Positive Accounting Theory (PAT) sets out to explain and predict the consequences will be if managers pursue given options. The explanation and prediction under PAT is done on the basis of a contracting process or agency relationship between managers and other groups such as shareholders, leading institutions, auditors, stock exchange officials and government institutions (Watts and Zimmerman, 1986). PAT is descriptive rather than prescriptive. Accordingly, unlike the normative theories which are based on the premise that managers should maximize the profitability or the utility, provided from their firms, positive theory is based on the premise that people always act from totally self-seeking motives and attempt to maximize their own personal returns.
Watts and Zimmerman (1986) argue that the profit maximization premise of the existing normative accounting theories has not been proven and is often at odds with the empirical evidence. They also argue that accounting theory construction should be free of the value judgments of the theorist, and emphasise the need for a new approach. They stated that ‘the objective of accounting theory is to explain and predict accounting practice’ (p.2), and ‘theory, as we explaining accounting practice’ (p.7) Watts and Zimmerman (1990) provide an overview of the progress of PAT since its introduction a decade ago. They include a summary of review articles on Watts and Zimmerman (1978 and 1979) and their response to some of the issues raised by various critiques.
Arguments for Free-Market Approach
- If accounting were ‘deregulated’, the market mechanism could generate sufficient information and reach an optimal equilibrium point where the cost of providing the information equals the benefits.
- Mandatory disclosures are therefore unnecessary and undesirable because markets forces can be depended on generate any desire information.
- The desired information could be obtained by privately contracting for information with the firm itself, with the firm’s owners, or indirectly with information intermediaries, such as stock analysts.
- Is the information is not publicly available and free of charge; private individuals would be able to buy the desired information.
- In this way, market forces should result in the optimal allocation of resources to the production of information.
Arguments Against Free-Market Approach
- Accounting information is a public good once available; people can use it without paying and can pass it on to others. Parties that use goods or services without incurring some of the associated production costs are referred to as ‘free-riders’. In the presence of free-riders, true demand is understated because people know they can get the goods or services without paying for them. Few people will have an incentive to pay for the goods or services, as they know that they themselves might be able to act as free-riders.
- The required reporting tends to create an over-production of information. This may create a ‘standards overload’, which many companies and accountants have complained. Few situations have also been identified with accounting standards overload such as too many standards, too detailed standards, no rigid standard and excessive disclosures, complex measurements or both.
- The effects of accounting standards overload are such as accountants may lose sight of their job because of the excessive data required when complying with existing standards. Audit failures may result, because the accountants may lose the focus of the audit and may forget to perform basic audit procedures. This situation will undoubtedly have serious implications for legal liability, erosion of professional ethics, loss of public support and dissonance within the accounting profession.
Regulatory approach
Advocated of a regulatory approach to accounting seem to believe that market failures or anomalies and perceived asymmetry in regard to the quantity and quality of financial information available to various interested parties, which lead to a decline in investor confidence, can be rectified through regulation. Furthermore, researchers have indicated that regulation particularly through accounting standards may be useful to preparers, auditors and regulatory agencies as it provides clear guidelines for reporting, verification and overseeing purposes, respectively. There are three regulation theory models. They are Public–Interest Theory, Regulation Capture Theory and Private–Interest Theory.
According to Posner (1974, p.335) Public-Interest Theories of regulation maintain that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market prices. They are instituted primarily for the protection and benefit of the general public. It is also based on the assumption that economic markets are subject to a serial of market imperfections or transactions failures, which, if left uncorrected, will result in both inefficient and inequitable outcomes.
The Regulation Capture Theories of regulation maintain that regulation is supplied in response to the demands of special-interest groups, in order to maximize the income of their members. This theory assumes, firstly, that all members of society are economically rational; therefore each individual will pursue his or her self-interest to the point where the private marginal benefit from lobbing regulators just equals the private marginal cost. Therefore, people lobby for regulations that increase their wealth or lobby to ensure that regulations are ineffective in decreasing their wealth. Second, the capture view assumes, as with public-interest theory, that the government has no independent role to play in the regulatory process. The capture theorists maintain that while the ‘purpose in fact’ or origin of regulation is to protect the public interest, this purpose is not achieved because; in the process of regulation, the regulate comes to control or dominate the regulator. The main versions of this theory are the Political Ruling-Elite Theory of Regulation (Posner, 1974) and the Economic Theory of Regulation (Peltzman, 1976). The political ruling-elite theory concerns the use political power to gain regulatory control. The economic theory concerns economic power.
