Suggested dot point solutions to tutorial (week 11 tut question; will be

discussed in week 12 tutorial): Chapter 2 and 3

(Please note that these answers are only hints. Students are strongly
encouraged to add your own points, examples and other information
that were discussed in the tutorials. Students are also strongly
encouraged to write points/examples in lectures and tutorials.)

Topic: The Regulation of Financial Accounting (Chapters 2 and 3)

Chapter 2: DQ: 2.3 (Answer this question with reference to the Accounting Headline 2.2 on
p. 52 of Deegan’s text), 2.6., 2.8, 2.12; 2.21; 2.24 and
Chapter 3: 3.19. 3.24; 3.28 and 3.31

Additional question (AQ): 2.26 and 3.10. (These questions will be discussed only if time
permits. Please go through at your own pace to understand the relevant concepts.)

Students’ critical thinking questions: 3.30 (No solution of this question will be given.
You have to think answer based on concepts you learned in your tutorials and
lecture notes). Of course you can discuss with your lecturer and tutors when you
are ready.

2.3 Do you believe that media portray accounting numbers such as profits, as
some sort of hard and objective performance indicators? Why do you think that
they might do it and if they do this, what are the implications that might arise as
a results of that ?

Hints to answer to 2.3

 Rarely is any mention made of the accounting methods used, even though the profits
ultimately reported are directly a product of the many decisions that would have been
made regarding how particular items should be accounted for. Hence, it does appear
as if profits are often held out as some form of ‘hard’, objective measure of
organisational performance.
 One possibility is that those responsible for writing the stories are ignorant that
financial accounting relies upon a great deal of professional judgement.

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 Alternatively, the writers might consider that people simply do not want to be
‘bogged down’ in the fine detail.
 The accounting profession, may have successfully cultivated an impression (with the
people in the media, and others and through CF projects) that the practice of
accounting is objective.
 Media and users are familiar with profit figures.

Implications of this approach:

 The implications of this approach to reporting profits in the media is that one entity’s
performance as represented by its profit might simply be compared to another

 The entity with the higher reported profit might be considered to be more successful

 Its management might also be considered in a more favourable light than the
management of the entity with the lower reported profits.

 Accounting ‘profits’ are not a comprehensive measure of organisational performance,

given that accounting profits typically disregard many of the social and
environmental implications of a reporting entity.

 However, researchers using the efficient market argument argue that there is not
much impact of profit figures and users may not place too much emphasis on profit
figures. The argument is that if information about accounting method selection is
disclosed, then market will understand how those methods affected profit figures and
users will not focus too much on the final profit figures

However, the opposite argument is that markets are not always efficient and users
may be naïve and may not be aware of choices of accounting methods which have an
impact on profit. So users may rely on profit figures and make decisions based on the
media published profit figures. If consequently users make decisions based on too
subjective or deceptive profit figures then that could lead to wrong decisions being
made and users can lose their life savings.

-----------------------------

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2.6: Briefly outlines some arguments in favour of regulating the practices of financial
reporting.

Hints to answer to 2.6

Some of the arguments in favour of regulating the practice of financial accounting are
provided in the text and include the following:

 Markets for information are not efficient and without regulation a sub-optimal
amount of information will be produced.
 The ‘free-market’ approach may ignore the rights of individual investors, some
of whom can lose their savings as a result of relying upon some unregulated
disclosures.
 Parties with limited power (limited resources) will generally be unable to
secure information about an organisation.
 Investors need protection from fraudulent organisations that may produce
misleading information, which due to information asymmetries, cannot be
known to be fraudulent when used.

 Regulation leads to uniform methods being adopted by different entities, thus

enhancing comparability.

 Regulation helps provide confidence to investors in capital markets, and it is often

considered that such confidence is important to societies.

2.8: Briefly outlines some arguments in favour of eliminating the regulations

pertaining to financial accounting

Hints to answer to 2.8

Arguments against regulation are often referred to as ‘free-market’ arguments.

Advocates of a ‘free-market’ approach typically base their arguments on an
assumption that markets (such as capital markets, labour markets and product

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markets) are efficient and that the markets will provide various incentives and
penalties to ensure that managers, on average, do as the market expects. For example,
if the capital market expects an entity’s managers to provide information and the
managers do not do that, then the market might penalise the entity by charging a
higher price for funds advanced to the entity (to compensate the investors for the
higher risk that they face as a result of having limited access to information to enable
them to monitor their investment).

