Securities regulation is vital to the development of an efficient capital market.
Accounting-based regulation embeds accounting numbers as a threshold.
There are both benefits and costs to accounting-based regulation.
The costs of accounting-based regulation include opportunistic behavior by management to manipulate accounting numbers, and capital resource misallocation.
The benefits of accounting-based regulation include the potential to mitigate resource misallocation by preventing poorly performing firms from entering the market and to avoid “adverse selection problems” by managers.
One of the most controversial debates in economic policy is: Should governments intervene in or regulate capital markets? Pure free-marketeers believe that the “invisible hand” can correct all market failures. However, advocates of intervention characterize the regulation process as one in which government intervention corrects market failures and maximizes social welfare. In the case of regulating stock issuance after initial public offerings (IPO), governments in many countries adopt a “disclosure-based approach” with limited government regulation and intervention. No official approval is needed to issue additional shares as long as companies provide adequate disclosure. There is no accounting-based profitability threshold that the company has to meet before making the stock issuance. The rationale is that such thresholds create additional costs for investors.
Costs of Accounting-Based Regulation
In a world without transaction costs, parties will naturally achieve an efficient outcome without any form of intervention. Regulation, then, is only bound to worsen the outcome, at the very least by imposing undue costs. Under regulation, governments must devote tremendous resources of money and time to screen new entrants, thus reducing social welfare. The money and time could have been allocated to other government projects that would enhance social welfare. Applicants also incur costs related to compliance. When an accounting-based threshold is embedded in a regulation, there may be agency problems for investors, as explained in the following paragraph.
Regulations based on accounting numbers, such as a minimum return on equity (ROE) threshold, can provide incentives for contracting parties to manipulate accounting data opportunistically to meet these thresholds. The reason for corporate managers to commit this opportunistic behavior is that they believe it will be costly for regulators to “undo” such behavior. If a manager opportunistically manipulates accounting data to meet criteria for issuing additional shares to the public, this action will trigger inefficient allocation of capital resources and hence diminish the welfare of investors.
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