GODFREYHODGSON

HOLMESTARCA

CHAPTER 3 APPLYING THEORY TO

ACCOUNTING REGULATION

The theories of regulation relevant to accounting and auditing

• Managers have incentives to voluntarily provide accounting information, so why do we observe the regulation of financial reporting?

• Explanations are provided by:– theory of efficient markets– agency theory– theories of regulation

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Theory of efficient markets

• The forces of supply and demand influence market behaviour and help keep markets efficient

• This applies to the market for accounting information and should determine what accounting data should be supplied and what accounting practices should be used to prepare it

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Theory of efficient markets

• The market for accounting data is not efficient• The ‘free-rider’ problem distorts the market• Users cannot agree on what they want• Accountants cannot agree on procedures• Firms must produce comparable data • The government must therefore intervene

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Agency theory

• The demand for accounting information: – for stewardship purposes– for decision-making purposes

• A framework in which to study the relationship between those who provide accounting information - e.g. a manager - and those who use it – e.g. a shareholder or creditor

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Agency theory

• Because of imbalances between data suppliers and data users, uncertainty and risk exist

• Resources and risk are likely to be mis-allocated between the parties

• To the extent the market mechanism is inefficient, accounting regulation is required to reduce inefficient and inequitable outcomes

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Theories of regulation

• There are three theories of regulation:– public interest theory– regulatory capture theory– private interest theory

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Public interest theory

• Government regulation is required in the ‘public interest’ whenever there is market failure (inefficiency) due to: – lack of competition– barriers to entry– information asymmetry– public-good products

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Public interest theory

• Governments intervene:– to get votes – because public interest groups demand

intervention– because they are neutral arbiters

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Regulatory capture theory

• The public interest is not protected because those being regulated come to control or dominate the regulator

• The regulated protect or increase their wealth• Assumes the regulator has no independent

role to play but is simply an arbiter between battling interest groups

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Regulatory capture theory

• Professional accounting bodies or the corporate sector seek to control the setting of accounting standards

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Private interest theory

• Governments are not independent arbiters, but are rationally self-interested

• They seek re-election• They will ‘sell’ their power to coerce or

transfer wealth to those most likely to achieve their re-election (if they are elected officials) or increase their wealth (if they are appointed officials) or both

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Application of public interest theory

• The Sarbanes-Oxley Act (US, 2002)• Accounting Standards Review Board (AUS,

1984)

• But:– Managers have incentives to voluntarily correct

market failure perceptions about their firms

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Application of capture theory

• Was the ASRB captured by the accounting profession?

• Is international harmonisation evidence of capture by large companies, the ASX and the accounting profession?

• Has the IASB been captured by the FASB?

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Application of private interest theory

• The private interest theory could be applied to the establishment of the ASRB

• The various theories of regulation are not mutually exclusive

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Standard setting as a political process

• Standard setting is a political process because it can affect many conflicting and self-interested groups

• The regulator must make a political choice• The regulator must have a mandate to make

social choices• The recognition of doubtful debts can affect

entities differently

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Financial instruments

• The adoption of IAS 39 Financial Instruments – Recognition and Measurement in the EU has been a highly political process

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Intangible assets

• The adoption of IAS 38 Intangible Assets in Australia illustrates the role of politics in the standard setting process

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Regulatory framework for financial reporting• A financial reporting environment is made up

of:– legal setting– economic setting– political setting– social setting

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Regulatory framework for financial reporting• The elements of a regulatory framework are :– statutory requirements– corporate governance– auditors and oversight– independent enforcement bodies

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Statutory requirements

• Company law• Securities market law• Accounting standards– force of law

• Taxation law

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Corporate governance

• ‘The structures, processes and institutions within and around organisations that allocate power and resource control among participants.’ Davis

• Supranational and national bodies have issued corporate governance recommendations

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Auditors and oversight

• Both auditors and auditing are usually regulated– statutory regulation– self-regulation

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Independent enforcement bodies• Independent enforcement bodies– EU

• Securities market regulators– SEC– ASIC

• The need for consistent enforcement across countries

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Institutional structure for setting accounting and auditing standards

• Formation of IASC – 1973• Aimed to develop accounting standards for use

throughout the world• IOSCO’s support for a set of core standards• IASC not independent so restructured in 2001 into

the IASB• In 2002 the EC decided to adopt IASB standards in

2005 in the EU• Australia adopted IFRS on 1 January 2005

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The IASB and FASB convergence program

• Convergence program commenced in 2002– Norwalk agreement

• Convergence is a complicated process

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Accounting standards for the public sector• Individual countries must decide the extent to

which IASB standards will be followed by public sector entities

• Australia has pursued one set of standards that can be used by both public and private sector entities

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International auditing standards• Historically auditing was self-regulated• Best auditing practice has become enshrined

in auditing standards• Governments have become involved due to

market failure

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Summary

In this chapter: we reviewed theories proposed to explain the practice and regulation of financial reporting and auditing

we reviewed the regulatory framework for financial reporting and the institutional structure for setting accounting and auditing standards

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Key terms and concepts

• Efficient markets• Agency relationships• Public interest • Regulatory capture • Private interest • Political process• Regulatory framework• Accounting and auditing standards

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