Toward a Theory of Financial Accounting

THE PURPOSE OF financial information (including accounting information), concerning the outcomes of business enterprises, is to facilitate the decision process utilized by rational investors in determining their consumption-investment plans. At the very least, any logical framework purporting to be a theory of accounting should be able to explain explicitly what the effects of information are on this process. Unfortunately, to date, this goal remains unrealized. The purpose of this paper is to discuss what we believe to be the setting necessary to analyze the role of information in the investors' decision process and to consider the details that characterize such a setting. Obviously, much effort has been devoted to analyzing many different aspects of the relationship between accounting information and the investors' decision process, but unfortunately very few noteworthy results have been derived. While it is not necessary to review these efforts, it is crucial to note that almost without exception they fail to explicitly recognize the implications which arise because use of accounting information in the decision process takes place within the context of a market' which allocates goods, resources and, implicitly, "risks." Conclusions regarding the effects of information or changes in information that are developed outside of a market context are most often incorrect. For example, if one considers the effect of more (costless) information on an isolated investor, one might conclude that the investor is no worse off since the set of available alternatives and "more" information contains as a subset the set of alternatives available with "less" information. However, if more information is to be provided by increased disclosure on published financial statements, the conclusion is not in general true. The analysis fails to recognize that some of the parameters (e.g., prices in the budget constraint) in the investors' decision problem are, in fact, endogeneously generated by the simultaneous action of all investors participating in the market. Indeed, this is what Hirshleifer [15] demonstrated in his seminal article. A necessary prerequisite for the general equilibrium approach is the judicious characterization of those specifics of the market setting which are crucial in capturing the effects of information. Indeed, judicious characterization is an art requiring an understanding of the results desired, the alternative characterizations available, insight and luck. With the hope that we will facilitate this process and hasten the development of a theory of accounting, the next section of the paper