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Critically examine and discuss the approaches to standard setting in accounting. Illustrate the application of such approaches / your analysis with relevant examples.
The globalization of increasing economic activity in recent years has demanded the high quality and internationally comparable financial information. Over the past years accounting has become the significant part of the modern business world and the demand for the accounting regulation significantly increased. In financial markets, legislation is very important to produce information, because of asymmetric information and there is no reason for supporting individual. The most discursive issue in financial reporting environment is if there needed any regulation in accounting. The basic purpose of accounting standards is to provide financial information to investors, analysts and creditors in order to allocate their recourses in efficient way. Effective financial reporting can be achieved with the relevant and organized accounting standard.
According to Deegan (Deegan et al..) the discussion of accounting regulation is discussion about the rules that have been introduced by an independent with no self-interest authorities body that has the power to set the standard of how should be prepared financial statement. In the discussion related to accounting standard settings it is necessary to determine Free Market approach and Regulatory approach.
Free Market Approach.
Watts and Zimmerman (1978), Smith and Warner (1979) are the proponents of this theory. Based on their studies it can be defined that in the free market approach accounting standards impacted by the demand from interested users and supply of interested preparers. The assumption of the approach that market forces create equilibrium, and there is no need for accounting regulation since market forces disclose generate an optimal supply of information. According to Barton and Waymire (2004) in unregulated environment there is have to be the private economic incentives in order to provide the adequate information of the organization’s operations to shareholders. They assumed that the absence of protection shareholders reduce the amount that they pay the shares, which is lead to reduction of the organization value. The proponents of the arguments (Francis and Wilson 1988, Watts and Zimmerman 1983) suggested that if there is an assumption that managers could act in their self-interests there are should be the external auditors in order to increase the confidence of the provided data.
In order to operate under unregulated environment there was developed the theories, which support and maintain the operation under the reduction of accounting regulation. In the accounting literature the most mentioned are positive accounting theory and agency theory. Agency theory is one of the most important components of the positive accounting theory. (!!!)
Positive accounting theory (http://wenku.baidu.com/view/902189ff04a1b0717fd5ddca.html)
Watts and Zimmerman (1978) developed positive theory of the determination of accounting standards. They focused on answering the question why firm expand their resources in order to influence on accounting standard settings. They came to understand the source of the pressure driving the accounting standard setting process, the effect of several accounting standards on special individual groups and the allocation of resources. They focused on costs and benefits generated by accounting standards, which contributed by management incentives to support or oppose different standards. They supposed that management plays an important role in the determination of accounting standards. They assumed that managers individually acted to maximize their own value, which consequently affect the corporate lobbying on accounting standards based on managers’ own interest.
Gordon (1964) identified the same assumption in attempt to develop the positive accounting theory. Watts and Zimmerman (1978) tested Gordon’s model and the outcome was that his model is “unconfirmed” and “lack of confirmation”. He also supposed that shareholder wealth is the positive aspect, which essentially avoids the conflict between mangers and shareholders. That is increases stock prices and consequently accounting income. However, later it was not proved that management could directly manipulate share prices by changing accounting standards.
Watts and Zimmerman identified that changes in accounting procedures affect indirectly on increases in share prices and increases incentive in cash bonuses. They defined factors that affect companies’ cashflows and in their turn affected by accounting standards. Taxes, regulatory procedures if the firm is regulated, bookkeepeing costs political costs and information production costs increase management wealth by increasing cashflows and therefore share price. Management compensation plan increases managerial wealth through altering the terms of the incentive compensation. The factors are combined in the model that expect that the big companies which are experience the earnings reduction due to accounting standards settings favor the change. The other companies against the changes because the additional bookkeeping costs justify the cost of lobbying. In other words the management position depends upon the size of the firm and the affect of the standards on firm’s earnings.
Watts and Zimmerman concluded that if the financial accounting standards have a positive effect on the future cashflows, standard setting by government bodies such as Accounting Principals Board, the Financial Accounting Standards Board or the Security and Exchange Comission would meet by corporate lobbying.
An agency relationship is one when one or more person (agent) engage to perform business on a behalf of another person (principal). Agency theory represents the study of agency relationships and the problems that arise between agent and principal. Firstly, the separation of ownership and control of business was present by Adam Smith (1976), Veblen (1923) and Berle and Means (1932) had the significant impact on accounting regulation. Under this theory they determined thesis that the separation of the ownership protect shareholders’ interests by enabling them to reviewer the managers’ decisions. The New York Stock Exchange implemented some of their thesis and for American Institute of Accountant Berle and Means thesis became the foundation of the Securities Act of 1933. The important thesis for this act was that accounting reports that containing the information of financial conditions of the company must be available by the managers of the company who interested in entering public security markets. Contracts between the managers and shareholders are designed in order to reduce agency costs that appear when agent assumes to maximize the utility of the contract between them and principal.
Accounting in such relationship determines to play an important role, such as monitoring the relationship between agents and principals. Watts and Zimmerman (1978) stated that accounting procedure have to affect the firm’ value. The principal-agent link also generate hypothesis regarding the accounting method choice, appropriate accounting regulations and informativeness of accounting reports.
