Chapter Two Financial Reporting Environment Learning Outcomes At the end of this section the students should be able

to: Describe the history of the accounting profession and of accounting regulation. Describe the theoretical arguments for and against accounting regulations. Describe how various groups within society influence the accounting standard-setting process. Discuss the role of professional judgment in accounting decisions. Assess the arguments advanced to support the view that the accountant can be considered to be powerful member of society. 2.1 Introduction Financial accounting tends to be heavily regulated in most countries in the world with many accounting standards and other regulations governing how particular transactions and events are to be recognized, measured and presented. While financial accounting is regulated by accounting standards and various legislations, considerable discretion remains in relation making financial reporting decisions. Accordingly the information reported in the financial statements and other reports partly depends on the financial reporting decisions that are made. The discretion to exercise professional judgment in making financial accounting decisions pertains to the following: Choices, which are available within accounting standards Financial reporting decisions for which there are no regulations in place In this context, this section of the course deals with the financial reporting environment focusing on the following aspects: The development and regulation of accounting practice The rationale for regulating financial accounting practice The role of professional judgment in financial accounting The power of the accountant 2.2 The Development and Regulation of Accounting Practice Although the practice of financial accounting can be traced back to many hundreds of years, the regulation of financial accounting in most capital market dominated economies generally began in the 20th century. One main contributory factor for lack of regulation in accounting was limited separation of ownership and management of business entities prior to this century. Twentieth century witnessed an increase in the degree of separation of ownership and management in many countries and it led to the increase tendency in regulating financial accounting. Under the historical evolution of accounting regulations, the following aspects need to be considered.

Reliance on double entry system Early development of professional associations Early codification of accounting rules Development of disclosure regulations

2.3 The Rationale for Regulating Financial Accounting Practice The different perspectives on regulations address the issue why it is necessary to regulate financial reporting. There are views both supporting and attacking the need to regulate financial accounting practices. These different views can be broadly classified as indicated below. The Free Market Perspective The proponents of free-market perspective propose that accounting information should be treated like any other good and argues that the provision of this information should be based on the laws of demand and supply rather on regulations. This approach has relied heavily on the work of the famous eighteenth century economist Adam Smith and his notion of invisible hand. The free-market perspective argues that even in the absence of regulations there are private economics-based incentives and market based incentives for the organizations to provide information about their operations and performance to the external parties. The Pro-Regulation Perspective If the information generated through the financial reporting process is considered as a public good, once it is available, people can use it without paying and can pass it to others. The parties who use the information without incurring the associated production cost are known as free riders. This could lead to an underproduction of information as only few people will have the incentive to pay for such goods as they themselves could act as free riders. This underproduction of information could have a negative impact on investors and other stakeholders of organizations who depend on the information for decision making. As a result there could be negative implications on the allocation of resources in the economy and thereby on the economic growth. Therefore, pro-regulation perspective provides a counter argument that free goods should be regulated otherwise a sub-optimal amount of information will be produced. 2.4 Regulation vs. Professional Judgment While the accounting treatment of many transactions and events is regulated, many others are unregulated. Further, even within the regulated areas, there are many alternatives available in relation to which a choice has to be made. In this context, the professional judgement of the accountant plays an important role. It is expected that accountants should be objective and free from bias when performing their duties. However, an often raised question is whether accounting can be neutral and objective as it is expected to be. On the one hand, the introduction of accounting standards is influenced by the economic and social considerations of these standards. On the other hand, there are different theoretical perspectives which provide explanations as to why a particular accounting method may be implemented by a

reporting entity. These include Positive Accounting Theory (PAT) as well as System Oriented Theories (Legitimacy, Stakeholder and Institutional). The point that all these theories explain is that the professional judgement of the accountant could play an important role in selecting accounting and disclosures policies even though there is much accounting regulation in place. 2.5 The Power of the Accountant Accountants are considered as a very powerful group of people in the society based on number of perspectives. They are as follows: Output of the accounting process impacts many decisions about wealth transfers so the judgement of accountants affects various parties wealth. The provision of accounting information leads to power of knowledge for others to drive changes to organisations behaviour. Accountants can give legitimacy to organisations which may not otherwise be deemed legitimate. Owing to this assertion that accountants are powerful group of people, questions are raised as to the objectivity and neutrality of information generated through financial accounting. Thus, some researchers (Handel, 19821 and Hines, 19882) argue that accountants can create different realities based on particular judgments made, the accounting standards available and so on. 2.6 Conclusion Although the concepts such as objectivity and neutrality is promoted within the conceptual framework for financial accounting, the factors such as the possible economic and social implications and the potential influences of management self-interest have led us to question the validity of these concepts. However, despite all these claims, accountants are considered as a very powerful group of people in the society particularly because many decisions which have widespread social and economic implications are made based on the accounting information. Hence, whether the supply of financial accounting information should be left to market forces or be subject to regulations is an issue to investigate further. Reading: Chapter 2 of the Recommended Text Book Tutorial: The following questions of the Chapter 2 of the Recommended Text Book. Question Nos. 2.4, 2.5, 2.11, 2.17 and 2.18

Handel, W. 1982, Ethnomethodology: How People Make Sense, Prentice Hall, Hemel Hempstead.

Hines, R. 1988, Financial Accounting: in communicating reality, we construct reality, Accounting, Organizations and Society, 13 (3): 251-62.