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
• IOSCO’s 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