Advanced Accounting Theory and Practice - The Regulation of Financial Accounting - Coursework Example

Advanced accounting theory and practice-The regulation of financial Accounting Free Market Perspective on Regulation. The free market perspective provides a platform through which the accounting information is treated like other goods and services. The natural forces of demand and supply should be in a position to operate freely to enable reaching an optimal supply of information concerning a certain business entity. Arguments Supporting Free Market Perspective 1) Market for Managers The managers past track of performance has a big impact on the remuneration that he or she will command in the future either from the current employer or elsewhere. The salary is at per with the level of skill and expertise portrayed by the manager. In this market, the managers will have the incentives to optimize the value of the firm as the successful actions that they portray will be known by the market. Since providing information to different parties with which the company contracts is of benefit to the firm, the managers will be motivated to provide information even in the absence of regulation. The assumptions under the market for managers include: a) The capital markets are efficient b) Information about the past performance of the managers is known to the company, and it will play a significant role of creation of future salaries c) The labor market for managers works efficiently. d) The strategies set up by the managers of the firm have proven to be of positive impact on the share prices. 2) Market for Corporate Takeover/ Control When the internal governance or board of directors of a company fails, market for corporate control comes into action. Market for corporate control is also referred to as the external corporate scrutiny. This control is a form of a takeover market in which the companies, that are underperforming or undervalued, become attractive targets for acquisition by other potential firms. Poor performance of a company is usually attributed to the internal governance. In this case, the external management control is needed to revive the company. The potential acquirers may opt to buy off a substantive amount of the enterprises equity so as to have maximum shares and take control of the board. Subsequently, the top management team will be replaced as the poor performance of the firm is attributed to poor management. The primary aim of a market takeover is to revitalize a poorly managed firm by restructuring the functions so as to achieve higher profits in the long run. The acquirers believe that they have the potential to position the business more efficiently than the current managers of the firm. The eminent threat of takeover plays an important role in aligning the goals and objectives of the organization by the current management. The managers tend to perform more efficiently to avoid the market takeovers 3) Market for Lemons The Lemons model indicates that there will be a market failure if two conditions exist in the economic market. First, if there is a differential product where buyers are offered both high and low-quality products. Secondly, there is asymmetry in information concerning the quality of the product that is favorable to the seller as compared to the buyer which is an expense. If the conditions hold, then the poor quality products will start replacing the high-quality products in the short run. The dishonest and crook sellers often take advantage of the buyers who are not well informed. In the market for lemons principle, all organizations are required to provide relevant information. The companies, that fail to provide the information, face punishment from the market. The information is characterized by a higher cost of capital. If the firm does not release any information, then the public might assume that the firm has negative news to disclose thus the silence. Therefore, no information is seen as wrong information or ‘lemons. The managers of the company are, therefore, motivated to release any piece of news they have voluntarily despite being good or wrong. 4) Private Economic Based Incentives The organizations decide on what information to provide and produce. The decision is primarily based on parties that the company is involved with and the total assets in question. There is an assumption that internal and external auditing will take place even in the absence of regulation. This measure minimizes potential risk to the stakeholders of the company. This principle assumes that the managers will act and operate the business to suit their personal benefits. Therefore, the management enters into contracts with the shareholders so as to constrain the actions of the managers that are of self-interest. The contracts are solely pegged on the accounting information of the company. The firms that do not produce any accounting information often face higher costs of capital as penalties. The arguments above will not hold in times of financial crisis. With an absence of accounting regulations, there exist private incentives in the production of accounting information. Consequently, companies that do not produce accounting information face penalties through higher cost of capital. Contribution of Adam Smith to Financial Accounting Regulation: Principle of Laissez Faire and Invisible Hand The Laissez-faire doctrine is a system wherein a competitive market economy, the commodity prices are determined by the forces of demand and supply. The economy is, therefore, free of any intervention or moderation hence driven by the natural market forces. The market is left to work on self-regulate basis (Henry 2008). This principle is based upon Adam Smiths principle of the ‘invisible hand where the individuals are driven by self-interest. Adam Smith contributed an economic principle known as the ‘invisible hand theory. The policy is set on a belief that if the acting government does not intervene in anything, then there