1.

7 SOME HISTORICAL PERSPECTIVE

One way to address the question of regulation is to examine the workings of securities
markets prior to the securities acts of 1933 and 1934, which created the Securities and
Exchange Commision (SEC) and the present disclosure-based regulatory structure of
securities markets in the United States. Prior to 1933, these markets were relatively
unregulated. Was the establishment of the SEC a knee-jerk overreaction to the 1929 stock
market crash and ensuing great depression, or were there substantial failures in these markets
which inevitably led to social catastrophe ?
Merino and Neimark (1982) examined the conditions leading up to the securities acts
of 1933 and 1934. In the process, they reported on some of the securities market practices of
the 1920s and prior. Apparently, voluntary disclosure was widespread, as also noted by
Benston (1973). However, Merino and Neimark claim that such disclosure was more to
support potential competition, that is, the encouragement of competition by enabling
potential entrants to identify high-profit industries than to inform investors. Investors were
protected by a 2-tiered market structure where by prices were set by knowledgeable
insiders, subject to a self-imposed moral regulation to control the problems of adverse
selection and moral hazard.
Unfortunately, moral regulation was not always effective and Merino and Neimark
refer to numerous instances of manipulative financial reporting and other abuses, which were
widely believed to be the immediate causes of the 1929 crash.
The 1933-1934 securities legislation can then be regarded as a movement away from
a potential competition rationale for disclosure toward the supplying of better-quality
information to investors as a way control manipulative financial practices. Thus, if the
question is one of regulation versus deregulation, Merino and Neimarks depiction of events
seems to support regulation.
If so, we may expect that regulation will be with us for the foreseeable future.
However, given the complexity of information, the extent of regulation, that is, the number
and content of accounting standards, must be determined by a political process rather than by
rigorous economic calculation. In effect, the measure of the success of a new standard is not
whether it is correct in some abstract, theoretical sense but whether different interest groups
are willing to support it. As we shall see, the structure of standard-setting bodies such as the

FASB is designed to facilitate the attainment of the consensus which is necessary for such
support.
1.9 RELEVANCE TO ACCOUNTING PRACTICE
The framework just described provides a way of organizing our study of financial accounting
theory. However, this book also recognizes an obligation to convince you that the theory is
relevant to accounting practice. This is accomplished in two main ways. First, the various
theories and research underlying financial accounting are described and explained in plain
language, and their relevances is demonstrated by means of numerous references to
accounting practice. For example, Chapter 3 describes how investors may make rational
investment decisions, and then goes on to demonstrate that this decision theory underlies the
Conceptual Framework of the FASB. Also the book contains numerous instances where
accounting standards are described and critically evaluated. In addition to enabling you to
learn the contents of these standards, you can better understand and apply them when you
have a grounding in the underlying reasoning on which they are based.
The second approach to demonstrating relevance is through review and assignment
problems. A real attempt has been made to select relevant problem material to illustrate and
motivate the concepts.
Recent years have been challenging, even exciting, times for financial accounting
theory. We have learned a tremendous amount about the important role of financial
accounting in our economy from the information economics research outlined earlier. If this
book enables you to better understand and appreciate this role, it will have attained its
objective.
ENDNOTES
1. Actually, Merino and Neimark pose a much deeper question. Widespread share
ownership had long been seen as a way of reconciling increasingly large and powerful
corporations with the popular belief in individualism, property rights, and democracy,
whereby the little gut could take part in the corporate governance process. With the
1929 crash and subsequent revelation of manipulative abuses, a new approach was
required which would both restore public confidence in securities markets and be
acceptable to powerful corporate interest groups. Merino and Neimark suggest that
the creation of the SEC was an embodiment of such a new approach.

2. The term hardness was introduced by Ijiri (1975), who defined it as, difficulty of

manipulation of financial reports by persons with a vested interest in those reports.