Approaches to Standard Setting in Accounting - Essay Example

? Approaches to standard setting in accounting Since the 1960s’, the accounting profession has been downplayed upon for its failures. This has led to the accounting practitioners to look for a way to legitimize the accounting standard setting. The body agreed to resolve upon what will be the nature of these settings (LeRoy, 2007). They said that these settings will give rules on how accountants will conduct themselves, they gave standards that will be used in an accountants work, they laid down the rules that will be accepted in firms, these rules consisted of three parts namely; the description of the problem to be tackled, ways to solve the problem and the theory used to reach those problems. The body also cited the reasons at which it was setting these accounting settings and some of them included; to give users of accounting information about their financial situation, their financial performance, and the financial conduct of a firm (LeRoy, 2007). Another reason was to assist public accountants with steps to enable them perform their work with care in offering their services in the accounting market. These standards were set so that all financial statements were consistent and had the ability to describe their financial performance. These accounting standards can also be known as Generally Accepted Accounting Principles (GAAP), they are generally accepted because there is an authoritative accounting body that set them and the body oversees the implementation of these standards. Without these standards the consumers of financial statements would need to learn accounting rules of different firms, this would be a difficult task for multi investors to compare these financial statement accounting rules. Some of the bodies that regulate these accounting standards are the Securities and Exchange Commission (SEC). This body was formed to establish these accounting standards for the public traded firms. The securities exchange act of 1934 needs specific financial reports to be filed with the SEC. the accounting Principles Board (APB) this board replaced the committee on Accounting Procedure (CAP), this board gave 31 opinions and 4 statements until it was dissolved in 1973 (Sharpe, 1982). GAAP was created from these opinions eventually. Then the financial Accounting Standards Board (FASB) was created after the wheat committee suggested the replacement of the GAAP board with new standards. After the dissolving the FASB board a new board International Accounting Standards Committee (IASC) was formed in 1973. This board was created to encourage a worldwide implementation of the accounting standards. This board was succeeded by a private sector body that was structured in a similar way as FASB (Sharpe, 1982). The accounting standards and regulations are very important. This is because they regulate accounting assumptions and methods. They also enable us to have consistency in the methods that are used to organize company’s financial statements. Although there are differences within these regulations, reliable conclusions can be deduced when comparing firms’ financial data for specific industries. If there were no accounting standards then the people who use financial statements like investors, banks and other institutions would require learning these accounting rules in a different manner for each firm. The accounting standards instill relevance to day to day accounting procedures and processes; this results into better financial performance from firms and represents faithfulness and accuracy (Sharpe, 1982). These standards ensure that neutral information is used hence eliminating the possibility of biasness in the financial statements. They give relevant information by enabling investors to know their specific points of investments to make. They save a lot of time since they give or point out clarity in the financial statements. The growth of financial transactions is making the compliance with accounting standards become an issue which require addressing immediately (Semmler, 2011). These standards are becoming complex in underlying financial transactions. At the same time although they are becoming complex, they are also assisting in giving transparency in the market thus reducing the costs of running a business. Most of these costs are not quantifiable but the direct costs include; the collection of information, the recovery of this information, the presentation of data, the interpretation of these standards and reviewing the compliance with the accounting standards. Even though the costs are not quantifiable the benefits also succeed them since these accounting standards benefit a large number of people including; investors, creditors and shareholders who benefit from these financial statements. There are two approaches to standard setting of accounting namely; Free-market approach and the Regulatory approach. 1. The Free-market Approach. Under this approach, accounting information is assumed to be an economic good or service that is similar to other commodities hence when it is subjected to other forces of demand and supply by firms in the form of financial statements equilibrium is reached, where an optimum amount of accounting information is disclosed at on optimum price (Semmler, 2011). The market then serves as a platform that dictates the type of accounting information that produces and the standards that are employed in that process. In the financial market securities are the free market stocks that are mostly traded and their prices are not affected by their availability/supply. In the foreign exchange market, free-market is whereby the exchange rates are not dictated by a certain organization or government hence these rates can rise or fall with the demand and supply for the currency. In the free-market approach there are different theories behind it, namely; the Positive Accounting and Agency theory. The Agency theory. This is a theory that concentrates in the relationship between the shareholder and a firms’ management. This relationship arises whenever shareholder also called principals hire individuals called agents to work and carry out duties for the principals. The decision making act in this relationship is divided between the two or more parties to make sure that the work is done in the best manner. This theory is then specialized with the conflicts that take place in this relationship between the principals and the agents. When agency takes place then it gives rise to the agency costs which in turn raises the costs that are required to assist in sustaining this kind of relationship (Poitras, 2006). This theory is a good model in the financial and economics literature; it is also used mostly in business ethics. This theory originates from early 1970s with concepts having history to the past. The agency theory raises alarm into the organization of a self invested behavior whereby one would find that a firm’s management has set its own targets and these targets will be competing against the principal’s target which is to maximize the shareholders profits. And since both the two parties have different opinions then they will always have a conflict of interest. This theory also suggested that in the case of imperfect labor then managers