Do we need to regulate financial reporting?
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Acoording to Leuz and Verrecchia (2000) the accounting literature presents proof that the quality of accounting has economic consequences for e.g. costs of capital , efficiency of capital assignment (Bushman et al. 2006)etc. Land and Lang (2002) in their research mentioned that economic changes also have homogeneous consequences by stating that the quality of accounting has improved globally since 1990s. Land and Lang (2002) also say that the reason for the advancement in the quality of accounting is primarily due to globalisation and visualization of international accounting consensus. The argument proposed by the accounting theory is that the main aim of financial reporting is to reduce information asymmetry between managers and owners and other stakeholders contracting with the company (Watts, 1977; Ball, 2001). Favouring this notion Frankel and Li (2004) states that financial reporting decreases information asymmetry by disclosing relevant and timely information.
Standard setting is 'a form of regulation which lays down generally accepted accounting principles (GAAP)' (Scott, 2003, p. 9). Also accounting standards for listed companies in the European Union are promulgated by the International Accounting Standards Board (IASB).
This report answers this question that whether or not we need this kind of regulation of financial reporting.
What is Financial Reporting?
To answer the report question, firstly, there is a need to answer the questions like what is financial reporting, who are the users of financial reports and how is financial reporting regulated and what are the bodies responsible for regulating the financial reporting. By answering these questions a better understanding of financial reporting will be achieved and which will ultimately aid in answering the report questions.
Financial reporting enables an organization to communicate information about its performance externally (Atrill et al. 2005). So, financial reports provide summarized information about an organization's transactions over a specific time period to external decision makers. (e.g. Investors).
The users of financial reports are employees, trade unions, government, creditors, lenders, customers, shareholders and investment analyst (Elloit et al. 2006). The needs of these various users of financial reports can be completely different. However, the main emphasis is put on the most usable statements like balance sheet, income statement and cash flow statement.
The Accounting standard boards (ASB) which is responsible for setting and issuing accounting standards, the ASB is part of a broader structure including the Financial Reporting Council, the review panel and the Urgent Issues Task Force (UITF). The Financial reporting Council (FRC) is the body charged with the broad overview of the standard setting system. Although the FRC oversees the process of producing accounting standards, it has no input into the detailed rules. Conversely the principle sources of such regulation are The Law and the Accountancy Profession.
The Law consists of certain Acts. Much of the legislation governing the UK's preparation of accounts is personified in the companies Act 1985 and companies Act 1989. They are mainly concerned with the accounts of limited liability companies. These Acts state that all financial statements constructed under the Act must present a true and fair view. The Act also deals mainly with minimum disclosure requirements and is foremost concerned with the protection of shareholders and creditors. It provides a framework for general disclosure by requiring that certain financial statements such as the profit and loss accounts and the balance sheet, should be prepared and presented to the shareholders and requires the specific disclosure of certain items such as depreciation and so on. These disclosure requirements resolve some of the problems associated with the asymmetry of information between the directors and some user groups. They also enable user groups to compare the level of their inducements with those received by the other groups. The Act also requires that the directors not only present the financial statements to the shareholders each year but also that independent auditors are appointed to examine the financial statements and report their findings to the shareholders.
The law addresses the problem of information asymmetry by requiring the disclosure of certain key items of interest to user groups. The Accountancy Profession also recommend the same but in this role as regulator. The accountancy profession is more influential in achieving a significant increase in the comparability of financial statements. Whereas the law provides the general framework for what is to be accounted for in the financial reports, the accountancy profession provides detailed rules in the form of accounting standards about how items and transactions should be accounted for.
The two main regulatory bodies of financial reporting are "The Law" and the "Accounting Profession" with the Accounting Standards Board usually known as ASB (Elliot et al. 2008). In UK, most of the legislation related to the publishing of accounts is embodied in the Companies Act 1985 and 1989. The Companies Act 1989 is the main frame which the companies and accountants have to follow. All the financial statement drawn up under the act 1989 must present a true and fair view and its function is to protect all the users of the financial reports and statements. The second and the most important regulatory body is the accounting profession. The standard setters should be aware of the information needed by all users of financial reports and should know the impact and the outcome of a different accounting method on the needs of those users. The standard setters should also be able to resolve the conflicts which exist between the needs of different users. So, they have to find an alternative way which best satisfy user needs and this could be achieved by choosing the improvement of the "social welfare" instead of welfare of individuals.
