Accounting Regulation and Market Failures

The Regulation of Financial Accounting

• Regulation is designed to control or govern conduct and is defined by the Oxford Dictionary, in terms of prescribed rules or authoritative direction.
• The Macquarie Dictionary defines regulation as a rule of order, as for conduct, prescribed by authority, a governing direction or law.
• When discussing regulations related to financial accounting, these are rules developed by an independent authoritative body.
• The body is given the power to govern how to prepare financial statements, restricting accounting options for organizations.

Why Examine Theories of Regulation

• It helps understand the reasons why some accounting prescriptions become legislation.
• Accounting students should gain insights into political factors influencing the rules learned.
• Accounting standard-setting is a political process that can prevent technical and logical requirements because of political influence.

'Free-Market' Perspective

• There are alternative views on regulating accounting disclosure with one being the free-market view.
• This view believes we don't need all the current regulations.
• Accounting information should be treated like other goods with demand and supply generating optimal supply.

Arguments Supporting 'Free-Market' Perspective

• Private economic-based incentives
• Market for managers
• Market for corporate takeovers
• Market for lemons

Private Economic-Based Incentives

• Assumes managers prioritize their benefit but they will be held accountable by shareholders and debtholders.
• If managers' self-interested behavior is not controlled, they will be paid a lower salary
• Management enters contracts with shareholders/debtholders to constrain their actions.
• Contracts are often based on accounting information e.g. management bonus schemes and debt covenants.
• Organizations not producing information will be penalized via higher costs of capital.
• Organizations determine what information should be produced based on involved parties and assets.
• Regulation restricting accounting methods decreases efficiency of contracting.
• Auditing reduces risk to external stakeholders, allowing organizations to attract funds at a lower cost.

Problems in Presence of Many Different Parties

• The 'contracting argument' has problems with many owners or debtholders.
• There may be too many parties for contracting or prohibitive negotiation costs if investors want conflicting information.
• There may be high negotiation costs for a single contract, and questions arise about whether everyone assumes self-interest.

'Market for Managers' Argument

• An argument countering regulation posits that managers will still do the 'right thing' due to the 'market for managers'.
• Managers' previous performance will impact future remuneration and therefore, managers will want to maximize firm value.
• Maximizing firm value includes providing the optimal amount of accounting information.

Assumptions Underlying 'Market for Managers' Argument

• The managerial labor market operates efficiently with information about past performance known by prospective employers.
• The capital market is efficient; effective managerial strategies are reflected in positive share price movements.
• Problems arise if a manager is nearing retirement, and the labor market's efficiency is questioned.

'Market for Corporate Takeovers' Argument

• Another mechanism is "market for corporate takeovers," which motivates managers.
• Underperforming organizations will be taken over by another entity and existing management will be replaced.
• Managers are motivated to maximize firm value and to minimize the cost of capital.
• This theory assumes managers know the marginal costs and benefits of information

'Market for Lemons' Argument

• The 'market for lemons' suggests no information is viewed as bad information.
• Silence implies the organization has bad news they won't disclose.
• Therefore, managers are motivated to disclose both good and bad news.
• Evidence shows that both good and bad news are disclosed voluntarily.

Additional 'Market for Lemons' Considerations

• Assumes the market knows managers have news to disclose, which might not always be realistic.
• The market is expected to react later if non-disclosure becomes available e.g. Enron.
• Several factors, mainly market for managers, corporate takeovers, lemons, self interest, are considered justification for restricting accounting regulation

Pro-Regulation Perspective

• Accounting information should be treated as a public good.
• In the presence of free riders, true demand is understated, leading to underproduction.
• Regulation is necessary to reduce the impacts of market failure, because the pricing system does not function properly

Supply of 'Free' Goods

• Some argue free goods can be overproduced as a result of regulation.
• The public, knowing they don't pay, will overstate their need for the service which for example, can lead to 'accounting standards overload'.

Role of Adam Smith's 'Invisible Hand'

• This notion is used in favor of the free market.
• Milton Friedman argued that market mechanisms protect market participants.
• The market prevents interference between individuals because consumers and sellers can choose to work with others.

Invisible Hand Criticisms

• The free-market argument ignores failures in markets and uneven distribution of power.
• Adam Smith was concerned with monopolistic powers due to government intervention.
• He advocated regulatory intervention in some instances to protect the vulnerable and the public interest.
• Businesses want reduced regulatory interference, using economists like Adam Smith to support positions.

