Solutions Manual: Accounting Theory 7e

Solutions Manual
to accompany
Accounting Theory 7e
by
Ann Tarca
Chapter
Chapter 3
Applying theory to accounting regulation
John Wiley & Sons Australia, Ltd 2010

Chapter 3: Applying theory to accounting regulation
THEORY IN ACTION
Theory in action 3.1 Companies should come clean on the value of leases in their
books
1. Describe current accounting practices for leases as outlined in this article.
Accountants distinguish between capital and operating leases. Capital leases go on the
balance sheet while operating leases do not. Australian standards require that lease
classification is based on the ‘substance’ of a transaction. However, the guidance
criteria for what constitutes a capital lease (e.g. the requirements relating to the lease
term covering a major part of an asset’s economic life) leave openings for companies
to exercise discretion in classifying leases. US GAAP includes criteria such as the
present value of minimum lease payments exceeding 90% of asset’s value.
2. Why does the author call leasing standards ‘silly accounting rules’?
The author says the rules mean that companies exclude real assets and liabilities from
their balance sheets. The effect of ‘off-balance’ sheet items is that a company’s assets
and liabilities are understated and performance ratios such as return on investment are
overstated. In addition, financial risk measures are not accurate and useful (‘bear no
relation to reality’).
Off-balance sheet items attracted attention at the time of the collapse of Enron in the
USA in 2001. A report by the SEC in 2005 estimated that US companies were
committed to US$1.25 trillion in lease payments relating to leases which did not
appear on balance sheet. The author estimates that 90% of Australian leases are off-
balance sheet.
3. Standard setters propose revising leasing standards to require

capitalisation of all leases. Explain the financial impact for Coles and
Woolworths in 2007-08 of having ‘off-balance sheet’ leases.
In the 2006-07 year, Woolworths had AUD $11.8 billion and Coles AUD $10.8
billion of off-balance sheet leases. Woolworths reports that net debt fell $1.3 billion,
but when analysts adjust for off-balance sheet leases, it actually remains unchanged at
$14.1 billion. Coles reported $900 million net debt, but the actual figure is $11.8
billion.
Invested capital (debt plus equity) is understated for both companies. Woolworths
adjusted debt/capital ratio is more that double that reported (71.9% compared to
30.7%); Coles is 75.1% compared to 19.4%.
© John Wiley and Sons Australia, Ltd 2010 3.2

Solution Manual to accompany Accounting Theory 7e
4. What are the advantages of capitalising leases? Given that most

companies usually reporting operating leases, will they oppose new
leasing rules?
The following points can be found in the article in relation to advantages of lease
capitalisation:
a. More accurate performance measures (avoid overstated
ROI);
b. Avoid misleading basis for assessing performance
trends;
c. Allow better assessment of financial risk (determining
risk/reward trade-off);
d. Allow more accurate comparisons between companies
and operating units.
The author suggests that companies will resist changes to leasing standards. He notes
there is a ‘huge industry’ which is involved in creating leases that can be classified as
operating. Members of this industry can be expected to oppose changes to current
rules.
We may expect companies to oppose rules to capitalise all leases because they
currently favour operating leases (based on their current practice). However, as long
as the new rules force all companies to show capitalised leases (that is, all companies
are affected in the same way by the new rules) companies may not oppose the change.
It is difficult to provide convincing reasons why leases should be allowed to be ‘off-
balance sheet’ so companies may be hard pressed to defend their current practices.
Off-balance sheet leases are an ‘open secret’, i.e. the impact of capitalising leases on
balance sheet can be calculated from the financial statement information. The article
states that analysts make adjustments to bring leases on balance sheet to improve the
information they use when assessing and comparing companies. We may expect
analysts to favour capitalisation of all leases. Analysts/investors are an influential user
group who may support the standard setters in changing leasing rules.

Theory in Action 3.2 Accountants draw the line at regulating
1. The article refers to a view circulating at the time, that fair value
accounting contributed to the ‘global financial crisis’ (from October 2008,
the near collapse of many banks caused capital flows to dry up and share
prices to fall dramatically.) How could fair value accounting exacerbate
the financial crisis?
Critics of fair value accounting claimed that the method forced banks to write down
asset values. The implication is that these write downs were not necessary and/or
caused the banks to be portrayed as being weaker than they really were (write downs
reduced their equity, affected their capital adequacy ratios and liquidity, and their
ability to lend funds). The implied assumption is that asset prices will recover; that the
impairment is only temporary and therefore should not be booked through profit and
loss.
There are several issues to consider. First, students should discuss why the IASB
mandated fair value for (at least some) financial instruments – to improve
transparency and comparability of information, thus assisting investors in evaluating
risk attached to the financial instruments. Fair value reporting shows market values
for financial instruments which previously were unreported or reported at (irrelevant)
historical cost, for example derivative contracts. Users benefit from more detailed and
relevant disclosures.
Second, the article notes that fair value reporting should have been more, not less.
That is, fair value measurement was used for some, but not all, financial instruments.
The article says the IASB’s preferred position is that fair value measurement applies
to all financial instruments not a selection as occurs under IAS 39. Wider use of fair
value aims to provide relevant information for users (for decision making) and to
avoid managerial discretion leading to manipulation of asset values.
Third, the banks’ claim that they should not have to book the write downs seems to be
a public relations exercise, that is, an attempt to obtain rules which will let them
present a favourable and optimistic picture. Avoiding taking a write down would be
favourable because the current value of the loans (actual or estimated) is below book
value and optimistic because it assumes the value of the loans will increase in the
future. The situation emphasises the differences in incentives of preparers and users of
financial reports. Preparers want to present the best possible picture of the company
(to maintain share price, investor confidence, remuneration) while users want the
most realistic picture to assist with decision making.
2. Why does the IASB member refuse to accept responsibility for the
financial crisis?
Mr Cooper of the IASB states that the role of the Board is not to promote financial
stability, which is the job of prudential regulators. (The IASB’s role is to set
accounting standards for private sector entities throughout the world. Those standards
aim to assist companies to produce information which is useful for a range of users.)
He states that people should not be asking the IASB to do something which it is not
equipped to do.

He highlights areas where the regulators should be active – in avoiding lax rules
which permitted companies to ‘make risky bets, dole out excessive bonuses and pay
too much in dividends.’ He argues that the banking regulators are close to the banks
and the markets and can make decisions about the extent of write downs necessary
which cannot be made by the IASB. It is not their role and they do not have the
expertise for this type of decision.
3. The IASB considers adoption of IASB standards in the USA to be

essential. Explain why it holds this view. To what extent does the IASB’s
position reflect self-interest?
The IASB’s mandate is promoting the development and adoption of one set of
international accounting standards around the globe. In favouring the use of IAS
standards in the USA, the IASB is of course promoting its own self interest but that is
to be expected. The IASB may also have informed economic views behind its position
(e.g. to avoid the risk of regulatory arbitrage, that is, the comparison of different rules
and use of more favourable rules on a selective basis to gain financial advantage) and
if it can convince regulators in the USA of the soundness of its arguments then
progress towards the adoption of IASB standards into the USA will continue.
At March 2009, adoption of IFRS in the USA had been delayed because of the impact
of the global financial crisis, which was absorbing regulators’ attention. In 2008
adoption was planned for 2011-2014. By 2009, the date had been pushed back to 2016
in response to serious liquidity problems in financial markets and asset write downs
among financial sector firms. In 2010 the SEC was reviewing its position on adoption
of IFRS in the USA.

