Lecture 3 Regulation of Financial Reporting in Australia (cont.)

1. Lecture 3Regulation of Financial Reporting in Australia(cont.) AASB

2. Lecture 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)

3. The Fundamental Problem of Financial Accounting Theory Provision of relevant info. to aid investor Decision making Provision of reliable info. to control management behaviour

4. Possible solutions • 1. Let market forces determine what information is supplied • 2. Regulate the provision of financial information

5. Current Sources of Accounting Regulations in 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

6. Is Regulation the Answer?(section 2.4)

7. Free 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

8. Incentives for managers to supply information • 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

9. Incentives for managers to supply 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

10. Incentives for managers to supply 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

11. Free 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

12. The ‘pro-regulation’ perspective • 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)

13. The ‘pro-regulation’ perspective • 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

14. The ‘pro-regulation’ perspective • 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’

15. Why is financial 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

16. Three Theories of Regulation(Section 2.5) 1 2 1 3

17. Three Theories of Regulation • 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’

18. Public 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

19. Public Interest Theory: 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

20. Review - 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

21. Interests of the Accounting 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

22. 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 • Regulatoryagencies empathise with those who are regulated • Subsequent regulations are advantageous to regulated parties

23. Capture Theory:Application to Accounting • 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!)

24. Impact 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

25. Private 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’

26. Who seeks the power in 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

27. Who is the highest Bidder? • The industry group (companies) often has the greatest ability to supply the desired payoffs to the political power brokers

28. Summary of theories of regulation • 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.

29. Standard Setting as a Political Process (Section 2.6)

30. The Politics of Accounting 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

31. The Process of Developing AASBs (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

32. Objective, neutral & apolitical • 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?

33. For Tutorials • Required reading • Text chapter 3 • Self assessment questions • Questions 8 - 17 from module 2 • Answers in tutorials