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 practice 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.

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.

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.

The institutional structure for setting accounting and auditing standards

In the final section of this chapter we provided an overview of the development of international
bodies that provide accounting and auditing standards. We discussed the background to the current
processes for developing international accounting standards, beginning with the formation of the
IASC in 1973 and then the IASB in 2001. Key issues discussed were: IOSCO's support for a set of core
standards; the EU's decision to adopt IASB standards from 2005; and the greater involvement of the
United States in international standard setting, resulting from the IASB/FASB convergence project,
which commenced in 2002.

We also discussed the setting of auditing standards. The professional accounting bodies have a long
history of involvement with standard setting, which parallels the history of legal requirements for
audits. Regulation of auditing occurred despite evidence that audits are demanded in the absence of
regulation. Professional accounting bodies wrote the first auditing standards but governments have
used market failures to justify regulating auditing standards in the United States and Australia.
However, the Australian auditing standards are based on the international standards which are
written by a body controlled largely by practising auditors. An oversight body has been established
to ensure the standards reflect the public interest and have due regard to the views of regulators.
Empirical research supports the role of accounting and auditing standards and their effective
enforcement in the development of financial markets around the world.