Free-Market Approach and Regulatory Approach to Standard Setting in Accounting - Case Study Example

? ASSESSMENT OF THE FREE-MARKET APPROACH AND REGULATORY APPROACH TO STANDARD SETTING IN ACCOUNTING By Lecturer: of Affiliation: City and State: Date: Executive Summary The provided an assessment standard setting approaches used in accounting including the free market approach, regulator; thereby, illustrated the applications for such approaches. The study employed literature materials to present systematic and clear understandings of accounting standard setting in relation to financial accounting standards. The researcher analyzed the free market approach to standard setting and provided a case study analysis to this approach. Within the free-market approach, the study revealed some theories including the positive accounting theory and agency theory, which recommends that entities should have incentives to make publicly accounting information munificently. The study also examined the regulatory approach, which aims to protect the interests of the public in the marketplace. The study further examined some of the frameworks within the regulatory approaches including the public interest theory and capture theory. Lastly, the researcher provided the case studies for both free-market and regulatory approaches in relation to standard setting in accounting. Lastly, the conclusion was provided that summed up everything that was discussed under the research topic. Assessment of the Free-Market Approach and Regulatory Approach to Standard Setting In Accounting Introduction The increased competitive which result due to increased technology contributing to a global village have encouraged financial analysts, regulators and lobbying groups to take significant interest in the market system. The accounting standards has created an ongoing debate as to whether accountants should regulate or set accounting standards or not. Thus, accounting standard settings has emerged as a language of business; thus, new accounting regulations have been set in many government institutions for financial accountability. The establishment of accounting regulation standards shapes varied aspects including the social, economic and political factors. This is because accounting regulations are needed for varied considerations including social, political, as well as, economic and market needs. The policymakers believe that the government should regulate standards in order to protect investors against market risks. However, there exist non-regulatory approaches known as the free-market approaches, which determine the accounting information and regulation in order to meet the interest of the public. Thus, the study attempts to examine varied approaches to standard setting in accounting including the free market approach, regulator, as well, as illustrates the applications for such approaches. Literature Review Varied literatures have attempted to provide systematic and clear understandings of accounting standard setting in regard to financial accounting standard setting. There is an ongoing debate that market should work freely, but the government should intervene and create regulatory standards to protect investors from encountering risk in the market. Therefore, this part offers an analysis on the way the previous scholars have attempted to argue about by developing varied approaches to standard setting in accounting including the free market and regulatory approaches. However, there have been a considerable debate over the accounting standards and some issues have been raised including the politicization of accounting standard setting for the concerned parties involved (Horngren 2006, 51). The debate on the advantages and disadvantages of accounting regulation standards settings is a realism of accounting setting. Thus, Britton and Waterston (2006, p.71) proposed varied limitations and benefits of accounting standard settings whether regulatory or non-regulatory, hence these can be based on the restructuring the accounting standard setting process. The literature offers critical assessment of varied approaches by illustrating relevant applications for such approaches. Free-market Approach The literature determines the free market approach as a non-regulated approach, which argues that the market and its mechanisms should determine the production of accounting information and regulation according to its needs (Papadopoulos (2011, p 6). The regulatory activities in the economic environment affect directly the accounting practices of entities across the globe. According to Deegan and Unerman (2011, p. 79), accounting standards are perceived as fiscal goods, which the interactive forces of demand and supply impact directly in the free market economy. The underscoring assumption for the free-market theory is that market forces may create an equilibrium optimal magnitude in relation to the concerned demand of customer within an entity. Therefore, the fundamental argument behind this framework is that entities do not need fiscal accounting regulations because market forces of demand and supply will unveil the equilibrium optimal accounting information. The proponent of free-market approach including Watts argued that there should be adequate incentives from the necessary organization to furnish stakeholders with reliable accounting information of the organization. This accounting information will signal to shareholders with adequate and reliable information, which