- The free market
- Incentives for disclosure
- The ‘pro-regulation’ perspective
- Supporting evidence
In every nation, there are standards that apply in regulating accounting and reporting procedures. These standards may be specific to that country or region or as is the case with many countries, they can be the generally accepted accounting principles (GAAPs). The case with Australia is quite different as the principles that apply in the nation are specific. Some concerns exist as to whether these are necessary with one side supporting the regulations while the other arguing that they are not necessary. Either party has posed arguments based on different theories to support their position. This paper aims at highlighting the arguments of both the proponents and the opponents of the issue and evaluating their evidence in order to shade more light into the issue.
The free market
The free market theory supposes that the accounting information is like any other product or service the organization provides and therefore is subject to the laws of supply and demand. Therefore, according to this theory the market forces and not the government regulations should regulate the information disclosure (Deegan, 2007; Baldwin & Cave, 1999). Ultimately, in this theory, market forces determine what information and the quality of information to provide at equilibrium.
The free market presents the idea of equilibrium. At this point, the cost of providing information is equal to the benefits reaped from providing that information. When these forces are not equal, it is a state of in-equilibrium and therefore the market forces of supply and demand interact to bring the situation back to equilibrium. Therefore, market based regulation will inspire non- supply or supply of misleading information.
Incentives for disclosure
Proponents argue that, the absence of regulation will not demean the accounting information provided, since there are various incentives that will prompt the provision of quality information. The first on this list is contractual incentives. Contractual requirements provide information for monitoring of managers thus overcoming the challenge of moral hazards; it also requires the disclosure of accounting numbers and thus the requirement for accounting and auditing (Deegan, 2007; Watts & Zimmerman, 1986). Furthermore, the threat for price protection transfers incentive to managers from other parties and thus acts as an incentive for them to supply information.
Another incentive for managers to provide information is the capital markets. Given this incentive, managers will provide information about potential investment to avoid adverse selection. The need to raise capital also provides an incentive for managers to provide financial reporting information and penalties for non-supply of misleading information will include higher cost of capital (Deegan, 2007; Watts & Zimmerman, 1986). Other aspects like corporate takeovers, market for ’lemons’ and potential litigation provide the incentive for managers to disclose even the bad information.
The ‘pro-regulation’ perspective
This perspective holds that the information of the organization is not like any other product or service because this would mean that those who require the information would pay to receive it. If they do not pay and the information is not available, the organizations will suffer the consequences of uncertainty of the organizations performance.
The proponents of regulation have come up with several theories to support their position on the matter. First is the theory of public interest. First, the market is prone to failure due to inefficient or inequitable market practices and therefore, the government has to intervene at the interest of the public (Smith, 1992; Bromwich, & Hopwood, 1983). This therefore makes the government a mediator as opposed to a market participant as a single unit. A good example is the 1984 intervention by the government, which was because of market failure resulting from failed companies with clean audit bills and lack of info stemming from information asymmetries. This evidence shows what would happen without regulation.
Another argument is that the government’s intervention is at the profession’s interests. The accounting profession has an interest in controlling and overseeing the regulation of financial reporting (Walker, 1987, p. 272). This interest failed because of non-compliance and lack of legitimacy and therefore, the government provides an alternative solution- regulation (capture). The professional body set these regulations and the government legitimized them. This translates to the fact that the outcome of those regulations is perfect for the accounting profession.
Furthermore, the proponents of regulation argue that, in as much as the free market at average is at equilibrium, the interest of individual investors, who are at risk of losing their investments because of this unregulated information disclosure are not considered (Briloff, 1972; Watts & Zimmerman, 1978; Clarke, Dean & Oliver, 2003). Therefore, the government regulation plays an important role in safeguarding the rights of these individual investors and thus regulation is a necessity.
The free market approach views the managers as having the incentive to disclose information while at the same time as having to weigh the cost and the benefits of disclosing certain information. It the costs outweigh the benefits, they withhold the information otherwise they disclose (Bromwich & Hopwood, 1983). This therefore, if not regulated, will lead to serious discrepancies in the financial information as managers may manipulate the information for their benefit. To prevent such, regulation is an important aspect of the reporting process.
Finally, some of the individuals demanding information in the market are more powerful compared to others. Because of this, regulation plays an important role in providing a level playground for all market participants and thus protecting the vulnerable one in the market.
Baldwin, R., & Cave, M. (1999). Understanding Regulation, Theory, Strategy and Practice. Oxford: Oxford University Press.
Briloff, A. J. (1972). Unaccountable Accounting. New York: Harper & Row.
Bromwich, M., & Hopwood, A. (1983). Accounting Standards Setting, an International Perspective. London: Pitman Books Limited.
Clarke, F., Dean, G., & Oliver K. (2003). Corporate Collapse, Accounting, Regulatory and Ethical Failure. 2 Ed. Cambridge: CUP.
Deegan, C. (2007). Australian Financial Accounting. Australia: McGraw-Hill.
Smith, T. (1992). Accounting for Growth: Stripping the Camouflage from Company Accounts, London: Century Business.
Walker, R. G. (1987). Australia’s ASRB. A Case Study of Political Activity and Regulatory Capture. Accounting and Business Research, v 17, 269–286.
Watts, R., & Zimmerman, J. (1978). The Demand and Supply of Accounting Theories: The Market for Excuses, The Accounting Review, v 54, 273-305.
Watts, R., & Zimmerman, J. (1986). Positive Accounting Theory. NJ, Englewood Cliffs: Prentice Hall.