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The case for accounting regulation: a theoretical approach

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The case for accounting regulation: a theoretical approach

Dr. Elie Menassa DBA CFE FAIA(Acad)

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1. Introduction
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The literature of accounting regulation identified the economic, social and political factors associated with the
development of accounting rules and examined the events that shaped the different international regulatory
frameworks. It has also established the aim and purpose of accounting regulation and identified the needs for
these rules from many different perspectives, in particular, the economic, social and professional viewpoints, and
the conditions which render them unnecessary. The present study attempts to gather and to contrast in one place
these different views. Nevertheless, only reference papers, those which have established the theory of
accounting regulation, are included and consequently the list of works discussed herein is neither exhaustive nor
necessarily represents the last research dealing with these issues. The relevance of such analysis springs from
the fact that many Middle-Eastern countries are trying to develop their accounting systems to respond to the ever
growing requirements of global accountancy bodies and international business. Therefore, this analysis could
provide these countries with the theoretical foundation needed to understand the importance of such rules and
later to build-up, restructure or improve their current accounting frameworks. From a different angle, this study
serves as a basis for future analyses by Arab faculty and researchers, as well as business and accounting
students, to improve their understanding of the subject matter, and to take further the ideas contained therein and
attempts to test them empirically in the Arab world.
For that purpose, this examination covers the following three main headings:

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A definition of accounting regulations and their boundaries.

Bringing to light the purpose and the aims of accounting regulation.
An identification of those conditions which render regulation in any form unnecessary.

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The first line of examination is of importance for this analysis because there exist currently different views related
to what mainly considers accounting rules. The second line examines the importance of accounting regulations
and their purpose and aims. It attempts to justify the need for these rules, in particular, to regulate the economic
consequences of resource allocation and information provision in the market, to achieve the welfare of the
society, to promote a high level of professional practice in the public interest, and to secure a safe business
environment and achieve the objectives for corporate reporting. The last section looks at the reasons put forward
by many researchers justifying why it is not necessary, from their angle, to have accounting regulation.
2. Defining the boundaries of accounting regulation

It is crucial at this stage to start this investigation by defining the boundaries of accounting regulation. Therefore,
for the purpose of this research, accounting regulations are taken to refer to the different GAAPs (mainly US and
UK Generally Accepted Accounting Principles and Practices (UK GAAP). GAAP are mainly the norms governing
financial reporting. However, UK GAAP does not have any statutory definition as elsewhere i.e. USA and Canada.
It is a dynamic concept that changes over time in reaction to changing circumstances. It goes beyond principles
and encompasses practice. This research acknowledges that the boundaries of GAAP extend far beyond
accounting standards and adopts the definition devised by Davies et al. (1997: 35) in describing UK GAAP: "UK
GAAP incorporates the requirements of accounting standards and UITF, of the Companies Act and of the Stock
Exchange, together with other accounting practices which are generally accepted by the accounting profession to
be permissible".
On a more practical level, accounting regulation (financial reporting) is seen as "the imposition of constraints
upon the preparation, content and form of external financial reports by bodies (governments, regulatory agencies
established by governments, trade and other associations in the private sector, loose industrial groups which
pursue collusive activities) other than the preparers of the reports, on the organisations and individuals for which
the reports are prepared" (Taylor and Turley, 1986: 1). Reporting requirements are therefore influenced by
environmental factors such as those identified by May and Sundem (1976) who examined the environment in
which financial reporting is conducted. They argued that there are four inter-linked elements affecting this
environment: the production of these reports is influenced by accounting and auditing regulations imposed by
public and private agencies, influenced in their turn by the preferences of users and the related costs-benefits
emerging as consequences of their decision choices.
3. The need for accounting regulation
In considering the need for accounting regulation, the literature concerns itself with many considerations such as
economic, socio-political, professional and cultural factors.
3.1. Economic and market considerations

