Arguments for and Against the Regulation of Financial Reporting

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Introduction

Corporate reporting regulation plays a significant role in ensuring that there is transparency and accountability in the financial reports of different organizations (McAuley 2005). Over the recent years, a lot of concerns have been raised regarding the efficiency of corporate reporting regulations (Leuz 2010). Such concerns are attributable to the past accounting scandals and fraud such as the case of US’s WorldCom, the Enron, as well as the financial crisis that was experienced in India in 1997 (Leuz & Wysocki 2007). Following such scandals, there has been the need to improve the financial regulation standards to carb such financial scandals in the future. In spite of this, several studies have provided divergent opinions regarding the significance of corporate financial reporting in the performance of organizations. This paper provides an in-depth analysis on the arguments for and against the regulation of financial reporting.

Background

In the last two decades, several large corporate organizations have collapsed. McAuley (2005) attributed such collapses to the laxity of the regulatory framework of financial reporting. This can be inferred from the increased call from various groups for strict regulatory measures on the financial activities of organizations. Nonetheless, it has been argued that financial reporting is highly regulated; a factor that questions the credibility of the current regulation on financial reporting (Bushman & Landsman 2010). Leuz (2010) asserted that financial crisis and accounting related scandals are influenced by regulatory interventions. For example, the consolidation of the financial regulations in the United Kingdom was considered after the country experienced numerous accounting scandals in the nineties (Leuz & Wysocki 2007; Singleton-Green & Hodgkinson 2010). In the US, the introduction of the Sarbanes Oxley Act of 2002 was as a result of increased cases of accounting fraud such as the Enron scandal.

Presently, following the financial crisis of 2007-2009, Leuz and Wysocki (2007) observed that there has been a lot of pressure on the standards of financial accounting and financial reporting with a lot of focus to restructure the global financial regulation. Resultantly, there have been debates on the significance of financial regulations as far as the creation and exacerbation of financial risks and related crises are concerned (Bushman & Landsman 2010). The debatable issues in this case are many with different scholars and economists expressing varied views on the concept of regulation of financial reporting.

Arguments for regulation of financial reporting

There are various arguments that have been presented by different researchers regarding the regulation of financial reporting. Leuz (2010) argued that standardization as far as financial regulation is concerned has the potential of spreading expert knowledge, as well as ensuring that there is high level of consistency in an organization’s financial reporting. According to this assertion, it is possible for auditors to offer justification on any type of financial decisions and approaches that they adopt. This is attributed to the fact that standardization of financial regulation gives the auditors a background for their decisions regarding any financial issues in an organization (Singleton-Green & Hodgkinson 2010). As such, through financial regulation, the associated ligation risk following any financial claim is reduced since the auditors have standards on which to base their justification decisions.

Leuz (2010), on the other hand asserted that regulation of the financial reporting of organizations is significant in that it results in cost saving in an organization. This assertion is based on the fact that it can be quite economical for organizations to have a background on which they can compare their financial reporting, and much more economical whereby firms can voluntarily provide disclosures if needed (Singleton-Green & Hodgkinson 2010). As such, regulation on financial reporting in the light of Leuz (2010) is significant in that having standard regulation in the financial reporting of organizations saves organizations the cost of having to negotiate for disclosures in an event that the variation in reporting results is not much among different parties. This can be attributed to the fact that regulating the process of financial reporting in organizations can lead to the production of ideal disclosure level. In support of this, Bushman and Landsman (2010) pointed out that organizations’ failure to disclose their financial position has a negative impact on the investors. For this reason, the availability of strong financial reporting regulations offers influential incentives to organizations as far as their disclosure of information is concerned.

According to Bushman and Landsman (2010), financial regulations are very important in ensuring that organizations are transparent and that they work towards achieving maximum profits. Often, it is assumed that organizations that do not wish to report their financial status have hidden motives and hence discourage investors.

Nonetheless, Leuz (2010) asserted that the absence of regulation in the financial reporting of organizations is effective in the realization of market failures such as externalities in organizations. This is attributable to the fact that negative externalities can be created by financial reporting that is unregulated (Bushman & Landsman 2010; Leuz 2010). The absence of regulation on firms’ reporting is likely to cause a lot of problems in organizations given that high level of disclosure is based on a specific firm as well as on a given context. However, effective regulation is always affected by political processes, and as a result limits the information available for investors and auditors (Leuz & Wysocki 2007). For this reason, it can be seen that political processes not only affect the setting of accounting standards but also the financial regulation structure. This affects the entire process of financial reporting making it impossible to measure risky situations.

For the regulation process to be effective, Bushman and Landsman (2010) suggested that it ought to consider the development of institutions, change in economic culture, as well as the political regime in a given region. Many researchers have ignored the role of countries in the regulation of financial reporting. Having robust strategies and standards that govern the financial reporting process in organizations has been considered an effective way of minimizing cases of financial fraud in organizations (Singleton-Green & Hodgkinson 2010). Following the Enron and WorldCom Scandals in US, the Sarbanes Oxley Act of 2002 was introduced to provide guidelines on the process of reporting financial data in US’s organizations. Since the establishment of this Act, a lot of things have changed in USA in relation to forensic accounting and the concept of financial reporting. For example, a lot of effort has been put in ensuring that organizations’ financial reporting is effective and follows the set guidelines (Leuz & Wysocki 2007). Similarly, the consolidation of the financial regulations in the UK under the FSA has increased the efficiency of financial reporting process as well as reduced cases of fraud in UK.

