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The final publication is available at www.degruyter.com:
Braun, E. (forthcoming): Accounting for Market Equilibrium – Comparing the Revenue-
Expense to the Balance-Sheet Approach, in: Accounting, Economics, and Law. A Convivium
DOI: 10.1515/ael-2018-0024
Accounting for Market Equilibrium – Comparing the Revenue-Expense to the Balance-
Sheet Approach
Abstract
This paper combines the market process approach developed by the Austrian School of
Economics with the theory of capital as worked out by the Historical School in order to
provide a suitable framework for discussing the two competing approaches to financial
accounting. Within this framework, it becomes clear that the revenue-expense approach with
its emphasis on actually realized, historical transactions plays an important role in creating a
tendency towards market equilibrium. Net income determined according to this approach
provides information to the market on where there are gaps in the price structure. The
balance-sheet approach, on the other hand, and particularly fair value measurement take
market equilibrium for granted. Based on fair value accounting, an equilibrium could never be
accomplished in the first place. Ironically, in order to be applicable, the balance-sheet
approach presupposes the perfect working of the market process, including financial reporting
based on the revenue-expense approach.
Keywords:
financial accounting; capitalism; market process; revenue-expense approach; balance-sheet
approach
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Table of Contents
1 Introduction
2 Equilibrium and the market process
3 The institutional requirements of the market process
4 The effect of the revenue-expense approach on the market process
5 The effect of the balance-sheet approach on the market process
6 What about financial assets and real estate?
7 Conclusion
1. Introduction
Recent years have witnessed an intense debate on the question of the appropriate system of
financial accounting. Of the two systems that are at issue, the first one, usually referred to as
‘balance-sheet’ or ‘asset-liability approach,’ is endorsed by the Financial Accounting
Standards Board (FASB) and the International Accounting Standards Board (IASB). It is
closely related to neoclassical economics and aims at the reporting of current market values of
assets and liabilities (Hitz, 2007). It is decidedly oriented towards the future. Market values
are the point of reference because they are supposed to be – at least in general – the best
proxy for the present value of the future cash flows that these items are expected to generate.
Accordingly, the income concept of the balance-sheet approach emulates the so-called
Hicksian Income N° 1 which is meaningful under the assumption of equilibrium but whose
applicability to the real world is debatable. The ‘revenue-expense approach’ to accounting, on
the other hand, emphasizes past and realized cash flows. It stresses historical costs and the
realization principle in the determination of net income and runs contrary to the market-value
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based concepts endorsed by the balance-sheet approach. Many of its adherents rely on ad hoc
suggestions like the superior ‘prudence’ of the traditional rules, or bring up historical
evidence for the relative instability of earnings based on fair value measurement. Some also
stress that the balance-sheet approach is adapted to the Anglo-American version of capitalism,
where the equity market plays a central role, whereas the revenue-expense approach fits better
into the countries of Rhenish capitalism, where debt financing via commercial banks is more
commonplace (Busse van Colbe and Fülbier, 2013, p. 45; Lütz and Eberle, 2008).
In this paper, the two ways of financial accounting are analysed from a new perspective that is
closely related to the idea underlying a recent agent-based simulation and artificial market
experiment by Biondi (2015). Based on Friedrich von Hayek’s (1937, 1945) vision of the
market as a process that combines and organizes knowledge that is dispersed among the
individual members of society, I discuss which one of the different accounting systems is
more appropriate when it comes to provide useful information to this process. By focusing on
the role of information for the market process, not for the close-to-ideal market conditions
assumed by FASB and IASB, this paper arrives at conclusions that deviate considerably from
those of Barth (2014). It will be shown that information reported on the basis of the revenue-
expense approach is congenial to Hayek’s view of how the market process works. Net income
figures help to guide entrepreneurial actions towards mutual coordination. The balance sheet
approach, and especially the fair value principle, in contrast, do not provide information that
is useful to the investors and entrepreneurs in the market process.
The paper arrives at the conclusion that the revenue-expense approach is a necessary
requirement for the equilibrating tendency of the market process. The adherents of the
balance-sheet approach simply assume that this process works, which means that they tacitly
assume the contribution of the revenue-expense approach to the equilibrating process. If the
fair-value program of this approach were fully installed, the market process would have to
perform without useful information provided by financial reporting. That is the reason why
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Eugen Schmalenbach ([1919] 1959) referred to the revenue-expense approach as ‘dynamic
accounting,’ and to the balance-sheet approach as ‘static accounting.’ The former assumes a
continuously changing, dynamic environment – a market process outside of equilibrium –
whereas the latter presupposes a static environment where equilibrium conditions already
prevail.
In the following two sections, I create the framework for the later discussion of the two
approaches to financial accounting. The paper starts, in section 2, with a discussion of the
market process. Following Hayek (1937, 1945), Mises (1980), and Kirzner (1997, 2013) – all
members of the ‘Austrian’ school of economics – I show that neoclassical economists, by
focusing on the analysis of market values in equilibrium, ignore the most important question
of economics, namely how these equilibria are brought about in the first place. To this end, it
is necessary that all market participants are able to contribute their particular knowledge to the
process of price formation. Section 3 builds a bridge between this analysis of the market
process and the institutions of economic calculation, including financial accounting. Whereas
most members of the Austrian school did not go into the details of the institutions that render
the market process possible – except for private property – several historical school
economists have analysed the institutions of business life at greater depth and worked on an
economic approach to capital that allows for them (Hodgson, 2014, 2015). Recently, Braun
(2017) and Braun and Roß (2018) made an attempt to show how the market process can be
explained based on this approach to capital. However, they did not discuss the role of
financial accounting in the equilibrating process. Based on their findings, and following up on
some short remarks made by Waymire (2009, pp. 57-8), Basu and Waymire (2010, pp. 141-2,
2019, pp. 2-3) and Braun (2019, pp. 20-1), section 4 demonstrate that financial reporting
according to the revenue-expense approach is an essential element of the market process.