Accounting rules are needed to regulate the economic consequences of resource allocation and information
provision in the market. In an ideal and perfect situation, market efficiency ensures the availability of accounting
information under the right costs. However, there are factors provoking the failure of ideal perfectly competitive
markets (information asymmetry, tax rates, etc.). This provides reasons for expecting some type of 'extra-market'
regulation (Cohen and Cyret, 1965).
Overcoming difficulties attributed to market imperfection and the lack of well-functioning markets for accounting
information and achieving the most efficient allocation of resources are reasons highlighted by several other
writers, such as May and Sundem (1976), Bromwich (1985) and Taylor and Turley (1986).
Bromwich (1985: 57) argued that "these problems of market imperfections and the lack of complete markets
seem to plague the provision of external accounting information". He added, "such problems may not require
regulation. For this to be the case necessitates that the results of such regulation are demonstrably better than
the results of a more freely functioning, but imperfect market mechanism".
According to Taylor and Turley (1986), accounting regulation is necessary to ensure this market efficiency. They
argued that markets may fail for several reasons, and in particular:
"The lack of rules governing market behaviour" (p.7) which must state the nature and the means commodities
(including accounting information) may be allocated together with the form of contracts governing these
allocations and the ways for settling disputes and enforcing rules.
A characteristic of achieving an efficient market is the supply of free information about market factors and
preferences. In reality, information is not free and transactions involving information provision are costly.
Taylor and Turley (1986: 8) argued that "the costs of information may mean that individuals are imperfectly
informed about present conditions or the outcomes of their decisions".
In addition to transactions costs, there may be incentives to obtain private information through insider trading
(Hirshleifer, 1971). Therefore, and from a general perspective, accounting information may affect the level
and distribution of risks among individuals, since "risk is a reflection of the supply of information", and the
economic aggregate (consumption, interest rates) and hence market players decisions through "the terms
of lending agreements, debt covenants, and dividend restrictions" (Taylor and Turley, 1986: 8).
Markets may also fail because of "market distortions". In the absence of controls on the pricing system, a
divergence of prices between producers and consumers of accounting information may occur where
producers could act as monopolists and hence the need for procedures guaranteeing the provision of
information.
In addition to the above points, accounting information, which may be considered to have the characteristics
of public good, should be available to all market players without any discrimination. Moreover, Taylor and
Turley (1986: 10-11) stated that accounting information can "be thought of as giving rise to externalities".
They argued that "rational persons would not buy information unless exclusion could be applied to its
consumption". Exclusion might be practised by allowing full property rights over accounting information
argued Gonedes and Dopuch (1974). Insider trading is an example: "an individual who has acquired
additional accounting information may use it to make trading decisions"; others observing his actions "may
draw inferences about the unknown information" (Taylor and Turley, 1986: 11). Therefore this leak of
information may reduce the value of the information and generate externalities (Grossman, 1977).
3.2.

