Public Interest in Theories of Regulation - Essay Example

? Financial Accountancy Table of Contents: Sl.No. Particulars Pg. No. Essay Public Interest in Theories in Regulation Situation Private Interest Theory Situation 3 4 5 5 Essay 2 Costs and benefits of Harmonizing Standards 6 Essay 3 Culture has no Influence on Accounting Practices 9 Essay 4 Agency Theory and Its Relation to Accounting 12 Essay 5 Meaning of Efficient Markets and Efficient Market Hypothesis 15 Essay 1: Public Interest in Theories of Regulation: Theories of regulation pertain to the explanation of allocation of resources in a market economy. Managers have a general responsibility of regulation and legitimacy towards financial accounting. Market mechanisms determine the resource disbursements and managers only have to report the statements according to the established accounting standards. However, due to various reasons, managers tend to voluntarily correct market imperfections to their advantage and give a wrong picture to the investors. Theories of regulation help us to find solutions so that investors do not get exploited. Public Interest in theories of regulation pertains to allocation of resources in a regulated manner to safeguard the best interests of public. These distributions may be haphazard or aimed towards satisfying fewer people’s interests, if not regulated. This failure of markets may occur due to several reasons such as: Absence of competition Monopolies try and create barriers of entry to other interested firms Asymmetry of information Products of public goods are produced The scarce resources get deployed towards their purposes with little resources remaining for other requirements. So, to avoid such discrepancies public interest of regulation has to be undertaken by the Government. (Hertog J.D., 1999) The Government will also intervene due to its own personal interests of: Gaining votes To act before any demand from public interested groups arises Acting as neutral arbiters before the issue becomes a problem However, there are cases where Governments also have failed as regulators as they are captured by self-interest of individuals who formed groups. The accounting professionals who have not confirmed themselves to self-regulation and legitimacy have thought of a way out of their irresponsibility. They started capturing the regulator and dictating it through manipulation of accounts. This is possible because accountants argue whether to release relevant or reliable information to the investor. In the guise of these terms, they undertake accounting standards which serve their interest and avoid regulation. Situation: The Act of Sarbanes-Oxley of 2002 is a classic example in this scenario. Public interest has made it mandatory that financial reporting has to adhere to the principles of corporate responsibility. Out of some eleven sections, 6 are construed to be very important as far as compliance matters. The gist of these sections is that financial reporting authorities have to prove their credibility very early by establishing detailed policy of financial security. They cannot relax till the end and try to capture public interests. They are required to report according to the IFRS mandates to the investors. (Anon. 2006). As per this mandate, Accounting Standards should also take into account social and economic consequences so that relevant and reliable information is pronounced to the investors. Private Interest Theory: This theory is based on the assumption that Government is not a neutral arbiter as supposed in public interest theory. It is in fact self-interested rationally due to various reasons such as: To avoid dispute with people of financial power during re-election To transfer their power readily if people who can help them in re-election so require. If they are in power, they would like to increase their wealth by doing so. If not in power, they want to attain power and so listen to these private individuals. There are many examples of private interest. The Oil Spill in Deep Waters in 2010 would help us in understanding the process of domination of private interest over regulatory board. The regulatory authority, MMS (Minerals Management Service) was restructured due to its irresponsibility into BOEMRE after the Oil Spill. This was further divided into three other agencies with Lease power vested to Department of the interior. This restructuring was aimed at regulating the awarding to lease contracts to environmentally responsible parties to avoid such disasters in future. However, to this day, it is reported that lease grants are done basing on previous reports of MMS and research done by the Lessees like BP who were the parties of contract in the catastrophe. This instance explains the procedure of discouraging expertise in the field and blindly believing private interest construers. This misnomer is accepted in the name of exclusionary category and the lease is still accepted, speaks about victory of private interest over regulator. (Anon. 2012) Situation: The recent Greek bailout wherein 50% of Credit Default Swaps were written down to save