Theory in Action 3.3 Enforcing requirements of accounting standards
1. Do you consider that the company Brocade Communications complied

with the requirement to record an expense for stock options?
The relevant accounting standard requires that a company recognises an expense in

relation to the fair value of goods and services provided in exchange for equity
instruments in the company. If the fair value of goods and services cannot be reliably
measured, then the fair value of the equity instruments at grant date is used. Thus,
companies must use a fair value (market value must be used if available, otherwise
fair value can be estimated using an option pricing model e.g. Black Scholes Merton
or Binomial) to determine the amount of the expense at grant date. The standard states
that options are valued on grant date. The article suggests that Brocade falsified the
grant date. If the grant dated used was incorrect, giving rise to a value which was
different to that on the actual grant date, then the company has not complied with the
accounting standard.
2. Who benefits from the ‘backdating’ of stock options? Who is harmed?
The backdating of stock options is beneficial for the executives who receive the
options. If the value at grant date is lower, then the ability to gain from the options is
greater, that is, a smaller increase in share price is required for the options to be ‘in
the money’. The larger the difference between value at grant date and value when
exercised, the greater the benefit to the executive. A lower value on grant date also
means that the expense recorded in the company’s accounts is lower, with a
favourable effect on profit. If the vesting of options is linked to accounting earnings,
then it may be easier for executives to achieve accounting earnings performance
hurdles and thus qualify to exercise their stock options. The parties who do not benefit
from the back dating of options are shareholders who are not receiving accurate
information about the value of options granted. In addition, the incentive effects of the
options scheme may not be transparent or operate as expected if the grant date is
manipulated, to the detriment of shareholders.
3. If options can be backdated, has the standard setting board (in the USA,
the Financial Accounting Standards Board or FASB) been effective in
role of promulgating accounting regulations?
The FASB promulgates accounting standards, but it does not enforce them. When we
measure the effectiveness of an accounting standard, we consider how it works in
practice. Does it achieve the desired outcome? In this case, the standard has not
achieved the desired outcome (the recording of the fair value of equity instruments on
grant date). However, the fault may not lie with the standard itself, but rather with the
party required to follow the standard or the way the standard is enforced. When we
come to a red light at an intersection with traffic lights, we are required by law to
stop. If we fail to stop, the problem is not with the requirement to stop but with our
wilful disobedience in relation to the law. Thus, the failure to comply with the
accounting standard (determine the expense at grant date) does not mean that the
standard is ineffective, but rather that companies have chosen not to comply with the
standard. The enforcement of the requirements of the standard (via auditors or the
securities market regulator) may be the weak link in the regulatory framework.

4. What is the role of the SEC in relation to the regulation of accounting

practice?
The US Securities and Exchange Commission is the US securities market regulator

set up under the 1934 Securities Exchange Act. It has many responsibilities including
monitoring trading on the stock exchanges and the provision of information by SEC
registrants. It has many, many regulations relating to disclosure that require company
compliance. It has delegated the specific function of setting accounting standards to
the FASB.
The SEC is responsible for ensuring compliance with accounting standards. When the
SEC became aware companies were selecting grant dates to suit their own purposes
rather than using the actual grant date, the SEC took action to indicate this breach of
the law was not acceptable. The success in the case against Brocade Communications
may serve as a deterrent to other companies.

Theory in Action 3.4 Many small caps to flash orange
1. What does the headline of the article mean by ‘small cap’ and ‘flash
orange’?
‘Small cap’ refers to companies with relatively smaller market capitalisation (i.e.
smaller companies in terms of total assets or total revenue compared to the entire
listed company sector). The article focuses on concerns about these companies
because they have fewer resources and are more likely to have difficulties generating
profits in adverse economic conditions. ‘Flash orange’ refers to a warning light, a
signal that these companies could be risky and for investors to take care because
returns are not guaranteed.
2. Explain the argument that merely by placing an ‘emphasis of matter’

section in an audit report you could start a chain reaction.
When auditors place an emphasis of matter paragraph in an audit report they are
making sure that the readers of the report have their attention drawn to a particular
matter. In this case the emphasis of matter refers to doubt about going concern issues,
which should be properly disclosed by management in the main body of the financial
report. If the auditor believed that the issue was not properly disclosed by
management then they would qualify the report. There is an argument that by drawing
the readers’ attention to this issue they are emphasising it to the point that the investor
would ‘take fright’ and believe the company was at very high risk of failure. This
could then lead to a sell-down of the company’s shares and a refusal by its customers
and other parties to do business with it. These reactions would serve to make the
uncertainty about the company’s going concern turn into a definite failure of the
company. Under this argument, if the auditor had not raised the issue in the audit
report, this chain of events would not have happened.
3. The article discusses bank covenants – explain the impact of asset

values on bank covenants and the potential repercussions for a
company.
Bank covenants are clauses in borrowing contracts between companies and banks
where the company promises to meet certain conditions. For example, the company
could promise to maintain certain debt/equity or profitability ratios. If the company
fails to meet these ratios, the bank is entitled to seek penalty interest, and/or early
repayment of the debt. The balance sheet based ratios rely on asset values. For
example, the debt/equity ratio is the amount of debt divided by the amount of equity.
Any asset impairment loss will reduce equity, increasing the relative amount of debt
in the company’s balance sheet. If this causes the relative amount of debt to exceed
the amount the company promised it would not exceed, the company is in breach of
its debt agreement. Given that the ratios are calculated using accounting numbers, the
bank contracts make the financial reports very important to the survival of the
business.

CASE STUDIES
3.1 Balancing the costs and benefits of regulatory intervention
1. Explain the reasons for the introduction of the Sarbanes Oxley Act (SOA)
in the United States in 2002.
The law was introduced in response to large-scale, highly publicised financial

scandals and subsequent corporate collapses at Enron and WorldCom. These scandals
resulted in the demise of the audit firm (Arthur Andersen who engaged in
questionable professional practices while auditor of Enron).
SOA is a classic example of regulatory intervention by government in the operation of

capital markets in the ‘public interest’. The government perceives it must be seen to
take action in response to a significant corporate scandal such as Enron. It can also be
argued that intervention reflected ‘vote buying’: politicians supporting SOA were
acting to restore financial stability and trust to ensure they would be re-elected. SOA
made changes to directors’ responsibilities for financial reporting and internal control
and sought to increase the independence of external auditors. Intervention via
congress reflected a view that action was necessary to (a) control unacceptable
behaviour and (b) reassure investors that their interests were being protected.
2. Why are some parties now opposed to SOA? Has their view changed from
when the law was first introduced?
It has become apparent that compliance with Section 404 of the law (which requires
managers to certify about the company’s internal control system) is a costly and time
consuming exercise. Law makers may have underestimated the costs of implementing
the section. Managers who initially supported the introduction of new regulation
(because of its role in restoring confidence in capital markets and thereby improving
share prices) may have become less enthusiastic as the cost of compliance became
more apparent.
3. According to John Snow, what criteria should be considered in

determining financial reporting rules?
According to John Snow, what criteria should be considered in determining financial

reporting rules?
Basically, his argument is that rules can have benefits, but they must be carefully
framed so as not to destroy business initiative and confidence. Criteria referred to in
the article include:
(a) rules should not dampen economic growth;