Positive net income appears where entrepreneurs have traced gaps in the price structure –
where disequilibrium conditions prevail – and serves as a guide post to investors and other
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entrepreneurs so that they can invest their capital accordingly. It thus creates a tendency
towards equilibrium. Finally, section 5 shows that for the proponents of the balance-sheet
approach the market process, and therefore the revenue-expense approach, are necessary but
tacit preconditions. The proponents of the balance-sheet approach start their argument from a
point where the market process has already solved the basic problem, and therefore they come
to ignore the role of the revenue-expense approach. Instead, as Nissim and Penman (2008),
Schildbach (2009, 2012, 2016), Sunder (2011a; 2011b), and Biondi (2015) have shown, they
end up with a circular argument whereby financial reports inform the market about market
data.
The argument developed in this paper is congenial to the idea that the enterprise not only
consists of contracts, assets, and/or property rights to those assets. From the point of view of
accounting, the enterprise is an entity, a going concern that generates profit as a coherent
whole, not as a mere aggregate of individual assets. It goes beyond the scope of the present
article to cover other theories of the firm in regard to their compatibility with the revenue-
expense or the balance-sheet approach. Biondi (2007) has demonstrated, however, that the
prevalent theories of the firm do not provide a synthetic notion of the firm that includes all
relevant aspects of economics, accounting, and law. Still, Tang (2019) indicates that the
application of agency theory to the firm leads to results that are similar to mine.
Two caveats must be made. At the moment, neither the balance-sheet nor the revenue-
expense approach have been fully implemented (Baker 2019, pp. 3-4). Probably, neither of
those has ever been nor will ever be the sole and absolute standard. If this paper concentrates
on the pure or ideal-typical versions of both approaches nonetheless, the reason is that their
respective roles and implications can thus be analysed in isolation, which can help when it
comes to evaluate them. Second, the main part of this paper does not deal with the important
issue of financial and other assets that are held by businesses profiting from buying and
selling assets on the same market, but concentrates on the ‘real’ economy, that is, on
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productive activities where the ultimate goal is to supply the final consumer with goods and
services. This distinction was also made by Penman (2007), Marshall and Lennard (2016),
and Bezemer and Hudson (2016). Section 6 contains only a short outlook on how the
argument developed in this paper applies to assets traded on the financial and real estate
markets.
2. Equilibrium and the market process
After Hayek had dealt with business cycle theory in the 1920s and early 1930s, he changed
his focus to the analysis of the spontaneous economic order (Witt, 1997). He criticized
neoclassical economists for confining themselves to the analysis of equilibrium situations and
neglecting the process that leads to equilibrium market prices in the first place (see esp.
Hayek, 1937, 1945). Restricting the analysis in this way, he argued, the main problem of
economics, namely how the ‘division of knowledge’ (Hayek, 1937, p. 49) is accomplished, is
simply assumed away. In the words of Hayek (1937, p. 49), this problem is ‘how the
spontaneous interaction of a number of people, each possessing only bits of knowledge,
brings about a state of affairs in which prices correspond to costs.’ If we concentrate our
analysis on the final state of equilibrium, we assume that all available knowledge in society
has already been processed and condensed into the prevailing prices (Hayek, 1937, p. 50).
The question as to how this process actually works, that is, how the knowledge dispersed
among the numerous persons in society is actually collected and organized, can therefore only
be answered once the equilibrium framework is dispensed with.
Hayek’s papers are commonly regarded as seminal contributions to economics, and it can be
argued that the importance of their general message is recognized by most economists (Arrow
et al., 2011, p. 4). However, his papers did not have a major influence on economic analysis
as such. Their impact has been confined mainly to the Austrian School whose adherents
continue to stress the role of the market process as against equilibrium analysis.
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The present paper does not take a stance on the compatibility of the equilibrium framework
with the market process view, nor does it try to demarcate the border between the two. It
rather focusses on one important and concrete issue of both theoretical and practical
relevance, namely the appropriate system of financial accounting in a disequilibrium
environment. In how far does the equilibrating market process depend on the financial
accounting regime?
In order to isolate the role of financial accounting in the market process, the following
discussion refers to the working of the undisturbed market process. The numerous problems
which might curtail the information function of prices, profits, and losses are therefore
blinded out. It seems reasonable to analyse market disturbances and failures only once the
connection between accounting and the market process is clearly understood.
According to Hayek (1945, pp. 519-20), the knowledge which is necessary to secure the best
use of resources in society is not given to anyone in totality. It only exists as ‘dispersed bits of
incomplete and frequently contradictory knowledge which all the separate individuals
possess.’ Through the price system, however, all market participants are connected directly or
indirectly to each other and the prices pass on the information concerning the scarcity or
abundance of the individual goods. By means of buying and selling, each market participant
influences market prices and in this way contributes his ‘knowledge of the particular
circumstances of time and place’ (Hayek, 1945, p. 521), so that prices, in a sense, tend to
reflect the knowledge otherwise dispersed in society (Erlei, 2007, pp. 80-1).
