Accounting Regulation: Word Count: 1195 Table of Contents:Page 1. 0 Argument in favour of tight accounting regulation: 1. 1 Introduction3 1. 2 The agency problem3 1. 3 Comparability of financial statements3 1.
4 Auditing4 1. 5 Auditor’s independence concerns4 1. 6 Credibility of financial reporting4 1. 7 Conclusion5 2. 0 Argument in favour of “Free market” regulation: 2.
1 Introduction6 2. 2 Information needs6 2. 3 Market for managers7 2. 4 Market for Corporate takeovers7 2. 5 Auditing7 2.
6 Conclusion7 3. 0 Summary of both arguments and position taken:8 . 0 Footnotes:9 5. 0 References:10 1. 0 In favour of tight accounting regulation: 1.
1 Introduction: Since the share market crash of 1929, accounting regulation has been introduced and developed to avoid further economic disasters.
Tight regulation of accounting standards provide users of financial information with reliable and accurate information free of charge that will contribute to informed and educated decision making. The aim of the following paper will be to support and confirm the need for tight regulation of accounting standard setting process. 1. 2 The Agency Problem: Management have more knowledge of the firm than outsiders such as shareholders and debt holders and could theoretically create individually tailored and individually audited financial reports to every financier.
Active trading in primary and secondary markets would mean that the number of separate contracts could become very large and thus strict uniform accounting standards have evolved as a low cost and efficient solution to a potentially expensive agency problem. 1. 3 Comparability of financial statements: The development of global businesses has led to demands for greater international comparability in financial reporting. Improved comparability benefits both producers and users of financial statements. Producers would achieve cost savings by avoiding the restatement by translation of accounting information, and there would be more efficient decision making by capital providers.
Financial markets would also become more liquid and competitive resulting in less information risk and a lower cost of capital to firms. 1. 4 Auditing: The free market perspective assumes that auditing will take place in the absence of regulation and thus reducing the risk to shareholders.
However how are these auditors going to effectively evaluate and analyse a company’s financial statements without a financial reporting framework to adhere to? The tighter the regulation of accounting standards, the more efficient the auditors conduct will be. External audits will be much more expensive and time consuming to comprehend the particular accounting methods the company chooses to adopt if high regulatory standards are not in place. 1. 5 Auditor’s independence concerns: Auditor’s independence has been a significant issue in recent times which has contributed to major corporate collapses such as HIH and Enron. If tight regulation is not in place auditors will need to continually interact with management to comprehend the accounting methods chosen by management.
This continuous interaction with management could represent a potential risk to the auditor’s independence and possibly lead to the public witnessing further corporate failures. 1. 6 Credibility of financial reporting: A question posed by Lafferty (1979) was “How do you explain to an intelligent public that it is possible for two companies in the same industry to follow entirely different accounting principles and both get a true and fair view audit report? The public may want to know how many true and fair views there are and whether there is any common standard against which to measure them all. ” 1. 7 Conclusion The agency problem solution and the comparability of financial statements both act to significantly reduce costs to the firm.
The continuous interaction between management and auditors would be a considerable risk without regulated standards and is a leading incentive to maintain strong regulation of accounting. Tight regulation of accounting standards is necessary to ensure shareholders and debt holders receive an optimal amount of information to make an informed decision. . 0 In favour of “free market” regulation: 2. 1 Introduction: The “free market” perspective on accounting regulation is the theory that demand and supply forces should be allowed to freely operate so as to generate an optimal supply of information about the entity. This approach would reduce the government’s regulatory authority over accounting standards and grant corporations with the power to decide which accounting methods best suit their businesses.
The aim of this paper will be to indicate and discuss the potential benefits to corporations of adopting a free market approach to accounting regulation. . 2 Information needs: A reduction of regulation would witness organisations that do not produce adequate financial information penalised by higher costs of capital. A lack of detailed information to supply debt holders with would increase the risks associated with any finance to be obtained and therefore incur higher interest rates on any loans. This would then encourage managers to produce the necessary information in the financial statements to all users without the forces of regulation. Firms whose managers acquire a reputation for failing to disclose bad news are less likely to be followed by analysts and money managers, thus reducing the price and/or liquidity of the firms stocks.
2. 3 Market for managers: Without regulation management are encouraged to adopt their own strategies to maximise the value of the firm. These strategies, if effective, would provide a favourable view of their own performance which will be known to prospective employers and be reflected in their future salaries as well as positive price movements for the firm. An optimal amount of accounting information would also need to be provided in order to achieve an effective strategy that would increase the value of the firm. 2.
4 Market for Corporate takeovers: In an active market, under – performing organisations may be taken over by another entity, with the existing managerial team possibly replaced. Managers are therefore motivated to maximise their firm’s value to avoid this happening. They will be encouraged to provide any information required by the market to minimise the cost of capital and thereby increase the value of the firm. . 5 Auditing: In the absence of regulation a contractual demand would be in effect to have the financial reports audited by an external party. The audit will then improve the reliability of the financial information which will then in turn be expected to reduce the perceived risk to shareholders and debt holders resulting in further decreases to the firm’s costs of capital.
2. 6 Conclusion: Regulation of accounting information is deemed to be unnecessary as the market will punish those who do not disclose, or who do not disclose enough information. Personnel reputations and the risk of a corporate takeover serve to motivate managers to provide all the necessary information to interested parties in the absence of accounting regulation. Audits would also prove to be effective at reducing the firms cost of capital if no accounting regulation existed. 3.
0 Summary: A free market approach entrusts in the market to either discipline or reward management based on the financial disclosure decisions, whereas regulation of accounting standards does not rely on the market to enforce disclosure provisions as these are already made mandatory through regulation. A strict and uniform accounting structure provides a solution to a potentially expensive agency problem. On the other hand the free market approach does not provide a means for eliminating management’s ability to individually tailor separate financial statements to outsiders. Without a solution to this problem, firms would be exposed to greater costs, and debt holders to greater risks. The free market approach relies heavily on external auditing to prevent potential increases to costs of capital in the absence of regulation, however the auditors risk breaching their independence via this approach where accounting regulation would require much less interaction and therefore lower risks.
The regulation of accounting standards provides comparability of financial statements that significantly reduce translation costs and costs to capital. The free market perspective on the other hand will incur greater translation costs and increased costs to capital without the ability to compare financial statements. The above points support the continuation of tight regulation of accounting standards as the free market approach cannot account for all the significant issues that surround financial reporting. The tight regulation of accounting standards stands as the most efficient and effective method for financial reporting. 4.
0 Footnotes: 1. Brown, P, & Tarca, A 2001, ‘Politics, Processes and the future of accounting standards’, Abacus, Vol. 37, no. 3, p. 268.
2. Brown, P, & Tarca, A 2001, ‘Politics, Processes and the future of accounting standards’, Abacus, Vol. 37, no. , p. 275.
3. Lafferty, M, (1979) ‘Why it is time for another leap forward’, accountancy, p. 51. 4. Skinner, D.
J. (1994), ‘Why firms voluntarily disclose bad news’, journal of accounting research, 32(1), p. 40. 5. 0 References 1.
Brown, P, & Tarca, A 2001, ‘Politics, Processes and the future of accounting standards’, Abacus, Vol. 37, no. 3, pp. 267-96. 2.
Lafferty, M, 1979 ‘Why it is time for another leap forward’, accountancy, p. 51. 3. Skinner, D. J.
1994, ‘Why firms voluntarily disclose bad news’, journal of accounting research, Vol. 32, no. 1, pp. 38-60.