Lecture Lecture 33Regulation of Financial Regulation of Financial Reporting in AustraliaReporting in Australia

(cont.)(cont.)

AASB

Lecture OverviewLecture Overview Review

The fundamental problem of financial accounting theory

Current Australian accounting regulations Is regulation the answer? (section 2.4)

‘free market’ perspective ‘pro-regulation’ perspective

Three theories of regulation (2.5) Standard setting as a political process

(2.6)

The Fundamental Problem The Fundamental Problem of Financial Accounting of Financial Accounting TheoryTheoryProvision of relevantProvision of relevantinfo. to aid investorinfo. to aid investorDecision makingDecision making

Provision of reliableProvision of reliableinfo. to controlinfo. to controlmanagement behaviourmanagement behaviour

Possible solutionsPossible solutions

1. Let market forces determine what information is supplied

2. Regulate the provision of financial information

Current Sources of Current Sources of Accounting Regulations Accounting Regulations in Australiain Australia

FRC - Financial Reporting Council oversight of the standard setting process

AASB - Aust. Accounting Standards Board Technical deliberations about new and

changed accounting standards Approximately 40 standards on issue Currently undertaking harmonisation with

International Accounting Standards

Is Regulation the Is Regulation the Answer?Answer?

(section 2.4)(section 2.4)

Free market approachFree market approach

Accounting information is like any other product, subject to: demand (from users/investors) and supply (by companies/managers)

Rely on market forces (including contractual demands) to determine what information to supply the quality of information supplied

Market-based penalties discourage non-supply and misleading information

Incentives for Incentives for managers to supply managers to supply informationinformation

Contractual Information for monitoring of managers (to

overcome problems of moral hazard) Contractual terms are often tied to

accounting numbers – creates demand for accounting and auditing (stewardship role of financial reporting)

Threat of price-protection transfers incentive from other parties to managers – managers have an incentive to supply information

Incentives for Incentives for managers to supply managers to supply information (cont.)information (cont.)

Capital markets Demand for information about potential

investments (to overcome problems of adverse selection)

Need to raise capital creates incentives for managers to supply the information (information role of financial reporting)

Penalties for non-supply and/or misleading information include higher costs of capital

Incentives for Incentives for managers to supply managers to supply information (cont.)information (cont.)

Markets for managers and corporate takeovers Impose further penalties for non-supply

and/or misleading information (manager remuneration, threat of takeover)

Market for ‘lemons’ Provides further incentives to disclose

information, including ‘bad news’ Potential litigation costs impose further

penalties in relation to misleading information

Free market approachFree market approach Equilibrium is where

costs of providing info = benefits Managers have incentives to supply

information, eg. to raise debt and equity capital, but must also consider the cost associated with disclosing the information

Investors demand information. However, once the information is available, they bear no costs, only benefits

Some parties demanding the info. are more powerful than others

TheThe ‘pro-regulation’ ‘pro-regulation’ perspectiveperspective

Accounting information is a public good once the information is released it can be made

available to everyone Free-riders (eg potential investors) do not pay

a price for the production of the information Causes underproduction of information due to

a decreased incentive to supply the information for free (market failure => need regulation)

Counter-argument (against regulation) Free-riders have greater incentives to demand

increased disclosure (there is a risk that the AASB responds to this exaggerated demand)

TheThe ‘pro-regulation’ ‘pro-regulation’ perspectiveperspective

Another problem with the ‘free market’ approach is that

Firms are monopolist suppliers of information about themselves tendency to under-produce and sell at a

high price These problems prevent optimal

operation of competitive market - market failure

The ‘pro-regulation’ The ‘pro-regulation’ perspectiveperspective

Regulation creates a ‘level playing field’ Everyone has access to the same

information Increases confidence in capital markets

Regulation is in the ‘public interest’ To protect the ‘more vulnerable’

Why is financial Why is financial reporting so regulated?reporting so regulated?

