agency theory
theories of regulation public interest, regulatory capture and private interest.
Theory of efficient markets
Free market economists would argue that markets function best without government intervention, and that maximum efficiency is achieved by allowing forces of supply and demand to dictate market behaviour. In the world's increasingly international capital markets, forces of demand and supply have a large influence on the flows of information and capital. However, governments also actively intervene in these markets, regulating not only how markets are conducted but also the provision of information which has been described as the 'lifeblood' of capital markets. At best, government intervention aims to assist market development and promote economic growth. Equitable and transparent markets, where there is a balance of wealth-enhancing opportunities and investor protection, are considered vital to attract participants. Nevertheless, optimal market regulation is an art rather than a science.
Accounting can be seen as an information industry; that is, the business of accounting is to produce information. Advocates of the free-market approach argue that, as with any other product, demand and supply forces should operate. There is a demand for accounting information by users and a supply of such information from companies in the form of financial statements. An equilibrium price therefore can theoretically be found for accounting information.
Suppose a new type of financial information is demanded by users and a supplier is willing to provide it for price. The price will finally adjust to one where the supplier still finds it advantageous to furnish the information and users believe the cost is equal to or less than the benefits of the information. If not, then the information will not be provided. In other free-market forces can determine what type of accounting data to provide and the necessary standards that underlie them.
It is highly unlikely that authoritative, regulatory bodies will relinquish their present power in accounting. Because of that, critics of the free-market approach say the theory is unrealistic. Furthermore, they argue that the theory is unworkable because the market mechanisms will not be able to achieve a socially ideal equilibrium price for accounting information for the following reasons.
Accounting information cannot be considered in the same way as other products, because it is a 'public' good. Once the information is released by a company, it is available to everyone. Although the information may be sold to certain people only, others who did not pay for it cannot be easily excluded from using the information. This phenomenon is referred to as the 'free-rider' problem, outlined overleaf. In the accounting setting, examples of free riders include financial analysts and potential investors. Because not all users can be charged for the cost of producing the accounting information, suppliers will have minimal incentive to produce it. Only regulatory intervention can persuade companies to produce the information necessary to meet real demand and to ensure an efficient capital market.
A company has a monopoly on the supply of information about itself and, therefore, the tendency will be for the company to underproduce and sell at a high price. From society's point of view, mandatory reporting will result in more information at a lower cost.
Even if free market existed for accounting information, a regulatory board would be needed because users are unable to agree on what they want and accountants will not agree on the procedures to derive the desired information. Further, the value of information provided by companies to users is greatly enhanced if it can be compared with information from other companies.
Agency theory
The demand for financial information can be categorised as being either for stewardship or for decision-making purposes. and state that agency theory considers mainly the stewardship demand for information.' The theory concentrates on the relationships in which the welfare of one person the owner) is entrusted to another, the agent a manager). and explain that the demand for stewardship information relates to the desire to:
motivate the agent distribute risk
The demand for information for decision-making purposes relates to the role of information in statistical decision theory. Information is valuable if it improves the allocation of resources and risks in the economy. It does this by reducing uncertainty.
Uncertainty in agency theory can be classified as ante or ex post. Ex ante (before the event) uncertainty exists at the time a decision is to be made, such as uncertainty about controllable events that will affect production or uncertainty about the skill of the manager. Ex post (after the event) uncertainty exists after the decision has been made and the results realised. This uncertainty is the same as ex ante uncertainty except that it can be reduced by post reports o n what actually happened. Agency theory focuses on the impact of alternative ex post reports that affect ex post uncertainty.
and see the role of standard setting as one of identifying situations where welfare improvements will be obtained from a given policy on financial reporting. Welfare improvements relate to Pareto comparisons. Policy A would be preferred to policy B if under the former every person is at least as well off as under the latter and at least one person is better off. Policy A would also be preferred to policy B if it resulted in a more efficient allocation of resources and risk. Thus, under this view, it appears that perceived economic consequences of accounting standards play an important role.
Agency theory gives us a framework in which to study contracts between principals and agents and to predict the economic consequences of standards. For example, it is often logical that managers' compensation be tied to reported profits or they may have less incentive to achieve profits. In this situation, one type of contractual relationship is between users of accounting data and the company. Contracts for financial data can be alternatives to public reporting. If accounting were 'deregulated', the market mechanism could generate sufficient information and reach a socially ideal equilibrium point where the cost of providing the information equals the benefits. Supporters of this view argue that mandatory disclosures are therefore unnecessary and undesirable because market forces can be depended on to generate any desired information. Further, companies have incentives to disclose information voluntarily, as evidenced by the significant level of voluntary disclosures by listed companies. The possibility of over-legislating reporting requirements also relates to the 'free-rider' effect. Basically, where the marginal cost of information is perceived to be less than the possible (marginal) benefits, users will demand increased levels of disclosure. However, interested parties who bear little or none of the costs of disclosure have greater incentives to demand increased levels of disclosure, hence the term 'free rider'.
Moreover, advocates argue, required reporting tends to create overproduction of information. Since the cost of producing information is not borne by users, they will demand more and more information. An authoritative body, such as the IASB, may be misled by this exaggerated demand and, consequently, prescribe more disclosure of information than necessary. This may create a 'standards overload', about which many companies and accountants have complained.