Socio-political considerations

Considerable attention has been given to the application of economic ideas to the provision of accounting
information (Bromwich, 1985). The economic perspective has been focusing primarily on accounting policy
making as a vehicle for achieving the most efficient allocation of resources. However, it fails to take into
consideration the non-economic criteria, such as social, psychological and political factors, which in their turn
exert major influence on accounting regulation and need explanation. Therefore, another focus must be
considered to incorporate the social view, in particular, the income and wealth of different social interests, and to
indicate the best form of regulation for achieving the welfare of the society.
Tower (1993) highlighted two important societal, intermediate goals for accounting as a social choice function
(efficiency and equity) and argued that corporate reporting should consider these criteria explicitly. He stated that
regulation is an important tool to promote accountability and proposed the provision of a greater amount of data
in corporate reports and the inclusion of a wider representation by stakeholders, including producers, in order to
increase 'the acceptability of accounting rules' and consequently promote compliance with accounting
regulations.
In fact, activities of regulatory bodies may have consequences for wealth and income distribution. "Their
competence for making such re-distributive judgements" is one item which needs to be included when
considering accounting regulation, argued Bromwich (1985: 51). These activities are one form of the political
aspect of accounting regulations. Politicisation of rule-making is not only inevitable but " when a decisionmaking process depends for its success on public confidence, the critical issues are not technical, they are
political" (Gerboth, 1973: 479). Moreover, the need to obtain consensus between regulators is also one reason
why accounting standards are regarded as political (Bromwich and Hopwood, 1983).
Therefore, the distribution of accounting information has to take into consideration the issues related to the fair
allocation between "economic units" and the impact they may have on the transfer of wealth, and consequently
social factors. Tower (1993) pointed out that by adopting different accounting procedures related to tax policies for
example, governments may exert direct influence on the distribution of income and wealth among economic
entities (including individuals) and consequently remove existent inequities.
The considerations outlined above require the application of social criteria rather than economic criteria.
Consequently, the choice of accounting regulation by regulatory bodies should account for users preferences
and the social and political requirements. The impact of such social influence was investigated by Arrow (1963).
Demski (1973, 1974) and Beaver and Demski (1974) have applied Arrow's impossibility theorem to the issue of
accounting regulation to show its political and social criteria and concluded that generally accepted accounting
regulations are impossible. Demski (1974: 232) stated that "since the evaluation of consequences ultimately
must entail trading off one person's gains for others this, in turn, implies that one set of accounting research
issues lies in discovering the restricted environments in which acceptable social evaluation criteria

