Chapter 3: The Regulation of financial accounting
Why examine theories of regulation?
Better placed to understand why some accounting prescriptions become part of legislation while others do not.
Accounting standard – setting is a very political process
While some proposed requirements may be technically sound and logical, they may not be mandated due to political ‘power’ or influence of some affected parties
What is regulation?
The Oxford Dictionary defines regulation in terms of a “prescribed rule”
Macquarie Dictionary defined regulation as “a rule of order, as for conduct, prescribed by authority; a governing direction or law”.
On the basis of these definitions  can say that regulation is designed to control or govern conduct
Hence, when we are discussing regulations relating to financial accounting, we are discussing rules that have been developed by an independent authoritative body that has been given the power to govern how we are to prepare financial statements, and the actions of the authoritative body will have the effect of restricting the accounting options that would otherwise be to an organisation.
‘Free Market’ perspective
Accounting information should be treated like other goods, with demand and supply forces allowed to operate to generate an optimal supply.

Arguments supporting ‘free – market’ perspective
Private economic – based incentives
‘Market for managers’
‘Market for corporate takeovers’
‘Market for lemons’
Private economic – based incentives
Assumed that managers will operate business for own benefit and this is expected by shareholders and debt holders
Therefore in interests of management to enter contracts with shareholders and debt holders to constrain managers’ actions
Contracts often based on accounting information
Organisations not producing information will be penalised by higher costs of capital.
Organisations best placed to determine what information should be produced
Dependant on parties involved and assets in place
Imposing regulation restricting available set of accounting methods decreases efficiency of contracting
Also assumed auditing will take place in absence of regulation – reduces risk to external stakeholders.

Problems in prescence of many different parties
May be too many parties for contracting to be feasible
Prohibitive cost of negotiation if different investors want different information
Costly to negotiate single contract with all investors as they need to agree on information provided.
Market for managers’ argument
Managers’ previous performance impacts on remuneration they can command in future
In absence of regulation assumed managers encouraged to adopt strategies to maximise value of firm (provides favourable view of own performance)
Includes providing optimal amount of accounting information.
Assumptions underlying market for managers’ argument
Managerial labour market operates efficiently.
Information about past performance known by prospective employers and will be impounded in future salaries
Capital market is efficient
Effective managerial strategies reflected in positive share price movements
However, problems arise if the manager is approaching retirement
Also, is the managerial labour market is always efficient.
Market for corporate takeovers argument
Underperforming organisations will be taken over by another entity with the existing management team subsequently replaced
Therefore managers motivated to maximise firm value
Information produced to minimise cost of capital, thereby increasing firm value
Assumes managers know marginal cost and marginal benefits of information.
Market for lemons argument
No information viewed in the same light as bad information
Market may make the assessment that silence implies the organisation has bad news to disclose
Therefore managers motivated to disclose both good and bad news
Evidence that both good and bad news disclosed voluntarily (Skinner 1994).
Assumes the market knows that managers have news to disclose.
May not always be a realistic assumption
If knowledge of non-disclosure becomes available later, market is expected to react at that stage
Taken together, the various factors just discussed (market for managers, market for corporate takeovers, market for lemons, expectations about self – interest and the resulting use of contracts, and so forth) are considered to provide justification for restricting accounting regulation.

Pro – regulation perspective
Accounting information is a public or a ‘free’ good
It should not be treated the same as other ‘goods’
In the presence of free – riders, true demand is understated
Pricing system does not function properly.
Leads to underproduction of information
Regulation necessary to reduce impacts of market failure.
Should supply of ‘free’ goods be regulated?
Some argue free goods often overproduced as a result of regulation
Public, knowing they do not have to pay,, will overstate their need for the good or service
E.g. investment analysts
Could lead to accounting standards overload.
Role of Adam Smith’s ‘invisible hand’
‘Invisible hand’ notion used as argument in favour of free market
Without regulatory involvement, as if by an invisible hand, productive resources will find their way to most productive uses.
Some (i.e. Milton Friedman) went on to argue that leaving activities to the control of market mechanisms will protect market participants.
Free market argument ignores market failures and uneven distribution of power
Smith was concerned where monopolistic powers were created by government invention
BUT Smith advocated regulatory intervention in some instances
Where in the public interest to protect the more vulnerable
Theories to explain regulation
Public interest theory
Capture Theory
Economic interest group theory (private interest theory)

Public Interest Theory
Regulation put in place to benefit society as a whole rather than vested interests
Regulatory body considered to represent interests of the society in which it operates, rather than private interests of the regulators
The enactment of regulation is a balancing act between the perceived social benefits and the perceived social costs of the regulation
Assumes that government is a neutral arbiter.

