Chapter 3: Applying theory to accounting regulation

1.             If the IASB concludes that the economic consequences of a

standard it is about to approve will disadvantage a powerful lobby group, what
should the IASB do about the situation?

Since this is an opinion question, there is no right or wrong answer.   Solution

manual

Die-hard proponents of the incrementalist view would argue that the IASB should
withdraw its proposal and seek a compromise solution. The IASB needs to be
political for its own survival, and compromise is a part of the political game.
Depending on the circumstances, if an opponent is too powerful, the wise course
of action is to retreat, because the possibility of defeat is great. As long as an
incremental step forward is made, the Board would argue that the accounting
profession should be satisfied. A series of incremental steps over time could
result in eventual victory.

Others would argue that if a proposal has theoretical merit, and especially if
there is also empirical evidence to support it, the IASB should seek to establish
the proposed standards. The proposal would result in more relevant and reliable
accounting information, which should be the primary consideration in the
formulation of standards. Incrementalists argue that the IASB should retreat for
its survival, but it is for the sake of survival that it should not back off. People
are watching the profession to see if it favours special-interest groups. If the
integrity of the IASB is tarnished, its survival will be jeopardised. However, if the
theoretical-empirical support for a proposal is weak, a wait-and-see attitude may
be justified.

2.             How do you think accounting standards should be set? Is that the

approach currently taken by the IASB?

Here is one possible answer. The most feasible way may be to be aware of both
the politics of the environment and the significance of scientific evidence in the
formulation and implementation of standards. Where there is substantial
theoretical and empirical evidence in support of a proposal, the IASB should be
resolute in seeking to establish the standard. But presently such strong support
does not occur often.
                                                                   
               
The fact is that pressing issues need to be resolved immediately, and there may
be little, if any, empirical evidence pointing to any particular direction. In such
cases, the IASB needs to follow a theoretical (rational) argument, based on the
objective of providing more useful information.
There is no question that the IASB needs to be politically aware. However, to be
aware of the political environment means different things to different people. If it
means to do a better marketing job of explaining to all interested groups why a
given proposal is being made, then that is acceptable. To receive and be aware
of the points of view of various groups of a proposal should be helpful to the
IASB because the proposed standard may not be as rational as the IASB
believes. The due process procedure should be taken seriously and not be a
perfunctory routine. Contrary arguments may have salient, legitimate points.

The IASB does attempt to be independent in the formulation of accounting

standards. Because the support of its standards is mainly theoretical (based on
rational arguments), and interpretation of theory can result in different
viewpoints, strong opposition is seriously considered and is likely to cause a
change in the proposed standard. Empirical evidence is considered. However,
that the evidence is often not persuasive; perhaps because it is not understood
by the non-academic community.

With the adoption of international financial reporting standards (IFRS), it has

been suggested that the AASB and Australian constituents will have less
influence over the IASB due process than was possible in the domestic standard
setting environment. The AASB has a specific strategy of contributing to
standard setting at the IASB to maintain its influence.

3.             ‘We should disband national standard setters. They are of no use

following the adoption of international accounting standards.’ Explain whether
you agree or disagree with this statement.

People who agree with this statement would argue that the national standard
setters such as the AASB no longer have a role to play in standard setting. The
standard setting function is carried out by the IASB and interpretations are
issued by the International Financial Reporting Interpretations Committee
(IFRIC). Australia has made a commitment to use IFRS and therefore it will be
accepting all standards issued by the IASB. The AASB is no longer necessary as
it will not be developing private sector standards. A common interpretation of
IFRS is necessary to assist companies in producing comparable financial
reports. However, this must come from an international body not the AASB or a
body associated with the AASB.  Solution manual

People who disagree with this statement would point to the fact the AASB has a
role in developing standards for the public sector and not-for-profit entities. This
role has not been assumed by the IASB. In addition, the IASB relies on the
contribution of national standard setters in the development of its standards.
National standard setters such as the AASB can contribute technical expertise
based on its past experience and skill of current staff. They can work on
research projects for the IASB. In this way, the AASB can actively contribute to
international standard setting. By maintaining the AASB, Australia can
contribute to international standard setting on issues of national importance.
One example is the forthcoming extractive industry standard which could be
important for Australian companies and the national extractive industry. 
Solution manual

4.             What are ‘free-riders’? How can a system ensure that those who
benefit most from an accounting standard requiring certain disclosures also bear
the greatest costs of it?

