Due to the advent of globalisation and liberalisation of the various economies worldwide, the function and utility of accounting has changed drastically. From merely being a recording system to compute profit and losses it has transformed itself radically to serve the needs of various stakeholders in making various economic decisions. One of the major aspects of accounting is to provide information to all the stakeholders who may not have access to the necessary information to contemplate transfer of funds to the organisation. This information asymmetry has paved the way towards accounting regulations. There always have been arguments of one or the other kinds over the necessity of regulations. Some says that regulations hamper the regular and natural working of the organisation and others contradict that by citing that regulations are indispensible in the proper working of the capital markets and also to boost the confidence of the investors.
History of Regulations
In the 19th century, due to the benefits the industrialisation brought in Britain, the government thought it to be unnecessary to intervene in the free market scenario. The theory of laissez faire or ‘invisible hand’ by Adam Smith was being used as the rationale behind the approach. But soon government had to intervene to stop the socially undesirable economic activities like long working hours, inhumane conditions, dangerous working situations etc., which led to acute poverty and despair among the people. The accounting regulations however became an issue after 1929. Before that available accounting information was largely unregulated. The main reason might be the fact that before that there was a limited separation between ownership and management and thus the primary purpose was only internal reporting to the owner. But with increased degree of separation between ownership and management the requirement for a sequential reporting process arose. It started with Congress empowering the SEC to assume the task of regulating the financial reporting. The backdrop to this was the economic depression and chiefly the stock market crash which affected many people. However, SEC allowed the accounting policy making power to remain in the private sector, first with AICPA and then with FASB. Oversight was maintained by SEC. Accounting professional bodies worked hard to maintain a regime of self regulation as SEC was getting more sceptical about the working of the same. Major differences continued throughout the rest of the 20th century between SEC and accounting profession on various issues which raised the questions about the aptness of self regulation scenario. The scandals like Enron, Tyco and World Com further acted as fuel to fire and huge public pressure on the government led to the passing of Public accounting reform and investor protection act 2002 (commonly known as SOX).
The main idea behind the regulatory framework is to reduce the information asymmetry, boost the confidence of the investors, increases the credibility and reliability of the financial reports and thus leads to the overall smooth working of the capital markets.
While financial reporting is a regulated activity and is possibly to remain as such, it is useful to evaluate the arguments for and against regulations to give us an insight about the nature of the regulations and its influence on various parties.
ARGUMENTS AGAINST UNREGULATED MARKETS
Those who support deregulation they advocate it on the grounds that accounting information should be treated like any other commodity and the people(users) must pay for it to the degree it has use to them. They further argue that firms have various incentives on disclosing the financial information to the users and thus they do it voluntarily to exploit the benefits from disclosures. The regulations only put a tab on their freedom to choose the type and the extent of information to be disclosed. Following are some reasons cited in favour of unregulated markets.
* There are incentives for the firms on voluntary disclosures. The capital markets require information and any organisation that fails to provide the timely information will be looked down upon by the markets. As in the absence of the information the owner and the other stakeholders will assume that the manager is operating the firm in his own benefit (agency theory). This will lead to the increase in the cost of capital and also hinder the remuneration paid to the manager. Thus it is in the interest of the manager to do the timely financial reporting and keep the agency costs low. As the manager has self interest in the whole reporting activity, he will also insist upon the reports being audited by an external auditor to increase the authentication and also reduce the cost of raising capital.
* The firms compete with one another for scarce risk capital, and voluntary disclosure becomes vital in order to compete successfully in the market for raising capital. In the absence of information, the capital market will assume the organisation to be a lemon i.e. no information will be viewed as bad news. Thus the organisation will be motivated to produce both good information and bad information about financial reporting and performance. Arguments that market will penalize organisation for failure to disclose information assumes that market knows that the management has something to disclose. But as seen with Enron, Parmalat, World com this anticipation is somewhat unrealistic.
Besides sometimes withholding some vital information could be in the interest of the organisation for the fear that competitors might exploit it.
Agency theory predicts and explains the behaviour of parties involved with the firm. Managers are hired by the owners of the firms to administer the activities o the firm. Goals of managers and owners may not be in perfect agreement and owners will try to mitigate these by keeping an eye on the manager and thus it will cost the owner and thus manager’s remuneration is related to this cost. Higher the cost lowers the remuneration and vice versa.
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* In order to kill competition the stronger firm will always remain on a hunt to take over the underperforming organisation and eventually will replace the management team as well. Thus the manager has his self interest and motivation to maximize the value of the organisation so that there are no fears of takeovers. This factor further is based on the fact that the manager is aware of the marginal costs and benefits associated with providing the information and it will provide the information to the extent where
* Marginal costs equate the benefits. But it again seems somewhat impractical as the cost benefits analysis is not easy to allocate.
* The advocate of unregulated markets believes in efficient market for managers as well capital market efficiency. The manager’s previous performance will have an impact upon the remuneration and perks he’s offered in future, either from the current employer or elsewhere. Thus the manager will do his level best to increase the value of the organisation and disclose full information as his own reputation is at stake. But this again would not always hold good in the scenario when the manager is approaching retirement and he might not be concerned about the reputation anymore. Further it’s unrealistic to assume about markets being totally efficient.
* Anyone who desires information about a firm beyond the point that is available publically and free of charge can do so by privately contracting for the information with either the firm, owner or indirectly with intermediaries such as stock analysts by making a payment. Information newsletter available on subscription is an example for the same. Thus even if there is not full voluntary disclosures there are opportunities for private contracting. A review of the stock exchange will reveal that there are many people that are willing to pay and get the information privately.
