ACT301 Week 3 Tutorial

Chapter 3: The regulation of financial accounting

3.1 The Oxford English Dictionary defines regulation in terms of a ‘prescribed rule’
or ‘authoritative direction’. This is similar to the definition provided by the
Macquarie Dictionary which defines regulation as ‘a rule of order, as for conduct,
prescribed by authority; a governing direction or law’. Therefore, on the basis of
these definitions we can say that regulation is designed to control or govern
conduct. Hence, when we are discussing regulations relating to financial
accounting we are discussing rules that have been developed by an independent
authoritative body that has been given the power to govern how we are to prepare
financial statements, and the actions of the authoritative body will have the effect
of restricting the accounting options that would otherwise be available to an
organisation. The regulation would also be expected to incorporate a basis for
monitoring and enforcing compliance with the specific regulatory requirements.

3.3 The basis of the ‘lemons’ argument is that if an entity elects not to disclose
particular information, and perhaps its competitors are making disclosures, then
the non-disclosing entity must have something to hide. In such respects it must
have bad news which it would prefer people not to know about. It is a lemon. If
we accept this perspective that no news will be considered as meaning that the
organisation is hiding bad news, then stakeholders will react negatively to
companies that do not make disclosures when some disclosure was expected
(this reaction might be in the form of capital market participants paying lower
amounts for the securities of the organisation).

The ‘market for lemons’ perspective is assumed to provide an incentive for

managers to release information, even in the absence of any regulation that
requires disclosure, as failure to disclose will have implications for the
organisation, and if we assume that various contractual arrangements are in
place, also for the managers’ own wealth. Of course, whether we actually
believe that the market will penalise non-disclosers is a matter of opinion. Is the
market really expected to be so efficient that it becomes aware of potentially bad
news about some (perhaps unexpected) issue which has not been disclosed?
What do the students think about this?

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3.6 A ‘public good’ is a good which, after it is first made available, others can use
without paying for and which can be passed on to others that also do not pay for
its use. Public goods, or free goods as they are often called, are traditionally
considered as goods which are not scarce and which do not have a price.

Relying upon market-based arguments to ensure that optimal amounts of a good

are produced assumes that all users pay for the good. If free-riders exist (people
who use but who do not pay) then the quantity of a good will be under-produced
relative to what would be produced if all that used did pay. It is possible that
users of a public good would pay for it if required, but if a good is public in
nature then there is no need to pay for it. Advocates of accounting regulation use
this argument to suggest that optimal amounts of information will not be
produced if we are to rely upon market-based mechanisms alone.

3.19 (a) In the public interest theory of regulation the regulators are assumed to
act in the interests of the public and will only introduce regulation if the
benefits to the public are believed to be greater than the costs. Regulation
is not introduced to support particular vested interests and the regulators
are not assumed to be driven by their own self interests.

(b) Advocates of capture theory also typically assume that regulation is also
initially introduced with the public’s best interests in mind. However,
once regulation is introduced, the parties that had been subjected to the
regulation tend to be able to capture the regulatory process. The regulated
parties typically do this for their own benefit. Hence, while it is assumed
that the regulators might act in the public interest, it is typically assumed
that those subjected to regulation act in their own self-interest. We can
debate whether it is consistent to believe that some people act in their
own self-interest whereas others (for example, the regulators) do not.

(c) Economic interest theories of regulation assume that everybody acts in

their own self-interest, including regulators and those people that are
regulated (perhaps not an overly pleasant view of human nature).

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Regulators will only propose and support regulation which leads to
favourable outcomes for themselves, perhaps in terms of their re-election.
This perspective does assume that all people have similar motivations (in
contrast to capture theory).

Students should be encouraged to consider which perspective of

regulators matches best with their own views.