The Regulation of Financial Accounting - Coggle Diagram
The Regulation of Financial Accounting
meaning of ‘regulation’
regulation refers to a prescribed rule or authoritative direction that is designed to control or govern conduct.
In the context of financial accounting, regulation refers to the rules that have been developed by an independent authoritative body that has been given the power to govern how financial statements are prepared. The actions of the regulatory body will have the effect of restricting the accounting options that would otherwise be available to an organization.
what is free market perspective
The free market perspective is an alternative view on the need to regulate accounting disclosure.
This perspective suggests that we do not need all the regulations we currently have in place.
According to this view, accounting information should be treated like other goods, with demand and supply forces allowed to operate to generate an optimal supply.
In other words, the free market perspective argues that the market should be allowed to regulate itself, without the need for external regulation. This perspective is based on the belief that the market is efficient and will naturally produce the best outcomes for all parties involved.
However, this perspective has been criticized for ignoring the social and economic consequences of financial accounting and the need for regulation to achieve social goals and protect the public interest
Private Economic-Based Incentives: Proponents of the free-market perspective argue that managers and firms have strong economic incentives to provide high-quality financial information to attract investors and maintain their reputation in the capital markets.
They believe that the pursuit of self-interest by managers and firms
will naturally lead to the production of reliable and relevant accounting information without the need for external regulation
Market for Managers: The free-market perspective suggests that the market for managers,
where skilled managers are in demand by investors and firms
, creates incentives for managers to provide transparent and reliable financial information.
The fear of losing their positions or facing legal consequences for providing misleading information serves as a self-regulating mechanism
within the market for managers
Market for Corporate Takeovers: Proponents of the free-market perspective argue that the market for corporate takeovers acts as a disciplinary mechanism. In the event of poor financial reporting practices, the
threat of a takeover
by more efficient and transparent firms incentivizes companies
to maintain high-quality financial reporting standards
to avoid being targeted for acquisition
Market for Lemons: The "Market for Lemons" argument, derived from the concept of asymmetric information, posits that in a free market, low-quality products or services (in this case, financial information) will be driven out by market forces. The free-market perspective argues that firms with poor financial reporting practices will naturally change as investors and stakeholders move towards companies that offer reliable and transparent financial information. This self-regulating mechanism within the market is believed to ensure that only high-quality financial information is valued and utilized, aligning with the principles of the free-market perspective.
Rationale for free-market approach to
financial accounting practice
The capital market requires information & failure to provide
indicate bad news;
Regulation leads to information overload because users
do not bear the cost of production & hence overstate their information needs
Regulation restricts the use of accounting methods which
may best reflect firms performance & position.
Criticisms for free market approach to financial accounting practice
Accounting information is considered a public good, meaning that once released, it is available to all. This leads to a "free-rider" problem, where some individuals obtain the information without paying for analysts, distorting the market and creating inefficiencies.
As companies are not able to charge all users for the cost of
producing accounting information, regulation is required to persuade companies to produce information necessary to
meet the real demand of users and ensure efficient capital markets.
Critics argue that companies have a monopoly on the supply of information, leading to a tendency to under-produce and sell information at a high price. Mandatory (regulated) reporting is seen as a means to counter this issue, resulting in more information being available at a lower cost
The pro-regulation perspective in financial accounting theory advocates for the necessity of regulatory intervention to address market failures and ensure the provision of high-quality accounting information.
1 )Accounting Information as a Public Good: This perspective acknowledges that accounting information is a
public or "free" good
and should not be treated the same as other goods. Due to the presence of
the true demand for accounting information may be understated, leading to the
underproduction of information
2) Reducing the Impact of Market Failure : Regulation is seen as necessary to
reduce the impacts of market failure
, address the "free-rider" problem, and counter the tendency for companies to under-produce and sell information at a high price due to their monopoly on information supply
Market failure refers to a situation where the market mechanism fails to allocate resources efficiently, leading to suboptimal outcomes. In other words, the market fails to produce the socially optimal quantity of goods or services (financial information), resulting in inefficiencies.
examples of market failures
lack of competition (Monopoly Power): A monopoly occurs when a single firm dominates the market, leading to higher prices and lower output than would be the case in a competitive market.