The regulation of financial reporting ensures that organizations follow the right standards of financial reporting, which leads to the provision of a clear picture of the given organization’s financial state. Such information is beneficial to investors as far as the need to make informed decisions is concerned.

Arguments against regulation of financial reporting

In spite of the numerous advantages of financial regulations, there are various researchers and economists who believe that regulation of financial reporting is not necessary. For example, some researchers argue that the regulation of the financial reporting process is costly especially for organizations (Leuz 2010). Arguably, regulations of financial reporting in organizations have been associated with the need to comply with a number of standards, which has increased organizations’ expenses (Singleton-Green & Hodgkinson 2010; Leuz & Wysocki 2007). This can be attributed to the fact that for organizations to achieve their set goals and objectives amidst such regulations, their employees need to have the necessary skills and knowledge in relation to the regulation of financial reporting. Additionally, organizations have to engage the services of trained individuals to provide the necessary interpretation of the financial regulations’ requirements, thereby increasing businesses’ cost of operation.

On the other hand, some researchers point out that regulating financial reporting of organizations does not add any value to the business (McAuley 2005; Leuz 2010). Instead, it is believed that the regulation of financial reporting in an organization diverts the attention of employees and resources in an organization whereby the focus shifts to risk management compliance that is costly, as opposed to the creation of value in the organizations. In the end, organizations gain small profit outcome that is quite insignificant in the growth of a country’s economy. In addition, the fact that regulation of the financial reporting of organizations does not add value to businesses weighs heavily on entrepreneurial businesses and start-ups.

As pointed out by Leuz (2010), there are cases whereby regulations have a lot of political influence, which implies that the entire process is ill-founded and inclined on the interests of particular groups of individuals only. As such regulations that are politically charged have adverse effects on the operations of organizations, as well as on the available sound business practices (Leuz & Wysocki 2007). While the regulation of financial reporting process is effective in various aspects of business operations, the process of enforcing such regulations is costly as well as difficult. McAuley (2005) argued that financial reporting regulations can be considered invaluable in an event that the enforcement process is not possible. Enforcing the regulation of financial reporting requires significant resources to achieve efficiency. As pointed out earlier, such resources could be diverted in enhancing value creation in organizations.

In addition, there have been various researchers that point out the inefficiency of regulations of financial reporting as far as the appropriate valuation of organizations’ accounts is concerned (Singleton-Green & Hodgkinson 2010). This can be attributed to the fact that regulation of financial reporting is based on ‘one-all-size-fits-all’ approach and such an approach has associated inefficiencies especially in cases whereby organizations are limited from providing the real value of particular accounts or even different activities of the concerned business (Leuz & Wysocki 2007). Often, regulations that are based on particular rules tend to be less effective especially to shareholders when compared to regulations and judgements that are based on situations as well as professional view of organizations’ financial reporting (McAuley 2005). Usually, accounting regulation requires businesses to report the value of their assets based on the purchase price without talking into consideration any depreciation that might have occurred on the asset.

Conclusion

From the following analysis, it can be seen that there are various opinions and variations in the concept of regulation of financial reporting. Notably, regulation of financial reporting is significant in an organization in that it is used to build the confidence of investors and in the minimization of accounting fraud in organizations as evident in USA and UK. In addition, the analysis has indicated the importance of regulation of financial reporting by pointing out that regulation is effective as a ground for comparison, as well as in the provision of the necessary standard definitions to guide financial reporting in any organization.

Nevertheless, the analysis presented a few arguments against the regulation of financial reporting. For example, it was evident that some individuals associate the regulation of financial reporting with high cost due to the various rules and regulations that organizations are required to adhere. As such, regulations result to an increase in an organization’s cost of operation. Secondly, the regulation of organizations’ financial process as argued by several researchers does not create value in organizations, and instead uses valuable resources in an organization. In addition, the analysis has pointed out that the regulation of financial reporting is at times politically influenced, which makes it inefficient as far as the achievement of the set goals and objectives is concerned. However, based on the arguments above, one can see that effective regulation of financial reporting is important in a country and ought to be enforceable, as well as be free from political interventions.

References

Bushman, R & Landsman, W 2010, ‘The pros and cons of regulating corporate reporting: A critical review of the arguments’, Accounting and Business Research, vol. 40, no. 3, pp.259-273.

Leuz, C & Wysocki, P 2007, ‘Economic Consequences of Financial Reporting and Disclosure Regulation: A Review and Suggestions for Future Research’, SSRN Electronic Journal.

Leuz, C 2010, ‘Different approaches to corporate reporting regulation: How jurisdictions differ and why’, Accounting and Business Research, vol. 40, no. 3, pp.229-256.

McAuley, S 2005, Financial accounting regulations, social accounting and principles of accounting, Learning and Teaching Scotland, London.

Singleton-Green, B & Hodgkinson, R 2010, ‘Financial Reporting Disclosures: Market and Regulatory Failures’, SSRN Electronic Journal.

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