When it comes to the firms producing output, the process of buying and selling is hereby
motivated by profit opportunities, most prominently indicated by price spreads, which firms
are eager to exploit (Kirzner, 1997, p. 68). It must be emphasized that not only the prices
themselves, but also the profits and losses that emerge as a result of entrepreneurial actions
are important carriers of knowledge. First of all, profits and losses tell the respective
entrepreneurs whether their expectations have been correct and whether their businesses have
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been successful. Without this feedback, they would hardly know whether they should
continue what they have done so far or not. Second, and more importantly for the discussion
of the market process, profits and losses function as guideposts for investors and other
entrepreneurs. According to the Austrian school, profits appear wherever there is a
maladjustment, to wit, a divergence between actual production and production as it would be
when it were directed towards the best satisfaction of consumer demands (Mises, 1980, p.
114). Competition among entrepreneurs who try to exploit these profit opportunities will
bring the discordant elements into ‘mutual adjustment’ (Kirzner, 2013, p. 58). Profits and
losses, in other words, send signals to investors and entrepreneurs and thus guide them to the
sectors and industries where demand and supply do not yet meet. Where there are profits,
competition between old and new enterprises will raise costs and lower revenues, thus
creating a tendency towards the equalization of marginal costs and marginal revenues. In
short, profit and loss have an equilibrating effect.
It is important to add that in this market process approach neither the market prices nor the
profits and losses are in any way supposed to be correct or perfect. They do not depict the
correct or equilibrium value of the traded goods. They are rather instruments that allow for a
tendency towards the equilibration of the business and consumption plans of all market
participants. Equilibrium as such, the ‘final state of rest,’ is but an ‘imaginary construction’
(Mises, 1949, p. 246) where the cause and effect relationship between price spreads and
equilibrating tendencies is bypassed, that is, taken as granted (Olbrich et al., 2015, p. 13).
3. The institutional requirements of the market process
It was and is especially the Austrian School that emphasizes the importance of the market
process and the limits of neoclassical equilibrium analysis. Yet, Austrian economists were
reluctant to elaborate on the question as to which institutions back this market process (Lee
and So, 2014, sect. 1.1). This might seem surprising, first, because Carl Menger, the founder
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of the school, is well known for his discussion of the evolution of institutions, especially
money, and second, because Mises’s (1920) famous argument against the long-term
possibility of socialist economies was based on the institutions of monetary calculation and
private property. Braun et al. (2016) and Braun (2017) argue that this reluctance is due to the
general method of Austrian economists. The latter’s aim is to deduce economic theories from
the logic of action as such, which is an ahistorical approach. Historical institutions like the
rules of accounting are therefore not considered to be central to their arguments and go easily
by the board.
If we want to determine the role of the different accounting regimes in the market process,
however, we must not ignore the institutional framework of the market economy of which
these regimes are a part. This lack of institutional underpinning has been identified and
criticized by the historical school of economics in both neoclassical and Austrian economics.
Hodgson (2015) is the most recent attempt to make the economic profession aware of the
tacit, institutional preconditions of economic theory. Hodgson (2015, ch. 7, 2014) picked out
the area of monetary calculation, which is important for the problem discussed in this paper,
as an especially illuminating case for the tendency of economists to define their concepts in a
way that makes them ignore historical and institutional questions. Similar to Schumpeter
(Biondi, 2008), Hodgson argues that before economists and sociologists came up with their
own concepts, ‘capital’ was a term of everyday business practice and common parlance and it
referred to money invested in business enterprises.
In capitalist societies, the production process is coated by a ‘veil of finance’ (Schäfer, 1991, p.
27). All actions by business enterprises start and end with financial processes, i.e., cash flows
(Dichev, 2017). Karl Marx famously condensed this idea in the general formula of capital:
Money – Commodity – Money’
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Zwiedineck-Südenhorst (1930) elaborated on this formula in order to demonstrate more
clearly how the technical production process is organized based on financial considerations.
Figure 1 is adapted from Braun (2017) and illustrates this point.
Figure 1: The veil of finance coating the production process in capitalism
The transformation of factors of production into the product is accomplished not for its own
sake, but because it is a means to achieve the goal of the business enterprise, namely to make
monetary profit. This implies, as Rambaud and Richard (2015, pp. 8-9) stress, that the capital
invested in the respective enterprises has to be restored out of revenues, so that only the
surplus counts as income. In capitalism production processes are judged on the basis of such
financial considerations, not technical ones, and nothing illustrates this better than that it is the
institutions of monetary calculation, especially financial and managerial accounting, that
inform business and investor behavior, and not the technical descriptions of the
transformation process.
Braun (2017, pp. 316-7) develops this basic idea to a description of how the tendency towards
equilibrium is accomplished by the market process where countless enterprises try to make
profit based on the considerations depicted in figure 1. I am going to paraphrase this passage
in the following, whereby I add the Hayekian idea of private information which was not
discussed by Braun (2017).
Land
Labor
Produced means of
production
Investment of money
Product
Sale
Money
revenue
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In a functional free market, the consumers make the final decision on whether the production
process was a success. They pay the revenues of the enterprises in the consumer industry.