human resource managers are utilizing to increase wealth and maintain operating cost at the minimum level. Many scholars argue that market regulates accounting standards are connected to the demand and supply needs; thus accounting standardization originates from the lobbying groups or interested users who wish to manipulate the market for personal advantage (Alexander, Britton and Jorissen 2007, p. 72; Brants 2003, p. 52). The aforementioned scholars further argue that the market would be more effective in case there is lack of a state regulatory interference. The work of these scholars justifies their proposal of market regulatory approaches, which is supported by agency theory. Chambless and Chambless (2005, p. 56) define agency theory as a framework that links the principal and an agent in which the principal entrusts his assets to the agent who manages it on his behalf. Deegan and Unerman (2011, p.52) added by arguing that there is a need for an optimal arrangement by which the agent costs should be minimized through the operating market mechanisms. Additionally, the agency theory recommends that entities should have incentives to release accounting information generously. For instance, the Australian and British companies voluntarily issued financial statements in the earlier 19th century because of lack for standards to prevent such publications. This disclosure benefited them because they incurred lower capital costs, which granted these entities access to gain capital funds in the Market (Carlson 1997, p.370). Consequently, Khadaroo (2005, p.82) revealed that some few companies in the United Kingdom disclose their cost of sales due to lack of legislative provision demanding disclosure for gross margin figures. Deegan and Unerman (2011, p.57) argue that the proponents of the free-market theory based on the agency theory affirms that “the natural conflicts are likely to evolve between the managers and shareholders.” This is because managers may seek to act upon their own interest; thus, private and associated financial reporting is vital because it will reduce conflicts of interest. The proponents of the free-market theory also argued that positive accounting is an effective theory for maximizing profits in the free market economy (Watts and Zimmerman 1986, p.71). According to Stigler (1998, p. 83), positive accounting theory is a framework that attempts to predict real world events and translates them to accounting practices. The role of positive accounting theory is to explain and predict actions such as the preferred accounting policies that a firm can choose. This theory also explains and predicts the way a firm can react or respond to the newly proposed accounting standards. Under this theory, accounting practices emerge to alleviate contracting costs through establishing an agreement between different parties (Amstrong 1971, p.101). For instance, absent conservatism and compensation agreements made can reward human resource managers basing on the present account reports. The assumptions for the positive accounting framework include the debt agreement, bonus plan and political cost assumptions. Therefore, to achieve positive accounting, managers, financial analysts, or the lobbying groups should change their accounting policies, manage discretionary accruals, change real variables, capitalize operations and adopt new accounting standards in a timely manner. Regulatory Approach Regulatory approach is advocated by the policymakers and this approach has been a centre for debate as to whether it should be implemented or not. The policy makers believe that by regulating the financial market in entities, they can safeguard the interest of the state. It is also one way of providing security to investors and protecting them against financial risks; thus attracting higher economic investments in the country. Foster (1980, p.31) argues that the regulatory approach is justifiable because it safeguards the interest of investors. However, the analogous public interest justification for the regulation of business have been heavily criticized and failures of this regulations have been revealed including regulation failure of the policy to the interested regulated entities and high cost of operating regulatory mechanisms. Regulation approach in the broader sense denotes governing the way in which public activities are decided upon and implemented (Kenneth and Rita 2006, p.21). Regulatory approach has taken a more specific meaning of achieving the interest of public and goals of investors through formulating regulations of standard behaviors backed up by the sanctions of the state. Therefore, varied approaches have been developed with regard to achieving the needs of the public. One of them is the public interest theory and this is a regulatory approach that simply focuses on the interest of the public in order to achieve the welfare of the state. According to Horngren and Harrison (2008, p. 65) public interest theory is defined as the interest of individuals by free markets in which there is voluntary exchange of commodities and services without market distortions. The regulations are formulated with an aim to correct market distortions or market failures, which may hinder the public from achieving their interests (Riahi-Belkaoui 2004, p. 92). There are numerous market failures such as externalities where prices fail to reflect social cost or benefits, monopolistic activities, which restrict competition and informational