TUTORIAL SOLUTIONS CHAPTER 3

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.

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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.

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
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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.

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

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information. Nonetheless, such systems would be difficult to administer and control, and are
unlikely to be successful.

3. 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.