Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

First, we consider a number of theories that are relevant to the practice of accounting and
auditing. We discuss the theory of efficient markets and agency theory to understand the
setting in which financial reporting occurs. We consider three specific theories of regulation,
which have been proposed to explain regulation in capital markets. The theories are public
interest, regulatory capture and private interest theory. In the next section, we consider
how the three theories apply in practice.

THE THEORIES OF REGULATION RELEVANT TO ACCOUNTING AND

AUDITING
Capital market theorists suggest that managers have many incentives to voluntarily provide
accounting information to parties external to the firm, and to have that information verified
by independent auditors. So why do we observe regulation of financial reporting through
company law and accounting standards? Why do most countries have legal requirements to
produce audited financial statements?
There are several theories which are relevant to understanding the regulation of financial
accounting reporting (i.e. the preparing, auditing and supply of accounting information
about an entity).
They include: - theory of efficient markets, agency theory, theories of regulation - public
interest, regulatory capture and private interest.

THEORY OF EFFICIENT MARKETS

Free market economists would argue that markets function best without government
intervention and that maximum efficiency is achieved by allowing forces of supply and
demand to dictate market behavior. In the world's increasingly international capital
markets, forces of demand and supply have a large influence on the flows of information
and capital. However, governments also actively intervene in these markets, regulating not
only how markets are conducted but also the provision of information which has been
described as the 'lifeblood' of capital markets.

Accounting can be seen as an information industry; that is, the business of accounting is to
produce information. Advocates of the free-market approach argue that, as with any other
product, demand and supply forces should operate. There is a demand for accounting
information by users and a supply of such information from companies in the form of
financial statements. An equilibrium price therefore can theoretically be found for
accounting information.

Suppose a new type of financial information is demanded by users and a supplier is willing
to provide it for a price. The price will finally adjust to one where the supplier still finds it
advantageous to furnish the information and users believe the cost is equal to or less than
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

the benefits of the information. If not, then the information will not be provided. In other
words, free-market forces can determine what type of accounting data to provide and the
necessary standards that underlie them.

Accounting information cannot be considered in the same way as other products, because it
is a 'public' good. Once the information is released by a company, it is available to everyone.
Although the information may be sold to certain people only, others who did not pay for it
cannot be easily excluded from using the information.
This phenomenon is referred to as the 'free-rider' problem. Because not all users can be
charged for the cost of producing the accounting information, suppliers will have minimal
incentive to produce it. Only regulatory intervention can persuade companies to produce
the information necessary to meet real demand and to ensure an efficient capital market.
Even if free market existed for accounting information, a regulatory board would still be
needed because users are unable to agree on what they want and accountants will not
agree on the procedures to derive the desired information.

AGENCY THEORY

The demand for financial information can be categorized as being either for stewardship or
for decision-making purposes. Atkinson and Feltham state that agency theory considers
mainly the stewardship demand for information. The theory concentrates on the
relationships in which the welfare of one person (e.g. the owner) is entrusted to another,
the agent (e.g. a manager). Atkinson and Feltham explain that the demand for stewardship
information relates to the desire to motivate the agent distribute risk efficiently.

Information is valuable if it improves the allocation of resources and risks in the economy. It
does this by reducing uncertainty. Uncertainty in agency theory can be classified as ex ante
or ex post. Ex ante (before the event) uncertainty exists at the time a decision is to be made,
such as uncertainty about controllable events that will affect production or uncertainty
about the skill of the manager. Ex post (after the event) uncertainty exists after the decision
has been made and the results realized. This uncertainty is the same as ex ante uncertainty
except that it can be reduced by ex post reports on what actually happened. Agency theory
focuses on the impact of alternative ex post reports that affect ex post uncertainty.

Agency theory gives us a framework in which to study contracts between principals and
agents and to predict the economic consequences of standards. For example, it is often
logical that managers' compensation be tied to reported profits or they may have less
incentive to achieve profits. In this situation, one type of contractual relationship is between
users of accounting data and the company. Contracts for financial data can be alternatives
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

to public reporting. If accounting were 'deregulated', the market mechanism could generate
sufficient information and reach a socially ideal equilibrium point where the cost of
providing the information equals the benefits. Supporters of this view argue that mandatory
disclosures are therefore unnecessary and undesirable because market forces can be
depended on to generate any desired information. Moreover, advocates argue, required
reporting tends to create overproduction of information. Since the cost of producing
information is not borne by users, they will demand more and more information. An
authoritative body, such as the IASB, may be misled by this exaggerated demand and,
consequently, prescribe more disclosure of information than necessary.

