Theories of Regulation and Appl to Acc and Aud Practices

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ACCOUNTING THEORY

FAR 600

Theories of Regulation andApplication to Accounting and

Auditing Practices

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LEARNING OBJECTIVES

At the end of this lesson, students should be able

to:

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

Financial reporting related activities

Examples:

Publish interim and annual reports

Auditors audit annual reports

Submit annual reports to regulatorybodies

Press release for investors and analysts


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Introduction - continued

How can theories assist inunderstanding 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.


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THEORYOF EFFICIENT MARKETS - FREEMARKET APPROACH

demand & supply of accounting information determine 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 & undesirablebecause market forces can generate desired information

Regulation may create overproduction of information whichgive rise to standard overload

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RATIONALEFORFREE-MARKETAPPROACHTOFINANCIALACCOUNTINGPRACTICE

Optimal supply of information ensured because users

prepared to pay for it to the extent it has use;

Capital market requires information & failure to

provide indicate bad news;

Regulation lead to information overload because

users do not bear the cost of production & hence

overstate their information needs Regulation restricts the use of accounting methods

which may best reflect firms performance & position.

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CRITICISMSFORFREE-MARKETAPPROACHTOFINANCIALACCOUNTINGPRACTICE

Accounting information is a public good, ie once

released , will be available to all;

Consequently, free rider problem arise;

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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CRITICISMSFORFREE-MARKETAPPROACHTOFINANCIALACCOUNTINGPRACTICE

In summary, as company has monopoly on the

supply of information, there is a tendency for

the company to under-produce and sell at ahigh price.

Hence, mandatory (regulated) reporting will

result in more information at a lower cost.


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AGENCY THEORYDEREGULATE

ACCOUNTINGINFORMATION

Arguments for non regulation of accountinginformation can be explained from the AGENCYTHEORY perspective.

Demand for financial information stewardshipor decision-making purposes

Stewardship motivate the agent and distributerisks efficiently (if information is valuable, it will

do this)

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AGENCY THEORYDEREGULATEACCOUNTINGINFORMATION

Agency theory contract between owners &managers.

Provide alternatives to public reporting.

Market mechanism can generate sufficientinformation.

Reason companies have incentive to discloseinformation voluntary to attract investors &

maintain continued investment of existingshareholders.


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REGULATORY

APPROACH

Market failure - believe that market

mechanisms will not be able to

achieve a socially optimal

equilibrium price for accounting

information.

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EXAMPLESOFMARKETFAILURES

Lack of competition (monopoly, oligopoly)

Barriers to entry

Imperfect information gap (informationasymmetry) between buyers and sellers

Public good nature of some productsavailability of information to certain individualsmakes it equally and costlessly available to otherindividuals.

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REGULATORY CONSIDERATIONS5/15/2012

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Accountinginformation:

Public good

Statutoryprovisions &

accounting stds

Public interest &public sectoraccountability

Public policyinstruments:legislative & dueprocess


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THENEEDFORREGULATIONOFACCOUNTINGSTANDARDS

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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WHATIS REGULATION?

Regulation is policing of the restrictions or rulesshould be by an entity not directly involved in theactivity.

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 nominallyindependent of those directly involved in the activity.

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WHY REGULATE?

To ensure full disclosure in order to protectindividuals who are at information disadvantaged

Improve operations of capital markets by enhancingpublic confidence

As such standard setting must

Involve every party

Ensure democratic & legislative process (consensus ofmajority is taken into consideration)

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[email protected].


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WHYREGULATE?

Accounting is not merely technical mapping exercise Accounting involves social and economic consequences

Necessary to regulate accounting information

For public interest

To achieve social goals

Due to Market failures

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REGULATIONIS POLITICAL

Regulation is political because accounting stds affectsmany interest groups, and affects them differently.

There is a need to establish the legitimacy of the stdsetting 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 legitimacywhen std setting was in the hands of the professions.

std setting body & profession are not representative ofthose affected by the stds. Hence have no power toenforce compliance with stds.

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A 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 because accounting stds affectsmany interest groups, and affects them differently.

Should establish legitimacy of the std setting bodybecause 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 legitimacywhen std setting was in the hands of the professions.

std setting body & profession have no power toenforce compliance with stds.

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RATIONALEFORREGULATINGFINANCIALACCOUNTINGPRACTICE

Markets for information are not efficient and without regulation a sub-optimal 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 secureinformation 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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THEORIESOF 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

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)

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

response to the demand of the public for the correction of

inefficient or inequitable market practices (Posner, 1974,p.335)

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 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 powersto 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.

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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 ofregulatory 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)

The political ruling elite theory concerns the use of political

power to gain regulatory control

The economic theory of regulation concerns economicpower.

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Private-interest theorists believe that there is a market forregulation 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 publicdemand, but rather regulation is sought by the producer

private interest group and is designed and operated

primarily for its benefit

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Regulation is a device to transfer profits to wellorganized groups in the form of subsidies, price-

fixing, control of entry of competitors, suppression

of the production of substitutes In return interest group will vote & contribute to

politicians

This theory predicts that regulators use theirpower to transfer income from those with less

political power to those with more.

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THANK YOU

Theories of Regulation and Appl to Acc and Aud Practices

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