the economy from pre-supposed worse financial situation is also an example of accounting deregulation. The contenders to the benefits were the parties themselves, who have initiated the swaps. They have secretly met and voted to elude from 50% of the obligation all by themselves. That means they have the right to create swaps and also evade from obligation in their own hands. This proves the victory of private interest over regulatory authority. (Spitzer. E., 2012) Thus, we can understand that public and private interests always dominate the scenario of regulation. These theories are so much inter-twined that they are now never mutually exclusive. The games of power and wealth always motivate these interests to entangle with regulations thus disrupting investor’s information. References for Essay 1: Hertog. J.D. “General Theories of Regulation.” (1999) Web: 13th April, 2012. http://encyclo.findlaw.com/5000book.pdf. “Sarbanes Oxley Act.” A Guide to the Sarbanes-Oxley Act. (2002). Web: 13th April, 2012. http://www.soxlaw.com/index.htm. “Scientific Integrity.” Union of Concerned Scientists, (2012). Web: 13th April, 2012. http://www.ucsusa.org/scientific_integrity/abuses_of_science/mms-badscience.html Spitzer. E. “Credit-Default Hypocrites.” Slate.com. (2012). Web: 13th April, 2012. http://www.slate.com/articles/business/the_best_policy/2012/03/credit_default_swaps_how_wall_street_is_gaming_the_greek_bailout_.html. Essay 2: Costs and benefits of Harmonizing Standards: Accountancy should adhere to concepts of relevance. The investors should be informed about the relevant information regarding the firm in which he is interested. These concepts pertain to measurement, disclosure of processes, globalization methodologies, trade relations, compliance to various regulations, a responsible approach to changing economic conditions. It is the voluntary responsibility of every manager to provide such accounting information. There was always deviation to these reporting standards due to reasons of private interest. Thus, regulatory authorities felt the need of harmonizing accounting standards. This is a step towards improving market efficiency and reduces the need of regulation. However, as customary with any initiation, harmonization is also associated with some costs. The costs also need to be categorized in view of: Politically powerful non-EU economies and Non-powerful non-EU economies. In the case of politically powerful non-EU, the major likely costs could be: 1. Switching costs from the existing Accounting Standards to the IFRS. In this journey, there is also a discouragement to local expertise which has developed over time to suit the needs of the existing systems. 2. Opportunity costs associated with switching: During the time of switch, the related market participants are supposed to learn new systems and hold back from practicing their old habitual systems. This may take a lot of time. They may feel that, had they not invited this switch, they would have made more money and with more convenience. This is the opportunity cost. 3. Training costs for the market participants: Even though the market participants are willing to shift, they need to be trained to cater to the requirements of highly developed capital markets while confirming to the new IFRS standards. These costs need to be borne by the economy. 4. Costs related to market risks: There can be inhibitions in the market traders that they may either take this shift positively or negatively. Their encouragement can improve the level of capital markets while their disapproval can prove negatively. This risk is mainly in case of powerful non-EU economies as the systems are highly developed and quality is already established in the existing systems. With regard to non-powerful non-EU economies, the major costs could be similar to that of powerful economies with an exception of market risk costs. This is because non powerful non-EU economies view harmonization as beneficial to their country as they can avail improved means of financial resources for their businesses. Thus, there is limited risk of capital market fluctuation. The benefits associated with these costs are: 1. Accounting transparency: The regulators are forced to adhere to set standards and thus cannot manipulate numbers for their benefit. There is a lot of debate continuing in this regard. For example, IAS 39 which stipulates for fair value recognition has to clauses in it. a. All financial instruments of any financial institution should be recorded to its fair value in the net income. b. Losses or gains of an instrument could be offset to a corresponding qualified hedged instrument’s gain or loss. The trifling issue is that, qualifying another hedged instrument to the former is very difficult as qualifying on the grounds of similarity seldom occurs. There are views of accepting IAS 39 with a carve-out clause for fair value realization into IFRS. But, many propounds of IFRS are not accepting this suggestion. Their conception is that, if this clause were accepted, the main benefit of transparency would be thwarted even if IFRS is adopted. 