Free-riders are people that can utilise information once it is publicly available.
Although information may be sold to certain people only, others who did not pay
cannot be easily excluded from using the information. Examples of free-riders
are financial analysts and potential investors. There is no simple solution to the
problem.

Students should be encouraged to offer ideas. Companies may act to restrict

access to the financial statements to shareholders and associated parties.
Companies may establish a user-pays system where financial information is
available to non-shareholders on a fee-for-information basis. If the fee was
sufficiently high, those who pay are less likely to share the information.
Nonetheless, such systems would be difficult to administer and control, and are
unlikely to be successful.

5.             The setting of accounting standards requires some assessment of

economic and other benefits and costs. What are the ethical issues involved? Is
it possible to avoid ethical issues in developing accounting standards?

There will always be ethical issues associated with the development of

accounting standards because there are ethics involved in deciding between
providing information that is representationally faithful for users and requiring
information that may be detrimental to the interests of preparers. The most
obvious example of this is where information is proprietary (that is, information
that competitors could use to the disadvantage of the reporting firm) — the
information may be useful to investors but disadvantage the firm that provides it.
Furthermore, the provision of additional accounting information may provide
information that is useful to investors and other users of accounts, but it may be
expensive to acquire the data and process it, thereby imposing costs upon firms
and reducing the value of the shares held by existing shareholders.
Accounting standards have the potential to affect levels of wealth and its
distribution because they affect:
      decisions made by individuals who rely upon the accounts
      the terms of contracts that rely upon accounting numbers (for example, debt
covenants requiring that a company not exceed a certain ratio of debt to total
tangible assets)
      decisions made by regulators who base assessments of ability to pay or of the
harm felt from regulation on the financial statements of the firms.

As long as accounting has economic consequences, some people gain from

certain regulations and others stand to lose. As such, its regulation necessarily
has ethical implications. Even the decision to ensure that the accounts always
give a faithful representation of the firm’s economic circumstances involves an
ethical assessment that needs or preferences of the users of the accounts have
primacy over the preferences of the preparers.  Solution manual

6.             You have been appointed as chief accountant of a firm that will be

adversely affected by the method of accounting that is proposed in an exposure
draft. Write a report of 500 words or less explaining to your Board of Directors
how you could lobby the AASB to change its mind and adopt an accounting
practice other than the one proposed in the exposure draft. Also comment on the
costs and benefits of each to the firm.

There are many ways in which organisations might lobby to affect the
requirements of an accounting standard:
      write responses to exposure drafts
      write to members of the accounting standards boards putting forward their
views
      make oral presentations to the boards, or to individual members of the boards
      hold meetings where key issues are discussed and ensure that members of
the accounting standards boards are invited, or get to hear the meetings
      hold demonstrations against a proposal that they do not favour — as occurred
in Silicon Valley where executives demonstrated against proposals for
accounting for executive stock options (the ‘Rally in the Valley’)
      release media releases expressing their disagreement with proposed
accounting regulation; these releases would then result in articles in the media
or announcements over the news
      form groups to lobby using any or all of the above methods
      offer to provide funding to the regulatory bodies for an accounting standard
that suits them.
The preceding methods have all been employed, and instructors may be able to
think of others. Other less acceptable methods that have been employed include
threats made to individual members of standard-setting bodies. Both financial
and non-financial costs and benefits of each should be discussed, including
reputational effects, the time and effort costs of organisation, and potential
benefits from a standard that reduces information, bookkeeping, and contracting
costs.

7.             In 2001 and 2002 there were several high-profile US corporate

collapses associated with misleading financial statements and accounting
practices. Following these collapses, new laws were introduced to improve the
quality of financial reporting.
(a)          In your opinion, will further regulation prevent deliberately misleading
reporting? Explain.
(b)         Are additional laws likely to prevent corporate collapses? Why or why
not?
(c)          How important is the enforcement of financial reporting requirements
in promoting high quality reporting?

(a)          Opinions may differ about the extent to which regulation can prevent
deliberately misleading reporting. One effect of regulation may be to make
directors and auditors more careful in relation to financial reporting. That is,
directors and auditors both want to see compliance with accounting standards
to ensure there are no adverse monetary or reputational effects from non-
compliance. We could expect that the effect of regulation which imposes
harsher penalties for non-compliance would be to increase the extent of
compliance, assuming non-compliance attracts penalties from regulators.
However, deliberately misleading reporting implies the perpetrators know that
they are breaking the law. We can assume they have a motivation to do so which
must be weighed against the likelihood of being caught and the possible penalty.
If the motivation for misleading reporting outweighs possible costs for the
perpetrators, then regulation will not prevent misleading reporting.