(b) there should be balance in enforcement (we can assume he means balance in
the extent to which government intervenes in the market place. Balance means

that people’s interests are protected, but not to the extent that business cannot
function efficiently);
(c) rules should emphasise substance over form to avoid penalising people who
make innocent mistakes.
4. Would you recommend a repeal of SOA? Why or why not?
Would you recommend a repeal of SOA? Why or why not?
The aim of this question is have students consider the implications of making a law to
regulate financial reporting in circumstances such as those surrounding SOA.
Arguments for repeal

The corporate governance process is ‘overdone’. Rationalisation is necessary to
reduce companies’ aversion to taking risks. Compliance with the law is too expensive.
It imposes an unfair burden on business which in turn suppresses business activity.
Thus the law hinders business rather than promoting it, as was intended.
Arguments for retaining the law

It would be difficult for the US government to repeal the law as this would imply that
it was no longer necessary; that the behaviour which caused the law (greed and
dishonesty?) was no longer a problem or did not occur any more. Since the
government would be unlikely to want to give this impression, repeal of the law is
unlikely. Of course, modification is possible but also unlikely as that would imply the
legislators got it wrong in the first place. Recent experience suggests governments are
more likely to add to regulations rather than remove them.

Case Study 3.2 Are Bean Counters to blame?
1. List possible factors contributing to the banking crisis (the problem of bad
debts relating to collateralised debt obligations, i.e. the so-called sub-prime
crisis, which began in mid-2007 and became a more general global financial
crisis in October 2008).
The article mentions several possible factors
(a) ‘Rapacious lenders’: a reference to greedy bankers, who extended credit,

without due regard to the riskiness of the loan.
(b) ‘Deadbeat borrowers’: a reference to borrowers who did not have sufficient
means to meet repayments in the long term, a fact which should have been
apparent to the lenders.
(c) FAS 157 fair value accounting rule: this US accounting standard sets out how
fair value measurement is to be undertaken when it is required by accounting
standards (FAS 133 requires the use of fair value for some financial
instruments. It is similar to IAS 39). FAS 157 requires that fair value be based
on the market value of an item at reporting date. If market value is not available,
then fair value is based on market value of a similar item. If this is not available,
then companies can estimate fair value based on an appropriate model.
2. Has the market benefited from the regulation requiring the use of fair value
accounting for financial instruments?
Fair value accounting for financial instruments aims to improve the transparency and
usefulness of information about financial instruments, assisting investors to better
evaluate potential risk and return associated with the instruments.
Mr Schwarzman claims that FAS 157 is ‘accentuating and amplifying potential

losses’. He claims that large write downs of CDOs are ‘theoretical’ because they are
currently unrealised. Banks are forced to write down loans, creating paper losses
which may not be realised but in the meantime are depressing earnings and adversely
affecting ratios, leading to ‘unadvantageous’ (for existing shareholders) new capital
raisings.
With the benefit of knowledge of subsequent events, we can see that the loans did not
recover in value so the write downs were more accurate rather than less accurate.
However, the article raises the question whether the write downs overstated the extent
of losses, causing a loss of confidence in some banks which was not warranted but
nevertheless fed into a complicated situation of frozen credit flows, collapse of
demand and a global economic recession by 2009.
The question of whether banks should reveal their losses can be discussed more
generally, for example in relation to some Japanese banks which were insolvent in the
1980s but propped up by government funding. Such banks must eventually fail or be
bailed out by taxpayer funds. The questions of whether this is an efficient use of scare

resources should be discussed. The extent and timing of government intervention can
be used to illustrate views about intervention in capital markets.
3. According to people quoted in the article, did the US capital market

efficiently price the collateralised debt obligations (CDOs)?
According to the article, the Chicago University view is that the market is efficient,
that is, ‘the market is always right’ and the current value is the current value. If loans
have declined in value, they should be shown at the reduced value to capture the
economic reality of the situation. However, the issue is complicated by the fact that
the CDOs do not have an observable market price, so fair value is estimated, which
may involve intentional or unintentional measurement error.
The article points out that an accounting rule should apply in all conditions (i.e.
irrespective of whether markets are ‘up’ or ‘down’) to assist investors’ decision
making. The rule should not be used selectively at managers’ choosing because this
could lead to manipulation of reported values. Students seeking a better understanding
of the financial crises should be directed to papers such as ICAA (2009) and Laux
and Leuz (2009) in the end of chapter readings.

Case Study 3.3
1. JUNE 2002 The European Commission announces plans to adopt

international accounting standards (IAS) for consolidated financial
statements of all listed companies in European Union (EU) member states
from 1 January 2005.
The EU comprises 26 countries, some with markedly different accounting systems

and requirements (see Nobes and Parker). Therefore, accounting lacked comparability
and transparency making inhibiting the growth of investment and making capital
raising more expensive. The EC has undertaken numerous initiatives to promote the
development of a single capital market in Europe. If successful, a single EU capital
market would rival the US market in size and provide European firms with large
amounts of capital at attractive prices. The adoption of IAS is an integral part of
promoting the development of a unified European capital market.
2. OCTOBER 2004 The European Commission endorses IAS for use in the EU,
with the exception of certain provisions of IAS 39 relating to hedging
accounting and fair value measurement of financial instruments. When
complying with IASB standards from 2005, companies will not be required to
follow the excluded provision of IAS 39.
The EC is committed to the use of a common set of accounting standards throughout

the EU (at least for listed companies) to assist with capital raising and promote
economic development. However, the commitments of the EC do not necessarily
extend to individual companies. An individual company or groups of companies could
support harmonisation in general but object to a particular accounting standard if they
perceived it was not in their best interests. This is the case with the European banks
(see C12 International View). Thus the banks have effectively lobbied and caused the
ARC to withhold endorsement of some parts of the IAS 39.
3. APRIL 2005 The European Commission seeks rule changes to make it easier
for EU companies cross-listed in the USA to de-list from USA stock
exchanges. The Commission is seeking agreement from the USA securities
market regulator the SEC to change the current requirement that companies
show they have fewer than 300 shareholders before they are permitted to
cease registration in the USA.
The Sarbanes Oxley Act (see C12) significantly increases the reporting obligations
and potential legal liability of EU firms cross-listed in the USA. Some US listed EU
companies objected to the requirement to comply with the Sarbanes Oxley Act and
have considered de-listing in the USA. They have sought assistance in expediting this
process through discussions with the SEC by a EC representative. One might argue
that the EC commissioner is encouraging companies to seek capital at home in Europe
and thus promote the EU capital markets, but it is just a speculation. I don’t have
evidence on this point.

