The theories of regulation which are relevant to accounting and auditing The aim of theory is to
explain and predict real world phenomena. In this chapter we reviewed theories proposed to
explain the pracrice of financial reporting and auditing. Theories from economics including the
theory of efficient markets and agency theory are relevant to understanding the environment in
which financial reporting occurs. Both these theories help us to understand the role of financial
information and the incentives for its production. Specific theories of regulation also provide
insights about how and why we observe the regulation of financial reporting. Public interest
theory proposes that governments or their agents introduce regulation to compensate for market
failure. Regulation is intended to protect the interest of individuals and society as a whole; with
regulation society is better off than otherwise. In relation to financial reporting, the assumption is
that regulation will improve information flows thus improving capital market efficiency. In this
theory the government is an independent party. Its agents respond to requests from
'entrepreneurial politicians' and public interest groups to intervene in the market. While it could
be argued that these parties are acting in part with self-interest, the regulatory intervention is
claimed to have some overall genuine public interest. Regulation is not costless. It involves
wealth transfers and therefore has economic consequences for the parties being regulated.
Capture theory proposed that parties subject to regulation seek to control the government or its
agents who are responsible for issuing the regulation. The theory assumes that individuals are
economic rationalists and they will pursue their own self-interest. Thus, they act to increase and
protect their wealth by seeking control of the regulating body. For example, they secure control
by dictating the body's activities and agenda or by neutralising it (i.e. ensuring that its
performance is ineffective). A third theory takes a somewhat different perspective. Private
interest theory proposes that, in contrast to the two prior theories, the government is not
independent. It has the 'power to coerce' and will exercise this power in the way which best suits
government objectives. Thus politicians are not neutral arbiters, but exercise their power to
maximise their future electoral success. The government does not regulate in the public interest
but rather in response to the private interest group with the most voting power. In capital markets
the group with the most incentive and resources to lobby for their preferred regulation is often
from the listed company or corporate sector.
PART 1 Accounting theory
How theories of regulation apply to accounting and auditing practice In this section, we explored
the extent to which public interest, capture and private interest theories can be applied in
practice. We observed that governments in many countries have intervened in the process of
setting accounting and auditing standards. Although standards were initially under the control of
the private sector, a succession of events led to government control in many countries. For
example, in Australia accounting standards were developed by the accounting profession. The
government intervened in the accounting standard setting process from the 1980s by setting up
bodies with the responsibility for promulgating accounting standards. We discussed the extent to
which such bodies were 'captured' by the parties for whom they were creating regulations. We
also considered the role of private interest groups in obtaining regulation favourable to their own
interests. The final part of this section expanded on the theme of the political nature of standard
setting and regulation. Noted US academic Stephen Zeff has described standard setting as an
inescapably political process. This view applies not just to the United States, but equally in other
countries as well. We observed that the adoption of IASB standards in the European Union has
taken the politicisation of accounting standard setting to a new level. Zeff explains that there are
a range of parties involved, with different objectives and cultural preferences, which has resulted
in a lengthy endorsement process subsequent to the IASB's standard setting process (already a
highly political process). We reviewed the adoption of IAS 39 in Europe to illustrate some of the
issues involved -I The regulatory framework for financial reporting Financial reporting does not
occur in a vacuum. There are many factors which influence the process of producing financial
information. In this section we described a number of key elements which may be observed in a
number of countries' financial reporting framework. Our aim was to provide a 'proforma' of the
regulatory framework and to show how the elements affect the production of financial reports.
First, we discussed statutory requirements, that is, the laws which require preparation and
auditing of financial reports. Such laws may be contained in company, securities market and
taxation law. Common requirements which affect preparation of financial reports are the duty to
prepare accounts (in accordance with accounting standards and other legal requirements), to have
them audited by an external auditor and to lodge them with a government body. Next we referred
to corporate governance. Some corporate governance practices follow requirements of law, while
others reflect 'best practice' recommendations developed by the private sector. Examples of the
former include the EU directives on corporate governance and examples of the latter are the
governance codes which have been adopted in the United Kingdom and Australia. Compliance
with financial reporting requirements is promoted by external auditors and independent
enforcement bodies. We observed that in many countries auditors have traditionally been the
most important parties for promoting compliance with accounting standards. As a result of
adoption of IASB standards in 2005 many countries have set up independent enforcement
bodies. While some people consider such bodies a waste of resources (they have been described
as 'checking the checkers'), many commentators point to the necessity of consistent enforcement
across countries to ensure comparable application of IFRS. It is argued that without coordinated
enforcement the benefits of adoption of international standards will not be achieved. We
described the types of body which have been set up and the enforcement coordination
mechanisms which have been put in place. An evaluation of the role and effectiveness of these
bodies will occur in the future.