the four main argument against regulation under the free market economy

1.

The term Accounting Regulation is the application of rules to financial reports of companies and other entities which require them to prepare those reports in ways other than might be chosen freely. In other words accounting regulation are rules that have been developed by an independent authoritative body that has been given the power to govern how companies and entities are to prepare financial statements. However the regulation would be expected to incorporate a basis for monitoring and enforcing compliance with the specific regulatory requirements. In considering accounting regulations, this essay will examine the arguments for eliminating the accounting regulation under the free market perspective.

According to accounting regulation, a fundamental assumption underlying the free market perspective is that accounting information should be treated like other goods, and demand and supply forces should be allowed to freely operate to generate an optimal supply of information about an entity. There are four main arguments that have been used to support this perspective.

According to Smith and watts (1982), even in the absence of regulation, there are private economics-based incentives for the organisation to provide credible information about its operations and performance to certain parties the organisation to avoid higher cost. The view is based on the fact that in the absence of information about the organisation’s operation, other parties including shareholders who are not involved in the management of the organisation will assume that managers might be operating the business for their own personal benefit. Furthermore, it is assumed that potential external shareholders expects to have opportunistic behaviour and in the absence of safeguards will reduce the amount they will pay the shares. The pessimistic assumption that all parties are working for the self-interest unless constrained to do otherwise, will have the effects of increasing the operating cost of the organisation – the cost attracting capital will have negative implications for the organisation. To achieve the maximisation of share value, managers voluntarily enter into contracts with shareholders and lenders which make a clear commitment that certain management strategies such as those that are against the interest of the shareholders will not be undertaken. These contracts are often based on the accounting information. According to proponents of this view, Organisations that do not produce information will be penalised by higher cost associated with attracting capital and this will damage the interest of those managers who own shares in their organisation. Furthermore, it is argued that organisation will be best placed to determine what information should be produced to increase the confidence of external stakeholders depending upon the parties involved and the type of asset in place. Imposing regulation that restricts the available set of accounting methods will decrease the efficiency with which negotiated contracts will reduce agency cost. It is also assumed that auditing will take place in absence of regulation which reduces risk to external stakeholders.

Another argument against accounting regulation under the free market perspective is ‘market for managers’. The ‘market for managers’ argument according to Fama (1980) relies upon an assumption of an efficient market for managers and that managers’ previous performance will impact on how much remuneration they command in the future periods. This assumption was further explained that in the absence of regulation, assumed managers are encouraged to adopt strategies to maximise value of firm to provide a favourable view of its own performance and this includes providing optimal amount of accounting information. However this argument assumes that managerial labour market operates efficiently and the information about past managerial performance will not only be known by potential employers but will also be fully impounded in future salaries. Furthermore, it also assumes that the capital market is efficient when determining the value of the organisation and the effective managerial strategies that will reflect positive share price movements.

Another important argument against accounting regulation under the free market perspective is ‘market for corporate takeovers’. This argument works on the assumption that under-performing organisation will be taken over by another entity that will subsequently replace the existing management team. Managers seeing such perceived threat would be motivated to maximise firm’s value to reduces chances that outsiders would take control of the organisation at low cost. Therefore, management provides information to minimise cost of capital thereby increasing the value of the firm. This argument further assumes that management will know the marginal cost and befits involved in providing information and in accordance with economic theories about the production to other goods, management will provide information to the point where marginal cost equals marginal benefit.

There is also a perspective that even in the absence of accounting regulation; organisations would still be motivated to disclose both good and bad news about the financial position and the performance of the firm. This perspective is known as ‘the market for lemons’ (Akerlof, 1970). This argument is based on the view that in the absence of disclosure of information the capital market assumes that the organisation is a ‘lemon’ which means the failure to provide information is view on the same light as providing bad information. Therefore, even though the organisation may be worried about disclosing bad news, the market may make an assessment that silence implies that the organisation has bad informant to disclose. Therefore managers disclose both bad and good news about the financial statements voluntarily (Skinner, 1994). The arguments that the market will penalise organisations for the failure to disclose information assumes that the managers has particular information to disclose. Although this may not be a realistic assumption as it has been seen with many apparently unforeseen accounting failures such as Lehman Brothers and Enron.

In conclusion, there are various arguments in favour of limiting accounting regulation such as private economic based incentives, ‘market for managers’, market for cooperate takeovers’ and ‘market for lemon’.