The document summarizes theories of financial reporting regulation in Australia. It discusses three main perspectives: the free market perspective, which relies on market forces to determine financial reporting; the pro-regulation perspective, which argues regulation is needed to address market failures; and three theories of regulation - public interest theory, capture theory, and private interest theory. It also outlines the standard setting and political process around financial reporting regulation in Australia.

1. Lecture 3
Regulation of Financial
Reporting in Australia
(cont.)
AASB

2. Lecture Overview
Review
The fundamental problem of financial accounting
theory
Current Australian accounting regulations
Is regulation the answer? (section 2.4)
‘free market’ perspective
‘pro-regulation’ perspective
Three theories of regulation (2.5)
Standard setting as a political process (2.6)

3. The Fundamental Problem of
Financial Accounting Theory
Provision of relevant
info. to aid investor
Decision making
Provision of reliable
info. to control
management behaviour

4. Possible solutions
1. Let market forces determine what
information is supplied
2. Regulate the provision of financial
information

5. Current Sources of Accounting
Regulations in Australia
FRC - Financial Reporting Council
oversight of the standard setting process
AASB - Aust. Accounting Standards Board
Technical deliberations about new and
changed accounting standards
Approximately 40 standards on issue
Currently undertaking harmonisation with
International Accounting Standards

6. Is Regulation the Answer?
(section 2.4)

7. Free market approach
Accounting information is like any other
product, subject to:
demand (from users/investors) and
supply (by companies/managers)
Rely on market forces (including contractual
demands) to determine
what information to supply
the quality of information supplied
Market-based penalties discourage non-
supply and misleading information

8. Incentives for managers to
supply information
Contractual
Information for monitoring of managers (to
overcome problems of moral hazard)
Contractual terms are often tied to
accounting numbers – creates demand for
accounting and auditing (stewardship role
of financial reporting)
Threat of price-protection transfers
incentive from other parties to managers –
managers have an incentive to supply
information

9. Incentives for managers to
supply information (cont.)
Capital markets
Demand for information about potential
investments (to overcome problems of
adverse selection)
Need to raise capital creates incentives for
managers to supply the information
(information role of financial reporting)
Penalties for non-supply and/or misleading
information include higher costs of capital

10. Incentives for managers to
supply information (cont.)
Markets for managers and corporate
takeovers
Impose further penalties for non-supply and/or
misleading information (manager remuneration,
threat of takeover)
Market for ‘lemons’
Provides further incentives to disclose
information, including ‘bad news’
Potential litigation costs impose further
penalties in relation to misleading
information

11. Free market approach
Equilibrium is where
costs of providing info = benefits
Managers have incentives to supply
information, eg. to raise debt and equity
capital, but must also consider the cost
associated with disclosing the information
Investors demand information. However,
once the information is available, they bear no
costs, only benefits
Some parties demanding the info. are more
powerful than others

12. The ‘pro-regulation’ perspective
Accounting information is a public good
once the information is released it can be made
available to everyone
Free-riders (eg potential investors) do not pay a
price for the production of the information
Causes underproduction of information due to a
decreased incentive to supply the information
for free (market failure => need regulation)
Counter-argument (against regulation)
Free-riders have greater incentives to demand
increased disclosure (there is a risk that the AASB
responds to this exaggerated demand)

13. The ‘pro-regulation’
perspective
Another problem with the ‘free market’
approach is that
Firms are monopolist suppliers of
information about themselves
tendency to under-produce and sell at a high
price
These problems prevent optimal operation
of competitive market - market failure

14. The ‘pro-regulation’
perspective
Regulation creates a ‘level playing field’
Everyone has access to the same
information
Increases confidence in capital markets
Regulation is in the ‘public interest’
To protect the ‘more vulnerable’

15. Why is financial reporting so
regulated?
Free-market approach and self-
regulation by profession had problems
Government intervention to protect the
public interest (investors and other
users of financial information)
This is what the public interest theory
proposes