Thus, at least in principle, consumers provide the most important private information to the
market process – which goods are to be produced and which are not – and they do so by
deciding on the profitability of the companies that produce consumer goods. These
companies, in turn, contribute their technical knowledge of how best to transform inputs into
consumer goods (Hayek, 1937, p. 50). Yet, it must not be forgotten that it is financial
considerations that tell them whether they are efficient in satisfying consumer needs or not.
Their business model is only successful when they make profit, and whether they do so is
communicated to them by financial accounting (Marshall and Lennard, 2016, p. 503). In other
words, it is financial accounting that determines whether the private knowledge applied by the
respective enterprises was able to satisfy consumer wants and thus to improve the allocation
of resources in society. It provides the crucial feedback of the market for the goods and
services delivered by the enterprise.
Similar considerations apply to those industries who produce the inputs of the consumer
industry based on their own knowledge of the ‘particular circumstances of time and place.’
The output of these enterprises is sold as input to the enterprises producing the consumer
goods. Whether this input has been adjusted to consumer needs and produced efficiently is
decided by the demand of the consumer industry; and it is again financial accounting that
determines the usefulness of the knowledge employed by the enterprises producing the input.
The same holds for even more ‘upstream’ enterprises who are situated further away from the
consumer industry. All production stages in the economy are linked to each other by financial
considerations of thousands of enterprises that try to profit from a spread between their costs
(calculated from input prices) and their revenues (calculated from output prices).
As long as the market works sufficiently well, the profits and losses of the particular
enterprises, determined by financial accounting, provide information whether their respective
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business plans contributed to the satisfaction of consumer needs. To make it clear: the price
system is not enough to coordinate the production process. It is their accounting systems that
enable enterprises to organize and govern their productive operations in accordance with the
plans and decisions of the rest of the economy (Biondi 2013a: 402). “The price system and
the accounting system complement each other in driving the market price formation through
time” (Biondi 2011: 30). The institutions of accounting are a “logical necessity” of the market
process (Shubik 2007: 76).
The appearance of profits and losses are obviously incompatible with equilibrium. Some
businesses and industries will regularly expand whereas others have to be divested from or
even abandoned. It is one of the main purposes of financial reporting to provide information
on financial performance to the actual or potential shareholders, lenders, or other creditors of
the enterprise (Nishikawa et al., 2016, p. 513). From a market process perspective, this
function of accounting has a reinforcing effect on the equilibrating process. Capital, that is,
investable funds, flees those enterprises and industries that report losses or are likely to make
losses and flows to those who report or promise to make profits; thus capital and the capital
market are central for the tendency towards equilibrium (Leffson, 1971, p. 4). They accelerate
the market process which is oriented by financial accounting.
At this point the question arises that will be discussed in the rest of this paper: If (1) the
market process is informed by the ‘knowledge of the particular circumstances of time and
place’ that the market participants have, if (2) this information condenses into prices, and if
(3) the accounting system provides a feedback on whether the private information was used
well – what then are the accounting rules which best guarantee the equilibrating tendency that
is assumed in neoclassical economics? To say it in other words: what are the accounting rules
that make possible the working of the famous invisible hand so that profit-maximizing
entrepreneurs who follow their individual interests still achieve a social goal that was not part
of their original intents, namely the satisfaction of consumer wants?
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4. The effect of the revenue-expense approach on the market process
If we compare in the following two different systems of financial accounting – the revenue-
expense approach and the balance-sheet approach – it should be clear that this can only be
done on an abstract level. We have to ignore the fact that both systems are sometimes
inconsistent and overlap on some issues (Ijiri, 1967, p. 98). My main purpose is to
demonstrate a fundamental difference between the two systems, and therefore it is necessary
to condense the many rules each accounting regime consists of into their decisive and
distinctive basic idea so that we get what can be called the pure or ‘ideal typical’ forms of the
respective systems (Müller, 2014, p. 540). Biondi (2015) employed an agent-based model to
compare the performance of similarly stylized representations of these accounting regimes in
a dynamic environment. The following discussion backs up his results by elaborating on the
role of financial accounting in providing the information that is necessary for the market
process to tend towards equilibrium.
The distinctive feature of the revenue-expense approach is that the rules it is based on have
evolved in a way that made them fit to determine net income, that is, the realized, monetary
profit that flows from the business operations of the accounting entity (Hodgson and Russell,
2014, p. 100, Rambaud and Richard, 2015, p. 10, Marshall and Lennard, 2016, p. 502,
Dichev, 2017, p. 627). It is important to stress that this approach does not focus on particular
assets and liabilities and their value, but on the performance of the enterprise as a whole, as an
entity. It copes with the monetary and economic process generated by the enterprise over time
and therefore lies at the core of the continuity and sustainability of the enterprise entity
(Biondi 2013a: 397). It tries to determine whether the expenses of the enterprise made sense,
given that shareholders – the source of funds – are waiting for eventual dividends (Biondi
2007: 250). The revenue-expense approach, in short, concentrates on the documentation and
imputation of cash flows so that profit can be calculated as the difference between incurred
expenses and earned revenues of the enterprise entity (Biondi, 2011, p. 7). Especially Eugen
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Schmalenbach ([1919] 1959) and Littleton (1953) worked out the rationale of the revenue-
expense approach. Schmalenbach argued that the central function of financial accounting is to
determine the success of past business actions by contrasting incurred expenses and realized
revenues. Therefore, he concluded, the income statement must be seen as the crucial
document in accounting (Schmalenbach [1919] 1959, p. 32). The balance sheet which states
assets and liabilities has only a subordinate function, namely as a kind of store for the income
statement (Schmalenbach [1919] 1959, p. 55; Penman, 2009, p. 37; Schildbach, 2009, p. 583).
