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Financial Accounting Issues

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With the spate of recent corporate failures there have been increased criticisms and calls for regulatory reform of existing accounting and auditing practices. The issue of regulation within the accounting profession has been highly contentious and led to many debates. Those in favour of a free-market stress that market forces will optimise the allocation of resources and as such regulation is not necessary. Whilst those opposing this view believe that markets are imperfect and as such outside intervention in the form of regulation is required. Both sides hold valid arguments as to why regulation is or is not necessary and this paper shall examine these opposing views before providing an informed opinion.

The anti-regulation or free-market approach to accounting is one that has been subscribed to for many years. The main thrust of the American Institute of Accountants in 1934 was anti-regulation, they stressed that, “no attempt [should be made] to restrict the rights of corporations to select detailed methods of accounting deemed by them to be best adapted to the requirements of their business” (May 1934, 80). The argument behind this notion is that the natural market forces or the “invisible hand” of the market will ensure self-regulation. Ross (1979, 379) implies this when he writes, “…disclosure regulations are generally neither required nor desirable, since left on their own, firms will have incentives to report accurately”. The belief that firms have internal incentives to report accurately is the crux of signalling theory. This theory holds that firms can increase their value through full disclosure and firms that fail to disclose will be seen in a negative light. Hence, every firm has reason to engage in financial reporting in order to lower its cost of capital. This incentive makes it a self-regulating system with no need for outside intervention as firms will innately disclose openly to the market due to the financial benefits obtained (Hakansson 1983).

Further to the anti-regulation argument is that the political process to develop and enact regulation is seen by free-market supporters as open to manipulation by lobbying groups and the self-interest of the regulators. Taylor (2009, 319) puts forward the view that self-interest within the political arena can impact the decisions of the law makers. Watts and Zimmerman (1979) go further stating that legislators decision making will be influenced by the impact those decisions may have on their future political career and Lev (1988, 11) adds to this by stating, “… [there is an] argument that regulators are not really concerned with economic efficiency or with equity… [rather they are] seeking to transfer wealth among competing interest groups”. This brings into question the influence that powerful lobby or interest groups can have on the regulators. Such groups invest heavily in the pursuit of favourable regulations which can lead to the development of regulation that is not necessarily effective or efficient, yet costly (Drever, Stanton and McGowan 2007, 73).

The next logical argument within this same issue is the difficulty that is found in altering or removing regulation that has been enacted. This issue is even more significant when you examine the relative speed with which key pieces of legislation relating to regulation have been drawn up. Taylor (2009, 320) points out that high profile accounting scandals across the world have led to public outrage followed by swift legislative responses that, “…were implemented in a very short period”. He goes on to argue that such drastic changes to legislation should involve rigorous research to consider the possible effects on the market rather than such a knee-jerk reaction. In these circumstances it takes time for the full implications to be understood and such legislation that is swiftly enacted is not so easily revised or withdrawn.

On the other side of debate are the advocates of regulation. Proponents of regulation within accounting generally fall into one of two categories; supporters of rules-based regulation or principles-based regulation. Rules-based regulation is seen as pure regulation in that it sets rules that remove ambiguity and contribute to certainty and enforceability, while principles-based seek more flexibility allowing professional judgment to be used (Wustemann and Wustemann 2010, 19). Principles-based supporters argue against strict rules by stating that such rules fail to capture the particular circumstances of individual cases and allow preparers to manipulate transactions to circumvent the rules (Wustemann and Wustemann 2010, 17).

The initial advantage that regulation was deemed to provide was the protection of public interest (Gaffikin 2005, para. 18). Regulation was considered necessary to correct imperfect or inefficient market systems, in other words to protect the public when the market failed. Such market failures have been seen throughout the years and regulation seeks to firstly stop the failure from occurring and in so doing maintain or build the public confidence that surrounds the financial statements (Drever, Stanton and McGowan 2007, 72). Other advantages of regulation, such as the standardisation of financial statements and increased communication also add to the strength of public confidence in the market.

