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REGULATING THE FINANCIAL REPORTING SYSTEM

Accounting Theory and Contemporary Issues ---- DFA4100

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Assignment Title:
Discuss the arguments for and against regulating the financial reporting system.

Submitted by:
Names:

Muruganandam Payaniandy (Student ID 1217700)

Course

Bsc (Hons) Financial Management (LCLM400)

Module:

Accounting Theory and Contemporary Issues - DFA 4100

Total words: 1,663

Introduction
History attests to the influence of crisis and scandals as an impetus for regulatory intervention
by politicians. After a series of scandals in the United Kingdom in the 1990s, there was a
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dramatic shift in the structure of financial regulation that consolidated regulation


responsibilities under the auspices of the Financial Services Authority. Today, in the
aftermath of the financial crisis of 2007-2009, financial accounting standard setting finds
itself entangled in political processes focused on restructuring the regulation of the worlds
financial markets. The crisis has ignited worldwide debate on issues of systemic risk and the
role played by financial regulation in creating and exacerbating the crisis. Proposals abound
for how regulation of financial markets and financial institutions should be changed to
mitigate the potential for such large-scale financial meltdowns in the future. The scope of
regulatory issues under debate spans many aspects of the financial system, including the
alleged role played by financial accounting standards in deepening the trajectory of the crisis.
The crisis has energized politicians, regulators, and economists to scrutinize financial
accounting standards as never before. Hence we will lay out basic arguments that have been
put forward both for and against the regulation of the Financial Reporting System..

This study will critically help us to understand whether regulation of the FRS
is necessary or not.

The argument for regulating the financial reporting system.

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Regulation of a profession is a specific response to the need for certain standards to be met by
the members of that profession. When a profession such as accounting that provide important
public services, it is imperative that serves and act in the public interest. The sustainability of
the accountancy profession depends upon the quality of service provided and capacity to
respond effectively and efficiently to demands of the society and economy. Regulation seeks
to ensure the right quality and consistency in the services provided.

There are various factors that move towards the fact that the financial report system should be
regulated.

The Market Failure Argument

One explanation is market imperfection. In a capital market without market imperfection,


firms will trade off the cost and benefit of disclosure and voluntarily disclose the efficient
level of accounting information. In that case, there is no need for regulation. However,
accounting information is perceived as a public good, as such, under provision of same would
lead to a market failure thus justifying the need for regulating. Scott (1997, p. 329) defines
market failure as an inability of market forces to produce a socially right amount of
information, that is, to produce information to the point where its marginal cost to society
equals its marginal benefit. Non regulation of this particular services would lead to an
underproduction of information and would not be able to meet with the demand of the market
for information

The Level Playing Field Argument

It suggests that all the people or entity should have access to same information on the basis of
fairness. This is the basis of law that prevents insider trading.
Very often Management are exposed to insider dealings which they can use in their
advantage to make more money, thus making this information erode potentials investors.
Hence regulation is necessary to enhance the confidence of all stakeholders that they are all
playing on the same level field.

Public Interest Theory

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The public interest theory stipulates that regulations should be able to benefit the society on a
whole rather than the interest of a particulate group. The regulation is provided in response to
the demand from the public for corrections to inefficient and inequitable markets. Thus,
regulation is pursued for public, as opposed to private, interest related objectives. When
corporate are disclosing only financial performance of organizations but they are disclosing
other non-financial but relevant information such as environmental and social impact of the
organizations activities, initiatives of the organizations to improve the undesirable impact of
their activities on the society and environment. With reference to the public interest theory it
is a rationale decision to introduce the legislation which mandates for the corporate to
disclose the impact of their activities on the society and environment and also disclose the
initiatives taken by them to protect the society and the environment from the adverse impact
of their activities.

Capture Theory

Regulatory capture is a theory associated with George Stigler, It is the process by which
regulatory agencies eventually come to be dominated by the very industries they were
charged with regulating. Regulatory capture happens when a regulatory agency, formed to act
in the public's interest, eventually acts in ways that benefit the industry it is supposed to be
regulating, rather than the public. Therefore regulation is a must to prevent these things to
happen.

Economic Interest Group Theory/ Private Interest Group Theory

The private interest theory of regulation assumes that groups will form to protect particular
economic interests. Different groups are viewed as often being in conflict with each other and
the different groups will lobby government to put in place legislation that economically
benefits them (at the expense of others). As an example, consumers might lobby government
for price protection, or producers lobby for tariff protection. This theoretical perspective
adopts no notion of public interest rather, private interests are considered to dominate the
legislative process. The regulatory outcomes reflect the interests of the most powerful
group(s). Posner asserts that this theory is committed to the strong assumptions of economic
theory generally, notably that people seek to advance their self-interest and do so rationally.
According to Stigler, the central task of the theory of economic regulation is to explain who
will receive the benefits or burdens of regulation, what form regulation will take, and the
effects of regulation upon the allocation of resources.

