Stephanie Shania Herlambang

Acc 3/008201700013

Chapter 3: Applying theory to accounting regulation

THEORY IN ACTION 3.1
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.

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 over stated. In
addition, financial risk measures are not accurate and useful (‘bear no relation to reality’)

3. Standard setters propose revising leasing standards to require capitalization 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 $10.8billion 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 $11.8billion. Invested capital (debt plus equity) is
understated for both companies. Wool worth’s adjusted debt/capital ratio is more than
double that reported (71.9% compared to30.7%); Coles is 75.1% compared to 19.4%

4. What are the advantages of capitalizing 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 capitalization:
a. More accurate performance measures (avoid over stated ROI); b. Avoid misleading basis
for assessing performance trends; c. Allow better assessment of financial risk (determining
risk/reward trade-off); d. Allow more accurate comparisons between companies and operating
units
THEORY IN ACTION 3.2

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. Second, the article notes that fair value reporting should have been
more, not less. 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 favorable and optimistic picture

2. Why does the IASB member refuse to accept responsibility for the financial
crisis?
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?
Solution Manual to accompany Accounting Theory 7eHe 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?

THEORY IN ACTION 3.3

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 recognizes 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 back dating 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 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?
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 willful 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.

4. What is the role of the SEC in relation to the regulation of accounting practice?
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

1. What does the headline of the article mean by ‘small cap’ and ‘flash orange’?
‘Small cap’ refers to companies with relatively smaller market capitalization (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.
hen 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 emphasizing
it to the point that the investor would ‘take fright’ and believe the company was at
very high risk of failure.

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.
QUESTION
1. 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?
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 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

2. 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.
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 organizations 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 favor —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.
3. 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
(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
 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
 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

(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 organizations (companies, audit firms,
government bodies, standard setters and professional bodies) which
contribute cash resources and skilled personnel.

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 free-
market approach to standard setting. Finally, analyses the arguments and
conclude in favor of one approach rather than the other (which
approach you favor is up to you, but you must decide which approach is better,
at least under a set of assumed circumstances)

In favor 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.

In favor 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.

5. 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?
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. Increment lists 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 favors
special-interest groups. If the integrity of the IASB is tarnished, its survival will
be jet praised. However, if the theoretical-empirical support for a
proposal is weak, a wait-and-see attitude may be justified

6. How do you think accounting standards should be set? Is that the approach
currently taken by the IASB?
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.

7. 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. Increment lists 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 favors
 special-interest groups. If the integrity of the IASB is tarnished, its survival will
be jeopardized. However, if the theoretical-empirical support for a
proposal is weak, a wait-and-see attitude may be justified.
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).
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.

8. 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 utilize 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.

9. 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?
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 payor 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.

10. 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 organizations might lobby to affect the
requirements of an accounting standard: write responses to exposure drafts
write to members of the accounting standards board’s 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 favor — 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.

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.
(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

12. 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.
Chapter 3: Applying theory to accounting regulation12. 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 opportunisticbehaviour 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 view point, 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 organize,
there must still be a mechanism by which the group acquires and uses
its influence. It also assumes that players are always seeking to maximize
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 neutralize 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.

13. On 1 January 2005 Australia adopted IASB standards.

(a) Do you agree with this change? Why or why not?
(a) Students’ answers will vary, but should cover the following points.
Australian accounting standard boards first articulated their goal of
working towards harmonization 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
(b) Who stands to gain from Australia’s adoption of IASB standards? Explain.
Adoption of IFRS will benefit: The users, as financial statements will be
more comparable there by 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) Who stands to lose from Australia’s adoption of IASB standards? Explain.
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.

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.

15. 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?

a) 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.
 (b) 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 capitalization of
development expenses (required under IAS38 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. (c)
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 recognize 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
realized. 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
1. Improved international comparability. For some industries, major competitors
use IFRS. All companies following the same standards will assist information
users e.g. analysts
Arguments against use of IFRS by US domestic companies
1. 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 USGAAP

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

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 allow
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.