Examining the case for accounting regulation

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The literature of accounting regulation identified the economic, social and political factors associated with the development of accounting rules and examined the events that shaped the different international regulatory frameworks. It has also established the aim and purpose of accounting regulation and identified the needs for these rules from many different perspectives, in particular, the economic, social and professional viewpoints, and the conditions which render them unnecessary. The present study attempts to gather and to contrast in one place these different views. Nevertheless, only reference papers, those which have established the theory of accounting regulation, are included and consequently the list of works discussed herein is neither exhaustive nor necessarily represents the last research dealing with these issues.  The relevance of such analysis springs from the fact that many Middle-Eastern countries are trying to develop their accounting systems to respond to the ever growing requirements of global accountancy bodies and international business. Therefore, this analysis could provide these countries with the theoretical foundation needed to understand the importance of such rules and later to build-up, restructure or improve their current accounting frameworks. From a different angle, this study serves as a basis for future analyses by Arab faculty and researchers, as well as business and accounting students, to improve their understanding of the subject matter, and to take further the ideas contained therein and attempts to test them empirically in the Arab world.

For that purpose, this examination covers the following three main headings:

A definition of accounting regulations and their boundaries.

Bringing to light the purpose and the aims of accounting regulation.

An identification of those conditions which render regulation in any form unnecessary.

The first line of examination is of importance for this analysis because there exist currently different views related to what mainly considers accounting rules. The second line examines the importance of accounting regulations and their purpose and aims. It attempts to justify the need for these rules, in particular, to regulate the economic consequences of resource allocation and information provision in the market, to achieve the welfare of the society, to promote a high level of professional practice in the public interest, and to secure a safe business environment and achieve the objectives for corporate reporting. The last section looks at the reasons put forward by many researchers justifying why it is not necessary, from their angle, to have accounting regulation.

2. Defining the boundaries of accounting regulation

It is crucial at this stage to start this investigation by defining the boundaries of accounting regulation. Therefore, for the purpose of this research, accounting regulations are taken to refer to the different GAAPs (mainly US and UK Generally Accepted Accounting Principles and Practices (UK GAAP). GAAP are mainly the norms governing financial reporting. However, UK GAAP does not have any statutory definition as elsewhere i.e. USA and Canada. It is a dynamic concept that changes over time in reaction to changing circumstances. It goes beyond principles and encompasses practice. This research acknowledges that the boundaries of GAAP extend far beyond accounting standards and adopts the definition devised by Davies et al. (1997: 35) in describing UK GAAP: "UK GAAP incorporates the requirements of accounting standards and UITF, of the Companies Act and of the Stock Exchange, together with other accounting practices which are generally accepted by the accounting profession to be permissible".

On a more practical level, accounting regulation (financial reporting) is seen as "the imposition of constraints upon the preparation, content and form of external financial reports by bodies (governments, regulatory agencies established by governments, trade and other associations in the private sector, loose industrial groups which pursue collusive activities) other than the preparers of the reports, on the organisations and individuals for which the reports are prepared" (Taylor and Turley, 1986: 1). Reporting requirements are therefore influenced by environmental factors such as those identified by May and Sundem (1976) who examined the environment in which financial reporting is conducted. They argued that there are four inter-linked elements affecting this environment: the production of these reports is influenced by accounting and auditing regulations imposed by public and private agencies, influenced in their turn by the preferences of users and the related costs-benefits emerging as consequences of their decision choices.

3. The need for accounting regulation

In considering the need for accounting regulation, the literature concerns itself with many considerations such as economic, socio-political, professional and cultural factors.

3.1. Economic and market considerations

Accounting rules are needed to regulate the economic consequences of resource allocation and information provision in the market. In an ideal and perfect situation, market efficiency ensures the availability of accounting information under the right costs. However, there are factors provoking the failure of ideal perfectly competitive markets (information asymmetry, tax rates, etc.). This provides reasons for expecting some type of 'extra-market' regulation (Cohen and Cyret, 1965).

Overcoming difficulties attributed to market imperfection and the lack of well-functioning markets for accounting information and achieving the most efficient allocation of resources are reasons highlighted by several other writers, such as May and Sundem (1976), Bromwich (1985) and Taylor and Turley (1986).

Bromwich (1985: 57) argued that "these problems of market imperfections and the lack of complete markets seem to plague the provision of external accounting information". He added, "such problems may not require regulation. For this to be the case necessitates that the results of such regulation are demonstrably better than the results of a more freely functioning, but imperfect market mechanism".

