CHRISTENSON (1983) - The Methodology of Positive Accounting

JOURNAL OF INTERNATIONAL ACCOUNTING RESEARCH American Accounting Association
Vol. 14, No. 2 DOI: 10.2308/jiar-51321

2015
pp. 235–265
COMMENTARY
Is There A Scientific Basis for Accounting?

Implications for Practice, Research, and
Education
Sudipta Basu
ABSTRACT: This essay is based on a keynote speech at the 2014 Journal of
International Accounting Research (JIAR) Conference. That talk was built upon a 2009
American Accounting Association (AAA) Annual Meeting panel presentation titled ‘‘Is
There Any Scientific Legitimacy to What We Teach in Accounting 101?’’ I evaluate
whether accounting practice, regulation, research, and teaching have a strong
underlying scientific basis. I argue that recent accounting research, regulation, and
teaching are often based on unscientific ideology but that evolved accounting practice
embeds scientific laws even if accountants are largely unaware of them. Accounting
researchers have an opportunity to expand scientific inquiry in accounting by improving
their research designs and exploring uses of accounting outside formal capital markets
using field studies and experiments.
Keywords: conservation laws; constructal law; economic evolution; mean reversion;

creation myths.
No scientific worker has a fixed level of significance at which from year to year, and in all
circumstances, he rejects hypotheses; he rather gives his mind to each particular case in the
light of his evidence and his ideas.
—Sir Ronald A. Fisher (1956)
But if we must willy-nilly live with [accounting] standards, we should be wide awake to
their defects and dangers. Let us look at these squarely. (1) The most important is
Sudipta Basu is a Professor at Temple University.
I thank Gregory Waymire for organizing the 2009 AAA Annual Meeting panel session that inspired this keynote address
and the 2014 JIAR Conference organizers for inviting me to speak alongside several distinguished commentators. I thank
JIAR conference attendees for feedback on my talk and Steve Balsam, Progyan Basu, Ervin L. Black (editor), Larry
Brown, Eric Press, and Gregory Waymire for detailed comments and suggestions on this essay.
Supplemental materials can be accessed by clicking the links in Appendix A.
Editor’s note: Accepted by Ervin L. Black.
Published Online: December 2015
235
236 Basu
concerned with the logic of science. Only god-like creatures know where the truth lies. Ex
cathedra pronouncements by human authority are pretentious, and inevitably must be
wrong sometimes. To trust them is to ask for disappointment.
—William T. Baxter (1979)
Our textbooks should be leaders, not followers, in accounting thought and practice. We
should place emphasis on concepts, and not on the details of practice. Concepts are
enduring; practice is not. In our teaching, we should stimulate students to think of
accounting as an activity that addresses questions of importance to society.
—Stephen A. Zeff (1989)
I. INTRODUCTION
D
uring a decade around 1960, the Ford Foundation, Carnegie Foundation, and other
foundations sought to elevate business education from vocational to scientific by investing
about $35 million in five U.S. business schools to jumpstart scientific academic research
in business (Jeuck 1986; Khurana, Kimura, and Fourcade 2011). For example, the Center for
Research in Security Prices (CRSP) stock-price database construction was funded by a 1960 Merrill
Lynch, Pierce, Fenner, and Smith seed grant of $50,000 (later increased to $300,000). The first
CRSP database was completed in 1964 and 60 universities subscribed to it in 1965.1 The Journal of
Accounting Research began publication in 1963 to ‘‘encourage early publication of research
efforts’’ on ‘‘applications of quantitative analysis’’ and ‘‘employment of behavioral science’’
(Dopuch 1963). I evaluate whether this seed investment in scientific accounting research had its
intended effects by individually analyzing whether accounting research, regulation, education, and
practice are scientific.2 Of course, most fields located in the College of Liberal Arts are proudly
nonscientific, so accounting would scarcely be an outlier if it were still unscientific. Indeed, I argue
that accounting regulation and education are based more in faith than in science.
The Merriam-Webster Online Dictionary (http://www.merriam-webster.com/dictionary/
science) defines science as ‘‘knowledge or a system of knowledge covering general truths or the
operation of general laws especially as obtained and tested through the scientific method and
concerned with the physical world and its phenomena.’’ While the definition’s focus on the physical
world and its phenomena limits coverage to the natural sciences such as physics and chemistry,
accounting is better classified as a social science concerned with economic relations. Does
accounting possess the other two primary characteristics of a science: general laws developed
through the scientific method? I do not know of any accounting textbook or other reputable source
that lists or discusses any scientific laws of accounting, as would be expected in a standard
undergraduate physics, chemistry, or economics textbook. But perhaps if accounting regulators use
the scientific method or base their regulations on academic or practitioner research following the
scientific method, then accounting practice might still incorporate scientific laws that just have not
been formally stated. I proceed to investigate this possibility.
Unfortunately, much institutional evidence suggests that accounting and many other social
sciences are not being improved using the scientific method. Feynman (1974, 10; emphasis in
original) describes several academic fields that follow ‘‘cargo cult science,’’ a caricature of the
scientific method, as follows: ‘‘There are big schools of reading methods and mathematical
1
See: http://www.crsp.com/50/ and http://www.crsp.com/about-crsp/history
2
In 1967, the American Assembly of Collegiate Schools of Business (AACSB) increased the degree requirements for
accredited accounting faculty to a Ph.D., starting in 1969. New accounting doctoral programs with quantitative
training were started in the 1960s to meet the new demand for scientific accounting researchers (e.g., Basu 2012).
Journal of International Accounting Research

Volume 14, No. 2, 2015
Is There A Scientific Basis for Accounting? Implications for Practice, Research, and Education 237
methods, and so forth, but if you notice, you’ll see the reading scores keep going down—or hardly
going up—in spite of the fact that we continuously use these same people to improve the methods.
There’s a witch doctor remedy that doesn’t work. It ought to be looked into; how do they know that
their method should work?’’
Now consider financial accounting, the regulation of which was handed to the Securities and
Exchange Commission (SEC) and delegated to the American Institute of Accountants (AIA) and
later the Financial Accounting Standards Board (FASB), with the goal of preventing another stock
market crash like that in 1929. Looking back at just the last three decades, after the FASB was well
established, we have gone through the Savings and Loan crisis of the 1980s; the 1987 and 1989
stock market crashes; the dot-com bubble of the late 1990s and its bursting in 2000–2002; the real
estate bubble of the mid-2000s and the Great Recession of 2007–2009; and the flash crashes of May
6, 2010 and April 23, 2013. During the Great Recession, we also discovered decades-long Ponzi
schemes and frauds run by Bernie Madoff, Allen Stanford, and many others, often operating right
under the SEC’s nose (Markopolos 2010).3 Whatever accounting regulators and researchers are
doing, the SEC is no closer to its goal than when it was created, since we still do not know why the
1929 or 1987 crashes occurred or how to prevent another crash.
I discuss three empirical accounting research practices that are unscientific. First, the near
universal reliance on logically invalid null-hypothesis-significance testing leads to incorrect
inferences permeating the accounting literature.4 Second, regression tables convey less information
than graphs (scatter plots), which makes inference less reliable. Third, researchers often
mechanically pose a nil hypothesis (zero slope coefficient or average difference) instead of
working out the theoretical null hypothesis (Ball 2013), which often has the same predicted sign as
the posited alternative hypothesis. Basu (2012) critiques recent accounting research more broadly
and suggests several potential remedies.
Current financial accounting textbooks encourage rote memorization of accounting rules so that
faculty can ‘‘teach to the test’’ for the CPA exams. Textbook authors credit the SEC’s formation for
good financial accounting rules, a creation myth like those found in sacred religious texts. Maybe out of
ignorance, these authors never mention over 10,000 years of accounting evolution, which is unfortunate
because exposing students to accounting fossils might spark a Darwinian heresy in the accounting faith.
Despite my dire views of accounting research, regulation, and education, I am optimistic about
accounting practice. I argue that the trial-and-error evolution of accounting over millennia led to
better competitive performance for individuals and organizations, and that evolved accounting
embeds several broad regularities that all accountants should learn as foundational concepts. Thus,
pre-SEC evolved accounting practice followed (unrecognized) general scientific laws, although
ideological standard setters have striven to replace them with their unscientific rules over the last
half century. I also suggest a few new research directions for international accounting scholars.
II. CURRENT ACADEMIC ACCOUNTING RESEARCH IS NOT SCIENTIFIC

The Merriam-Webster Online Dictionary defines scientific method as ‘‘principles and
procedures for the systematic pursuit of knowledge involving the recognition and formulation of
a problem, the collection of data through observation and experiment, and the formulation and
testing of hypotheses’’(http://www.merriam-webster.com/dictionary/scientific%20method). Many
accounting professors and doctoral students would find this definition familiar, having encountered
3
For a list of major Ponzi schemes, see: https://en.wikipedia.org/wiki/List_of_Ponzi_schemes. Deason, Rajgopal,
and Waymire (2015) study a sample of 376 Ponzi schemes prosecuted by the SEC between 1988 and 2012.
4
For examples of invalid inferences, see the forum on ‘‘The State of Accounting Scholarship’’ in the December 2013
issue of Accounting Horizons.