Free-market approach and self-regulation by profession had problems

Government intervention to protect the public interest (investors and other users of financial information)

This is what the public interest theory proposes

Three Theories of Three Theories of RegulationRegulation

(Section 2.5)(Section 2.5)

1

1 2 3

Three Theories of Three Theories of RegulationRegulation

1. Public Interest Theory 2. (Regulatory) Capture Theory 3. Private Interest Theory (Economic

Interest Group Theory of Regulation)

Important - these theories help is to understand ‘what is’ rather than prescribing ‘what should be’

Public Interest TheoryPublic Interest Theory Government intervention in markets is in

the ‘public interest’ due to inefficient or inequitable market practices

Government intervened in accounting regulation in 1984 (ASRB) due to market failure failed companies with clean audit bills lack of info stemming from information

asymmetries Theory based on some unrealistic (?)

assumptions

Public Interest Theory:Public Interest Theory: Assumptions Assumptions

Markets are subject to failure Politicians help investors by regulating the

supply of financial information There are agents (politicians / public

interest groups) who genuinely seek regulation in the public interest

Government has no independent role to play in the development of regulation - it is a neutral arbiter. ie theory ignores self-interest of politicians and government officials

Review - Self InterestReview - Self Interest

An important concept that helps us understand the way the world works

Financial reporting and its regulation are affected by the self interest of the individuals involved

Individuals form into groups to help achieve their objectives

Interests of the Interests of the Accounting ProfessionAccounting Profession

The accounting profession has an interest in controlling and overseeing the regulation of financial reporting

Self-regulation by profession failed due to non-compliance and lack of legitimacy

Alternative solution - ‘capture’ government regulation of financial reporting

The Capture Process The Capture Process

Regulators set out to protect public interest, but are subsequently captured by regulated parties

Due to the interaction during the process of regulating

Regulatory agencies empathise with those who are regulated

Subsequent regulations are advantageous to regulated parties

Capture Theory:Capture Theory:Application to Application to AccountingAccounting

Walker (1987) argues that Government initially created the ASRB

(now AASB) to protect the public interest

Professional bodies (the regulated industry) subsequently managed to capture the ASRB

Outcome – Standards set by accounting profession and legitimised by Government (Perfect for profession!)

Impact of Self InterestImpact of Self Interest Capture theory builds on public interest

theory by considering the self-interest of regulated parties

However, capture theory ignores the self interest of other groups and individuals

Private interest theory (economic interest group theory) does not have this limitation

Private Interest TheoryPrivate Interest Theory

Acknowledges that individuals form into groups to pursue their self interest

Proposes that private interests rather than public interests dominate the regulatory process

Regulatory outcomes reflect the interests of the most powerful group

Politicians are not neutral arbiters – they seek re-election and are able to be ‘bought’

Who seeks the power in Who seeks the power in financial reporting?financial reporting?

Accounting profession was not the only group to focus on the AASB

The producer group (companies) are likely to seek control of accounting regulation

Major interest groups are: Members of accounting professional bodies Managers of companies (producer group) Government officials and politicians

Who Who isis the highest the highest BidderBidder??

The industry group (companies) often has the greatest ability to supply the desired payoffs to the political power brokers

Summary of theories of Summary of theories of regulationregulation

Public interest theory ignores self interest completely - niave

Regulatory capture acknowledges some self interest - part of the story but not all of it

Private interest theory acknowledges self interest of all parties involved

Theories build on each other.

Standard Setting as a Standard Setting as a Political Process Political Process

(Section 2.6)(Section 2.6)

The Politics of The Politics of Accounting RegulationAccounting Regulation

Standard setting is a political process Standard setting is political because it

affects the well-being of a wide variety of interest groups

Expect these groups to pursue their interests and attempt to influence the process

Accounting standards are developed having regard to social and economic consequences

The Process of The Process of Developing AASBs Developing AASBs (Due Process)(Due Process)

1. Selection of topics 2. Appointment of advisory panel 3. Discussion paper / theory monograph 4. Key issues 5. Exposure draft 6. Accounting standard 7. Legislation

Objective, neutral & Objective, neutral & apoliticalapolitical

Financial Reporting and the Regulation of Financial Reporting are not: Objective Neutral Apolitical

Financial reporting is a function of (a) accounting regulations, and (b) financial reporting decisions

If neither of these are objective, neutral or apolitical, how can financial reporting be?

For TutorialsFor Tutorials

Required reading Text chapter 3

Self assessment questions Questions 8 - 17 from module 2 Answers in tutorials