Importance of Accounting Regulations
Many theoretical explanations have been developed to illustrate the importance of accounting regulations. The financial statements are essential for both the internal and external stakeholders of an organization. Due to this importance, accounting regulations would be necessary for ensuring that what people report is accurate and does not present misleading information. Accounting standards provide the framework through which accounting is regulations occur. The main reason for the accounting regulations is to promote transparency, consistency and reliability of the financial statements ( Shroff 2017 ). A primary argument in support of accounting regulations is to protect the public interest and improve market efficiency. The markets are fragile and would only move in favor of individual investors at the expense of the public good.
One primary explanation for the need for accounting regulations is to improve the reliability of the financial statement and other accounting reports. A large number of stakeholders rely on the information provided in the financial statements to make decisions. The investors also rely on such information to make investment decisions. As a result, the reports must reflect the actual position of the firm. Regulations through accounting standards are essential to promote this reliability. Besides, accounting stare used to improve comparability when all the entities follow similar standards in their financial accounts. Despite these theoretical explanations of the importance of accounting regulations, certain parties try to influence the regulatory processes. In most cases, the government or the accounting body issues standards for regulations. However, certain parties usually have interests and seek to influence the provision of accounting. These are majorly explained though the public interest theory, capture theory and economic interest theory.
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Public Interest Theory
The public interest theory of accounting regulation is based on the assumption that the economic markets are usually fragile and operate through inefficiency. In these operations, the individual concerns get favor at the expense of the public. The intervention of the government is therefore required to direct and monitor the economic markets. Developed by Pigou in 1932, the public interest theory holds that the control of the regulation by the government is necessary to correct inefficiencies and promote public interests ( Kňažková and Ondrušová 2020 ). In this context, accounting regulations should be in the best interest of the public, not individual interests. The need for government involvement in the regulations is a way to protect the public from adverse effects that can arise due to a lack of regulations. For example, the requirement that firms disclose only their financial accounting reports to the public has raised criticism from many scholars. The government may require that the firms also reveal the impact of their activities on the environment and society. Under this requirement, the government's regulation is to protect the community from the environmental effects of business activities. The disclosures usually present in corporate social responsibility and environmental impact accounting. The government, therefore, plays a significant role in ensuring that the public interests are also protected.
The primary issue that arises is whether the accounting needs to be regulated by the government. One group supports the need for government regulation of accounting as a way to protect the public interest. The public is a key stakeholder for the organizations, and their interests must be considered before individual interest. However, the other side of the debate argues that the government needs not to interfere with regulations of the accounting practices and market economies. Even though the government tends to act in the public's best interest, critics argue that it is challenging to ensure that the regulator is working in the public interests and not individual interests. Even in events where accounting bodies issue the regulations, the public interest theory still supports the need for government intervention to promote efficiency and benefit the general public ( Kňažková and Ondrušová 2020 ). While one group sees the public interest theory as a way for the government to affect the regulatory process, others view it as the best strategy to promote public interests. Without the influence of governments on the regulation process, most corporations would not disclose the impact of their environmental activities to the public. And with the environmental pollution increasingly becoming a key concern, accounting for the environmental costs and impacts remains a critical activity for the business.
Capture Theory
This theory was introduced in 1971 by George Stigler. The theory states that firms or the industries regulated can benefit from such regulations by controlling the regulator to act in their interests. As argued in the public interest theory, the rules are necessary to promote public interests. The capture theory agrees with the public interest theory that the regulations are essential to promote public benefits at first. However, laws tend to limit individual firms' interests, which are always ready to invest more to control the regulators ( Heese, Khan and Ramanna 2017 ). The regulated firms are usually keen to ensure that they have a significant influence on the regulators so that they can maximize their self-interests. Issues such as pollution standards can adversely affect the public. Still, the regulated firms would invest more to influence the regulators' decision to act in their favor, thus eroding the initial public interest goal.
Once captured, the regulators will act in the best interest of the firms and not the public interests. Many multinational corporations have taken control of regulatory bodies and agencies, making them work in their favor. In this situation, the initial intended purpose for regulation is lost. For example, firms that have taken control of the regulatory agencies can fail to adhere to specific accounting principles to maximize their benefits at the expense of the public. One of the major arguments of the capture theory is that the regulated party gets harmed by regulations and has to fight back through control. It is undoubtedly true that regulating accounting is important in promoting reliability and public benefit ( Heese, Khan and Ramanna 2017 ). However, the capture theory presents a negative aspect of this regulation. Even though the initial aim of the regulation is promoting the public good, control of the regulators affects the overall objectives of the rules.
