Lecture 3

Regulation of Financial
Reporting in Australia
(cont.)

AASB

Lecture Overview

Review

Is regulation the answer? (section 2.4)

The fundamental problem of financial

accounting theory
Current Australian accounting regulations
free market perspective
pro-regulation perspective

Three theories of regulation (2.5)

Standard setting as a political process (2.6)

The Fundamental Problem

of Financial Accounting
Theory
Provision of relevant
info. to aid investor
Decision making

Provision of reliable
info. to control
management behaviour

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

Current Sources of
Accounting Regulations
Australia
FRCin
- 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
Answer?
(section 2.4)

Free market approach

Accounting information is like any other

product, subject to:

Rely on market forces (including

contractual demands) to determine

demand (from users/investors) and

supply (by companies/managers)

what information to supply

the quality of information supplied

Market-based penalties discourage nonsupply and misleading information

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

Incentives for
managers to supply
Capital
markets
information
(cont.)
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
managers to supply
Markets
for managers and(cont.)
corporate
information
takeovers

Market for lemons

Impose further penalties for non-supply and/or

misleading information (manager remuneration,
threat of takeover)
Provides further incentives to disclose
information, including bad news

Potential litigation costs impose further

penalties in relation to misleading
information

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

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)

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

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

Why is financial
reporting so regulated?
Free-market approach and selfregulation 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
Regulation
(Section 2.5)
1

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

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

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 selfinterest of politicians and government
officials

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

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

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:
Application to
Walker
Accounting
(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 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 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

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 is the highest

Bidder?

The industry group

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

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.

Standard Setting as a
Political Process
(Section 2.6)

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

The Process of
Developing AASBs
(Due Process)
1. Selection of topics

2.
3.
4.
5.
6.
7.

Appointment of advisory panel

Discussion paper / theory monograph
Key issues
Exposure draft
Accounting standard
Legislation

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?

For Tutorials

Required reading
Text

chapter 3

Self assessment questions

Questions

8 - 17 from module 2
Answers in tutorials