Private-Interest Theories believes that there is a market for regulation with similar supply and demand forces operating as in the capital market. The fundamental assertion of private-interest theory is that there is a law of diminishing returns in the relationship between group size and the costs of using the political process. Given this assertion, theorists believe that regulation does not arise as a result of a government’s response to public demands. Instead, regulation is sought by the ‘producer’ private-interest group and is designed and operated primarily for its benefits. The theory therefore predicts that regulators will use their power to transfer income from those with less political power to those with more. The private-interest theoretical framework focused on the argument that the ‘supply’ of government intervention in the accounting standard-setting process was the result of its ‘demand’ by corporate managers and directors who wanted to protect themselves from the possibility of over-regulation following the media and shareholder backlash associated with the spate of corporate crashed.
Private-Sector Regulation of Accounting Standards
The private-sector approach to the regulation of accounting standards rests on the fundamental assumption that the public interest in accounting is best served if standard-setting is left to the private sector. Private standard-setting in the United States has included the Committee on Accounting Procedures (1939-1959) and the Financial Accounting Standards Board (1973-present). Since the FASB is the ongoing standard-setting body in the private sector, it will be used to illustrate the advantages and the limitations of private-sector regulation of accounting standards.
Arguments in Support of Private Sector Regulation
- Private sector regulation would mean close association with the accounting profession. This would automatically ensure involvement by knowledgeable and experienced people in standard setting process.
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A board in the private sector commands more prestige and acceptability amongst the business community because a board in the public sector would be seen to be subjected to pressures to help accomplish the social-economic objectives of the government (Kam, 1990, p.553).
- Since a government body staffed with bureaucrats is likely to be insensitive to the cost effectiveness of additional disclosure requirements, the cost of compliance with government regulation would be substantially higher than private sector regulation.
- There is the danger that political appointees to the board may feel that witch hunts are necessary to protect the public interest or may want to take certain actions at the expense of accounting standards and the accounting profession.
- The legislative process and government authority could be as susceptible to political lobbying and pressures as private bodies.
- Government standards would be drawn up with an overriding concern for enforceability and thus would tend to be more rigid, leaving less room for judgments than standards developed in the private sector. The procedures to be followed in formulating standards would make them less adaptive to changing circumstances than standards generated by the private sector.
Arguments Against Private Sector Regulation
- The FASB lacks statutory authority and enforcement power and faces the challenges of an override by either Congress or a governmental agency.
- The FASB is often accused of lacking independence from its large constituents, public accounting firms and corporations. This lack of independence translates into a lack of responsiveness to the public interest.
- The FASB is often accused of responding slowly to major issues that are of crucial importance to some of its constituents. This situation is generally attributed to the length of time required for due process and extensive deliberations of the board.
Public-Sector Regulation of Accounting Standards
Public-sector regulation of any activity is always the subject of heated debate between advocates and opponents. Public-sector of regulation has gained a high degree of legitimacy and became part of American and international traditions and legal framework.
Arguments for Public Sector Regulation
- A public sector regulatory body has greater legitimacy through its explicit statutory authority. Added to that is greater enforcement power than a private agency. Standards set by non-public body are difficult to enforce.
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A governmental board would be less subject to the influence of corporate management and large professional accounting firms and would work for better disclosure for investors (Kam, 1990, p.553).
- A governmental body can be catalyst for change. The private sector and market forces do not provide the leadership necessary to effect such change.
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Public sector regulation of accounting standards in motivated by the need to protect the public interest. It provides mechanisms to offset the preparer bias that institutionally exists in the standard-setting process as well as to offset the economic limitations of investors seeking adequate information (Burton, 1980, pp.79-80).
- The private sector has to be watched and controlled, given that its objectives may sometimes contradict the public interest. A minimum of government intervention may be necessary to avoid extreme and negative behaviours.
- Accounting standards have the effect of law and should therefore be established in accordance with the general rules and procedures for making laws. As the public interest is at stake, it would be wrong to leave the setting of standards to non-public bodies which could be affected by conflicts of interest.
Arguments Against Public Sector Regulation
- It is generally maintained that there is a high corporate cost for compliance with government regulation of information.
- Some have argued that bureaucrats have a tendency to maximize the total budget of their bureau. This argument assumes that the SEC is staffed with people who tend to maximize their own welfare with no consideration for the costs and benefits of additional disclosures.
- There is the danger that standard-setting may become increasingly politicized. Special-interest groups may possess the assed initiative to lobby the governmental agency for special treatment.
- Some have questioned the need for a governance system backed by a police power. It is claimed that such a situation may hinder the conduct of research and experimentation of accounting policy and is not essential to achieve standardization of measurement.
Conclusion
In my opinion I choose regulatory approach is better than the free-market approach. The main reason is because of market failures. The firm is a monopoly supplier of information itself. Mandatory disclosure would results in more information and lower cost. Corporate frauds undetected and corporate failures not signaled in advance and underproduction of public good.
(2,539 words)
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