issues lies in discovering the restricted environments in which acceptable social evaluation criteria
arise". Similarly, Marshall (1972) argued that 'optimal' accounting regulations are possible only if individual
preferences were known.
Cushing (1977) showed that Demski and Marshall's conclusions may not hold under some circumstances. He
stated that different factors should be considered and suggested the following avenues:
The relaxation of the assumption of complete heterogeneity of tastes and beliefs among financial statement
users, which he described as an assumption with no systematic empirical support, and may not be
appropriate at all times.
The possibility of replacing the requirement for complete accounting regulations.
and the importance of concentrating on the mechanism of social choice.
He argued that it is likely that there will be a significant degree of homogeneity of users' beliefs and tastes and
consequently, accounting regulators must identify politically feasible procedures which spring within an
acceptable framework that is able to identify the required degree of homogeneity and the tolerated degree of
heterogeneity of users' preferences. He also argued that if there is general agreement amongst stakeholders
that the mechanism for selecting accounting regulations is suitable, this may be seen as a surrogate for general
agreement on the regulations themselves.
Cushing's alternative lines of inquiry were investigated by Walker (1984), Bromwich (1980), Dobbs and Keasey
(1990) and other researchers. Bromwich (1980) established a framework which allows for the application of
partial standards that will maximise the utility of a decision-maker using the accounting reports. He argued that
standard-setters should have individual's expected utility in mind while deciding about the desired information
system. Walker (1984) investigated Cushing's suggestion of relaxing the assumption of complete heterogeneity
of tastes among users and concluded that "a fruitful theory of social choice will require restrictions on both the
heterogeneity of individual's preferences and on the structure of the public information problem they face" (p.
285).
Cushing's focus on the mechanism of social choice has been explored by Dobbs and Keasey (1990). They noted
that once certain minimal institutional factors and their effects on preferences are included in a model of public
information system choice, the choice need not be chaotic. They argued that in order to resolve accounting policy
choice dilemma, there must be some agreement among the accounts users regarding how they want to see the
present system changed.
To conclude, accounting regulation, like other forms of regulation, is enveloped within a particular social context
and professions legitimate themselves by attaching their knowledge to social values (Abbott, 1988). Maximising
social welfare by behaving in the public interest should be one of the main governmental objectives from
regulations (May and Sundem, 1976). Social and political choices by regulators are inevitable. However, they
require an explicit and careful consideration of the preferences of all those who are affected by policy alternatives.
3.3. Professional considerations
Being a professional form of social regulation, accounting has also developed in response to the rise of
professionalism. Professional integrity and expertise, business opportunities and lobbying behaviours are some
of the factors that emphasis the need for regulations. Tower (1993), Richardson (1997), Broadbent and Laughlin
(1999) and several others have highlighted the importance of these elements. They argued that accounting
regulations are important to promote a high level of professional practice in the public interest and maintain the
professional status and integrity.
Beside this need for accountants to compete for professional integrity, Richardson (1997) argued that accounting
operates as a profession in two domains. One of these is the regulatory domain of the standard setters and one
is the market place. The first domain is concerned with the development and protection of professional
knowledge and access to the professional community and the efforts to distance other groups by language and
expertise; the other concern is with the market opportunities. These two domains are interrelated "as the
availability of market opportunities rests on the existence of the professional knowledge and the restriction to
access it" (Broadbent and Laughlin, 1999: 6).
The regulation of the profession is usually carried out by a mix of state, institutional and self-regulation. However,
the issue of self-regulation by the profession is delicate and needs close consideration. Ogus (1995) argued that
self-regulation may reduce the cost of the regulator acquiring information and makes adjustments to regulations
easier. Therefore, the justification is seen to be based on reducing the costs of regulation.
Conversely, much of the literature sees regulation working in the interests of members of the profession.
Economists have long been sceptical of the competition and welfare effects of the self-regulation of the
professions. Friedman and Kuznets (1945) and Arnauld (1972) have criticised many of its aspects. The main
criticism by those economists is their traditional cartel argument, in particular, its controlling power over the entry
to the market, its controlling power over prices, advertising and competition.
The history of regulatory activity contains also many examples of lobbying by interested parties and such
behaviour has come to be recognised as important in accounting policy making. This lobbying behaviour
highlighted by Watts and Zimmerman (1986), Mian and Smith (1990) and others has significant effect on the
efficiency of regulations and the standard setting process. Consultation between the regulators and interest
groups may carry the danger that undue emphasis may be put upon the views of certain groups to the detriment
of others.
Taylor and Turley (1986: 29) stated that "private regulatory bodies may restrict access to their service or may
discriminate against certain of their members". They also stated that "their regulatory power may be used to
exploit the public for private interest" and hence the need for supervision and control by governments.
In addition to the above points, there is also a need for creation of opportunities in the market. However, the
creation of these opportunities is influenced by competition. Armstrong (1985) noted that the issue of
professional rivalry is an important aspect of the dynamics of professional development. This issue of
professional rivalry, together with the need for the creation of new market opportunities are best described by
Broadbent and Laughlin (1999). They noted that in the context of the discussion of the Private Finance Initiative in
the UK, competition between accounting and other professionals, such as lawyers, actuaries, bankers is very