THEORIES OF REGULATION

PUBLIC INTEREST THEORY

The central economic reason for the origins of government intervention in the operations of
various markets in the 'public interest' is that of market failure. Within this theoretical
framework, regulation is intended by legislatures to 'protect consumer interests by securing
improved economic performance. . . compared with an unregulated situation.
A potential market failure occurs when there is a failure of one of the conditions necessary
for the best operation of a competitive market. Examples of potential failures include:
-lack of competition (monopoly, oligopoly)
-barriers to entry
-imperfect information gaps (information asymmetry) between buyers and sellers or
-certain market signals (e.g. seller reputation) the 'public-good' nature of some products
(e.g. financial information), where the provision of the product to a single individual makes
it equally and costlessly available to other individuals. Market failure occurs here because -
since other individuals can receive the product free of charge - the normal pricing system in
the market cannot function.

Public interest theory is based on the assumption that economic markets are subject to a
series of market imperfections or transaction failures, which, if left uncorrected, will result
in both inefficient and inequitable outcomes.

REGULATORY CAPTURE THEORY

A second theory proposed to understand regulation of financial reporting is capture theory.
This theory maintains that although the 'purpose in fact' or origin of regulation is to protect
the public interest as discussed above, this purpose is not achieved because, in the process
of regulation, the regulatee comes to control or dominate the regulator. Capture theory
assumes, firstly, that all members of society are economically rational; therefore, each
person will pursue his or her self-interest to the point where the private marginal benefit
from lobbying regulators just equals the private marginal cost. Regulation has the potential
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

to redistribute the wealth, Therefore people lobby for regulations that increase their
wealth, or they lobby to ensure that regulations are ineffective in decreasing their wealth.'
Second, the capture view assumes, as with public interest theory, that the government has
no independent role to play in the regulatory process, and that interest groups battle for
control of the government's coercive powers to achieve their desired wealth distribution.

PRIVATE INTEREST THEORY

A third theory has emerged in response to dissatisfaction with explanations provided by
both the public interest and the capture theories. The assumptions of these theories, that
regulation comes into existence as a result of government response to public demands to
rectify inefficient or inequitable practices by individuals and organizations, was strongly
challenged in 1971 by George Stigler. The basic theme of Stigler's challenge is that
governments have one basic resource which 'is not shared even with the mightiest of its
citizens: the power to coerce'. This 'power to coerce' is a potential resource or threat to
every business firm in that with its power to prohibit or compel and/or to provide or
withdraw taxes and subsidies, the government can and does selectively help or hurt many
businesses.
Stigler argues that regulatory activity reflects the relative political power of interest groups.
Their interaction is with politicians who are not neutral arbiters (as in the public interest and
capture theories) but, rather, are like business executives or consumers, and are thus
rationally self-interested. The politicians seek to maximize their chances of future electoral
success. Government officials will 'sell' aspects of their right to coerce others in the form of
supplying regulatory programs and legislation, which will act to enhance their ability to win
votes and raise money to finance election campaigns.
Stigler's second assumption is that government officials, like business executives or
consumers, are rationally self-interested. They seek to maximize their votes (if they are
elected officials) or their wealth (if they are appointed officials). or both. 'Producer' private
interest groups can supply these resources by providing campaign contributions and
political advertising to elected officials and lucrative opportunities for post-government
employment.
Thus, regulation can simply be seen as a device for transferring profits to well organized
groups in the form of subsidies, price-fixing, control of entry of political competitors, and
suppression of the production of substitutes if the groups will return the favor with votes
and contributions to politicians. 'The theory [therefore] predicts that regulators will use
their power to transfer income from those with less political power to those with more.

HOW THEORIES OF REGULATION APPLY TO ACCOUNTING

AND AUDITING PRACTICE
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

We explored a number of theories of regulation, which have been proposed to explain the
regulation of accounting and auditing. We now consider the application of the public
interest, capture theory and private interest theories in practice.

APPLICATION OF PUBLIC INTEREST THEORY

Under public interest theory, governments intervene in the regulation of financial reporting
in response to market failure and 'in the public interest'. The basic argument is that market
mechanisms have failed and government action is necessary for the greater good. The
introduction of the Sarbanes-Oxley Act in the United States in 2002 following the collapse of
the Enron Corporation and the audit firm Arthur Andersen can be viewed through the lens
of 'the public interest'. New financial reporting and corporate governance requirements
were introduced and new standards and oversight structures for auditors were created.