2. Arrest of transfer pricing: This is done by institutions which have their presence in many countries. They transfer goods to economies in which there is no or less taxation. These goods are further delivered to the destined economy. In this way, they can avoid taxes. This could be arrested if IFRS is adopted globally. 3. Cost efficiency: As they already have quality in their hands, once market participants get trained in the new systems, they will have more work and more pay thus leading to cost efficiency. Not only that, over a period of time, these costs also reduces and almost become zero. 4. Better access to and Enhanced participation in the global capital markets by traders. 5. Convenience of comparison of financial statements sector to sector and even industry to industry for establishing peer competence. 6. Investor risk is reduced. 7. Reduction in audit costs. 8. Costs of preparing reports and their portability would also be reduced. These all will lead to better capital market efficiency as all abovementioned benefits are pre-cursors for efficiency. Comparison of costs to benefits is always done to know the net effect of such exercise. Similarly, only comparison of the costs enumerated towards adoption of IFRS and benefits have to be compared to realize the net effect. Research suggests that, though there is a debate of adoption of some standards and procedures to IFRS, benefits for adoption can never be overruled. The only hitch being that politically powerful non-EU countries are reluctant to adopt IFRS as they view domination of EU in IFRS implementation as a major obstruction. However, they are also falling in line of adoption after series of debates in this manner. Thus harmonization of accountancy to IFRS though may incur costs at the inception, it will lead to benefits which can regularize accounting and encourage expertise in the field. (Cullen. L., 2010), (Ray. K., 2010) & (Armstrong. C., Barth. E., Jagolinzer. A.& Riedl. E., (2006)). References for Essay 2: Cullen. L., (2012). Accounting (Decision Analysis) 308., PPTx 3. Australia. Curtin University. Ray. K., (2010), One Size Fits All? Costs and Benefits of Uniform Accounting Standards. Mc Donough School of Business. Available at: http://faculty.msb.edu/kr268/Papers/one_size_sum.pdf Last Accessed: 13th April, 2012. Armstrong. C., Barth. E., Jagolinzer. A.& Riedl. E., (2006). Market Reactions to Events Surrounding the Adoption of IFRS in Europe. U.K. Stanford Press. http://gsbapps.stanford.edu/researchpapers/library/RP1937.pdf Essay 3: Culture has no Influence on Accounting Practice: The statement though technically should be true, is not unfortunately reality in the accounting scenario. Several researches have understood that interpretation of accounts is done very differently by accountants in diverse countries basically due to their cultural differences. The differences were enunciated in terms of: Avoidance of uncertainty Orientation for long-term Lower individualism and A bit suppressed masculinity These researches identified economies of diverse cultures (Brazil VS U.S. etc) and also accounting standards which required personal judgment for analysis of financial statements. The standards like IAS 18 which recorded contract profit and IAS 11 pertaining to recording of contractual loss were more researched as they required personal judgment in their interpretation. They observed that the main two values of accounting namely, secrecy and conservatism are affected the most due to diverse cultures. Reflections of core values in the culture were influential for some accounting practices pertaining to: Statutory VS Professionalism: Individual preference whether to adhere to professional regulation by self or achieve compliance to statutory and legal control requirements Flexibility VS Uniformity: Enforcement of accounting practices and following them uniformly over a period of time or judging according to the circumstances giving way for flexibility. Optimism VS Conservatism: A perspective of risk-taking as against to approach of caution by the management. Transparency and Secrecy: Whether there is more inclination towards transparency of disclosure or towards maintaining secrecy. It has been observed that there is a difference between an authority of statute and its enforcement levels with regard to disclosure and measurement characteristics of financial accountants. The cultural values that are shared in a society lead to values which shape accounting systems and also systems of the nation as a whole. The implications which are practically applicable are that of accounting standards which require personal judgment for financial analysis. (Doupnik. T.S., & Riccio. E.L., (2006)). The simple understanding is that the more tolerance levels of a society, the less can they be driven towards harmonization of IFRS. The idea behind being that tolerance breeds individual agreeability, flexibility, optimism and secrecy. It is observed in nations which have low financial power and non-EU economies, tolerance levels are high with regards to accounting deviations. The vice-versa is