According to Taylor and Turley (1986), accounting regulation is necessary to ensure this market efficiency. They argued that markets may fail for several reasons, and in particular:

"The lack of rules governing market behaviour" (p.7) which must state the nature and the means commodities (including accounting information) may be allocated together with the form of contracts governing these allocations and the ways for settling disputes and enforcing rules.

A characteristic of achieving an efficient market is the supply of free information about market factors and preferences. In reality, information is not free and transactions involving information provision are costly. Taylor and Turley (1986: 8) argued that "the costs of information may mean that individuals are imperfectly informed about present conditions or the outcomes of their decisions".

In addition to transactions costs, there may be incentives to obtain private information through insider trading (Hirshleifer, 1971). Therefore, and from a general perspective, accounting information may affect the level and distribution of risks among individuals, since "risk is a reflection of the supply of information", and the economic aggregate (consumption, interest rates…) and hence market players decisions through "the terms of lending agreements, debt covenants, and dividend restrictions" (Taylor and Turley, 1986: 8).

Markets may also fail because of "market distortions". In the absence of controls on the pricing system, a divergence of prices between producers and consumers of accounting information may occur where producers could act as monopolists and hence the need for procedures guaranteeing the provision of information.

In addition to the above points, accounting information, which may be considered to have the characteristics of public good, should be available to all market players without any discrimination. Moreover, Taylor and Turley (1986: 10-11) stated that accounting information can "be thought of as giving rise to externalities". They argued that "rational persons would not buy information unless exclusion could be applied to its consumption". Exclusion might be practised by allowing full property rights over accounting information argued Gonedes and Dopuch (1974). Insider trading is an example: "an individual who has acquired additional accounting information may use it to make trading decisions"; others observing his actions "may draw inferences about the unknown information" (Taylor and Turley, 1986: 11). Therefore this leak of information may reduce the value of the information and generate externalities (Grossman, 1977).

3.2.   Socio-political considerations

Considerable attention has been given to the application of economic ideas to the provision of accounting information (Bromwich, 1985). The economic perspective has been focusing primarily on accounting policy making as a vehicle for achieving the most efficient allocation of resources. However, it fails to take into consideration the non-economic criteria, such as social, psychological and political factors, which in their turn exert major influence on accounting regulation and need explanation. Therefore, another focus must be considered to incorporate the social view, in particular, the income and wealth of different social interests, and to indicate the best form of regulation for achieving the welfare of the society.

Tower (1993) highlighted two important societal, intermediate goals for accounting as a social choice function (efficiency and equity) and argued that corporate reporting should consider these criteria explicitly. He stated that regulation is an important tool to promote accountability and proposed the provision of a greater amount of data in corporate reports and the inclusion of a wider representation by stakeholders, including producers, in order to increase 'the acceptability of accounting rules' and consequently promote compliance with accounting regulations.

In fact, activities of regulatory bodies may have consequences for wealth and income distribution. "Their competence for making such re-distributive judgements" is one item which needs to be included when considering accounting regulation, argued Bromwich (1985: 51). These activities are one form of the political aspect of accounting regulations. Politicisation of rule-making is not only inevitable but "… when a decision-making process depends for its success on public confidence, the critical issues are not technical, they are political" (Gerboth, 1973: 479). Moreover, the need to obtain consensus between regulators is also one reason why accounting standards are regarded as political (Bromwich and Hopwood, 1983).

Therefore, the distribution of accounting information has to take into consideration the issues related to the fair allocation between "economic units" and the impact they may have on the transfer of wealth, and consequently social factors. Tower (1993) pointed out that by adopting different accounting procedures related to tax policies for example, governments may exert direct influence on the distribution of income and wealth among economic entities (including individuals) and consequently remove existent inequities.

The considerations outlined above require the application of social criteria rather than economic criteria. Consequently, the choice of accounting regulation by regulatory bodies should account for users' preferences and the social and political requirements. The impact of such social influence was investigated by Arrow (1963). Demski (1973, 1974) and Beaver and Demski (1974) have applied Arrow's impossibility theorem to the issue of accounting regulation to show its political and social criteria and concluded that generally accepted accounting regulations are impossible. Demski (1974: 232) stated that "since the evaluation of consequences ultimately must entail trading off one person's gains for others… this, in turn, implies that one set of accounting research issues lies in discovering the restricted environments in which acceptable social evaluation criteria arise". Similarly, Marshall (1972) argued that 'optimal' accounting regulations are possible only if individual preferences were known.

Cushing (1977) showed that Demski and Marshall's conclusions may not hold under some circumstances. He stated that different factors should be considered and suggested the following avenues:

The relaxation of the assumption of complete heterogeneity of tastes and beliefs among financial statement users, which he described as an assumption with no systematic empirical support, and may not be appropriate at all times.

