Accounting and Society - Essay Example

? Accounting and Society PART A The video includes a brief discussion of the importance of regulations in the field of accounting and the need to follow the same in order to ensure the accounting is being done with absolute transparency (Deakin Air, 2013). The discussion also focused on the need to implement a particular accounting perspective (pro-regulation or free market perspective). However, no such conclusion was provided within the video as to which perspective is better of the two. This creates a knowledge gap and thus provides the researchers with the opportunity to bridge the gap by setting forth an in depth research regarding the best perspective that should be implemented in accounting practices. Previous literatures have suggested that the arguments in favour of implementing the pro regulation perspective of accounting and arguments against the utilization of free market perspective have been influenced by political, social, economic and research consequences. Thus the primary objective of this research is to do a critical evaluation providing evidence regarding the implementation of the above mentioned approaches. The paper will also highlight the political, social, economic and research influences that have historically impacted on the level of accounting regulation in a developed economy with established security markets. Following the in-depth analysis of the factors, remarks will be put forward as to which accounting standard should be implemented. In order to carry on the research efficiently and effectively specific set of tasks will be divided between the two members. One member of the group will be primarily responsible for doing a critical evaluation of the pro-regulation perspective whereas the other member will be assigned with the responsibility of analyzing the free market perspective. Ideas will be put forward regarding the advantages and drawbacks of implementing the perspectives. Analysis will also be done as to whether these factors resulted in any changes that have been brought about in the regulation perspectives. In order to give this research a solid shape, secondary data will serve as the main resource. The secondary data includes peer reviewed journals from online databases, articles and other online sources. Extensive literature review will be done in order to justify every comment that will be made. The literatures that will form the groundwork of this research are peer reviewed journals that cover different aspects of these accounting regulation perspectives. Three peer reviewed articles will be used in order to explain the implementation of the literature in order to explain the topic of issue. In addition to that, the video that has been used as the basis for initiating the research process will also serve as a useful resource. The overall time frame required for this research is 2 months. The tasks that will be performed over the course of these 2 months have been explained in the following table. Timeline (Source: Author’s creation) PART B Previous literatures in the field of accounting regulation acknowledged the social, economic, and political factors that are associated with the advancements made in the accounting rules and explained the events that led to the formulation of different regulatory frameworks that are internationally accepted. Those literatures have also highlighted the aims and purposes of accounting regulation and also identified the necessity for imposing these rules from many different perspectives, particularly, the social, economic and professional perspectives. The present study endeavours to gather and to contrast in one place the different perspectives regarding the pro-regulations and free market approach to accounting practices. This study will only include reference papers and articles which have explained and established the theory of accounting regulation. Thus issues that have been discussed within this essay are not exhaustive they do not necessarily represent the last research dealing with these issues.  The relevance of this analysis stems from the fact that developed countries are still in the process of modifying their accounting systems in order to respond to the elevating requirements of international business and global accountancy bodies. Therefore, this analysis will provide a detailed explanation of the two perspectives that can be used in accounting along with the arguments that were made in favour and against those approaches. Free Market Perspective It often provides a perspective that accounting information should be treated like other goods, and demand and supply forces should be allowed to operate so as to generate an optimal supply of information about an entity. Smith and Watts (1982) were the authors who were in complete supporters of the free market approach of accounting. The argument by some advocates of the ‘free-market” perspective is that in the absence of regulation there will be private incentives to produce accounting information. Organizations that do not produce information will be penalized by higher cost of capital. This view depends on the perspective that the stipulation of convincing information enables other parties to monitor the activities that are being carried out within the organization. Thus, having the option of monitoring the activities of an entity reduces the risk exposure that investors face while investing in the entity and this in turn leads to a reduction in the cost that is required to attract capital to the organization. Arguments have also been presented regarding the free market perspective that stated the fact that more often than not there will be situations that will give rise to conflicts between different parties who have an interest in a particular organization. As such, account information will be disclosed in the absence of regulation in order to reduce the effects of these conflicts. An example that can be set forward to explain this issue is when an owner appoints a manager; there will always be a concern