The arguments cited above have explained that there is no need for mandatory disclosures. The manager himself will make sure to disclose the necessary information due to various incentives. Reporting to the capital market is based on the competitiveness of the same and finally it is argued that any other information can be obtained by contracting privately and there is no need to overfeed the investors as there are huge costs attached to the same.
ARGUMENTS SUPPORTING REGULATED MARKETS
The major reason cited for regulations is that it is in the public interest. To protect the public from the frauds and failures it becomes justified to put some sort of regulations. Following reasons support the arguments.
* As firm being the monopoly supplier of information, it can under produce the information than required and also charge monopolistic prices for the same. Thus it would lead to the problem of market failure when there is sub optimal allocation of resources and the intervention of government becomes necessary. This problem can be curbed by making public disclosures mandatory. This will lead to a cost effective means of getting firm specific information than private contracting.
However the free market counter argues that owing to the competitive nature of the capital markets, the firms have an incentive to report the information voluntary about itself. Further individuals have a lot of investment opportunities available, firms won’t be able to charge monopolistic prices.
* The auditing and financial reporting fiascos have always made the government and the public question the free market approach .Recent corporate failures and frauds undetected and not signalled in advance like Enron, Parmalat, Worldcom, Satyam etc have signalled towards the need of better regulations to raise the quality and standards of financial reporting. Due to the competitive nature of capital markets and cut throat competition managers in the short run might be instigated to provide misleading information to raise capital or serve some other motive. Regulations protect the public from such situations. However corporate frauds and failures don’t always imply towards flaws in financial reporting. Risk is inherent in the investments and regulations can only reduce it not eliminate it.
* As accounting is a public good in the sense that accounting information can be freely transferred from one person to another; and anyone can consume it by not paying for it. This will make the firms to under produce it due to the fear of free riders and thus they don’t have an incentive to produce it as they won’t be able to charge for the same and opportunities to private contracting will also be little. Thus intervention becomes more or less vital.
* Even if there are no market failures still social goals are not in the agenda of the private sector unless imposed by the government. The regulating authorities all over the world have always been concerned about fair reporting and protection of investors. Fairness in reporting comes from when all the investors have the equal access to the same information. This is called information symmetry and regulation of insider trading is an example of this. This is a social goal and free markets are not always capable or may be motivated to achieve this.
The above arguments states that as accounting is a public good, it is unrealistic to leave dissemination of accounting information on the forces of demand and supply. It can’t be treated like other goods. Since users of financial information can obtain it at no cost(there can be free riders),producers will tend to under produce the information than required. Further to protect the insiders trading which leads to information asymmetry, regulation of some sort is a must.
Thus regulations are put in place by the regulators in the public interest. However a counter view is quoted by the proponents of ‘economic interest theory of regulation’. As according to this approach the members of the regulatory body can’t be totally free from the bias and they have their own self interest attached to the whole process. They might be seeking being re elected or election funding and thus they will enforce those regulation that benefit them rather the public. Capture theory also argues that the regulator eventually is captured by the regulated and thus the whole process of regulation is a gimmick.
SURPLUS OF REGULATIONS:
Regulations are not always ideal and they can be excessive as well. This problem mainly affects the accountant, user of the information and the management. The accountant if burdened by too many formalities and red tape then he might be diverted from the main task which is fair reporting. Users of the information will also be affected as too much of technical and flowery language leaves them baffled and perplexed. Management will always be concerned about the cost and benefit analysis and thus will try to pass on the cost to the consumers as there is too much cost attached with hiring auditors and preparing so many pages of reports.
Who will regulate
If we accept the need for regulations then the question arises is who will regulate? Private sector advocates that as they have experience and knowledge they must be allowed to regulate on the other hand supporters of the public sector favours that government should be given the task as it has the enforcement powers. The best solution would be if both the govt. sector and the private sector work together as knowledge, experience and enforcement will be the key to benefit the society and the profession.
Conclusion
The arguments against and for the regulations forces us to ponder over why to regulate, who regulates and who pays the cost? In reality voluntary disclosures is beneficial for the reasons already cited. Yet there are justifications for the mandatory disclosures; for example standardisation of accounting will lead to the uniformity between companies and thus comparisons will be easier to draw. Besides mandatory public reporting leads to the fairness in the capital markets. As most of the information is produced as a by product of the firm’s accounting data, cost of producing the information will be low as compared to the social benefits. But there is no way to determine what and how much is beneficial and exactly what is optimal. The arguments against regulations puts across that there are incentives for the firms for voluntary disclosures and thus they will report. However the focus of regulations is not only on reporting but on the quality of information reported. The emphasis is on the refining and unifying the systems used in the preparations of financial statements and thus helping the public make investment decisions wisely and also leading towards proper functioning of capital markets. Only the adoption of regulations won’t serve any purpose unless enforced by the authorities and strict actions to be taken against the defaulters. Regulations coupled with suitable internal control measures and good corporate governance only will lead to desired results. The decision to regulate or not to regulate and further which standards to adopt varies from country to country and a lot many factors like cultural, legal systems, political systems, state of economy, social factors affect the choice. For example the choice of standards and disclosure norms will certainly be different in USA than from Afghanistan or other developing countries. But the profession and authorities in any country should work towards making the dealings of the companies more transparent and also managers and auditors accountable. This can only bring back the lost faith in the capital market and the profession.