Discuss the Arguments for and Against Regulating the Financial Reporting System

REGULATING THE FINANCIAL REPORTING SYSTEM

Accounting Theory and Contemporary Issues ---- DFA4100

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Assignment Title: “Discuss the arguments for and against regulating the financial reporting system.”

Submitted by: Names:

Muruganandam Payaniandy (Student ID – 1217700)

Course

Bsc (Hons) Financial Management (LCLM400)

Module:

Accounting Theory and Contemporary Issues - DFA 4100

Total words: 1,663

Introduction History attests to the influence of crisis and scandals as an impetus for regulatory intervention by politicians. After a series of scandals in the United Kingdom in the 1990’s, there was a Accounting Theory and Contemporary Issues ---- DFA4100

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dramatic shift in the structure of financial regulation that consolidated regulation responsibilities under the auspices of the Financial Services Authority. Today, in the aftermath of the financial crisis of 2007-2009, financial accounting standard setting finds itself entangled in political processes focused on restructuring the regulation of the world’s financial markets. The crisis has ignited worldwide debate on issues of systemic risk and the role played by financial regulation in creating and exacerbating the crisis. Proposals abound for how regulation of financial markets and financial institutions should be changed to mitigate the potential for such large-scale financial meltdowns in the future. The scope of regulatory issues under debate spans many aspects of the financial system, including the alleged role played by financial accounting standards in deepening the trajectory of the crisis. The crisis has energized politicians, regulators, and economists to scrutinize financial accounting standards as never before. Hence we will lay out basic arguments that have been put forward both for and against the regulation of the Financial Reporting System..

This study will critically help us to understand whether regulation of the FRS is necessary or not.

The argument for regulating the financial reporting system.

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Regulation of a profession is a specific response to the need for certain standards to be met by the members of that profession. When a profession such as accounting that provide important public services, it is imperative that serves and act in the public interest. The sustainability of the accountancy profession depends upon the quality of service provided and capacity to respond effectively and efficiently to demands of the society and economy. Regulation seeks to ensure the right quality and consistency in the services provided.

There are various factors that move towards the fact that the financial report system should be regulated.

 The Market Failure Argument

One explanation is market imperfection. In a capital market without market imperfection, firms will trade off the cost and benefit of disclosure and voluntarily disclose the efficient level of accounting information. In that case, there is no need for regulation. However, accounting information is perceived as a public good, as such, under provision of same would lead to a market failure thus justifying the need for regulating. Scott (1997, p. 329) defines market failure as ”an inability of market forces to produce a socially “right” amount of information, that is, to produce information to the point where its marginal cost to society equals its marginal benefit.” Non regulation of this particular services would lead to an underproduction of information and would not be able to meet with the demand of the market for information

 The Level Playing Field Argument

It suggests that all the people or entity should have access to same information on the basis of fairness. This is the basis of law that prevents insider trading. Very often Management are exposed to insider dealings which they can use in their advantage to make more money, thus making this information erode potentials investors. Hence regulation is necessary to enhance the confidence of all stakeholders that they are all playing on the same level field.

 Public Interest Theory

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The public interest theory stipulates that regulations should be able to benefit the society on a whole rather than the interest of a particulate group. The regulation is provided in response to the demand from the public for corrections to inefficient and inequitable markets. Thus, regulation is pursued for public, as opposed to private, interest related objectives. When corporate are disclosing only financial performance of organizations but they are disclosing other non-financial but relevant information such as environmental and social impact of the organizations activities, initiatives of the organizations to improve the undesirable impact of their activities on the society and environment. With reference to the public interest theory it is a rationale decision to introduce the legislation which mandates for the corporate to disclose the impact of their activities on the society and environment and also disclose the initiatives taken by them to protect the society and the environment from the adverse impact of their activities.

 Capture Theory

Regulatory capture is a theory associated with George Stigler, It is the process by which regulatory agencies eventually come to be dominated by the very industries they were charged with regulating. Regulatory capture happens when a regulatory agency, formed to act in the public's interest, eventually acts in ways that benefit the industry it is supposed to be regulating, rather than the public. Therefore regulation is a must to prevent these things to happen.

 Economic Interest Group Theory/ Private Interest Group Theory

The private interest theory of regulation assumes that groups will form to protect particular economic interests. Different groups are viewed as often being in conflict with each other and the different groups will lobby government to put in place legislation that economically benefits them (at the expense of others). As an example, consumers might lobby government for price protection, or producers lobby for tariff protection. This theoretical perspective adopts no notion of public interest – rather, private interests are considered to dominate the legislative process. The regulatory outcomes reflect the interests of the most powerful group(s). Posner asserts that this theory is committed to the strong assumptions of economic theory generally, notably that people seek to advance their self-interest and do so rationally. According to Stigler, the central task of the theory of economic regulation is to explain who will receive the benefits or burdens of regulation, what form regulation will take, and the effects of regulation upon the allocation of resources.