4. NOVEMBER 2007 The SEC announces that companies cross-listed on US

stock exchanges which prepare accounts based on IAS are permitted to file
financial reports with the SEC without reconciling the reports in accordance
with US GAAP.
It seems reasonable that EU companies want to be able to list in the USA without
reconciliation to US GAAP following their adoption of IAS. Consequently, EU
companies lobbied hard (through their EC representatives) for the US GAAP
reconciliation requirements to be removed. Pressure on the SEC comes from several
areas. First, the US stock exchanges do not want companies to be discouraged from
listing or to de-list, which may occur while the US GAAP reconciliation requirements
are in place. Second, the US standard setter FASB is converging its standards with
IAS, suggesting that IAS are of acceptable quality. To converge US GAAP and IAS
on the one hand, yet not accept the use of ‘converged’ IAS standards in US markets,
seems inconsistent. In response to various markets pressures the SEC made the 2007
announcement.
5. OCTOBER 2008 The IASB announces amendments to IAS 39 which permit

companies to choose to reclassify items out of categories requiring fair value
measurement into categories where amortised cost is used. The amendments
were announced in response to the 2007- 2008 financial crisis and were made
without following the IASB’s due process.
The IASB amended IAS 39 and IFRS 7 to allow the reclassification of some financial
instruments. As a result of the financial crisis, the Board was under pressure to amend
the standards to permit a reclassification practice that was allowed under US GAAP.
The Board did not follow due process because they considered an immediate response
was required. Some parties were highly critical of the Board for making the change
and doing so without consultation. The Board made an assessment of the political and
economic situation and decided that their action was warranted in the circumstances.
It should be remembered that the view in October 2008 was that the world’s financial
system was in crisis (market liquidity was frozen) so taking no action may have been
politically unacceptable.

QUESTIONS
1. General acceptance of accounting standards is important to the accounting

profession. By whom does the profession require general acceptance of the
standards, and why is it important to the profession?
Until the establishment of the ASRB and subsequent legislative support for
accounting standards, compliance with accounting standards could not be legally
enforced. The profession could take disciplinary action against members for non-
compliance; however, large-scale monitoring was impossible, and so discipline was
on a very ad hoc basis. The problem of enforcing standards detracted from the
professional status of the accounting profession and also meant that the standard-
setting process may be lost to a third party. As such, the profession sought legislative
backing for standards in order to enforce compliance and increase the professional
status of the accounting bodies. The profession did not want to lose control of this
standard-setting process, but sought to use legislation to enforce compliance.
The profession sought to make its standards ‘generally accepted’:

 to ensure control of accounting outcomes and the regulatory process
and to maintain effective barriers to entry to the accounting profession
 to legitimise the accounting process, particularly in the face of
increased criticisms of the standards of accounting information reported
 to increase status by virtue of association with legislative support
 to increase demand for full GAAP statements and for interpretation
of accounting standards and financial statements
 to reduce risk associated with abidance with a set of legislated rules.
2. The standard-setting process is highly political. Describe an accounting

regulation that would be politically controversial, and the types of political
pressures that could be brought to bear in the standard-setting process.
Students might choose any accounting issue as long as they can explain why it is
political in the sense of affecting the wealth of parties in the political process.
Legislating for accounting standards reduces the outcomes to one of the political
trade-offs of competing interests. The political process, as identified by Watts &
Zimmerman (1978), involves competition for wealth distributions between different
interest groups. In the accounting arena it involves politicians who have incentives to
increase government resources and retain their political positions; companies who
have an incentive to avoid political costs, such as increased taxes or regulations; and
voters whose participation in the political process is a function of the cost of
interpreting and processing vast amounts of information. Managers have incentives to
adopt procedures that would decrease the political sensitivity of reported earnings
and/or increase their personal wealth.

There are many groups who will lobby in the standard-setting process for preferred
outcomes. The groups include trade unions, financial institutions, analysts and social
groups. Individuals also lobby in the process.
Overall, the political process is seen as a means of pursuing individual or group self-
interest (Watts & Zimmerman, 1979).
Some ways in which organisations have lobbied to affect the requirements of an

accounting standard include:
 writing responses to exposure drafts
 writing to members of the accounting standard boards putting
forward their views
 making oral presentations to the boards, or to individual members of
the boards
 holding meetings where key issues are discussed and ensuring that
members of the accounting standard boards are invited, or get to hear of the
meetings
 holding demonstrations against a proposal that they do not favour —
as occurred in Silicon Valley where executives demonstrated against
proposals for accounting for executive stock options
 releasing media releases expressing their disagreement with
proposed accounting regulation; these releases would then result in articles in
the media or announcements over the news
 forming groups to lobby for using any or all of the above methods
 offering to provide funding to the regulatory bodies for an
accounting standard that suits them.
The lobbying may also be indirect and framed in a manner that draws attention away
from the direct benefits of those lobbying.
3. The text describes a theory of regulatory capture.

(a) What is regulatory capture?
(b) How can standard-setting bodies such as the AASB avoid regulatory
capture?
(c) If a standard-setting body is ‘captured’ by the profession, are there
any steps that the government can take to make the body
independent? If so, should the government take those steps? Justify
your answer.
(d) Do you believe that the current international accounting standard-
setting arrangements, based around the IASB, are at risk of
regulatory capture? Why or why not?
(a) Regulatory capture is the domination (capture) of a regulatory agency by the

industry it seeks to regulate, thus rendering it unable to balance competing
interests when making social decision choices. The industry can then direct
topics for possible legislation and reject others, which are not seen as important
or in the interests of the industry. Walker (1987) argues that the ASRB was
effectively captured by the accounting profession (see Chapter 3).

(b) A possible means of avoiding capture for the AASB is to:

 expand the number of members on the panel and/or restrict the number of
members that can come from any one industry. However, a large panel may
still see groups concentrate as a voting block, and the larger the panel, the
greater the organisational costs and the potential for ineffective of inefficient
decision making.
 provide the board with adequate resources to promulgate and review standards
so that the board is truly financially independent.
 adopt a more relaxed format for proposed standards. This will allow non-
technical groups to make submissions for standards. However, this approach
is also likely to result in less effective standards because of greater scope for
misinterpretation.
 subject the board and the constitution of its members to annual review.
(c) If the AASB is captured or there is a perception of capture, the government