In the United States, the revenue-expense approach reached its epitome with the publication
of Paton and Littleton (1940), which also stressed the importance of the income statement and
relegated the balance sheet to a ‘peripheral status’ (Dichev, 2008, p. 455; see also Mattessich,
2013, p. 20).
It does not need much explanation to show that the revenue-expense approach fits well into
the market process as developed above. But before, there is a terminological curiosity that
seems worth mentioning in this regard. Schmalenbach called his approach ‘Dynamic’
accounting, whereas he referred to the balance-sheet approach as ‘Static’ accounting (Busse
van Colbe and Fülbier, 2013, p. 43). This is the same terminology that is used by market
process theorists. The latter are unsatisfied with the analysis of equilibrium market values –
which they call ‘static’ (Kirzner, 1997, p. 71) – because they are unwilling ‘to surrender the
economists’ insights into the dynamic character of active markets’ (Kirzner, 1997, p. 64). In
both accounting theory and economics there is a dispute between a static and a dynamic
approach, and it seems that the dynamic versions complement each other. It is an even larger
curiosity that many Austrian economists did not themselves recognize the relationship
between their own dynamic market process approach and Schmalenbach’s dynamic
accounting. As Braun (2019, p. 9) demonstrates, both Hayek (1935) and Mises (1949)
endorsed the static balance-sheet approach, and only later Austrians like Pascal Salin (2010,
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p. 58) and Jesús Huerta de Soto (2012) have briefly suggested a return to the dynamic
revenue-expense approach (see also Drewes forthcoming).
If net income is calculated according to the revenue-expense approach, it serves the
information function that is necessary for the working of the invisible hand in the market
economy. On the individual level, it informs the single enterprise about the success of its
proper business actions. Net income in revenue-expense accounting is calculated as a result of
a firm’s actual business operations. Historical costs refer to expenses that have actually been
made by the respective firm, and revenues are only recognized when they have actually been
realized, that is, when there has been a sale (Ijiri, 1967, p. 94, Hax, 2003, p. 678). As net
income refers to particular expenses made and particular revenues obtained by the reporting
entity, the information generated is new and specific. The individual firm is informed about
the success of its proper past actions when it comes to achieve its goal, i.e., making monetary
profit (Braun, 2019, p. 21).
It must be mentioned that the matching of expenses and revenues, particularly when durable
assets are involved, is a problem that cannot be solved perfectly (Hax, 2003, p. 676). Given
the uncertainty of the future, it is impossible to know the economic life expectancy of durable
assets and therefore the correct amortization rate. Thus net income is not and cannot be a
perfect measure of success or failure. Yet, depreciations in the revenue-expense approach are
consistent with the overall idea: they are supposed to match the expenses on assets with the
revenues those assets generate if those cash flows fall into different periods (Nissim and
Penman, 2008, p. 15, Dichev, 2017). In fact, assets are basically considered as costs that have
to be allocated to different periods. The purpose of depreciation is to guarantee, as far as
possible, that net income from durable assets still results as the difference between the
expenses on the purchase of the durable assets and the revenues from the sales of their
production. This is accomplished by imputing the expenses on these assets to those periods
where the revenues accrue. Positive net income determined this way implies that the firm has
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done well in its proper operations, whereas a loss means that it should probably reconsider its
business plan.
On a more social level, net income determined according to the revenue-expense approach
can guide capital to those business lines where maladjustments between demand and supply
exist so that in the long run the production process tends to be adapted towards the
satisfaction of consumer demands. Two sorts of feedback are provided by net income if it is
determined according to this approach. First, it confirms the existence of a spread in the price
structure which implies a mismatch between supply and demand. Second, net income also
communicates something about the size of the mismatch and, consequently, about the profit
potential in the respective line of business. Once again, the point is that, under the revenue-
expense approach, a positive net income occurs only when a good or a service has actually
been sold to customers, be it consumers or other enterprises. There has been a concrete cash
flow, based on actual transactions, which has led to profit. The amount of net income
corresponds to the size of the mismatch. If the mismatch is large – if supply and demand are
materially unbalanced – net income will be high and the business line will appear to be more
attractive to outsiders. In short, the size of net income provides information on the mismatch
between supply and demand in the area where the profitable enterprise is operating, and so
guides investors and entrepreneurs into those sectors where they are needed the most.
Inversely, the existence of negative net income implies that the production in a certain
enterprise or a whole business line does not correspond well to what consumers want, such
that capital will flee those activities. In any case, the positive or negative gap between input
and output prices will be reduced. If there are no monopolies or other restrictions involved,
there will be a tendency to eliminate net income altogether, so that, as in equilibrium theory,
marginal costs tend to equal marginal revenues and total costs tend to equal total revenues.
Net income, if calculated according to the principles of historical cost and realization, play an
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important role in generating a tendency towards equilibrium. It is an integral part of the
market process that leads towards equilibrium.
