Chapter 13 Summary Notes
The fact that information asymmetry exists creates a demand among investors for information from firms. However, since the amount of information that managers wish to produce, in all likelihood, differs from that desired by investors, a demand for regulation of information production exists. Thus, as one can see, the regulation of information production is not merely an economic matter; it is quite clearly a political one as well.
Theories of Regulation
There are two theories of regulation to be considered. One is the public interest theory. This theory assumes that the regulatory body is concerned with what is for the best of society. Essentially, regulations are made by considering the tradeoff between the costs of regulation and its benefits to society. There are two major problems with this theory though. First, this does not indicate what the right amount of regulation is. Thus, this only creates more questions. Without the ability to determine the right amount of regulation, the regulatory body may do more harm than good. Second, the regulatory body answers to no one. Therefore, it is possible that it will only act in its own best interests. Since monitoring it would be costly and difficult to do, there is no way to tell if the body is shirking in its duties or not. Hence, the public interest theory appears useful in ideal conditions. However, these may not exist.
The second theory is the interest group theory. This theory states that the regulatory body’s decisions are affected by various interest groups that demand regulation in one form or another. The regulatory body is concerned with remaining in power and will choose actions that will allow it to remain in power. In short, the regulation will be made based on balancing the demands of these groups. The most effective groups politically will be rewarded with more favourable regulation in their opinions. This theory appears to be a better representation of how regulation is made than the public interest theory.
The Standard Setting Bodies and Process
The major source of accounting and auditing standards is the CICA Handbook, which is written and updated by the Accounting Standards Board (ASB) and Auditing Standards Board (AuSB) of the Canadian Institute of Chartered Accountants (CICA). The process for standard setting, as will be shown, is quite political and seems to affirm the interest group theory of regulation.
- The ASB publishes accounting standards independent of the CICA
- New standards require support of two-thirds of ASB members
- Two-thirds of ASB members must be from the CICA
- An Exposure Draft is issued allowing people to comment on the standard before it is implemented. This may lead to changes. This point, in particular, supports the interest group theory.
- Membership on the ASB is entirely voluntarily. Thus, it is largely represented by members of professional accounting firms. This can create concerns due to the lack of representation of other parties.
- The Standards Advisory Board helps determine which issues are placed on the ASB agenda
- Guidelines are issued in some instances to clarify issues in the Handbook and to address issues not in the Handbook, as implementation of a new standard can take a long time
- The Emerging Issues Committee (EIC) helps to identify and deal with new issues in a timely manner. The EIC includes 14 voting members of various backgrounds.
For the purposes of accounting regulation, the Ontario Securities Regulation (OSC) plays a small role. The OSC has recognized GAAP as being equivalent to the CICA Handbook in OSC National Policy Statement 27. The only exceptions permitted are if the OSC is satisfied that GAAP is not practical or the OSC has previously allowed non-GAAP statements and is certain that circumstances have not changed. Also, if it is a foreign-based company, it may use foreign-based statements.
The Financial Accounting Standards Board (FASB) acts as the operational part of a three-part organization including the Financial Accounting Foundation (FAF) and the Financial Accounting Standards Advisory Council (FASAC). The FAF consists of both appointed and elected members. The FAF appoints the FASAC’s members. Finally, FASB members are appointed by the FASAC. Members in all groups are given term limits. This points out the highly political nature of the regulatory bodies. FASB follows similar guidelines for standard setting as does the ASB.
Similar to the OSC, the Securities Exchange Commission (SEC) delegates regulatory authority. In this case, it is to the FASB.
The International Accounting Standards Committee (IASC) acts to create international standards and seeks to harmonize accounting globally. Compliance with the IASC is voluntary, but many countries either follow its guidelines or use them in determining their own guidelines. Its structure is similarly political in nature.
Evidence for the Interest Group Theory
After viewing the nature of regulation in Canada, the U.S., and internationally, it is apparent that the interest group theory of regulation is a good predictor. When one group feels its opinions have been heard, there is a greater chance that it will accept the results. This appears to be recognized by the regulatory bodies through their actions and their intentional inclusion of various stakeholders in their memberships.
SFAS 115 (marking-to-market) points out how a proposed standard was changed to accommodate the interest of various parties, thus gaining more acceptance. However, the changes made do not appear to be in the best interest of investors, as gains trading can still take place. This standard seems to be a good start and would likely have been met with fervent opposition had it been implemented unchanged. This supports the interest group theory. Also, SFAS 130 (comprehensive income) appears to support the interest group theory.