should conduct a review to determine the source of the capture. Then, it should
take appropriate steps to remedy this particular problem. However, where will
it end? One would expect an ongoing cycle of capture–adjustment–capture
adjustment. The Financial Reporting Council was established as a result of
reforms to accounting standard-setting arrangements pursuant to CLERP1.
The Council is responsible for setting the AASB’s agenda, but it is not to get
involved in technical deliberations. The establishment of the FRC is designed
to give more stakeholders a say in the accounting standard-setting process.
The FRC comprises members representing interests such as public and private
entities, regulators, directors and shareholders. This reform reduces the
possibility of regulatory capture as parties other than accountants are included
in the accounting standard setting arrangements.
(d) The structure of the IASB from 2001 aims to ensure the Board is independent.
Members are appointed based on their expertise and experience. They do not
represent the countries from which they are drawn. The Board has an oversight
body (the IASC Foundation) which acts to ensure the Board can operate
without interference. Fund raising is the responsibility of the IASC, allowing
the Board to be independent of parties providing contributions. A large
number of parties are involved in the operations of the IASC and the IASB.
These include organisations (companies, audit firms, government bodies,
standard setters and professional bodies) which contribute cash resources and
skilled personnel. A range of people serve on the Board, its technical staff and
advisory committees. These organisations and people are drawn from many
countries throughout the world, suggesting that any one country or group of
constituents is unlikely to come to dominate the standard setting process.
Nevertheless, some commentators have expressed concern that the IASB is at

risk of being captured by the USA, through the operation of the FASB. The
concern is that IASB standards will align with US GAAP but the process will
be one-way. Current participants in the standard setting process deny that the
IASB is captured by the FASB, although the FASB is influential in the IASB’s
processes and outcomes. The FASB makes a significant contribution to the
IASB through its work on various IASB projects. IASB members point to the

fact that the IASB and FASB work together and that convergence involves
changes to both sets of standards (US GAAP and IFRS) not just to IASB
standards.
4. In under 500 words, provide an argument for the regulatory approach to

standard setting. Then, in under 500 words, provide an argument for the
free-market approach to standard setting. Finally, analyse the arguments
and conclude in favour of one approach rather than the other (which
approach you favour is up to you, but you must decide which approach is
better, at least under a set of assumed circumstances).
In favour of the regulatory approach (and against the free-market approach)

 It is highly unlikely that existing authoritative, regulatory bodies
will relinquish their present power in accounting. Therefore, the free-market
theory is unrealistic.
 The free-market theory is unworkable, because a socially optimal
equilibrium price for accounting information cannot be achieved. This is true
for the following reasons:
– Accounting information is a public good. Once the information is released, it
is available to everyone, not just those who paid for it. Since not all users
can be charged for the information, suppliers will have little incentive to
provide it.
– A firm has a monopoly on the supply of information about itself, and
therefore the tendency will be for the firm to underproduce and sell at a high
price.
 A regulatory board is still necessary even if a free market existed,
because accountants will not agree on the procedures to use to derive the
desired information. A regulatory board is necessary to make the required
decisions.
In favour of the free- market approach (and against the regulatory approach)
 As with other products, information about a company is subject to
the factors of demand and supply, with price as the operating mechanism. An
equilibrium price can be found — this is the price where the supplier still
finds it advantageous to furnish information, and users believe the price is
equal to the benefits (value) of the information.
 Free-market forces would determine what type of accounting data to
provide, and therefore what standards are necessary in order to gather such
data. In this way, unnecessary information is avoided — that is, information
where the cost exceeds the benefits. This can be determined because people
will not be willing to pay the price.
[The question could be raised — will regulation necessarily prevent fraud or flag the
corporate collapses we have seen in recent years?]

5. If the IASB concludes that the economic consequences of a standard it is

about to approve will disadvantage a powerful lobby group, what should
the IASB do about the situation?
Since this is an opinion question, there is no right or wrong answer.
Die-hard proponents of the incrementalist view would argue that the IASB should
withdraw its proposal and seek a compromise solution. The IASB needs to be political
for its own survival, and compromise is a part of the political game. Depending on the
circumstances, if an opponent is too powerful, the wise course of action is to retreat,
because the possibility of defeat is great. As long as an incremental step forward is
made, the Board would argue that the accounting profession should be satisfied. A
series of incremental steps over time could result in eventual victory.
Others would argue that if a proposal has theoretical merit, and especially if there is
also empirical evidence to support it, the IASB should seek to establish the proposed
standards. The proposal would result in more relevant and reliable accounting
information, which should be the primary consideration in the formulation of
standards. Incrementalists argue that the IASB should retreat for its survival, but it is
for the sake of survival that it should not back off. People are watching the profession
to see if it favours special-interest groups. If the integrity of the IASB is tarnished, its
survival will be jeopardised. However, if the theoretical-empirical support for a
proposal is weak, a wait-and-see attitude may be justified.
6. How do you think accounting standards should be set? Is that the approach
currently taken by the IASB?
Here is one possible answer. The most feasible way may be to be aware of both the
politics of the environment and the significance of scientific evidence in the
formulation and implementation of standards. Where there is substantial theoretical
and empirical evidence in support of a proposal, the IASB should be resolute in
seeking to establish the standard. But presently such strong support does not occur
often.
The fact is that pressing issues need to be resolved immediately, and there may be
little, if any, empirical evidence pointing to any particular direction. In such cases, the
IASB needs to follow a theoretical (rational) argument, based on the objective of
providing more useful information.
There is no question that the IASB needs to be politically aware. However, to be

aware of the political environment means different things to different people. If it
means to do a better marketing job of explaining to all interested groups why a given
proposal is being made, then that is acceptable. To receive and be aware of the points
of view of various groups of a proposal should be helpful to the IASB because the
proposed standard may not be as rational as the IASB believes. The due process
procedure should be taken seriously and not be a perfunctory routine. Contrary
arguments may have salient, legitimate points.

The IASB does attempt to be independent in the formulation of accounting standards.

Because the support of its standards is mainly theoretical (based on rational
arguments), and interpretation of theory can result in different viewpoints, strong
opposition is seriously considered and is likely to cause a change in the proposed
standard. Empirical evidence is considered. However, that the evidence is often not
persuasive; perhaps because it is not understood by the non-academic community.
With the adoption of international financial reporting standards (IFRS), it has been
suggested that the AASB and Australian constituents will have less influence over the
IASB due process than was possible in the domestic standard setting environment.
The AASB has a specific strategy of contributing to standard setting at the IASB to
maintain its influence.
7. ‘We should disband national standard setters. They are of no use following
the adoption of international accounting standards.’ Explain whether you
agree or disagree with this statement.
People who agree with this statement would argue that the national standard setters
such as the AASB no longer have a role to play in standard setting. The standard
setting function is carried out by the IASB and interpretations are issued by the
International Financial Reporting Interpretations Committee (IFRIC). Australia has
made a commitment to use IFRS and therefore it will be accepting all standards issued
by the IASB. The AASB is no longer necessary as it will not be developing private
sector standards. A common interpretation of IFRS is necessary to assist companies in
producing comparable financial reports. However, this must come from an
international body not the AASB or a body associated with the AASB.
People who disagree with this statement would point to the fact the AASB has a role
in developing standards for the public sector and not-for-profit entities. This role has
not been assumed by the IASB. In addition, the IASB relies on the contribution of
national standard setters in the development of its standards. National standard setters
such as the AASB can contribute technical expertise based on its past experience and
skill of current staff. They can work on research projects for the IASB. In this way,
the AASB can actively contribute to international standard setting. By maintaining the
AASB, Australia can contribute to international standard setting on issues of national
importance. One example is the forthcoming extractive industry standard which could
be important for Australian companies and the national extractive industry.