also true with regards to economies which have efficient capital markets and more financial power. With respect to accounting perspective if the country is conservatism oriented, the accountants prefer to defer assets and income which may report higher net income. This culture is usually associated with avoidance of higher uncertainty, low individualism and higher orientation of achievement. This may act as a distortion to preparation of uniform IFRS. Similarly national culture also influences the resident accountants to interpret IFRS in their own thought process rather than the principles on which IFRS have been built. For example in the case of construction loss in contracts (IAS11), German accountants would assign a 66% chance of occurrence in case of a probable loss than their U.S. counterparts who would assign 74% for its occurrence. Thus, we can conclude that Germans are more conservative even in realizing income as well as loss than U.S. Thus cross country comparison of financial statements may be difficult. It was found that only 33% U.S. accountants would recognize a lawsuit in the financial statement as a contingent asset while 65% of Greek accountants were convinced to do so. Similarly recognition of contingent liabilities was to the tune of 84% in U.S. while only 56% responded positively in Greece. Thus, we can understand that the cultural differences in countries may influence the interpretation of IFRS statements. Similarly, Greek and Brazilian accountants favored more secrecy than their U.S. counterparts in reporting contingencies in financial statements while German and French favored recording higher estimates of warranty than U.S. accountants. (Tsakumis. G.T., Campbell. D.R., & Doupnik. T.S., (2009)) & (Chan K.H., Lin K. Z., & Mo P.L.L., (2003)). Effects of culture on Accounting: These distortions in IFRS due to diversities in culture could have a negative in the harmonization of IFRS thereby leading to negative capital markets. Moreover, taking the cue of culture, there may be many instances where accountants could manipulate accounts for their personal interest and tax avoidance. Thus, we need to understand that culture exerts its influence in the financial statement analysis in the first instance. Efforts need to be made to minimize such effect so that uniformity in IFRS could be achieved to realize the pre-conceived benefits. References for Essay 3: Chan K.H., Lin K. Z., & Mo P.L.L., “An Empirical Study on the Impact of Culture on Audit-Detected Accounting Errors.” Questia: Journal Article. (2003). Web: 13th April, 2012. http://www.questia.com/googleScholar.qst?docId=5002446728. Doupnik. T.S. & Riccio. E.L. “The influence of Conservatism and Secrecy on the Interpretation of Verbal Probability Expressions in the Anglo and Latin Cultural areas.” (2006) Web: 13th April, 2012. http://www3.uma.pt/eduardog/IMG/pdf/Article_Riccio_-_Doupnik_IJA_Cross_Cultural.pdf. Tsakumis. G.T., Campbell. D.R., & Doupnik. T.S., “IFRS: Beyond the Standards. Journal of Accountancy.” (2009). Web: 13th April, 2012. http://www.journalofaccountancy.com/Issues/2009/Feb/IFRSBeyondtheStandards Essay 4: Agency Theory and its relation to accounting: Agency theory revolves around three perspectives: Relationship of Agent and Principal Transactional cost and economies Model of positivist The agency contracts are usually entered to minimize costs and maximize profits for an organization. However, as there is a separation of control of company matters with that of ownership, there may be an incurrence of problems in such relationship. Agency theory attempts to explore theory based explanation to: understanding the processes in an organization Perspectives of a Principal and an Agent The relationship of agency arises when a party (the Principal) hires another individual (agent) to ensure performance of a task. Mostly, agents are supposed to act in the situations by taking prudent decisions as a proxy to the principal. The most common contract of agency which we come across is the employer and his contract agent relationship. There are two main assumptions which underlie this theory basically and which can influence the efficiency of the relationship. They are: Each party holds interests which are exclusively individualistic and opportunistic towards self Uncertainty and information incompleteness exacerbates the situation further As a consequence of experiencing this uncertainty, the principal may embark on: Observing behavior of the agent Include incentives in the contract of employment so that the agent’s interests get aligned to the interests of the organization. The significant role played in this scenario is the trade-off between the risk taken and return enjoyed by taking that risk. Contracts which can offer optimal return in diverse situations of risk and uncertainty are to be considered. In this juncture, Agency theory helps in incorporating explicitly: The possibility of interest conflicts in the agent Proposals of incentives to mitigate such conflicts Mechanisms to control proposals of incentives after certain point The framework of Agency Theory is a