The Ecological Rationality of Historical Costs and Conservatism

Abstract

The principles characterizing the traditional revenue-expense approach to accounting cannot be traced back to a distinct event. I argue that they are ecologically rational. Their functionality is the result of cultural evolution, not of unitary human design. This is the reason why the efforts to defend them against the balance-sheet approach endorsed by standard-setters have encountered severe difficulties. Only the latter is clearly based on a coherent model of the economy, namely neoclassical economics. I further argue that a solid basis for explaining the rationale of the culturally evolved accounting principles can be found in behavioral economics. These principles are in line with human behavior as found in numerous laboratory and field experiments. It is especially with respect to Prospect Theory that a close parallel can be identified. I combine this observation with a market process view of the economy. Financial accounting according to the balance-sheet approach does not add new information to the market process; it only summarizes on the firm level information provided by the market. In contrast, the revenue-expense approach provides private information to the market à la Hayek (1945). The revenue-expense approach thus turns out to be congenial to the organization of the market economy.