What are the arguments against regulation of financial reporting?
What will be an ideal response?
ANSWER:
The arguments supporting unregulated markets for accounting information are based on agency theory, signalling theory, and private contracting opportunities. Agency theory predicts a conflict between owners and managers. Owners are interested in maximizing return on investment and security prices, while managers desire to maximize their total compensation. Because of this potential conflict, owners incur costs monitoring agency contracts with management, and these costs reduce managers’ compensation. Financial reporting is a way to mitigate this conflict to some extent, and allow owners to monitor employment contracts with their managers. Minimizing agency costs is an economic incentive for managers to report accounting results reliably to owners. Good reporting will enhance the reputation of a manager; and a good reputation should result in higher compensation because agency monitoring costs are minimized if owners perceive that accounting reports are reliable.
Signalling theory explains why firms have an incentive to report voluntarily to the capital market: voluntary disclosure is necessary in order for firms to compete successfully in the market for risk capital. Insiders know more about a company and its future prospects than investors do; therefore, investors will protect themselves by offering a lower price for the company. However, the value of the company can be increased if the firm voluntarily reports (signals) private information about itself that is credible and reduces outsider uncertainty.
Another argument against regulation is the presumption that anyone who genuinely desired information about a firm would be able to obtain it by privately contracting for information with the firm itself, with the firm’s owners, or indirectly with information intermediaries, such as stock analysts. If information were desired beyond that which is publicly available and free of charge, private individuals would be able to buy the desired information. In this way, market forces should result in the optimal allocation of resources to the production of information.
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