Regulatory and Political Influence on Accounting Practice Lecture 2

1. Regulatory and Political Influence on Accounting PracticeLecture 2

2. Learning Objectives • Understand the scope of regulation relating to Australian external financial reporting. • Describe the main regulatory bodies that encompass the Australian reporting environment. • Review some of the arguments proposed for both regulating and for reducing the extent of regulation of financial accounting. • Outline the relevance of potential economic and social impacts to the accounting standard setting process.

3. Introduction • Financial Accounting

4. What is Regulation? • Definition: • The Oxford Dictionary defines regulation in terms of a “prescribed rule” or “authoritative direction” • The Macquarie Dictionary defines regulation as “a rule of order, as for conduct, prescribed by authority; a governing direction or law” • Hence regulations relate to the rules that have been developed by an independent authoritative body that has been given the power to govern how we prepare financial statements, and the actions of the authoritative body will have the effect of restricting the accounting options that would otherwise be available to an organisation.

5. Regulators • Change in the development of accounting standards and regulation with an enhanced emphasis being placed on government rather than accounting profession — reducing ability of accounting profession to ‘self-regulate’. • There are four main bodies that create and/or enforce accounting regulation in Australia

6. Regulators International Accounting Standards Board (IASB) Australian Accounting Standards Board (AASB) Public Sector Accounting Standards Board

7. Australian Accounting Standard Setting Minister for Superannuation and Corporate Law

8. Financial Reporting Council • Broad membership base – 18 members • Oversees activities of AASB. • Advises Govt. on standard setting. • Responsible for decision that Australian reporting entities would adopt accounting standards issued by IASB. • Now also oversees Auditing and Assurance Standards Board (AUASB). • Auditing standards made by AUASB require legislative backing.

9. AASB • Functions (under s. 227 of ASIC Act) to include: • Majority of standards underwent change in 2003–04 • Reports to the Financial Reporting Council (FRC) • Has one full-time chairperson and the balance are part-time members appointed by the FRC

10. ASIC • Formerly the Australian Securities Commission (ASC) Name changed to reflect increased responsibility for regulating investment products • Regulatory “Watchdog” - Responsible for administering corporation legislation • Independent of state ministers or state parliaments • Reports to the Commonwealth Parliament and Treasurer • Investigates companies suspected of non-compliance with the Act or accounting standards • Issues its own interpretation of the financial reporting requirements of the Corporations Act

11. Australian Securities Exchange (ASX) • One nationally operated securities exchange with a set of listing rules for all trading floors in each capital city • Sets out the listing and trading rules that apply to nationally listed securities. Failure to comply may lead to removal from the Board. • Rules help ensure that information is disseminated in an efficient and timely manner. • ASX Listing Rules divided into 20 chapters—key chapters are Chapter 3 (continuous disclosure) and Chapter 4 (periodic disclosure). • For example, Listing Rule 3.1

12. Corporate Governance Principles and Recommendations • A company should: • Lay solid foundations for management and oversight • Structure the board to add value • Promote ethical and responsible decision making • Safeguard integrity in financial reporting • Make timely and balanced disclosure • Respect the rights of shareholders • Recognise and manage risk • Remunerate fairly and responsibly ASX Corporate Governance Council, Good Corporate Principles and Recommendations, ASX, Sydney, Aug 2007.

13. Impact of Adopting IFRS • In 2002 FRC committed Australia to adopt IFRS’s issued by the International Accounting Standards Board (IASB) by 2005 • Key decision to adopt IFRS was influenced by the European Unions decision to adopt. • IFRSs are converted into Australian (AASB) accounting standards: • AASB standards have general applicability to not-for-profit and local government sectors—material added by AASB that describes the scope and applicability to the Australian context. • AASB issuing standards to match IFRSs, and to cover areas not addressed by IASB:

14. Impact of Adopting IFRS • The adoption of IFRSs has meant significant changes post-2005 in some standards: • Intangible assets — now expensed and not capitalised • Revaluation of intangible assets greatly restricted to the requirement of an active market for assets and associated prices are publicly available • Amortisation of goodwill abolished — replaced by impairment testing • More stringent tests for classifying items as equity vs liability • The US has not adopted IFRSs (as yet)

15. IASB • IASB comprises 14 individuals (although this is expected to increase in coming years) • Each IASB member has one vote on technical and other matters • Publication of standard or exposure draft requires approval by approx 63% of the Board. • On publication of a standard, also publishes a ‘Basis for Conclusions’ to explain publicly how conclusions were reached, background information to assist application, and dissenting opinions. www.aasb.com.au • IASB has an International Financial Reporting Interpretations Committee

16. The ‘Theories’ of Regulation • Australia is fairly heavily regulated – response to Enron, Worldcom, HIH Insurance. • Is this level of regulation really needed? • Opinions on the need for regulation vary and range between the ‘free-market’ perspective and the ‘pro-regulation’ perspective. • ‘Influence’ and ‘Power’ play a role in standard setting. • Political process

17. Free Market Perspective • Accounting information should be treated like other goods, with demand and supply forces allowed to operate to generate an optimal supply • In other words, the market will determine the optimum supply of information about an entity.

