Introduction

There is an increasing trend that more timely and sophisticated financial information are required by the general public as well as owners and managers. There are two possible solutions to this increasing demand. Either let the market force decides what information to be supplied or through regulations. It is more than evident that accounting standard setting is becoming highly regulated all over the world. The question is whether a free-market approach to standard setting should be adapted?

Free Market Approach

Free market approach to standard setting basically means eliminating regulations and relying on the ‘invisible hands’ to guide the supply of financial information. This is based on the assumption that markets are efficient and there will be incentives to encourage the managers to disclose financial information, including bad news. One of the major incentives is to gain access to capital market. When investors don’t have a certain level of information to gain confidence in the entity, they require a higher rate of return to compensate the risk they are bearing. In order to avoid paying a higher price for capital, managers will have incentives to voluntary disclose financial information. Interestingly, advocates argue that manager also have incentives to disclose bad news. This can be explained in a in the used car market. Sellers of used cars tend to disclose as much as information as they can, including the existing problems of the car. Not like a brand new car, buyers of a used car expect that there will be some problems of the car and if sellers choose not to disclose any problems of the car they tend to think there are more problems than it actually is. Consequently, they are not willing to pay a good price for it. The same rule applies to financial information. If managers do not disclose bad news, investors normally picture a much worse scenario thus require a higher rate of return.

There are also other incentives such as to avoid over take, to fufill managers contractual obligation to the owners and gain a competitive position in the managers market etc, all of which are profit driven or self-interest driven. Managers use the basic cost benefit analysis to decide what information to disclose and to what extend to disclose.

However, the free-market approach does not always work as expected for the following reasons.

First of all, the assumption of efficient market can be overturned. As a matter of fact, market failures do exist. One of the reasons is failure to take into account the externalities which normally cannot be measured in monetary terms. For example, the pollution caused by burning coals. When managers apply the cost benefit pinciple, they generally fail to incorporate the cost to the environment. As a result, the price of the good does not reflect the actual cost. The benefits exceed costs conclusion can not be relied on. In the case of financial information, failure to disclose or dislosure of misleading information might have significant negative impact to the overall stability of the economy as well as the level of the confidence of the general public. Further more, accounting information is a ‘public good’. Once the informaiton is available, it is available to every one. This is the so called ‘free rider” problem. The actual benefit is almost impossible to be calculated accurately. After all, the cost benefit analysis is only valid within a limited scope and does not apply to the society as a whole.

Secondly, when free-market approach is adapted, it is more of a game for the big players. The nees of individual investors are ignored most probably. Managers will satisfy the powerful parties first. When there is a conflict between the small parties and the big parties, the big parties needs prevail. This eventually forms some kind of monopoly power and interests of the vunerable general public are sacraficed.

Finally, there might be fraudulent information produced by the managers because of the conflict betwen personal interest and the public interest. This is also know as ‘creative accounting’. Since there are no regulations specify the treatment of certain accouting issues, mamanger normally treat them the way which benefits themselves the most.

Pro-regulation Perspective
An alternative approch to standards setting is through tight regulation.
According to Scott (2003), tight regulations to accounting standards provide a ‘Level playing field’ where the movement of comparability can be shown within uniform methods. There are not much space left with the managers to make up their own mind about what to disclose. There will a clear requriement of disclosure of certain accounting information and non compliance will cause serious consequences. Consequently, the confidence of external stakeholders increases.
Another strong argument is that regulation is in the interest of the general public. Every one will have access to the accounting information required by the regulation regardless of the their power.
However, the tight regulation approach is not perfect. The regualtion setting approach is a political procedure. It can be infulenced by powerful lobby parties who try to maximise their own interests. Further more, the standard setting procedure can take a quite significant time which fails to provide the necessary regulations on a timely basis.

Conclusion
In my opinion, while an ideal standard setting approach should be based on the demand of the market, it should not relying on the market forces completely. When the market fails to capture the externalities, regualtions should be produced on a timely basis to guide the disclosure of information. Further, when the market dominated by powerful parties, regulation should take place to protect the general public. Overall, we should combine the advantages of the two approach to serve the purpose of maximise social welfare in a sustainable manner.