GODFREY

HODGSON
HOLMES
TARCA
CHAPTER 3
APPLYING THEORY TO
ACCOUNTING REGULATION

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
2
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

3
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


4
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

5
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
6
Theories of regulation
There are three theories of regulation:
public interest theory
regulatory capture theory
private interest theory
7
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

8
Public interest theory
Governments intervene:
to get votes
because public interest groups demand
intervention
because they are neutral arbiters
9
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
10
Regulatory capture theory
Professional accounting bodies or the
corporate sector seek to control the setting of
accounting standards
11
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
12
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
13
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?

14
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
15
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
16
Financial instruments
The adoption of IAS 39 Financial Instruments
Recognition and Measurement in the EU has
been a highly political process

17
Intangible assets
The adoption of IAS 38 Intangible Assets in
Australia illustrates the role of politics in the
standard setting process
18
Regulatory framework for
financial reporting
A financial reporting environment is made up
of:
legal setting
economic setting
political setting
social setting

19
Regulatory framework for
financial reporting
The elements of a regulatory framework are :
statutory requirements
corporate governance
auditors and oversight
independent enforcement bodies
20
Statutory requirements
Company law
Securities market law
Accounting standards
force of law
Taxation law
21
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
22
Auditors and oversight
Both auditors and auditing are usually
regulated
statutory regulation
self-regulation
23
Independent enforcement
bodies
Independent enforcement bodies
EU
Securities market regulators
SEC
ASIC
The need for consistent enforcement across
countries
24
Institutional structure for setting
accounting and auditing standards
Formation of IASC 1973
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 in
2005 in the EU
Australia adopted IFRS on 1 January 2005

25
The IASB and FASB convergence
program
Convergence program commenced in 2002
Norwalk agreement
Convergence is a complicated process
26
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
27
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
28
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

29
Key terms and concepts
Efficient markets
Agency relationships
Public interest
Regulatory capture
Private interest
Political process
Regulatory framework
Accounting and auditing standards

30
31