GODFREYHODGSONHOLMESTARCACHAPTER 3 APPLYING THEORY TO ACCOUNTING REGULATION

The theories of regulation relevant to accounting and auditingManagers have incentives to voluntarily provide accounting information, so why do we observe the regulation of financial reporting?Explanations are provided by:theory of efficient marketsagency theorytheories of regulation*

Theory of efficient marketsThe forces of supply and demand influence market behaviour and help keep markets efficientThis 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 marketsThe market for accounting data is not efficientThe free-rider problem distorts the marketUsers cannot agree on what they wantAccountants cannot agree on proceduresFirms must produce comparable data The government must therefore intervene

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Agency theoryThe demand for accounting information: for stewardship purposesfor decision-making purposesA 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 theoryBecause of imbalances between data suppliers and data users, uncertainty and risk existResources and risk are likely to be mis-allocated between the partiesTo the extent the market mechanism is inefficient, accounting regulation is required to reduce inefficient and inequitable outcomes *

Theories of regulationThere are three theories of regulation:public interest theoryregulatory capture theoryprivate interest theory*

Public interest theoryGovernment regulation is required in the public interest whenever there is market failure (inefficiency) due to: lack of competitionbarriers to entryinformation asymmetrypublic-good products

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Public interest theoryGovernments intervene:to get votes because public interest groups demand interventionbecause they are neutral arbiters*

Regulatory capture theoryThe public interest is not protected because those being regulated come to control or dominate the regulatorThe regulated protect or increase their wealthAssumes the regulator has no independent role to play but is simply an arbiter between battling interest groups*

Regulatory capture theoryProfessional accounting bodies or the corporate sector seek to control the setting of accounting standards*

Private interest theoryGovernments are not independent arbiters, but are rationally self-interestedThey seek re-electionThey 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*

Application of public interest theoryThe Sarbanes-Oxley Act (US, 2002)Accounting Standards Review Board (AUS, 1984)

But:Managers have incentives to voluntarily correct market failure perceptions about their firms*

Application of capture theoryWas 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 theoryThe private interest theory could be applied to the establishment of the ASRB

The various theories of regulation are not mutually exclusive*

Standard setting as a political processStandard setting is a political process because it can affect many conflicting and self-interested groupsThe regulator must make a political choiceThe regulator must have a mandate to make social choicesThe recognition of doubtful debts can affect entities differently*

Financial instrumentsThe adoption of IAS 39 Financial Instruments Recognition and Measurement in the EU has been a highly political process *

Intangible assetsThe adoption of IAS 38 Intangible Assets in Australia illustrates the role of politics in the standard setting process *

Regulatory framework for financial reportingA financial reporting environment is made up of:legal settingeconomic settingpolitical settingsocial setting

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Regulatory framework for financial reportingThe elements of a regulatory framework are :statutory requirementscorporate governanceauditors and oversightindependent enforcement bodies*

Statutory requirementsCompany lawSecurities market lawAccounting standardsforce of lawTaxation law*

Corporate governanceThe 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*

Auditors and oversightBoth auditors and auditing are usually regulatedstatutory regulationself-regulation*

Independent enforcement bodiesIndependent enforcement bodiesEUSecurities market regulatorsSECASICThe need for consistent enforcement across countries*

Institutional structure for setting accounting and auditing standardsFormation of IASC 1973Aimed to develop accounting standards for use throughout the worldIOSCOs support for a set of core standardsIASC not independent so restructured in 2001 into the IASBIn 2002 the EC decided to adopt IASB standards in 2005 in the EUAustralia adopted IFRS on 1 January 2005

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The IASB and FASB convergence programConvergence program commenced in 2002Norwalk agreementConvergence is a complicated process*

Accounting standards for the public sectorIndividual countries must decide the extent to which IASB standards will be followed by public sector entitiesAustralia has pursued one set of standards that can be used by both public and private sector entities*

International auditing standardsHistorically auditing was self-regulatedBest auditing practice has become enshrined in auditing standardsGovernments have become involved due to market failure*

SummaryIn 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 conceptsEfficient marketsAgency relationshipsPublic interest Regulatory capture Private interest Political processRegulatory frameworkAccounting and auditing standards

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