Volume 14, No. 2, 2015
238 Basu
FIGURE 1
Different Statistical Hypothesis Testing Frameworks as Summarized in Gigerenzer (2004)
something similar in a research methods class. Certainly, most accounting papers published in
North American journals study quantitative data and claim to test statistical hypotheses.5
Accounting (and Social Science) Researchers Are Taught Incorrect Statistical Hypothesis
Testing
Unfortunately, our statistics and econometrics instructors teach a mangled ‘‘null-hypothesis-
significance-testing procedure’’ that conflates mutually inconsistent theories by Sir Ronald Fisher
(1955, 1956) and Jerzy Neyman and Egon S. Pearson (Neyman 1950, 1957), without ever
mentioning their inherent contradictions. Gigerenzer (2004, 588–590) summarizes these three
approaches to hypothesis testing, as depicted in Figure 1.
The first approach is the ‘‘Null Ritual’’ or null-hypothesis-significance testing (NHST) that
most social scientists use today. Of course, many accounting researchers specify an alternative
hypothesis instead of a null hypothesis—often a coefficient sign or a signed difference in means—
but then one rarely sees an explicit theoretical argument for the implicit null hypothesis of zero.
5
Pfleiderer (2014) and Romer (2015) argue that the misuse of mathematical models is severely impeding scientific
progress in finance and economics and the theory of economic growth, respectively. In Basu (2012), I argue that
accounting research is in a similar crisis caused by excessive mathematization (e.g., McCloskey 2002) and abstraction
from reality (e.g., Shapiro 2005).

Volume 14, No. 2, 2015
Most accounting researchers do not know that the Null Ritual that they learned in graduate school is
‘‘an exceptionally bad idea’’ and a ‘‘meaningless parlor game’’ (Ziliak and McCloskey 2008, 2). The
few researchers who are aware of the fatal flaw keep following the Null Ritual because most
reviewers and editors do not know or care that published inferences are often wrong, and
administrators count published papers but rarely read them.
The second approach is ‘‘Fisher’s Null Hypothesis Testing.’’ While Fisher’s thinking about
statistics and hypothesis testing evolved over his long career, Gigerenzer (2004, 590) summarizes
Fisher’s (1955, 1956) last major writings as shown in Figure 1. In Fisher’s formulation, there is a
null hypothesis but no specific alternative hypothesis, which means that concepts like Type II error
and statistical power are undefined. Furthermore, one should always report exact p-values rather
than whether they fall above or below a critical threshold.6 One can discuss how close an estimate is
to the null hypothesis, but hypotheses are never accepted or rejected.
The third approach is the Neyman and Pearson decision-theoretic framework used to choose
between two distinct hypotheses with costs and benefits attached to each choice. For example, one
hypothesis would reflect acceptable product quality whereas the second hypothesis would reflect
defective quality, and the decision is whether a particular product batch should be shipped to
customers or discarded. The economic costs and benefits of the two choices are used to set Type I
(a) and Type II (1 b) error rates ex ante. Fisher’s Null Hypothesis testing differs considerably
from Neyman-Pearson decision making and Fisher (1955, 70; 1956, 100) argued strenuously
against the latter approach.
Gigerenzer (2004, 591) compares the current Null Ritual to its two predecessors, arguing that
Null Ritual’s first step borrows primarily from Fisher, except that for Fisher the null hypothesis
always means ‘‘chance,’’ such as a zero difference. This first step is inconsistent with Neyman-
Pearson decision theory where two specific (usually) non-zero hypotheses are tested against each
other. The second step is superficially consistent with Neyman-Pearson decision theory, except that
the critical significance level is held constant rather than depending on a, b, and the sample size.
The third step is consistent with neither theory because Fisher, Neyman, and Pearson all agreed that
statistics should never be used mechanically.
In addition, there is the deeper problem that even if applied correctly, NHST is logically
invalid. Cohen (1994, 998) states an incorrect syllogism: ‘‘If a person is an American, then he is
probably not a member of Congress. This person is a member of Congress. Therefore, he is
probably not an American.’’ Although the major premise (the first statement) is true, the final
inference is clearly false because members of Congress must be American citizens. Cohen (1994)
explains that this is the same incorrect logic used in NHST: ‘‘If H0 is true, then this result (statistical
significance) would probably not occur. This result has occurred. Then H0 is probably not true and
therefore formally invalid.’’ As the first syllogism illustrates concretely, NHST cannot logically tell
us whether a hypothesis is (probably) true or not.
Cohen (1994, 997) summarizes:
What’s wrong with NHST? Well, among many other things, it does not tell us what we
want to know, and we so much want to know what we want to know that, out of
desperation, we nevertheless believe that it does! What we want to know is ‘‘Given these
data, what is the probability that H0 is true?’’ But as most of us know, what it tells us is
‘‘Given that H0 is true, what is the probability of these (or more extreme) data?’’ These are
not the same.
6
Fisher (1935, 13) said, ‘‘It is usual and convenient for experimenters to take 5 percent as a standard level of
significance, in the sense that they are prepared to ignore all results which fail to reach this standard,’’ which became
incorporated in the Null Ritual, although Fisher (1956) later recanted this position (see opening quote to this paper).

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240 Basu
We can write these two conditional probabilities as P(H0jD) and P(DjH0), respectively, where
H0 denotes ‘‘H0 is true’’ and D denotes ‘‘data observed.’’ Social science researchers, desperate to
appear scientific, incorrectly equate the transposed conditional probabilities to infer logically
invalid claims. The conditional probabilities are defined as P(H0jD) ¼ P(H0 \ D)/P(D) and P(DjH0)
¼ P(H0 \ D)/P(H0). Using these definitions, Bayes Theorem relates the two transposed conditional
probabilities with the equation: P(H0jD) ¼ P(DjH0) 3 P(D)/P(H0). Thus, one can infer P(H0jD)
from P(DjH0) only if one knows the unconditional P(H0) ex ante, which would render NHST moot.
Bayes Theorem reveals that P(H0jD) ¼ P(DjH0) if P(D) ¼ P(H0), which is rare, so researchers are
almost always wrong to equate the transposed conditional probabilities. It is ironic that some
accounting theoreticians model decision makers as rational if they use Bayesian updating, but most
U.S. accounting researchers behave irrationally by explicitly violating Bayes Theorem when
drawing inferences from NHST.
Incorrect inferences from the Null Ritual extend far beyond accounting. Ioannidis (2005)
shows that most published research is false; and this is true of even the most highly cited papers in
the top medical journals, which doctors and regulators presumably rely on to make decisions that
affect the health of countless patients.7 Fanelli (2010) shows that social science researchers are five
times as likely to report statistically significant results as those in the natural sciences, suggestive of
strong publication bias. Fanelli (2012) shows that, across all disciplines, statistically significant
results increased by 22 percent during 1990–2007, with social sciences leading the way. Simmons,
Nelson, and Simonsohn (2011) argue that ‘‘flexibility in data collection, analysis, and reporting
dramatically increases actual false-positive rates’’ and show using standard experimental protocols
that listening to The Beatles’ ‘‘When I’m Sixty-Four’’ made subjects physically younger as
measured by their birth dates. Similar to earnings management to meet thresholds, Basu and Park
(2014) report that p-values in accounting papers published in 2011 are bunched below standard
statistical significance levels, suggesting yet another source of unreliability.
If they continue using NHST, accounting researchers should follow best practices including
power analysis (e.g., Lindsay 1993), robust estimation (e.g., Basu and Markov 2004; Ohlson and
Kim 2015), adjustment of standard errors for dependent observations (e.g., Bernard 1987; Petersen
2009), adjustment of significance level (a) for sample size (e.g., Johnstone 1990) and multiple
comparisons (e.g., Burgstahler 1987; Basu, Holland, and Sun 2012), and use out-of-sample tests,
replications, and meta-analyses to reduce the likelihood of biased inferences. Simmons et al. (2011)
recommend six author disclosures and four reviewer guidelines to reduce flexibility in experimental
research.
Ideally, social science researchers would abandon NHST, emphasize practical or economic
significance (incremental explanatory power and/or effect size), and trace causal mechanisms
before drawing inferences (Hill 1965; Dyckman and Zeff 2014). Accounting researchers would
analyze more historical and institutional evidence and conduct case studies to generate ‘‘thick
associations’’ that ground the ‘‘thin associations’’ of formal algebraic models or statistical analyses
(Waymire and Basu 2008, 41).
7
As a recent example, on June 17, 2015, the U.S. Food and Drug Administration (FDA) ‘‘made a final determination
that there is no longer a consensus among qualified experts that partially hydrogenated oils (PHOs), which are the
primary dietary source of industrially produced trans fatty acids (IP-FTA) are generally recognized as safe (GRAS)
for any use in human foods.’’ The FDA banned the use of PHOs in U.S. food supply effective June 18, 2018. The
final regulation is available online at: https://www.federalregister.gov/articles/2015/06/17/2015-14883/final-
determination-regarding-partially-hydrogenated-oils. The FDA earlier affirmed that partially hydrogenated low
erucic acid rapeseed (LEAR) oil was GRAS for use in food (50 FR 3745 [January 28, 1985]) ‘‘through scientific
procedures’’ including review of 62 published studies and had promoted the health benefits of PHOs over butter and
margarine for decades.

