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History is filled with examples where crisis and scandals paved the way for regulatory interventions in the financial markets. The UK introduced major changes in its regulatory practice after the fall of the Barings Bank as a result of the financial scandals during the 1990s. The Financial Services Authority was deregulated in order to develop more rigid and consolidated regulations that conformed to the practice that were prevalent in the industry. Similarly, the US saw a major shift in its financial accounting regulations after the Enron catastrophe. The financial crisis of 2007-2009 has resulted in bringing the issue of standardizing the regulations on financial accounting practices. Regulators worldwide have realized the systematic risks inherent in the financial markets and the critical role that regulations can play in sprouting and exacerbating the fiasco.
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Accounting standards plays a vital role in financial accounting and reporting in order for investors to make good decisions. Financial accounting and reporting are subjected to various regulations such as the Securities exchange Commission (SEC), the financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB).
They differs from countries due to the differences in the economic, social and political factors involved. (P. Brown)
The Securities and Exchange Commission (SEC) was created in response to the major stock market crash in 1929 to restore investor confidence. At that time, financial statements were often poor in quality and not audited.
Arguments for regulation
Over the years there have been many arguments over the necessity for regulation. Accounting regulations are needed in the industries that are susceptible to monopolistic behaviours to protect stakeholder’s interests. These monopolies undermine the competition, as they would try to beat the competitor that poses a threat to their share in the market. Hence, regulation can help the governments in maintaining the efficiency of the markets to keep them attractive for investors and maintaining fair trade.
Arguments in favour of regulation correspond to the market failure, government will be able to help through regulations.
Moreover, regulations should be considered when there are businesses and financial institutions that offer windfall profits due to new innovation; the organization is able to achieve high profits. Suppliers will use unethical practices to charge a large sum of money by excluding the true cost, which is known as externalities. In addition to these, there are information asymmetries that exist where firms do not fully disclose their decisions. Bushman and Landsman (2010) suggest that optimal disclosure of financial information are beneficial because failure to do so might cause investors sceptical assumptions.
Proponents of the regulations maintain that markets usually place their interest above the best benefit of the society. Thus, interventions in the regulations are necessary.
Regulations are considered to provide a strong and focused control over the activities that are deemed important by the society. In the meantime, regulations can be seen as the strict process for performing and action in the corporate environment such as in order to set up, manage and end an organization, one has to follow the regulations laid out in the corporations’ law (Sloan, 2001). But regulations should not be considered as “negative” as it helps in managing, controlling and getting results from various business activities. For example, the rules and checks that are built into the regulations, give people the confidence that these regulations would not allow people to step out of their authority and conform to the regulatory requirements; that are developed keeping their interests in perspective.
The move from governments brought light into the issue of regulating the accounting processing in the industry. Accounting is primarily responsible for providing relevant information for decision making required to make decisions of economic nature. This information is prepared by accountants and professionals in the industry which are responsible for maintaining the record of the financial and accounting data for the company. This information is published in the annual financial reports as well as the stock exchange helping investors to make informed decisions.
Moreover, there are regulations relating to the application of taxes as well as the procedure through which organizations are formed and established. The statutory and financial requirements ensure that the organizations are capable of meeting their financial and corporate responsibilities (Bushman and Landsman, 2010)
Hence, regulations play an integral role in the functioning of daily business organizations in the modern world.
There are a large number of operations that need regulations as they contain data that is critical for efficient operation of the organizations. This information should not be put at risk and placing regulatory requirements on its collections and maintenance is a safe way to ensure the efficiency of the accounting process (Hoogendoorn, 2006).
Arguments against regulation
Nonetheless, there are a number of perspectives on the issue of regulating the financial markets. The critics of the idea present the argument that these regulations are not needed as the market player’s act in an efficient manner to serve the society and efficiently utilize their resources.
Characteristics of ‘principles-based’ and ‘rules-based’ standards
A standard consist of principles and rules that apply to given accounting issue (Nelson, 2003). Schipper (2003) suggested that accounting standards in US are more rules-based but often based on principles while IAS and IFRS are more principles-based.
According to ICAS (2006), principles-based accounting standards are based on a conceptual framework. They suggest that such standards “require a clear hierarchy of overarching concepts, principles that reflect the overarching concepts and limited further guidance” (ICAS, 2006). The principles-based deliver a comprehensive way in preparing the financial statement yet has the flexibility to overcome any situations. Sarbanes-Oxley Act of 2002 required the SEC to assess the viability of a principles-based accounting system. The SEC focused their studies on “objective-oriented” standards, which is similar to FASB’s definition of principles-based standards but Benston et al., (2006) propose that it is more optimal as it offer a narrower framework that limits the scope of professional judgement but allowing more flexibility.
In 2008, Grant Thornton issued a White Paper suggesting six high-quality characteristics of principles-based accounting standard. This include; “faithful presentation of economic reality, responsive to users’ needs for clarity and transparency, consistency with a clear Conceptual Framework, based on a defined scope that addresses a broad area of accounting, written in a clear and understandable language, use of appropriate judgment” (Grant Thornton, 2008). Benston et al., (2006) agrees that principles-based tend to have more professional judgement. The practice of professional judgment is reinforced to give a true and fair view of the organisation’s performance.
The fundamental advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. Precise requirements can sometimes compel managers to manipulate the statements to fit what is compulsory.