(b)          The extent to which additional laws can prevent corporate collapses

will depend on the cause of the corporate collapse. If the cause is failure of the
audit function, it is possible that effective regulation to improve independence
and performance of auditors could reduce the likelihood of corporate collapse.
However, if the corporate collapse stems from fraudulent behaviour of company
officers, it will not be prevented by additional laws. If a person considers that
the benefits of breaking the law outweigh the risk of being caught and punished,
then the law will not be effective in preventing criminal behaviour leading to
corporate collapse. It may be that a government introducing additional
regulation will be satisfied with a law that makes corporate collapse less likely,
even if it does not remove it completely.
(c)          Regulators have indicated that they consider enforcement to be an
important element in promoting high quality reporting. In its Concept Release,
issued in 2000, the US Securities and Exchange Commission (SEC) argued that
high quality financial reporting required not only high quality accounting
standards but that there should be enforcement mechanisms to ensure
companies comply with standards. A similar view was endorsed by the
Committee of European Securities Regulators (CESR) who required that all EU
countries set up an independent enforcement body responsible for promoting
compliance with IFRS following their adoption in the EU from 1 January 2005.

Enforcement agencies have increased their activities since the corporate

scandals in 2001 and 2002. The SEC has been given a larger budget and
increased its surveillance activities. In Australia, ASIC has been very active.
The Federal Government provided funding for ASIC to review the financial
statements of all listed companies in 2003. ASIC now has a program of reviewing
all listed companies at least every four years. These activities suggest that
governments consider the presence of an active regulator (i.e. one that conducts
proactive, not just reactive, surveillance of financial reporting) is important to
promote high quality reporting by companies, to ensure auditors are active in
obtaining compliance with accounting standards and to improve investor
confidence following significant corporate collapses.

8.             Each of the three theories of regulation discussed in this chapter

has its strengths and limitations in describing accounting standard setting,
either past or present. What do you believe are those strengths and
weaknesses? Provide an example of where you believe each of the theories has
applied, or is likely to apply.

Three theories of regulation are outlined in the text:

      Public-interest theory      Legislation is intended to protect consumer
interests by securing improved performance when compared with an unregulated
situation. This assumes that there is market failure and consequently some
groups will need to be protected from the opportunistic behaviour of others.
If there is a market failure and the legislation can redress the failure’s impact
then the public interest will be served. However, this assumes that the
legislation will redress the failure and not introduce alternative forms of market
failure. It ignores the fact that equity will often be a matter of viewpoint, and
legislation is often the outcome of a complex lobbying process. Further, the
theory assumes that the regulators do not have their own interest set.
      Private-interest theory   Private-interest theorists believe that there is a
market for regulation with supply and demand forces operating as in the capital
market. Within this political market, while there are many bidders, only one
group will be successful, and that is the group that makes the highest bid.
Theorists believe that regulation does not come into existence as a result of a
government’s response to public demands, but rather (as a rule) regulation is
 sought by the producer private-interest group and is designed and operated
primarily for its benefit.
But even if a group has a strong incentive to organise, there must still be a
mechanism by which the group acquires and uses its influence. It also assumes
that players are always seeking to maximise their wealth.
      Regulatory capture theory   This theory argues that those who are regulated
have an incentive to dominate the process, or in some way manipulate it to their
advantage. Four such situations have been identified:
–          where the regulated entities control the regulation and the regulatory
agency
–          where the regulated entities succeed in coordinating the regulatory body’s
activities, so that their private interest is satisfied
–          where the regulated entities manage to neutralise or insure non-
performance by the regulating body
–          where the regulated entities use a subtle process of interaction with the
regulators to ensure a mutual perspective.
The concept assumes that the parties subject to regulation can form into a
group or subgroup capable of capturing the process. In addition, capture will
normally become apparent to observers in the community.

9.             On 1 January 2005 Australia adopted IASB standards.

(a)          Do you agree with this change? Why or why not?
(b)         Who stands to gain from Australia’s adoption of IASB standards?
Explain.
(c)          Who stands to lose from Australia’s adoption of IASB standards?
Explain.