8. What are ‘free-riders’? How can a system ensure that those who benefit
most from an accounting standard requiring certain disclosures also bear
the greatest costs of it?
Free-riders are people that can utilise information once it is publicly available.
Although information may be sold to certain people only, others who did not pay
cannot be easily excluded from using the information. Examples of free-riders are
financial analysts and potential investors. There is no simple solution to the problem.
Students should be encouraged to offer ideas. Companies may act to restrict access to
the financial statements to shareholders and associated parties. Companies may
establish a user-pays system where financial information is available to non-
shareholders on a fee-for-information basis. If the fee was sufficiently high, those who
pay are less likely to share the information. Nonetheless, such systems would be
difficult to administer and control, and are unlikely to be successful.
9. The setting of accounting standards requires some assessment of economic

and other benefits and costs. What are the ethical issues involved? Is it
possible to avoid ethical issues in developing accounting standards?
There will always be ethical issues associated with the development of accounting
standards because there are ethics involved in deciding between providing
information that is representationally faithful for users and requiring information that
may be detrimental to the interests of preparers. The most obvious example of this is
where information is proprietary (that is, information that competitors could use to the
disadvantage of the reporting firm) — the information may be useful to investors but
disadvantage the firm that provides it. Furthermore, the provision of additional
accounting information may provide information that is useful to investors and other
users of accounts, but it may be expensive to acquire the data and process it, thereby
imposing costs upon firms and reducing the value of the shares held by existing
shareholders.
Accounting standards have the potential to affect levels of wealth and its distribution
because they affect:
 decisions made by individuals who rely upon the accounts
 the terms of contracts that rely upon accounting numbers (for
example, debt covenants requiring that a company not exceed a certain ratio
of debt to total tangible assets)
 decisions made by regulators who base assessments of ability to pay
or of the harm felt from regulation on the financial statements of the firms.
As long as accounting has economic consequences, some people gain from certain
regulations and others stand to lose. As such, its regulation necessarily has ethical
implications. Even the decision to ensure that the accounts always give a faithful
representation of the firm’s economic circumstances involves an ethical assessment
that needs or preferences of the users of the accounts have primacy over the
preferences of the preparers.

10. You have been appointed as chief accountant of a firm that will be
adversely affected by the method of accounting that is proposed in an
exposure draft. Write a report of 500 words or less explaining to your
Board of Directors how you could lobby the AASB to change its mind and
adopt an accounting practice other than the one proposed in the exposure
draft. Also comment on the costs and benefits of each to the firm.
There are many ways in which organisations might lobby to affect the requirements of
an accounting standard:
 write responses to exposure drafts
 write to members of the accounting standards boards putting
forward their views
 make oral presentations to the boards, or to individual members of
the boards
 hold meetings where key issues are discussed and ensure that
members of the accounting standards boards are invited, or get to hear the
meetings
 hold demonstrations against a proposal that they do not favour — as
occurred in Silicon Valley where executives demonstrated against proposals
for accounting for executive stock options (the ‘Rally in the Valley’)
 release media releases expressing their disagreement with proposed
accounting regulation; these releases would then result in articles in the
media or announcements over the news
 form groups to lobby using any or all of the above methods
 offer to provide funding to the regulatory bodies for an accounting
standard that suits them.
The preceding methods have all been employed, and instructors may be able to think
of others. Other less acceptable methods that have been employed include threats
made to individual members of standard-setting bodies. Both financial and non-
financial costs and benefits of each should be discussed, including reputational
effects, the time and effort costs of organisation, and potential benefits from a
standard that reduces information, bookkeeping, and contracting costs.
11. In 2001 and 2002 there were several high-profile US corporate collapses
associated with misleading financial statements and accounting practices.
Following these collapses, new laws were introduced to improve the quality
of financial reporting.
(a) In your opinion, will further regulation prevent deliberately
misleading reporting? Explain.
(b) Are additional laws likely to prevent corporate collapses? Why or
why not?
(c) How important is the enforcement of financial reporting
requirements in promoting high quality reporting?
(a) Opinions may differ about the extent to which regulation can prevent
deliberately misleading reporting. One effect of regulation may be to

make directors and auditors more careful in relation to financial reporting.

That is, directors and auditors both want to see compliance with
accounting standards to ensure there are no adverse monetary or
reputational effects from non-compliance. We could expect that the effect
of regulation which imposes harsher penalties for non-compliance would
be to increase the extent of compliance, assuming non-compliance attracts
penalties from regulators. However, deliberately misleading reporting
implies the perpetrators know that they are breaking the law. We can
assume they have a motivation to do so which must be weighed against
the likelihood of being caught and the possible penalty. If the motivation
for misleading reporting outweighs possible costs for the perpetrators,
then regulation will not prevent misleading reporting.
(b) The extent to which additional laws can prevent corporate collapses will
depend on the cause of the corporate collapse. If the cause is failure of the
audit function, it is possible that effective regulation to improve
independence and performance of auditors could reduce the likelihood of
corporate collapse. However, if the corporate collapse stems from
fraudulent behaviour of company officers, it will not be prevented by
additional laws. If a person considers that the benefits of breaking the law
outweigh the risk of being caught and punished, then the law will not be
effective in preventing criminal behaviour leading to corporate collapse. It
may be that a government introducing additional regulation will be
satisfied with a law that makes corporate collapse less likely, even if it
does not remove it completely.
(c) Regulators have indicated that they consider enforcement to be an

important element in promoting high quality reporting. In its Concept
Release, issued in 2000, the US Securities and Exchange Commission
(SEC) argued that high quality financial reporting required not only high
quality accounting standards but that there should be enforcement
mechanisms to ensure companies comply with standards. A similar view
was endorsed by the Committee of European Securities Regulators
(CESR) who required that all EU countries set up an independent
enforcement body responsible for promoting compliance with IFRS
following their adoption in the EU from 1 January 2005.
Enforcement agencies have increased their activities since the corporate

scandals in 2001 and 2002. The SEC has been given a larger budget and
increased its surveillance activities. In Australia, ASIC has been very
active. The Federal Government provided funding for ASIC to review the
financial statements of all listed companies in 2003. ASIC now has a
program of reviewing all listed companies at least every four years. These
activities suggest that governments consider the presence of an active
regulator (i.e. one that conducts proactive, not just reactive, surveillance
of financial reporting) is important to promote high quality reporting by
companies, to ensure auditors are active in obtaining compliance with
accounting standards and to improve investor confidence following
significant corporate collapses.

