BFIN732 Financial Accounting Policy and Practice

“Critically examine and discuss the approaches to standard setting

in accounting. Illustrate the application of such approaches / your

analysis with relevant examples.”

Submitted by: Zhaklin OlevaStudents ID: w1472453Course Leader: Petar Sudar Word Count: 2498

Table of Contents

1. Introduction…………………………………………………………………..1

2. The two approaches to standard setting in accounting: Free-market

and Regulatory approaches……………………………..…………………2

2.1 The Free-market approach…………………………………………………2

2.2 The Regulatory approach…………………………………………………..5

3. Conclusion…………………………………………………………….….…..9

References…………………………………………………………………..…..11

1. Introduction

Financial accounting standards dominate the accountant’s work (Riahi-

Belkaoui, 2004:124). These standards are continuously amended, deleted

and added throughout the world. They are believed to offer practical and

useful rules for the conduct of the work of accountants. Studies about the

process of accounting policy making are constantly growing. In the US some

of the most influential studies include Gerboth 1972, Solomons 1978, Zeff

1978, Watts and Zimmerman 1978 and in the UK Morris 1975, Hope and

Briggs 1982. From the growing literature has emerged the idea that the lack of

a clear ‘agreed conceptual framework’ and policy guidelines have made it

impossible for policy setters to implement a single non-controversial

accounting standard on any type of the major issues they have encountered.

These studies have also brought the main question whether accounting

information actually needs to be regulated. There are two main views on this

issue, the free market approach and the regulatory approach. The free market

approach suggests that forces of demand and supply will determine the

amount of information to be disclosed, whereas the regulatory approach

maintains that markets are not efficient and they need to be regulated.

The aim of the paper is to critically discuss both approaches to

standard setting in accounting and provide examples to support the

arguments. The main criticism of the paper is that the free market approach

cannot ensure that companies will voluntarily provide fair and accountable

financial information but neither the regulatory approach can fully guarantee

that powerful groups will not have significant influence over approaches to

standardization and failing to create representational faithfulness and full

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neutrality. Finally the paper will conclude by summarizing the main points and

highlighting that humans are rational and imperfect beings, therefore it is

important that there are regulations to minimize the consequences of

opportunistic management behaviour but nevertheless accounting regulations

will most likely not be able to completely guarantee the production of fair

financial accounting information.

2. The two approaches to standardization: Free-market versus the

regulatory approach

2.1 The Free-market approach

The ‘free-market’ perception of accounting regulation is that accounting

information should be treated the same way as other goods (Deegan and

Unerman, 2011:62). This approach maintains that the forces of supply and

demand will determine the optimal supply of information for an entity required

by the market. This view is based on the assumption of ideal market

mechanism for determining the types of information to be disclosed (Riahi-

Belkaoui, 2004). This perspective has been famously supported by Adam

Smith (1776) and his notion of the ‘invisible hand’ of the market which will

ensure justice and equality.

The free-market approach is supported by a few theories including the

agency theory, the positive accounting perspective, ‘market for managers’ and

‘market for takeovers’ arguments. Agency theory identifies the relationship

where one party, the principal(s) (shareholders) delegates work to another

party the agent(s) (managers) (Jensen and Meckling, 1976). This theory is

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based on the assumption that both parties are focused on utility maximizing

and managers undertake opportunistic actions to look after their self-interest

instead of in the interest of the principal. The principal can limit the aberrant

activities of the executives by establishing monitoring powers such as auditing

by an independent party (Jensen and Meckling, 1976). External auditing could

provide accountable information about the performance of the firm and could

create confidence in investors. If investors are confident in their investment

this could increase the value of the firm. Jensen and Meckling (1976) link the

agency theory with the free market approach to accounting standards by

highlighting that firms are sets of contracts between the principal and the

agent where both parties agree to work together and protect the interest of the

firm (Coase, 1937). In addition, the positive accounting theory can also be

related with the contractual view of the company (Watts and Zimmerman,

1990). Financial accounting disclosure is seen as an instrument to facilitate

the making and performance of contracts (Watts and Zimmerman, 1990). The

contracts between the agent and the principal could be that managers get

remunerated based on their performance and disclosure practices,

shareholders vote for executive remuneration, directors bonus can be linked

to performance measurements or some managers might be given options to

buy shares at a preferential price which could motivate executives to

maximize the value of the firm as it could bring them personal benefits (Smith

and Watts, 1982). The free market approach imply that in case managers fail

to work towards shareholder value maximization the market control

mechanisms will punish them personally and the value of the firm itself (Smith

and Watts, 1982). For example, they will not receive a bonus, they can suffer

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capital losses if they have firm’s shares, and they could possibly be removed

from office by request of powerful shareholders (institutional investors) or via

mergers and acquisitions.

