Course : F0812 Accounting Theory

Year
: February 2011

Applying Theory and Accounting

Regulation
Session 2

GODFREY
HODGSON
HOLMES
TARCA

CHAPTER 3
APPLYING THEORY TO
ACCOUNTING REGULATION

The theories of regulation

relevant to accounting and
Managers have incentives to
auditing
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
to prepare 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 it
e.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 misallocated 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

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 selfinterested
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
correct market 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
18

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

19

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

20

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

21

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

23

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

25

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 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
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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

29

International auditing
standards
Historically auditing was selfregulated
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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