Chapter 4 - Financial Accounting Flashcards
Free Market Perspective
- Provision of accounting information should be based on the laws of supply and demand rather than on regulation.
Invisible hand, Adam Smith. Even though Smith, stated that there is need for some regulation.
- Argues that there are private economics-based incentives for the organisation to provide credible information otherwise the cost of the organisations operations would rise (e.g. higher cost of attracting capital). The perception of the risk will increase, and managers will be assumed to be operating for their personal gain.
- Based on Agency Theory proponents assert that there will (naturally) be conflicts between external owner (such as shareholders) and internal managers (because it is assumed that everybody acts in their own self-interest), and the cost of these potential conflicts will be mitigated through the process of private contracting and associated financial reporting.
Likewise there will be contractual demands for independent auditing. - Government regulators are not objective, but like everybody else are driven by their own self-interest. They will introduce regulation that ultimately benefits them, or particularly vested interests.
Market related incentives
(i) Market for managers, (ii) market for “corporate take overs” and (iii) market for lemons.
Market for “managers”
The “market for managers” argument relies on an assumption that there is an efficient market for managers, and that managers previous performance will impact on how much remuneration they are able command in future periods, either from their employer or elsewhere. Even in absence of regulation managers will be incentivized to provide financial reporting as this is linked to reducing the cost of capital but more broadly in past performance. Does the market for managers operate efficiently, is all past information available? And if managers approach retirement do they consider future employees evaluating their past performance?
Market for “Corporate Takeovers”
Works on the assumption that an underperforming organisation will be taken over by another entity that will see opportunities for financial gain. Therefore managers will be incentivized to maximise organisational value which in turn will lead to information being produced as this minimise the cost of capital thereby increasing the value of the organisation. Managers will know the marginal costs and marginal benefits involved with providing information.
Market for “Lemons”
There is also a perspective that, even in the absence of regulation, managers would still be motivated to disclose both good and bad news about their organisations financial position and performance. Such a perspective is often referred to as the “market for lemons”, the view being that in the absence of disclosure, the capital markets will assume that the organisation is a “lemon”. That is, the failure to provide information is viewed in the same light as providing bad information. Hence, even though the organisation may be worried about disclosing bad news, the market may make an assessment that silence implies that the organisation has very bad news to disclose (otherwise it would disclose it). May incur “reputational costs” to if managers do not disclose bad news in a timely manner.
Corporate failures such as Enron and WorldCom indicates that the market will not always know that there is information available to disclose.
Pro-regulation perspective
Enlightened self-interest
This would be in operation when managers of an organisation respond to community concerns (as if to appear to be caring) in those situations where doing so also fulfils the goal of maximising the value of the organisation, and therefore the wealth of owners and managers. Can be tied to free-market perspective.
Public interest theory
In line with the pro-regulation approach.
A theory of regulation which suggests that regulation is developed in the public interest. Regulators are assumed to be motivated by the public interest and will select regulation on the basis that the social benefits of the regulation exceed the social costs. For example, the introduction of the Sarbanes-Oxley Act which was introduced in the “public interest” in order to reduce the risk of large corporate collapses and poor accounting and auditing practices, and in turn increase the confidence of investors.
However, proponents of the economics based assumption of sel-interest would argue that the government acts in self-interest when introducing new regulation. Perhaps to increase the likelihood to be re-elected.
Capture Theory
This theory suggests that although regulation is often introduced to protect the public, the regulatory mechanisms are often subsequently captured so as to protect the interests of particular self-interested groups within society, typically those whose activities are most affected by the regulation.
E.g. particular industry bodies, or large organisatins within an industry, are known to offer jobs to people who previously worked within regulatory bodies.
Economic interest group theory (private interest theory)
This theory of regulation assumes that groups will form to protect particular economic interest. Private interests are considered to dominate the legislative process. The expectation is that the product – in this case regulation - will ultimately be demanded by, and supplied to, those parties who value it the most. Regulation is viewed as a product which is allocated to particular constituents in accordance with the basic principles of supply and demand. Particular industry groups may lobby the regulator to accept or reject a particular accounting standard.
Regulation is put in place to serve the private interests of particular parties, including politicians who seek re-election. Hence, power of lobbier plays a big role.
