Professional Documents
Culture Documents
Chapter 4
Chapter 4
TRUE/FALSE
1. Financial reporting for publicly-listed companies in the United States was first
regulated in the 1950s.
ANS: F
3. The SEC has allowed accounting policy-making power to remain in the private
sector.
ANS: T
5. All of the arguments supporting the case for unregulated markets relate to the
incentives for a firm to report information about itself to owners and to the capital
market in general.
ANS: T
6. Empirical tests of the free market position are impossible since we live in a
regulated environment.
ANS: T
7. Agency theory explains that firms have an incentive to report voluntarily to the
capital market because they are competing for risk capital.
ANS: F
8. The major agency relationship is between the management of a firm and a firm’s
creditors.
ANS: F
10. Only firms that perform well have incentives to report their operating results.
ANS: F
11. According to signalling theory, firms have an economic incentive to report bad
news.
ANS: T
12. The value of a company can be increased when the firm voluntarily reports
private information about itself if the information reduces uncertainty about the
firm’s future prospects.
ANS: T
13. There is usually information symmetry between the firm and outsiders.
ANS: F
14. Early adoption of new financial accounting standards generally indicates “bad
news” whereas late adoption generally indicates “good news.”
ANS: F
15. The stock market shows that people are willing to contract privately for
information about a firm.
ANS: T
21. Public goods are commodities that once consumed, the opportunity for
consumption by others is reduced.
ANS: F
22. True markets demand for public goods may be determined by the number of
consumers that pay for the goods.
ANS: F
23. An argument supporting regulated markets is that more and better regulation is
necessary to raise the quality of financial reporting in order to protect the public
from frauds and failures.
ANS: T
24. An argument supporting regulation is that the only way to increase production of
public goods to meet the real demand of the public is through regulatory
intervention.
ANS: T
26. Information symmetry exists when potential investors do not all have equal access
to the same information.
ANS: F
29. The Impossibility Theorem implies that once the free market pricing system is
abandoned, there is no way of determining aggregate social preferences.
ANS: T
31. The present financial disclosure system imposes costs on users rather than the
companies themselves.
ANS: F
32. In setting policy, due process, means that a regulatory agency seeks to involve all
affected parties in its deliberations.
ANS: T
MULTIPLE CHOICE
3. Which of the following concepts explains why firms have an incentive to report
voluntarily to the market even if there were no mandatory reporting requirements.
a. Signalling theory XXXXX
b. Life-cycle theory
c. Information overload
d. Capture theory
4. Which of the following concept holds that anyone who genuinely desires
information about a firm is able to obtain it?
a. Signalling theory
b. Agency theory
c. Information symmetry
d. Private contracting XXXXX
8. Goods that possess hard property rights so that non-purchasers are excluded from
consuming them are called:
a. Public goods
b. Regulated goods
c. Private goods XXXXX
d. Under produced goods
11. Which of the following is considered a social goal related justification for
imposing financial reporting regulation?
a. Information symmetry
b. Comparability
c. A competitive capital market
d. All of the above XXXXX
12. Which of the following does not apply to a codificational system such as
accounting standards?
a. It is pragmatic because maximizing the standards is impossible.
b. Outputs are evaluated on the basis of whether they work correctly.
c. Outputs are evaluated on the basis of whether they provide information to
users at a reasonable cost.
d. Outputs are correct in terms of deductive logic. XXXXX
13. Mandatory public reporting of financial information:
a. Enhances the perceived fairness of the capital market. XXXXX
b. Increases the total cost to society of obtaining the information.
c. Results in costs greater than benefits.
d. Requires companies to generate a lot of information that would not
otherwise be produced by its accounting system.
16. Which of the following is not a reason cited in the text for the failure of the CAP
and the APB as regulatory bodies?
a. The SEC did not officially endorse private-sector standard setting until
1973.
b. The CAP and the APB lacked the necessary political structure to ensure
their survival.
c. Policy making was exposed to outside influence. XXXXX
d. There appeared to be no due process in the determination of accounting
and disclosure rules.
