Accounting has been referred to as the language of business and accounting standards as the grammar of this language. However, accounting standard setting has been highly debated and contentious. Some of the issues raised include the politicization of the accounting standard setting for the maximization of involved parties own interests (Horngren 1973: 61); new accounting regulations promulgated by standard-setting bodies which are inconsistent with the current institutional regulations and the interferences of governments and the corporate sector in the standard setting process. A direct consequence was an aged old dispute on whether accounting standards should be regulated or not. While the debate on the benefits and limitations of regulation continue, standard setting is a reality of the accounting environment (Belkaoui, 2004: 136). Belkaoui (2004) further proposed that the advantages and limitations of the different standard setting forms, whether they are regulatory or non-regulatory, can be assessed as a means of ameliorating the accounting standard setting process. Such assessments can be performed by critically examining various approaches as discussed as follows.
In the Free Market approach, according to Deegan (2006: 57) and Belkaoui (2004, 86), accounting standards are viewed as economic commodities which are directly impacted by the interactive forces of demand from interested users and supply from interest preparers. The underscoring assumption of this approach is that market forces will create an equilibrium optimal quantity of information in response to interested users demand about an entity. The central argument is that there is no need for accounting regulation since market forces will disclose this equilibrium optimal information. Proponents of this argument such as Watts and Zimmerman (1978), Smith and Warner (1979) postulated that there is adequate incentive available from organizations to furnish stakeholders with reliable information about the organization. This available information firstly will signal to shareholders that managers are functioning to maximize their wealth and secondly, to keep operating cost at minimal. Hence, the aforementioned researchers argue that the market regulates accounting standards in relation to its needs while the demand for accounting standardization emanates from specific interested users who desire to manipulate the market for their personal benefit. The implications of Watts and Zimmermans research, as with the others above, is that the marketplace would be more efficient without a state regulatory interference (Lehman 1992: 27).
The work of these researchers on justifying their proposal of market regulations is supported by efficient market theories and the agency theory. According to Ma (1997: 95), agency theory postulates a relationship between a principal and an agent in which the principal entrusts his wealth to the agent to be managed on his (i.e. the principals) behalf. Gonedes and Dopuch (1974) added by stating that an optimal arrangement is determined through agency theory such that agents costs are minimized through the operations of market mechanisms. The agency theory suggests that organizations have incentives to release information liberally. For example, in the early 19th century, some British and Australian organizations voluntarily published financial statements since there was no requirement by any standards or statutes to thwart such publications. The benefits of these disclosures included lower capital costs which granted these companies access to gain capital funds in the market (Watts, 1977; Morris, 1984). On the other hand, Stamp (1978) also pointed out that in the United Kingdom very few companies disclose their cost of sales or gross margin figures because there were no legislative provisions requiring the disclosure of these figures nor has the British Standard Board Committee introduced any such requirement.
According to Deegan (2006:58), proponents of the free market approach based on the agency theory affirm the view that there will be natural conflicts between shareholders and managers since the latter will seek to act in its own interest. However, private contracting and associated financial reporting can be a useful means to reduce the cost of these conflicts. Firms which fail to produce the required information will be imposed with high capital costs. Advocates therefore believe that the organizations in the market are the best candidates to determine the nature of the information that should be produced in an effort to increase the external interested users confidence and decrease agency costs.
Ma (1997) counteracts by explaining that the presence of free riders in the market will make it impossible for an equilibrium optimal quantity and price of accounting information to be determined by market forces. This is because the market is not cognizant of the exact request for accounting information generated by these free riders. He continues to outline that managers possess a monopolistic dominance on the information on a firm and, hence, the reports on its performance. This begins to question the fairness and veracity of the information disclosed in the market by the various organizations. Nevertheless, there have been some counter arguments which include the monitoring of managements activities as noted by Fama (1980). There is the notion that due to the efficiency of the market, there exist high demand and competition for and between managers. There is also the existence of disciplinary actions against managers within the market. The third counter-argument is that there is also provision in the market for corporate takeover such that a more competent management team will replace the ineffective one. Hence, managers are forced to employ tactics to maximize the value of their organizationsand provide an optimal amount of financial accounting information (Deegan 2006).
The free market approach proposes a longitudinal equilibrium process which is undertaken by market to determine optimal accounting information and price in the absence of regulation. However, this approach is not without strong opposition from other researchers. Cooper and Keim (1983), Demski and Feltham (1976) argued by such a free market approach leads to market failure and pandemonium among organizations will ensue as there will be no uniformity in the accounting information disclosed since the needs of their individual users will vary extensively. They also contended that there was a higher propensity for firms to disclose in adequate information or even engage in creative accounting practices due to the absence of regulation and minimum standards of financial reporting. Ronen (1979: 426), further adds to the rebuttal by stating that the audit of financial statements and the application of uniform standards are mechanisms and social arrangements that facilitates the kind of monitoring that reduces uncertainty and ambiguity of erroneous inferences at minimal costs. He claimed that the pricing system is designed to identify good management and poor management and as a result, information disclosed cannot provide assurance to stakeholders. He also disagrees that the market system has sufficient incentives for an organizations management, operating in itself interest and to be optimally accountable and informative. He emphatically dismissed the notion that market forces automatically resulted in the efficient allocation of resources as proposed by Watts and Zimmerman but rather contended that regulation is probably a more efficient way of dealing with problems such as agency costs under conditions of information asymmetry.