Volume 14, No. 2, 2015
Accounting Researchers Do Not Understand Even Their Summary Regression Outputs

If a picture is worth a thousand words, how many tables is a scatterplot worth? Anscombe (1973)
provides a nice test of how well a researcher can interpret the simple regression output from a standard
computer package. Mentally picture the 11 observations summarized by the following output.
Number of observations (n) ¼ 11;
Mean of the x’s ðxÞ ¼ 9.0;
Mean of the y’s ðyÞ ¼ 7.5;
Regression coefficient (b1) of y on x ¼ 0.5;
Equation of regression line: y ¼ 3 þ 0.5 x;
Sum of squares of x ¼ 110.0;
Regression sum of squares ¼ 27.50 (1 df );
Residual sum of squares of y ¼ 13.75 (9 df );
Estimated standard error of b1 ¼ 0.118; and
Multiple R2 ¼ 0.667.
Now look at Figure 2, which reproduces Figures 1 through 4 from Anscombe (1973, 19–20).
Which of the four candidate plots is closest to your initial mental picture? Which of the alternative
datasets represented in these four plots is most likely to have generated the regression output you
just studied? Please take a moment to jot down your answers before reading further.
What were your answers to the two questions above? Were your answers the same for both
questions? Many accounting doctoral students will pick the first plot for both questions because this
looks like the typical bivariate Normal distribution illustrated in econometrics textbooks, and I venture
that many senior accounting researchers will do the same. However, all four datasets generate the
identical regression output even though the relationship between the two variables is clearly very
different in each case. The second plot displays a deterministic nonlinear relationship with a potential
R2 of 100 percent. The last two plots reflect the polar effects of outliers. Plot 3 shows how an outlier
can disguise a deterministic linear relationship, while Plot 4 shows how an extreme outlier can mimic
a strong statistical relationship even when there is none. Without analyzing scatter plots, the average
researcher will likely never consider the possibility of the last three plots, even though these are far
from uncommon phenomena (for example, price-level regressions behave very differently when you
include or exclude Berkshire Hathaway). Even trained econometricians find it harder to forecast when
given regression output rather than the equivalent scatter plots (Soyer and Hogarth 2012), consistent
with tables providing less useful data than graphs. The econometricians did better with graphs alone
than with both regression output and graphs, suggesting that regression tables actually reduce
understanding of data. Easton (1999) points out that several nonlinear earnings-return relations could
have been discovered at least 20 years earlier if researchers routinely plotted their data instead of just
assuming a linear relation, as in Anscombe’s (1973) first plot.
Accounting researchers should habitually plot their main variables so as to better understand the
relationship they are estimating (Basu 2012). Editors and reviewers should press accounting authors
to replace tables with graphs, as recommended by statisticians (e.g., Tukey 1977; Chambers,
Cleveland, Kleiner, and Tukey 1983; Wainer 2009). Gelman, Pasarica, and Dodhia (2002) show
how different statistical output tables can be replaced by graphs that take up as little space but
provide more data than the equivalent tables, so journal space constraints need not be an issue.
An Example of Misapplied Null Hypothesis Testing in a Prominent Accounting Research

Stream
In a 2012 AAA Annual Meeting panel discussion, Ray Ball (2013) and Jerry Zimmerman
(2013) independently identified practitioners’, regulators’, and researchers’ exaggerated beliefs

Volume 14, No. 2, 2015
242 Basu
FIGURE 2
Four Possible Scatterplots Corresponding to Regression Output in Anscombe (1973)
about the importance of external financial reporting and the extent of accounting manipulation as
their candidate for ‘‘The Most Incorrect Belief of Accounting Experts.’’ Healy and Wahlen (1999)
and Dechow and Skinner (2000) point that out many legitimate business transactions appear
manipulative when viewed through the lens of researchers’ earnings management models. Because
these standard earnings management models are deterministic and do not account for economic
shocks, the literature based on these models is ‘‘dismally unscientific’’ (Ball 2013).
Earnings management researchers routinely ignore the role of ‘‘chance’’ in setting up the
statistical null hypothesis as recommended by Fisher (1955, 1956). Many papers sort firms on
‘‘discretionary’’ or ‘‘abnormal’’ accruals into deciles each year, and then plot the average
discretionary accruals for the extreme deciles for several years before and after the sorting year
(e.g., Dechow, Sloan, and Sweeney 1995; Hirshleifer, Hou, Teoh, and Zhang 2004). Researchers
typically find a (inverse) V-shaped pattern for the (highest) lowest decile with the (apex) trough in

Volume 14, No. 2, 2015
FIGURE 3
Mid-Height Distribution of 205 Pairs of Parents and 930 Adult Children
Source: Galton (1886).

This graphic is unedited from the source material. Any inaccuracies in this graphic are original to the source material.
A full-size version of this table is available as a downloadable PDF file. Please see Appendix A.
the sorting year, and interpret these patterns as symptomatic of accruals or earnings management
that peaks in the sorting year.
But what would we expect if firm performance results only from a mixture of managerial skill
and random economic shocks that last more than a year, with the latter producing greater time-series
variation? Assume that managers cannot manipulate reported financial statements at all, either
because managers have no input into their production or because of perfect auditing. Would we
expect to see flat lines over time for the extreme accruals (or earnings) firms identified each year
under these conditions, the unstated economic null hypothesis in these earnings management papers?
Sir Francis Galton (1886) identified the phenomenon of ‘‘reversion to the mean’’ by studying
the heights of 930 adult children of 205 pairs of parents. Figure 3 reproduces Table 1 from Galton
(1886, 248), which reports his main results. Galton (1886) found that when he sorted the parents by
their average heights, the children of the tallest parents were shorter on average than their parents,
and similarly the children of the shortest parents were taller on average than their parents (women’s
heights were multiplied by 1.08 to account for gender height ratios). More interestingly, when he
sorted families by the average height of the children, parents of the tallest children tended to be
shorter than them on average and, similarly, parents of the shortest children tended to be taller than
them on average. While parents of extreme height could conceivably interfere in their children’s
growth, there is no way for children to interfere in their parents’ adult height achieved before they
were born! Galton interpreted his V-shaped pattern for shortest heights and inverse V-shaped
pattern for tallest heights as arising partly from genetic propensity for height and partly from

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244 Basu
variation in nutrition during growth stages due to economic shocks. The tallest families in any
generation had both the genetic predisposition for height and had also been lucky and gotten the
best nutrition during all their growth periods. However, succeeding and preceding generations were
unlikely to get the best nutrition in all their growth periods, and thus would be shorter on average. If
genetic predisposition for height is analogous to managerial skill and nutrition during growth
periods is similar to economic shocks, then we would expect mean reversion even if managers
could not and did not attempt to manipulate earnings.8 In other words, if there is random variation
in firm performance (i.e., performance is literally a random variable), then ‘‘chance’’ in Fisherian
terms leads to a null hypothesis of mean reversion both going forward and backward in time.9 I find
it dreadful that our top accounting journals publish papers that do not incorporate basic statistical
insights that are 130 years old!
Ball (2013) argues that earnings management researchers often draw incorrect inferences
because they do not think through the economic null hypothesis, which is how earnings would
behave in the absence of agency costs, which are the basis for the alternative hypothesis being
tested. This section gave another example of this phenomenon. Instead of mechanically assuming
that the relevant null hypothesis is always a nil hypothesis (zero mean difference or slope
coefficient) simply because it is computationally convenient, accounting researchers should work
out whether the economic null hypothesis actually predicts a zero value and, if not, how to best test
which hypothesis better explains the data.
III. MODERN ACCOUNTING REGULATION IS BASED NOT IN SCIENCE BUT FAITH