18. Private Economic Based Incentives • Assumed that managers will operate business for own benefit and this is expected by shareholders and debtholders. • Based on agency theory – (assumption that all parties will assume that others will work in their own self-interest unless constrained to do so). • Therefore in interests of management to enter contracts with shareholders and debtholders to constrain managers’ actions and align them with goals of the organisation. • Contracts often based on accounting information - therefore, an incentive to produce accounting information. • Organisations not producing accounting information will be penalised by higher costs of capital – damaging the financial interests of those managers who own shares in those orgn. • The higher transparency – the less the risk – the cheaper the cost of finance

19. Private Economic Based Incentives • Organisations best placed to determine what information should be produced to increase the confidence of external stakeholders (therefore decreasing cost of capital). • Imposing regulation restricting available set of accounting methods decreases efficiency of contracting. I.e. Changing method of depreciation, not allowing revaluation of goodwill etc. • Limitations

20. Market for Managers • Managers’ previous performance impacts on remuneration they can command in future. • In absence of regulation assumed managers encouraged to adopt strategies to maximise value of firm (providing a favourable view of own performance). • includes providing optimal amount of accounting information • Limitations

21. Market for Corporate Takeovers Argument • Underperforming organisations will be taken over by another entity with the existing management team subsequently replaced. • Threat. • Therefore managers motivated to maximise firm value. • Information produced to minimise cost of capital thereby increasing firm value. • assumes managers know marginal cost and marginal benefits of information.

22. Market for Lemons • No information viewed in the same light as bad information (Akerlof, 1970). • Absence of disclosure the market will deem orgn as a ‘lemon’ • Therefore managers motivated to disclose both good and bad news. • Evidence that both good and bad news disclosed voluntarily (Skinner, 1994).

23. Market for Lemons

24. Pro-Regulation Perspective • We have reviewed reasons for eliminating regulation • If someone wants information they will pay for it! – leaving it to the ‘market’ to determine the optimum level. • If info is not produced there will be greater uncertainty of orgn performance – resulting in increased cost of capital for orgn. • Relies on users paying for accounting information • ‘Freeriders’ – not paying for the good or service • True demand understated – knowledge they can obtain free info • Results in an underproduction of information from producers

25. Pro-Regulation Perspective • Some argue free goods often overproduced as a result of regulation – Individuals know they do not have to pay, will overstate their need for the good or service • Could lead to ‘accounting standards overload’. • Invisible hand – mentioned once in Adam Smiths text ‘The Wealth of Nations’ • In the absence of regulation, productive resources will, as a result of individuals pursuing their own self-interest, somehow, as if by an ‘invisible hand’, find their way to their most productive users. • But Smith advocated regulatory intervention in some instances - where in the public interest to protect the more vulnerable.

26. Public Interest Theory Public interest theory “holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices” – Posner (1974 p. 335) • Regulation put in place to benefit society as a whole rather than vested interests. • Regulatory body considered to represent interests of the society in which it operates, rather than private interests of the regulators – neutral. • Society needs confidence that capital markets efficiently allocate resources to productive assets – regulation is the tool • The enactment of regulation is a balancing act between the perceived social benefits and the perceived social costs of the regulation. • Assumes that government is a neutral arbiter.

27. Critics of Public Interest Theory

28. Capture Theory • While regulation might be introduced with the goal of benefiting the public this goal may not subsequently be achieved. • The regulated seeks to take charge of (capture) the regulator – as the regulator will potentially have significant impact on their industry. • Seek to ensure rules subsequently released are advantageous to the parties subject to regulation. • See for example • Although regulating initially in the public interest, difficult for regulator to remain independent.

29. Captured! • Walker (1987) analysed the capture of Australian standard-setting through the ASRB, arguing that: • the accounting profession lobbied before the board (ASRB) established to ensure • priorities only set after consultation with Australian Accounting Research Foundation – professionally sponsored body funded by accounting profession i.e. sole control. • ASRB ‘fast-tracked’ only AARF submissions • majority of board membership were from the accounting profession

30. Criticisms of Capture Theory

31. Economic Interest Group Theory • The release of new or revised accounting standards have real economic and social consequences • For example, the introduction of AASB 2 share-based Payment or consider how the adoption of AASB 138 Intangibles might have created real economic impacts within Australia. • The economic interest group theory of regulation assumes that groups will form to protect particular economic interests. • Groups are often in conflict with each other and will lobby government to put in place legislation which will benefit them at the expense of others. • No notion of public interest inherent in the theory. • Regulators (and all other individuals) deemed to be motivated by self interest.

32. Economic Interest Group Theory

33. Accounting Regulation – A Political Output

34. Accounting Regulation – A Political Output • Compliance with accounting standards usually seen to indicate financial statements are ‘true and fair’ • can or should financial statements that have been prepared on the basis of accounting standards (with such standards having been developed after taking into account various economic and social consequences) be deemed to be ‘true and fair’?

35. Exercise

36. References • Deegan (2009) Financial Accounting Theory (3ed), McGraw Hill Ltd: Australia. • Deegan (2009) Australian Financial Accounting (6ed), McGraw Hill Ltd: Australia.