Theories to Explain the Introduction of Regulation

• Public interest theory
• Capture theory
• Economic interest group theory (private interest theory)

Public Interest Theory

• Regulation benefits society rather than any vested interests.
• Regulatory bodies/politicians represent society's interests over private ones.
• The enactment of regulation is a balance of perceived social benefits and costs.
• It assumes government is a neutral arbiter, but these assumptions may conflict with knowledge of politicians.

Capture Theory

• Regulation initially benefits the public, but this might not always be achieved.
• The regulated party or industry will seek to 'capture' the regulator.
• Once captured, they try to ensure rules are advantageous to affected parties.
• Although regulation starts in the public interest, it's difficult for regulators to stay independent.

Capture of Accounting Standard-Setting in Australia

• Walker (1987) said that the accounting profession lobbied to ensure there was no research capability and no academic chair.
• Priorities were set with AARF consultation, with ASRB fast-tracking submissions, and board membership was primarily from the accounting profession

Criticisms of Capture Theory

• There's no reason to think the regulated industry is the only group that can influence the regulator.
• There's no reason regulated industries can only capture existing, not new agencies
• There's no reason regulated industry could not prevent creation of the regulatory agency

Economic Interest Group Theory

• Assumes groups form to protect their economic interests and will lobby the government and conflict with each other.
• There is no public interest in the theory, and assumes that regulators and politicians are self-interested.
• The regulator is not neutral, but an interest group motivated to stay in power
• Regulation serves the private interests of influential groups while weaker groups can't lobby for regulation

Examples of Application to Accounting Standard-Setting

• New or revised standards cause social and economic consequences.
• Industry groups lobby to accept/reject standards.
• For example, European Banks lobbied in relation to IASB 39
• Large politically sensitive firms found to lobby in favor of general price level accounting in US for lower profits.
• Accounting firms lobby to protect their own interests

Accounting Regulation as Output of Political Process

• The idea that financial accounting is objective is questionable
• There are political elements involved that affect wealth distribution within society
• Standard-setters encourage submissions by affected parties on draft standards.
• Accounting standards and financial reports relate to society's values, norms, expectations.
• Compliance with accounting standards shows that financial statements are 'true and fair'.
• Though financial reports are exposed to political pressures, users may not realize this
• Regulators should then respect the views of preparers given that the standards restrict the preparers

Malaysia's Financial Reporting Regime

• Financial Reporting Act 1997
• Financial Reporting(Amendment) Act 2004
• Companies Act 1965
• Income Tax Act 1967
• Guidelines of the Securities Commission 1995
• Corporate disclosure
• Post-listing obligations
• The country's accounting standards include valuation/revaluation of assets.
• KLSE Listing Requirements necessitate the submission of reports.
• Additional disclosures are mandatory and regulated by Bank Negara Malaysia.

Financial Reporting Act 1997

• Sets up the Financial Reporting Foundation(FRF)
• A trustee body oversees the MASB's financial performance and fund arrangements
• FRF is an initial source of views for MASB standards

Other Key Points of the FRA 1997

• Section 27 notes that companies under the Companies Act of 1965 must comply with MASB approved accounting standards.
• MASB approved accounting standards have a statutory duty for directors/management to ensure financial statements comply with MASB

Functions of FRF

• Providing opinions to the MASB on the development of accounting standards and the conceptual framework
• Review the performance of the MASB
• Manage the financial operations of the MASB and FRF
• Approve the MASB budget
• Appoint staff to aid MASB/FRF in their functions of FRA 1997
• Manage finances of FRF and MASB
• Maintain proper books and annual statements of FRF
• Appoint auditors for annual statements
• Forward statements and audit report to the Minister of Finance and report on activities of MASB/FRF at year's end
• They also perform all other functions defined by the Minister of Finance upon direction

Companies Commission of Malaysia

• The commission amalgamates work of former Registered of companies (ROC) and Registrar of Business (ROB).
• It ensures compliance around related provisions of the Acts and Laws
• S 169(4) of the Companies Act 1965 requires companies to have their P/L and B/S audited before AGM.
• Accounts should comply with approved accounting standards.
• Coordinated efforts between accounting profession and the MASB aims to solve related issues

Securities Commission

• Set up under the SC Act 1993, this Commission promotes security market and investor confidence.
• Before 1993, Malaysia lacked a single authority to develop capital market through regulations
• It has the power to investigate and enforce rules
• Reports to the Ministry of Finance, with accounts tabled annually in Parliament

Additional Responsibilities of the Securities Commission

• Enforces Capital Markets and Services Act 2007
• Is recognized as a member of International Organisation of Securities Commission (IOSCO)
• It is a public company obligation to fully disclose public information to give sufficient information for investment decisions
• Public companies must also readily release material information that may have an effect on prices of, its listed securities
• Proper legal action is taken towards companies of which improper action have occurred (e.g. price manipulation)

Securities Commission Objectives

• Rule-Making
• Authorization
• Supervision
• Reduced Systemic Risk, which leads to fair, efficient, and transparent markets
• Enforcement
• Protect Investors

Proportionality

• To achieve a balanced and effective regulatory environment.
• The degree to which the SC would be commensurate with the risks posed, standards of conduct practiced, and the desired outcome.

