AF301

Semester 1, 2020
Unit 3
Theories of Regulation
LO 1

Learning Outcomes
On successful completion of this unit, you should be
able to :
1.Apply and critique the free market (anti-regulation)
approach to financial reporting
2.Apply and critique public interest theory
3.Apply and critique regulatory capture theory
4.Apply and critique private interest theory
Questions for Reflection
1. Imagine you are a bank manager.
 How would you respond if a client applied for a
loan without providing any/adequate financial
reports?

2. Provide an example of a regulation (not necessarily

an accounting regulation) that applies to you.
 Are you in favour of this particular regulation?
 Why or why not?
LO 1

ANTI-REGULATION APPROACH

Relies on the Market

LO 1

Anti-regulation Approach
The main argument is that
 Firms have incentives to provide financial
disclosures
 even in the absence of regulation
Therefore regulation is not required since firms will
report voluntarily

Next we will consider two scenarios, which both seem

to support this conclusion
1.Market for Equity capital
2.Market for Debt capital
LO 1
Capital Markets - Equity
Consider an Initial Public Offering (IPO)
 The first time a firm offers its shares to the public
 Investors would be reluctant to buy shares in a
company which they know little (or nothing) about
As firms provide more (and higher quality) disclosures
1.They are more likely to secure equity
2.Investors are willing to accept a lower risk premium
Recall from AF208 that R = rf + B(Rm – rf) P0 = d1/(k-g)

3.i.e. investors accept a lower ROE (share price rises)

4.This reduces the firm’s cost of capital because Cost
of capital to the firm = ROE to the investor
LO 1

Capital Markets - Debt

Consider a loan application by a new client
Banks would be reluctant to lend to a company which
they know little (or nothing) about
 They might even reject the application outright

As clients provide more (and higher quality) disclosures,

1.They are more likely to secure funding, which is
limited
2.Banks charge a lower risk premium (interest rate)
3.This reduces the client’s cost of capital
LO 1
Critique of Free Market Approach
Both scenarios rely on individual contracts/agreements
1.Individual contracts don’t facilitate comparability
 Since disclosures will be prepared on different bases
 Lack of comparability makes it difficult for investors
to evaluate where to obtain the best returns
2.This arrangement works well for powerful stakeholders
e.g. investors and lenders
 But not for users with less bargaining power e.g.
small customers, individual employees
 Unless they can form strong lobby groups
3.May amplify “good news” i.e. favourable disclosures
 Because users choose what information to disclose
LO 2

PUBLIC INTEREST THEORY

LO 2
Public Goods
Accounting information is an economic good, with
 Demand and Supply
 Quantity and Price
However, it’s a public good (not a private good)
 Like a bridge, highway, public park etc.
 Once provided to 1 person, it can be obtained by
other users (‘free riders’) at zero cost.
 It is difficult to determine a fair price for a good
with zero cost
 Subsequent users receive the same potential
benefits as the initial user
LO 2

Behaviour of Monopolies
Each firm has a monopoly over (accounting)
information about itself
e.g. if you need information about Fiji Airways, there’s
no point asking Air New Zealand
Firms have no incentive to produce a good for which
they can’t charge. Therefore we expect:
1. Under-disclosure of accounting information
2. Sub-optimal decision making because of limited
disclosure
3. Inefficient allocation of capital because of
uninformed decision making
LO 2

Government Intervention
Assumption of public interest theory
Governments act in the public interest
Therefore government intervenes to
1. Ensure efficient capital allocation; and
2. Protect weaker groups in society who can’t
demand disclosures from firms
Government may
1. Set standards directly; or
2. Delegate responsibility to another group. In Fiji,
this is the Fiji Institute of Accountants (FIA)
LO 2

Public Interest Theory in action

US introduced the Sarbanes-Oxley Act in 2002
 Following the collapse of Enron and Arthur
Andersen
 Introduced new requirements for financial
reporting & corporate governance, applying to
a) Directors e.g. independence
b) Auditors e.g. compulsory change after a
maximum term
LO 2