According to Nelson (2003), rules-based standards have more ‘bright line threshold’, more rules, have more scope exceptions and large volume of implementation guidance. Example for bright-line rules-based standards is the managing of capital lease and operating lease. The principle contrast being that a capital lease might need to show up on the asset report of the carrier whereas operating lease do not need any recording. Two distinguishable lease transactions are characterized contrastingly based upon the GAAP renting guidelines (Maines, 2007).
Rules-based increases the comparability especially when accountants and regulators have different opinions on interpretation of accounting issues.
The FASB developed rules-based standards to increase verifiability for management, auditors and regulators who seek for a clear view of accounting issue. This is related to the reduction in litigation as guidance to protect them from any lawsuits or criticism for aggressive reporting (Benston et al., 2006). If organisation fails to conform to these rules, it has to face legal consequences due to the fact that investors entrust the organisation to meet the regulatory requirements and make their decisions based on the interpretation of financial data.
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Regulators often prefer rules to avoid unpredictable of later enforcement. Rules reduce discretion of preparer making their judgement less likely to be motivated by the yearning of personal benefits (Coglianese et al., 2004). Moreover, some managers prefer rules-based standards as business arrangement to prepare financial statement. To achieve desirable financial result, they get to gain opportunities by lobbying for treatment of different type of business arrangements (Maines, 2007).
Why are ‘principles-based’ standards more useful than ‘rules-based’ standards?
Many commentators have suggested that the US accounting standard is more rules-based. Rules are thought to be simple but in reality it could complex and easily be manipulated. For instances, tax regulations are mainly rules-based causing problem to arise when organisation start a new transaction not under the rule guideline. Making it difficult for auditors to clarify the inconsistencies (Coglianese et al., 2004). Benston et al., (2006) agree that the complexity of rules can become dysfunctional when the economic changes or when managers structure transactions that meet the rules. Therefore, there’s no need to reduce earnings management and improve the quality of financial reporting because mangers’ will eventually find his way to meet rules by violating them that overcompensate for judgemental discretion. Thus, many regulators are now leaning towards the principles-based approach.
Application of rules-based according to Schipper (2003) is undesirable because the ‘check-box’ mentality tend to risk the quality of financial reporting whereas principles-based exercises professional judgement. Regulators believe that rules-based approach foster creative accounting, neither comprehensive nor comparable. It is a delusion that rules-based could completely eliminate risk of litigation. Instead of rules-based, principles-based accounting systems provide a true and fair framework with effective communication that are required by stakeholders. Risk of litigation will always remain but principles-based will minimise the risk (ICAS, 2006).
Rules exist because a standard is based on poor principles. Using applicable principle would reduce the need of having detailed set of rules, therefore complexity of the rules could be minimised and standard will increase its comparability (Nobes, 2005). Furthermore principles-based standards are meant to provide a more precise accounting statement reflecting the company’s performance reason because as the used of principles-based increase, manipulation of rules would reduce.
Study result shows that corporate managers prefer principles-based. Objectives are yet again the flexibility when they could report what they believe of the consequences, beneficial of forecast earnings and if management reimbursement is related to their target (Philips et al., 2010). The study have also indicated that principles-based focus more on reporting the true economic circumstances, however with that much liberty auditors might challenge management’s misappropriation of standards. Thus, focusing on one or the other standard will not necessary solve the transparency of financial reporting.
There are two matters to take into consideration when engaging into principles-based standards. The issues are to reduce the weighting given to comparability relative to other qualitative characteristics in the conceptual framework and to increase professional judgement in both transaction and financial statement (Bennett et al., 2006).
Problems standard setters have in promulgating standards that are ‘principles-based’
Accounting standards are promulgated to assist the objective of financial reporting; some parties believe that collapse of a company was caused by the incompetent standards. Problems standard setters find promulgating principles-based standard is because rules-based standard is favourable at times. Rules-based standards are able to achieve qualitative characteristic of comparability in financial reporting whereas principles-based are not able to. Criticism of principles-based arise when uncertainty of the standard reflects a risk of regulator sanctions. Uncertainty can be accepted only if regulator agree to the firm’s interpretations and respond correspondingly (Black, 2007). Level of uncertainty will increase if standard setter developed internal understanding of the guideline not shown in the firm’s statement. Moreover, applying principles-based standard will have diminishing effect on the aggressive reporting than strengthening audit committee. (Agoglia et al., 2011)
According to Coglianese et al., (2004) move to principles-based may rise problem such as insufficient training to make professional judgment, therefore training will be required. Moreover in the absence of rules, managers may disclose biased information thus company may need to professional resolve (Maines, 2007). Managers do not always apply accounting standards in good faith, they are always biased and now with the flexibility of principles it is criticised that rise of potential for earning management (Nelson, 2003). Providing suitable resolve may be challenging because auditors find difficulty in predicting how principles will be applied to certain litigation. Despite the limitation of rules-based, some standard setter would still prefer rules to principles just to avoid both uncertainties and litigations.
We can conclude from this discussion that accounting has been not been able to receive a complete regulatory pack that can provide a theoretical foundation for the financial accounting domain. The individualistic approach to developing these theories has not been successful because they miss out on some important factual information. Globalization has caused a number of challenges to the accounting domain as more and more companies have moved their systems from manual to computerized systems. Therefore, regulators face a raising problem of devising regulations that ensure the integrity and confidentiality of the accounting information.
There are many mixed feelings regarding the ideas to regulate accounting. However, despite the mixed opinions, the idea to regulate accounting is strong. It is not only the responsible thing to do, but it will also safeguard the public form companies and fraudulent activities that could occur. To not regulate accounting laws and practices will only leave room to gather more mistrust in the accounting.
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