ACCOUNTING THEORY

FAR 600 Theories of Regulation and Application to Accounting and Auditing Practices

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LEARNING OBJECTIVES
At the end of this lesson, students should be able to:

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Evaluate the theories of regulation:

Public interest theory

Regulatory capture theory

Private-interest theory

Apply the theories of regulation to accounting and auditing practices

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Introduction
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Financial reporting related activities Examples: Publish interim and annual reports Auditors audit annual reports Submit annual reports to regulatory bodies Press release for investors and analysts
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Introduction - continued

How can theories assist in understanding the occurrence of these activities?

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Relevant theories: i. Theory of efficient markets. ii. Agency theory. iii. Theories of regulation public interests, regulatory capture and private interest.

THEORY OF EFFICIENT MARKETS - FREE MARKET APPROACH

demand

& supply of accounting information determine

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what type of information to provide and the necessary standards that underlie that information
Assumes

accounting information is economic good & subject to market price mechanism Optimal information is produced to match the user information needs at optimal price Advocates of free market claims that
mandatory disclosures are unnecessary & undesirable because market forces can generate desired information Regulation may create overproduction of information which give rise to standard overload

RATIONALE FOR FREE-MARKET APPROACH TO

FINANCIAL ACCOUNTING PRACTICE
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Optimal

supply of information ensured because users prepared to pay for it to the extent it has use; market requires information & failure to provide indicate bad news;

Capital

Regulation

lead to information overload because users do not bear the cost of production & hence overstate their information needs restricts the use of accounting methods which may best reflect firms performance & position.

Regulation

CRITICISMS FOR FREE-MARKET APPROACH TO

FINANCIAL ACCOUNTING PRACTICE
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Accounting

information is a public good, ie once free rider problem arise;

released , will be available to all;

Consequently, As

companies are not able to charge all users for the

cost of producing accounting information, regulation is required to pursuade companies to produce information necessary to meet the real demand of users and ensure efficient capital markets.
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CRITICISMS FOR FREE-MARKET APPROACH TO

FINANCIAL ACCOUNTING PRACTICE
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In

summary, as company has monopoly on the

supply of information, there is a tendency for the company to under-produce and sell at a

high price.
Hence,

mandatory (regulated) reporting will

result in more information at a lower cost.

AGENCY THEORY DEREGULATE ACCOUNTING INFORMATION

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Arguments

for non regulation of accounting information can be explained from the AGENCY THEORY perspective. Demand for financial information stewardship or decision-making purposes Stewardship motivate the agent and distribute risks efficiently (if information is valuable, it will do this)

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AGENCY THEORY DEREGULATE ACCOUNTING INFORMATION

theory contract between owners & managers. Provide alternatives to public reporting. Market mechanism can generate sufficient information. Reason companies have incentive to disclose information voluntary to attract investors & maintain continued investment of existing shareholders.
Agency
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REGULATORY APPROACH
Market

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failure - believe that market mechanisms will not be able to achieve a socially optimal equilibrium price for accounting information.
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EXAMPLES OF MARKET FAILURES

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Lack

of competition (monopoly, oligopoly) Barriers to entry Imperfect information gap (information asymmetry) between buyers and sellers Public good nature of some products availability of information to certain individuals makes it equally and costlessly available to other individuals.
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REGULATORY CONSIDERATIONS
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Accounting information: Public good

Public interest & public sector accountability

Statutory provisions & accounting stds

Public policy instruments: legislative & due process

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THE NEED FOR REGULATION OF ACCOUNTING

STANDARDS
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Accounting information is a commodity

Evolution of accounting practices significantly influence public interest . Therefore there is a need for public policy. If accounting information is considered as public good, then public interest and public sector accountability has to be considered.

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WHAT IS REGULATION?
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Regulation is policing of the restrictions or rules should be by an entity not directly involved in the activity. Three elements to regulation

Intention to intervene A restriction on choice in order to achieve certain goals An exercise of control by a party at least nominally independent of those directly involved in the activity.

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WHY REGULATE?
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To ensure full disclosure in order to protect individuals who are at information disadvantaged Improve operations of capital markets by enhancing public confidence As such standard setting must

copyright @ 2005 by Rohana Othman. All rights reserved.

Involve every party Ensure democratic & legislative process (consensus of majority is taken into consideration)

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WHY REGULATE?