5. The effect of the balance-sheet approach on the market process
It is well known that the standard setters reject the revenue-expense approach and instead
adhere to the so-called balance sheet approach (Perry and Nölke, 2006, p. 563). In their view,
accounting is not, for the main part, concerned with the determination of profit from actual
transactions. Standard-setters have even removed every reference to actual monetary flows
from their frameworks (Biondi, 2011, p. 8). Instead, profit and loss only play an ancillary role
(Dichev, 2008, p. 454). The balance sheet itself is supposed to provide useful and relevant
information to the capital market, i.e., mainly to potential investors (Barth, 2006, p. 272; Hitz,
2007, p. 327), by providing the ‘fair value’ of all assets and liabilities of the respective
company. As we have seen, the revenue-expense approach concentrates on the net income of
the enterprise entity, considered as a going concern. The balance-sheet approach, in contrast,
does not view the enterprise as a coherent whole, but as being composed of various separate
assets and liabilities, each with its own specific value. It thus tends ‘to dilute the firm into the
price system’ (Biondi 2013b: 370).
Before we go into more details of the nature of fair values, it is important to stress that the
purpose of accounting according to the balance-sheet approach seems to be in line with the
idea of the market process as propagated by Hayek and others (Barker and Schulte, 2017, p.
57). It is only that it is not the income statement that is supposed to provide information to the
market, but the values of assets and liabilities on the balance sheet are. The reason that is
given for this change of focus is that ‘existing and potential investors, lenders and other
creditors need information to help them assess the prospects for future net cash inflows to an
entity’ (IASB, 2010, §OB3, emphasis added). From this viewpoint, reporting historical costs
on the balance sheet does not make much sense. Past market prices are not very useful to
18
investors when it comes to predict future cash flows. Therefore, the FASB ‘considers fair
value to be more relevant to financial statement users than cost for assessing the current
financial position of an entity […]. With the passage of time, historical prices become
irrelevant in assessing an entity’s current financial position’ (quoted in Nissim and Penman,
2008, p. 61).
In short, in the revenue-expense approach the income statement is supposed to contain the
relevant information, whereas in the balance-sheet approach, the balance sheet is. For the
balance-sheet approach, income is but a residual or by-product, it results from the difference
between the value of the firm’s net assets – as determined by the fair value balance sheet – at
the beginning of the period and their present value at the end of the period, excluding
transactions with shareholders (Barth, 2006, p. 272, Rayman, 2007, p. 217, Saito and Fukui
2019, p. 4). That is why in this approach it is possible that value added is reported even if no
historical exit transactions have taken place (Nissim and Penman, 2008, p. 4). All that is
necessary is that the fair values of the assets or liabilities of the respective company have
changed.
The creation of such an all-inclusive concept of income results ‘from a desire to incorporate
in one final figure all nonowner changes in equity for a period’ (Robinson, 1991, p. 108). In
the following I will adhere to the general usage and call this kind of income – that includes
revaluation increments – ‘comprehensive income.’ Comprehensive income is what IASB and
FASB are clearly heading for (Dhaliwal et al., 1999, p. 44, Cauwenberge and Beelde, 2007, p.
5).
It is obvious, and it has been noted by many observers, that the balance-sheet approach to
accounting and the concepts of fair value and comprehensive income draw heavily on
neoclassical economics (Hitz, 2007, pp. 327, 332, Barker and Schulte, 2017; Braun 2019, pp.
8 ff.). This is especially apparent in John Hicks’ (1946) discussion of income serving as a
reference point for standard setters and other proponents of this approach (Bromwich et al.,
19
2010, p. 350). Standard-setters explicitly aim at what is sometimes called John Hicks’ income
concept N° 1 (Barth, 2006, p. 280), which is defined as
the maximum amount which can be spent during a period if there is to be an
expectation of maintaining intact the capital value of prospective receipts (in money
terms) (Hicks, 1946, p. 173).
We must of course be careful with terms like ‘neoclassical economics.’ There are economists
who consider themselves ‘neoclassical’ but still do not fully endorse the equilibrium concept
in matters of accounting. Cochrane (2011, p. 1088), for example, although he does not argue
‘that mark-to-market accounting is bad,’ still doubts whether it provides ‘a sufficient statistic.’
A loss of asset-value can have various reasons and therefore various implications, but,
according to Cochrane, mark-to-market accounting is not able to distinguish between them
and does therefore not always provide enough information for decision-making. Furthermore,
Jameson (2005) and Fukui (2011: 6 f.) show that even John Hicks was actually in favor of the
revenue-expense rather than the balance-sheet approach when it came to financial accounting.
But Hicks’s reservations notwithstanding, standard-setters still follow his income concept N°1
– and therefore assume that the economy is in equilibrium (Barlev and Haddad, 2003, pp. 405
f.).
The origins of the balance-sheet approach in equilibrium economics shine especially through
in the concept of fair value. Fair value basically means the present value of the cash flows that
the items in the balance sheet are going to produce in the future (Barlev and Haddad, 2003, p.