From 1 January 2005 the AASB will issue Australian equivalents to IFRS. This
process involves the AASB issuing IASB exposure drafts as exposure drafts
in Australia. Constituents can provide comments on standards to the AASB and
IASB. Final standards issued by the IASB are subsequently issued
in Australia with any additional paragraphs necessary to make the standards
suitable for public sector and not-for-profit entities.

(a)           Students’ answers will vary, but should cover the following points.

Australian accounting standard boards first articulated their goal of working

towards harmonisation of Australian standards with international standards in
1996. The desire for uniformity is premised on the following advantages:
      preparer preparation costs reduced
      reduced investor confusion
       increasing cross-border competition
      consistency in external and internal reporting
      enhancement of credibility of financial reporting
      lower cost of capital.

Barriers cited against uniformity are:

      different business environments
      legal systems   Solution manual
      culture
      political considerations.

Commentators who support adoption will refer to the advantages of

harmonisation of accounting standards listed above. In Australia the
advantages of adoption of international standards are considered to outweigh
any disadvantages. The main parties benefiting from adoption are large,
internationally active companies and the government itself which can distance
itself from the politics of standard setting. The adoption of IFRS in other markets
such as the EU (particularly the UK) and New Zealand suggests
that Australia has no choice but to participate in the global harmonisation
process.

Critics of adoption refer to the costs involved, such as acquiring technical

expertise, changing accounting systems and educating investors. Adoption
affects all reporting entities in Australia, irrespective of whether harmonisation
has any benefits for the company. For example, smaller firms may not benefit
from improvements in international comparability. Critics also point to loss of
influence in the standard setting process.

(b)          Adoption of IFRS will benefit:

      The users, as financial statements will be more comparable thereby enhancing
their usefulness in decision making
      Multinational companies may no longer have to prepare dual sets of accounts
providing that the exchange on which they are listed accepts financial
statements prepared using IFRS without the need for reconciliation.
      The resources dedicated to standard-setting arrangements in Australia may be
reduced as a consequence of IFRS adoption, representing a cost saving to the
Commonwealth Government. The Government can distance itself from the
political aspects of standard setting, as reporting requirements are decided on
an international, rather than national, basis.

(c)     If adoption of IFRS results in changes to preparers’ financial reporting then

firms are potential losers if their existing choices are efficient and optimal. It
will be necessary to restructure contracts to accommodate the financial
reporting consequences associated with adoption. Australian constituents are
 unlikely to influence the standard setting process to the extent they did in the
past. The future of the AASB is uncertain given the commitment to the adoption
of IFRS. It can be argued that Australia’s intellectual capital in relation to
accounting standard setting will be jeopardised.

10.         What is the role of the Financial Reporting Council? Do you think that
all members of the Financial Reporting Council should be qualified accountants?
Why or why not?

The responsibilities of the FRC are:

      to oversee the operations of the AASB (not involved in technical deliberations)
      to monitor the development of international accounting standards
      to promote adoption of international best practice accounting standards
      to monitor the operation of Australian accounting standards to assess their
continued relevance and effectiveness
      to seek contributions towards the costs of the Australian accounting
standard-setting process.

Members are appointed by the Treasurer and are to be representative of

stakeholder organisations.

The FRC does not get involved in technical deliberations so it is not necessary
that members be qualified accountants. (This would create the impression of
regulatory capture theory.) It would be expected that the members of the FRC
have significant business experience and are aware of accounting issues and
the economic consequences associated with regulation. In their capacity as
Council members they are interacting with the various stakeholders and should
have an understanding of contemporary accounting issues.

11.         The IASB and FASB began a convergence project in 2002.

(a)     What are the expected benefits of the convergence project?
(b)     What factors make convergence difficult?
(c)     How is the future of the IASB tied to convergence?

(a)           Convergence is the process of aligning US GAAP and IASB standards

(See Chapter 3). The Norwalk Agreement (2002) was a memorandum of
understanding entered into by the FASB and the IASB whereby they would work
together to eliminate differences between the requirements of US GAAP and
IAS/IFRS. They would also align their work agendas. The benefits of convergence
are to reduce the differences between financial statements prepared in
accordance with US GAAP and IFRS thus increasing international comparability
of reporting. This has potential benefits for investors and companies.
 (b)           There are some significant differences between US GAAP and IFRS
which make convergence difficult. Resolution of these differences requires one
party to make a significant adjustment to reporting practices which may not be
supported by constituents. Two such examples are capitalisation of
development expenses (required under IAS 38 but not permitted under US GAAP)
and upward revaluation of fixed assets (prohibited in the US since the 1930s,
but allowed under IAS 16).

