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Cunningham, Lawrence A. --- "The Influence of Law and Economics on Law and Accounting: Two Steps Forward, One Step Back" [2012] ELECD 471; in Hill, A. Claire; McDonnell, H. Brett (eds), "Research Handbook on the Economics of Corporate Law" (Edward Elgar Publishing, 2012)

Book Title: Research Handbook on the Economics of Corporate Law

Editor(s): Hill, A. Claire; McDonnell, H. Brett

Publisher: Edward Elgar Publishing

ISBN (hard cover): 9781848449589

Section: Chapter 16

Section Title: The Influence of Law and Economics on Law and Accounting: Two Steps Forward, One Step Back

Author(s): Cunningham, Lawrence A.

Number of pages: 17

Extract:

16. The influence of law and economics on law and
accounting: Two steps forward, one step back
Lawrence A. Cunningham



1. THEORY

Models and their Limits

Under agency theory, shareholders are treated as principals and corporate managers as agents.
The theory, elaborated since the 1970s, notes how interests of principals and agents diverge.
The cost of controlling that divergence and the cost of the part that cannot be controlled are
called agency costs (Jensen & Meckling 1976; Tirole 2006). Agency costs are limited by vari-
ous markets, especially capital and corporate control markets. In the law and accounting
context, divergence of interests between managers and shareholders can be further reduced
by investing in monitoring devices, such as internal controls, board oversight, and indepen-
dent auditing, and bonding devices, principally transparent accounting and financial disclo-
sure.
To evaluate agency costs and ways to reduce them, scholars sought a proxy to express the
shareholder interest and manager actions in relation to it. They found it in the efficient capi-
tal market hypothesis (ECMH), cornerstone of modern finance theory. For centuries, share-
holders were seen to be interested in maximization of profits and managerial performance
was measured in those terms. Beginning in the 1960s, theorists saw stock market price as a
proxy for the shareholder interest. They developed the ECMH, a hypothesis that stock price
incorporates all public information about a firm, including accounting measures of profits,
and supplies a measure of value. The ECMH thus also suggests that stock price incorporated
agency costs: ...