Theories of Financial Accounting Essay Example

Question 1

Describe and evaluate the three theories of regulation. In your answer, explain the assumptions underlying motivations of regulators under each of the perspectives.

Dennis (2003) defines regulation as the imposition of limitations upon the preparation, form and of external reports by bodies other than the report preparers or the individuals or the organisations for which reports are prepared. Based on this definition, regulation can be carried out by different bodies. There are three major theories of regulation.

Public-Interest Theory

The public-interest theory (PIT) promotes regulation as being created to protect the public interest. According to Mourik and Walton (2004), PIT proposess that regulation, supplied in reaction to public demand for the correction of inequitable and inefficient market practices is designed to benefit and protect society as whole instead of certain vested interests. Beikaoui (2004) supports this assertion by indicating that the PIT is supplied in reaction to the demand of the public for the correction of inequitable and inefficient market prices. New regulation is usually developed in reaction to high profile accounting failures where it is contented that such regulation would help in preventing a repeat of accounting malfunctions and protect members of the public who have suffered a financial loss from such malfunctions. Under the PIT, the regulatory body is presumed as neutral intermediary that represents the interests of the public, one which does not allow own self-interest or self-interest of given groups or individuals subject to regulation to influence the rule-making.

The rationale behind PIT is that government regulation is principally a re-distributive social welfare mechanism that seeks to correct the misallocations emanating from failure of the market or political crisis. The regulatory process facilitates promotion of price competition, for instance, removal of restricted trade practices linked to abuse of power monopoly. PIT views regulators as neutral and independent arbitrators reacting to the demands of the public to rectify inequitable or inefficient market prices. The tents of the PIT assume that markets are apposite to operate in an inequitable and inefficient manner if they are not regulated. The theory also assumes that regulation is costless and politicians perceive that the advantages linked to intervention counteract the detrimental effects (Mourik and Walton 2004). However, opponents of PIT assert that the theory fails as a strong theoretical blueprint because it does consider economic realities and does not appreciate that governments comprise of self-motivated interest groups. The PIT underestimates the impacts of political and economic power influences on regulation.

Private Interest Theory

With respect to the private interest theory, regulatory agencies tend to be possessed by the groups that government intervention is initially created to regulate. The private interest theory maintains that regulatory intervention is a product of powerful interest groups mounting pressure on regulators to capture rents at the expense of diversified groups. Akin to public interest theory, the private interest theory contends that regulatory bodies and their enacted regulations are originally established to protect the interests of the public in response to systemic failures (Mourik & Walton, 2004). However, the theory is different from public interest theory in that it unwinds the assumption that regulators are unprejudiced and envisages that regulatory mechanisms are in due course controlled by regulated parties.. According to Belkaoui (2004), the private interest theory maintains that regulation is supplied in reaction to the demands of certain interest groups to maximise the income of their members. The theory assumes that regulation emerges from individual or groups actions that are motivated to maxims self-interests.

The private interest theory postulates that regulation is a partisan political procedure that confers benefits on politically productive groups, which dominate and capture the process of regulation. According to Bush and Hunt (2009), private interest theory postulates that interests groups are frequently enlisted regulators and politicians in their fight with one another over proposals of regulation. The basic assumption of the theory of this theory is that public interests are a myth and not a reality. The reality is that society consists of social aggregates whose interests are more prone to be in disagreement with one another although with some overlapping common goals. Given that interests groups are principally interested in endorsing their own interests, public policy hurts someone and help some else and the laws function to the benefit of some people and to the disadvantage of others. Although the theory assumes that regulation serves special-groups, it can also serve the interest of individuals and small business and not the interests of big corporate groups. Additionally, the interests promoted by agencies of regulation can also be in accordance with the interests of other groups instead of those controlled by firms only.

Regulatory Capture Theory

Akin to public interest theory, regulatory capture theory argues that regulatory bodies and the regulations they enact are established to protect public interests in reaction to systemic failures. Regulatory capture takes place when an agency of regulation established to function in the interests of the public acts in a manner that is advantageous to the industry instead of the public. Regulatory capture relaxes the postulation that regulators are neutral and predicts that the regulated parties control mechanisms of regulation (Bush & Hunt, 2011). The regulatory capture theory protects the public from some unfavourable activities. During the change from one position to another, the public is believed to become uninterested to the regulation objectives while the private interests hold. Therefore, the body of regulation becomes predisposed to reschedule its attention from public to private interest. The regulated parties capture the regulators and the captures ultimately seek to guarantee benefits of regulation to regulated bodies.

