Academic journal article Journal of Markets & Morality

Accounting and the Auditing Function in Economic History: Transaction Costs, Trust, and Economic Progress

Academic journal article Journal of Markets & Morality

Accounting and the Auditing Function in Economic History: Transaction Costs, Trust, and Economic Progress

Article excerpt


"We shouldn't teach accounting here at this college," claimed a former colleague at another school. His blunt view reflects a sentiment common among faculty members at liberal arts colleges. This article refutes that claim. While modern accounting methods can be distorted to commit financial fraud, the private and public purposes of modern accounting have had important social value since businesses developed these methods in the 1300s and 1400s. Moreover, accounting methods and the auditing function have historically enhanced private and public virtues, promoting better moral behaviors of partners and workers and more effective stewardship of resources. For these reasons among others, accounting deserves a place in the liberal-arts curriculum.

A principal-agent problem emerges when managers direct operations and finance on behalf of a firm's owners. While investigating details of the problem, Michael Jensen and William Meckling noted that Adam Smith in 1776 had described agency problems. Managers of "other people's money," Smith wrote, will not "watch over it with the same anxious vigilance with which the partners in a private [partnership] frequently watch over their own.... Negligence and profusion [of waste and abuse]... must always prevail, more or less, in the management of the affairs of such a company." (1) Effective collection and monitoring of accounting data help owners of growing firms to limit costs arising from such agency problems.

Accountants design systems to measure, process, record, and report numerical information about real and monetary activities of businesses and their particular ventures. Financial accounting specifically records and reports on a business's financial transactions, especially the monies that change hands in arm's-length market transactions, with a view to assessing the overall financial success of the business or venture. Cost accounting measures, classifies, and records data on the value of resources expended in the business or venture, and is routinely reported to managers with a view to improving efficiency. Auditing is an accounting specialty through which expert accountants review the books of a business for the pu[phi]ose of verifying the accuracy and reliability of the acounts. Modern accounting methods allow a business's own accountants to conduct regular and accurate internal audits of the company's books. Since the early 1900s, however, US law has also required publicly traded corporations to engage independent certified external auditors for regular, official examinations of their accounts to assess whether they properly represent actual business conditions and activities.

Before modern accounting emerged in the late medieval period, orderly businesses kept mainly sequential lists of transactions. The most remarkable historical developments in financial accounting, those associated with the rise of double-entry methods of keeping accounts, occurred after 1300. With improved accounts and the rise of printing centers in northern Italy, the improved methods of accounting spread intensively among Italian businesses and extensively throughout Europe. (2) At the start, double-entry bookkeeping served mainly a private function to track an owner's costs, revenues, and profitability. The new methods reduced financial risks and increased operating efficiency. As economic theory suggests, increased efficiency in competition means lower costs and greater supply to the public.

Traditional European commercial practices allowed companies to accept active partners who participated materially in the business. Over time, Italy and then England permitted companies to take on silent partners with limited liability. By the 1900s in the United States, when the corporate form was well developed with limited liability for owners, a distinctly different social function of accounting emerged: the certified auditing of corporate accounts on behalf of investors. …

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