in the mind of the owner regarding the transparency of work being demonstrated by the manager. The owner will always be wary of the fact that the manager will not serve the interest of the owner. In order to align the interests of both the owner and the manager, the manager has to be provided with a higher proportion of profitability which would mean that the manager will work hard in order to maximize the profit for the company. In such a way the manager would be working for the interest of the owner. In order to determine the profits accrued by the company, accounting reports will be displayed and the demand will come from the owner in terms of presenting these accounting reports in an unbiased manner. Another argument associated with this accounting perspective is that accounting reports can be utilized in order to reduce the conflict between the managers and the providers of loan also known as the debt holders. This idea is consistent with the idea of stewardship which explains that the management of a company is expected to report an account of how the funds that were provided have been utilized in order to conduct the operations within the company. In addition to that, depending the types of assets in place as well as the parties who are involved, it has been argued that, managers of the organization will be in the best place to determine the appropriate information that should be disclosed in order to the increase the confidence level of external stakeholders thus, bringing down the cost of organization’s capital. Regulations that put a limitation on the available set of accounting methods that can be implemented (such as forbidding a particular method of amortization that has been used previously by some organizations) decreases the efficiency with which the information is provided to the investors. Arguments have also been presented explaining that certain permitted disclosures will prove to be costly to the organization if those disclosures enable the competitors to take advantage of specific proprietary information. This argument has been used in previous literatures in order to explain the costs that would be imposed as a consequence of mandating segment disclosures. Although the discussion is about preparing the financial reports, a related issue that should also be highlighted is the external auditing of such reports. It has been argued that in a free market perspective of accounting regulation where there is absence of regulation, external parties chose to demand that financial statements should be audited appropriately. If such auditing is not done, then, financial reports will not be considered having the same credibility or authenticity and thus less reliance would be placed on them. If reliable information is not disclosed, and then the risk that is associated with investing in such an organization might be recognized as being higher thereby leading to the cost of attracting funds to the organization will be higher. Thus arguments were made in such context that managers would always choose to get the financial reports audited even in the absence of regulation. Thus, it can be said that, financial reports auditing can be done by companies even in the absence of regulation and previous evidences have suggested the statement made above where organizations were witnessed having their financial reports audited at the time when there were no legislation requirements. However, Healy and Palepu (2001), highlighted that for auditing to be an effective strategy by means of which the cost of attracting funds can be reduced, the auditor must be truly independent and the accounting methods that are to employed and the statements that are to be prescribed must be adequately well defined. Another perspective in terms of accounting regulation is the fact that even in the absence of regulation organizations would still be inclined towards disclosing both bad and good news regarding the financial performance and position of a business entity. Such kind of perspective is often referred to as being the ‘market for lemons perspective’. This perspective suggests that in the absence of regulation regarding the disclosure of financial information, the capital market will make an assumption that the entity is a ‘lemon’. Here the word lemon is used to express condition of an entity which initially appears to be of good quality compared to other company’s particularly because the market does not have adequate information regarding the company. Later it turns out that that the company is actually inferior. Thus acquiring the company will be as a result of information asymmetry that will work in favour of the seller. This explains that, no particular information is viewed in the same scale as bad information. Thus, although the firm might be concerned about disclosing bad news, it is presumed that the market will perceive that organization has bad news to disclose particularly because they chose to remain silent or delayed in disclosing their financial information. The ‘market for lemons’ perspective thus provides an incentive to the managers to disclose appropriate and proper information in the absence of regulation. This is particularly because of failure to do so will have its own repercussions that will have severe implications for the organization. Previous research done by author such as Skinner (1994) states that there is evidence that managers tend to disclose both bad and good information as well as forecasts voluntarily. These statements has been supported by his own empirical research which highlights that when firms are performing very well, managers disclose good information in order to distinguish their forms form those firms who are performing relatively less well. Thus, when firms are not doing well managers disclose bad news which is consistent with arguments related to reputational effects. Arguments which are produced are that market will penalize organizations for failing to disclose authentic information (whether bad or good). The arguments come with an assumption that