The proponents of regulations support the need for rules to monitor businesses that might harm society in seeking individual interests. By regulations, the firms will adhere to the set standards and principles, thus promoting reliability and public interests. However, the opponents of the regulations use the capture theory to argue that regulations create no benefits. The regulatory agencies work in favor of the same firms they are supposed to regulate, leaving the society with no protection. Many firms continue to use unacceptable practices to maximize their profits despite the existence of regulatory agencies to oversee compliance. The fact that firms can invest in controlling regulatory agencies has made regulations more beneficial to the regulated parties than the public good. The application of this theory occurs when the professional accounting bodies and the corporate sectors seek to have control of the accounting standards.
Economic Interest Theory
This theory states that there are many players in the industry, each of which has self-interests. Even though the professional body sets the regulations for the benefit of the industry as a whole, many interest groups and even the government are not neutral players. The interest groups work to lobby the regulators to work in their favor and interests. These groups seek for individual economic interests and do not have the public interest in their plan. The government also has players with interests to retain their positions and gain reelection. As a result, they would act in favor of the economic interest groups that influence their reelection ( Ramanna 2015 ). The economic interest group theory holds that corporations cannot be held accountable concerning social and environmental performance.
Like the public interest theory, this perspective also holds that accounting regulations benefit the broader public interests. The conflict of interest amongst many players within the system leads to each seeking to influence the regulation process. The regulators end up working for the economic interest groups, who want to protect their self-interests by failing to follow the set principles ( Ramanna 2015 ). Due to the differences in the group's interests, many policies, standards and guidelines emerge to favor the key players. An example is when the regulators make policies that do not require significant firms to disclose the impact of their social and environmental activities. Some regulations on pollution also been made to favor major firms as a way of protecting their interests, but little public interest in the plan.
Based on these controversies on accounting regulation, the best way to ensure accounting regulations meet its goals remains unclear. In a system where every party is driven by self-interest, individuals will always seek to influence the accounting regulations in their favor. Even though the initial objective of the regulation is to promote efficiency, reliability and public interest, conflict of interests has led to deviation from such objectives. Therefore, the regulators' self-interests and economic interest groups entirely drive the current accounting regulations. The benefits of such rules go to a few groups with economic interests at the expense of the public stakeholders.
Question 3
Importance of Disclosures
Corporations have the responsibility to prepare and publish the audited financial reports to the investors and many other users. The major purpose of disclosures in accounting is to present any relevant information that is considered material enough to affect the decision of the users of financial statements. Accounting disclosures remains one of the Generally Accepted Accounting Principles (GAAP). As such, it is a requirement that the financial statements have full disclosures of the relevant information that relates to the financial activity of the firm ( Roychowdhury, Shroff and Verdi 2019 ). However, some disclosures are sometimes left to the individual management to decide on the policy to use. Whether it follows the GAAP or the managerial decision, all the financial information relevant to the investors and other stakeholders must be disclosed. Materiality plays a vital role in the disclosure decision. Any information that is considered material and can have a significant impact on the decision of the users of financial statements must be disclosed. Due to the existence of flexibility in the choice of specific accounting treatments, the management should disclose information relating to changes in accounting methods or any other relevant therapies.
Investment Decisions
Investment decisions are one of the crucial actions, and investors must take a due care to avoid making risky investments. Investors can be adversely affected when they rely on inaccurate or misleading information to make investment decisions. As a result, every investor requires an "understanding of the cash flow statement, value-added statement, income statement, the price, earnings, value and dividend per share and other relevant financial statements to avoid irrationality in investment decision making" ( Roychowdhury, Shroff and Verdi 2019 ). Besides, they need to understand any other changes in accounting methods or accounting policies that can affect their investments and earnings. All this information can only be acquired if the management discloses all the firm's relevant financial information. The preparation of the financial statements must, therefore, be prepared under the GAAP and the IFRSs. Even in cases where managers have the autonomy to choose the accounting principle, the disclosure choice should be in the investors' best interest.
Capital Market Research Perspectives
The management disclosure decision would affect how and whether the investors decide to put their capital on various projects. The disclosures can either be full, fair or adequate, depending on the objective of reporting. The investors are more likely to risk their investment if they rely on incomplete financial information to make investment decisions. In this expectation, investors will always avoid making investments in cases where they perceive that financial statements are not complete. Investors rely on capital market research perspectives to make investment decisions. The capital market research majorly tests the efficiency of the market to the accounting information and the reliability of financial reporting ( Shroff 2017 ). Investors would rely on the capital market research to determine the impact that the accounting information has on the share returns and security prices. The changes in the accounting policy can have a direct impact on share prices. When making investment decisions, the investors would require the disclosure of any changes in the accounting methods and policies and how this affects the share prices for the firm.