Accounting standards were historically induced from practice (e.g., Littleton 1953) and the
American Institute of Accountants (AIA) recommended perceived best practices to its members
through several channels before 1930 (Moonitz 1970; Zeff 1971). When the SEC was created and
charged with setting accounting ‘‘principles,’’ it delegated this activity to the private sector AIA,
which continued to identify and recommend best accounting practices. Sanders, Hatfield, and
Moore (1938) and Paton and Littleton (1940) were academic attempts to compile best ‘‘standards,’’
which then connoted norms in practice. Soon however, Accounting Series Release No. 4 (SEC
1938) required public companies to file financial statements with the SEC using only SEC-approved
principles.10 Overnight, principles became mandatory rules rather than voluntary norms (Baxter
1979), and in an Orwellian manner, ‘‘generally accepted’’ now denoted ‘‘SEC approved.’’ The AIA
continued to identify (a few) best practices as before for any accounting topic, but these were now
effectively rules enforced with administrative sanctions.
The push to make business school research and education more scientific in the decade around
1960 likely induced academics to consider whether accounting principles could be based on a
consistent theoretical framework rather than created case by case. At this time, the economics and
finance fields that had adopted quantitative methods early, starting with Samuelson (1947), were
perceived as scientific and prestigious. In the 1960s, accountants borrowed the concepts of decision
8
Samuels (1991) provides a general and intuitive proof of mean reversion and shows that mean reversion is more likely
to be observed than regression to the mean for general classes of distributions.
9
This is especially true if the economic shocks are reported in earnings and accruals as moving average processes (e.g.,
Ball and Watts 1972; Beaver, Lambert, and Morse 1980). Indeed, Hirshleifer et al. (2004) report that firms in their
extreme net operating asset (NOA) deciles have their peak or trough stock returns in the previous year, suggesting that
NOA sorting is a delayed and weaker version of a contrarian trading strategy.
10
The exact language is: ‘‘In cases where financial statements filed with this Commission pursuant to its rules and
regulations under the Securities Act of 1933 or the Securities Exchange Act of 1934 are prepared in accordance with
accounting principles for which there is no substantial authoritative support, such financial statements will be
presumed to be misleading or inaccurate despite disclosures contained in the certificate of the accountant or in
footnotes to the statements provided the matters involved are material’’ (SEC 1938).

Volume 14, No. 2, 2015
usefulness from decision science and market efficiency from finance as core concepts on which to
build a new accounting conceptual framework (e.g., Staubus 1999; Zeff 1999). The market efficiency
concept provided a new justification for reporting current market values instead of traditional
historical cost, while Sprouse (1966) misrepresented Graham and Dodd’s (1934) Security Analysis to
justify an ‘‘asset-and-liability’’ approach to financial reporting (Basu and Waymire 2010). As FASB
vice chairman, Robert Sprouse infused a few early FASB rules, and the later conceptual framework,
with both the balance-sheet approach and current-value reporting (e.g., Zeff 2005).
Robert Sprouse, Jim Leisenring, Sir David Tweedie, and other fair-value advocates exemplify
Adam Smith’s (1759, paragraph VI.II.42) ‘‘man of system’’:
The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so
enamoured with the supposed beauty of his own ideal plan of government, that he cannot
suffer the smallest deviation from any part of it. He goes on to establish it completely and in
all its parts, without any regard either to the great interests, or to the strong prejudices which
may oppose it. He seems to imagine that he can arrange the different members of a great
society with as much ease as the hand arranges the different pieces upon a chess-board. He
does not consider that the pieces upon the chess-board have no other principle of motion
besides that which the hand impresses upon them; but that, in the great chess-board of human
society, every single piece has a principle of motion of its own, altogether different from that
which the legislature might chuse to impress upon it. If those two principles coincide and act
in the same direction, the game of human society will go on easily and harmoniously, and is
very likely to be happy and successful. If they are opposite or different, the game will go on
miserably, and the society must be at all times in the highest degree of disorder.
This paragraph expresses beautifully why rule makers so strongly desire to coerce private
individuals and firms to adhere to their idealized conceptual framework, and the possible
consequences of their hubris. In his preceding paragraph, Adam Smith (1759, paragraph VI.II.41)
describes the ‘‘man of humanity and benevolence,’’ which captures pre-FASB thought leaders like
Arthur L. Dickinson, William Lybrand, Henry Rand Hatfield, George O. May, and A. C. Littleton,
who sought to persuade other accountants to voluntarily adopt better practices rather than impose
rules upon them:
The man whose public spirit is prompted altogether by humanity and benevolence, will
respect the established powers and privileges even of individuals, and still more those of the
great orders and societies, into which the state is divided. Although he should consider some
of them as in some measure abusive, he will content himself with moderating, what he often
cannot annihilate without great violence. When he cannot conquer the rooted prejudices of
the people by reason and persuasion, he will not attempt to subdue them by force; but will
religiously observe what, by Cicero, is justly called the divine maxim of Plato, never to use
violence to his country no more than to his parents. He will accommodate, as well as he can,
his public arrangements to the confirmed habits and prejudices of the people; and will
remedy as well as he can, the inconveniencies which may flow from the want of those
regulations which the people are averse to submit to. When he cannot establish the right, he
will not disdain to ameliorate the wrong; but like Solon, when he cannot establish the best
system of laws, he will endeavour to establish the best that the people can bear.
So how does the modern conceptual framework era of FASB and IASB standard setting
compare to the unregulated pre-SEC era of accounting norms? Figure 4 summarizes some of the
key differences between the two regimes. The pre-SEC era was one where accounting norms
evolved in an unregulated bottom-up descriptive process, while rules are created in a top-down
prescriptive process in the modern era. In the pre-SEC era, spontaneous norms emerged as a result

Volume 14, No. 2, 2015
246 Basu
FIGURE 4
Different Processes for Developing U.S. Generally Accepted Accounting Principles
of competition between firms, whereas today’s rules are set by government-chartered monopolists
using the intelligent design of their conceptual frameworks.11 Before the SEC, new accounting
problems were addressed inductively by experimenting with solutions to similar problems to see
which worked best, while regulators today deduce the optimal solutions from their conceptual
frameworks. Pre-SEC norms were based on what made sense to managers and auditors, whereas
today’s rules are designed for rational Bayesian decision makers or, more accurately, computer
programs. Pre-SEC norms emerged voluntarily if they helped firms become more efficient and
survive in competition, whereas mandatory accounting rules are based on faith in anointed rule
makers (backed by government coercion of nonbelievers). In other words, pre-SEC norms were
ecologically rational whereas the FASB/IASB conceptual framework relies on constructivist
rationality (Smith 2003, 2008). Pre-SEC accounting norms could be learned within an accounting
practice or from a network in which the practice was embedded, whereas modern accounting rules
are memorized from infallible holy texts (e.g., FASB’s Accounting Standards Codification)
interpreted by the priesthood of rule-makers’ permanent staff members. Modern accounting rule
makers rely on ‘‘the pretence of knowledge’’ (Hayek 1975) because they cannot possibly know
everything they need to know to set optimal accounting rules (Madsen 2013).12 As Hayek (1975)
noted in the closing of his Nobel lecture:
11
Thomas Sargent’s (2008) presidential address to the American Economic Association titled ‘‘Evolution and Intelligent
Design’’ compares the optimal macroeconomic policies developed via rational expectations equilibria to their
application in practice where they appear to inevitably fail and policymakers then have to adaptively develop new
policies to handle crises that the models did not anticipate.
12
Easterly (2006) argues that foreign aid has had little impact on development because ‘‘planners’’ impose their top-
down plans on poor countries and dominate ‘‘searchers’’ who seek bottom-up solutions to specific needs. Much
earlier, Hayek (1944b, 1945) argued that central economic planning was bound to underperform the competition of a
free market because planners could never gather all the local information that the price system incorporates.

