Security Design, Incomplete Contracts and Relational Contracting: Implications for Accounting and Auditing

Abstract:     
After locating accounting and auditing within a broadly conceived contracting paradigm which includes relational as well as discrete transactions, the paper analyses three economics-based contractual theories. Two of these theories are concerned with the security design problem which is the contractual basis of various financial instruments such as debt and equity. Given the assumption of costly state verification, the paper explains why financial reporting and auditing are especially important to outside equity holders because although debt-with-costly-bankruptcy can, under very restrictive circumstances, eliminate the need for output verification, a revenue sharing security such as outside equity is highly sensitive to the monitoring technology. However, since security design alone cannot explain the richness and variety of accounting and auditing institutions, the paper contends that contracting parties have a more general problem of contractual completion which requires flexibility in the determination of accounting numbers and an adjudicating audit process. The paper argues that although accounting and auditing are best initially understood within a relational rather than discrete contracting framework, the accounting infrastructure has an interactive relationship with the market for securities which generates informational demands from market participants.

JEL Classification: M41, M49, L14

Accepted Paper Series