GODFREY HODGSON HOLMES TARCA 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

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

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

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

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

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

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

Public interest theory Governments intervene: to get votes because public interest groups demand intervention because they are neutral arbiters

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

Regulatory capture theory Professional accounting bodies or the corporate sector seek to control the setting of accounting standards

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

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

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?

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

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

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

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

Regulatory framework for financial reporting A financial reporting environment is made up of: legal setting economic setting political setting social setting

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

Statutory requirements Company law Securities market law Accounting standards force of law Taxation law

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

Auditors and oversight Both auditors and auditing are usually regulated statutory regulation self-regulation

Independent enforcement bodies EU Securities market regulators SEC ASIC The need for consistent enforcement across countries

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

The IASB and FASB convergence program Convergence program commenced in 2002 Norwalk agreement Convergence is a complicated process

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

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

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

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