Incomplete contracting theory in empirical accounting research

In three essays, the implications of the costly contracting approach in accounting are investigated. First, the consequences of changing the set of acceptable accounting techniques in the banking and insurance industry are examined. The regulations imposed by a government agency alter the contracting equilibrium and cause some contractual parties to wield more power in the new equilibrium. Second, the contractual function of accounting earnings, cash flows, and accruals as institutional prices is used to predict their cross-sectional and dynamic statistical behavior. These properties of accounting numbers are the outcome of an evolutionary process in which procedures survive only if they are efficient within the contracting mechanism of firms. Cross-sectional differences in the properties of these numbers can be explained by the wide variety of contracting mechanisms employed by firms, each of which face a myriad of contracting partners and circumstances. Managers are found to use accounting earnings to improve contracting with outside parties. Third, the organization of audit firms is examined. The organizational architecture of audit firms is related to the role of auditing in a firm's contracting process. The value of the services provided by auditors as adjudicators depends on the degree to which they are able to guarantee the independence and competence of their certification procedures. The contractual arrangements of audit firms are explored, primarily focussing on the changes that occur owing to limiting the legal liability of auditors. The efficiency of the organization of the firm is evaluated in terms of the 'fit' between its contractual arrangements and the demands placed on the audit firm by customers and by owners of production factors.