Further, it is also believed by some people that the absence of information probably
implies that the reporting entity has bad news that it has elected not to disclose (it is a
‘lemon’). There are also a number of other arguments that have been advanced to
support a ‘free-market’ approach to providing accounting information. These include
the following:
 Accounting information is like any other good, and people (financial statement
users) will be prepared to pay for it to the extent it has use. This will, it is
assumed, lead to an optimal supply of information by entities.
 Because users of financial information typically do not bear its cost of
production, regulation will lead to oversupply of information (at cost to the
producing firms) as users will tend to overstate the need for the information.
 Regulation typically restricts the accounting methods that can be used. This
means that some organisations will be prohibited from using accounting
methods that management believe best reflect their particular performance and
position. This is considered to impact the efficiency with which the firm can
inform the markets about their operations. This will have implications for the
costs involved when a firm needs to attract investment capital.
------------------------

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 Q-2.12: Pursuant to the capture theory, how, by whom and why would a
regulators be captured ?

Hints to answer to 2.12

Pursuant to capture theory, while regulation might initially be introduced in the public
interest, the regulatory mechanisms are often subsequently captured by those groups
that are subject to the regulation. The regulated parties seek to capture the regulatory
process so that they can then act to ensure that any subsequent regulations do not
disadvantage them. This chapter referred to the work of Walker (1987) who provided
evidence that the Australian accounting profession was able to capture the
government controlled accounting standard-setter (at the time, the standard-setter was
known as the Accounting Standards Review Board). Across various industries there
has been historical evidence of related regulatory bodies being captured by vested
industry interests.

Q: 2.21: Solomon quotes the American Accounting Associations “ ”

Evaluate the statement.

Hints to answer to 2.21
The accounting standard-setting process is a political process in which constituents
typically provide various submissions during the period in which accounting
standards are developed (and for some accounting standards this period has been as
long as a number of years). Depending upon the force of the argument, some
arguments will have more effect on the regulators than others.

Further, standard-setters have publicly stated (in projects such as conceptual

frameworks) that they consider the economic and social implications of potential
requirements as part of the process of developing new standards. Once the potential
costs and benefits to various constituents are considered and weighted, which
necessarily requires much judgement about the nature and relevance of the costs, and
once the views of various constituents are taken into account, it is indeed difficult to

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believe that the ultimate accounting standards have been developed in a manner that
can be considered objective.

We have seen in this chapter, there are a number of theories of regulation which
suggest that regulators are driven by issues associated with their reappointment, rather
than the public interest. Capture theory and economic interest group theories also
suggest that groups lobby to influence regulators so that so that regulators formulates
rules in favour of the groups by which they are influenced.

Questions: 2.24:
Provide examples of situations when the release of accounting standards could
create social and economic effects that reverberate throughout society.

Hints to answer to 2.24

There can be many examples provided here, and therefore a comprehensive answer is
not possible.

One example might be the international release of IAS 38 Intangible Assets. This
standard requires, among other things, that all research must be expensed as incurred.
This can be contrasted with the requirements previously in place within Australia. In
Australia, prior to the adoption of IFRS in 2005, reporting entities were allowed to
capitalise research expenditure (subject to certain tests for deferral). The new
requirement to immediately expense research expenditure would arguably have
caused some entities to defer or even cancel some research activity. We are never to
know whether such deferred or cancelled research might have led to some important
‘break-throughs’ that might have provided significant social benefits. Therefore, the
adoption of IAS 38 in various countries might have had real social implications

As another example we can consider the ongoing (and very protracted) efforts of the
IASB and FASB to develop a new accounting standard on leasing. This new
accounting standard – which has proved to be very ‘political’ in nature in terms of the
number of submissions being made by various vested interests (all of which have

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contributed to years of delay in issuing a final standard) will likely lead to a reduction
in the use of leasing of various assets. The reduction in leasing will obviously have
direct cash flow consequences for various organisations. Requiring many leases to be
recorded in the statement of financial position (many of which were previously
excluded from recognition) could also have implications for many organisations in
terms of potentially defaulting on various debt covenants – and this will also create
various economic consequences.

Additional questions: 2.26:

Hints to answer to 2.26
This quote suggests that if accountant do not report any numbers with regard to any
issues (for e.g. social and environmental costs), then it is as if these costs did not exist
by virtue of the fact that accountants did not report these on accounting or CSR issues.
This shows as if accountants can create reality. This also shows that accounting
reporting is very subjective. Accountants can decide what to report and what not to
report and by doing this it looks like accountants create their own reality.