The argument against regulating the financial reporting system.

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Although, regulation is vital to the accounting profession and the business environment, there are many theories which tend to favour reducing if not eliminating regulation.

Deegan, 2004 argues that regulation is not necessary because:    

Financial information will reach its optimal supply level in response to demand. Capital markets will “penalise” companies that do not provide correct and sufficient financial information. Users typically do not bear the costs of providing information…leading to an oversupply of information at the expense of companies. Regulation will restrict companies from adopting accounting practices that best reflect a company’s performance, solely because some other companies will abuse of the rule to manipulate their performance.

 THE FREE MARKET PERSPECTIVE It often provides a perspective that accounting information should be treated like other goods, and demand and supply forces should be allowed to operate so as to generate an optimal supply of information about an entity.

Jensen and Meckling, Watts and Zimmerman, Smith and Watts are supporters.

The argument by some advocates of the ‘free-market” perspective is that in the absence of regulation there will be private incentives to produce accounting information. Organizations that do not produce information will be penalised by higher cost of capital. Hence the Free Market perspective is against the idea of regulation since accounting information is considered to be a good whose demand and supply will determine the optimal amount of information to be generated by an economic entity.

Example:

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Shareholders will require information so as to minimise agency cost of equity and maximise firm’s value and they hence will make contractual arrangements with the managers on the basis of profit tied bonuses. Debt holders will also require information on gearing and interest cover to determine an appropriate weighted cost of capital in accordance to the level of risk the company is exposed to. As such, there is automatically a supply of information that is created, since managers would like to provide information, especially to investors and creditors to show good performance.  Market for Managers Theory In accordance with this theory, even in the absence of regulation, managers will be motivated to adopt strategies that will maximise the value of their organisation and also report this performance. This voluntary disclosure of information about the organisation's past performance will influence their future remuneration, in the same company or elsewhere. The excellent reputation they would have built as a result of their performance, translated in the annual reports, is expected to be impounded in their future salaries, assuming the labour market is efficient.

 Market for Corporate Takeovers Theory This theory puts forward that if an organisation is not performing at its best, then it becomes a target of a possible takeover where the actual management team will be replaced. In order to prevent such a situation from arising, the agents would be motivated to maximise the firm's value and report the firm's performance even in the absence of regulation.

 Market for Lemons Theory

“Market for Lemons” perspective will encourage companies to provide information since no information is viewed as bad information. By not disclosing information, the company gives the signal that there are problems with the profitability, or that there may be bad news regarding both the liquidity and solvency of the firm. The shareholders will lose confidence in the company and withdraw their investment by selling their shares, which results in share price falls, leading to the company losing value. Therefore, even in the absence of regulation, managers would disclose both good and bad news voluntarily. It should be noted that the Market for Lemons Theory assumes that the market knows that managers have some piece of news to disclose which is assumed to be ‘bad’.

Conclusion Accounting Theory and Contemporary Issues ---- DFA4100

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We have explained the arguments for and against regulation of the Financial Reporting system. We have gone through the theories describing compliance with regulation is necessary and also, in the other hand, seen in the free market perspective that information is considered to be a good whose demand and supply will determine the optimal amount of information to be generated by an economic entity. But which theory to adopt will depend on the perception of person dealing with this information.

Referencing: Accounting Theory and Contemporary Issues ---- DFA4100

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 The manual on Accounting Theory and Contemporary Issues.  http://public.kenanflagler.unc.edu/faculty/bushmanr/Bushman_and_Landsman_ABR_ 3-2010.pdf  http://ro.uow.edu.au/cgi/viewcontent.cgi?article=1049&context=accfinwp  www.umanitoba.ca/faculties/management/acctfin/.../9.../group132.doc  http://www.studeersnel.nl/nl/document/university-of-melbourne/financial-accountingtheory/lecture-notes/lecture-notes-about-financial-accountingtheorypdf/267588/view?auth=0&auth_prem=0&prem_doc=1  http://www.um.edu.mt/fema/studyunit/ACC2112  Gaffikin, M.(2005) Regulation as Accounting Theory, Accounting & Finance Working Paper05/09, School of Accounting & Finance, University of Wollongong  http://greg-accounting.blogspot.com/2012/12/capture-theory-and-regulation.html  Bushman and Landsman. (2010) The Pros and Cons of Regulating Corporate Reporting, Kenan-Flagler Business School University of North Carolina

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