The regulation of financial accounting Prepared By: Dewan Mahboob Hossain Assistant Professor; Dept. of Accounting & Information Systems; University of Dhaka; Dhaka; Bangladesh Financial Accounting Theory Craig Deegan Ch. 3
A rule of order, as for conduct; prescribed by authority.
A governing direction or law.
Regulation is set to control or govern conduct.
The free-market perspective
Accounting information should be treated like other goods.
The demand and supply forces should be allowed to freely operate so as to generate an optimal supply of information about the entity.
Supporters of free-market perspective
Jensen and Meckling (1976)
Watts and Zimmerman (1978)
Smith and Warner (1979)
Smith and Watts (1982)
Even in the absence of regulation, there are private economics based incentives for the organization to provide credible information about its operations and performance to certain parties outside the organization, otherwise the costs of the organization’s operations would rise.
Free market perspective (contd..)
In the absence of information about the organization’s operations, other parties, including the owners of the firm who are not involved with the management of the organization, will assume that managers might be operating the business for their own benefit.
Less information higher cost of capital.
To maximize the share value, managers will voluntarily enter into the contracts with shareholders and lenders of giving optimal information.
Information higher confidence of the shareholders and lenders.
Free market perspective (contd..)
There will be conflict between external owners and internal managers and this conflict will be mitigated through audited financial reporting.
These are called the private incentives to produce information.
Market related incentives
Market for managers: Manager’s previous performance will impact on how much remuneration they will command in future periods, either from current employers or elsewhere.
Even in the absence of regulations, managers will adopt strategies that will maximize the value of their organization. To highlight the performance of the managers, optimal amount of financial information will be provided.
Market related incentives (contd..)
Market for corporate takeovers: an underperforming organization will be taken over by another entity that will subsequently replace the existing management team.
Managers would be motivated to increase the firm value to minimize the likelihood that outsiders could seize control of the organization at low cost.
The ultimate argument:
The alignment of managerial cost and benefit.
While the disclosure of accounting information will be in the interest of the shareholders, it will also be in the interests of managers – there will be an alignment of interests.
Even in the absence of regulation, organizations would still be motivated to disclose both good and bad news about their financial position and performance.
‘no’ information = ‘bad’ information
Even though the firm may be worried about disclosing bad news, the market may make an assessment that the silence implies that the organization has very bad news to disclose.
The ultimate argument: (contd..)
Manages may incur reputational costs if they fail to disclose bad news in a timely manner.
Money managers may choose not to hold the stocks of firms whose managers have a reputation for withholding bad news and analysts may choose not to follow these firms’ stocks.
economic forces in the advanced markets provide managers with incentives for beneficial financial reporting even in the absence of regulatory mandate.
The pro-regulation perspective
Anti-regulation perspective says: if somebody really desired information about an organization, they would be prepared to pay for it and the forces of supply and demand should operate to ensure an optimal amount of information is produced.
Accounting information is a public good. Once available, people can use it without paying and can pass it to the others- free riders.
When other individuals can receive the goods without purchasing, the price system cannot function properly. So, market failure occurs.
Public good lacks the exclusion criteria: excluding the non-purchasers.
The pro-regulation perspective (contd..)
Unlike other products, information is not necessarily destroyed or even altered through private consumption by one individual. This characteristic may induce market failure.
‘Level playing field’ argument: everybody should have the access to the same information.
Putting in place greater disclosure regulations will increase the confidence of external stakeholders that they are playing on a ‘level playing field’.
Regulation for ‘public interest’.
Adam Smith (1776)
Free market supporters rely on Adam Smith’s notion of ‘invisible hand’.
But actually, Smith did not advocate that there should be no regulatory intervention.
He was aware of the problems that might arise in an unregulated free market. But it is rarely mentioned by the advocates of free market.
Smith actually wrote of the need for the govt. to be involved in the public interest to protect the more vulnerable.
It is in the interests of many businesses that regulatory interferences be reduced. Many businesses used the works of acclaimed economists as a from of ‘propaganda’ to support their arguments for reduced regulations.
Seeing market as a natural mechanism is an interesting perspective.
But, social and environmental groups, consumer associations, employee groups and individuals who made their submission to inquiry tended to adopt a pro-regulation view.
They believed that regulation needs to be put in the place to protect the interests of various stakeholders.
When left to invisible hand of the market, corporations do not operate in public interest.
Regulators often cite investor protection as a basis for more stringent financial reporting requirements enacted after financial crisis.
Implicit in the investor protection justification for financial reporting regulations is that higher quality reporting would have lessened investor losses during the recent crisis and that managers lacked incentives to supply higher quality financial information voluntarily.
Public Interest Theory
Regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices.
Regulation is initially put in place to benefit society as a whole, rather than particular vested interests.
The regulatory body is considered to be a neutral arbiter that represents the society in which it operates, rather than the private interests of the regulators.
Society needs confidence that capital markets efficiently direct resources to productive assets.
Regulation is deemed to be an instrument to cr4eate such confidence.
Public Interest Theory (contd….)
There is a good deal of evidence that the socially undesirable results of regulation are frequently desired by groups influential in the enactment of the legislation setting up the regulatory scheme.
In the process of introducing regulation, the organizations that are subject to the regulation will ultimately come to control the regulators.
The regulated industries will seek to gain control of the regulatory body because they know that the decisions made by the regulator will potentially have a significant impact on their industry.
Capture theory (contd..)
How to capture?
Capture is said to occur if the regulated interest controls the regulation and the regulated agency, or,
If the regulated parties succeed in coordinating the regulatory body’s activities so that their private interest is satisfied. or.,
If the regulated party somehow manages to neutralize or ensure non-performance by the regulating body.
Co-opting the regulators into seeing things from their own perspective and thus giving them the regulation they want.
Private/economic interest theory
The regulator itself is an interest group- one that is motivated to embrace strategies to ensure re-election, or to ensure the maintenance of its position of power or privilege within the community.
Here, it is proposed that regulation is put in place to serve the private interests of particular parties, including politicians who seek re-election.
It can be defined as a process wherein the regulators involve those parties likely to be affected by the proposed regulation in the discussion leading to the regulation.
It provides an opportunity to ‘be heard’.
Accounting regulation as an output of a political process
If we accept that accounting standard setting is a political process, then the view that financial accounting should be objective, neutral and apolitical is something that can be easily challenged.
Because financial accounting affects the distribution of wealth within a society, it consequently would be political.
If through due process, the views of various parties are not considered, the implication might be that the very existence of the regulatory body could be challenged.
Accounting standards are results of various social and economic considerations.
Hence, they are much tied to the values, norms and expectations of the society in which standards are developed.
Accounting regulation as an output of a political process (contd..)
When a decision making process depends for its success on the public confidence, the critical issues are not technical; they are political.
Compromise is essential.
Therefore, it is questionable whether financial accounting can claim to be neutral and objective.