Volume 14, No. 2, 2015
If man is not to do more harm than good in his efforts to improve the social order, he
will have to learn that in this, as in all other fields where essential complexity of an
organized kind prevails, he cannot acquire the full knowledge which would make
mastery of the events possible. He will therefore have to use what knowledge he can
achieve, not to shape the results as the craftsman shapes his handiwork, but rather to
cultivate a growth by providing the appropriate environment, in the manner in which
the gardener does this for his plants. There is danger in the exuberant feeling of ever
growing power which the advance of the physical sciences has engendered and which
tempts man to try, ‘‘dizzy with success,’’ to use a characteristic phrase of early
communism, to subject not only our natural but also our human environment to the
control of a human will. The recognition of the insuperable limits to his knowledge
ought indeed to teach the student of society a lesson of humility which should guard
him against becoming an accomplice in men’s fatal striving to control society—a
striving which makes him not only a tyrant over his fellows, but which may well make
him the destroyer of a civilization which no brain has designed but which has grown
from the free efforts of millions of individuals.
How well did these two competing accounting standard-setting mechanisms perform? Before
the SEC, regulatory and technological changes induced new accounting practices that spread
quickly via imitation (e.g., Sunder 2010). Examples include the rapid spread of depreciation in the
late nineteenth century (Watts and Zimmerman 1979), of consolidated financial statements in the
early twentieth century (Basu, Madsen, Reppenhagen, and Waymire 2014), of retail inventory
methods in the 1920s (Walsh and Jeacle 2003), and of LIFO in the 1930s (Davis 1982). Although
the FASB issued some uncontroversial rules quickly, a few contentious rules took longer to be
developed and issued. The FASB used small teams to address emerging practice problems such as
the Emerging Issues Task Force and the Derivatives Implementation Group, and the recent FASB/
IASB Joint Transition Resource Group for Revenue Recognition, which are similar to the ‘‘Students
Department’’ and ‘‘Tax Department’’ in the Journal of Accountancy in the 1910s and 1920s
(Moonitz 1970; Basu et al. 2014). Mandatory accounting rules lead to greater uniformity of
practice, but the current rule makers do not have a speed advantage.
Have the monopolist rule makers produced better standards? The FASB-IASB focus on fair-
value reporting and the balance-sheet approach leads naturally to using value-relevance regressions
as a measure of accounting quality (e.g., Barth, Beaver, and Landsman 2001).13 Ely and Waymire
(1999) examine the value relevance of U.S. accounting from 1927 through 1993 across four
different rule-making regimes: Before the Committee on Accounting Procedure (1927–1938), the
Committee on Accounting Procedure period (1939–1960), the Accounting Principles Board period
(1960–1973), and the Financial Accounting Standards Board period (1973–1993). Their Figure 1,
which plots annual estimates of earnings value relevance, is reproduced as Figure 5. The figure
displays considerable time-series variation in annual value relevance. Before the SEC, when
accounting norms evolved spontaneously, value relevance increased. In contrast, during the
conceptual-framework period, value relevance declined precipitously. In other words, fair-value
and balance-sheet-approach advocates who seek to make financial statements more useful to capital
markets are failing according to their preferred research metric.
13
Beaver and Dukes (1972, 321) state, ‘‘The method which produces earnings numbers having the highest association
with security prices is the most consistent with the information that results in an efficient determination of security
prices. Subject to [certain] qualifications . . ., it is the method that ought to be reported.’’ Critics of this criterion
include Gonedes and Dopuch (1974), Holthausen and Watts (2001), and Sunder (2008).

Volume 14, No. 2, 2015
248 Basu
FIGURE 5
Annual Value-Relevance Regressions from 1927–1993
Source: Ely and Waymire (1999, Figure 1).
Of course, there is much more institutional evidence that the modern conceptual framework is
ineffective. The FASB and IASB banished conservatism from their joint Conceptual Framework
‘‘because including [it] would be inconsistent with neutrality’’ (FASB 2010, BC 3.27). However,
accounting practice has become much more conservative over the last several decades (e.g., Basu
1997; Holthausen and Watts 2001), suggesting that the standard setters are battling history (Brown
2013). Conditional conservatism improves firm outcomes in financing, investing, and corporate
governance (e.g., Watts 2003; Qiang 2007; Ruch and Taylor 2015) contrary to some rule makers’
long-held beliefs.14
Why have the FASB and IASB gone so wrong? The primary culprit is their unscientific
decision to forever root their conceptual frameworks in the late 1960s’ state-of-the-art
knowledge of finance and economics (Baxter 1979). As Cajal (1897, 124), the discoverer of the
neuron, attests, ‘‘In politics, the worship of inflexibility or resistance to change is considered a
14
In belated response to comments from constituents, the IASB (2015, 9) in its solo Exposure Draft titled ‘‘Conceptual
Framework for Financial Reporting,’’ now proposes ‘‘to reintroduce an explicit reference to the notion of prudence
(described as caution when making judgements under conditions of uncertainty) and state that prudence is important
for achieving neutrality’’ in its Conceptual Framework. Barker and McGeachin (2015) show that many International
Financial Reporting Standards (IFRS) require conservative reporting, which is inconsistent with the IASB’s
Conceptual Framework. They argue that reconciling IFRS with the Conceptual Framework requires an
acknowledgement and understanding of the agency/contracting perspective that the IASB has hitherto ignored.

Volume 14, No. 2, 2015
virtue, whereas in science it is almost always an unmistakable sign of pride or

shortsightedness.’’ The regulators’ choice ensures that subsequent advances such as option-
pricing theory (Black and Scholes 1973), behavioral economics (e.g., Tversky and Kahneman
1974), agency theory (Jensen and Meckling 1976), stock-market anomalies (Ball 1978), and
positive accounting theory (Watts and Zimmerman 1978, 1979) were not incorporated in the
conceptual frameworks. Recent stock market bubbles call into question the core market-
efficiency assumption, while Williams and Ravenscroft (2015) critique the other core ‘‘decision-
usefulness’’ assumption. Another problem is that rule makers respond to crises with big changes
to mollify the legislature, but the regulatory process is often captured by policy entrepreneurs
who enact unpopular and untested reforms such as the Sarbanes-Oxley Act of 2002 and the
Dodd-Frank Act of 2010 (Waymire and Basu 2011).
Paton (1922) and Canning (1929) were early U.S. attempts to develop conceptual frameworks
for accounting (Zeff 1999). If the Committee on Accounting Procedure had adopted either of these
works as the basis for its accounting standards and committed future standard setters to this
conceptual framework, how confident would we be that we had the best accounting standards
possible today? Given how much knowledge has accumulated in the decades since the current
conceptual framework was set, we are surely very far from the best accounting standards available
on a purely deductive basis.
IV. TEXTBOOKS’ ACCOUNTING CREATION MYTHS SHOW THAT ACCOUNTING

EDUCATORS HAVE BEEN CAPTURED BY STANDARD SETTERS
Current U.S. financial accounting textbooks usually start with a historical chapter on
accounting rules and regulators. This history usually begins with the SEC’s creation in the 1930s
and quickly moves on to describe the various private sector bodies to which the SEC delegated its
standard-setting powers, with limited discussion of why the early ones failed. However, these
textbooks rarely mention accounting before the SEC (Zeff 1989) or that double-entry bookkeeping
is 700 years old (e.g., Lee 1977). Today’s accounting textbooks preach a creation myth where the
formation of the SEC initiated and spread good accounting to the benighted populace, whose
previous barbaric practices do not merit mention.
The reality, of course, is that most of the early SEC-era rules codified longstanding
practices, such as the lower-of-cost-or-market rule (e.g., Littleton 1941). By crediting the SEC
with promulgating good accounting rules, our textbooks promote the cult of a benevolent,
omniscient, and infallible regulator. The touching faith in accounting experts appointed to rule-
making bodies is directly opposite to Feynman’s (1969) definition of science as ‘‘the belief in the
ignorance of experts.’’ The textbooks describe rule-making rituals such as due-process
procedures that signal the apparent objectivity, neutrality, and impartiality of regulators (Young
2014). However, the textbooks ignore the interpretive flexibility regulators often use to reach
preconceived decisions behind the veil of impartiality, especially by ignoring or silencing their
critics (Young 2003) or making up users (Young 2006). Many textbooks also ignore the
lobbying and political process that shapes accounting rules (Zeff 1989), as well as regulators’
ideological preconceptions.
Why do today’s textbook authors worship in a quasi-religious cult? Unfortunately, the ability
to bestow status by invitation to select conferences and citation in official documents lets regulators
set our research and teaching agendas (Zeff 1989), not just in accounting but also in development
economics (Klein and DiCola 2004), monetary policy and banking (White 2005), and other fields.
Risk-averse publishers imitate the market-leading textbooks, so a textbook template can persist and
spread for decades. By coercively equating good accounting with rote memorization of rules rather
than professional judgment, the SEC has blocked the intellectual development of accounting