12. Each of the three theories of regulation discussed in this chapter has its
strengths and limitations in describing accounting standard setting, either
past or present. What do you believe are those strengths and weaknesses?
Provide an example of where you believe each of the theories has applied,
or is likely to apply.
Three theories of regulation are outlined in the text:

 Public-interest theory  Legislation is intended to protect consumer
interests by securing improved performance when compared with an
unregulated situation. This assumes that there is market failure and
consequently some groups will need to be protected from the opportunistic
behaviour of others.
If there is a market failure and the legislation can redress the failure’s impact
then the public interest will be served. However, this assumes that the
legislation will redress the failure and not introduce alternative forms of
market failure. It ignores the fact that equity will often be a matter of
viewpoint, and legislation is often the outcome of a complex lobbying
process. Further, the theory assumes that the regulators do not have their
own interest set.
 Private-interest theory  Private-interest theorists believe that there
is a market for regulation with supply and demand forces operating as in the
capital market. Within this political market, while there are many bidders,
only one group will be successful, and that is the group that makes the
highest bid. Theorists believe that regulation does not come into existence as
a result of a government’s response to public demands, but rather (as a rule)
regulation is sought by the producer private-interest group and is designed
and operated primarily for its benefit.
But even if a group has a strong incentive to organise, there must still be a
mechanism by which the group acquires and uses its influence. It also
assumes that players are always seeking to maximise their wealth.
 Regulatory capture theory  This theory argues that those who are
regulated have an incentive to dominate the process, or in some way
manipulate it to their advantage. Four such situations have been identified:
– where the regulated entities control the regulation and the regulatory
agency
– where the regulated entities succeed in coordinating the regulatory
body’s activities, so that their private interest is satisfied
– where the regulated entities manage to neutralise or insure non-
performance by the regulating body
– where the regulated entities use a subtle process of interaction with the
regulators to ensure a mutual perspective.
The concept assumes that the parties subject to regulation can form into a
group or subgroup capable of capturing the process. In addition, capture will
normally become apparent to observers in the community.


13. On 1 January 2005 Australia adopted IASB standards.

(a) Do you agree with this change? Why or why not?
(b) Who stands to gain from Australia’s adoption of IASB standards?
Explain.
(c) Who stands to lose from Australia’s adoption of IASB standards?
Explain.
From 1 January 2005 the AASB will issue Australian equivalents to IFRS. This
process involves the AASB issuing IASB exposure drafts as exposure drafts in
Australia. Constituents can provide comments on standards to the AASB and IASB.
Final standards issued by the IASB are subsequently issued in Australia with any
additional paragraphs necessary to make the standards suitable for public sector and
not-for-profit entities.
(a) Students’ answers will vary, but should cover the following
points.
Australian accounting standard boards first articulated their goal of

working towards harmonisation of Australian standards with international
standards in 1996. The desire for uniformity is premised on the following
advantages:
 preparer preparation costs reduced
 reduced investor confusion
 increasing cross-border competition
 consistency in external and internal reporting
 enhancement of credibility of financial reporting
 lower cost of capital.
Barriers cited against uniformity are:

 different business environments
 legal systems
 culture
 political considerations.
Commentators who support adoption will refer to the advantages of harmonisation of

accounting standards listed above. In Australia the advantages of adoption of
international standards are considered to outweigh any disadvantages. The main
parties benefiting from adoption are large, internationally active companies and the
government itself which can distance itself from the politics of standard setting. The
adoption of IFRS in other markets such as the EU (particularly the UK) and New
Zealand suggests that Australia has no choice but to participate in the global
harmonisation process.
Critics of adoption refer to the costs involved, such as acquiring technical expertise,
changing accounting systems and educating investors. Adoption affects all reporting
entities in Australia, irrespective of whether harmonisation has any benefits for the
company. For example, smaller firms may not benefit from improvements in
international comparability. Critics also point to loss of influence in the standard
setting process.

(b) Adoption of IFRS will benefit:

 The users, as financial statements will be more comparable thereby
enhancing their usefulness in decision making
 Multinational companies may no longer have to prepare dual sets of
accounts providing that the exchange on which they are listed accepts
financial statements prepared using IFRS without the need for
reconciliation.
 The resources dedicated to standard-setting arrangements in Australia
may be reduced as a consequence of IFRS adoption, representing a
cost saving to the Commonwealth Government. The Government can
distance itself from the political aspects of standard setting, as
reporting requirements are decided on an international, rather than
national, basis.
(c) If adoption of IFRS results in changes to preparers’ financial reporting

then firms are potential losers if their existing choices are efficient and
optimal. It will be necessary to restructure contracts to accommodate the
financial reporting consequences associated with adoption. Australian
constituents are unlikely to influence the standard setting process to the
extent they did in the past. The future of the AASB is uncertain given the
commitment to the adoption of IFRS. It can be argued that Australia’s
intellectual capital in relation to accounting standard setting will be
jeopardised.
14. What is the role of the Financial Reporting Council? Do you think that all
members of the Financial Reporting Council should be qualified
accountants? Why or why not?
The responsibilities of the FRC are:

 to oversee the operations of the AASB (not involved in technical
deliberations)
 to monitor the development of international accounting standards
 to promote adoption of international best practice accounting
standards
 to monitor the operation of Australian accounting standards to
assess their continued relevance and effectiveness
 to seek contributions towards the costs of the Australian accounting
standard-setting process.
Members are appointed by the Treasurer and are to be representative of stakeholder

organisations.
The FRC does not get involved in technical deliberations so it is not necessary that
members be qualified accountants. (This would create the impression of regulatory
capture theory.) It would be expected that the members of the FRC have significant
business experience and are aware of accounting issues and the economic
consequences associated with regulation. In their capacity as Council members they

are interacting with the various stakeholders and should have an understanding of
contemporary accounting issues.
15. The IASB and FASB began a convergence project in 2002.

(a) What are the expected benefits of the convergence project?
(b) What factors make convergence difficult?
(c) How is the future of the IASB tied to convergence?
(a) Convergence is the process of aligning US GAAP and

IASB standards (See Chapter 3). The Norwalk Agreement (2002) was a
memorandum of understanding entered into by the FASB and the IASB
whereby they would work together to eliminate differences between the
requirements of US GAAP and IAS/IFRS. They would also align their
work agendas. The benefits of convergence are to reduce the differences
between financial statements prepared in accordance with US GAAP and
IFRS thus increasing international comparability of reporting. This has
potential benefits for investors and companies.
(b) There are some significant differences between US GAAP
and IFRS which make convergence difficult. Resolution of these
differences requires one party to make a significant adjustment to
reporting practices which may not be supported by constituents. Two such
examples are capitalisation of development expenses (required under IAS
38 but not permitted under US GAAP) and upward revaluation of fixed
assets (prohibited in the US since the 1930s, but allowed under IAS 16).
Political issues also make convergence difficult. The FASB issued

proposals to expense stock options in the early 1990s that did not become
mandatory because of extensive lobbying by companies and employees
with stock options and the threat of intervention by congress to prevent
FASB from issuing the standard. The IASB issued IFRS 3 Share based
payment, requiring expensing of stock options. Subsequently, the FASB
introduced (from June 2005) similar but not identical requirements.
(c) The future of the IASB is linked to convergence. The

IASB’s aim is to develop private sector standards for use throughout the
world. If the US does not use or recognise these standards as high quality,
the IASB’s aim has not been achieved. If US GAAP are considered to be
the ‘best’ standards, then IFRS are second best and the goal of one set of
international standards has not been realised. Convergence is a process of
dealing with the differences between US GAAP and IFRS and working
toward one set of high quality international standards.

