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Regulation is defined as a set of rules that is designed to control and govern conduct by authority (Deegan 2009, p. 59). On the basis of this definition, Deegan (2009, p. 59) has defined regulations relating to financial accounting as rules that are developed by independent authoritative body to govern the preparation of financial statements which are accounting standards. Since decades ago, there have been arguments for and against the existence of accounting regulations.
With a stance of pro-regulation, this essay is going to examine the reasons that financial accounting and reporting should be regulated and the merits of accounting regulations. Firstly, financial reports are normally prepared by the management of the company who are not the owners but are involved in managing the company. They possess more information than the shareholders and stakeholders so information asymmetry arises between them. Without regulation, even though management might disclose relevant accounting information voluntarily in order to get funding, the degree of credibility and completeness of information is unclear.
According to the analysis of Lang and Lundholm, the accounting disclosures specifically for firms that make equity offerings has a significant increase within the six months before the offering occurs particularly in those categories the firm has discretion (cited in Healy and Palepu 2001, p. 421). It shows that the business might not disclose all relevant information to users or is withholding information unless the disclosures is for their benefits, which posts a question of the reliability of voluntary disclosures. Furthermore, the existence of asymmetric information will lead to inequality of opportunity and returns among investors.
According to Schroeder (cited in Lee, Rosenthal and Gleason 2004, p. 79), before Regulation Fair Disclosure imposed in America, Wall Street brokerage companies and their best customers managed to reap trading profits before most investors get the news because they processed market-moving information such as earnings forecasts and mergers. With accounting regulations that create minimum disclosure requirements, all investors will then be equipped with same accounting information so insider information and inequity of opportunities will be reduced.
Secondly, the claim made by ‘free market’ perspective to treat accounting information as other normal goods should be rejected because accounting information are unlike normal goods such as bread or house. It is a public good because the use of it by one investor does not prevent the usage of others (Hendriksen & Breda 1992, p. 247). As non-investors have right to use the accounting information such as income statement and balance sheet as much as investors, investors will not agree to pay for the financial reports because others will become free-rider; thus, this prevent the function of normal pricing system of accounting information.
As no income is received by producers of financial reports, they will not willing to produce it or will underproduce it so ‘free-market’ perspective is not applicable. Under this circumstance, Demski and Feltham (cited in Deegan 2009, p. 65) states that for public good like accounting information, a more collective approach to its production is more desirable. This can be achieved by legislatively regulating the productions of accounting information so companies will produce the accounting information to meet the demands of external users and thus ensuring efficient capital market.
According to Godfrey, Hodgson, Holmes and Tarca (2006, p. 386), when conditions like information asymmetry and free-riders or public goods problems arise, a potential market failure can occur because the market is inequitable and inefficient. Without sufficient regulation, public will be left unprotected and suffer unreasonable losses during the occurrence of market failures such as corporate collapses of Enron and HIH Insurance. This will lead to the decrease in confidence of public regarding the efficiency of the capital markets and they might not be interested in investing in capital market anymore.
With regulation, consumer interests will be protected by securing improved economic performance as compared to an unregulated situation (Godfrey et al. 2006, p. 386). It can be shown by the example of European Union which chooses to adopt a ‘watered-down’ version of IAS 39 (Deegan 2009, p. 98). As the adoption of full version of IAS 39 is expensive but the non-compliance of it might cause a widespread of social and economic effects such as undue impact in the confidence of stakeholders in European capital markets, the European Union has chosen to adopt a ‘watered-down’ version.
Although the ‘watered-down’ version is not the best practice, it is economical and public interest can be protected as financial instrument of companies is still under regulation, which is better than an unregulated situation. Furthermore, the international harmonization also raises some problems with respect to the applicability of capture theory embraced by the opponent of regulation. The lobby groups in many countries have lost their ability to influence the process of developing the national accounting standards due to the adoption of international standards.
It is evidenced in the event that the failure of Australian companies with substantially internally generated intangible assets or intangible assets without an active market to lobby the IASB, AASB and Australian Government for relief from the impacts of IAS 38 (Godfrey et al. 2006, p. 390). It shows that international harmonization of accounting standards has significantly reduced the influence of lobby groups and the interest of public is the main focus of accounting standards setting.
Moreover, accounting regulations can enhance the uniformity of accounting information because accounting information will be presented by using the available uniform alternatives. It will then increase the comparability of accounting information which reduce research costs of users and simplify users’ process of comparing companies. Moreover, according to Hendriksen and Breda (1992, p. 248), availability of many alternatives permits firms to manipulate the accounting figures to produce a biased view of the performance of company. Thus, with regulations to restrict the alternatives, the credibility of financial reports can be improved.
Furthermore, the increase in globalization has led increase in contribution of capital by foreign investors. Due to this, the comparability of accounting information has become more important because investors need to compare financial performance of companies across countries in order to make investment decisions. Therefore, the existence of regulations ensures the consistency, credibility and comparability of financial reports; which allow users to easily compare performance of companies in either same or different countries and increase the efficiency in investment decision-making.
In conclusion, due to globalization and harmonization of international standards, the accounting standards have evolved to a higher level more reflective of quality financial information. Despite there is still a lot of opposition of accounting regulations, its existence can protect public interest, correct inefficiency and inequitable opportunities in the market and increase comparability of financial reports. Therefore, it is undeniable that the existence of accounting regulation is important as it brings more good than harm to the society. References Deegan, C 2009, Financial Accounting Theory, 3rd edition, McGraw Hill, Australia.
Godfrey, J, Hodgson, A, Holmes, S & Tarca, A 2006, Accounting theory, 6th edn, John Wiley & Sons Australia, Milton, Queensland. Healy, PM & Palepu, KG 2001, ‘Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature’, Journal of Accounting and Economics, vol. 31, nos. 1-3, pp. 405-440, viewed 13 August 2009, . Hendriksen, ES & Breda, MFV 1992, Accounting theory, 5th edn, McGraw-Hill, United States of America. Lee, C, Rosenthal, L & Gleason, K 2004, ‘Effect of regulation FD on asymmetric information’, Financial Analysts Journal, Vol. 60, No. 3, pp. 79-89, viewed 12 August 2009,