16. Three Theories of Regulation
(Section 2.5)
1
1 2 3

17. Three Theories of Regulation
1. Public Interest Theory
2. (Regulatory) Capture Theory
3. Private Interest Theory (Economic
Interest Group Theory of Regulation)
Important - these theories help is to
understand ‘what is’ rather than
prescribing ‘what should be’

18. Public Interest Theory
Government intervention in markets is in the
‘public interest’ due to inefficient or
inequitable market practices
Government intervened in accounting
regulation in 1984 (ASRB) due to market
failure
failed companies with clean audit bills
lack of info stemming from information
asymmetries
Theory based on some unrealistic (?)
assumptions

19. Public Interest Theory:
Assumptions
Markets are subject to failure
Politicians help investors by regulating the
supply of financial information
There are agents (politicians / public interest
groups) who genuinely seek regulation in the
public interest
Government has no independent role to play
in the development of regulation - it is a
neutral arbiter. ie theory ignores self-interest
of politicians and government officials

20. Review - Self Interest
An important concept that helps us
understand the way the world works
Financial reporting and its regulation
are affected by the self interest of the
individuals involved
Individuals form into groups to help
achieve their objectives

21. Interests of the Accounting
Profession
The accounting profession has an interest in
controlling and overseeing the regulation of
financial reporting
Self-regulation by profession failed due to
non-compliance and lack of legitimacy
Alternative solution - ‘capture’ government
regulation of financial reporting

22. The Capture Process
Regulators set out to protect public
interest, but are subsequently captured
by regulated parties
Due to the interaction during the
process of regulating
Regulatory agencies empathise with
those who are regulated
Subsequent regulations are
advantageous to regulated parties

23. Capture Theory:
Application to Accounting
Walker (1987) argues that
Government initially created the ASRB (now
AASB) to protect the public interest
Professional bodies (the regulated industry)
subsequently managed to capture the ASRB
Outcome – Standards set by accounting
profession and legitimised by Government
(Perfect for profession!)

24. Impact of Self Interest
Capture theory builds on public interest
theory by considering the self-interest of
regulated parties
However, capture theory ignores the self
interest of other groups and individuals
Private interest theory (economic interest
group theory) does not have this limitation

25. Private Interest Theory
Acknowledges that individuals form into
groups to pursue their self interest
Proposes that private interests rather than
public interests dominate the regulatory
process
Regulatory outcomes reflect the interests of
the most powerful group
Politicians are not neutral arbiters – they
seek re-election and are able to be ‘bought’

26. Who seeks the power in
financial reporting?
Accounting profession was not the only
group to focus on the AASB
The producer group (companies) are likely to
seek control of accounting regulation
Major interest groups are:
Members of accounting professional bodies
Managers of companies (producer group)
Government officials and politicians

27. Who is the highest Bidder?
The industry group
(companies) often has the
greatest ability to supply
the desired payoffs to the
political power brokers

28. Summary of theories of
regulation
Public interest theory ignores self interest
completely - niave
Regulatory capture acknowledges some self
interest - part of the story but not all of it
Private interest theory acknowledges self
interest of all parties involved
Theories build on each other.

29. Standard Setting as a Political
Process
(Section 2.6)

30. The Politics of Accounting
Regulation
Standard setting is a political process
Standard setting is political because it affects
the well-being of a wide variety of interest
groups
Expect these groups to pursue their interests
and attempt to influence the process
Accounting standards are developed having
regard to social and economic consequences

31. The Process of Developing
AASBs (Due Process)
1. Selection of topics
2. Appointment of advisory panel
3. Discussion paper / theory monograph
4. Key issues
5. Exposure draft
6. Accounting standard
7. Legislation

32. Objective, neutral & apolitical
Financial Reporting and the Regulation of
Financial Reporting are not:
Objective
Neutral
Apolitical
Financial reporting is a function of (a)
accounting regulations, and (b) financial
reporting decisions
If neither of these are objective, neutral or
apolitical, how can financial reporting be?

33. For Tutorials
Required reading
Text chapter 3
Self assessment questions
Questions 8 - 17 from module 2
Answers in tutorials