Critique of Public Interest Theory

1. Users may over-demand accounting information
 Since they don’t pay anything for it
 this creates unnecessary cost and reporting
burdens for firms
2. In reality, government is faced with various interest
groups representing different sections of the public
 Potential disagreement over specific regulations
i.e. members of the public have different
information needs
3. How neutral are governments and politicians?
 They may serve their own private and/or party
agendas rather than the public interest
LO 3

REGULATORY CAPTURE THEORY

Although regulation may be intended

to serve the public interest, this may
not eventuate due to capture
LO 3

Capture
Regulatee captures or dominates the regulator
Example
Standards are designed to regulate the accounting
profession
 But the profession may capture/infiltrate/control
the standard setter
 This results in loss of independence by the
regulator
 Consequently standards are not set in the public
interest, but in the interest of the profession
 Such capture negates the whole point of regulation
LO 3

Pre-conditions for Capture

Capture is more likely to occur when
1.There is a small number of client entities
2.The information and product is complex
3.The regulated industry controls the information
needed for regulation
4.The regulator has limited resources compared to the
industry being regulated
5.The regulator has regular contact with the regulatee
and
 a background in the industry; or
 potential for future employment in the industry
LO 3

Pre-conditions for Capture

Here is an example from
the USA.
Note how Sue and Tom
both worked for the
industry, the regulator and
the lobby group (at
different times).
How “independent” do you
think they were as
regulators given their
career history and
career aspirations?
After leaving the regulator,
consider how they might
contribute to the
consequences outlined on
the next slide?
LO 3

Consequences of Capture
The regulatee is able to do one or more of the
following:
1.Neutralises or ensures mediocre performance by the
regulator
2.Successfully coordinates the regulator’s activities
with their own, to satisfy their own interests
3.Subtly co-opts regulators into a mutually shared
perspective, thus giving them the regulation they seek
LO 3

Regulatory Capture Theory in action

White & Chand (2006)
 FIA adopted IFRS, which may not be relevant for
Fiji’s culture, size and level of economic
development
 IFRS was beneficial for the Big 4
 Big 4 accounting firms dominate FIA and the AASC

 FIA believes IFRS was important for Fiji’s

economic trade and growth
LO 4

PRIVATE INTEREST THEORY

Here is another example from the USA
where there is a powerful gun lobby.
Some lobby groups make large political
donations to candidates who support
their position/view.
Certain political donations are permitted
(with disclosure) in some jurisdictions.

How would you summarise the main

message conveyed in the cartoon
above?
LO 4

Role of Government
Government regulations affect wealth distribution
 This helps some groups through subsidies; and
 penalises other groups through (special) taxes or
exclusion from benefits
Governments (and those they delegate power to) have
the power to coerce
Assumptions of private interest theory
 Governments are not neutral
 They are willing to sell their coercive power to the
highest bidder
LO 4

Private Goods
There is a market for regulation
 Supplied by regulators (standard setters)
 Demanded by firms and industry groups

Regulation favours the group that bids the highest in

terms of:
 Funding (financial support e.g. lobbying)
 Votes
LO 4

Lobbying
This is an expensive process, which requires
1. Funding
2. Ability to organise members of the group in
terms of meetings, submissions etc.

Compared to individuals, firms have greater

1. Resources Any financial benefit to the public is
divided by a larger number of people
2. Incentives to lobby so the per capita benefit is quite small.
 Since they have higher per-capita gains than
the general public
LO 4

Lobbying in Action
IAS 39 (Financial Instruments)
 Was amended following extensive lobbying within
the European Union (European Financial
Reporting Advisory Group, EFRAG)
 Involving governments and the French President
Banks were concerned that the use of fair value
 would create volatility in assets/liabilities
 Their concerns may also reflect cultural
differences between countries (Conservatism vs
Optimism in measurement)
LO 4

Critique of Private Interest Theory

1. This theory adopts a very cynical view of regulators
 Assumes they are all guided by political self-
interest, not public interest

2. Can private interests initiate and remove

standards?
 or simply amend them
 AF301

Semester 1, 2020
Unit 3
Theories of Regulation