1. GODFREY HODGSON HOLMES TARCA
CHAPTER 3
APPLYING THEORY TO ACCOUNTING REGULATION

2. 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

3. 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

4. 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

5. 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

6. 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

7. Theories of regulation
There are three theories of regulation:
public interest theory
regulatory capture theory
private interest theory

8. 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 products

9. Public interest theory
Governments intervene:
to get votes
because public interest groups demand intervention
because they are neutral arbiters

10. Regulatory capture theory
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

11. Regulatory capture theory
Professional accounting bodies or the corporate sector seek to control the setting of accounting standards

12. 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

13. 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

14. 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?

15. 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

16. 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

17. Financial instruments
The adoption of IAS 39 Financial Instruments – Recognition and Measurement in the EU has been a highly political process

18. Intangible assets
The adoption of IAS 38 Intangible Assets in Australia illustrates the role of politics in the standard setting process

19. Regulatory framework for financial reporting
A financial reporting environment is made up of:
legal setting
economic setting
political setting
social setting

20. Regulatory framework for financial reporting
The elements of a regulatory framework are :
statutory requirements
corporate governance
auditors and oversight
independent enforcement bodies

21. Statutory requirements
Company law
Securities market law
Accounting standards
force of law
Taxation law

22. 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

23. Auditors and oversight
Both auditors and auditing are usually regulated
statutory regulation
self-regulation

24. Independent enforcement bodiesEU
Securities market regulators
SEC
ASIC
The need for consistent enforcement across countries

25. Institutional structure for setting accounting and auditing standards
Formation of IASC – 1973
Aimed to develop accounting standards for use throughout the world
IOSCO’s support for a set of core standards
IASC not independent so restructured in 2001 into the IASB
In 2002 the EC decided to adopt IASB standards in 2005 in the EU
Australia adopted IFRS on 1 January 2005

26. The IASB and FASB convergence program
Convergence program commenced in 2002
Norwalk agreement
Convergence is a complicated process

27. Accounting standards for the public sector
Individual countries must decide the extent to which IASB standards will be followed by public sector entities
Australia has pursued one set of standards that can be used by both public and private sector entities

28. International auditing standards
Historically auditing was self-regulated
Best auditing practice has become enshrined in auditing standards
Governments have become involved due to market failure

29. Summary
In this chapter: we reviewed theories proposed to explain the practice and regulation of financial reporting and auditing we reviewed the regulatory framework for financial reporting and the institutional structure for setting accounting and auditing standards

30. Key terms and concepts Efficient markets Agency relationships
Public interest
Regulatory capture
Private interest
Political process
Regulatory framework
Accounting and auditing standards