Volume 14, No. 2, 2015
250 Basu
FIGURE 6
Ancient Accounting Tokens from Iraq and Possible African Accounting Device
Panel A: Tokens from Jarmo, Iraq, 6500 BC
Reproduced from Schmandt-Besserat (2015) with permission from the author.

http://sites.utexas.edu/dsb/tokens/from-accounting-to-writing/
(continued on next page)
students (Baxter 1953, 1979; Sunder 2010), while increasing its control over the accounting
profession and academy (Zeff 1989).15
How can textbook authors do better? They should begin by studying accounting history and
conveying this knowledge to their readers.16 I would start all textbooks with accounting prehistory,
which dates back at least 10,000 years, and ask students why accounting was invented so long ago.
For example, Figure 6, Panel A displays Mesopotamian accounting tokens from circa 6500 BC,
which were used to track agricultural commodities for thousands of years before firms and capital
markets came into being (Schmandt-Besserat 1992; Mattessich 1994). Figure 6, Panel B displays
15
Madsen (2015) reports that the quality of incoming accounting students has declined relative to other business majors
over the last 40 years, consistent with accounting education worsening, as predicted by Baxter (1979). More
worryingly, Arum and Roksa (2011) report that 45 percent (36 percent) of traditional college students at four-year
institutions show no statistically significant gain in critical thinking in their first two (four) years, and that the least
gains are found in business schools, and I suspect particularly in accounting.
16
Most accounting professors are woefully ignorant of accounting history (e.g., Zeff 1989). A narrow knowledge of
only current rule-based accounting makes it impossible for professors to imagine or appreciate unregulated
accounting or challenge regulators. Such historical ignorance of their own fields is widespread among academics
(Hayek 1954) including among accomplished monetary economists (Selgin 2015).

Volume 14, No. 2, 2015
FIGURE 6 (continued)
Panel B: Tokens from Uruk, Iraq, circa 3300 BC
Reproduced from Schmandt-Besserat (2015) with permission from the author.

http://sites.utexas.edu/dsb/tokens/from-accounting-to-writing/
(continued on next page)
later tokens from circa 3300 BC, which were used to represent manufactured goods after cities
emerged. Accounting students can be challenged to use these tokens to create an effective
accounting system and asked to consider how an accounting system without writing or numerals
could be useful. Panel C of Figure 6 displays a piece of ochre from 100,000 years ago that could be
a counting device, suggesting the roots of accounting might be very ancient. The 80 (40) years of
SEC (FASB) regulation pale in comparison and raise basic questions about the miniscule
contribution of recent rules to this long history. Studying and comparing evolved accounting
techniques and practices from cultures around the world through the millennia is likely to instill a
greater respect for the quality of accounting practice in today’s students than the religious pieties
conveyed by today’s textbooks, increase students’ ability to critique and challenge official
accounting rules, and even suggest improved accounting practices (Zeff 1989).17
V. IS ACCOUNTING PRACTICE SCIENTIFIC IN ANY WAY, SHAPE, OR FORM?

In contrast to my earlier gloomy outlook, I now switch to more optimistic evaluations of
evolved accounting practice (e.g., Basu and Waymire 2006; Waymire and Basu 2008). In the
17
Grafton and Grossman (2015) argue that having students research historical archives will ‘‘teach them to understand
and appreciate the past on its own terms’’ that will eventually make each student ‘‘an independent, analytical thinker
and a reflective, self-critical person.’’

Volume 14, No. 2, 2015
252 Basu
FIGURE 6 (continued)
Panel C: A Geometric Pattern made by Homo sapiens on Piece of Ochre at Blombos Cave in
South Africa about 100,000 Years Ago
Left: Photo and tracing of piece M3-10. Right: Close up view of the engraving. Scale ¼ 1 cm. See Henshilwood,
d’Errico, and Watts (2009, Figure 20).
Reprinted from Journal of Human Evolution, Vol. 57 /No. 1, Christopher S. Henshilwood, Francesco d’Errico, Ian
Watts, Engraved ochres from the Middle Stone Age levels at Blombos Cave, South Africa, Copyright 2009, with
permission from Elsevier.
The full-color version of Figure 6 is available as a downloadable PDF file. Please see Appendix A.
introduction, I used the Merriam-Webster definition of a science as knowledge of general laws

developed using the scientific method. Scientific laws summarize many experiments, can be stated
briefly and often as an equation, and have been verified repeatedly and never falsified (https://en.
wikipedia.org/wiki/Laws_of_science). I briefly propose three potential scientific laws underlying
evolved accounting practice, which can be tested and verified more rigorously. In other words, I

Volume 14, No. 2, 2015
argue that accounting evolved historically as if it was designed scientifically. I hope that researchers
will propose additional accounting laws that will enable us to jointly develop a scientific
understanding of accounting practice.
The Law of Accounting Evolution

The Law of Accounting Evolution is that the trial-and-error accounting experimentation over
several millennia increased the average fitness of firms adopting the pre-SEC evolved accounting
norms (Waymire and Basu 2008; 2011). The argument parallels Charles Darwin’s (1859) biological
evolution through natural selection where species that are better adapted to the natural environment
are more likely to survive, and is a direct application of the economic Darwinism of Alchian (1950)
and Hodgson and Knudsen (2010). A corollary of this law is that accounting standards based on a
politically determined conceptual framework are likely to be fitness neutral at best and more likely
fitness reducing.
Dickhaut, Basu, McCabe, and Waymire (2010) describe the emergence of accounting principles
underlying pre-SEC accounting and ‘‘hypothesize that the accounting principles induced in this
fashion persisted because they were consilient with how the human brain had evolved to evaluate
social exchange.’’ Alchian (1950) argues that firm survival in competition requires actual realized
profits rather than theoretical profit maximization. Firms that exploit profit opportunities are those that
survive, regardless of whether it is by luck or by intent. Before organizations were created, similar
survival benefits likely accrued to individuals who could engage in mutually beneficial exchanges,
explaining why we observe ancient accounting long before firms emerged (Basu and Waymire 2006).
Thus, historical cost accounting that enables evaluation of completed past exchanges helps people
identify profitable future exchanges that improve survival odds (Waymire 2009).
Dickhaut et al. (2010) review the neuroscientific literature on brain function during economic
decision making and highlight the parallels with evolved accounting principles such as revenue
realization, expense matching, conservatism, and historical cost. In other words, people and animals
use similar mental processes to accounting principles when considering economic exchanges even if
they are completely unaware of accounting. From an evolutionary perspective, such brain function
can only have emerged if it increased survival prospects in ancestral environments. Unless the
economic environment has changed considerably, something regulators have never demonstrated
satisfactorily, it is likely that evolved pre-SEC accounting principles are still survival enhancing.
Waymire and Basu (2011) use the Price (1970, 1972) equation from evolutionary biology to
theoretically analyze accounting method changes similar to analyzing genetic mutations in living
beings. In comparing changing characteristics of a given population through time, we can identify
three sources of change: selection, transformation, and migration (Kerr and Godfrey-Smith 2009).
Consider a population of firms for which we can catalog the set of accounting policies (i.e.,
‘‘accounting practice’’) used at both the start and the end of a given time period. Accounting
practice could change during the period for several reasons. First, some firms with unique
accounting practices may fail more or less often than the modal firm, which is similar to Darwinian
selection. Second, firms change accounting policies, either because managers voluntarily switch or
because standard setters ban a current policy or mandate a new one—the transformation cases
studied in prior accounting research (e.g., Watts and Zimmerman 1979). Finally, entrepreneurs may
create new firms that experiment with a different set of accounting policies than existing firms,
which is a case of migration into the environment.
The generalized Price equation (Kerr and Godfrey-Smith 2009) decomposes the changes in
accounting practices (or any other population characteristics) and allocates them to these three
causes. I propose empirically analyzing the publicly disclosed accounting choices of the Compustat
population to model the evolutionary dynamics of accounting method choice. We can then quantify