16. Should the SEC allow the use of IASB standards for US domestic listed
companies? Discuss reasons for and against the use of IFRS by US
companies.
Arguments in support of use of IFRS by US domestic companies
1. Improved international comparability. For some industries, major competitors

use IFRS. All companies following the same standards will assist information
users e.g. analysts.
2. The USA is the world’s major capital market. Adoption of IFRS in the USA
means that common accounting standards are widely used throughout the
world. Common standards are claimed to improve efficiency of information
exchange.
3. US companies with subsidiaries that use IFRS will benefit from reduced
accounting preparation costs. Use of common standards will help with
budgeting, tax planning and control. Training costs (in multiple GAAPs) will
be reduced.
4. All SEC registrants should have the same options in policy choices. Currently
some SEC registrants follow IFRS and others US GAAP. There are
differences between the standards that make reports not fully comparable.
5. Standard setting will be more efficient as standard setters can pool their
resources and work on solutions to accounting issues that confront companies
irrespective of their country of domicile.
Arguments against use of IFRS by US domestic companies
1. US GAAP and IFRS are not the same. It is not clear that IFRS is higher
quality GAAP than IFRS. IFRS standards are not as comprehensive as US
GAAP.
2. Standard setting benefits from competition between standard setters. One set
of standards will not necessarily mean that the highest quality standards are
developed.
3. The USA will lose sovereignty in standard setting. Use of IFRS will reduce
the influence of the SEC and FASB.
4. Many US companies are not SEC registrants. The cost of changing to IFRS
will be expensive, possibly without benefit for private companies lacking
international operations.
5. US accountants and auditors are not technically proficient in IFRS.
17. Why has IFAC established a Public Interest Oversight Board?
IFAC has established the PIOB to ensure the independence of the IAASB from the
auditing profession. Most members of the IAASB are, or have been, professional
auditors. This raises the suggestion that the IAASB has been captured by the auditing
profession and causes doubt about whether the standards are written to protect the
public interest or the interest of auditors. If IFAC (and the IAASB) are to be able to
continue to write international auditing standards and exert influence, it needs to
establish structures to guard against this accusation. The PIOB also offers a place for
regulators to go to express their opinion about auditing standards and functions as a

liaison body with the IASB’s Monitoring Group (see Chapter 14 for more details).
This assists a greater level of cooperation between the auditing and accounting
standard setters.
18. Why would the quality of accounting and auditing standards affect the
development of financial markets? Why is the strength of enforcement of
the standards and investor protection important in this relationship?
High quality accounting standards assist the production of high quality financial
information which is useful for decision makers, including investors. High quality
auditing standards guide auditors to conduct audits which are more likely to reduce
the risk of material misstatement due to fraud or error in the financial statements.
High quality and credible financial information allows investors to have less
uncertainty, and greater confidence in trading. Confident investors are more likely to
participate in the share markets, providing greater liquidity. Greater trading volumes
mean that share prices are more likely to reflect all publicly available information.
Enforcement of the standards and investor protection laws are vital to ensure the high
quality accounting and auditing standards impact positively on share market trading.
Investors gain confidence from standards only if they are enforced. Unenforced
standards are ‘not worth the paper they are printed on’, that is, they may as well not
exist because all parties know there are no consequences of breaching the standards.
Investor protection laws give investors the right to sue if accountants and auditors are
negligent, particularly when they also include provisions that ensure the audit firms
are likely to have the resources to meet their negligence liability.

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John Wiley & Sons Australia, Ltd 2010

Chapter 3: Applying theory to accounting regulation

1. Describe current accounting practices for leases as outlined in this article.

3. Standard setters propose revising leasing standards to require

© John Wiley and Sons Australia, Ltd 2010 3.2

4. What are the advantages of capitalising leases? Given that most

© John Wiley and Sons Australia, Ltd 2010 3.3

Theory in Action 3.2 Accountants draw the line at regulating

© John Wiley and Sons Australia, Ltd 2010 3.4

3. The IASB considers adoption of IASB standards in the USA to be

© John Wiley and Sons Australia, Ltd 2010 3.5

Theory in Action 3.3 Enforcing requirements of accounting standards

1. Do you consider that the company Brocade Communications complied

The relevant accounting standard requires that a company recognises an expense in

2. Who benefits from the ‘backdating’ of stock options? Who is harmed?

© John Wiley and Sons Australia, Ltd 2010 3.6

4. What is the role of the SEC in relation to the regulation of accounting

The US Securities and Exchange Commission is the US securities market regulator

© John Wiley and Sons Australia, Ltd 2010 3.7

Theory in Action 3.4 Many small caps to flash orange

2. Explain the argument that merely by placing an ‘emphasis of matter’

3. The article discusses bank covenants – explain the impact of asset

© John Wiley and Sons Australia, Ltd 2010 3.8

3.1 Balancing the costs and benefits of regulatory intervention

The law was introduced in response to large-scale, highly publicised financial

SOA is a classic example of regulatory intervention by government in the operation of

3. According to John Snow, what criteria should be considered in

According to John Snow, what criteria should be considered in determining financial

(a) rules should not dampen economic growth;

© John Wiley and Sons Australia, Ltd 2010 3.9

4. Would you recommend a repeal of SOA? Why or why not?

Would you recommend a repeal of SOA? Why or why not?

Arguments for repeal

Arguments for retaining the law

© John Wiley and Sons Australia, Ltd 2010 3.10

Case Study 3.2 Are Bean Counters to blame?

The article mentions several possible factors

(a) ‘Rapacious lenders’: a reference to greedy bankers, who extended credit,

Mr Schwarzman claims that FAS 157 is ‘accentuating and amplifying potential

© John Wiley and Sons Australia, Ltd 2010 3.11

3. According to people quoted in the article, did the US capital market

© John Wiley and Sons Australia, Ltd 2010 3.12

Case Study 3.3

1. JUNE 2002 The European Commission announces plans to adopt

The EU comprises 26 countries, some with markedly different accounting systems

The EC is committed to the use of a common set of accounting standards throughout

© John Wiley and Sons Australia, Ltd 2010 3.13

4. NOVEMBER 2007 The SEC announces that companies cross-listed on US

5. OCTOBER 2008 The IASB announces amendments to IAS 39 which permit

© John Wiley and Sons Australia, Ltd 2010 3.14

1. General acceptance of accounting standards is important to the accounting

The profession sought to make its standards ‘generally accepted’:

2. The standard-setting process is highly political. Describe an accounting

© John Wiley and Sons Australia, Ltd 2010 3.15

Some ways in which organisations have lobbied to affect the requirements of an

3. The text describes a theory of regulatory capture.

(a) Regulatory capture is the domination (capture) of a regulatory agency by the

© John Wiley and Sons Australia, Ltd 2010 3.16

(b) A possible means of avoiding capture for the AASB is to:

(c) If the AASB is captured or there is a perception of capture, the government

Nevertheless, some commentators have expressed concern that the IASB is at

© John Wiley and Sons Australia, Ltd 2010 3.17