Also if an organisation is required to publicly disclose information about a particular

aspect of its performance, then various stakeholders will have knowledge about that
aspect of the organisation’s performance and will act accordingly. Conversely, if no
information is publicly available about particular aspects of an organisation’s
performance then people will not be sufficiently informed to take action in support of,
or against, an organisation.

Of course, some theorists might argue that if ‘the market’ requires such information
and the organisation does not supply the information, then ‘the market’ will penalise
the organisation. But such market-based arguments ignore the fact that markets are
not always efficient.

In relation to this question we can consider the accounting treatment of green-house

gas emissions. Traditionally, the release of carbon gases into the environment have
not been accounted for in financial accounting terms (unless particular fines were

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 imposed). This has meant that many carbon intensive firms have shown massive
profits at the same time they were damaging the environment. It also has meant that
by not reporting this environmental pollutions accountants have been able to create an
impression that such pollutions and their environmental costs do not exist.

However, had the accounting profession developed an approach to account for carbon
emissions and to place a cost on damaging the environment, then this would have had
the very visible impact of reducing reported profits – and this would have been very
visible. Expenses related to environmental costs would have been reported which
would have led to less profit reported. Reduced profits would have had the
implications of reducing dividends. Those with a financial stake in the organisation
would have then had a very good reason to encourage organisations to reduce their
damaging impacts on the environment and would have encouraged companies to
adopt methods less damaging to the environment

-------------------
Chapter 3

Questions: 3.19. What assumptions are made about motivations of the regulators in (a)
The public interest theory of regulations (b) the capture theory of regulations (c) The
economic interest theory of regulations?

Hints to answer to 3.19

(a) In the public interest theory of regulation the regulators are assumed to
act in the interests of the public and will only introduce regulation if the
benefits to the public are believed to be greater than the costs. Regulation is
not introduced to support particular vested interests and the regulators are not
assumed to be driven by their own self interests.

(b) Advocates of capture theory assume that the parties that had been subjected to
the regulation tend to be able to capture the regulatory process. The regulated
parties typically do this for their own benefit. Hence, while it is assumed that
the regulators might act in the public interest, it is typically assumed that those
subjected to regulation act in their own self-interest.

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 (c) Economic interest theories of regulation assume that everybody acts in their
own self-interest, including regulators. Regulators will only propose and
support regulation which leads to favourable outcomes for themselves, perhaps
in terms of their re-election. Also different groups lobby the regulators to get
those regulations passed which benefit their own interests most.

3.24: What do we mean when we say that financial accounting standards are the
outcomes of political process? Why is the process political?

Answer:
In many countries throughout the world, accounting standards have traditionally been
developed following a particular due process in which draft standards are developed and then
released for public comment before final standards are developed. This process is also
adopted by the International Accounting Standards Board (IASB)—the body responsible for
developing the accounting standards that are now used in many countries. During the time in
which comments are sought, written submissions will generally be made. It is generally
accepted that the more that the proposed standard represents a departure from existing
generally accepted accounting practice, the more submissions are likely (for example,
consider the development of the new standard on accounting for leases).

Since the standard setters consider the contents of the various submissions when
finalising the standard, the process is considered to be political—different people
provide an opinion in an attempt to influence the development of the standard. Some
opinions are likely to have more impact than others. Because the accounting standards
used in many countries are developed in this manner, and because the views of the
people in different countries can be expected to be different (due to such things as
‘cultural differences’, an issue investigated in Chapter 4) we might consequently
expect there to be international differences in accounting standards. Such differences
which have traditionally existed however, are now declining as more countries adopt
the standards released by the IASB, rather than having their own domestic standard-
setting body.

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 If a standard setter did not behave in a political manner (that is, if it did not take
account of the views of its constituents) there is some likelihood that the standard-
setter may not be able to maintain its legitimacy and hence may be forced out of
existence.

3.28: Read Accounting Headlines 3.8 from your text book (page no 100) and explain
senate committee concern from a capture theory perspective.

Suggested Answer to Question 3.28:

Capture theory would suggest that while regulation might initially be put in place to serve the
public interest, ultimately those parties who have their actions impacted or controlled by the
regulation will take actions that lead to them (the regulated party) subsequently controlling
the regulatory process.