The standardisation of reporting seeks to maximise the comparability of financial statements. In order to achieve standardisation regulation is used to limit options concerning disclosure and in so doing increase the resulting consistency. The supporters of rules-based regulation use the issue of the comparability of financial statements to argue against the less stringent principles-based accounting standards. They state that the ambiguity of principles-based accounting standards dilutes the comparability benefit that disclosure regulation provides (Wustemann and Wustemann 2010, 1). In other words, by providing limited options rather than strict rules to follow the desired consistency is not attained. Either way, regulation regarding disclosure requirements will provide a level of consistency that ensures users will be able to make informed comparisons between the financial statements of different organisations (Deegan 2007, 35).

The final benefit of regulating the disclosure of financial statements to be examined is the increase regulation provides in the magnitude of information communicated. Lev (1988, 3) identifies that information asymmetry does occur without regulation and the consequences borne out are high transaction costs, low liquidity and decreased gains from trade. To combat this information asymmetry and avoid the consequences that Lev talks of regulators set disclosure requirements to ensure the information flows to the extent deemed necessary (Drever, Stanton and McGowan 2007, 72). Drever, Stanton & McGowan go on to state that for a market to be truly efficient it requires perfect competition and to achieve this level of competition the market needs perfect information. Regulation steps in to ensure this information flows.

This paper has examined key arguments from both sides of this issue. It has shown that theoretically the market will self-regulate and regulation has the capacity to create inefficiencies but it has also identified that market failures are a reality and regulation is a tool to guard against these failures.

I believe that the free-market theory holds a lot of weight but ultimately it is just that, a theory. The idea that individuals or organisations will fully disclose information as it is in their best interest may hold true in some situations but ultimately it is debunked by history. History has shown us that imperfections within markets do exist and that markets do fail due to the actions of individuals and organisations. The effects of these failures can be and have been monumental and as a result there needs to be something put in place to mitigate such failings. As such I believe that some form of regulation is required within the accounting profession to direct it in the best path.

I also believe that regulation creates inefficiencies within the market as the arguments above have pointed out but the benefits that regulation provides far outweigh any of these inefficiencies. I see the most important benefit of regulation being is its ability to standardise financial statements and in so doing allow greater comparability. This comparability increases public confidence in the financial statements and the accounting profession and reduces the asymmetry of information which in theory allows for an increase in productivity.
In closing, I do believe that regulation is required within the accounting profession but I feel that the next step and possibly a more important question is what form of regulation should be implemented within the accounting profession?

Reference List

Deegan, C. 2007. Australian Financial Accounting. 32-45. Macquarie Park, N.S.W. : McGraw-Hill.

Drever, M., P. Stanton and S. McGowan. 2007. Contemporary Issues in Accounting. Singapore: Wiley.

Gaffikin, M. 2005. Regulation as Accounting Theory. Working Papers. http://ro.uow.edu.au/accfinwp/50 (accessed March 10, 2010).

Hakansson, N. H. 1983. Comments on Weick and Ross. The Accounting Review 58 (2) : 381-384.

Lev, B. 1988. Toward a Theory of Equitable and Efficient Accounting Policy. The Accounting Review 63 (1) 1-22.

May, G. O. 1934. American Accountants and Corporation Audits. The Accountant, 2 June 1934.

Ross, Stephen A. 1979. Disclosure Regulation in Financial Markets: Implications of Modern Finance Theory and Signalling Theory. In Issues in Financial Regulation, ed. F. R. Edwards, 177-202. New York: McGraw-Hill.

Taylor, S. 2009. Capital Markets Regulation: How Can Accounting Research Contribute? Australian Accounting Review 51 (19) : 319-325.

Watts, R. L. & Zimmerman, J. L. 1979. The Demand For and Supply of Accounting Theories: The Market For Excuses. The Accounting Review 54 (2) 273-305.

Wustemann, J. & S. Wustemann. 2010. Why Consistency of Accounting Standards Matters: A Contribution to the Rules-Versus-Principles Debate in Financial Reporting. Abacus 46 (1) 1-27.…...

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