problems. Therefore, regulatory approach in this case aims to correct such market failures in order to bring about improvements to generate the wellbeing of the state. The second is the capture theory and this is a regulation framework that offer an insight into close relation that rise between the business entity and the government regulatory agency. Capture theory also aims to meet the interest of the public or consumers; thus the government agency amount power to the business industry in order to shape the interest of the public (Holmes, Bromiley, Devers, Holcomb and McGuire, 2011). Regulatory capture unlike public choice theory is a risk to the agency and it is worse than any other regulation. This is because regulatory capture exercises the government authority over the business industry but even so, this regulatory approach is effective because it increases transparency of the agency involved. For instance, consider a bureaucrat agency in one of the manufacturing companies including Shady, Sundial and Grass Valley. Therefore, the capture regulatory was established to ensure that these industries manufacture safe and high quality commodities. They also make sure that the agency also ensured that the firms do not monopolize their market. McLeay and Riccaboni (2000, p. 121) explore the tension between the power of the state and market forces, as well as, offer varied political dimension aspects to accounting regulations. The authors analyze the significant roles that standard setters play in setting accounting standards vital in a free market economy. In the contemporary competitive business environment, companies must seek innovative means for rapid and sustainable growth, not by just surviving but thriving, in the competitive business world (Clayman, Fridson and Troughton 2012, p.23). Therefore, employing regulatory approaches and corporate financial approaches to financial analysis is one way through which financial analysts and investors can achieve their business objectives effectively. Case Study There are varied real world examples and case studies that have been provided by many scholars on varied approaches to standard setting in accounting. Dye reveals some case studies in order to provide the readers with a concrete understanding or real-world issues for critical business growth (Dye 2001, 221). Coggins (1998, p. 102) argues that government intervention is necessary in any business activities because they protect the public from exploitation; hence enable the public meet their demanding needs effectively. Therefore, one of the case studies is the OIAC (Oil Industry Accounting Committee), which is the focal point for the United Kingdom upstream oil and gas industries, which deals with financial reporting issues (Oil Industry Accounting Committee and Accounting Standards Committee 1987, p.21). OIAC was established in 1984 after the Accounting Standards Committee recognized them as an effective organization for implementing SORPs (Statements of Recommended Practice. The company follows the regulatory approaches set forth by the UK government in relation to the way it conducts their business. This regulatory approach is effective because they have enabled the company to progress; thus becoming the UK GAAP (Generally Accepted Accounting Principles) for bigger companies. The organization is effective because it is programmed for varied reasons including increasing responsibility and working together as a group to achieve the organizational needs (Kothari 2002, p.122). Moreover, the SORP is effective because it promotes consistency amongst companies, which reports under the accounting and financial reporting standard of UK in relation to effective application of the standards to the oil and gas production activities. Another case study is that of MacDonald Company, which is one of the leading American companies and it has varied branches across the globe. This company has few technical calculations but it presents an excellent opportunity for realistic assessment of alternative measures for evaluating revenues and valuing assets (Dye 2001, 222). The company utilizes GAAP for conducting successful business activities in their various places, where they operate. MacDonald Company can be equated with the free-market approach in regard to accounting standard settings. According to Winston and David (2005, p. 45), the free-market approach has an assumption that accounting information is an economic good, which is similar to other goods and services. The interaction between the equilibrium and market forces may be reached, whereby the company would be required to disclose an optimal price for commodities. Hence, whenever the given pricing information for products will be demanded, the market will generate information in case the company will offer the right price. Conclusion In conclusion, the study attempted to examine varied approaches to standard setting in accounting including the free market approach, regulator, as well, as illustrated the applications for such approaches. It utilized numerous literature materials to provide systematic and clear understandings of accounting standard setting in regard to financial accounting standards. The literature provided critical assessment of varied approaches by illustrating relevant applications for such approaches. One of the approaches revealed was the free market approach, which is a non-regulatory mechanism. Under this approach, there is an agency theory, which