiri, Jaedicke and Knight (1966), and Sterling (t970b).

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Few of the early critics explicitly mode1 accounting information as an economic good. Instead, they present normative models of the type of accounting information that ‘should be’ produced to satisfy hypothesized information is objectives. l7 The output of the private market for accounting then criticized if it does not correspond to the information called for by the normative models. When those criticisms are subjected to economic analysis, it becomes obvious that they imply that. because of one or more of the features of the private market listed in (i)-(vi) above, an unregulated market cannot produce the (naive) ideal quality or quantity of information, i.e., there are market failures when accounting information is produced privately. Typically, the critics recommend increased government regulation to improve the quality or quantity of accounting information.” As is the case with explicit theories of market failure discussed above, the ideal quality or quantity of information is determined in normative accounting models independently of the set of institutional arrangements necessary to produce that information. The supposed ideal is thus unattainable and is not an appropriate benchmark for comparison with the actual information produced by a particular regime, such as a market. Proponents of increased regulation seldom present evidence of the alleged defects in privately produced accounting information, and the evidence that is presented is, at best. anecdotal.” In this section of the paper, the early criticisms of accounting are analyzed to reveal the nature of the market failures implied by the criticisms. The implied market failures are discussed and some empirical implications of those alleged failures are developed.

(i) Monopol,:

control

otter inform&ion

by manugemenr

(a) The criticism. It is alleged that published accounting reports provide exclusive access to information about corporations.20 According to this allegation, alternative sources of information for investment decisions either do not exist or are not used by investors. Since investors cannot corroborate published accounting numbers against any alternative source, errors in those numbers result in faulty investment decisions. Moreover, to the extent that accounting numbers ignore (or even obfuscate) some aspects of a corporation’s performance, investors base their decisions on incomplete information. “Jensen (1976, pp. 11-12) and Gonedes and Dopuch (1974, pp. 49-50) discuss the futility of this type of theory development. “See Chambers (1973) and Briloff (1972, 1976). “For a review of the problems associated with relymg on anecdotal evidence, see Anderson and Leftwich (1974) and Benston (1974). 20Ball (1972, pp. 3-4) contams a summary of the monopoly arguments. See also Chambers (1969, p. 601), Simpson (1969, p. 806), and Spacek (1969, pp. 137-138).

murket failure. Supposedly, alternative sources of (b) The implied information do not exist or are not used. No explanation of why they might not exist is given. If the costs of gathering corroborative information are greater than the benefits of that information, there is no cause for criticism because rational investors do not invest in that information. If the costs of gathering the information are lower than the benefits, there is a profit opportunity for an entrepreneur who sells the information. It is difficult to understand why that profit opportunity would remain unexploited. Perhaps it remains unexploited because sellers of information find it costly to capture the benefits of the information. However, such an explanation is no more than a disguised way of saying that the costs of providing the information are greater than the benefits.21 If alternative sources of information exist but are not used by investors, the prices of a firm’s securities do not incorporate all of the available information. Thus, there are profit opportunities which can be exploited by acting on the alternative sources of information. Those who allege that alternative sources of information are not used do not present any evidence of the profit opportunities implied by their allegations. Until evidence of those unexploited opportunities is presented, no credence can be given to the claim that managers exercise monopoly power over accounting information. Why owners of firms would cede managers that monopoly power is a further puzzle, and is discussed in (v) below. (ii) Naive investors (a) The criticism. Some critics maintain that accounting information cannot be interpreted by investors who have no training in the machinations of accounting procedures. Even sophisticated users, it is said, experience great difficulty in determining the impact of a particular collection of accounting techniques on reported income.22 Thus, when different accounting techniques are used to record essentially identical transactions, unsophisticated investors are unlikely to ‘correctly’ compare accounting numbers, either across firms or through time for a given firm. This problem is magnified by the great diversity of accounting procedures [discussed in (v) below]. The terms ‘naive’ and ‘sophisticated’ are (b) The implied murket fuilure. misnomers, albeit emotive misnomers. From an economic perspective, ‘sophisticated’ users have invested in a knowledge of accounting, finance, and economics, and, perhaps, have some natural abilities in financial analysis. “Ardent advocates of the monopoly argument could contend that the costs of collecting corroborative information are not independent of management behavior, i.e., management can raise the cost of other sources of information. The adverse effects of such behavior on the value of managers’ human capital are discussed in (v) below. ?*These arguments appear in Briloff (1967, 1972, 1976).