In the case referred to in Accounting Headline 3.8 it appears that the mining industry was in
favour of a process that facilitated the deposit of greenhouse gases underground. Government
approval would be necessary to be permitted to undertake this process. If the mining industry
was able to get an employee to also be part of the government assessment process then this
might potentially allow the mining industry to capture the approval process. Of course this
would assume that the person in question would not act objectively in his role with
government, but would make decisions that favour the mining industry. Of course, this might
not actually be the case.

3.31 Read Accounting Headlines 3.10 from your text book (page no 102) and using a
particular theory of regulations (chose the most appropriate one) explain what factors
might have been motivated the then President Jacques Chirac to lobby against the
accounting standards in questions.

Suggested Answer to Question 3.31:

As the newspaper article indicates, President Jacques Chirac supported the opposition to the
requirements of the standard (IAS 39) even though experts were saying the changes that
would be brought about through the adoption of the standard were necessary in an endeavour
to curtail accounting practices adopted at organisations like Enron.

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Although students are required to adopt the ‘most appropriate theory’ to explain the actions
of Chirac, it must be emphasised to them that the theory they select will be driven by their
own values and expectations about what motivates politicians like Chirac.

If the students believe that politicians are likely to act in the public interest and are not
driven by their own self-interest, then they might adopt public interest theory to
explain Chirac’s actions. They might argue that Chirac considered that the standard
might cause financial instability in France, and that such instability was not in the
interests of the broader society.

If however, the students believe that politicians’ actions are driven by their own self-
interest then they might embrace the private economic interest group theory of
regulation. In this case there might be a perception that Chirac’s continued presidency
required the support of the business sector and the best way to maintain that support
was to lobby for the changes that the business sector wanted. In this way the lobbying
activity was being swapped for votes.

Additional questions:

Q-3.10: It is argued by some researchers that even in the absence of regulations

organisations have incentives to provide credible information about their
operations and performance to certain parties outside the organisations,
otherwise costs of organisational operations would rise. What is the basis of this
belief?

3.10 (Answer this questions adding points from answers to 2.8)

A number of reasons that have been proposed by certain researchers (‘free market
proponents’ that oppose regulation) to support a view that even in the absence of
regulation, organisations will provide optimal amounts of accounting information.

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There will be private economics-based incentives for organisations to produce
information. For example:

 It is assumed that managers like all individuals, will operate the organisation
for their own benefit and this is expected by shareholders and debtholders (free
market proponents hold a maintained assumption that all individuals are
motivated by self interest and hence everyone expects everybody else to act in
a self interested manner)
To maximise their own rewards it will be in the interests of management to
enter contracts with shareholders and debtholders to constrain managers’
actions (these contracts will act to constrain the actions of management and to
align the interests of managers with those of the owners of the organisation)
Many of these contracts will be based on accounting information (for example,
paying the manager a bonus based on accounting profits)
Therefore, organisations not producing information will be penalised by higher
costs of capital
 There is also a view that organisations are best placed to determine what
information should be produced. The introduction of accounting standards
creates inefficiencies by imposing a ‘one-size-fits-all’ approach on external
reporting. Imposing regulation restricting the available set of accounting
methods decreases the efficiency of contracting (for example, the organisation
might have developed what it considers is the best way to reflect managers
performance, but an accounting standard may disallow the use of this
accounting technique)

There are also anti-regulation arguments based on the operation of efficient

managerial labour markets. Pursuant to the ‘market for managers’ arguments:

 It is believed that the managers’ previous performance impacts on

remuneration they can command in future
 In the absence of accounting regulation it is assumed that managers are
encouraged to adopt strategies to maximise value of firm (provides favourable
view of own performance)

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  Such strategies include providing optimal amounts of accounting information

Yet another argument against the introduction of accounting regulation is the ‘market
for lemons arguments’. The basis of this argument is that:

 No information is viewed in the same light as bad information

 The market may make the assessment that silence implies the organisation has
bad news to disclose
 Therefore managers will be motivated to disclose both good and bad news

As we can see from the broad discussion above, proponents of the free market (anti-
regulation) approach to providing accounting information have a number of
arguments to counter any calls for regulation.

However, there are many other researchers who would reject the above arguments and
would argue that regulation is required for a multitude of reasons including a belief
that markets are not efficient and that less powerful stakeholders will not always be
protected by freely operating market mechanisms.

……………………………………………………………………………………………………………………

Group discussion:

Read all articles uploaded on canvas about political nature of accounting standard
setting process and participate discussion with your tutor.

Relevant articles are: Jesmine et al (2017), Chen et al (2022), Cortese et al (2010) and
Forgerti et al (1994).

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