Financial reports, accounts and accountants have been in place for many hundreds of years but it wasn’t until the nineteenth century that formal regulation of these practices became an issue. In earlier times regulation, in most cases, was uncalled for as accounting was simply required for the owner/manager of a business. However, as companies have increasingly started to operate as public entities and there has become an increasing separation between the owner and the management of companies there has been a need to ensure that accounting practices were consistent, effective and honest.
The first real moves towards formal regulation occurred shortly after the Wall Street Stock Market crash in 1929 as a result of popular opinion that the breakdown in the financial system had been directly caused by poor accounting which had led to poor investment decisions. Although the accuracy of this can actually be debated, it is a fact that these events triggered requests from the public for more controlled and regulated financial reporting.
Today there are vast numbers of accounting rules and regulations covering different countries, markets and issues and there are a number of theories available which address who benefits from the regulations and why they are in place. Alongside this a number of key theories relating to who is likely to benefit from regulation and how such benefits can be assured.
This paper will review these issues in more detail. We will start with a broad overview of why regulation is needed before progressing onto a discussion of some of the economic, social and mathematical theories that have been prevalent in this field both before, and after, the Wall Street Crash of 1929.
Why Do We Need Regulation?
There are many schools of thought on the need for regulation and many theorists present conflicting theories as to why it is, or is not, required. Baldwin and Cave (1999) presented a number of reasons in favor of regulation that was defined as the “sustained and focused control exercised by a public agency over activities valued by a community” (Selznick quoted in Baldwin and Cave, 1999, p 2).
One of the main purposes of regulations within the accountancy field is to maintain an environment of free competition and protect against monopolies. This is needed, it is argued, to ensure trading is fair and just and the public is able to access service/ products at a fair cost. Where natural monopolies have emerged, for example within the utilities companies within the UK, these are also regulated to ensure the customer is treated fairly and is served at a reasonable cost.
A second purpose of regulation concerns an area known as “windfall profits”; above average profits that are secured as a result of an unexpected event or occurrence. An example of this would include a pharmaceutical company that is able to profit from an unexpected outbreak of avian flu for which they have an antidote. In these scenarios the large requirements for the drugs could dictate that the company was able to charge excessive prices for their product in order to gain huge financial benefit from the outbreak. Regulation is needed in these scenarios in order to ensure that the public’s best interests are protected.
A third major requirement of accounting regulations is to ensure that information is presented in a consistent and fair way. This is based on several points. The view here is that without regulation the information will not be presented efficiently and consistently and therefore rules are needed in order to ensure comparability across different companies.
A further need for regulation within the accountancy industry is to prevent profit skimming or selective supply from occurring. This can occur when companies pick and choose whom they supply to and fail to operate on a fair or equal basis. Returning to the example of a pharmaceutical company, this can occur where perhaps the company chooses to supply people in certain states an antidote drug as their future custom is considered to be more important. In these scenarios the regulations exist in order to ensure an equitable continuity of service.
Finally, regulation is required to protect shareholders and stakeholders from fraudulent internal operations within organizations. Policies such as Sarbanes Oxley are implemented in order to protect investors and ensure that organizations operate with due diligence.
Whilst the reasons for regulations quoted thus far provide an insight into the need for regulation within the accountancy environment they are by no means exhaustive it can be due to these, a combination of these or other reasons that a regulation is created and enforced.
The Purpose of Accounting Theory
The objective of accountancy theory will depend according to the model being studied. Prior to the Wall Street Crash in the late 1920s two main theories were in circulation; the positive view and the normative view. We shall explore each one in turn.
The positive view of accounting theory is based on the premise that accounting theory is needed in order to explain accountancy procedures and rules as they are and was the view of theorists such as Watts and Zimmerman (1978) and Dopuch (1980) who believed that the theory used to describe accountancy should be a neural representation of what actually happens and should be used to explain and predict interesting occurrences.
