Financial ACCG224-Intermediate Accounting
Tutorial 1-Week 2-Model Answers to Tutorial Questions
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 freemarket 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 under-produce 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.
Conclusion:
The accounting information is vital to operate the healthy financial markets. The accounting
information should have the relevant qualitative characteristics of relevance, reliability,
comparability and understandability. In order to maintain these qualitative characteristics, the
production and distribution of accounting information have to be regulated.
(The question could be raised will regulation necessarily prevent fraud or flag
the corporate collapses we have seen in recent years?)
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, will it not
be prevented by additional laws. If a person considers that the benefits of the
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 it 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.
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 be 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.
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.