397). The important point in relation to the topic of this paper is that fair values are to be
determined by the accountant with the help of the market (Barker and Schulte, 2017). IFRS
13.9 stresses the market basis of the fair value concept by specifying that the fair value is the
‘price that would be received to sell an asset or paid to transfer a liability in an orderly
20
transaction between market participants at the measurement date.’ The best way to measure
fair value (Level 1) is accordingly to use quoted prices in active markets for identical assets or
liabilities. But also Level 2 inputs are market-based and include quoted prices from identical
or similar assets in inactive markets, quoted prices for similar assets or liabilities in active
markets, and other relevant market data. Only if observable inputs on markets are not
available are accountants allowed to use unobservable inputs, that is, to mark to model (Level
3) (Laux and Leuz, 2009, p. 827).
Now, as comprehensive income is but a correlate of two different balance sheets containing
fair values, it is obvious that it does not provide any additional information on the
performance of the reporting entity or the meaningfulness of the underlying business plans. It
provides information on the movement of market price – the best proxy for the fair value – of
a firm’s assets or liabilities. It informs, in other words, about the change of the market
expectations concerning the items on the balance sheet. It therefore reports how the fair
values have changed unexpectedly, so that it rather informative for value at risk (Penman,
2007, p. 36).
It is appropriate to elaborate on this point a little further. In this, I concentrate on the
information content of ‘Other Comprehensive Income,’ that is, those components of
comprehensive income that stem from price changes of asset and liabilities in the balance
sheet. The second component of comprehensive income is of course net income from
operations, that is, the income concept of the revenue-expense approach, and if it were only
for this component, no controversy would be necessary.
Other comprehensive income informs only about the development of the market price of
assets (and liabilities), that is, about the fact that someone else in the immediate past was
ready to pay a certain amount of money for a certain asset. It does not tell whether the actions
of the respective enterprise reporting this event as income have been successful or not. There
is no guarantee that the prices will remain high until the enterprise itself decides to sell the
21
asset. Only when the entity actually sells the asset or its products there is meaningful
information concerning the success of its actions.
Consider the price of coal. In a severe winter, consumer demand for coal may rise so that the
price of coal increases. All companies that have provisions of coal will make other
comprehensive income as one of their assets has increased in value, no matter whether they
process coal for consumers or for completely different reasons like the production of steel.
This increase of the coal price might be considered to be useful information for the
management when it comes to decide whether to keep operating or to sell the coal. But as
long as the management has not yet decided on this issue, investors and outsiders are misled if
income figures change on the basis of this price increase. The rising comprehensive income of
steel companies when coal becomes dearer in winter does not necessarily imply that they are
suddenly satisfying an urgent demand or that a mismatch between supply and demand has
been detected. The opposite might be the case. What has happened is that the costs of these
enterprises have gone up, and that the stock of their cost-goods has appreciated is but a
symptom of this increase in expected expenses (Hodgson and Russell, 2014, p. 101). Their
comprehensive income does not mean that they have become more profitable. It does not
imply a gap in the price structure and thus cannot serve as a guidepost concerning the location
of mismatches in the market.
Net income stems directly from a detected and exploited gap in the price structure. It more or
less directly reflects the mismatch. Other comprehensive income, in contrast, arises in all
enterprises which own certain relevant assets, no matter whether they participated in filling
the gap or not. As long as they own assets whose prices rise as a consequence of other
entrepreneurs’ actions, their balance sheets report other comprehensive income. Yuan and Liu
(2011, p. 23) speak of ‘double-counting’ in this regard. Profit is not only counted in those
companies which actively try to close the gap, but also in those which only happen to be in
the same industry and thus participate in the price changes. Consequently, the total of
22
comprehensive income reported in one particular industry exaggerates by far the actual
market gap.
Other comprehensive income resulting as the difference between a firm’s present values at
two different dates neither informs the firm about the success of its business actions nor can it
guide investors and entrepreneurs in society at large to those areas where there are gaps in the
price structure. Reporting comprehensive income does therefore not induce a tendency
towards equilibrium because it does not, like the revenue-expense approach, focus on actual
cash flows, but on current values.
And here we come to the decisive point. To argue that market prices reflect present values
implies that one assumes the existence of markets for all relevant assets and liabilities and that
these markets are efficient and actually in equilibrium (Beaver and Demski, 1979, pp. 39–43,
Hitz, 2007, p. 332). That is, one accepts the notorious assumptions that come along with
neoclassical equilibrium theory. To name but the most relevant ones: perfect competition,
complete information, and rational decision-making. Even adherents of the fair-value program
(Barlev and Haddad, 2003, pp. 405-6) admit that if this were not the case the present value of
the firm’s assets and liabilities could neither be determined nor defined in a meaningful way.
It is implicitly assumed that the market process has already done its job. It is assumed that it is
no problem for the market to attain equilibrium and, what is more important, that it can do so
without being informed by financial reporting. This is because fair values are themselves to
be found on the basis of market data. If the market depended on information provided by fair
values, we would be in a circle where the market is informed by and at the same time informs
the accountant (Schildbach, 2012). ‘[Market value] certainly cannot serve to inform the
market about the firm’s performance. The result of information processing through the market
cannot at the same time be the information input needed to give a valid result’ (Hax, 2003, p.
680). This would transform ‘the market price into the reference point of the whole process
23
that is supposed to generate it’ (Biondi, 2015, p. 3654, similarly Sunder 2011a: 298; 2011b:
126 f.).