Normative accounting theory, on the other hand, is viewed in a slightly more subjective way and considers what accountancy should be like or what accountants should do in an ideal world. This view is supported by theorists such as Patton and Littleton (1940) and Alexander (1944) who specified that accounting should, “record, collate and present economic truths” (Patton et al,)
The Development of Accounting Theory
Up until the 19th century accounting was very much viewed as an internal operation that was performed for the benefit of business owners and had very limited public impact. However, the popularity and growth of public limited and owned companies entailed that accountancy began to become an important element of a businesses operations within which many members of the public were interested. It was on this basis that many specialists in the field such as Patton (1962) and Canning (1929) began to propose basic ideas upon which the principles of accounting should be based, i.e. generalized practices in order to make recommendations.
Patton, for example, developed eleven accounting postulates that addressed issues such as businesses continuity and entity. It was during this time that a large number of economists became interested in the field and many economic models emerged which examined the processes accountants used and how economic models could be used to great effect within the field. Such economists included Hatfield (1927), Sweeney (1936) and MacNeal (1939) as representative of the normative approach with Canning and Alexander being of the positivist school of thought.
It wasn’t just economists and scholars who were interested in developing accounting theories during this period. Professional bodies began to emerge such as the American Institute of Public Accountants (formed 1887) and The Institute of Chartered Accountants in England and Wales (1852). However, it wasn’t until the stock market crash of 1929 that institutions such as these began to gain real political powers and accountancy began to be viewed as a real profession and discipline.
The events of 1929 necessitated the need for the standardization of practices and scholars began to search for a framework that could standardize practices. Accompanying this was the realization that accounting had social implications and there emerged two main approaches to regulation; the European and the USA approaches. For the USA regulation is viewed as a process that should be conducted through independent organizations whereas the European approach determines that regulations should be owned and conducted by the public. In recent years the USA approach has begun to take precedence and the Europeans have begun to shift from the public ownership philosophy to that of the US model.
The main reason for this has been due to the realization that public groups may be too easily influenced by businesses and may lack the power to enforce difficult and controversial concepts. However, this too may not be an ideal solution, as the private sector cannot fully be trusted to put in place standards that are in the best interests of the public. Doubtlessly the regulation of accountancy impacts many different areas, both public and private and it is perhaps therefore worthwhile to explore some of the theories pertaining to this in more detail.
Public Interest Theory of Regulation
The public interest theory of regulation states that regulations are created and enforced for the primary purpose of protecting the public as opposed to being in the interests of any private interests. These processes and systems will usually be required as a result of inefficiency in the securities market and will be enforced in order to achieve the results that the public demand or need.
The public interest theory of regulation is based on the assumption that the body responsible for overseeing and implementing the regulator process is neutral and is without any self-interested motivations, “<the regulator> does its best to regulate so as to maximize social welfare. Consequently regulation is thought of as a trade-off between the costs of regulation and its social benefits in the form of improved operation of markets”. (Scott, 2003, p.449).
One of the main criticisms of the public interest theory is that, in order to operate fairly and justly, a regulation should be based on objective aims and that this is extremely difficult to achieve for the interests of a wide and diverse public. Secondly the assumption that the regulators can be neutral is challenged.
The Economic Theory of Regulation
The Economic Theory of Regulation was introduced by Stigler in 1971, enhanced by Peltzman in 1976 and is known by many different names including Capture Theory, Special Interest Theory or Public Choice Theory. This theory proposes that the state consists of self-interested groups who will form regulations on the basis of the opportunity for such regulations to promote their reelection into power. For this purpose regulation may not necessary be for the benefit of the public or the private markets but will be formed on the basis of gaining competitive advantage for the power.
Furthermore, individuals will form themselves into collective groups in order to gain the voting powers necessary for success. As a direct result of this special interest groups who “seek to expropriate wealth or income influence the regulators. Income may take various forms, including a direct subsidy of money, restrictions on the entry to an industry of new rivals, suppression of substitute and competitive products, encouragement of complementary products, and price fixing” (Stigler, 1971, pp 3-7).
