The Three Theories of Regulation - Assignment Example

Advanced Financial Accounting Questions Name Institution Date Question 1 Describe and evaluate the three theories of regulation. In your answer, explain the assumptions underlying the motivations of regulators under each of the perspectives. Over the years, arguments and debates have been made in regard to the significance for regulation. On the one hand, non-supporters of regulation belief in the stability of markets to operate on their own to best serve society, utilizing the allocation of resources. On the other hand, supporters of regulation argue against the stability of markets which they emphasize that do not often operate within the best interests of societies. In this case, some protective mechanisms in the form of regulation is perceived to be necessary to control the market as a way ensuring that the best interest of societies are protected. Regulation can protect societies from the many instances of undesirable activities in the market. Due to the economic crash of the 1920-30s which caused the need for having accounting principles and theories described below, accounting and accountants are currently subject to different forms of regulation. For example, laws have been put in place which governs the operation of organizations, particularly those involving the disclosure of any financial information (Gaffikin, 2005). The Three Theories of Regulation Public interest theory The theory advocates for the need to use regulation as a means to protect the public. The assumption of this theory is that regulation body which in most cases it is the government, exists as a neutral arbitral of specifically the ‘public interest’, and thus cannot allow its own self-interest affect its rule-making processes. Therefore, the rationale for the public interest theory is to provide protection in the circumstances of inefficient market. The regulation made based on this theory is aimed at providing equal benefit to all people or the society at large rather than certain interests. It should be noted that the regulatory body is required to represent interests of the entire society instead of protecting the private interests of the regulators. Capture theory The capture theory of argues that albeit using regulation to protect the public, the mechanisms used are subsequently captured or controlled purposely to secure the interests of a given self-interested groups in a society. Therefore, the justification for this theory is that the regulated often develop a tendency of capturing the regulator. It means that the regulated endeavour to capture the regulator, making the rules subsequently required of the parties subject to regulation to follow more advantageous. Initially, the regulating body was expected to protect the public interest but now it has become difficult for regulator continue executing its mandate as an independent body. Economic Interest Group Theory (Private Interest Theory) With the economic interest theory of regulation, it is assumed that each and every person acts in his or her own self-interest, and thus both regulators and individuals that are regulated act in their own self-interest. The rationale for this theory, therefore, is that regulators will focus only on favouring the outcome the will specifically benefit them, for instance, re-electing them in the office for the positions they hold in an organization. Basically, the theory assumes that groups will unite to protect specific economic interests yet groups conflict with each other. As a result, the government may be required to pass legislation through which a group will benefit at the expense of others. The idea of public interest is not addressed in this theory, and thus both regulators and all other parties seem to be motivated by their own self-interest (Deegan & Rankin, 2006). Ordinarily, the standard-setting was to promote the public interest more than the private interest. It is notable that public interest is common within the capital markets which are characterized by efficient and effective operation of equity and debt. In efficient markets, it should be expected that firms will fail. However, firm failure is not necessarily caused by delay in manipulation of financial reporting system. A number of corporate failures, occurring at the same time, are supported by claims that there are faults within the financial reporting system. As a result, legislations changes frequently which also affect the financial reporting framework. Basically, the public interest theory of regulation argues that the significance of regulation and the regulatory changes caused are intended to protect the public whilst avoiding the market failures. However, the private interest theory assumes that parties subject to regulation would search for regulations that work best or favourable to them. Although it is obvious that lobbying regulations will be focused on ensuring public interest, it is only the most authoritative lobby group that will dominate the nature and power of regulation (Godfrey & Langfield-Smith, 2005, p.1983). Question 2 Describe the normative measurement theories proposed in the 1950s, 1960s and 1970s as alternatives to historical cost accounting. Discuss the effectiveness of these theories in improving accounting measurement. The normative measurement theories explain the alternative methods of accounting also known as ‘alternatives to historical cost accounting or’. The theories were proposed by different people based on the idea that historical