LECTURE 3 APPLYING THEORY TO

ACCOUNTING REGULATION

ARTHIK DAVIANTI, SE. MSI. AK. CA.

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

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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

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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

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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

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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

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THEORIES OF REGULATION There are three theories of regulation: public interest theory regulatory capture theory private interest theory

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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 productsAssumption: economic markets are subject to a series of market imperfection or transaction failures.

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PUBLIC INTEREST THEORY Governments intervene: Legislative action – to get votes (competing

candidates) because public interest groups – agents -

demand intervention in pursuit of public interest objective

Government has no independent role because they are neutral arbiters – intervene costlessly

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REGULATORY CAPTURE THEORY The purpose to protect the public interest is not achieved 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

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REGULATORY CAPTURE THEORY Assumption:• All member of society are economically

rational – private marginal benefit from lobbying

• Government has no independent role in the regulatory process

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REGULATORY CAPTURE THEORY Situations of occurrence – the regulated entities:• Control the regulation and regulation agency• Succeed in coordinating the regulatory body’s

activities• Neutralise or ensure non-performance• In a subtle process of interaction Professional accounting bodies or the corporate sector seek to control the setting of accounting standards

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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 This theorists believe – a market for regulation with similar supply and demand (with many bidders) Only the highest bidder will be successful

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PRIVATE INTEREST THEORYProducer groups of regulation able to use the power of government for their own advantage:1. Organised interest group – seeking political

protection. Other groups (more diffuse) have limited ability to bid effectively (due to organisation and information cost)

2. Government officials are rationally self-interested

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

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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

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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?

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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

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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

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REGULATORY FRAMEWORK FOR FINANCIAL REPORTING A financial reporting environment is made up of: legal setting economic setting political setting social setting

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REGULATORY FRAMEWORK FOR FINANCIAL REPORTING The elements of a regulatory framework are : statutory requirements corporate governance auditors and oversight independent enforcement bodies

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STATUTORY REQUIREMENTS Company law Securities market law Accounting standards force of law

Taxation law

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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

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THE IASB AND FASB CONVERGENCE PROGRAM Convergence program commenced in 2002Norwalk agreement

Convergence is a complicated process

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