will be a controlling factor in the individuals themselves who can aid in guiding the markets. The government should be liable in the definition of the property rights, imposition of different taxes so as to compensate the market failures and most importantly to establish honest courts (Henry 2008). Adam Smiths theory of the ‘invisible hand states that if each of the consumers chooses freely what to buy and each of the producers chooses freely what to sell and what method of production, the market will settle at affordable prices and beneficial product distribution to all the individual consumers and the whole community. The application of self-interest provides a drive to the market actors to engage in useful behavior. The producers employ efficient methods of production that are needed to maximize the firms profits. In order to maximize the revenue, the company charges low prices by undercutting the competitors and increasing the businesss market share. The investors invest more in those types of markets in order to maximize the returns. The investors in turn withdraw their capital from those organizations that are less efficient in the creation of value. The idea of the ‘invisible hand theory is to become the sole producer of a particular commodity. The producer is considerate to lower the commodity price for the consumers to afford the product thus creating a commendable reputation of the company. If the users are content with the merchandise, they will collectively support the business hence making it harder for other companies to open market. The individuals try to maximize their good so as to become wealthier and this leads to the society becoming better off. According to this doctrine, there is no need for government intervention as the theory of the ‘invisible hand provides the best guide to the economy. The main idea behind the ‘invisible hand theory is the same idea behind laissez-faire capitalism. According to laissez-faire capitalism, the capitalist community functions without anyone influence the control of it (Block & Barnett 2005). There is no visible hand that dictates to the companies what to produce, or there exists an invisible hand. Instead, the producers try to become wealthier by producing commodities that they think the consumers will want. In this case, the customers are the one to determine the survival of the products and the company. They determine the survival by choosing whether to buy the companies commodities or not. Hence, there exists an invisible hand based on the consumers will that ultimately determines what happens in the market or the economy. Adam Smiths doctrine of the ‘invisible hand is in favor of a free market. On the contrary, the principle of laissez-faire gives a recommendation that the government should have minimal interference in the economic affairs. It is possible for monopolistic powers in markets to arise due to government intervention. Therefore, there is need for a level of regulatory intervention so as to protect the most vulnerable on issues of public interest. Arguments for Financial Accounting Regulation Through financial accounting regulation, there is the reduction of litigation risk to the internal and external auditors of a firm. Therefore, the standardization of accounting information helps in enhancing consistency and ultimately boosts the spread of expert knowledge. The auditors can, therefore, make professional decisions and actions and justify them by using the set regulations and following the best practices. Thus, the level of professionalism increases among the stakeholders. With the increased level of expertise, there is greater consistency that leads to the development of network externalities through the standardized products. As the number of users increase, then the optimal value of the product or service also increases. Through accounting regulation, there is cost saving in the vast market. Through this avenue, it is easy to manage relevant information and compare across others. More costs are avoided if the standardization requires the disclosures that the companies are ready to provide voluntarily. The regulation helps in keeping the cost of negotiating disclosures with different parties when the result does not have an enormous variance across the companies. The primary aim of the rules of reporting is to produce the optimum level of efficient disclosure. Accounting regulations promote comparability. Accounting standards creates a sense of universality to financial record keeping. Therefore, it becomes easy to compare the financial positions of the same entities. The ease of comparability helps the internal and external individuals or observers to weigh the state of one entity in the context of the other comparable entity. Accounting standards promote transparency within the organizations. The principles, norms and procedures that constitute the accepted accounting principles are there to provide direction to the company and provide information to the public. Transparency is essential more so for public entities such as government owned organizations and the businesses that trade in public. The organizations, that employ accounting regulations, provide the most relevant information and in a reasonable way. The companies generate pertinent information that the observers or public are most interested in knowing and that are guided by accounting principles. Therefore, companies should provide information in a way that is appropriate and fair that represents the current financial position of the enterprise. The use of regulations makes it difficult for firms to misdirect and misinform the public and observers through the provision of relevant information. Accounting standards bring immense value to financial documents for the various potential audiences that base their critical decisions on them. If there are no accounting regulations, it will be a hard and risky task for investors, auditors, taxpayers and reporters to analyze the company. An investor