Standard Setting Criteria
Because there are many parties affected by regulation standards, there is more than one criterion that standard setters must consider. Obviously, decision usefulness must be considered. Though it may be difficult to determine how useful a new standard will be in decision-making, the theory of the rational investor can be used to predict how useful it will be. They must also consider the reduction of information asymmetry. If investors perceive a high level of information asymmetry, they will be more likely to withdraw from the market because they are at a disadvantage. Thus, to ensure properly working markets, information asymmetry must be considered. Also, regulators must consider the economic consequences of standards. The cost to produce information relative to its usefulness is an important consideration. If the information would cost a great deal for management to produce but be of only marginal value, perhaps its production should not be required. Finally, regulators must consider the political aspects of standard setting. They must ensure that whatever standards they introduce will have sufficient support that it will be seen as fair and that due process occurred. This did not happen with SFAS 8, which had to be replaced with SFAS 52. This point out further that standard setting is best predicted by the interest group theory.
Review Quiz
Definitions 8 points
Multiple Choice 10 points
True / False 6 points
Short Answer 30 points
Long Answer 16 points
Total70 points
Define each of the following (2 points each, 8 points total)
Public Interest Theory
Interest Group Theory
Standards Advisory Board
Comprehensive Income
Multiple Choice - Choose the best possible answer (2 points each, 10 points total)
1.New standards for the CICA Handbook require a ______vote by the CICA Board of Governors to be approved.
a)Majority
b)2/3
c)60%
d)Unanimous
2.Which of the following is true of the EIC of the CICA? *
a)It provides guidance in the absence of a clear accounting standard.
b)It ignores the political aspects of standard setting.
c)It consists of highly skilled practising public accountants.
d)It reduces the timeliness of standard setting.
3.According to public interest theory, the regulatory body answers to:
a)Ontario Securities Commission
b)Financial Accounting Standards Board
c)Board of Governors
d)Nobody
4.Which of the following alone is sufficient for an accounting standard to be successful? *
a)It must be decision useful.
b)It must have no technical weakness.
c)It must reduce information asymmetry.
d)It must be accepted by all constituencies.
5.The authority of the OSC is endowed by ______.
a)Charter of Securities
b)Board of Governors
c)The Securities Act
d)CICA
True / False (2 points each, 6 points total)
- According to the OSC and GAAP, if a company is foreign-based, it can use foreign-based statements.
True / False
2.It is apparent that the public interest theory is a better predictor than interest group theory.
True / False
- If the cost of producing accurate information outweighs the benefits, it should be produced anyway, because investors have a right to accurate information.
True / False
Short Answer (30 points total)
1.List the two major problems with public interest theory (8 points)
2.What is the purpose of the FASB? (5 points)
3.List the stages in the due process the FASB uses in setting and updating accounting and reporting standards (7 points)
4.How do politics help certain standards gain more acceptance? (6 points)
5.In setting standards, why must information asymmetry be considered? (4 points)
Long Answer (16 points total)
1.After reading the following article, evaluate the pros and cons of a body such as the EIC for standard setting in Canada. (16 points)
Emerging Issues Committee
Introduction
Status of the deliberations of the Emerging Issues Committee
During 1988, as part of its response to the Report of the Commission to Study the Public's Expectations of Audits, The Canadian Institute of Chartered Accountants created a new committee to handle emerging accounting issues. The objective of the Emerging Issues Committee (EIC) in reviewing any particular issue is to reach a consensus as to the appropriate accounting practice to be followed.
Information about the deliberations of the committee is made available to users, preparers and auditors of financial information by means of the publication of abstracts of the issues discussed. The abstracts include a description of the matter, the accounting issues identified, reference sources, and a summary of the EIC discussion thereon including whether there was consensus as to the appropriate accounting treatment. The information in each abstract is derived from the Issue Summary Sheet and related attachments, which are the discussion materials distributed to each committee member, and the official minutes of each EIC meeting. The status of EIC deliberations are set out in its Terms of Reference as follows:
The abstracts record the views of the Committee as to the appropriate accounting practice to be followed in the particular circumstances as summarized therein. In accordance with its terms of reference, abstracts of the issues discussed including the results of Committee discussions thereon are made publicly available by the Committee for the guidance of users, preparers and auditors of financial information.
Where the abstracts record that a consensus was reached on an issue, this indicates that not more than two members of the Committee present at the meeting dissented from the view expressed as to the appropriate accounting practice. Such consensus views have been neither approved nor disapproved by the Accounting Standards Board.
The Committee forms its views as to the appropriate accounting treatment for any particular issue within the framework of the principles established in Accounting Recommendations and Guidelines in the CICA Handbook - Accounting and nothing in these abstracts should be construed as amending or overriding those principles.
SOLUTIONS
Define each of the following (2 points each, 8 points total)
Public Interest Theory – theory that regulation should maximize social welfare and do what is best for society.
