Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference

Home > Accountancy Best Practice > Accounting and Economics—Critical Perspectives

Accountancy Best Practice

Accounting and Economics—Critical Perspectives

by John C. Groth

Executive Summary

  • Managers must recognize that accounting and economics have different objectives. Accounting and economic measures and objectives meet by accident.

  • Economic events and accounting events can differ greatly. Awareness of cross-firm, industry, and country differences is important to those making decisions.

  • Accounting “values” often differ from the opportunity cost of assets employed.

  • Accounting income is quite different from economic income.

  • Understanding a few key accounting concepts such as retained earnings is important in terms of decision-making and to avoid embarrassment.

  • Recognizing the fundamental issues of cash flow versus accrual income is essential.

  • Accounting is important for many reasons, but mixing accounting and economics together in an analysis is dangerous.

  • The analyst and manager should employ economic analysis to identify opportunities and to avoid peril. Separately, you should examine the impact of a decision on accounting variables of interest to investors.

Introduction

This article reveals some important differences between accounting and economics. It does not seek to explain the various arguments that prompt, support, or question such differences. The ultimate objectives are an awareness that accounting and economics differ, and that knowledge of the differences allows the manager to benefit from both. At the same time, this understanding helps to avoid errors in the application of accounting and economics.

Accounting versus Economics

Both accounting and economics may focus on the “local” or micro, or on the more “global” or macro. Beyond that, accounting and economics meet by accident. The objectives of accounting and economics often differ.

Accounting Objectives

Accounting seeks to determine, explain, and provide, using certain measures,the state of a company at a point in time, and the results of operating a company for a period of time. These measures often are not economic measures. For example, earnings are an accrual measure rather than an economic or cash flow measure. Accounting lets us: review what has happened, for example, the accounting return earned on assets; estimate what is needed for the future, for example, future funding needs; and predict the effects of decisions on accounting measures in future periods, for example, the impact of a decision on future earnings.

Accounting also provides information that can be used as input in an economic analysis performed to support decisions about what the firm should do to add value. For example, accounting provides variable cost information that is essential in an economic analysis which examines whether to sell on credit to a group of less creditworthy customers. Accounting measures also help one to assess the state of a business at a point in time, for example, in evaluating a customer’s short-term liquidity.

Different objectives in the use of accounting often prompt the categorization of accounting into several areas: financial reporting, tax, and managerial. Some add a fourth category, behavioral, and further classify the areas of managerial, audit, compliance, financial reporting, and tax.

For example, accounting might seek to measure historical performance employing certain measures. Some measures, such as “income,” employ “accrual units” rather than cash, which is an economic measure. On another occasion, accounting identifies assets available for use, and reveals the claims against assets.

Example: At one point in time a company had specific assets that it had financed in a particular way. At another time the company had these same or possibly different assets with the same/different financing arrangements. Accounting seeks to portray circumstances at these two points in time (for example with balance sheets) and what “happened” in the period between these points in time using, for example, a statement of income and a statement of cash flows.

Objectives of Economic Analysis

In contrast, economics focuses on the opportunity cost or current value of a circumstance, and it measures in cash or cash equivalent; it takes account of risk; and frequently it approaches analysis and decisions in terms of the incremental effect of taking a course of action.

An economic event is one that is, or could be converted into, a cash flow at a particular point in time. If an economic event is risky, uncertainty exists as to the amount and the timing of the event. The timing of the impact of the economics (cash flow) of a project often differs from the impact of the project on accounting in a particular period. For example, a very attractive project (on an economic basis) may not add to (or even diminish) accounting earnings in one or more periods.

The fundamentals of economics are the same in each economy—which is not the same as suggesting that each economy enjoys the same structure, “imperfections,” impediments, or other factors that influence behavior and resultant decisions and consequences in a particular economy.

As an example of the differences in accounting versus economics, “earnings” reported by accounting would only by coincidence measure the economic income for the period. The economic income represents the time-adjusted cash flow returns after allowing for all costs, including the cost of capital. Shortly, we will illustrate a common approach for determining accounting income.

Back to Table of contents

Further reading

Book:

  • Fraser, Lyn M., and Aileen Ormiston. Understanding Financial Statements. 9th ed. Upper Saddle River, NJ: Prentice-Hall, 2009.

Article:

  • Groth, John C., and Steven S. Byers. “Creating value: Economics and accounting—Perspectives for managers.” Management Decision 34:10 (1996): 56–64. Online at: dx.doi.org/10.1108/00251749610150702

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share