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‘Naive’ users have not made the investment or lack natural talent in the endeavor. Sophisticated users make the investment or exercise their skills in the expectation of earning a return on their activity. The return is captured by trading on information or by selling the information to naive investors. Nothing in this scenario is inconsistent with a well-functioning economic market. For example, many consumers of stereo equipment possess only a rudimentary understanding of the technical specifications of the equipment. However, there is a flourishing market which supplies would-be consumers with information. Stereo magazines, consumer testing societies, and stores wishing to generate repeat purchases all provide information to enable ‘naive’ consumers to make informed choices. The presence of ‘naive’ participants in a market does not imply that those participants are exploited.23 If naive participants elect not to ‘purchase’ advice, they will, almost by definition, make more mistakes than sophisticated participants. However, naivete does not preclude rationality - we expect naive consumers, and all consumers for ihat matter, to trade off the marginal costs of making mistakes with the marginal costs of obtaining information to avoid those mistakes. If information is costly, it is likely that even sophisticated consumers will risk making mistakes.24 Naive participants in the market for accounting information can purchase information from sophisticated participants. For example, Value Line. Standard and Poors, and other investment services sell financial analyses of published accounting information. Moreover, there is a body of empirical evidence which supports the efficient market hypothesis; i.e., the hypothesis that the market price of securities rapidly incorporates an unbiased estimate of the impact of new accounting (and other;) information on the values of the securities.25 If market prices of securities fully reflect all available information (both favorable and unfavorable), naive investors are protected -- they earn a return, on average, which compensates them for the risk of the investment.

(iii) Functionul fixation (a) The criticism. Investors, it is argued, may be affected by the psychological phenomenon of ‘functional fixation’.26 Investors are said to be ‘functionally fixated’ if they attach the same meaning to accounting numbers (such as net income and asset values) independently of the set of accounting rules used to calculate those numbers. This phenomenon allegedly results in “Gonedes (1976) makes this point also. ‘40f copse, some may argue that investors are not only naive, but also irrational. The irrationality issue is discussed in (iii) below. *‘Fama (1976) provides a detailed discussion of the hypothesis and the empirical tests of the hypothesis. 261jiri. Jaedicke and Knight (1966) introduced the term to the accounting literature, Chang and Birnberg (1977) provide a review of research directed at functional fixation.

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incorrect decision making by investors and even in destruction of accounting’s ability ‘to facilitate the rational operation of the economic system’.27 Mere disclosure or availability of relevant information (in, for example, footnotes to annual accounts, the chairman’s address to stockholders, or press releases) does not overcome the problems associated with functional fixation. Functionally fixated investors focus exclusively on reported numbers, and, unless those numbers are adjusted to reflect all relevant information, investors do not incorporate that information in their decisions. Some evidence of apparent functional fixation is obtained from research into how recipients of accounting information incorporate the reported numbers in their decision processes. Interviews, questionnaires, and laboratory experiments are used to elicit information about investment decisions from subjects presented with accounting reports based on different accounting techniques. This research reveals that individuals possess limited information-processing ability, and use very simple decision rules which they change only with reluctance. ” However, the experimental design seldom presents subjects with economic incentives to search for, and evaluate, new information. For example, students in a laboratory situation or managers completing a questionnaire are not faced with the same trade-offs that confront individuals deciding how to invest, say, $100,000 of their own funds. Furthermore, it is difficult to draw inferences about aggregate behavior from these studies because the experiments lack survival and imitation mechanisms which are, as is discussed below, present in markets.l’ In economic terms, functional tixation (b) The implied market fuilure. questions the assumption of investor rationality. In contrast with other this ‘criticism explicitly points to a criticisms of accounting information, limitation of individual decision makers rather than of accounting information per se. Investors’ limited information processing abilities are said to cause inefficiencies in the private production of information. The notion of functional fixation or any other theory casting doubt on investor rationality is devoid of content if it amounts to no more than a claim that investors maximize subject to constraints. Economic models of investor behavior recognize that information processing abilities of individuals (and machines, for that matter) are limited and it is costly to augment those abilities. Rational behavior does not require searching for and evaluating all information, nor does it preclude relying on simple rules of thumb. Indeed, rational behavior dictates searching and evaluating “Dyckman (1964, p. 294). ‘*For recent examples of this research, see the 1977 supplement to the Journal of .4ccounting Research. Libby and Lewis (1978) provide a survey of the human information processing literature. *%onedes and Dopuch (1974, pp. 104-107) discuss the limitations of the experimental design in these studies.