Accounting is not merely technical mapping exercise Accounting involves social and economic consequences Necessary to regulate accounting information

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For public interest To achieve social goals Due to Market failures

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REGULATION IS POLITICAL
Regulation

is political because accounting stds affects many interest groups, and affects them differently. There is a need to establish the legitimacy of the std setting body because this body requires others outside the accounting profession to obey its rules. Non-compliance rates with accounting stds are evidence of the difficulty in establishing this legitimacy when std setting was in the hands of the professions. std setting body & profession are not representative of those affected by the stds. Hence have no power to enforce compliance with stds.
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REGULATION IS POLITICAL
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challenge to the profession to establish stds that is

acceptable to all groups affected by the std.

To

ensure stds acceptable to all users use the due

process approach
However,

due process approach not successful

because the process still dominated by accountants

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REGULATION IS POLITICAL
Regulation

is political because accounting stds affects many interest groups, and affects them differently. Should establish legitimacy of the std setting body because this body requires others outside the accounting profession to obey its rules. Non-compliance rates with accounting stds are evidence of the difficulty in establishing this legitimacy when std setting was in the hands of the professions. std setting body & profession have no power to enforce compliance with stds.
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RATIONALE FOR REGULATING FINANCIAL

ACCOUNTING PRACTICE

Markets for information are not efficient and without regulation a suboptimal amount of information will be produced;

Capital market that is on average efficient may not be efficient enough to protect the rights of individual investors who may lose their savings as a result of relying upon unregulated disclosures.
Parties with limited power (resources) will generally be unable to secure information about an organization although the organization may have an impact on their lives. Investors need protection from fraudulent organizations that may produce misleading information (due to information asymetries cannot be known to be fraudulent when used) Regulation leads to uniform methods being adopted by different entities, thus enhancing comparability.
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THEORIES OF REGULATION

Three regulatory models or frameworks have been developed to provide broad analysis of the economic, social and political influences involved in the regulatory process
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The theories are

Public-interest (market failure) theory

protect public interests

Regulatory capture theory

redistribution of wealth

Private-interest theory

the power to coerce in order to maximize the income of their members

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PUBLIC-INTEREST THEORIES

The public-interest theories of regulation maintains that regulation is essential

to serve public interest in ensuring efficient and equitable market prices Primarily for the protection and benefit of the general public (consumer interests)

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Without regulation enterprises provide insufficient, irrelevant, unreliable or fraudulent information

Information asymmetry reduce benefits to society

Information is Public good

Enterprise disclose minimum amount of information to minimize cost
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PUBLIC-INTEREST THEORY

Public interest theory holds that regulation is supplied in inefficient or inequitable market practices (Posner, 1974,p.335)

response to the demand of the public for the correction of

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This theory holds that the regulators do not have their

own set of interest

This theory assumes there is market failure & consequently some groups will need to be protected from the opportunistic behaviour of others.
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REGULATORY CAPTURE THEORY

Assumes all members of society are economically rational (pursue self-interest). As such people lobby

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for regulations to increase their wealth; or To ensure regulations are ineffective in decreasing their wealth

Assume government has no independent role in regulatory process. As such interest group

strive to influence governments coercive powers to achieve their desired wealth distribution

Governments coercive power allows it to prohibit or compel and/or provide or withdraw taxes and subsidies The coercive powers of government can and does selectively help or hurt many business. 26

REGULATORY CAPTURE THEORY

Capture theorist maintain that in the process of regulation the regulatee gain control or dominate the regulator

Original purpose of regulation to protect the public interest is reversed by the interest group
Regulated industries intensely influence decisions of regulatory agencies because the agencies decisions significantly affects the industries overall financial position Example: regulatory agency may not give permission to operate a business

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PRIVATE-INTEREST THEORIES

The private-interest theories of regulation maintain that regulation is a respond to the demand of special-interest group to maximize the wealth of their members Involves either use of political (political ruling elite theory) or economic power (economic theory of regulation)

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The political ruling elite theory concerns the use of political power to gain regulatory control
The economic theory of regulation concerns economic power.
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PRIVATE-INTEREST THEORIES

Private-interest theorists believe that there is a market for regulation with supply and demand forces operating as in the capital market.

Within this political market, while there are many bidders, only one group will be successful, and that is the group that makes the highest bid. Theorists believe that regulation does not come into existence as a result of governments response to public demand, but rather regulation is sought by the producer private interest group and is designed and operated primarily for its benefit

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PRIVATE-INTEREST THEORIES
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Regulation

is a device to transfer profits to well organized groups in the form of subsidies, pricefixing, control of entry of competitors, suppression of the production of substitutes

In

return interest group will vote & contribute to politicians

theory predicts that regulators use their power to transfer income from those with less political power to those with more.

This

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THANK YOU

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