useful and attractive tool for predicting models of organizational and managerial outcomes as responsiveness to accounting practices and information. The objectives of such framework are: Introduce fundamental concepts pertaining to Agency Theory (even the basic model of Principal-Agent), the assumptions to be made and the types of agency relationships which could exist in an organization. The common relationships can be itemized as: 1. Relationship of a share-holder to that of a manager 2. Relationship of a debt-holder to that of a share-holder Demarcate main available strategies of observation and incentives and thus ensure reduction in the opportunistic ideas of the manager Using Agency Theory in accounting research to critically evaluate advantages and disadvantages of: 1. Principal-Agent relationship 2. Transaction economies of cost and 3. Positivist approach Review such studies empirically in accounting in relation to managerial contracts of employment. Suggestions if any to improve the circumstances. This theory was rampant in the 1970’s and 80’s where problem of risk sharing arose due to divergent attitudes of principal and agent which were expected to achieve organizational profit through work sharing. Both the parties were supposed to have different goals and experience division of labor sentiments. The managers were clearly playing active role in demonstrating their self-interest in contradiction to the previously conceived passive role in the organization. Accounting relation to agency theory can be viewed in two situations: Relationship of Share-holder to Manager: The manager may expend higher amounts of money by indulging in: Extracting higher perquisites than what is required. He may also involve in building of empire by expanding business over and above the means of the owner thus placing the organization into high risk He may heighten his reputation in the market for achieving prospective of better opportunities of employment for himself. Shirking away his necessary duties and reducing his load of work, thus enjoying the salary which he is not entitled to Investment option selection which may not be right for the organization because he may be risk-averse as against the owner who may go for higher risk for achieving better return. Relationship of Debt-Holder to Share Holder: The behavior is more opportunistic in this case: Announcing higher dividend payouts: To fill his own pockets, he will declare higher dividends, if he possesses shares of the company as a perquisite. Checking avenues of under investment as he is least interested in enhancing profits by investing in projects of higher NPV’s. His rationale is that he will not be benefited in any way and the rewards accrue to debt-holders. Dilution of Claim: Manager may lift higher debt with equal rights of claim to the new debt-holders in parlance to the existing debt-holders. The old holders will have a diluted right of claim thereby reducing their probability of returns. These agency situations are mainly enlisted to understand situations of fraud by managers through accounting figures. Strategies to mitigate such tendencies have to be sought after to organizational profit. Previously, observation, incentives and positivist approaches were used as such strategies. The harmonization of accounts of recent times can be one added strategy to curb such opportunistic behavior of the agents and restore due returns to the Principal. (Cullen. L, 2012) & (Hoque. Z.2006) References for Essay 4: Hoque. Z., Methodological Issues in Accounting Research: Theories, Methods and Issues. Ch. 5. U.K. Spiramus Press. (2006) Web: 13th April, 2012: http://books.google.com.au/books?id=3X3UXIPrqHoC&pg=PA55&lpg=PA55&dq=%22Agency+theory+and+accounting+research+:+an+overview+of+some+conceptual+and+empirical+issues%22&source=bl&ots=rmlPxWpSys&sig=nF9qjl85LcG-_qItu92G5m3vD-4&hl=en&ei=IOmmSvKFCo7s6gOCiayjBg&sa=X&oi=book_result&ct=result&resnum=1#v=onepage&q=%22Agency%20theory%20and%20accounting%20research%20%3A%20an%20overview%20of%20some%20conceptual%20and%20empirical%20issues%22&f=false Cullen. L. “Positive Accounting Theory (1)”, Capital Markets & Agency Theory, PPT 4, (2012). Australia. Curtin University Press. “Agency Theory.” Investor Words.com. (2012). Web: 13th April, 2012. http://www.investorwords.com/6398/agency_theory.html Essay 5: Meaning of Efficient Market and Efficient Market Hypothesis: Efficiency market hypothesis represents that the security’s price is reflective of the market consensus about its value. All the information relating to the security is already priced in the current valuation of the share. In an efficient financial market hypothesis, all publicly available information about the share and economy is already factored in the security price. The share prices of individual stocks of a market are highly volatile. They adjust rapidly for any information which could impact the earnings of the share-holders. As such, along with the share movements, their intrinsic worth also gets fluctuated without any trending pattern as a Random Walk. As such, predicting share prices on the basis of