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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%. 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: More accurate performance measures (avoid overstated ROI); Avoid misleading basis for assessing performance trends; Allow better assessment of financial risk (determining risk/reward trade-off); 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 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. 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. 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: rules should not dampen economic growth; 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); rules should emphasise substance over form to avoid penalising people who make innocent mistakes. 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 ‘Rapacious lenders’: a reference to greedy bankers, who extended credit, without due regard to the riskiness of the loan. ‘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. 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 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. 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. The text describes a theory of regulatory capture. What is regulatory capture? How can standard-setting bodies such as the AASB avoid regulatory capture? 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. 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). 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. 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?] 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. 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. ‘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. 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. 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. 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. 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. In your opinion, will further regulation prevent deliberately misleading reporting? Explain. Are additional laws likely to prevent corporate collapses? Why or why not? How important is the enforcement of financial reporting requirements in promoting high quality reporting? 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. 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. 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. 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. On 1 January 2005 Australia adopted IASB standards. Do you agree with this change? Why or why not? Who stands to gain from Australia’s adoption of IASB standards? Explain. 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. 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. 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. 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. 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? 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. 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. 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 Improved international comparability. For some industries, major competitors use IFRS. All companies following the same standards will assist information users e.g. analysts. 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. 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. 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. 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 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. Standard setting benefits from competition between standard setters. One set of standards will not necessarily mean that the highest quality standards are developed. The USA will lose sovereignty in standard setting. Use of IFRS will reduce the influence of the SEC and FASB. 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. 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. Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152