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alternatives and using sophisticated decision rules orrl~ as long as expected benefits exceed costs. If the concept of functional fixation is to have any substance, it must imply that investors do not maximize subject to constraints; that is, the decisions they arrive at are frequently irrational. However, unless survival and imitation mechanisms in a market fail, irrational behavior cannot be characteristic of market participants. Even if investors select their decision rules haphazardly, some will prosper and some will suffer losses. Those who select rational decision rules will prosper in the long run, regardless of whether they choose those rules because of superior insight or because of revelations from some mystic being. Accumulation of wealth in such a scenario acts as a signal to identify investors who have adopted, knowingly or unknowingly, rational decision rules. 3o If the rules can be kept secret, there are opportunities to sell investment advice. If the rules cannot be kept secret, imitation ensures that market participants make rational decisions. Provided survival and imitation mechanisms operate in the market, irrational decision making cannot be a pervasive feature of the market. (iv) Meaningless

numhers

(a) The criticism. Accounting relies heavily on allocations of historical cost, e.g., to calculate depreciation charges and to absorb manufacturing overhead in inventory values. Some contend that the resulting accounting numbers are unlikely to provide useful information for investment decisions because such allocations are arbitrary, and because sunk costs are irrelevant for decision making. 31 Furthermore, even within the confines of historical cost accounting, the valuation methods are not uniform. For example, the lower of cost or market rule is used to value inventories, estimated realizable value is used for accounts receivable, and the discounted value of future lease payments is used to record the liability for some lease commitments. It is claimed that, if the numbers produced by these different valuation methods are aggregated, the resulting total cannot be given a valid interpretation, just as it would be impossible to interpret (n+ m), the total of n oranges and m gallons of oil.32 (b) The implied market &Are. If there is a system of accounting which provides better information, firms will produce that information in a wellfunctioning private market, provided they can capture enough of the benefits to offset the costs. If the superior information is not produced, either firms are ignoring profit opportunities, or the critics have incorrectly evaluated the cost-benefit tradeoff. 3”For a discusslon of this ‘economic Darwinism’ see Alchian (1950). 3’See Thomas (1969 and 1974), Sterling (1970a), and Chambers (1966a) ‘2This problem is stressed by Chambers (1966a) and Sterling (1970a).

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Evidence presented in Leftwich (1980) suggests that participants in private loan agreements contract to provide information which differs from the regulated set of accounting information. The participants negotiate measurement rules which contain some elaborate departures from generally accepted accounting principles. However, the negotiated rules specifically endorse the use of depreciated historical cost and other so-called ‘meaningless numbers’. The evidence suggests that, unless firms are overlooking profit opportunities, the costs of other types of numbers are greater than their benefits, at least for participants in the lending market. Advocates of increased regulation of accounting provide no evidence that regulated accounting numbers are more ‘meaningful’ than privately-produced numbers. In fact, those advocates ignore evidence suggesting that regulation inhibits rather than encourages the release of some information which market participants value. For example, Securities and Exchange Commission (SEC) regulations prohibit firms from releasing profit forecasts when they issue debt to the public and until recently the SEC discouraged upward revaluation of assets. Such forecasts are provided routinely to subscribers to private issues which are not regulated by the SEC. Benston (1969, pp, 524-528) suggests that the opportunity to provide the forecast information and information about asset values in excess of book value is so valuable to some firms that those firms are induced to make private issues rather than public issues. (v) Diversity

of procedures

(a) The criticism. There are several alternative accounting techniques which may be used to record particular events. For example, there are at least five methods of charging depreciation, five inventory valuation methods, and four alternative methods of revenue recognition. According to one estimate, when just a subset of possible events is considered, management can choose from among 30 million alternative ‘packages’ of accounting methods.33 The financial position that is reported depends upon management’s choice of a set of methods. By judicious ‘shopping’, management can exercise that choice to paint a picture of whatever hue it desires. Consequently, managers can disguise any inept performance and can conceal good or bad news until they or their associates trade on that information.34 In addition, it is claimed that the lack of uniformity of accounting procedures hampers comparison of performance across firms and over time for a particular firm, especially if investors are unsophisticated.35 “The calculations are performed by Chambers (1965, 1966a). 34Notice that these criticisms assume that alternative sources of information used or not available [see the discussion in (i) above]. “%ke Keller {1965) for a review of the proposals for reducing the flexibility procedures. Stephan (1966, p. 413) presents the lawyers’ case for uniformity procedures.

