Chapter 3

Standard setting

©2018 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

3.1understand the institutional framework of
Australian accounting standard setting
3.2explain and define an accounting standard
3.3evaluate the distinction between rules‐based and
principles‐based standards
3.4analyse standard setting as a political process
 Learning objectives

3.5understand the benefits of harmonisation of

accounting standards.
Presentation overview
 Institutional framework

• Australian accounting standard setting:

– Organisational structure:
 Institutional framework

• The FRC:
– The FRC is a statutory body operating within a
framework set out in the ASIC Act.
• The AASB:
– Functions of the AASB are to make accounting
standards under the Corporations Act 2001.
– This accomplishes by promoting international
standards.
 Institutional framework

• Interpretation advisory panel:

– Provide guidance on the application of a standard.
– Particularly IFRSs application in Australia.
– Focus on the private sector, the public sector and
not‐for‐profit entities.
– IASB standards are focused on business entities.
• Other groups:
– User Focus Group.
– Not‐for‐Profit (Private Sector) Focus Group.
 Accounting standards

• The process of standard setting is designed to produce

quality financial reporting.
• The standard‐setting process:
– Accounting standards were issued in 1946.
– A standard’s origin lies in the identification of a
technical issue by the:
• IASB
• IFRS Interpretations Committee
• the International Public Sector Accounting
Standards Board (IPSASB).
 Accounting standards

• The AASB standard-setting process:

 Rules-based versus principles-based
standards

• Rules-based standards:
– sets of detailed rules
– must be followed when preparing financial
statements.
 Rules-based versus principles-based
standards

• Principles-based standards:
– based on a conceptual framework
– provides a broad basis for accountants to follow
– focus on:
• economic substance of a transaction
• engaging professional judgement and expertise.
 Advantages of rules-based standards

• Advantages:
– Improved guidance:
• when there is a lack of a clear and appropriate
principle
• where standards are inconsistent with the
conceptual frameworks.
– Increased comparability between financial
statements.
 Advantages of rules-based standards

• Advantages:
– Improved accuracy with communication of:
• intentions
• requirements.
– Reduced:
• imprecision (affecting reporting)
• opportunities for earnings managements
through judgements
• exposure to litigation.
 Advantages of rules-based standards

• Advantages:
– Increased:
• verifiability for auditors and regulators.
 Disadvantages of rules-based standards

• Disadvantages:
– Rules-based standards can be very complex.
– Organisations can structure transactions to
circumvent unfavourable reporting.
– Standards are likely to be incomplete or even
obsolete by the time they are issued.
– Manipulated compliance with rules makes
auditing more difficult.
 Advantages of principles-based standards

• Advantages:
– Principles‐based standards should be simpler.
– Broad guidelines:
• applicable to many situations
• improve the representational faithfulness of
financial statements.
– Allows use of professional judgement in assessing
the substance of a transaction.
Disadvantages of principles-based standards

• Disadvantages:
– Managers may select treatments that do not
reflect the underlying economic substance.
– The judgement and choice involved in many of the
decisions mean that comparability among
financial statements may be reduced.
 Theories of regulation

• Accounting information is a ‘public good’.

• Therefore some argue it is likely to be under
produced without regulation.
• Others suggest supply would exist without regulation
• There are competing theories regarding the need for
and intention of regulation.
 Defining regulation

• Regulation is a rule or order, as for conduct,

prescribed by authority.
• Elements of regulation:
– intention to intervene
– restriction on choice to achieve certain goals
– exercise of control by a party independent of
those directly involved in the activity.
 Signalling theory

• Suggests reporting entities can increase their value

through financial reporting.
– Companies face a competitive capital market
populated by sophisticated investors.
– Above-average entities motivated to show that they
are better than non-reporting entities.
– Non-reporting entities are perceived as of even
poorer quality than before.
– Creates a virtuous cycle where regulation is not
necessary.
 Public interest theory

• Argues signalling theory relies on the function of a

perfect, free-market economy.
• Public interest theory assumes:
– economic markets are generally not perfect
– regulation is virtually costless.
• Concludes that regulation:
– is supplied in response to the demands of the public
– for the correction of these inefficient or inequitable
market practices.
 Capture theory

• Capture theory:
– regulation is supplied in response to the demands of
self-interested groups
– who are trying to maximise their incomes or
interests.
• People are rational utility maximisers.
• The coercive power of government can be used to give
valuable benefits to particular groups.
• Regulation can be viewed as a product that is governed
by the laws of supply and demand.
 ‘Bushfire’ theory

• Bushfire theory:
– The political and public nature of regulatory
influences.
– Takes into account:
• the reactions of users
• society in general
• ‘failures’ of regulatory processes.
 ‘Bushfire’ theory

• Regulations tend to arise from crises.