market already has an idea that the manager has particular information to disclose. The expectation might always not be practical as the market does not always have this idea whether or not there is any information available to the managers in order to disclose. Thus, when there is information asymmetry (which refers to the situation when information is not available evenly to all-for example a manager has access to certain specific information which is not available to the public), a manager might have some bad news regarding the company, but the market does not expect any sort disclosure of information in that particular time window. Later if it comes to the knowledge of the market that information was available to but was not disclosed appropriately, the market is expected to adopt strict measures against the company. However, in the presence of regulation, we could expect regulators to take steps instead of the market. This is particularly because failure to disclose information properly is a breach of the accounting laws. In addition to that, in certain situations managers tend to conceal information (specifically of proprietary nature) in order to safeguard the interest of the organization. An example to support the statement made above is when a company chooses to not disclose information about certain market opportunities in order to prevent their competitors to utilize such information. Thus, in summary of the points that have been presented in order to critically evaluate the free market perspective for accounting, it can be said that there are various mechanisms or arguments which are in favour of reducing accounting regulation. This is particularly because even in the absence of regulations, organizations have the incentives to disclose proper information. In the following section, we will discuss about the alternative arguments presented in favour of regulating financial accounting practices. The ‘Pro-regulation’ Perspective Accounting standards that have been set impose certain regulations to managers in terms of the reporting choices that are available to them while preparing and presenting the financial statements of an organization. Imposing regulations potentially decreases the processing costs for the users of financial statements by providing a incorporating a universally accepted language that the managers can use for the purpose of communicating with the investors. Empirical researches done by authors such as Alford et al. (1993) and Ball, Kothari and Robin (2000) suggested that financial reports that are prepared according to the stated regulations provide relevant and new information to investors which give them a good understanding of the financial status of the firm. However, the authors have also suggested that the methods adopted to report accounting information varies systematically with country and firm characteristics. This is particularly because of the influence that the political, social and economic factors have in the accounting regulations. Over the last two decades, the relevance of earnings and other items that are stated within the financial statements of a company have declined. The association between stock returns and earnings as well as between the stock returns and book values has significantly deteriorated over the due course of time (Chang, 1998; Lev and Zarowin, 1999; Brown et al. 1987). The statements provided above highlights the importance of the pro-regulation perspective of accounting method. According to the pro-regulation perspective, accounting information is a “Public Goods”. With the availability of information, the public can use it and can pass it on to others without paying anything for the service. The users of this information are called ‘free-riders’ as they do not incur any production cost for availing these goods or service. In certain cases information is under-produced because few people have the incentive to pay for availing these goods and services and so does the producer of the goods and services. In order to lessen this underproduction, imposing regulation has been considered to be necessary so as to reduce the impacts of market failure. Empirical researches have suggested that in case of public goods, market failure does tend to occur. This is due to the fact that price system does not function properly as other individuals can receive goods without paying for it. The supporters of a free market approach argue that the market is averagely efficient and that it tends to ignore the rights of individual investors which might lead to the investors losing their savings as a consequence of relying upon unregulated disclosures which does not happen eventually. In addition to that, whether or not an individual has the ability to obtain information regarding the status of an entity depends largely on the individual’s control over scant resource that is required by the entity. Even though an individual might be affected by the activities conducted within the organization in the absence of regulation and insufficient control over resources, they might still be unable to attain the required amount of information. These facts have influenced the regulators to use the ‘level playing field’ argument to justify the imposing of strict legislations in the field of accounting. As far as the perspective of financial accounting is concerned, each and everyone (on the ground of fairness and transparency in terms of information) have access to the same information. There should not be any information asymmetry. Thus the pro regulation perspective is the groundwork behind the law that prohibits the practice of insider trading. The regulation has been stated with an underlying idea that accepts the view that there will not or should not be any movement of wealth between parties who have access to insider information and those who do not enjoy the equal accessibility. This is primarily because such a practice if not regulated will render the market inefficient. Rich will become richer and poor will become poorer. This is detrimental to the