recommends that entities should have incentives to release accounting information generously. The proponents of the free-market theory also argued that positive accounting is an effective theory for maximizing profits in the free market economy. The second one is the regulatory approach and this approach aims to protect the interests of the public or consumers in the market. There are varied approaches that have been developed with regard to achieving the needs of the public including the regulated capture theory and the public interest theory. Lastly, the case study was included that revealed the application of regulated free-market and regulatory approaches in an organization. ` Bibliography Alexander, D., Britton, A., & Jorissen, A. (2007). International financial reporting and analysis . London [etc.: Thomson Learning. Amstrong, M.S. (February 1971). “The politics of establishing accounting standards”, Journal of Accountancy. PP 76-9. Brants, K. (January 01, 2003). Auditing public broadcasting performance: its theory and practice. Javnost, 10, 3, 5-10. Britton, A., & Waterston, C. (2006). Financial accounting. Harlow, England: Financial Times/Prentice Hall. Carlson, P. (January 01, 1997). Advancing the harmonisation of international accounting standards: Exploring an alternative path. International Journal of Accounting, 32, 3, 357-378. Chambless, J. A., & Chambless, J. A. (2005). A free market approach to microeconomics. Reno, NV: Bent Tree Press. Clayman, M. R., Fridson, M. S., & Troughton, G. H. (2012). Corporate finance: A approach. Hoboken, N.J: John Wiley & Sons. Coggins, B. (1998). Does financial deregulation work?: A critique of free market approaches. Cheltenham, UK: Edward Elgar. Deegan, C., & Unerman, J. (2011). Financial accounting theory. London: McGraw-Hill. Dye, R. A. (January 01, 2001). An evaluation of "essays on disclosure" and the disclosure literature in accounting. Journal of Accounting and Economics, 32, 181-235. Deegan, C., & Unerman, J. (2011). Financial accounting theory: European edition. Maidenhead: McGraw-Hill. Foster, G. (March 01, 1980). Accounting policy decisions and capital market research. Journal of Accounting and Economics, 2, 1, 29-62. Horngren, C. T., & Harrison, W. T. (2008). Financial and managerial accounting. Upper Saddle River, N.J: Pearson/Prentice Hall. Horngren, C. T. (2006). Financial accounting. Frenchs Forest, N.S.W: Pearson Education Australia. Khadaroo, M. I. (January 01, 2005). An institutional theory perspective on the UK's Private Finance Initiative (PFI) accounting standard setting process. Public Management Review, 7, 1, 69-94. Kothari, S. P. (2002). Contemporary accounting research: Synthesis and critique. Amsterdam: Elsevier Science. Kenneth, A. S., & Rita, H. C. (September 01, 2006). Assessing Reforms of Government Accounting and Budgeting. Public Performance & Management Review, 30, 1, 14-34. Holmes, R., Bromiley, P., Devers, C., Holcomb, T., & McGuire, J. (January 01, 2011). Management Theory Applications of Prospect Theory: Accomplishments, Challenges, and Opportunities. Journal of Management, 37, 4, 1069-1107. Monem, R., Deegan, C. M., Deegan, C. M., & Griffith University. (2009). Financial accounting theory. North Ryde, N.S.W: McGraw-Hill. McLeay, S., & Riccaboni, A. (2000). Contemporary issues in accounting regulation. Dordrecht, Netherlands: Kluwer Academic Publishers. Oil Industry Accounting Committee., & Accounting Standards Committee. (1987). Accounting for oil and gas exploration and development activities. London?: Oil Industry Accounting Committee. Palm, C., & Bisman, J. (January 01, 2010). Benchmarking Introductory Accounting Curricula: Experience from Australia. Accounting Education, 19, 1-2. Papadopoulos, P. (2011). Approaches and Theories to standard setting in Accounting. Business and Economics. GRIN Verlag, Norderstedt Germany. Quiry, P., & Vernimmen, P. (2011). Corporate finance: Theory and practice. Chicester, West Sussex, U.K: Wiley. Riahi-Belkaoui, A. (2004). Accounting theory. London: Thomson Learning. Richardson, A. J., & Eberlein, B. (January 01, 2011). Legitimating Transnational Standard- Setting: The Case of the International Accounting Standards Board. Journal of Business Ethics, 98, 2, 217-245. Roland, B. (January 01, 2006). Management control in a business network: new challenges for accounting. Qualitative Research in Accounting & Management, 3, 2, 161-181. Rustici, T. C., Milton, C., & Snow, N. (2010). Microeconomics: A free market approach. San Diego, CA: Cognella. Stigler, G. I. (January 01, 1998). 'The Theory of Economic Regulation', Bell Journal of Economics and Management Science, 2, Spring, 3-21. International Library of Critical Writings in Economics, 94, 2, 81-99. Sikka, P., Haslam, C., Kyriacou, O., & Agrizzi, D. (January 01, 2007). Professionalizing Claims and the State of UK Professional Accounting Education: Some Evidence. Accounting Education, 16, 1, 3-21. Scott, W. R. (2009). Financial accounting theory. Toronto, Ont: Pearson Prentice Hall. Wyatt, A. R., & Staats, E. B. (March 01, 1979). Who Should Set Governmental Accounting Standards?. Journal of Accountancy, 147, 3, 65-70. Watts, R. L., & Zimmerman, J. L. (1986). Positive accounting theory. Englewood Cliffs, N.J: Prentice-Hall. Winston, C. C. K., & David, S. (January 01, 2005). Power and international accounting standard setting: Evidence from segment reporting and intangible assets projects. Accounting, Auditing & Accountability Journal, 18, 1, 74-99. Read More