Accounting Regulation

Chapter 3 (Godfrey)

The text describes a theory of regulatory capture.

(a) What is regulatory capture?

(b) How can standard-setting bodies such as the AASB avoid regulatory
capture?

(c) 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.

(d) 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).

(b) 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.

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.

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.

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?

Answer:

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, 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.

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 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.