An earlier example is the Australian government establishing the Accounting Standards

Review Board (ASRB) in 1984. The government's intervention in the accounting standard
setting process is seen as justified by failures in the market for accounting information,
evidenced by the significant number of corporate collapses even after auditors had certified
accounts as 'true and fair'. Similarly, calls for stricter accounting standards or for changes in
standard setting processes following major corporate collapses in the late 1930s and early
2000s (Enron and Worldcom in the United States; HIH and One.Te1 in Australia) are seen as
justified under the public interest theory.

Corporate collapses are deemed to indicate that there were serious violations of
competitive conditions. The violations stemmed from information asymmetries between the
suppliers (corporate management and accounting professionals) and external financial
statement users (investors) who do not know what accounting information they need
and/or are unable to determine the value of the accounting information they receive.

APPLICATION OF CAPTURE THEORY

Walker argues that although the Australian government originally introduced the ASRB to
ensure the protection of the 'public interest, he believes capture theory is more applicable
in explaining the events. He argues that the board was successfully captured by the
accounting profession, the regulated industry.
Basically, Walker's argument is that the accounting profession needed to legitimize
accounting standards (that is, ensure compliance with the standards) which could be
achieved only by standards that had the 'force of law' by ensuring that accounting standards
were backed by legislation. However, the accounting profession had an economic interest in
retaining the standard setting process, which it did not want to relinquish to the
government. In turn, therefore, the only way the profession could both legitimize
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

accounting standards and maintain its economic interests was to 'capture' the ASRB, the
body that had the power to make accounting standards mandatory for corporate entities.
Under the capture view, regulatory intervention in the accounting standard setting process
was designed, as with the public interest theory framework, to protect the public interest.
However, Walker's study portrays the accounting profession as an elite group that, in effect,
was not accountable to the public interest, which sought and achieved control of the
standard setting process for its own gain, and which was constrained only by the fear of
state intervention.

Application Of Private Interest Theory

Private interest theory provides another approach to understanding behavior of parties with
an incentive to influence the regulation of financial reporting. Rahman sought to apply the
private interest theory of Stigler, Posner and Peltzman to the establishment of the ASRB.
Rahman's conclusion was that there were several limitations in Walker's study. He asserted
that a systematic review of the Board's organization and functions indicated that the Board
was dependent on and susceptible to influence from several interest groups. Thus, while
Rahman confirmed the influence of the accounting profession on the preparation and
review of standards, he also found that other parties secured important roles that enabled
them to constantly scrutinize and influence the Board's activities.

From this perspective, the accounting profession did not 'capture' the standard setting
process in Australia. Rather, it could be argued that the producer group, which is well
organized and capable of wielding significant political influence compared with either the
accounting profession or the much larger but more diffuse 'user' group, became extensively
involved in, and ultimately controlled, the debate on the regulation of the standard setting
process in the 1980s. Arguably, it did so in order to achieve a particular form of regulatory
intervention which 'secures them from over-deregulation.

A limitation of these theories of regulation is that they are not mutually exclusive, that is,
events explained by one theory may be explained equally well by another theory. It is not
clear that a single explanation can be defended.

THE REGULATORY FRAMEWORK FOR FINANCIAL REPORTING

In the preceding discussion, we have referred to many parties with an active role within the
financial reporting environment. They include the preparers of the financial reports
(company directors and their executives and managers) and a company's external auditors
as well as the rule-makers, such as private sector groups, stock exchanges and governments
and their agencies. The activities of these parties will be influenced by the environment in
which financial reporting takes place; that is, its legal, economic political and social setting.
The specific environmental features of the financial reporting environment make up what
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

can be called the regulatory framework of financial reporting. While regulatory frameworks
vary between countries, they often have common elements. We outline these elements
below to provide an overview of the regulatory framework for financial reporting and to
demonstrate how the elements of the regulatory framework influence the output of the
financial reporting process - the financial statements. The elements of the regulatory
framework which we discuss are: statutory requirements corporate governance auditors
and oversight independent enforcement bodies.
STATUTORY REQUIREMENTS
The key participants in the production of financial reports are corporate directors (and their
executives and managers) and independent auditors. Elsewhere in this book, we have
explained that there are many motivations for managers to voluntarily provide financial
information and to have that information independently verified through the audit process.
Now we turn to the role of statutory requirements as an incentive to produce financial
statements and have them audited. In many countries company law mandates that
directors provide audited account. Thus a primary influence on directors and auditors is the
need to fulfill statutory reporting requirements, as contained in company law. On the one
hand, company law will likely mandate basic requirements relating to which reports are to
be prepared and their frequency of preparation. But it may also include particular
requirements relating to the information to be included; for example, in Australia
companies must disclose information about their environmental performance. Additional
financial reporting requirements are derived from specific accounting standards and in
many jurisdictions these standards have the force of law. For example, listed companies in
the European Union that prepare consolidated financial statements are required by law to
use IASB standards adopted by the EU.

