Developed and third world countries are classified by a comparative lack of predictable accounting systems as well as availability of new and untested standard-setting institutions. Despite these shortcomings, there has been an improvement of basic accounting systems and events, as well as procedures of benchmark-setting. This is attested to by the increasing number of professional organizations, standard setting books and academic accounting associations, as well as the increasing membership of these groups in international standard-setting bodies.
Globalization of the financial system, internationalization of companies, the adoption of the free markets economies and implementation of consistent standards has become an essential necessity (PorwalTop of Form, 2001). This is because assessment of financial statements of firms in different countries can be better made, if the accounting standards are uniformly applied to all countries (PorwalTop of Form, 2004).
The founding of accounting standards is promising to be an intricate issue (Riahi-Belkaoui, 2004). Firstly, benchmarks are based on broad, deliberated principles and assessment of the merits and demerits of the pertinent theories selected on that basis by the concerned body. Secondly, there is anticipated conflict of interests and needs among the entities concerned with accounting principles and the emerging free market economies. Riahi-Belkaoui (2004) noted that the development of accounting principles has been quite hectic because it is subjugated by management, then regulated by the career and finally becoming a truly political endeavor (2004). Another impediment to the standard-setting in accounting is that in the free market, the private and public sector have their advantages and disadvantages because there is no clear-cut winner.
Presently, external financial reports are based on rules and demand and supply market forces that may differ extensively from country to country, and in some cases even within a country (Norton, Diamond & Pagach, 2006). This implies that accounting reports may lack comparability, which is one of the most imperative qualities of financial reports. Duska, Brenda & Ragatz (2011), on the other hand, determined that accounting standard-setting process and its products should be considered on a continuum ranging from undeniably rigid standards to universal definitions of economics-based concepts.
Approaches to Standard Accounting Setting
There are two approaches to standard accounting setting which include rule-based and free market approaches to accounting standard setting. Accounting and accounting reports are only credible if differing national standards compel a company to report a change in profit numbers in different countries for the identical transactions (Norton, Diamond & Pagach, 2006). Norton, Diamond & Pagach (2006) indicated that “according to the Bureau of Economic Analysis, foreign-owned assets in the US totaled over $8.5 trillion at the end of 2002, and the US-owned assets abroad totaled over $6.4 trillion, a situation which calls for a need of a single set of standards to recognize and measure assets, liabilities and income” (p. 65).
The free market relies heavily on market forces of demand and supply. The major purpose of free market accounting standard setting is to improve the quality of financial reporting (Ma, 1997). There is a threat to the development of a good accounting theory if methods and solutions to accounting problems prescribed by the authority of a committee are perceived and accepted by practitioners and teachers of accounting as truth. According to Ma (1997), under the free-market approach, accounting information is seen as an economic good, the optimal production of which can be determined by demand and supply factors in the market place, like any other economic good. Ma (1997) says that market forces can ensure that optimal disclosure will take place.
The proponents of rule-based accounting standard setting are concerned that free market approaches may provide misleading numbers. Belkaoui (2004) says that this is because accounting depends heavily on various asset valuation bases and various allocation procedures deemed arbitrary and incorrigible, the accounting output is at best meaningless or misleading for the purpose of decision-making. Those who support rule based accounting approach also say that free market approach promotes monopoly control over information by management. Belkaoui (2004) established that “accountant’s posses a monopolistic influence over the data provided and utilized by the market. As a result, the market cannot really distinguish between real and accounting effects and may be misled by the accounting changes” (pg. 138).
The FASBs rule based procedure for setting accounting standards includes various steps, and calls for input from a number of parties involved. Critics of this process find errors with the amount of time required to come up with standards, which is due to the fast-changing business environment (Norton, Diamond & Pagach, 2006). Due to the many cases of accounting manipulations in the news, the FASB has been forced to reassess its approach to accounting standards setting and move from a rule-based approach to a broader principles-based approach. Norton, Diamond & Pagach (2006) mentioned that participants on both sides of the argument agree that a reliable system of accounting standards is essential for re-establishing self-belief of the investors.
On the other hand, the free market approach to the production of accounting standards starts from the basic assumption that accounting information is an economic good, much the same as other goods and services. Belkaoui (2004) as a result says that it is subject to the forces of demand by interested users and of supply by interested prepares. What results is an optimal amount of information disclosed at an optimal price.
The current rules-based accounting approach is based on prevailing principles and provides comparability and uniformity in financial reporting (Norton, Diamond & Pagach, 2006). Antagonists claim that switching to principles-based accounting will bear no tangible results. According to them, a rules-based system differs from a principles-based system in that it depends even more profoundly on judgment calls (Norton, Diamond & Pagach, 2006). It also leaves little space for maneuvering and is based on the needs and goals of corporate managers.
Through the free market approach, it is important to note that whenever a given piece of information is required and the right prices is offered for it, the market will generate the information if the price exceeds the cost of the information (Belkaoui, 2004). Belkaoui (2004) noted that “through this approach the market is presented as the ideal mechanism for determining the types of information to be disclosed, the recipients of the information and the accounting standards to govern the production of such information” (p. 137).
Supporters of a rules-based approach concur that the system may have become too rule-centric, yet auditors, clients, and lawyers continue to command clear instructions and reporting regulations. Norton, Diamond & Pagach (2006) state that supporters of a rules-based approach fear that a shift to a principles-based system may reduce transparency and minimize the amount of elements presently available in financial reporting. In addition, a rules-based system ensures more consistency in application and aids in comparability of statements between companies.