Volume 14, No. 2, 2015
254 Basu
how much each of the three forces contributes to U.S. accounting evolution. We can also test if
accounting evolution occurs in intense short bursts amid periods of relative stability, labeled
‘‘punctuated equilibrium’’ (Eldredge and Gould 1972), using methods developed by Pagel, Venditti,
and Meade (2006). LIFO creation in the 1930s and LIFO switches in the 1970s both occurred
during high inflation periods, but firms were less likely to switch inventory methods during other
periods. We can also test whether accounting changes more after economic crises (as proxied by
NBER recessions or major income tax increases), especially via selection and migration as posited
by Waymire and Basu (2011). For example, are the new firms that build apps for mobile phones
more likely to capitalize software development costs? Were firms that capitalized software
development costs less likely to survive the bursting of the dot-com bubble? We could also study
non-GAAP and nonfinancial measures in the U.S., although that would require data collection.18
Another possibility is to study data in jurisdictions like the U.K., which were slower to mandate
rules and still permit GAAP overrides (e.g., Livne and McNichols 2009). A scientific knowledge of
the evolutionary dynamics of accounting choices would better inform accountants, managers,
investors, regulators, and academics and could lead to better rule making (or help us banish it).
The Constructal Law of Bookkeeping

The Constructal Law of Bookkeeping states that the number of accounts kept by an
organization follows a power law in the quantity of resources flowing through the organization. The
number of accounts in a U.S. firm’s Chart of Accounts will increase in the dollars flowing through it
in the form:
Number of accounts ¼ K 3ðNumber of dollarsÞN ; ð1Þ

where K and N are positive real numbers.
This law applies to all forms of bookkeeping including double-entry bookkeeping and its many
precursors including single-entry bookkeeping, charge-and-discharge accounting, and accounting in
ancient cultures such as Rome, Greece, Egypt, and Mesopotamia. The logic is that bookkeeping is a
costly activity and separate accounts are only likely to be created if the benefits from tracking a
particular group of transactions outweigh the costs of tracking them separately from related groups
of transactions.
The Constructal Law of Bookkeeping is a social science application of a more general physical
Constructal Law, which applies to a vast range of situations involving the flow of water (river
deltas), blood (circulatory systems of animals), electrical resistance (in electronic networks), travel
time (in business and transportation), etc., analyzed by Adrian Bejan and collaborators in many
articles and books. The broad Constructal Law states, ‘‘For a finite-size open system to persist in
time (to survive) it must evolve in such a way that it provides easier and easier access to the currents
that flow through it’’ (e.g., Bejan 1997). Bejan (2005) labels this the law of configuration
generation, or the law of design, and shows that tree-like structures often emerge as the optimal
solution for maximizing flow.
Figure 7 presents several examples of flow structure that have been analyzed by Bejan and co-
authors, reproduced from Bejan and Marden (2009, Figure 1). Examples include the development
of river deltas, the bronchial tubes in human lungs, the spread of cracks, and the growth of
snowflakes. Although the parallels between these tree-like structures are visually obvious, Bejan
18
Reppenhagen (2010) studies the diffusion of stock option expensing using the fair-value method, which was
concentrated in the period immediately following the 2000–2002 crisis. Hennes and Schenck (2014) examine the role
of SEC comment letters during 2005–2007 in reducing the initial diversity of financial reporting and disclosure for
unused gift cards (also known as breakage), a topic for which FASB (2015) is still developing authoritative guidance.

Volume 14, No. 2, 2015
FIGURE 7
Different Examples of Flow Systems in Nature
Reprinted from Physics of Life Reviews, Vol. 6 /No. 2; Adrian Bejan, James H. Marden; The constructal unification of
biological and geophysical design. Copyright 2008, with permission from Elsevier.
and co-authors mathematically derive the functional relation between flow and access and then test
them with data. For example, constructal theory predicted the proportionality between metabolic
rate and body mass raised to the power 3/4, as well as the proportionality between breathing (or
heart beating) time and body size raised to the power 1/4 (Bejan 2000). More recently, researchers
have applied constructal theory to analyze the emergence and development of written languages
(Amoozegar 2007), the design of airport terminals, the evolution of academic systems, and other
social dynamics (Bejan and Zane 2012).
The power law for the Constructal Law of Bookkeeping can be estimated with currently
available data for different bookkeeping technologies that differ in their cost, e.g., paper versus
electronic records. For example, we have surviving account books for 261–229 BC for a large
Egyptian estate (Grier 1932). Over 600 ledgers for the Datini group of companies have survived for
the period 1363–1410 (http://www.istitutodatini.it/schede/archivio/eng/arc-dat1.htm). Many ac-

Volume 14, No. 2, 2015
256 Basu
count books have survived from the English East India Company, the Dutch East India Company,
and the Hudson Bay Company covering hundreds of years. Similarly, many U.S. railroads and
industrial corporations have archived their account books for several decades. The annual charts of
accounts contained in these archives can be used to estimate the Constructal Law of Bookkeeping
based on annual resource flows in these organizations.
The Law of Conservation of Exchange Value

The Law of Conservation of Exchange Value is that arm’s length transactions in perfect and
complete markets do not create or destroy exchange value. If information costs are zero, then
buyers and sellers know the competitive price for goods and services being bought and sold or
exchanged. More precisely, following Coase (1960), in a world of zero transactions costs, the
bundles of well-defined private property rights being exchanged in an arm’s length transaction will
be of equal value because each transacting party will search for the best price available and, in
equilibrium, the total values exchanged must equate for the transaction to be consummated. This
Conservation Law is the underlying driver for the symmetry of debits and credits in double-entry
bookkeeping (DEB), or the idea that for any exchange transaction, the value of goods and services
being given up (sum of the credits) always equals the value of goods and services received (the sum
of the debits). Like many scientific laws, this Conservation Law’s application in the real world is
qualified by information frictions, just as Newton’s conservation of angular momentum does not
hold exactly in the presence of friction or air resistance. Nevertheless, the Law of Conservation of
Exchange Value and the symmetry of DEB have important implications for economics, finance, and
other related fields.
In a commencement address to the Department of Economics at the University of California,
Berkeley, future Nobel Laureate Thomas Schelling (1995; emphasis added) recalled that 40 years
earlier, the noted development economist Peter Bauer had claimed provocatively, ‘‘the number of
things that economists knew that were true, important, and not obvious, is no more than the fingers
on one hand.’’ Unfortunately, their conversation was interrupted and Schelling never found out
which ideas met Bauer’s threshold, but he continued to ponder the question. Eventually Schelling
settled on a few candidates:
Some things are obvious in a different way from other things; in fact some things are
believed true precisely because they become obvious. I say ‘‘become obvious,’’ because
my candidates for Peter Bauer’s collection all have the characteristic that, while at first
glance they appear paradoxical, once understood they are seen as incapable of being false.
These are what are sometimes called accounting identities. When I was an undergraduate
they were often disparaged as ‘‘mere identities.’’ They were unfalsifiable statements and
did not count as scientific truths. They were said to be true by definition.
Actually the truth of all scientific propositions depends on careful definition; but the truth
of the so-called identities depends only on careful definition. They are not merely
definitions; if they were, they would be obvious. But they can be derived from definitions
if the definitions are carefully made consistent.
The simplest possible (accounting) identity—it sounds obvious when I say it—is that in
any sales transaction the value of the item sold equals the value of the item purchased.
The last sentence above pithily summarizes the Law of Conservation of Exchange Value.
Schelling (1995) lists other important accounting identities in economics including national
income accounts (‘‘quadruple entry consolidated income statements’’), balance of payments,
input-output matrix, the earth’s carbon budget, etc. Schelling (1995) observes, ‘‘In the physical