The argument against regulating the financial reporting system.

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Although, regulation is vital to the accounting profession and the business environment, there
are many theories which tend to favour reducing if not eliminating regulation.

Deegan, 2004 argues that regulation is not necessary because:

Financial information will reach its optimal supply level in response to demand.
Capital markets will penalise companies that do not provide correct and sufficient
financial information.
Users typically do not bear the costs of providing informationleading to an
oversupply of information at the expense of companies.
Regulation will restrict companies from adopting accounting practices that best reflect
a companys performance, solely because some other companies will abuse of the rule
to manipulate their performance.

THE FREE MARKET PERSPECTIVE


It often provides a perspective that accounting information should be treated like other goods,
and demand and supply forces should be allowed to operate so as to generate an optimal
supply of information about an entity.

Jensen and Meckling, Watts and Zimmerman, Smith and Watts are supporters.

The argument by some advocates of the free-market perspective is that in the absence of
regulation there will be private incentives to produce accounting information. Organizations
that do not produce information will be penalised by higher cost of capital. Hence the Free
Market perspective is against the idea of regulation since accounting information is
considered to be a good whose demand and supply will determine the optimal amount of
information to be generated by an economic entity.

Example:

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Shareholders will require information so as to minimise agency cost of equity and maximise
firms value and they hence will make contractual arrangements with the managers on the
basis of profit tied bonuses. Debt holders will also require information on gearing and interest
cover to determine an appropriate weighted cost of capital in accordance to the level of risk
the company is exposed to. As such, there is automatically a supply of information that is
created, since managers would like to provide information, especially to investors and
creditors to show good performance.
Market for Managers Theory
In accordance with this theory, even in the absence of regulation, managers will be motivated
to adopt strategies that will maximise the value of their organisation and also report this
performance. This voluntary disclosure of information about the organisation's past
performance will influence their future remuneration, in the same company or elsewhere. The
excellent reputation they would have built as a result of their performance, translated in the
annual reports, is expected to be impounded in their future salaries, assuming the labour
market is efficient.

Market for Corporate Takeovers Theory


This theory puts forward that if an organisation is not performing at its best, then it becomes a
target of a possible takeover where the actual management team will be replaced. In order to
prevent such a situation from arising, the agents would be motivated to maximise the firm's
value and report the firm's performance even in the absence of regulation.

Market for Lemons Theory

Market for Lemons perspective will encourage companies to provide information since no
information is viewed as bad information. By not disclosing information, the company gives
the signal that there are problems with the profitability, or that there may be bad news
regarding both the liquidity and solvency of the firm. The shareholders will lose confidence
in the company and withdraw their investment by selling their shares, which results in share
price falls, leading to the company losing value. Therefore, even in the absence of regulation,
managers would disclose both good and bad news voluntarily. It should be noted that the
Market for Lemons Theory assumes that the market knows that managers have some piece of
news to disclose which is assumed to be bad.

Conclusion
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We have explained the arguments for and against regulation of the Financial Reporting
system. We have gone through the theories describing compliance with regulation is
necessary and also, in the other hand, seen in the free market perspective that information is
considered to be a good whose demand and supply will determine the optimal amount of
information to be generated by an economic entity. But which theory to adopt will depend on
the perception of person dealing with this information.

Referencing:
Accounting Theory and Contemporary Issues ---- DFA4100

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The manual on Accounting Theory and Contemporary Issues.


http://public.kenanflagler.unc.edu/faculty/bushmanr/Bushman_and_Landsman_ABR_
3-2010.pdf
http://ro.uow.edu.au/cgi/viewcontent.cgi?article=1049&context=accfinwp
www.umanitoba.ca/faculties/management/acctfin/.../9.../group132.doc
http://www.studeersnel.nl/nl/document/university-of-melbourne/financial-accountingtheory/lecture-notes/lecture-notes-about-financial-accountingtheorypdf/267588/view?auth=0&auth_prem=0&prem_doc=1
http://www.um.edu.mt/fema/studyunit/ACC2112
Gaffikin, M.(2005) Regulation as Accounting Theory, Accounting & Finance
Working Paper05/09, School of Accounting & Finance, University of Wollongong
http://greg-accounting.blogspot.com/2012/12/capture-theory-and-regulation.html
Bushman and Landsman. (2010) The Pros and Cons of Regulating Corporate
Reporting, Kenan-Flagler Business School University of North Carolina

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