Excerpt
Table of contents
Executive Summary
Table of contents
1.Introduction
2.Literature Review
3.Application& Theory
3.1 Non-Regulation approaches
3.2 Pro-Regulation approaches
3.2.1 Public InterestTheory
3.2.2 Capture Theory
3.2.2.1 The Political Ruling Elite Theory
3.2.2.2 The Economic Theory
4.Conclusion
References
Executive Summary
This paper critically examines the different approaches and theories to standard setting in accounting.The reader can find a brief introduction to the discussion about accounting regulation after the 2008 crisis.In the literature review the term regulation in relation to accounting is discussed. Furthermore, a link between accounting theories and approaches to standard setting process and practice is provided. In addition, an overview of the different regulated and non-regulated approaches is given. A more in-depth analysis of the free market approach supported by the literature is provided. Next, we analyze the different pro-regulation approaches including the sub-approaches followed. Moreover, this paper addresses the issue of how these theories are present in practice and on what limitations and assumptions they are based on.
1. Introduction
Since the financial crisis in 2008 the topic regulation of the markets at all revived. The world was looking for guilty parties in Rating agencies, financial institutions, governments and lastly audit firms and institutions which gave them their working framework – the accounting standards. On the one hand the scream for more regulation in the private sector to protect the public good became louder and on the other hand scientists were warning of such overbearing steps because they would be damaging the economy.
This issue provides the basis for this paper where accounting is seen as an economic good. Accounting information is not costless to produce for the corporations and it raises compliance costs. On the one hand managers are using accounting rules that minimize information costs and on the other hand shareholders want accounting rules that improve their ability to control and monitor the manager’s action.
Theoretically, financial accounting and reporting should be objective, neutral and apolitical. However, the standard setting process can be influenced by external groups with different interests.
2. Literature Review
Over the years there have been many debates about the necessity for regulation in accounting. (Gaffikin, 2005) According to den Hertog (1999) there is no legal and economic definition for the term ‘regulation’. However, he describes regulation as “the employment of legal instruments for the implementation of social-economic policy objectives. A characteristic of legal instruments is that individuals or organizations can be compelled by government to comply with prescribed behavior under penalty of sanctions[…] furthermore government regulation is the instrument for overcoming the disadvantages o imperfect competition, unbalanced market operation, missing markets and undesirable market results” For Posner (1974) regulation modestly means the intervention of the government in the market. According to Gaffikin (2005) a believer in a strong form of market efficiency would support that regulation is unnecessary.
In advance we need to provide a link between standard setting approaches in accounting (Deegan and Unerman, 2006), which are the objective of this paper, and several Theories of Economic Regulation and non-Regulation (Posner, 1974). It is to state that regulatory activities in the economical environment affect directly the accounting practice of corporations. Therefore, the standard setter in accounting is either the regulator such as government-controlled institutions or independent institutions such standard setter bodies or corporations. These two major approaches of regulated and non-regulated standard setting activities are mainly discussed in this paper.
The non-regulated approach is in the literature know as the Free Market approach which states that the market and its mechanism determine the production of accounting information and regulation according to its needs. A strong supportive argument for the Free Market approach comes from the Agency Theory in which managers provide theoretical justification motivated by several self-interest reasons described in Watts and Zimmerman(1978; 1979; 1990) who are strong supporters of the Free Market approach.
The other parts discussed in this paper are the pro-regulation approaches which are divided in two main topics: the Public Interest Theory of Regulation and the Capture Theory of Regulation which is also known as Private Interest Theory of Regulation. (den Hertog, 1999) Recognizing that accounting in this area is a political process, according to Fogarty et al (1994) there will be conflicting interests among participants. A necessary further step is to assume that those interests will have an impact in the output of the standard setting process.
3. Application& Theory
3.1 Non-Regulation approaches
The main idea in the Free Market approach is that the demand for financial statements comes from users such investors and creditors. (Taylor and Underdown, 1985) Market mechanism would ensure the information published to be prudent. Managers would effort to provide adequate and reliable information to attract investors and therefore to maximize welfare. Related to this fact, the Agency Theory supports the Free Market approach by assuming that individuals seek to maximize their own utility.
According to Watts and Zimmerman (1978) management plays the central role in determination of standards. Furthermore, they argue that managers (agents) self-interest is congruent with that of the share- and bondholders (principals) and that financial reporting constrain managers to act in shareholders’ interest. The management selects accounting procedure to maximize own utility and therefore Watts and Zimmerman (1978) give several factors such as taxes, regulatory procedures, and political costs etc. which affect management wealth. By evaluating these factors in an empirical study they result that managers have greater incentives to choose adequate and reliable accounting standards.
According to Watts and Zimmerman (1979) corporations produced financial statements voluntarily, for example in the US before disclosures became an obligation by government mandate. This means not producing information will be penalized by higher costs of capital, resulting to a good reputation with respect to financial reporting will improve the firm’s ability to raise capital and so to lower firm’s cost of capital – so called Signaling Theory. (Dodd et all, 2000) In addition they argue that even in regulated environments the corporations have direct or indirect contact and influence to regulators and so to the standard setting process. In doing so, unneeded costs are generated by government intervention.
The main question here is if the Free Market approach works, why do modern economies persist on bureaucratic money-consuming regulatory structures? Empirical tests of the Free Market approach are impossible since we live in a regulated environment.The Free Market approach is the main argument against the regulated approaches. However, there are several limitations. Watts and Zimmerman (1978; 1979; 1990) assume in all their papers that individuals are behaving rational. They are not taking into account frauds opportunities because of human erratic behavior. Next they assume that markets, market mechanism and managers operate fully efficient. As we nowadays know, the literature agrees that we are facing semi-efficient markets. Furthermore, it is to state that disclosed financial statements are seen as public goods. According to Taylor and Underdown (1985) public goods are which, if supplied to one person, are available to all others. Otherwise, people would avoid demanding for such goods till somebody else demands it and so it will be freely available to all – so called free-rider problem. Free markets could be in contrary to social goals because they may not communicate enough information to the security markets. In this case insiders have information that are not available to investors. This could lead in turn to underproduction and asymmetry of information.
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