LECTURE 3

APPLYING THEORY TO
ACCOUNTING REGULATION

ARTHIK DAVIANTI, SE. MSI. AK.

CA.

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

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

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

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

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

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
Assumption: economic markets are subject to
a series of market imperfection or transaction
failures.
8

PUBLIC INTEREST
THEORY
Governments intervene:
Legislative action to get votes (competing
candidates)
because public interest groups agents demand intervention in pursuit of public
interest objective
Government has no independent role
because they are neutral arbiters
intervene costlessly

REGULATORY CAPTURE
THEORY
The purpose to protect the public interest is
not achieved
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
Assumption:
All member of society are economically
rational private marginal benefit from
lobbying
Government has no independent role in the
regulatory process

11

REGULATORY CAPTURE
THEORY
Situations of occurrence the regulated entities:
Control the regulation and regulation agency
Succeed in coordinating the regulatory bodys
activities
Neutralise or ensure non-performance
In a subtle process of interaction
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 reelection (if they are elected officials) or increase
their wealth (if they are appointed officials) or both
This theorists believe a market for regulation with
similar supply and demand (with many bidders)
Only the highest bidder will be successful
13

PRIVATE INTEREST
THEORY
Producer groups of regulation able to use the power
of government for their own advantage:
1. Organised interest group seeking political
protection. Other groups (more diffuse) have
limited ability to bid effectively (due to
organisation and information cost)
2. Government officials are rationally self-interested
This theory predicts regulators will use their power
to transfer income from those with less political
power to those with more.
14

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
15

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?

16

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

17

STANDARD SETTING AS
A POLITICAL PROCESS
Standard setting is a political process because
it can affect many conflicting and selfinterested 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

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

THE IASB AND FASB

CONVERGENCE
PROGRAM

Convergence program commenced in 2002

Norwalk agreement
Convergence is a complicated process

23