cost accounting had several shortcomings, during the period of rising prices and volatile market conditions. These alternatives have been developed purposely to cope with the emerging issue dynamic prices as well as changing market conditions. It is notable that information from historical cost accounting suffers greatly from issues of irrelevance, particularly during the period of rising prices. Such information is always questioned whether if it can be regarded as useful or not to inform that a particular item cost a given amount years back when its current value is considerably different. By converting the figures originally measured in the basic historical cost accounts into a more advanced CPP statement, there is a distinction made between monetary items and non-monetary items (Deegan, 2011). Current purchasing power (CPP) accounting also known as ‘general purchasing power’ accounting or general price level accounting was proposed in the early works of Sweeney (1964) and it has gained favour of several other researchers. Professional accounting bodies across the world have supported CPP accounting, particularly in the supplementary disclosure of an organization’s financial statements that were originally prepared from historical cost accounting. The normative measurement theory of accounting was developed based on the assumption that during the period of rising prices, entities that would distribute unadjusted profits obtained from historical costs, there could be a reduction within the real value of such an entity. This implies that the entity could be in a risk of distributing a section of its capital (Deegan, 2011). CPP accounting ensures reliable use of indices, hence is universally accepted because of it is easier and less costly to use as compared to methods that focus on current valuations of some assets. Although CPP measured based on price indices, it is important to understand how indices are constructed. Generally, CPP accounting uses a general price index to measure the non-monetary items within historical cost financial statements. It converts the figures originally measured in the basic historical cost accounts into a more advanced CPP statement, creating a distinction between monetary items and non-monetary items (Deegan, 2011). This helps to assess the general change in the purchasing power of money. Based on the index applied, the increase in the value of net assets over the previous period results in a ‘real’ profit for that particular time. CPP is simple and objective because it works based on the standard index. Since it is able to adjust for changes within the unit of measurement, CPP becomes a real system which can be used in inflation accounting. It is also efficient in measuring the impact on an organization from the perspective of shareholders purchasing power (Ryan, 2001). Current cost accounting (CCA) is one of the different alternatives to historical cost accounting. The supporters of this normative measurement theory include Edward and Bell (1961) who rejected historical cost account and CPP proposed for the need to have a method that could provide actual valuations. CCA distinguishes profits from trading as well as gains achieved from holding an asset. Different versions of CCA, particularly those mentioned in the works of Edwards and Bell, utilize a physical capital maintenance method in income recognition. By determining valuations based on replacement costs, it means that operating income will represent the achieved revenues and minus the replacement costs incurred for the assets valuated. In so doing, a measure of income is generated to represent the maximum amount to be distributed and at the same time ensuring the stability of operating capacity. Therefore, CCA applies asset-specific price indices to costs incurred on goods sold as well as assets consumed so as to generate the values based on the cost at the real time of consumption. With this measurement in which assets consumed can be valued at a current value, it implies that the profits are lower accurately representing either an increase or decrease in the capital of a given organization. Use of the current value system of accounting helps to measure assets and liabilities regularly and record changes within the value as they occur. It becomes easy to calculate the profit that shows the capability of an organization to continue operating, or an improved level of activity that took place in past or a reduced level in situations where loss occurs. This normative measurement operates on the assumption of deprival and value to a business. Therefore, CCA gives users ability to evaluate the current state or recent level of performance of an organization’s business activities (Lunt, 2009, p.341). References Deegan, C & Rankin, M., (2006). Financial Accounting Theory: Chapter 3: The Regulation of Financial Accounting. McGraw-Hill Australia Pty Ltd. Deegan, C., (2011). Chapter 5: Normative Theories of Accounting 1:The Case of Accounting for Changing Prices and Asset Values, pp.157-203. Godfreyô, M.J & Langfield-Smith, A.I.,(2005). Regulatory capture in the globalization of accounting standards. Environment and Planning 37, pp.1975 -1993. Gaffikin, M., (2005). Regulation as Accounting Theory. Research Online. University of Wollongong. Lunt, H., (2009). Fundamentals of Financial Accounting, CIMA official learning system. Elsevier. Ryan, B.J., (2001). Measurement in financial accounting: critical support for historical cost. Research Online. University of Wollongong. Read More