economy of a country. Another perspective that has been given in favour of having a regulated environment in the field of accounting is that in the absence of regulation firms tend to do insider trading which in turn may corrode the investors’ confidence over the market to such an extent that ultimately the market efficiency might be weakened. Thus, imposing stricter regulations regarding the disclosure of information will make the external stakeholders of an organization more confident about the efficiency of the market and will make them feel that they are on the ‘level playing field’. If the investors have the confidence in the capital markets, it means that the regulations that have been imposed are appropriate and thus are believed to be in the interest of the public. In the 20th century the accountants and the regulatory bodies emphasized on maintaining a system of self regulation. The professional bodies in the field of accounting worked hard in order to evade the imposition of regulation on the discipline. This is the reason why regulatory bodies attempted to develop a universally accepted accounting principle (GAAP – Generally Accepted Accounting Principle) and then a conceptual framework which thereafter served as the basis of the accounting theory. Following the imposition of such regulations, confidence was maintained while conducting operations of the market. In such a context, regulations were viewed as a tool of guidance that provides rules to correct the slight imperfections in the way the market operates (Gaffikin, 2006). The last decade witnessed a number of cases related to accounting frauds. The involvement of accountants and the practice of accounting itself in spectacular corporate collapse and major issues of business fraud stressed the need for accounting regulation. Thus, it can be said that, there is a public interest concern that led to the creation of regulation. In other words, the pressure that was created by the various sections of the society set forward the demand of regulation. However, researchers have stated diametrically opposite interpretations regarding the imposition of regulation. They have stated that it is always better to adopt a free market approach as legislation damages capitalism (investment) and that it should be repealed. Gaffikin (2006), highlighted specific problems regarding the regulations in accounting that concerns the issue of independence. The author suggested that there are many interrelated concerns related to the independence with which financial accounting is done. Initially, accounting firms used to earn most of their income from fees that they charged for auditing. The imposition of regulation in here suggests that accounting firms are investigating their own employers which give rise to an initial conflict of interest between them. The professional bodies in the field of accounting have the primary responsibility to ensure that the conflict of interest that might arise between auditor and clients is minimized and that the highest standards of professionalism are maintained. The statements made above also highlights the importance of regulation in the field of accounting. Economic factors The fact that accounting rules are required to regulate the economic outcomes of information provision and resource allocation in the market is absolutely true. In a perfect situation, market efficiency ensures that accounting information is available at the right cost. However, there are certain economic factors that provoke the failure of perfectly competitive markets thus highlighting the importance of regulation. The difficulties that arise due to market imperfection and the lack of availability of accounting information are reasons highlighted by authors who stressed on the need for an extra regulated market. These problems that arise due to the market imperfections and because of the lack of complete markets seem to affect the provision of external accounting information. Although such problems do not require regulation but if imposed, the results are demonstrably better than the results of a market that operates in an absence of regulation (LACPA, 2010). In order to ensure this market efficiency accounting regulation is necessary. Markets fail because of many reasons which if not dealt with immediate effect can lead to severe consequences. The reasons are: Inadequate rules that govern the market behaviour. The rules must state the means by which accounting information may be allocated along with the form of contracts that govern these allocations. The rules must also state the ways by which disputes can be settled and rules can be enforced. In an efficient market information regarding market factors and preferences should be freely available. However, practically information is not free and information oriented transactions are costly. Healy and Palepu (2001), argued that the cost of information suggest that individuals are inappropriately informed regarding the present conditions and the results of their decisions. Apart from transactions costs, insider trading is also another actor that highlights the importance of regulation as there are lucrative incentives for officials to obtain private information through such practices. Thus, accounting information, from a general perspective, affects the level and distribution of risks among individuals, since risk is associated with the extent to which information is available. The greater the information availability, lesser is the risk and vice versa. These factors also explain the need for a regulated market. As in a free market, information supply is not consistent as in the absence of regulation managers might choose to conceal information as and when they deem appropriate. Market distortion is also another factor that is hugely responsible for market failure or an imperfect market. In the absence of regulation on a crucial economic factor such as the pricing system, deviation of prices between the producers and the users of accounting information may occur in situations when