CORPORATE GOVERNANCE
Another important element within a country's regulatory framework is the system of
corporate governance. Davis takes a broad view of corporate governance and states that it
refers to 'the structures, processes and institutions within and around organizations that
allocate power and resource control among participant. Some corporate governance
practices are derived from laws which require directors to carry out specific actions in
relation to the management for their companies. For example, requirements to hold
meetings with shareholders and to disclose matters of interest such as directors'
remuneration and related party transactions are basic corporate governance matters -
which may be covered by company law.

AUDITORS AND OVERSIGHT

In many countries auditors perform a vitally important function in providing assurance
about the quality of information provided by companies in their financial statements. It is
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

common for the auditing profession to be regulated in some way. The most basic form of
regulation of the profession is limiting of membership to persons with particular
qualifications and experience and requiring registration to practice. Other forms of
regulation involve requiring membership of a professional body and commitment to an
ethical code of conduct. Professional bodies may also sanction members in breach of their
rules.

INDEPENDENT ENFORCEMENT BODIES

A study by the FEE includes an independent enforcement body as part of the overall system
for enforcement of financial reporting requirement. The role of such a body in the
regulation of financial reporting is to promote compliance with the regulations governing
the production of financial statements, which are contained in law, and accounting
standards.

THE INSTITUTIONAL STRUCTURE FOR SETTING ACCOUNTING AND AUDITING

STANDARDS
The development of international accounting standards began formally with the formation
of the International Accounting Standards Committee (IASC) in London in 1973. The
committee comprised representatives of professional accounting bodies from nine countries
(Australia, Canada, France, Japan, Mexico, the Netherlands, the United Kingdom and
Ireland, the United States and West Germany). Its aim was to develop accounting standards
for the private sector suitable for use in countries throughout the world. Prior to 2005,
International Accounting Standards (IAS) were influential in the following ways. They were
adopted for use in countries without a national standard setting structure; for example in
Papua New Guinea and Indonesia. In other cases, they were used in the development of
national standards, such as in Singapore and Hong Kong. IAS were also used voluntarily from
the early 1980s in the consolidated accounts of companies from countries such as
Switzerland and Germany.

The members of the IASC hailed from countries with a range of accounting practices and
different approaches to setting accounting standards. Early IASC standards often allowed a
choice of accounting policy to include the preferences of various member nations. During
the late 1980s the IASC began work on the Improvements Project, to improve the quality of
IAS and remove many optional treatments. Although use of IAS throughout the world was
increasing, further acceptance was limited by the fact the IASC was not an independent
standard setting board. Consequently, it was restructured in 2001 to create the
International Accounting Standards Board (IASB), an independent board based on the
structure of the Financial Accounting Standards Board (FASB) in the United States. The
board comprised fourteen full-time members, chosen for their expertise and experience in
professional accounting and standard setting. It was supported by dedicated technical staff,
located in London.
Faculty: FZC Chapter 3- Lecture Notes Accounting Theory

The IASC Foundation became the oversight body of the IASB and an interpretations
committee was formed. The IASB has responsibility for updating existing IAS (which still
carry the IAS label) and producing International Financial Reporting Standards (IFRS). The
importance of the activities of the IASB increased dramatically with the decision in 2002 by
the European Commission (EC) to adopt IASB standards in 2005. The EC announced that all
listed companies in European Union (EU) member countries would prepare consolidated
accounts based on IASB standards. This fundamental change was an important step
promoting the production of more transparent and comparable financial information by
listed European companies.

THE IASB AND FASB CONVERGENCE PROGRAM

The work program of the IASB was further complicated by the announcement of the IASB/
FASB convergence program, called the Norwalk Agreement, in 2002. The FASB was formed
in 1973 and is highly regarded throughout the world as a leading standard setter. The FASB
has power delegated by the SEC to develop standards for financial reporting for listed
companies. It has produced several accounting concept statements and a series of financial
reporting standards focusing on providing high quality financial information which is useful
for decision making. In the meantime, the IASB/FASB convergence program has generated
considerable work for both Boards. It complicated the process of producing the 'stable
platform' of standard for 2005 as the IASB was working to this aim while at the same time
considering the extent to which standards could be revised to converge with US GAAP. The
convergence program requires the FASB and IASB to identify differences between their
respective standards, to review available solutions and to adopt the better treatment. In
practice, convergence is a complicated process. Some of the differences arise because of
underlying differences between the two sets of standards. US GAAP have been described as
rule-based standards while IAS aim to be principles-based.