Some of researchers such as Zmijevski and Hugerman (1981), Jones (1990), Holthausen, Larker and Sloan (1995) have used formal management compensation plan and firm debt contract in order to present the tightening role of accounting in context of simple agency model of the relationship between shareholders and managers. They have generated the hypotheses regarding mangers’ choice of accounting procedures and how it affects the stock prices.
Accounting researchers such as Beaver (1973), Benston (1969 and 1973) supported the accounting regulation by applying the theories of CAPM and market efficiency. And as was stated in study of http://www.thebhc.org/publications/BEHprint/v027n2/p0486-p0499.pdf , their researches were used as the basis of the Financial Accounting Standard Board, the Accounting Principles Board and the Securities and Exchange Comission.
Regulatory Approach. (3003113, seobaroven)
The criticizers of Free Market Approach defend the theory how it is unreal. Many of the researchers promoted the theory that Adam Smith’s work (1776, republished in 1937) was misrepresented, especially Collison (2003). He stated that Adam Smith did not support that there should be no regulation; he meant that government should be involved in the public interest in order to protect public needs.
Public Interest and Capture theories are the main theories that advocate why the regulation is necessary in the financial environment and also describe the stakeholder who wins in regulated market. They explain the pattern of the government intervention in the market. According to Posner (1974) public interest theory holds that regulations are provided according to public demand in order to correct market inefficiency. Capture theory holds that regulations are introduced in order to satisfy the demand “of interest groups struggling among themselves to maximize the income of their members”.
Public Interest theory of regulation.
Public interest theories are based on the principle that the regulator generates the rules and regulation according public interests objective (Posner, 1974), such as consumer or investor protection and safety. The regulator is acting as an agency that operates on behalf of the society, without any self-interest. The government intervention is aiming to control the situation where no social or professional sides can influence on the information is provided to interested parties. In the Hydman and McMahon (2010) study it can be find a case of the UK charity companies, where was introduced regulatory act of the Statement Recommended Practice in order to control the poor provided accounting information by charity organizations in the UK.
As was mentioned before, this theory gives the benefits for society as whole, not for the particular individual groups. The regulatory bodies, government, are considered as a neutral and it represents the interests of the public in which it operates. Posner (1974) emphasize two assumptions about economic markets – that is it is very fragile and operate inefficiently; and the other assumption that government regulation is “virtually costless”. This assumption let the government intervention respond to public demand very easy and behind every regulation it should be distinguished market imperfection in order to operate more effectively and without any costs. Peltzman (1976) and Stigler (1971) supported his arguments.
Posner (1974) have also mentioned that this theory of regulation is not positively correlated with external economies or diseconomies or with monopoly. For example, airline industry, trucking, taxi services, stock brokerage and ocean shipping, even in the health care and in the legal profession industries the market failure is significantly high.
Posner (1974) also argued that the reformulation of the theory, where was stated that regulatory agencies are designed for the conscientious purposes are then mismanaged, is not satisfy two factors. Firstly, it does not take into account that socially undesirable results desired by individual groups influenced by legislation settings up to regulatory scheme. He gave a number of examples, such as when American Telephone and Telegraph required for state regulation of telephone services, because they wanted to stop competition between telephone companies. The second prove of mismanagement is that the regulatory agency operates with the knowingly inefficiently. He proved the reasonable evidence of that statement the main idea of which is that regulatory statue put legislation not only because of public interest; they pursue their own interest.
The main problem of this theory as was mentioned in Posner’s article that the theory does not have any mechanism to translate public needs into legislation statue. He also suggested a possible ways to resolve the problem. One of them was introduced by Ronald Coase (1959), which holds that it needed to be distinguished the moral differences between private and political actions. Posner also suggested observing the conspiracy among the politics.
Based on the assumption of the public interest theory that all actors are rational self-interested utility maximizers, which is define their actions regarding the rules and regulations. Capture theory was introduced in order to examine the behavior of the actors. According this theory the public interests are in the first place. However, there is a possibility that regulation might be controlled by the company that suppose to introduce those regulations.
Posner (1974) suggested a number of versions of capture theory, such as the Marksits, from the political scientists point of view and economic theory of regulation. The most appropriate according to Posner (1974) is economic version, which is based on two insights. Firstly, the power of government can give the benefits to particular groups and individuals. Secondly, this theory help to place supply and demand curve. He showed in the articles the strengths and weaknesses of the theory. According to Posner (1974) the economic theory can be used to explain why it is more often observed protective legislation in such industries like agriculture, labor and the profession, however it does not predict the industries where regulation will be needed. He has also given an example where the theory provides the testable prediction: the number of firms is small, but the number of employee in the industry is great. The profit from the protective legislation is great therefore firms can force the employee to vote for the regulation, which is lead to diminishing the payoff to the employees, and thus it reduce their voting power. Thus, the main advantage of the capture theory is that it fully concerns public interests and that the society at which it operates has the access to information of the insights of the firm. However, the theory ignores the firms’ self-interest.
Walker (1987) also suggested that capture might be achieved in several ways, such influencing the agenda of the regulator, neutralizing its pressure and when the regulated party see the interest of the group from their perspective in trough the regulation give them what they want. Thus the capture will be the inevitable result of regulation. Also Bernstein and Cave (1955) provide the expanding capture theory by suggesting that regulation is experiencing the life-cycling process, which leads to political and economic cooperation and creating a new regulation body.