Market efficiency is achieved within the capital market research perspective when the prices of security entirely reflect the available information. The major interest of the investors is the availability of information on security markets. The kind of financial information disclosures influences security prices. The capital market research perspectives are based on the assumption of the publicly available information. In this perspective, the financial statements and other disclosures need to be publicly available to help in investment decisions (Henry and Leone 2016). A switch from one accounting method to the other with direct cash flows would directly affect the security prices in an efficient market. Alternatively, the disclosure choice on whether to use footnotes or recognize in the financial statements could affect the security prices. All the investors are risk-averse and would want to make investment decisions with the least risks. They would rely more on security prices to make investment decisions. Because the security prices are affected by the disclosure choice and accounting method, full disclosure of all material information is essential in investment decisions. In an even where the firm fails to disclose market-wide and firm-specific events, the investors face more risks. The assumption holds that the security prices and returns to investors are affected by the firm-specific circumstances.
The capital market research focuses on the aggregate impact of decision making by the investors based on the analysis of the movement of the share prices. The financial statement should provide information on the timeliness and uncertainty of the future cash flows, according to the FASB. Therefore, the disclosure decision used by the management would impact investors' decision to put their capital in certain ventures ( Shroff 2017 ). For example, the use of historical cost profit figures in the investment decisions has been based on its impact on the share prices. When a firm chooses to use historical cost accounting, such action needs to be disclosed to the public. Such disclosure will then make the investors seek more information on such accounting practices on the security prices and returns before making investment decisions. Investors majorly seek secondary information before any investment decisions. However, such secondary data can only be useful if the financial statements capture all relevant information that is material enough for decision making. It is, therefore, a requirement that management use accounting methods and policies as required by the GAAP and IFRSs. In events where there is autonomy to choose the method, it has to be a method that protects investors' assets. However, all this information needs to be disclosed in the financial statements to aid in investor decisions. The decision by investors to sell shares can be driven by certain disclosure decisions and the use of accounting methods that affect the share prices ( Henry and Leone 2016 ). If a specific disclosure or accounting method threatens to lower the share prices, investors are more likely to sell or withdraw their shares. Alternatively, a disclosure or accounting method that seems to add value to the shares could attract demand and lead to more investments. Depending on the direction of share prices, investors would use capital market research to make investment decisions.
Behavioral Research Perspectives
The behavioral accounting research perspective, on the other hand, examines the decision making and judgments by professional accountants. The output of the accountants' decision in the disclosure decisions has a direct influence on the judgment and decision making by the investors ( Saleh and Alghusain 2018 ). In areas where accounting principles are not specific, it is up to the accountants to make judgments on what they believe is the right accounting treatment or disclosure. This research provides insight into how users use and process accounting information. Because investors may not necessarily be accountants, they may have different judgments of the accounting information when making investment decisions. Therefore, investors rely on judgment and decision making by accounting professionals to make investment decisions.
The financial statements need to contain all the relevant disclosures that would be understood even by investors who do not have accounting knowledge. Whether the disclosures are made in the footnotes or within the financial statements, they should communicate to the investors. Whether or not to invest in a decision made based on the profitability, share prices, rate of return and other firm events that impact the investment. The ability to make judgments and accurate predictions on the presented accounting information would determine the investment decision.
Accounting disclosures objectives seek to ensure that stakeholders have all the information they require to make decisions. One such objective is to provide the investors with clear and understandable financial statements that they can rely on to make decisions ( Saleh and Alghusain 2018 ). From the financial statements and kind of disclosure used, investors can understand the company's financial status. Such information is then used to figure out the feasibility of investment in these companies. The financial position, share prices and rate of return of the company are determined by the accounting practices and policies adopted by the management. Therefore, it remains essential to have full disclosure of the accounting methods and all material information used to make investment decisions. Without such disclosures, the investors could put their money in a risky investment.
Reference List
Heese, J., Khan, M. and Ramanna, K., 2017. Is the SEC captured? Evidence from comment-letter reviews. Journal of Accounting and Economics , 64 (1), pp.98-122.
Henry, E. and Leone, A.J., 2016. Measuring qualitative information in capital markets research: Comparison of alternative methodologies to measure disclosure tone. The Accounting Review , 91 (1), pp.153-178.
Kňažková, V. and Ondrušová, L., 2020. Public interest entities in the context of accounting and auditing legislation in the wake of the globalization process. In SHS Web of Conferences (Vol. 74, p. 01013). EDP Sciences.
Ramanna, K., 2015. Political standards: Corporate interest, ideology, and leadership in the shaping of accounting rules for the market economy . University of Chicago Press.
Roychowdhury, S., Shroff, N. and Verdi, R.S., 2019. The effects of financial reporting and disclosure on corporate investment: A review. Journal of Accounting and Economics , 68 (2-3), p.101246.
Saleh, I. and Alghusain, N., 2018. Disclosure of Financial Statements and Its Effect on Investor’s Decision Making in Jordanian Commercial Banks. International Journal of Economics and Finance , 10 (2), pp.20-27.
Shroff, N., 2017. Corporate investment and changes in GAAP. Review of Accounting Studies , 22 (1), pp.1-63.