17. Which of the following theories argues that the group being regulated eventually
comes to use the regulatory process to promote its own self-interest?
a. Life-cycle theory XXXXX
b. Agency theory
c. Signalling theory
d. Contracting theory
18. Life-cycle theory argues that:
a. Regulation eventually becomes an instrument for protecting the
information users
b. The regulatory body often protects the regulated group from competition.
XXXXX
c. Regulation goes through several phases, but is never in the public interest.
d. Both b & c.
19. Prior to the FASB, accounting regulation was done primarily by:
a. The SEC
b. The FTC
c. AICPA subcommittees XXXXX
d. Large accounting firms
20. Which of the following groups is not listed in your text as being affected by
accounting regulation?
a. The FASB XXXXX
b. Companies
c. Auditors
d. Free riders
21. Which of the following is a reason that the FASB should closely watch the
lobbying behavior of free rides?
a. Responding to the interests of free riders could lead to an underproduction
of accounting information.
b. Free riders claim to be acting in the public interest but actually make the
market less competitive.
c. Free riders are not affected by accounting regulation.
d. Free riders do not have the direct economic interests in information
production that others have. XXXXX
ESSAY QUESTIONS
It is also possible that free markets are contrary to social goals because they may
not communicate enough information to the security markets, resulting in insiders
having information that is not available to shareholders. In addition, the
information that would be available in unregulated markets might not provide
enough comparability among firms.
Signalling theory explains why firms have an incentive to report voluntarily to the
capital market: voluntary disclosure is necessary in order for firms to compete
successfully in the market for risk capital. Insiders know more about a company
and its future prospects than investors do; therefore, investors will protect
themselves by offering a lower price for the company. However, the value of the
company can be increased if the firm voluntarily reports (signals) private
information about itself that is credible and reduces outsider uncertainty.
3. Discuss the regulation question in terms of determining and meeting the demand
for accounting information. Who pays for and who benefits from accounting
information?
There is another argument that regulated markets result in a tendency for over-
production. This over-production can be avoided only if a pricing system can be
imposed on public goods, creating non-purchasers who are effectively excluded
from consuming the good. If accounting information had to be purchased, such as
through the SECs EDGAR system, there would be incentives for users not to pass
on the information to free riders. In this way, real economic demand for
information could be determined, and production costs could be recovered from
the real users of accounting information. By contrast, the present disclosure
system imposes costs on companies rather than on users. One of the negative
consequences of regulating accounting is that it results in a wealth transfer from
nonusers to users of accounting information. A wealth transfer occurs because
users receive the benefits of free accounting information while nonusers implicitly
incur the production costs.
4. What is meant by “the paradox of regulation?”
5. What is due process, and how has the political nature of regulation affected the
CAP, the APB and the FASB?
ANSWER: Due process means that a regulatory agency seeks to involve all
affected parties in its deliberations. Due process is important in maintaining the
legitimacy of the regulatory process. The CAP and APB failed as regulatory
bodies for at least two reasons:
(1) They had only a weak mandate to regulate financial reporting. Until the
issue of ASR 150 in 1973, the SEC did not officially endorse private-
sector standard setting.
(2) Their apparent lack of due process sometimes led to a low level of
acceptance by affected parties.
ANSWER: Capture theory and the life-cycle theory of regulation both argue that
the group being regulated eventually comes to use the regulatory process to
promote its own self-interest. When this occurs, the regulatory process is
considered captured. The life-cycle theory of regulation argues that a regulatory
agency starts out in the public interest, but later becomes an instrument for
protecting the regulated group.
From 1976 to 1978, the United States Congress investigated the allegation that
accounting regulation had been captured by the Big Eight group of accounting
firms, who were the predominant auditors of publicly listed corporations. Prior to
the FASB, accounting regulation was done primarily by AICPA subcommittees,
which were undoubtedly heavily influenced by the Big Eight accounting firms.
However, with the implementation of the independent FASB the capture theory
argument lost much of its validity.