are either

not

of accounting of accounting

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Proponents of increased regulation of accounting argue that both the diversity of procedures and management’s freedom to choose among those procedures should be reduced by regulatory intervention. can be, and are, written to (b) The implied market ~uilure. Contracts restrict management’s behavior. If contracting and monitoring are costly, can transfer some resources to themselves by way of managers misappropriations, i.e., rational behavior dictates that resources are devoted to monitoring only to the level where the expected marginal costs are equal to the expected value of the reduction in marginal misappropriations by induce. However, managers ‘pay’ for their that they managers misappropriations by a reduction in current and future wages to reflect the expected cost of the misappropriations.3h Contracts can be written to reduce the accounting alternatives available to management. Evidence in Leftwich (1980) suggests that resources are devoted to restricting the set of accounting techniques available to managers of borrowing corporations when reporting their compliance with restrictive covenants. At least in that market, priv?!e contracts impose more stringent restrictions than those imposed by regulators. It is not necessarily in the interests of stockholders to constrain managers to use the same accounting rules for external reporting regardless of the circumstances facing the firm, even if those uniform rules reduce stockholders’ decision-making costs. Management’s choice cJf accounting methods can affect a firm’s cash flows because the firm’s reported accounting numbers influence its negotiations with government regulatory bodies, wage and price control agencies. unions, civil rights groups, politicians, environmentalists and consumer groups. If measurement rules are flexible. managers can choose rules which maximize the value of the firm, given the effect of those rules on negotiations with various parties. For example, if there is a world sugar ‘shortage’, managers of sugar-refining firms can select rules which reduce reported income so that congressional committees find it more costly to accuse the firm of exploiting consumers.37 (vi) Lack 01 objectivity (a) The criticism. There are no objective criteria for choosing among the set of available accounting techniques. Even if the particular techniques were selected by independent observers, the numbers produced by the accounting process would not be independent of the observer. Different accountants of unimpeachable integrity, presented with the same facts, could report different accounting numbers.3” %ee Jensen and Meckling 37For a discussion of the Watts (1977) and Watts and %3erling (1970a) criticizes

(1976) and Fama (1980). effect of reported income Zimmerman (1978). this lack of ‘objectivity’.

numbers

on the value

of the firm, see

(b) The implied market @lure. If accountants develop a set of measurement rules as objective as rules used to measure weight, for example, profit-maximizing firms in an unregulated market will adopt those rules provided the net benefits are positive. If the net benefits are positive and we do not observe firms using objective measurement rules, we infer that accountants have failed to produce such a set of rules or that managers of firms do not adopt rules which increase the value of the firm. It is not clear that the net benefits of objective accounting measurement rules are positive. As is discussed in (v) above, restricting management’s choice of accounting rules for external reporting can impose costs on stockholders if a firm’s net cash flows are affected by management’s choice of accounting methods. Even if accountants developed an objective set of measurement rules, value-maximizing firms would not necessarily adopt them. An even stronger argument can be made - the lack of demand for objective accounting measurement rules explains why those rules have not been produced by accounting theorists.‘”

4. Summary and conclusions Those who favor increased regulation of accounting base their arguments on allegations that accounting information produced in unregulated markets is defective, and that, because of implicit or explicit market failures, an unregulated market is unable to remedy those defects. Evidence of the alleged market failures is seldom presented and no evidence is offered to support the claim that regulation improves the output of the private market for accounting information. Market failure theories contain a fundamental flaw. The output identified by those theories as optimal is optimal in name only -- it is defined independently of any institutional arrangements that can produce the output. None of those theories identifies a level of output which is optimal giuerz the existing technology of markets, regulation, or any other regimes. Thus, unless market failure theories incorporate attainable institutional arrangements, they can yield no policy implications. It is illogical to condemn the actual output of an existing market (or government agency) merely because the quantity or quality of that output differs from an unattainable norm that is falsely described as optimal. Accountants are not alone in their reliance on abstract models for policy analysis. Economists pioneered such policy analysis, but, as Coase (1964, p. 195) contends, with counterproductive results: Contemplation of an optimal solution may suggest ways of improving the system, may provide techniques of analysis that would otherwise -I%ee Watts and Zimmerman

(1979) for an analysis

of the market

for accounting

ideas.

R. Leftwich, Market

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have been missed, and, in certain special cases, it may go far to providing a solution. But in general its influence has been pernicious. It has directed economists’ attention away from the main question, which is how alternative arrangements will actually work in practice. It has led economists to derive conclusions for economic policy from a study of an abstract model of a market situation. It is no accident that in the literature we find a category of ‘market failure’ but no category ‘government failure’. Until we realize that we are choosing between social arrangements which are all more or less failures, we are not likely to make much headway. Accountants’ attempts to develop likely to suffer a similar fate.

policy

implications

from ideal models

are

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