We know that Accounting Standards Board is the main accounting standard setter. Because the ASB is composed of professional accountants, they may be unfamiliar with the user needs. So , when there is a need for a change in accounting standard the ASB prepare and publish a draft standard called the FRED (Financial Reporting Exposure Draft). After the publishing of these drafts the comments from the public is invited and in the light of these comments the FRED is changed (or unchanged). Now the FREDs are issued as FRS (Financial Reporting Standard). The main disadvantage of this system is the ASB members are unfamiliar with the different user needs and the comments from the general public may not be equally represented.
There are four things that standards in financial reporting supply people using it. The first one is "Comparability"; financial statements must allow people to compare one company with another one and evaluate the management's performance without spending time and money adjusting them to a common format and common accounting treatments. It is essential that users of financial reports or investment decision makers be supplied with relevant and standard financial reports which have been regulated and hence standardized. The second thing that standards and regulations supply is called "Credibility". Because all this standards and regulations exist accountants have to treat every company in the same way. If the accountancy profession permitted companies experiencing similar events to produce financial reports that disclosed markedly different results simply because of a freedom to select different accounting policies they would lose all of their credibility. So, the standards should be composed of rigid rules and should not be broken. The third thing is "Influence" that means, setting up the standards has encouraged a constructive appraisal of the policies being proposed for individual reporting problems and has been a stimulus for the development of a conceptual framework. The last thing that the standards have to supply is "discipline". Companies left to their own devises without the need to obey standards will eventually be disciplined by the financial markets. But in the short run investors in such companies may suffer loss. The Financial Reporting Council is aware of the need to impose discipline because most of the company failures in recent years are because of obscure financial reporting. Why should the Accounting Standards set? As we argued before, an important role of the regulations is to increase the comparability of accounts by limiting the choice of alternative accounting methods and to supply standardized accounts. This standardization can be achieved only by uniform accounting practice. If all accounting methods were standardized, two organizations which began the year with same balance sheets and which made the same transactions during the year, they would report the same balance sheets and the same profit and loss account at the end of the year. In addition to these advantages of regulations in financial reporting, there are also some more useful functions. Regulations can help to reduce the influence of personal biases and political pressures on accounting judgments. They can increase the level of user confidence in, and understanding of, financial reporting by clarifying the basis on which all accounts are prepared and presented. Finally, they can provide a frame of reference for resolving accounting problems which are not mentioned in legislation or accounting standards. As we argued earlier although the regulations in financial reports have very advantages it has many disadvantages too; One if these disadvantages is the "Adverse Allocative Effects", this could occur if the ASB did not take into account of the economic consequences of the new standard or regulation they have issued. For example, additional costs could be imposed on preparers of accounts and suboptimal managerial decisions might be taken to avoid any reduction in earning or net assets. "Consensus-seeking" can be another disadvantage and this means the issuing of standards that are over-influenced by those with easiest access to the standard-setters. Most of the time this could happen with complex subjects. "Standard Overload" is composed of a number of statements which creates the most important disadvantages of standards. Some of them are; 1. There is more than one standard-setter body so, as well as it becomes more difficult to follow the new changes, the accountants are becoming so regulated that it becomes very difficult to use his/her accounting profession, to make judgments. 2. There are too many standards and regulations, so in the long run, they restrict the development of accounting profession by discouraging the accountants from experimenting new ways of recording transactions. 3. Some points are too detailed and some of them are not sufficiently detailed so, makes it hard to obey. 4. Standards are for general-purpose and sometimes they fail to respond to user's and the firm's needs. For example, a company which wants to attract investment finance can not make the necessary judgment of how much information is necessary and what form it need take so, it couldn't take the actions necessary to attract investors and may bankrupt. Some of the standards are lack of a conceptual framework this means they haven't got a clear defensible logic and the rules tend to be rather arbitrary. This causes the standards to lose its credibility and acceptability.