The possibility of replacing the requirement for complete accounting regulations.

and the importance of concentrating on the mechanism of social choice.

He argued that it is likely that there will be a significant degree of homogeneity of users' beliefs and tastes and consequently, accounting regulators must identify politically feasible procedures which spring within an acceptable framework that is able to identify the required degree of homogeneity and the tolerated degree of heterogeneity of users' preferences. He also argued that if there is general agreement amongst stakeholders that the mechanism for selecting accounting regulations is suitable, this may be seen as a surrogate for general agreement on the regulations themselves.

Cushing's alternative lines of inquiry were investigated by Walker (1984), Bromwich (1980), Dobbs and Keasey (1990) and other researchers. Bromwich (1980) established a framework which allows for the application of partial standards that will maximise the utility of a decision-maker using the accounting reports. He argued that standard-setters should have individual's expected utility in mind while deciding about the desired information system. Walker (1984) investigated Cushing's suggestion of relaxing the assumption of complete heterogeneity of tastes among users and concluded that "a fruitful theory of social choice will require restrictions on both the heterogeneity of individual's preferences and on the structure of the public information problem they face" (p. 285).

Cushing's focus on the mechanism of social choice has been explored by Dobbs and Keasey (1990). They noted that once certain minimal institutional factors and their effects on preferences are included in a model of public information system choice, the choice need not be chaotic. They argued that in order to resolve accounting policy choice dilemma, there must be some agreement among the accounts users regarding how they want to see the present system changed.

To conclude, accounting regulation, like other forms of regulation, is enveloped within a particular social context and professions legitimate themselves by attaching their knowledge to social values (Abbott, 1988). Maximising social welfare by behaving in the public interest should be one of the main governmental objectives from regulations (May and Sundem, 1976). Social and political choices by regulators are inevitable. However, they require an explicit and careful consideration of the preferences of all those who are affected by policy alternatives.

3.3.      Professional considerations

Being a professional form of social regulation, accounting has also developed in response to the rise of professionalism. Professional integrity and expertise, business opportunities and lobbying behaviours are some of the factors that emphasis the need for regulations. Tower (1993), Richardson (1997), Broadbent and Laughlin (1999) and several others have highlighted the importance of these elements. They argued that accounting regulations are important to promote a high level of professional practice in the public interest and maintain the professional status and integrity.

Beside this need for accountants to compete for professional integrity, Richardson (1997) argued that accounting operates as a profession in two domains. One of these is the regulatory domain of the standard setters and one is the market place. The first domain is concerned with the development and protection of professional knowledge and access to the professional community and the efforts to distance other groups by language and expertise; the other concern is with the market opportunities. These two domains are interrelated "as the availability of market opportunities rests on the existence of the professional knowledge and the restriction to access it" (Broadbent and Laughlin, 1999: 6).

The regulation of the profession is usually carried out by a mix of state, institutional and self-regulation. However, the issue of self-regulation by the profession is delicate and needs close consideration. Ogus (1995) argued that self-regulation may reduce the cost of the regulator acquiring information and makes adjustments to regulations easier. Therefore, the justification is seen to be based on reducing the costs of regulation.

Conversely, much of the literature sees regulation working in the interests of members of the profession. Economists have long been sceptical of the competition and welfare effects of the self-regulation of the professions. Friedman and Kuznets (1945) and Arnauld (1972) have criticised many of its aspects. The main criticism by those economists is their traditional cartel argument, in particular, its controlling power over the entry to the market, its controlling power over prices, advertising and competition.

The history of regulatory activity contains also many examples of lobbying by interested parties and such behaviour has come to be recognised as important in accounting policy making. This lobbying behaviour highlighted by Watts and Zimmerman (1986), Mian and Smith (1990) and others has significant effect on the efficiency of regulations and the standard setting process. Consultation between the regulators and interest groups may carry the danger that undue emphasis may be put upon the views of certain groups to the detriment of others.

Taylor and Turley (1986: 29) stated that "private regulatory bodies may restrict access to their service or may discriminate against certain of their members". They also stated that "their regulatory power may be used to exploit the public for private interest" and hence the need for supervision and control by governments.

In addition to the above points, there is also a need for creation of opportunities in the market. However, the creation of these opportunities is influenced by competition. Armstrong (1985) noted that the issue of professional rivalry is an important aspect of the dynamics of professional development. This issue of professional rivalry, together with the need for the creation of new market opportunities are best described by Broadbent and Laughlin (1999). They noted that in the context of the discussion of the Private Finance Initiative in the UK, competition between accounting and other professionals, such as lawyers, actuaries, bankers is very obvious, "hence in order to maintain their market opportunities, accountants must engage actively in the promotion of the market for services… However, as the profession also has to operate on the level of regulation, it cannot ignore the need to develop a robust set of regulations" (p. 9).