The free market argues that the market forces which are the demand and supply should determine the standards in financial information preparation while rules-based accounting approach is footed on existing principles and provides comparability and uniformity in financial reporting. In the United States the rule based approach is widely used (Pendlebury & Groves, 2004). It has been stated repeatedly that the problem with a rules-based approach is that it might be possible during accounting and financial engineering to account for transactions in a way that does not break the rules, but it quite evidently fails to mirror the current economic certainty (Pendlebury & Groves, 2004). For example, the downfall of Enron confirmed limitations of a rules-based approach, with special purpose entities being put together in such a way that the full extent of Enron liabilities did not appear in the group’s accounts.
According to Belkaoui (2004), explicit market failure is assumed to happen when either the quantity or quality of a good produced in an unregulated market differs from the private costs of, and benefits derived from, that good, and the market solution results in a non-Pareto resource allocation. Belkaoui (2004) indicated that the same explicit market failure is also applied to the private market for the accounting information, with the assumption that the quantity and quality of the accounting information differ from the social optimum.
In the free market approach to standard setting, accounting information is viewed as a public good and as a result of the inability to exclude non-purchaser, there is a non-Pareto optimal production of the information of firms (Belkaoui, 2004). Belkaoui (2004) noted that “due to the asymmetry of the demand and supply forces dictates that market participants leads to higher transaction costs and lower liquidity for trading shares of the firm, causing a raise in the required rate of return and lowering in current stock prices” (pg. 138).
The rule-based accounting standard setting uses broad guidelines that rely on the will of underlying rules (Yu, 2008). The application of rule-based accounting standard approach focuses on the objective of the regulators rather than the free market rule, thus minimizing the gamesmanship of thwarting the rules. The accounting standard setting approach also encourages the use of professional judgment with a focus on what is right.
Consequently, business processes have become more complex, accounting rules have rapidly changed and expanded. Yu (2008) indicated “that a rules-based approach has become more complicated because of the numerous exceptions woven into the standards” (pg. 51). These exceptions make applying a standard to a given transaction more difficult. Epstein & Saafir (2010) says that the rule-based accounting standards played a big role in Enron, WorldCom and other collapses. This is on the basis of certain detailed rules found under the US GAAP. For example, capital lease requirements, such as 90% test, have promoted watchfully constructed envisions known as 89% leases, which often aggravate even more comprehensive rules followed by yet more engineered dealings and reporting tricks (Epstein & Saafir, 2010).
In the context of free market approach, managers present a convincing commitment to improve disclosures and hence increase the precision of public information about firm value, current stock prices will increase as a result of reduced information irregularity and increased liquidity. Belkaoui (2004) further says that the essence of the information asymmetry perspective in the sense that value-maximizing managers will choose from the set of available accounting techniques with the objective of reducing information symmetry to the level where the expected benefits of new disclosure is offset by the expected costs for example the preparation and proprietary cost, of making the disclosure.
The rules-based accounting standards approach recognizes accrual accounting as the fundamental concept underlying income statement. Needles & Powers (2010) says that the rules-based accounting standard emphasizes the equivalent rule and measurement of items on the income statement. In this context, the incomes are recognized in the periods received, and expenditures are recorded in the periods in which they occurred. Needles & Powers (2010) continue to say that “the balance sheet impacts which include increases, decreases or both in assets and liabilities result from the recognition of revenue and expense” (p. 35).
Those who favor the rule based approach say that free market approach as ineffective and claim that regulation is superior in improving accounting output (Belkaoui, 2004). The main idea in the free market approach is that the demand for financial statements comes from users such as investors and creditors. Papadopoulos (2011) says that “market mechanism would ensure the information published is prudent and at the same time managers make efforts to provide adequate and reliable information to attract investors and therefore maximize welfare” (pg. 4). Empirical tests of the free market approach are impossible because we live in a regulated environment. Proponents of rule based approach indicate that free markets could be in contrary to social goals because they may not communicate enough information to the security markets. In this context, insiders have information that is not available to investors (Papadopoulos, 2011). This could lead to underproduction and asymmetry of information.
In his studies, Ittonen (2009) noted that in publicly owned firms, the demand for financial reporting arises from reducing information asymmetry between managers and other parties. For example tax, dividend, compensation and payment policies affects the demand for financial reporting in privately owned firms. Ittonen (2009) indicated that “the ownership in privately owned firms is typically more concentrated and shareholders have a more active role in management” (pg. 30). It is proposed that demand for public financial reporting quality is reduced in private firms. On the other hand higher quality financial reporting is demanded from publicly owned firms.
In addition, Bebbington, Gray & Laughlin (2001) indicated that the free market approach to the accounting standard setting shifts the emphasis for determining the information to be supplied from the needs of the receiver to that of the supplier. In this approach accounting information is provided as long as there is demand for it. Bebbington, Gray & Laughlin (2001) further says that the actual information demands of the finance-providing organizations from the background for the focal organization’s decision as to what to supply. This decision is always assumed to be heavily influenced by the demands of the principal and what agents want to actually declare.
In conclusion, it is important to note that the free market approach presents a universal platform on which companies can report and investors can judge financial information. The free market accounting standard-setting should be preferred because it provides more general direction by commencing with broad objectives, outcomes and principles without providing thorough guidance. A comprehensive guidance is likely to result in a check-off mindset when compiling financial information. As a result of the elasticity presented by the free market approach in the choice of accounting techniques used to report specific events and the preference of the management to present a desired picture, the accounting outcomes from one firm to another is less than comparable and useful.