This idea is also supported by the ‘market for managers’ argument

(Fama, 1980) which relies on the assumption that managers’ previous

performance will have effect on their future remuneration. By adopting this

theory it is assumed that even in the anti-regulation environment controlling

market mechanisms will encourage executives to adopt best strategies to

maximize the value of their company and such strategies can involve

provision of optimal amount of financial accounting information and

transparency. However, this idea is based on the assumptions that the

managerial labour marker functions efficiently and that information about past

performance of managers is fully and equally available to everyone.

Nevertheless, in the real world it is very likely that markets will not be efficient

and that these assumptions will not be met. Based on similar assumptions the

‘market for corporate takeovers’ argument assumes that information will be

disclosed to the point where the marginal cost equals the marginal benefits

(Deegan and Unerman, 2011:65). Furthermore, absence of accountable

information and transparency about a certain company can lead to significant

increase in operational costs by creating mistrust in investors and lenders.

This could make shareholders pay less for company’s shares and lenders to

charge the organization higher price for their funds (Smith and Watts, 1982).

However, supporters of the regulation approach of regulation of

accounting standards strongly criticize the free market approach as being

ineffective and maintain that regulation is essential in improving financial

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accounting output. Leftwich (1980) argues that the unregulated market can

lead to various problems including lack of objectivity and comparability in

presentation, misleading information, over diversity of presentation and non-

optimal resource allocation. Ball (1972) maintains that the free-market

approach allows accountants to exercise a monopolistic impact over the

information disclosed and used by the market.

2.1 The Regulatory approach

The regulatory approach suggests that because markets are inefficient

there has to be some power to regulate the presentation of accounting

information. Thus either market imperfection or the need to achieve social

goals imply a regulation of accounting (Riahi-Belkaoui, 2004). The main social

goals regulations try to achieve are fairness of reporting, protection of

investors and information asymmetry. Posner (1974:335) suggests that

regulation is used as a response to the demand of the public for inadequate or

inefficient market practices. Thus, regulations are put in place to benefit the

society as a whole but not just interest groups. The application of this

perspective to financial accounting suggests that regulations serve as a tool

for confidence.

Nevertheless, the regulation approach to according standards has

been heavily criticized by many theories including the ‘capture theory’, the

economic, political and lobbying interest group theories. The ‘capture theory’

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suggests that even though regulation aims to protect the ‘public interest’ it will

not necessarily be successful because in the process of producing the

regulation some organizations which will be influenced by the regulation will

seek to exercise control (capture) over the regulator (Mitnick, 1981). Interest

groups will seek to ensure that regulations released will be advantageous for

the industry. According to Mitnick (1981) there are various ways in which the

regulatory body can be captured by private interests including if the ‘regulated

parties somehow manages to neutralise or ensure non-performance by the

regulatory body’ and ‘if the regulated body succeeds in co-opting the

regulators into seeing things from their perspective and hence giving them the

regulation they want’. The main versions of the capture theory of regulation

are the political ruling-elite theory, concerning the use of political influence to

gain regulatory control and the economic theory dealing with the economic

power to influence accounting regulators (Peltzman, 1976). In support, Kaplan

(1981) implies that the Financial Accounting Standards Board (FASB) in the

US lacks statutory authority and enforcement power thus faces the threat to

be overruled by the Congress or a governmental agency. This issue

originates form the fact that Congress is accepted to be a legal authority for

standard-setting and the Securities and Exchange Commission (SEC)

recognized the influential nature of pronouncements of the FASB and

meanwhile retained its role as adviser and supervisor which makes it a

constant challenger to policies implementation (Kaplan, 1981). Furthermore,

the FASB has not only been accused for being overly politicized but also that

it lacks independence from big public accounting corporations and firms. This

lack of independence turns into lack of responsiveness to public interest

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(Kaplan, 1981:183). Big accounting firms are believed to exercise pressure

over the FASB to avoid standards that would engage subjective estimates,

specifically standards that would require the use of recent market price.

Kaplan (1981:183) further highlights that ‘given the present litigious climate,

auditors wish to avoid having to certify figures for which objective verifiable

evidence is unavailable’, also ‘the production of subjective data is expensive

and introduces a degree of uncontrolled volatility to a company’s financial

statements’.