Interest Group Theory – theory that individuals in a regulatory body form coalitions to protect and promote their interests by lobbying the government.
Standards Advisory Board – a body with widely based membership set up to provide an outside perspective on priorities for possible new standards in the CICA Handbook.
Comprehensive Income – all changes in equity during the period, except those resulting from investments by or distributions to owners.
Multiple Choice - Choose the best possible answer (2 points each, 10 points total)
1.New standards for the CICA Handbook require a ______vote by the CICA Board of Governors to be approved.
a)Majority
b)2/3
c)60%
d)Unanimous
2.Which of the following is true of the EIC of the CICA?
a)It provides guidance in the absence of a clear accounting standard.
b)It ignores the political aspects of standard setting.
c)It consists of highly skilled practising public accountants.
d)It reduces the timeliness of standard setting.
3.According to public interest theory, the regulatory body answers to:
a)Ontario Securities Commission
b)Financial Accounting Standards Board
c)Board of Governors
d)Nobody
4.Which of the following alone is sufficient for an accounting standard to be successful?
a)It must be decision useful.
b)It must have no technical weakness.
c)It must reduce information asymmetry.
d)It must be accepted by all constituencies.
5.The authority of the OSC is endowed by ______.
a)Charter of Securities
b)Board of Governors
c)The Securities Act
d)CICA
True / False (2 points each, 6 points total)
- According to the OSC and GAAP, if a company is foreign-based, it can use foreign-based
statements.
True / False
- It is apparent that the public interest theory is a better predictor than interest group theory.
True / False The opposite is true.
3.If the cost of producing accurate information outweighs the benefits, it should be produced anyway, because investors have a right to accurate information.
True / False If the benefits outweigh the costs, it should not be produced.
Short Answer (30 points total)
1.List the two major problems with public interest theory (8 points)
- The very complex task of determining the correct amount of regulation. This creates more questions about how the amount of regulation is to be determined.
- It is difficult to monitor the regulatory body, as it answers to nobody. Therefore, the regulatory body may act in its own interest.
2.What is the purpose of the FASB? (5 points)
The purpose of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public in the United States.
3.List the stages in the due process the FASB uses in setting and updating accounting and reporting standards (7 points)
- Preliminary evaluation of problems related to accounting and reporting standards
- Admission to the agenda of FASB
- Early deliberations
- Tentative resolution
- Further deliberations
- Final resolution
- Subsequent review
4.How do politics help certain standards gain more acceptance? (6 points)
When one group feels its opinions have been heard, there is a greater chance that it will accept the results. This appears to be recognized by the regulatory bodies through their actions and their intentional inclusion of various stakeholders in their memberships. SFAS 115 points out how a proposed standard was changed to accommodate the interest of various parties, thus gaining more acceptance.
5.In setting standards, why must information asymmetry be considered? (4 points)
If investors perceive a high level on information asymmetry, they will be more likely to withdraw from the market because they are at a disadvantage.
Long Answer (16 points total)
1.After reading the following article, evaluate the pros and cons of a body such as the EIC for standard setting in Canada. (16 points)
Arguments in favour of the EIC for standard setting include:
- The EIC enables relatively fast reaction to new accounting problems as they arise. The due process of formally establishing new standards by the AcSC [now the Accounting Standards Board (ASB)] in Canada can take considerable time and, in the meantime, a variety of methods to cope with the new accounting problem may spring up. As the introduction states “The Emerging Issues Committee is established by the Accounting Standards Board to provide a forum for timely review of emerging accounting issues”
- The EIC allows for representation from the users, preparers, and auditors of financial information by means of the publication of abstracts of the issues discussed. This provides a vehicle to enable major constituencies to have input into the EIC’s deliberations, consistent with the interest group theory of regulation. Thus, these major constituencies of users are more likely to support the EIC’s pronouncements.
Arguments against include:
- A new body such as the EIC will incur costs. This increases the costliness of the standard-setting process in Canada.
- In effect, a new constituency in the standard-setting process is created. There is always the possibility that it may become more difficult to establish and implement new standards when more constituencies are involved. For example, what would happen if the ASB disagreed with an EIC pronouncement? In this regard, it is interesting to note that “nothing in these abstracts should be construed as amending or overriding those principles” This is an attempt by the CICA to prevent conflicts from arising.
- There is a tradeoff between increased timeliness of standard setting and due process. To the extent that fast reaction reduces the ability of interested and affected constituencies to have input, the democratic nature of standard setting will suffer, and the EIC could come under political attack for this reason. Note that the EIC terms of reference provide partial protection against reducing due process, since the EIC may not take positions that modify or conflict with standards established through due process.
* taken from CGA AT1 CD