Conventional Accounting Theories
Today accounting theory has become a multidisciplinary subject that incorporates economic, social, mathematical, business and psychological issues. The Statement of Accounting Theory and Theory Acceptance produced by the AAA in 1977 concluded that there is no single accounting theory which can be given universal recognition and acceptance rather there are a large number of different theories. They were, however, able to develop three broad categories of theories; classical- inductive and true income, decision usefulness and information economics.
Classical- Inductive and True Income
These theories are heavily based on classical theories of accounting principles, which SOATATA sub divided into, normative-deductive and the inductive theories. As before, the normative theory looks at how accounting practices should perform and disregards historical costs which they believe have little to no relation to the decisions made. These theorists harness a number of economic theories in their view of accountancy and have the ultimate objective to create recommendations that can be globally implemented and accepted.
The objective of the Decision usefulness Approach is to use accountancy as a medium through which meaningful decision making information can be generated. This theory is extremely popular in mainstream accounting but has faced a number of criticisms from theorists who argue that such an approach fails to consider the benefits of society as a whole with decision usefulness being measured by the benefit to shareholders (Page, 1991).
This category addresses accountancy as an economic commodity and examines how demand for accountancy services can determine the cost of the accountancy. The most basic way to look at this is as a cost benefit exercise. In an unregulated market companies will only provide information if the benefit or doing so far outweighs the cost.
Many critics argue that the three categories of theory presented by the SOATATA have failed to address a key concept, that of the need for accountability. Chua (1986) argues that the positivist ideas such as decision usefulness create social realities such as poverty and environmental degradation and fort this reason they propose a regulatory theory that is based on accountability.
A framework based on the concept of accountability is a key component of a socially responsible company and is aimed at holding businesses responsible for their actions (Grey et al 1996). Within this theory two types of responsibilities exist; legal and non-legal. These responsibilities allow for moral and ethical issues to come into play and necessitate the need for Corporate Social Reporting. One of the main issues with this model concerns the definition of morals and ethics; what is morally acceptable to one person may not be so to another.
The area of financial accountancy regulation is an extremely complex multidisciplinary science which addresses a large number of issues and schools of thought. Whilst the need for regulation within the financial markets has increased dramatically over the years following the Wall Street Crash of 1929 there has yet to emerge a universally recognized theory which is able clearly define accounting theory.
Baldwin, R, Cave, M (1999) Understanding Regulation: Theory, Strategy and Practice Oxford University Press
Watts, R. and J. Zimmerman (1986), Positive Accounting Theory, Edgewood Cliffs, NJ: Prentice Hall.
Dopuch, N. and S. Sunder, (1980) “FASB’s Statements on Objectives and Elements of
Financial Accounting: A Review.” The Accounting Review pp. 1-21.
Paton, W.A. and Littleton, A.C (1940)., An Introduction to Corporate Accounting Standards
(Columbus: Ohio, American Accounting Association)
Paton. W.A (1962), Accounting Theory with Special Reference to the Corporate Enterprise
(New York: Ronald Press, 1992 reprinted by Scholars Book Co., Lawrence:
Canning, J.B (1929), The Economics of Accountancy (New York: Arno Press reprint 1976,
published by The Ronald Press company, New York).
Hatfield, H.R.(1927), What Is The Matter With Accounting?, The Journal of Accountancy
Scott, W.R. (2003) Financial Accounting Theory, 3rd Edition Toronto, Pearson Canada
Stigler, G.J (1971) The Theory of Economic Regulation Bell Journal of Economics and Management Science (Spring) pp 2-21
Peltzman, S (1976) Towards a more general theory of regulation” Journal of Law and Economics (August) pp. 211-40
Chua (1986) Radical Developments in Accounting Thought , The Accounting Review LX1 607-609
Grey (1992) Accounting and Environmentalism: An exploration of the challenge of gently accounting for accountability, transparency and sustainability Accounting Organizations and Society, 17 (5) pp.399-426
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