Accounting Theory

5/20/2018 Accounting Theory

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GODFREY

HODGSON

HOLMES

TARCA

CHAPTER 3

APPLYING THEORY TOACCOUNTING REGULATION


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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 toprepare 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 ite.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 products

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Public interest theory

Governments intervene:

to get votes

because public interest groups demand

intervention

because they are neutral arbiters

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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

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Regulatory capture theory

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

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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 correctmarket 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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Financial instruments

The adoption of IAS 39 Financial Instruments

Recognition and Measurement in the EU has

been a highly political process

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Intangible assets

The adoption of IAS 38 Intangible Assets in

Australia illustrates the role of politics in the

standard setting process

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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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Auditors and oversight

Both auditors and auditing are usually

regulated

statutory regulation

self-regulation

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Independent enforcement

bodies

Independent enforcement bodies

EU

Securities market regulators

SEC

ASIC

The need for consistent enforcement across

countries

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Institutional structure for setting

accounting and auditing standards

Formation of IASC1973

Aimed to develop accounting standards for use

throughout the world

IOSCOs 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 in2005 in the EU

Australia adopted IFRS on 1 January 2005

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The IASB and FASB convergence

program

Convergence program commenced in 2002

Norwalk agreement

Convergence is a complicated process

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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

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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

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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

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Key terms and concepts

Efficient markets

Agency relationships

Public interest

Regulatory capture

Private interest

Political process

Regulatory framework

Accounting and auditing standards

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Accounting Theory

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