Political issues also make convergence difficult. The FASB issued proposals to
expense stock options in the early 1990s that did not become mandatory
because of extensive lobbying by companies and employees with stock options
and the threat of intervention by congress to prevent FASB from issuing the
standard. The IASB issued IFRS 3 Share based payment,   requiring expensing
of stock options. Subsequently, the FASB introduced (from June 2005) similar
but not identical requirements.

(c)           The future of the IASB is linked to convergence. The IASB’s aim is to

develop private sector standards for use throughout the world. If the US does
not use or recognise these standards as high quality, the IASB’s aim has not
been achieved. If US GAAP are considered to be the ‘best’ standards, then IFRS
are second best and the goal of one set of international standards has not been
realised. Convergence is a process of dealing with the differences between US
GAAP and IFRS and working toward one set of high quality international
standards.  Solution manual

16.     Should the SEC allow the use of IASB standards for US domestic listed
companies? Discuss reasons for and against the use of IFRS by US companies.

Arguments in support of use of IFRS by US domestic companies

1. Improved international comparability. For some industries, major

competitors use IFRS. All companies following the same standards will assist
information users e.g. analysts.
2. The USA is the world’s major capital market. Adoption of IFRS in
the USA means that common accounting standards are widely used throughout
the world. Common standards are claimed to improve efficiency of information
exchange.
3. US companies with subsidiaries that use IFRS will benefit from reduced
accounting preparation costs. Use of common standards will help with
budgeting, tax planning and control. Training costs (in multiple GAAPs) will be
reduced.
4. All SEC registrants should have the same options in policy choices.
Currently some SEC registrants follow IFRS and others US GAAP. There are
differences between the standards that make reports not fully comparable.
 5. Standard setting will be more efficient as standard setters can pool their
resources and work on solutions to accounting issues that confront companies
irrespective of their country of domicile.

Arguments against use of IFRS by US domestic companies

1. US GAAP and IFRS are not the same. It is not clear that IFRS is higher
quality GAAP than IFRS. IFRS standards are not as comprehensive as US GAAP.
2. Standard setting benefits from competition between standard setters. One
set of standards will not necessarily mean that the highest quality standards are
developed.
3. The USA will lose sovereignty in standard setting. Use of IFRS will reduce
the influence of the SEC and FASB.
4. Many US companies are not SEC registrants. The cost of changing to
IFRS will be expensive, possibly without benefit for private companies lacking
international operations.
5. US accountants and auditors are not technically proficient in IFRS.

17.       Why has IFAC established a Public Interest Oversight Board?

IFAC has established the PIOB to ensure the independence of the IAASB from the
auditing profession. Most members of the IAASB are, or have been, professional
auditors. This raises the suggestion that the IAASB has been captured by the
auditing profession and causes doubt about whether the standards are written to
protect the public interest or the interest of auditors. If IFAC (and the IAASB) are
to be able to continue to write international auditing standards and exert
influence, it needs to establish structures to guard against this accusation. The
PIOB also offers a place for regulators to go to express their opinion about
auditing standards and functions as a liaison body with the IASB’s Monitoring
Group (see Chapter 14 for more details). This assists a greater level of
cooperation between the auditing and accounting standard setters.

18.       Why would the quality of accounting and auditing standards affect the
development of financial markets? Why is the strength of enforcement of the
standards and investor protection important in this relationship?

High quality accounting standards assist the production of high quality financial
information which is useful for decision makers, including investors. High quality
auditing standards guide auditors to conduct audits which are more likely to
reduce the risk of material misstatement due to fraud or error in the financial
statements. High quality and credible financial information allows investors to
have less uncertainty, and greater confidence in trading. Confident investors are
more likely to participate in the share markets, providing greater liquidity.
Greater trading volumes mean that share prices are more likely to reflect all
publicly available information.
Enforcement of the standards and investor protection laws are vital to ensure
the high quality accounting and auditing standards impact positively on share
market trading. Investors gain confidence from standards only if they are
enforced. Unenforced standards are ‘not worth the paper they are printed on’,
that is, they may as well not exist because all parties know there are no
consequences of breaching the standards. Investor protection laws give
investors the right to sue if accountants and auditors are negligent, particularly
when they also include provisions that ensure the audit firms are likely to have
the resources to meet their negligence liability.     

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