Transparency

• Supports accountability to public stake holders
• Provide support to help design and apply proportionate regulation
• Disclose important information
• Have an open door policy with feedback

Auditing Oversight Board

• Established under the Security Commission Act (1993; Part IIIA), this board assist the SC in auditing
• The Act came into force on April 1st, 2010.
• The mission is to assist the commissions with overseeing public interest entities to protect investors with high quality and reliable financial statements.
• "Fostering high quality independent auditing on financial statements of public interest entities and schedule funds in Malaysia”""

Auditing Oversight Board Responsibilities

• Registration
• Recognition
• Inspection
• Enforcement
• Revocation and Suspension of Registration

Registration

• The AOB registers auditors under the Securities Commission Malaysia Act 1993.
• Registration ensures proper auditors are correctly auditing financial statements of public interest.
• A priority of the board supports high quality audit practices.

Recognition

• Part IIIA of the Security Act of 1993 set a framework to allow the AOB to grant recognition to foreign auditors to audit financial statements of foreign cooperation's listed on the Bursa Malaysia

Inspection

• Section 31E (1)(d) of the Security Commission Act, AOB, requires inspections be preformed monitor programs to access degree of compliance with ethical and auditing standards.
• Discharging duties, AOB, may inspect PIE audits under regular and special program inspections.
• A firm review focuses the audit firm, quality of control system/practicing, and compliance with requirements of international standards of Quality Control (“ISQC 1”).
• Assessments are done toward the degree of compliance with ethical and auditing standards through tests, and also audits by auditors

Enforcement

• Proportionality, efficiency and outcomes, are essential to the AOB.
• When determining offences or breaches, the AOB considers regulatory record, among other mitigating/aggravating factors.
• AOBs focus is complying with auditing and ethical standards, with which actions do not imply financial information should generate a true and fair view.
• The person in breach must follow the SCA, written notice or guideline.

Other actions can be taken by the AOB:

• Assign a reviewer to oversee action, and reprimanding parties.
• Professional Education Revisions (PER)
• Financial penalty of about RM500,000.
• Prohibition of the right to accept a financial entity as they're a client.
• Auditing financial statements from the company

Malaysian Accounting Standards Board

• the Financial Reporting Act 1997 establishes the FRF and the MASB.
• The FRF provides financing arrangements for operations of the MASB and review its performance.
• The MASB is an authority that develops and Issues Accounting Standards

Important to Note:

• FRF along with the MASB make the framework for financial reporting.

The Structure of the MASB

• Financial Reporting Act ( 1997)
• Financial Reporting Act
• MASB
• Issues Committee
• secretariat
• Working groups

The goals of MASB

• Implementing that effective structures and due process of the MASB, and all forms of authoritative guidance.

Members of the Board :

• Minister of Finance holds control to appoints these particular people
• The main person or Chairman
• The accountant general
• six possess knowledge and experience that relate towards fields.
• three people who advise

The Comittee

The purpose for this committee is to replace its predecessor, or interpretation committee to assess concerns, while providing recommendations. The issues have been brought up from The Big Four, Academic analysts.

MASB Working Group

• Appointees debate regarding some of today's issues.
• A member of the MASB is the chairperson
• The comprises industry experts, auditors, regulators, and educators.

Exposure Drafts

• WG prepares drafts, and is refined via review after MASB provides to the FRF which invites comments.

MASB Other Roles

• Approves Accounting Standards from International Accounting Standards Board.
• Provide technical guidances concerning implementation of GAAP for accounting issues
• To develop international accounting frameworks
• To participate in the International Standard Set process
• Encourage accounting standards convergence.

Issues: Accounting Standard Overload

• Amount of information > more than that what is needed and reasonably made by Users.
• Not following a specific standard when it comes to different entities
• The issue that arises when the standards don't provide enough information.
• There is no rigid standards for everyone.

Additional issues that occurs

• It is more than that what accountants should leave judgments as well over time.
• Government creates multiple regulators due to the pressure.

Accounting has different effects such as:

• Accountants may focus on the excessive data rather than compliance.
• Accountants focus to mainly comply and not focus to what they are doing.

Solving:

• Standards apply to everyone as well.
• IASB needs to enforce separate accounting standards for small and medium-sized companies (SMES)