the UK, competition between accounting and other professionals, such as lawyers, actuaries, bankers is very
obvious, "hence in order to maintain their market opportunities, accountants must engage actively in the
promotion of the market for services However, as the profession also has to operate on the level of regulation,
it cannot ignore the need to develop a robust set of regulations" (p. 9).
3.4. Other considerations
Accounting standards aim to promote comparability, consistency and transparency in the interests of users of
financial statements. Experience shows that, in the absence of regulation, companies reports may not give the
information that users need to make informed assessments of companies. Therefore, great emphasis is placed
on to the role of regulations in raising the quality of accounts and achieving the objectives for corporate reporting.
These objectives were highlighted by Baxter (1978: 25). He stated that "standards raise the quality of accounts,
make company reports more intelligible and foster comparability; they dispel doubts and we hope soon bring
harmony of principle. In a world made safe enough by standards, accounting will be plagued by few scandals
and our noisy defamers will have to hunt elsewhere for quarry". This need for accounting regulations to make the
business world a safer place was emphasised by the scandals of the 19th and 20th century and the noncompliance activities of the 1980s and 1990s. Moreover, one central focus of accounting is the measurement of
business performance. A good set of accounting regulations can protect stakeholders by making the profession
more accountable to external interests. Fair accounting standards can ensure public confidence in the
impartiality and effectiveness of professional regulations and discipline.
However, Bromwich (1985: 63) noted that despite control factors, enterprises have considerable discretion as to
the accounting practices embodied in this accounting package. Choices are often permitted in the method of
dealing with given accounting items. He argued that "it is likely that where such freedom existsthe information
provided might be expected to support the picture of the financial position of the enterprise which those in power
in the corporation wish to present to the outside world". In recent years, evidence has increased of the active
management of reported financial performance by listed corporations (Briloff, 1972; Griffiths, 1986; Smith, 1992).
In his best-selling book, Smith (1992) named and analysed 208 UK companies which practised different
degrees of creative accounting. Tweedie and Whittington (1990) provided both an academic review of the major
technical weaknesses in UK standards and set of illustrative cases, and Griffiths (1986, 1995) and others
provided a professional and popular review of these manipulations.
4. The case against accounting regulation
The legal and regulatory environment in which firms operate has evolved rapidly in recent years. However, some
have suggested that accounting regulations (law, principles and standards) are not necessary, because the
market can decide what accounting principles to demand. Bromwich (1985) tried to identify those conditions
which render regulation in any form unnecessary in order to indicate those general characteristics of accounting
which seem to make imperative regulation in some form. He stated that most of those who urge that the
provision of accounting information should be left to the free market argue that the institutional framework does
not correspond to the 'ideal' market settings. Moreover, they suggest that accounting regulation is ineffective in
achieving its aim of accurate, reliable, consistent and comparable financial reporting.
Those who favour the provision of accounting information by the market would expect firms managers to be
willing to issue sufficient information to allow interested outsiders to monitor their behaviour (Jensen and
Meckling, 1976). They also point to evidence that supports their theory. They cite, for example, the voluntary
provision of accounting information by enterprises prior to any legal or societal requirements for such information
(Benston and George, 1976).
Those who are against accounting regulation suggest that the standard setting process is biased in favour of the
setters. The involvement of different bodies and institutions in this process has significant influence. Such
influences are highlighted in the constitution and the finance of regulatory bodies. Shah (1996) noted the
involvement of different groups in the creation of the regulation and raised questions over the integrity and
morality of the accounting system. Hopwood and Page (1985) and Tinker et al. (1982) stated that the imbalance
of economic and political considerations of the setting process leads to the creation of inefficient regulations.
Other dangers are directly related to the nature and procedures of the regulation setting process. Baxter (1978:
34) warned of the defects and dangers of standards: "the truth is relative standard procedures may become
petrified procedures accounting figures are not docile, and do not lend themselves to standardisation the
wording of standards will inevitably bring difficulties of interpretation standards-makers may have to bow
political pressures even if a standard lay down a principle well, it may leave scope for personal estimates".
4.2. Conclusion
The literature of accounting regulation identified the economic, social and political factors associated with the
development of accounting rules and examined the events that shaped the regulatory systems around the world.
In response to the growth of business enterprises and shareholders demanding more stringent accounting
regulations, and in response to financial abuse and shocks in the form of scandals and important failures,
business laws gradually incorporated more extensive accounting provisions. These provisions were imposed on
corporations as a promise to restore order and provide a new basis for the trust in economic transactions.
Therefore, the fortune of accounting has always been tied to the general fortunes of the business climate.
The literature also established the aim and purpose of accounting regulations and identified the needs for these
rules and the conditions which render them unnecessary. The general view in the literature is that arguments in
favour of non-regulation are unconvincing, despite concerns about the quality of financial reporting practices and
compliance with applicable accounting standards. It was shown that these rules have consequences for
information provision and resource allocation in the market and for wealth and income distribution.
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