Chapter 3
Standard Setting
PowerPoint Presentation
by Matthew Tilling
©2012 John Wiley & Sons Australia Ltd
Institutional Framework
Accounting Standards
Rules-based Versus Principles-based
Standards
• Rules-based standards are sets of detailed rules
that must be followed when preparing financial
statements.
• Principles-based standards are based on a
conceptual framework that provides a broad basis
for accountants to follow
– The focus is on the economic substance of a
transaction, engaging the professional judgement and
expertise of those preparing financial statements.
Disadvantages of
Rules-Based Standards
• Rules-based standards can be very complex.
• Organisations can structure transactions to
circumvent unfavourable reporting.
• Standards are likely to be incomplete or even
obsolete by the time they are issued.
• Manipulated compliance with rules makes
auditing more difficult.
Advantages of
Principles-Based Standards
• Principles-based standards are simpler.
• They supply broad guidelines that can be
applied to many situations.
• They improve the representational faithfulness
of financial statements.
• They allow accountants to use their
professional judgement.
• Evidence suggests that managers are less likely
to attempt earnings management.
Disadvantages of
Principles-Based Standards
• Managers may select treatments that do not
reflect the underlying economic substance.
• The judgement and choice involved in many of
the decisions mean that comparability among
financial statements may be reduced.
Theories Of Regulation
• Accounting information is a ‘public good’
• Therefore some argue it is likely to be
underproduced without regulation
• Others suggest supply would exist without
regulation
• There are competing theories regarding the
need for and intention of regulation
Defining Regulation
“[R]egulation is the policing, according to a
rule, of a subject’s choice of activity, by an
entity not directly party to or involved in the
activity.”
• Elements of regulation
– Intention to intervene
– Restriction on choice to achieve certain goals
– Exercise of control by a party independent of
those directly involved in the activity.
Signalling Theory
• Suggests reporting entities can increase their
value through financial reporting.
– Companies face a competitive capital market
populated by sophisticated investors.
– Above-average entities motivated to show that they
are better than non-reporting entities.
– Non-reporting entities are perceived as of even
poorer quality than before.
– Creates a virtuous cycle where regulation is not
necessary
Public Interest Theory
• Argues signalling theory relies on the function
of a perfect, free-market economy.
• Public interest theory assumes:
– Economic markets are generally not perfect.
– Regulation is virtually costless.
• Concludes that regulation is supplied in
response to the demands of the public for the
correction of these inefficient or inequitable
market practices.
Capture Theory
• Capture theory holds that regulation is
supplied in response to the demands of self-
interested groups trying to maximise the
incomes or interests of their members.
– People are rational utility maximisers.
– The coercive power of government can be used to
give valuable benefits to particular groups.
– Regulation can be viewed as a product that is
governed by the laws of supply and demand.
‘Bushfire’ Theory
• Bushfire theory highlights the political and
public nature of regulatory influences by
attempting to take into account the reactions of
users, and society in general, to ‘failures’ of
regulatory processes.
– Regulations tend to arise from crises.
– Resulting rules do not necessarily deal with the
issues that caused the crisis.
– Rather they gain media exposure so that politicians
are more likely to gain re-election.
Ideology Theory of Regulation
• Ideology theory of regulation relies on market
failure but introduces the role of lobbying in
influencing the actions of regulators.
– Lobbying is viewed as a mechanism through which
regulators are informed about policy issues.
– Predicts that the effectiveness of regulation will
depend on
• the political ideologies of the regulators, and
• the impact of special interest lobby groups.
Advantages of Regulation
• Increased efficiency in allocating capital.
• Cheaper production.
• Check on perquisites.
• Public confidence.
• Standardisation.
• Public good.
Disadvantages of Regulation
• Difficult to achieve efficiency and equity.
• Determining the optimal quantity of
information is problematic.
• Regulation is difficult to reverse.
• Communication is restricted.
• Reporting entities are different.
• There is lobbying.
• Monopolisation of accounting standards.
Theory And Accounting Regulation
Research
• There are few accounting studies which apply
regulatory theories to standards setting.
• The majority of such studies support a version
of regulatory capture.
‘the shift of accounting regulation to the private
IASB has been caused by the sheer dominance of
a highly organized financial sector . . . [whose]
actors are the best connected and most
represented in the standard-setting network’
Political Nature Of Setting Accounting
Standards
• There is a mix of private and public
participation in the standard setting process.
• Parties that have an interest in accounting
standards often have conflicting interests. E.g.
– Internal stakeholders may like flexibility
– External stakeholders may like comparability
– Auditors like objective (auditable) reporting
Lobbying
• Those affected by accounting standards have
an incentive to lobby standard setters to
achieve a favourable outcome.
• Those affected must decide:
– Whether they should lobby.
– Which method of lobbying they should use.
– When they should lobby.
– What arguments they should use to support their
position.
Lobby Groups
• Industry and Management
– Highly motivated and resourced
• Casual non-professional users
– Disparate interests, few resources
• Full-time professional users
– Secretive and non-responsive
• Auditors
– Accused of self-interest
• Academics
– Strangely quiet
Lobby Groups in Australia
• Major players in Australia seem to be
– G100
– Large accounting firms
– Professional accounting bodies
– ASX
– Major banks
Harmonisation
• One of the functions of the AASB is to
participate in and contribute to the
development of a single set of worldwide
accounting standards.
• Three main benefits have been identified
– International comparability
– Reduced cost of capital
– Reduced conflicting reporting requirements
International Lobby Groups
• International Accounting Standards Board
• European Union
• Asian-Oceanian Standard-Setters Group
• G20
• International Organisation of Securities
Commissions
• FASB
Problems with Harmonisation
• Various methods of implementation leads to
inconsistencies
• Listed entities underestimated the
complexities, effects and cost of IFRSs
• Compromise leads to diversity
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