Lecture 1.0 Regulation PDF

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Regulation Notes...

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Regulation Accounting Information and Agency Theory -

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Basic Idea: split of shareholders (principals) and managers (agents) leads to problems due to each aiming to achieve their own (diverse) goals. o Solution: performance-related pay, to align their interests and thus achieve ‘goal congruence’. o Further problem: such pay is usually based on reported profit… and who produces the reporting profit figure? Another example of an agency relationship: between a lender, the principal, and the company, the agent. The principal lends money for a specific purpose, e.g. new PPE, BUT the agent then uses it for something else, e.g. a risky new venture. o Solution: again, different goals, need for an aligning contract, here the loan covenant that uses ratios such as gearing/leverage to limit the agent’s ability to “misuse” the funds. o Further problem: ratios are based on accounting numbers, produced by…?

Arguments AGAINST Regulation / Too Much Regulation -

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There is no need for regulation: the market will ensure a proper allocation of resources. o There is competition between information suppliers for scarce risk capital. o Signalling theory – based on the assumption that information is not equally available to parties at the same time. o Voluntary disclosure to prove your firm is not a ‘lemon’ – second hand/bad. o Incentives to build a good reputation. o However: market failure (sub-optimal allocation of resources). Government may impose unnecessary costs in regulating.

Arguments IN FAVOUR OF Regulation -

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Public Interest o the firm is the monopoly supplier of information about itself (= information asymmetry exists, which will lead to market mistrust). o Corporate failures and misleading reports o Regulation ‘forces’ the information to be made public o Reporting involves only small incremental costs to the company But if the information is a public good o Free riders reduce incentives to produce information and hence not enough information produced (i.e. under-production)

Theoretical Arguments Relating to Regulatory Intervention - FOR: o Cheap resolution of public good problem. o Independent verification of information o Comparability - AGAINST: o The paradox of regulation – its not possible to unambiguously improve the status quo – Arrow’s impossibility Theorem o Issues around regulatory capture.

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Possibility of standards overload since regulators do not bear COSTS.

Summary -

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Theory: Agency Theory “pro-marketeers” argue that enough accounting information will be produced in the absence of regulation. “anti-marketeers” point to externalities and the possibility of market failure to justify regulation. It is difficult (some claim impossible) to determine the optimum level of regulation. Regulation can come from various sources. o Legal requirements o Accounting standards The first source to be examined = The Law!

Regulation of Financial Reporting: Practice – The Law Relationship of Financial Reporting Standards & The Law -

The law, in particular Company Law, provides the framework within which financial reporting in the UK is conducted. The companies Act, together with IAS 1, specify the information to be disclosed in company accounts. The way in which the required information, the accounting numbers, are arrived at is largely determined by financial reporting standards.

Reasons for International Differences in Financial Reporting -

Character of the national legal system The way their industries are finances, equity-financed, data financed, etc. The relationship of the tax and reporting systems. Influence/status of the accounting profession “accidents” of history (colonisation, wars, etc.) Language

Globalization of Capital Markets -

Companies recognized, measured, formatted, and disclosed differently under different national GAAPs. This seriously hampered international transparency, comparability, and investor projection. Merging security markets and internet investing hastened globalization. In the 70s and 80s, countries with developed capital markets sought harmonisation of standards. In the 1990s, national governments and tax authorities joined international bodies seeking global accounting standards instead....