have to look for means that will help them maximize their own job at the expense of the principal (Poitras, 2006). The agency costs are those expenses that increase the managements to maximize the principal’s profits. There are three kinds of agency expenses which include; the cost to oversee the agents activities, costs to structure the firm such that to limit undesirable behaviors and the opportunity expenses. There are several ways to deal with the principal-agent conflicts. One of them is to compensate the managers on the basis of share price changes. The agency expenses are very low since the managers will have a great motivation to maximize the profits. At the same moment it will be a hard job to get managers with the passion to maximize these profits under these employment terms that is the contract basis employment (Lengwiler, 2006). Another option is that the principal will manage and oversee the managerial jobs which will be very expensive. However, if the principal will employ some of these mechanisms then the managers will be more motivated to perform their duties well enough to maximize the principal’s profits. Agency and ethics, Because of the complexity that comes with this principal- agent relationship, then the principal must have enough courtesy to enable the agents do a better job. There is also an agency conflict between the principal and creditors. This is whereby creditors also have a claim in part of a firm’s earnings or in the event that the firm becomes bankrupt the creditor will rush to seize the firm’s assets. Although the principal will remain the key decision maker in the firm the creditors will give the firm its capital depending on how risky the firms’ business is. The positive accounting theory is another theory for the free market approach. This theory has the assumptions that all individuals are encouraged by self interest or the interest to maximize their profits and that they use an accounting method that will help in the profit maximization (Poitras, 2006). This theory has got a few hypothesis which include; the bonus plan hypothesis whereby agents are paid on a bonus based in their net income and to get more bonus then the agents have to choose an accounting method that will maximize this profit, the political expense hypothesis here the regulations and taxes will get the manager to decide which accounting methods to use so that there will be maximized profits and the debt covenant hypothesis when the firm is near to breaking these covenants then the manager should select an appropriate accounting procedure that will change this to the better. The theory has got an opportunistic and efficiency perspective. The theory is found faulty for not being able to improve the accounting practices and not getting any positive thinking to humans. 2. The Regulatory Approach. There is an uncertainty as to whether accounting should be regulated or not. This has sparked off various debates in many places. There are people who are for unregulated market; these are the people who use the agency theory. To solve this conflict, the financial reporting used monitors employment and judges on how to reward agents. People arguing for regulated market are using the public interest to support their argument (Lengwiler, 2006). They also use the need to achieve social goals as an argument. These social goals include; fairness, information symmetry and the need to protect investors. Regulatory accounting approaches can either be set by governments and the benefits of regulating the accounting standards include; allowing investors to make better decisions and judgments about the profitability of their firms, the government uses regulatory accounting approach to assess firms with the compliance of the standard accounting settings, the regulatory approach helps managers to reassess their performance and it also assists creditors to provide better goods and services to firms without running bankrupt. Firms can be self or public regulated. The benefits of self regulation are that, companies are responsive to changes, they use expertise that originate from inside the company, the companies are observed more since they are made public, they allow innovative behaviors and have an agreement for many industry players hence making their compliance key. On the other hand there are disadvantages of regulating oneself (Lengwiler, 2006). These include; they lack legal recovery paths for breaking the agreement, these arrangements might be used to remove the competitive spirit and the compliance to these arrangements may be very minimal. Potential investors do not pay anything for the production of information in the regulatory approach (Kettell, 2001). This approach results into underproduction of data since there is a decreased amount of incentive to produce the information. Financial reporting has been regulated since it had some problems like the free-market approach and self regulation could not work in the accounting profession. There was government intervention to protect the public interest from investors. In the regulation approach there are three theories that govern the approach. These theories include; the public or political interest theory, capture theory and the private interest theory. In the public or political interest theory it is concerned with the use of power to gain regulatory control. The government’s intervention in the markets is done because of the interest of its people. This theory has got some assumptions which state that markets are prone to failure. Another assumption is that politicians assist investors and developers to regulate financial information. Another assumption is that there are politicians who seek the regulation for public interest genuinely. The government has got no role for it to play in the regulation hence the government becomes a neutral party (Panjer, 2009). The accounting professionals have an interest in managing the regulation of financial reporting. They state that self regulation failed because there was lack of compliance and responsibility. The capture process, here regulators came in to protect the public interest and regulate the information that was getting out to the public. Regulatory agencies work with those firms that that are regulated. The outcome of the standards set out by the accounting professionals was legalized by the government hence protecting the common public (Bianconi, 2003). The private interest theory acknowledges that individuals create grouped that will pursue their own self interest in information circulation. They proposed that their own private will dominate those of the public interests. Standard setting is a political business since it involves the wee being of the public and since the development of these settings will have effects to the socioeconomic well being of the public. The political class is the powerful group since after setting these standards the accounting profession will need to face the political class for approval and legitimization (Semmler, 2011). References Bianconi, M. (2003). Financial economics, risk and information: an introduction to methods and models. Singapore: World Scientific. Cebula, S. (1999). Financial Economics: An Empirical Analysis. 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