Public good nature of some products – availability of
information to certain individuals makes it equally and costlessly available to other individuals.
Information Asymmetry: Information asymmetry occurs when one party in a transaction has more information than the other party, leading to inefficiencies. For example, a used car seller may have more information about the car's condition than the buyer, leading to an inefficient transaction.
Why it is needed for regulation of accounting information & the rationale for regulating financial accounting practice
Protection of Investors: Regulation is essential to protect individual investors who may be at an information disadvantage, ensuring that they have access to reliable and transparent financial disclosures to make informed decisions
Safeguarding Against Fraud: Investors need protection from fraudulent organizations that may produce misleading information, particularly due to information asymmetries that make it difficult to discern fraudulent practices
Market Inefficiencies: Information markets are often inefficient, and without regulation, an inadequate amount of information may be produced, leading to suboptimal outcomes. thus, Improve operations of capital markets by
enhancing public confidence
Ensuring Uniformity and Comparability: Regulation leads to the adoption of uniform methods by different entities, enhancing the comparability of financial information and improving the operations of capital markets
should supply of 'free' goods be regulated?
Some argue that
free goods are often overproduced
as a result of regulation. The public, knowing they do not have to pay,
may overstate their need for the good or service
, leading to potential overproduction. For example, in the context of accounting standards, it is suggested that regulation
could lead to "accounting standards overload"
due to the perception that free goods are often overproduced as a result of regulation.
Role of Adam Smith’s ‘invisible hand
The ‘Invisible hand’ notion is used as an argument in favor of a free market
without regulatory involvement, as if by an invisible hand, productive
The "invisible hand" suggests that individuals, by pursuing their self-interest within competitive markets, unintentionally promote the well-being of society as a whole. This concept is central to Smith's argument for the benefits of free markets and limited government intervention.
Theories to explain the introduction of regulation
Public interest theory
Public interest theory is a regulatory approach that suggests that
regulation is put in place to benefit society as a whole rather than serving the interests of specific groups
regulatory bodies and politicians represent the interests of the society in which they operate, rather than the private interests of specific stakeholders.
The enactment of regulation is
viewed as a balancing act between the perceived social benefits and the perceived social costs of the regulation
(reflects the idea that when regulations are introduced, policymakers and regulatory bodies must carefully consider the potential positive and negative impacts on society as a whole.)
Key aspects of the public interest theory include:
Societal Benefit: The primary objective of regulation under the public interest theory is
to promote the overall welfare of society.
Regulatory actions are intended to address market failures, protect consumers, and ensure the efficient functioning of markets for the benefit of the public at large.
Neutrality of Government: The theory assumes that
government and regulatory bodies act as neutral arbiters
, making decisions based on the broader societal interest rather than being unduly influenced by specific interest groups or individuals.
Capture theory, also known as regulatory capture, posits that regulatory agencies, originally intended to act in the public interest, may instead become unduly influenced or "captured" by the industries or entities they regulate. This influence can lead to the regulatory agency prioritizing the interests of the regulated industry over the broader public interest.
private interest theory (economic interest theory)
Economic interest group theory is a concept in regulatory economics that suggests that
groups with economic interests may form to protect their interests and lobby the government to put in place legislation
that benefits them at the expense of others.
This theory assumes that regulators and politicians, like all individuals, are
motivated by self-interest
regulatory agencies are not neutral arbiters
but are seen as interest groups themselves.
Regulation serves the private
interests of politically effective groups
Those groups with insufficient power
will not be able to effectively lobby for regulation to protect their own
Accounting regulation as an output of a political
This concept highlights the idea that accounting standards and regulations are developed through a political process that involves various stakeholders, including standard-setters, regulators, industry representatives, and public interest groups.