may find it hard to trust the financial reports of a publicly trading company if there are no accounting standards observed. Rules mean that the regulators follow the laws and the taxpayers can trace how the tax is being spent. Arguments against Financial Accounting Regulation On the contrary, regulation is a costly mechanism to the firm. Through standardization, the compliance costs increase. The business needs to invest in trained and experienced personnel who are expensive. The experts interpret and put into action the regulations on a regular basis to the financial aspects of the business. Regulation can promote anti-value creation for the company. The most valuable resources of the company can divert focus from value creation to decreased profit outcome and costly risk management measures. These are of fewer benefits to the economy at large. The regulations are of little or limited value if the firm is not capable of enforcing them. The enforcement of the standards is both costly and challenging. The resources, that the makers of the regulations require to enforce the accounting standards, is significant given the volume of financial transactions of the firm each year and the complexity. The resources can instead be used in the creation of value-adding activities within the society. Financial accounting regulation does not always value accounts appropriately. The process of the rules usually adopts a one-size-fits-all approach. This process limits the potential of a business from reporting the real value of particular accounts or the actual resource value of the enterprise. Judgment based on regulations can have a lesser value to the shareholders than a situation informed or expertise-based judgment. The use of controls can be politically influenced. Regulations can be biased to a particular political point of view. These types of regulations are detrimental to any upcoming or existing business. Political influence driven regulations destabilize markets during crisis by making it difficult for investors to measure risks. Regulatory Theories 1) Public Interest Theory This theory holds that the industry regulators tend to find and implement economically efficient market solutions. In imperfectly competitive markets, the market power of the firms should be adequately controlled. The regulatory body is assumed to be a neutral arbiter and is after the interest of the public. The body does not let its self-interest affect the decision-making process and instead has the interest of the public. The regulation exists so as to correct the shortfalls of the free market economy mechanism. The market failures include externalities and monopoly. Through the public interest theory, competition is insured, the economy is stabilized and there is the introduction of social objectives in economic policies. Economic regulation is necessary especially where monopoly exists, and the conditions make sustained collision likely. The public interest theory completely ignores self-interest. Therefore, there are no verified outcomes making this theory completely naïve and invalid. The public interest theory does not take into consideration the political and social impacts of the accounting regulations. 2) Capture Theory This theory argues that although regulation is usually for the sake of safeguarding the public, the mechanisms of the regulator are subsequently captured or controlled so as to safeguard the interests of a particular interest group within the society. In as much as the primary aim of the regulator is to safeguard public interest, it has proven difficult for the governor to remain neutral. Therefore, the regulated firms tend to take charge or capture the regulating body so that the regulators eventually become the controlled. The capture theory ensures that the regulations, that govern the market, are of advantage to the industry. The large accounting companies are the ones that control the regulation setting process. On the other hand, the upcoming regulatory bodies that are set up are often populated by the firms that are meant to be regulated. In conclusion, there is no form of decision independence by the regulator. Self-interests are vested in the standard setting process hence there is a lot of bias from the existing large accounting firms. The regulated companies can also create a regulating agency to vest promotion of self-interest. 3) Private Interest Theory The theory assumes that companies will form different groups so as to protect their economic interests. It is evident that the different groups will be in conflict with each other since they have different vested interests. Therefore, the groups will lobby the government to intervene and put in place legislative measures that will benefit particular groups at expense of others. This theory does not put into consideration public interest. The regulators, who are individuals, are motivated by self-interest. The regulator is not neutral but is viewed as an interest group. The governor will try all means possible to maintain its position of power. Due to the imperfect information concerning the ultimate gains and losses resulting from accounting regulation, there is a reduction in the winning groups coalition. Therefore, the winning group coalition will not receive a fat gain as compared to the way it could be by the regulator. In as much as groups, organize themselves according to the economic interests, it would be favorable if the regulator produces a coalition that includes members of the loser group. The groups, that do not have adequate power, do not have the mandate to lobby effectively for regulations that will protect their interests. The agents face rationality when choosing actions that aim at maximizing utility. Bibliography Block, W., & Barnett, W 2005, The Economic Case For Laissez Faire Capitalism. Humanomics, Vol.  21(3), Page 49-61. Henry, F, J 2008, The Ideology of the Laissez Faire Program. Journal of economic issues, Vol. XLII (1), Page 1-5. Read More