Volume 14, No. 2, 2015
sciences many of these accounting identities are dignified with the title, ‘law’; and like the
identities in economics they were not obvious without an intellectual struggle.’’ Schelling (1995)
concludes:
It is sometimes said, in textbooks and in learned volumes, that these accounting
statements, being unfalsifiable, do not count as science. I don’t care. The question is
whether they tell you something important you did not know. The history of our discipline
demonstrates that they are not obvious. Disparaging them as ‘‘mere identities’’ at least
testifies to their truth. They are the foundation of any macroeconomics. They have their
counterparts in physics, chemistry, biology, genetics, and our sister discipline,
demography.
Noether (1918) develops the deep mathematical connections between conservation laws
and symmetry in physics, which I believe extend to finance and economics as well. For
example, Williams (1938, 72) stated the Law of Conservation of Investment Value as, ‘‘Since
the value of an enterprise is the ‘present worth’ of its future distributions—whether interest or
dividends—it ‘in no way depends on what the company’s capitalization is.’’’ This law is now
more famous as the Modigliani and Miller (1958) theorem that ‘‘capital structure is irrelevant.’’
Williams’s proof implicitly embeds DEB through the balance-sheet equation. He argues that,
ignoring taxes and transactions costs, a sole proprietor would be indifferent between an all-
equity claim on the firm’s assets or a 50–50 (or any other) debt-equity mix because he has full
control of the firm’s investments and the priority of cash distributions is irrelevant since he
receives all of them. Again, the Law of Conservation of Investment Value is only an
approximate law, as we have learned from the emergence of agency theory and the
development of corporate finance.
The Law of Conservation of Exchange Value likely has deep scientific significance. Feynman
(1965) observes that many important laws in physics are conservation laws. Berlinski (2000)
suggests that all discoverers of physical conservation laws were trained in DEB and likely
transferred this way of thinking to their respective subjects.19 This claim is historically plausible
because the Genoan Massari accounts incorporate full DEB by 1340, and Pacioli’s (1494) printed
textbook was widely distributed and translated. By the mid-thirteenth century, clerks and
accountants were being trained at universities, and by the end of the fourteenth century, business
was being taught at schools alongside universities (Hoskin and Macve 1986). Thus, scientists with
a university education would have had ample opportunities to learn accounting and DEB, and
especially the embedded idea that in an arm’s length transaction, the seller receives an exchange
value equal to those of the goods sold, i.e., that exchange value is conserved.
Physical conservation laws were identified from the late 1600s onward. Isaacson (2003)
suggests that Benjamin Franklin’s (1747) discovery of the Law of Conservation of Electric
Charge—i.e., that when electrically charged particles interact, then the sum of the electric charges is
invariant—was enabled by his use of DEB in running his publishing business. Antoine-Laurent
Lavoisier (1789) stated the Law of Conservation of Mass in chemical reactions, i.e., that in any
chemical reaction, the total mass of the reactants or starting materials must be equal to the mass of
the products, based on experiments he conducted in 1774. Lavoisier likely became familiar with
DEB because he became a tax collector in France in 1769. Sir Isaac Newton (1687), who
discovered the conservation of angular momentum (Newton’s Second Law of Motion), was familiar
enough with DEB to serve as warden, and later master, of the Royal Mint for the last 30 years of his
19
Sombart (1924, 118–119) and Kaplan (1999, 110–111) also claim that DEB led to future scientific laws (Yamey
2005, footnote 9), although they do not propose a causal mechanism.

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258 Basu
FIGURE 8
Comparison of Well-Studied Astronomical and Accounting Systems
Percentage estimates of universe composition from http://en.wikipedia.org/wiki/Dark_energy
life. In other words, DEB and its embedded Law of Conservation of Exchange Value could be
Schelling’s prototypical ‘‘paradoxical’’ thought process that led to many of the major laws in the
natural sciences, especially physics and chemistry.
VI. ACCOUNTING RESEARCHERS SHOULD EXPLORE NEW ACCOUNTING

DOMAINS
Mainstream U.S. accounting researchers study easily accessible databases that typically cover
large publicly traded firms. However, these databases cover only a small proportion of accounting
usage and members of the International Accounting Section of the AAA can take the lead in
studying unexplored accounting domains. A comparison with astronomical research might be
instructive in this regard, as depicted in Figure 8.
I view the study of the solar system in astronomy as easily accessible and prominent data
similar to the study of accounting in publicly traded U.S. firms. Similarly, the study of nearby
galaxies can be compared to the study of publicly traded firms in other (large) economies such as
Canada, the U.K., and Japan. The study of galaxies located much further away can be compared to
the study of accounting in smaller countries, as well as the study of other organizational forms such
as charities and government bodies. The astronomical units listed so far constitute most of the
visible matter in the universe, while the organizational units comprise most of the accounting use in
formal or legal organizations. The latest astronomical estimates indicate that visible matter
constitutes less than 5 percent of the matter in the universe (https://en.wikipedia.org/wiki/Dark_
energy).
The universe is largely made up of dark matter (27 percent) and dark energy (68 percent),
whose existence astronomers deduce from the gravitational behavior of galaxies and the
acceleration of the expansion of the universe, but are unable to study because they do not interact
with visible matter. What might be the accounting analogues to such hidden or invisible accounting
behavior? I propose the use of accounting in informal or unorganized sectors such as families,
clans, and tribes as the equivalent of understudied dark matter. Dark energy could be analogized to
accounting in illegal organizations such as gangs (Venkatesh 2008), black markets, corrupt
governments, etc. This category might also cover accounting use in primitive cultures and societies
and even other species. For instance, chimpanzees are known to reciprocally groom each other,

Volume 14, No. 2, 2015
suggesting that they mentally track the quantity and quality of grooming services they receive so
that they can reciprocate in the future, suggestive of a biological market in grooming services (e.g.,
Newton-Fisher and Lee 2011), while crows can count (Ditz and Nieder 2015).
VII. CONCLUSION
I investigate whether a 50-year-old initiative to make scientific academic research the basis for
accounting education has indeed resulted in scientific research, regulation, education, and practice.
After analyzing each of these areas individually, I reach some depressing conclusions. First, U.S.
accounting research is highly unscientific primarily because we teach graduate students scientism
that relies on incorrect null-hypothesis-significance testing rather than the scientific method.20
Accounting regulation is conceptually petrified because it relies almost exclusively on 50-year-old
theories and ignores virtually all the scientific advances since. Even though Baxter (1953, 1979)
warned of precisely this outcome when standard setting started, rule makers ignored him to our
collective cost. While accounting researchers have developed alternative conceptual frameworks
that better fit what accounting does based on modern scientific theories (e.g., Ijiri 1983; Ball 1989;
Dickhaut et al. 2010), the IASB and FASB remain tied to their ‘‘irreparably flawed’’ conceptual
frameworks (Demski 2007) because they cannot afford to admit mistakes. Accounting education
has been captured by accounting regulators and our textbooks ‘‘teach to the test’’ in the sense of
almost exclusively preparing students to pass the CPA exam rather than teaching them critical
thinking (Zeff 1989; Sunder 2010), the ostensible purpose of college education.21
On the bright side, evolved accounting practice over the 10,000 plus years before the SEC
follows a few broad regularities that we can investigate and verify scientifically. If we can identify a
set of general accounting laws using the scientific method, then we can truly claim that accounting
is a social science similar to economics. Finally, most U.S. accounting research is based on
databases of publicly listed companies. However, these visible organizations collectively are a
small proportion of accounting users. International accounting researchers can take the lead in
investigating accounting use by less visible organizations and individuals, and in promoting the
teaching of accounting as a way to increase literacy and numeracy in less-developed countries and
cultures.
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APPENDIX A
Figure 3: http://dx.doi.org/10.2308/jiar-51321.s01
Figure 6: http://dx.doi.org/10.2308/jiar-51321.s02

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CHRISTENSON (1983) - The Methodology of Positive Accounting

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JOURNAL OF INTERNATIONAL ACCOUNTING RESEARCH American Accounting Association

Vol. 14, No. 2 DOI: 10.2308/jiar-51321

Is There A Scientific Basis for Accounting?

Keywords: conservation laws; constructal law; economic evolution; mean reversion;

Sudipta Basu is a Professor at Temple University.

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II. CURRENT ACADEMIC ACCOUNTING RESEARCH IS NOT SCIENTIFIC

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Accounting Researchers Do Not Understand Even Their Summary Regression Outputs

An Example of Misapplied Null Hypothesis Testing in a Prominent Accounting Research

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Source: Galton (1886).

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III. MODERN ACCOUNTING REGULATION IS BASED NOT IN SCIENCE BUT FAITH

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Source: Ely and Waymire (1999, Figure 1).

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virtue, whereas in science it is almost always an unmistakable sign of pride or

IV. TEXTBOOKS’ ACCOUNTING CREATION MYTHS SHOW THAT ACCOUNTING

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Panel A: Tokens from Jarmo, Iraq, 6500 BC

Reproduced from Schmandt-Besserat (2015) with permission from the author.

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Panel B: Tokens from Uruk, Iraq, circa 3300 BC

Reproduced from Schmandt-Besserat (2015) with permission from the author.

V. IS ACCOUNTING PRACTICE SCIENTIFIC IN ANY WAY, SHAPE, OR FORM?

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introduction, I used the Merriam-Webster definition of a science as knowledge of general laws

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The Law of Accounting Evolution

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The Constructal Law of Bookkeeping

Number of accounts ¼ K 3ðNumber of dollarsÞN ; ð1Þ

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The Law of Conservation of Exchange Value

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Percentage estimates of universe composition from http://en.wikipedia.org/wiki/Dark_energy

VI. ACCOUNTING RESEARCHERS SHOULD EXPLORE NEW ACCOUNTING

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