• Resulting rules do not necessarily deal with the
issues that caused the crisis.
• Rather they gain media exposure so that politicians
are more likely to gain re-election.
 Ideology theory of regulation

• Ideology theory of regulation:

– relies on market failure
– introduces the role of lobbying in influencing the
actions of regulators.
• Lobbying is a mechanism through which regulators are
informed about policy issues.
• Predicts that the effectiveness of regulation will depend
on:
– the political ideologies of the regulators
– the impact of special interest lobby groups.
 Advantages of regulation

• Advantages:
– Increased efficiency in allocating capital.
– Cheaper production.
– Check on perquisites.
– Public confidence.
– Standardisation:
• comparability
• understandability.
– Public good.
 Disadvantages of regulation

• Disadvantages:
– Difficult to achieve efficiency and equity.
– Determining the optimal quantity of information is
problematic.
– Regulation is difficult to reverse.
– Communication is restricted.
– Reporting entities are different.
– There is lobbying.
– Monopolisation of accounting standards.
Theory and accounting regulation research

• There are few accounting studies which apply

regulatory theories to standards setting.
• The majority of such studies support a version of
regulatory capture.
 The political nature of setting accounting
standards

• There is a mix of private and public participation in

the standard setting process.
• Parties that have an interest in accounting standards
often have conflicting interests.
• For example:
– internal stakeholders may like flexibility
– external stakeholders may like comparability
– auditors like objective (auditable) reporting.
 Lobbying

• Those affected by accounting standards have an

incentive to lobby standard setters to achieve a
favourable outcome.
• Those affected must decide:
– whether they should lobby
– which method of lobbying they should use
– when they should lobby
– what arguments they should use to support their
position.
 Lobby groups

• Industry and management:

– Highly motivated and resourced.
• Casual non-professional users:
– Disparate interests and few resources.
• Full-time professional users:
– Secretive and non-responsive.
• Auditors:
– Accused of self-interest.
 Lobby groups

• Academics:
– Lack of comment on exposure drafts.
 Lobby groups in Australia

• Major groups in Australia seem to be:

– G100
– large accounting firms
– professional accounting bodies
– ASX
– major banks.
 Harmonisation

• One of the functions of the AASB is to participate in

and contribute to the development of a single set of
worldwide accounting standards.
• Three main benefits have been identified:
– international comparability
– reduced cost of capital
– reduced conflicting reporting requirements.
 Harmonisation

• Australia and the European Union (EU) ‘adopted’

IFRSs on 1 January 2005.
• IFRSs is for the regulator to adopt a process of
standard setting and thereby the standards produced
under that process.
• An Asian‐Oceanian Standard‐Setters Group (AOSSG)
was formed with the aim to represent Asia’s view on
financial reporting.
 Harmonisation

• European setting it was found that:

– listed entities underestimated the complexities,
effects and cost of IFRSs.
– there is tension between principles‐based and rules‐
based interpretation of IFRSs.
• Trying to avoid diversity results in a rules‐based
approach.
 Harmonisation

• European setting it was found that:

– Under a principles based approach:
• not testing whether accounting treatments are
identical
• but testing whether they are appropriate in the
particular circumstances.
 Summary

• The FRC is the oversight body and appoints the

standards setters other than the chair of the AASB.
• The AASB is responsible for making accounting
standards and contributing to a set of worldwide
standards.
• Accounting standards are authoritative statements
that guide the preparation of financial statements.
• Principles-based and rules-based standards.
 Summary

• Regulation is the intervention in an activity by a party

nominally independent of those engaged in the
activity.
• Signalling, public interest, 'bushfire' and capture
theory.
• Various parties have conflicting interests in reporting
entities, which impacts the political process of
standard setting.
 Summary

• Australia embarked on its international

harmonisation program because of the perceived
benefits.
• Australia adopts the content and wording of
international standards, although some changes may
be made.
• Australia provides technical input and regional insight
into the international standard-setting process.