3.4.      Other considerations

Accounting standards aim to promote comparability, consistency and transparency in the interests of users of financial statements. Experience shows that, in the absence of regulation, companies reports may not give the information that users need to make informed assessments of companies. Therefore, great emphasis is placed on to the role of regulations in raising the quality of accounts and achieving the objectives for corporate reporting. These objectives were highlighted by Baxter (1978: 25). He stated that "standards raise the quality of accounts, make company reports more intelligible and foster comparability; they dispel doubts and - we hope - soon bring harmony of principle. In a world made safe enough by standards, accounting will be plagued by few scandals and our noisy defamers will have to hunt elsewhere for quarry". This need for accounting regulations to make the business world a safer place was emphasised by the scandals of the 19th and 20th century and the non-compliance activities of the 1980s and 1990s. Moreover, one central focus of accounting is the measurement of business performance. A good set of accounting regulations can protect stakeholders by making the profession more accountable to external interests. Fair accounting standards can ensure public confidence in the impartiality and effectiveness of professional regulations and discipline.

However, Bromwich (1985: 63) noted that despite control factors, enterprises have considerable discretion as to the accounting practices embodied in this accounting package. Choices are often permitted in the method of dealing with given accounting items. He argued that "it is likely that where such freedom exists…the information provided might be expected to support the picture of the financial position of the enterprise which those in power in the corporation wish to present to the outside world". In recent years, evidence has increased of the active management of reported financial performance by listed corporations (Briloff, 1972; Griffiths, 1986; Smith, 1992). In his best-selling book, Smith (1992) named and analysed 208 UK companies which practised different degrees of creative accounting. Tweedie and Whittington (1990) provided both an academic review of the major technical weaknesses in UK standards and set of illustrative cases, and Griffiths (1986, 1995) and others provided a professional and popular review of these manipulations.

4.    The case against accounting regulation

The legal and regulatory environment in which firms operate has evolved rapidly in recent years. However, some have suggested that accounting regulations (law, principles and standards) are not necessary, because the market can decide what accounting principles to demand. Bromwich (1985) tried to identify those conditions which render regulation in any form unnecessary in order to indicate those general characteristics of accounting which seem to make imperative regulation in some form. He stated that most of those who urge that the provision of accounting information should be left to the free market argue that the institutional framework does not correspond to the 'ideal' market settings. Moreover, they suggest that accounting regulation is ineffective in achieving its aim of accurate, reliable, consistent and comparable financial reporting.

Those who favour the provision of accounting information by the market would expect firms managers to be willing to issue sufficient information to allow interested outsiders to monitor their behaviour (Jensen and Meckling, 1976). They also point to evidence that supports their theory. They cite, for example, the voluntary provision of accounting information by enterprises prior to any legal or societal requirements for such information (Benston and George, 1976).

Those who are against accounting regulation suggest that the standard setting process is biased in favour of the setters. The involvement of different bodies and institutions in this process has significant influence. Such influences are highlighted in the constitution and the finance of regulatory bodies. Shah (1996) noted the involvement of different groups in the creation of the regulation and raised questions over the integrity and morality of the accounting system. Hopwood and Page (1985) and Tinker et al. (1982) stated that the imbalance of economic and political considerations of the setting process leads to the creation of inefficient regulations.

Other dangers are directly related to the nature and procedures of the regulation setting process. Baxter (1978: 34) warned of the defects and dangers of standards: "the truth is relative… standard procedures may become petrified procedures… accounting figures are not docile, and do not lend themselves to standardisation… the wording of standards will inevitably bring difficulties of interpretation… standards-makers may have to bow political pressures… even if a standard lay down a principle well, it may leave scope for personal estimates".

4.2. Conclusion

The literature of accounting regulation identified the economic, social and political factors associated with the development of accounting rules and examined the events that shaped the regulatory systems around the world. In response to the growth of business enterprises and shareholders demanding more stringent accounting regulations, and in response to financial abuse and shocks in the form of scandals and important failures, business laws gradually incorporated more extensive accounting provisions. These provisions were imposed on corporations as a promise to restore order and provide a new basis for the trust in economic transactions. Therefore, the fortune of accounting has always been tied to the general fortunes of the business climate.

The literature also established the aim and purpose of accounting regulations and identified the needs for these rules and the conditions which render them unnecessary. The general view in the literature is that arguments in favour of non-regulation are unconvincing, despite concerns about the quality of financial reporting practices and compliance with applicable accounting standards. It was shown that these rules have consequences for information provision and resource allocation in the market and for wealth and income distribution.