Criticisms of public interest theory
Critics question assumptions that economic markets operate inefficiently if unregulated
Question the assumption that regulation is virtually costless
Others question assumption of government neutrality
Argue that government will only legislate and groups will only lobby for regulation if it will increase their own wealth.

Capture Theory
While regulation might be introduced with the goal of benefiting the public, this goal may not subsequently be achieved
The regulated seeks to take charge of (capture) the regulator
Seeks to ensure rules subsequently released are advantageous to the parties subject to regulation
Although regulating initially in the public interest, difficult for regulator to remain independent.
Capture of accounting standard setting
Walker (1987) analysed capture of Australian standard – setting through the ASRB  arguing that:
The accounting profession lobbied before the board established to ensure no independent research capability, no academic as chair, to receive admin officer not a research director
Priorities only set after consultation with AARF
ASRB fast tracked AARF submissions but not others
Majority of board membership were members of the accounting profession

Criticisms of capture theory
No reason to suggest that regulated industry the only interest group able to influence the regulator
No reason why regulated industries only able to capture existing agencies rather than procure the creation of an agency
No reason why regulated could not prevent creation of the regulatory agency
Economic interest group theory
The release of new or revised accounting standards have real economic and social consequences
AASB 138 Intangibles caused real economic impacts within Australia
The economic interest group theory of regulation assumes that groups will form to protect particular economic interests
Groups are often in conflict with each other and will lobby government to put in place legislation which will benefit them at the expense of others
No notion of public interest inherent in the theory
Regulators (and all other individuals) deemed to be motivated by self interest
The regulator is not a neutral arbiter but is seen as an interest group itself
Regulator motivated to ensure re-election or maintenance of its position of power
Regulation serves the private interests of politically effective groups
Those groups with insufficient power will not be able to effectively lobby for regulation to protect its own interests
Examples
Industry groups may lobby to accept or reject a particular accounting standard
E.g. European banks in relation to IASB 39
Large politically sensitive firms found to lobby in favour of general price level accounting in US (led to reduced profits)
Accounting firms lobbying to protect their own interests
Accounting regulation as an output of a political process
The view that financial accounting should be objective, neutral and apolitical can be challenged
Will inevitably be political as it affects wealth distribution within society
Standard – setters encourage affected parties to make submissions on drafts of proposed standards
If standard setters give consideration to views in submissions, accounting standards and therefore financial reports are the result of various social and environmental considerations
Tied to the values, norms and expectations of the society in which standards are developed
Questionable whether financial accounting can claim to be neutral and objective
Compliance with accounting standards usually seen to indicate financial statements are ‘true and fair’
Users are unaware that financial reports are the outcome of various political pressures

Recent Internal Control Legislation
Sarbanes – Oxley Act (SOA) of 2002
Created public company oversight board
Increased accountability for company officers and board of directors
Increased white collar crime penalties
Prohibits audit firms from providing design and implementation of financial information systems.
Section 302  CEOs and CFOs must certify quarterly and annual financial statements
Section 404  Mandates the annual report filed with the SEC include an internal control report
Fraud and its Relationship to Control
Fraud --? Deliberate act or untruth intended to obtain unfair or unlawful gain
Management charged with responsibility to prevent and/or disclose fraud
Control systems enable management to do this job
Management responsible to provide internal control system per the Foreign Corrupt Practices Act of 1977.
Section 1102 of the Sarbanes – Oxley Act specifically addresses corporate fraud
Instances of fraud undermine management’s ability to convince various authorities that it is upholding its stewardship responsibility

New York Stock Exchange Crash
The disaster of the NYSE collapse was largely due to the measuring of assets
“the view of measuring income by matching of costs and revenues because the focus for the development of accounting thought”
Bedford and Ziegler 1975
Securities Exchange Commission
Established  1933
To guide measurements of elements and to impose rules relating to income determination, which was to be compatible with the matching concept
Bedford and Ziegler 1975.