producers act as monopolists and thus highlights the need for regulations that would guarantee the provision of information (LACPA, 2010). Socio-political factors Substantial emphasis has been laid in order to explain the economic factors that influenced the imposition of regulations in the accounting system. This section will explain the influence that the socio-political factors had in the arguments that were made in favour of pro market regulation approach in accounting. The views that need to be incorporated in order explain the influences of this factor are particularly social views which are the wealth and income of diverse social interests. The explanation will also highlight the best form of regulation which can be implemented in order to achieve the welfare of the society. Two important societal, intermediate goals for accounting as a social choice function are to ensure efficiency and explain equity properly. Arguments have been made that corporate reporting should take into account these functions properly. Authors have highlighted the relevance of regulation as an important tool that promotes accountability and proposed that detailed information should be provided in the corporate financial reports and wide representation by stakeholders and the producers should be included in order to increase the acceptability and verifiability of accounting reports thereby complying with the accounting regulations (Chang, 1998; Brown et al., 1999). Certain activities of the regulatory bodies in the field of accounting have consequences over the income and wealth distribution. As far as accounting regulation is concerned, the regulatory bodies’ competence of making re-distributive judgments needs to be included. These are the activities that form the political aspect that influence the arguments made in favour of the accounting regulations. Politicization of rules-stating is not only inevitable but is very critical. This is particularly because the success of a decision-making process in the field of accounting depends largely on public confidence. This issue is certainly not technical but is definitely political (LACPA, 2010). The sharing of accounting information has to be done appropriately thereby taking into account the factors that are related to the proper allocation between economic components and the impact this sharing of information may have on the transfer of wealth, and consequently social factors. Thus, the preference of accounting regulation stated by the regulatory bodies should consider the preference of users as well as the social and political requirements. These are the socio-political factors that influenced the arguments that were made in favour of imposing regulations in the field of accounting rather than having a free market approach which might render the market imperfect and inefficient. While this study only provides a fairly brief review of the free market and the pro regulated perspective of accounting, it needs to be kept in mind that this is an ongoing debate with respect to many activities that are being conducted in many industries. These activities are being carried out in order to safeguard various vested interests that put forward many different and conflicting arguments that are sometimes in favour and sometimes against the imposing of regulations. However, having done a robust study of both the perspectives it can be said that free market approach and pro-regulated approach offers different types of flexibility to the accounting system through which efficient accounting practices can be done. However, severe criticisms have been highlighted by authors as far as the free market perspective is concerned. This is particularly because this approach might render the market inefficient and imperfect as in the absence of regulations proper information might not be shared. Moreover, the free market perspective of accounting does not take into account the social, economic and political factors which are crucial factors that ensure an efficient market. Consequently, arguments were made in favour of a pro-regulated perspective of accounting as this approach facilitated effective information sharing which is a crucial characteristic of an efficient market. Moreover, a regulated accounting mechanism will always give the confidence to the investors about the fact that transparency is being maintained in the field of accounting. Reference list Alford, A., Jones, J., Leftwich, R., and Zmijewski, M., 1993. The relative informativeness of accounting disclosures in different countries. Journal of Accounting Research, 31, pp. 183–224. Ball, R., Kothari, S.P., Robin, A., 2000. The effect of international institutional factors onproperties of accounting earnings. Journal of Accounting and Economics, 29, pp.1–51. Brown, L., Griffin, P., Hagerman, R., and Zmijewski, M., 1987. Security analyst superiority relative to univariate time-series models in forecasting quarterly earnings. Journal of Accounting and Economics, 9, pp. 61–87. Chang, J., 1998. The decline in value relevance of earnings and book values. Working paper, University of Pennsylvania, Philadelphia, PA. Deakin Air., 2013. MAA310 Pro-Regulation and Free Market perspectives of regulation. [online] Available at: [Accessed 2 December 2013]. Gaffikin, M. J. R., 2006. Regulation as accounting theory. Working paper, University of Wollongong, Australia. Healy, P. M. and Palepu, K. G., 2001. Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature. Journal of Accounting and Economics, 31, pp. 405-440. LACPA., 2010. The case for accounting regulation: a theoretical approach. [online] Available at: [Accessed: 3 December 2013]. Lev, B., and Zarowin, P., 1999. The boundaries of financial reporting and how to extend them. Journal of Accounting Research, 37, pp. 353–386. Skinner, D. J., 1994. Why firms voluntarily disclose bad news. Journal of Accounting Research, 32(1), pp. 38-60. Smith, C. W. and Watts, R., 1982. Incentive and tax effects of executive compensation plans. Australian journal of Management, pp. 139-157. Read More