Not only has the regulatory approach been accused to implement

biased regulations to accounting standards but also it has been blamed for

responding too slowly to major issues, difficulties of reversing a given

regulation, tendency of regulation to expand continually which may cause

accounting standards overload (too many, overly detailed standards) and

lastly, regulators do not bear the cost of their failures (Mosso, 1983). These

strong arguments can be supported by the role of the SEC as a major tool for

setting public-sector regulation of accounting standards. SEC has the main

purpose to protect investors and other interested users against perceived

abuses established by the Securities Acts of 1933 and 1934. The

mechanisms include ‘suggestions through speeches, the exercise of rule-

making powers granted by Congress under Securities act of 1933 and 1934,

the use of review and comment’ (Burton, 1980). Different from the FASB, the

SEC is set to provide greater enforcement power.

The SEC has been criticized for various flaws. Compliance with all the

SEC regulations create immense corporate governance costs. The financial

reports of the company has to meet increasing number of requirements such

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as OSHA, NHTAS, NRC and others. The compliance has an impact on the

company in terms of paper costs and bigger staff requirements (Niskaven,

1971). There is a risk that the standard-setting may become overly politicized.

Some interest groups may try to lobby the governmental agency for special

treatment. The economic interest group theory of regulation suggests that

interest groups will form to look after a particular economic benefits. Posner

(1974) argues that the ‘economic theory of regulation is committed to the

strong assumptions of economic theory generally, notably that people seek to

advance their self-interest and do so rationally’. The theory maintains that

groups with incompatible interests are often in conflict with each other and

each group will lobby regulators or government to ensure that only regulations

economically beneficial for them (and not for others) will be put in place. For

instance, certain industry group can lobby the government or the accounting

standard-setter to reject or accept a specific accounting standard. In support,

Watts and Zimmerman (1978) and their study on lobbying of accounting

regulators revealed that ‘large politically sensitive companies’ supported the

offered method of accounting which managed to lead to reduced profits.

Reduced profit statements was opposed to the argument that companies

always try to show increasing profit tendency but nevertheless reporting lower

profits by big companies could allow them to reduce the likelihood of negative

wealth implications. They will be less vulnerable to forms of government

intervention, claims for wages increase by employees and consumer boycotts,

thus they could perhaps save on tax payments.

An example of self-interest influence over accounting standards can be

the aeroplane industry. Hope and Gray (1982) demonstrate how a group of

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aerospace firms turned to be effective in changing the detailed requirements

of a UK accounting standard on R&D through lobbying. Regardless of the

overwhelming majority of participants in the lobbying process the aerospace

companies successfully argued that in certain situations they should be

permitted to treat R&D spending as a form of capital expenditure and thus

‘charge it as an expense in future years by matching it against the income

which it eventually generated’ (Hope and Gray, 1982). This accounting

treatment resulted in higher net assets being reported in the balance sheet

each year during a project than would have been the case if the development

expenditure had been charged against profits in the year it was taking place.

The higher the reported net assets in a year, the more the firm could charge

the government for a contract.

Furthermore, some European banks has also managed to lobby

against revised provisions in International Accounting Standards (IAS) 39

(ICAEW, 2015). Banks in several European Union (EU) countries argued that

some requirements of IAS 39 (which has now been supervised by

International Financial Reporting Standards (IFRS 9) could result in displaying

significant volatility in their accounts which did not in reality reflect the

economic reality. This volatility could damage the bank’s perceived financial

strength. As a result of the lobbying the IASB made some changes in

response to the bank’s concerns but refused to change the IAS 39

significantly. Nonetheless, the accounting standards issued by IASB in 2005

became the accounting regulations which had to be followed by all companies

which have their shares listed on any stock exchange in the EU. In response

to lobbying from interest groups in certain EU member states, the EU has

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significantly delayed the recognition of IFRS 9 so some firms listed on the

stock exchange within the EU could not primarily use it in repairing their

financial statements.

3. Conclusion

The paper looked at various arguments for both the free market and

the regulatory approach to accounting standard setting. The free-market

approach is based on various assumption and suggests that the private

economic motivations of organizations can sufficiently supply the market with

the needed financial accounting information. In contrast, the regulatory

approach maintains that there should be regulations to determine the

comprehensiveness and truthfulness of information provided by companies.

Both approaches have been analysed by various theories such as the agency

and the capture theories. Overall, both approaches to standard setting have

their advantages and disadvantages, nonetheless it is important to have a

certain level of regulations to minimize the consequences of misleading

accounting representation.

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