Question 2

Describe the normative measurement theories proposed in the 1950s, 1960s and 1970s as alternatives to historical cost accounting. Discuss the effectiveness of these theories in improving accounting measurement.

The normative measurement theories prescribe how individuals such as accountants should conduct themselves to attain a moral, just, right and good outcome (Belkaoui, 2004) . Between 1950s and 1960s, which is normative accounting research golden age, accounting researchers were more concerned with policy proposal and what ought to be done instead of elucidating and assessing acceptable or current practices. The researchers focused on deriving the ‘true income’ for an accounting period and discussion of the kind of accounting information that would be resourceful in creating economic decisions. The normative account theory is founded on observation instead of the way the process of accounting should be done. The theory heavily focuses on the anecdotal proof.

True Income theory and Decision-usefulness Theory

The normative measurement theories proposed in the 1950s, 1960s and 1970s include true income and decision-usefulness theory. True income theory entails obtaining true income in an accounting time while concentrating on obtaining a distinct profit figure and a single assets’ measure. According to Belkaoui (2004), the true income theory assumes the existence of economic proceeds dispersed by premeditated earnings or by measurement mistakes entrenched in accounting role. More so, the true income perspective assumes strident unrestrained earning obtain management of novel properties with respect to variance, bias or amount.

Decision-usefulness entails discussing the accounting information essential in making decisions. With respect to decision-usefulness theory, normative theory assumes that the fundamental objective of accounting is to help the decision-making procedure of certain users of accounting reports through provision of relevant or applicable accounting data. The decision-usefulness accounting theories are founded on classical concepts of wealth and profit or economic ideas of rational decision-making. According to Belkaoui (2004), the decision-usefulness theory assumes that earnings is one of the signals utilised for judgement and decisions and that managers hold private information which they can utilise when choosing components within GAAP under diverse sets of agreements that determine their behaviour and conversation. The decision-usefulness theory ascribes certain form of information users based on decision-making needs. The theory focuses on performing research that asks the users the type of information they need

Both the true income accounting theories and decision-usefulness theories are effective and make adjustments of historical cost measures for the market assets value or inflation. The two theories are normative in temperament because they assume that accounting should be a systems measurement, value, profit can be measured precisely, and financial accounting is essential in making decisions linked to economy. More so, the two theories assume that there is only one distinct measure of profit and markets are unproductive. According Masoom (2013), normative research seeks to establish what should be done in practice notwithstanding what is actually be done. Therefore, normative theories can make use of ideas that lie outside the sphere of what is being done. Although the normative theories have failed to be implemented by the profession of accounting or consented within regulations of financial account, they help in improving accounting measurements.

Accounting measurements entails a unit of some measurable component utilised to evaluate and compare accounting data. True income theory of accounting and decision-usefulness theory are measurement accounting theories. They improve accounting measurements through evaluating assumptions statistically with respect to how likely the prove supporting the prediction is representative (Belkaoui, 2004). The theories make a great contribution to the comparability of income statements and the interpretation of trends over time. In addition, the true income theory and decision-usefulness theory adopt a current value accounting that promotes measurements of all liabilities and assets devoid of historical data through matching current costs with current revenues on the income statements including both realised and unrealised holding losses and gains in income (Staubus, 2013). Once the information is determined, the knowledge is utilised to prescribe the data that should be supplied to financial statements users (Staubus, 2013). The decision-usefulness theory maintains that changes in residual equity and shifts in cash or other linked pool of liquid funds are relevant to cash-flow oriented decisions. Both cash flow and earnings flow provide foundations for investment.


Belkaoui, A.(2004). Accounting theory. UK: Cengage Learning.

Bush, R., & Hunt, S.(2011). Marketing theory: Philosophy of science perspectives. USA: Marketing Classics Press.

Dennis, I.(2003). The nature of accounting regulation. UK: Routledge.

Masoom, K.(2013). The entrepreneur’s dictionary of business and financial terms’. USA: Trafford Publishing.

Mourik, C., & Walton, P.(2013). The Routledge companion to accounting, reporting and regulation. UK: Routledge.

Staubus, G.(2013). The decision usefulness theory of accounting: A limited history. UK: Routledge.