So we seem to be in the same situation as neoclassical economists who, according to Hayek
(1937, p. 49), only ‘pretend to solve’ the problem as to how the spontaneous interaction of
market participants brings about equilibrium but who ‘fall in effect back to the assumption
that everybody knows everything and so evade any real solution of the problem’ (see also
Zappia, 1996, p. 112). Only that, when it comes to financial accounting, the proponents of the
balance-sheet approach pretend that fair values provide information to the market, yet they
fall back to the assumption that the market process, including financial reporting according
to the revenue- expense approach, has already done its job so that the market prices simply
reflect all available knowledge. They start from the market efficiency hypothesis and assume
that market prices already contain all available information (Chiapello, 2015, p. 19), ignoring
the knowledge-generating process that is required to achieve this result.
As Nissim and Penman (2008, p. 33) note, the adoption of fair value accounting destroys the
historical cost information. This implies, as I would like to add, that fair value accounting
destroys the very basis of the price-formation process that is behind the tendency of the
market to create fair values. And it is not explained in which alternative way the market is
supposed to be informed and in how far this is possible (Schildbach, 2012, p. 532).
Accordingly, Biondi’s (2015) simulations and experiments have demonstrated that historical
cost accounting regimes stabilizes the financial system much better than a fair-value
accounting regime.
However, what goes around, comes around – as fair-value accounting and historical-cost
accounting concur in equilibrium (Moore, 2011, p. 2), and as fair-value accounting
presupposes equilibrium conditions, the nature of the void left by the revenue-expense
approach is hardly recognized.
24
6. What about financial assets and real estate?
So far, this paper discussed the role of financial accounting in the market process where
resources are allocated according to the demands of the final consumer. The point that was
made related to the physical production process and its organization by profit-oriented
enterprises. In this environment, it was argued, the revenue-expense approach with its
emphasis on historical cash-flows is an important element of the equilibrating process. The
question remains whether the revenue-expense approach is also suited for assets that are not
used in any production process, but which are expected to generate income for their owners
from merely holding them over a period of time, either by yielding dividends, or by
increasing in value, or both. The most important assets in this category are of course financial
assets and real estate.
At this point I only discuss the question as to the information content of fair values of
financial and similar assets. It was already noted above that fair values are based on the
assumption of perfect competition. Specifically, it is assumed that no market participant is
able to influence the market price so that each one is able to buy and sell at this price.
Otherwise, it would not make sense for all owners of the respective assets to value them
according to the market price. However, as Chiapello (2015, p. 18) remarks, it is but an
illusion that there is such an amount of liquidity for all assets. Only marginal transactions
were possible at the current market price (Schildbach, 2016, p. 463). Not all possible
transactions could be exercised at this price at the same time since the selling process itself
would alter the current price.
Outside equilibrium, a market price only implies a short-term balance of supply and demand.
It is not the price at which the whole available supply could be traded if the suppliers decided
to do so. That this is actually the case is demonstrated regularly in times of financial turmoil
when panic sales lead to dramatic price falls of financial assets. Yuan and Liu (2011, p. 15)
argue that modern accounting is in a ‘fair value trap.’ The current market price is supposed to
25
reflect the true (or fair) value of the assets, even if this could only be the case in equilibrium
under the heroic condition of perfect liquidity at par.
In reporting fair values and comprehensive income, entities provide more information to the
market than they actually possess. They not only report market values of their assets and
liabilities, but they do so with the subtext that they actually own this value. Yet they only own
the asset. They would own its value only if the market were perfectly liquid at par which, of
course, cannot be assumed in any circumstances.
7. Conclusion
In this paper I have developed a new basis for the discussion of the role different accounting
regimes play in the market process. By combining the ‘Austrian’ approach to the market with
the theory of capital as developed by the Historical School, I created a framework for
analysing the performance of financial reporting rules in non-equilibrium situations. It was
demonstrated that the revenue-expense approach to financial accounting is congenial to this
framework and plays an important role in creating a tendency towards equilibrium. It adds
new information to the market process in accordance with the vision of Hayek (1945). The
balance-sheet approach to financial accounting, on the other hand, takes the working of the
market process as given and starts right away from the assumption of equilibrium where all
available information has already been processed. It therefore is not able to explain how a
tendency towards equilibrium is achieved in the first place. The market process, including the
revenue-expense approach, must already have done its job in order that the adherents of the
balance-sheet approach have a research object.
The main purpose of this argument is to provide an alternative starting-point for the
discussion of accounting rules. The focus on equilibrium analysis by neoclassical economics
has led standard setters to endorse the balance-sheet approach and fair value accounting. Yet,
similar to how equilibrium analysis has been complemented with a market process analysis in
26
economics, it might be useful to complement the equilibrium-based arguments for the
balance-sheet fair value program with some market-process oriented ones. After all, the
events in the last decade have demonstrated that equilibrium is still something to be achieved,
not something that can be taken for granted.
Acknowledgements: I thank Professors Thomas Schildbach, and Andreas Scholze for their
very helpful comments on earlier drafts of this paper. I further profited from the comments by
several participants of the 4th Witten Conference on Institutional Change (2018) and the
Prague Conference on Political Economy (2018).
I am especially and deeply grateful to Professor Mathias Erlei, who supported this project
from the beginning, for his invaluable feedback and our numerous discussions on the
relationship between economics and accounting – and many other issues. Unfortunately, and
much to my regret, Professor Erlei died unexpectedly before this paper was finalized.
Requiescat in pace!
27
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