On the economics of accounting and contracting in firms

This essay explores the economics of contracting in firms and the role accounting plays in it. It views firms as specialist contracting intermediaries, obtaining scale economies from repetitive contracting with owners of factors of production and consumers. It builds on the Coase (1937) insight that firms exist due to contracting-cost advantages over markets and proposes that common accounting methods are a source of that advantage: that they are “contracting-useful.” This perspective provides economic rationales for accrual accounting, cost-based accounting depreciation, cost allocation, standard costing and accountants taking a transactional rather than holistic view of firms. Decision-usefulness theory – the thesis that the function of financial reporting is to assist investors and lenders in deciding among alternative actions – fails to explain these methods, even though it is the sole objective of reporting expressed in the FASB/IASB Conceptual Framework. Financial reporting contributes much more to aggregate economic welfare than that objective implies.