ACCT6375

Accounting Theory
Week 2
Applying Theory to Accounting
Regulation
 The entire slide
comes from:
Accounting Theory 7 th
edition, chapter 3.
Image(s)
Area
 Learning Outcome
• Describe the purpose of accounting theory as it served from time to
time.
• Define theories and approaches used in accounting theory and
describe how the theories were constructed.
• Describe positive accounting theory, capital market and understand
the role of theories as abstractions of reality and their application in
real world phenomena.
 Outline
• The Theories of Regulation Relevant to Accounting and Auditing
• How Theories of Regulation Apply to Accounting and Auditing
Practices
• The Regulatory Framework for Financial Reporting
• The Institutional Structure for Setting Accounting and Auditing
Standards
 SUB TOPIC:
THE THEORIES OF REGULATION
RELEVANT TO ACCOUNTING AND
AUDITING
 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 mis-allocated 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 Theories

• 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
 Public Interest Theories

• Governments intervene:
– to get votes
– because public interest groups demand intervention
– because they are neutral arbiters
 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
 Regulatory capture theory

• Professional accounting bodies or the corporate sector seek

to control the setting of accounting standards
 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
 SUB TOPIC:
HOW THEORIES OF REGULATION
APPLY TO ACCOUNTING AND
AUDITING PRACTICES
 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
 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?
 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

 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
 Financial instruments

• The adoption of IAS 39 Financial Instruments – Recognition

and Measurement in the EU has been a highly political
process
 Intangible assets

• The adoption of IAS 38 Intangible Assets in Australia

illustrates the role of politics in the standard setting process
 SUB TOPIC:
THE REGULATORY FRAMEWORK FOR
FINANCIAL REPORTING
 Regulatory framework for financial
reporting

• A financial reporting environment is made up of:

– legal setting
– economic setting
– political setting
– social setting
 Regulatory framework for financial
reporting

• The elements of a regulatory framework are :

– statutory requirements
– corporate governance
– auditors and oversight
– independent enforcement bodies
 Statutory requirements

• Company law
• Securities market law
• Accounting standards
– force of law
• Taxation law
 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
 Auditors and oversight

• Both auditors and auditing are usually regulated

– statutory regulation
– self-regulation
 Independent enforcement bodies

• Independent enforcement bodies

– EU
• Securities market regulators
– SEC
– ASIC
• The need for consistent enforcement across countries
 SUB TOPIC:
THE INSTITUTIONAL STRUCTURE
FOR SETTING ACCOUNTING AND
AUDITING STANDARDS
 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
 The IASB and FASB convergence
program

• Convergence program commenced in 2002

– Norwalk agreement
• Convergence is a complicated process
 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
 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
 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
 Key terms and concepts

• Efficient markets
• Agency relationships
• Public interest
• Regulatory capture
• Private interest
• Political process
• Regulatory framework
• Accounting and auditing standards
 Reference

• Godfey, J., Hodgson, A., Tarca, A., Hamilton, J. & Holmes, S.

(2010). Accounting Theory 7th edition chapter 3. Wiley.
Brisbane.
Thank You