past prices or through paying attention to news about shares is not at all helpful. The share prices imbibe the changes even before the news is released. Thus, an average investor cannot make more than risk adjusted average return from the share market unless he has some insider information which again is an impediment to the concept of efficient markets. In other words, efficiency of markets means that the portion of unanticipated return that is earned on a security for the risk borne is not predictable at all. It is that element of surprise for which share-holders bet their money on the stock. Market efficiency hypothesis has some assumptions like: 1. Absence of transactional costs while security trading 2. Cost-free information is available to all participants of the market 3. The share price reflects an agreement of information which is currently available and also future price gets discounted. Some misconceptions which need to be cleared about markets are: 1. Every market participant need not be knowledgeable about the information spread in the market 2. All the information known to the investor is presented and interpreted by him in the right manner 3. The decisions made by managers is the best to their knowledge 4. Prediction of future by the investors is done precisely There are three forms to market efficiency: Weak form: The prices of previous unpredictable returns are no curser to the current returns. There is no memory in the market and prices fluctuate rapidly on the basis of information factored into those prices. Semi-strong form: Market efficiency has no correlation to the public information available to the investor. The changes would have occurred much before such information is spilt out into the markets. However, some insider news could have some correlation to the share price fluctuations that too only for a short period of time. Strong form: The return anticipated is not correlated to any type of information be it public or insider information. Based on this Efficient Market Hypothesis, two types of market researches were carried on: The influence of released information of accounts on the returns of shares The change effect of policies of accounting on the prices of shares It is surprising to note that, these changes were already factored in the share prices by the time; they were released to the general public. The only exception was that when a share-holder had some insider information, he could utilize that opportunity to make higher than risk adjusted return. This implies that our stock markets are reflective of Efficient Markets in the Semi-Strong form. Attempts were made to disprove the market efficiency hypothesis in relation to efficient markets. A little breakthrough was achieved when the researchers explored on the Price to Earnings ratio. It was observed that stocks which: Suffered low P/E ratio over a period of time was supposed to earn higher returns than those which enjoyed higher P/E ratio over that period. Similarly time series trending lines also were indicative to some extent the trend movements of shares but, the precise prices could not be predicted during that trends. As a caution, investors could be advised to stay away from those stocks for a period of time. These exceptions were also not conclusively proved every time suggesting that, they present only a chance of better returns that too only for a limited period of time. Thus, the efficient market hypothesis could be sustained in case of stock market efficiency. (Dimson. E. & Mussavian. M., (2000)) Based on this market efficiency, the CAPM (Capital Asset Pricing Model) and the (APT) arbitrage Pricing Theory are formulated. CAPM deals with calculating the risk associated with a security to estimate the return expected, as risk is usually a precursor to the return. APT professes that individuals try to eliminate arbitrage profits of a security by selling the stock when it is over-priced and buying into stocks which have lower P/E multiple price. Thus, the market equilibrium is always maintained. Both these models depend on the theory of market equilibrium and efficient markets. The unexplained disasters are the stock market crashes like the 1987 and 2008 fall where the investors find it very difficult to recoup their lost capital. These times can be recorded as an exception to efficient market hypothesis in the history of our efficient markets. (Horne. J.C.V., 1995). Thus, as an investor, to maximize our returns, we need to: Diversify Avoid tax Get insider information if possible and Minimize costs of trading. (Philips. G., 2000). References for Essay 5: Book Reference: Horne Van. J.C. Financial Management and Policy. 10th ed. 1. New Delhi. Prentice Hall India. 1995. 51-88. Print. Internet Reference: Dimson. E., Mussavian. M., “Market Efficiency”. The Current State of Business Disciplines. 3. (2000). (959-970). Web: 13th April, 2012. http://faculty.london.edu/edimson/assets/documents/spellbou.pdf . Philips. G. “Capital Market Efficiency”. (2000). Web: 13th April, 2012. http://www.rhsmith.umd.edu/faculty/gphillips/courses/Bmgt640/Effic.pdf. Read More