Chapter 3 & 4

Question 1

Definition financial accounting

Answer 1

A process involving the collection and processing of information of a financial nature for the purpose of assisting various decisions to external parts

Question 2

Why General Purpose financial reports (GPFR)?

Answer 2

In the presence of many users it is not generally possible to generate reports to meet individuals needs

Question 3

Why regulation and what does it involve?

Answer 3

Need for regulation in general (not specific) purpose financial reporting. Involves:
- an authoritative body (accounting standards board) setting…
- … accounting standards

Question 4

What accounting knowledge is expected of the users of the general purpose financial reports?

Answer 4

“Reasonable knowledge of business and economic activities and who review and analyse the information diligently”

Question 5

Regulation regulated private or publicly?

Answer 5

• Private - the accounting profession is best able to develop accounting standards
• Public - the government has greater enforcement power, hence the rules are more likely to be followed and consider overall public interest

Question 6

Development of regulation

Answer 6

• Introduced following the great depression, argued that problems with accounting information led to poor and uninformed investment decisions
• High-profile corporate collapses
• The sub-prime banking crisis in 2007/2008

Question 7

Arguments in favour of regulation

Answer 7

• Without regulation - sub-optimal amount of information
• investors need protection
• uniform methods enhance comparability
• less powerful stakeholders need to be secured by regulations
• market mechanisms do not work for public goods (free riders)

Question 8

Arguments against regulation (free market arguments)

Answer 8

• no need cause people are prepared to pay for information - supply and demand
• regulation will lead to over-supply of information as users overstate the need
• organisations will be prohibited from using other more efficient methods
• regulations will lead to information overload-cost vs benefit

Question 9

Theories/perspectives for regulation

Answer 9

• the free-market
• the pro-regulation

Question 10

The free-market perspective - definition

Answer 10

A perspective on accounting regulation which says that information should be treated like other goods, where demand and supply forces should be allowed to freely operate to generate an optimal supply of information

Question 11

The free-market perspective - arguments for

Answer 11

• Private economic based incentives
• Market for managers argument
• Market for corporate takeovers argument
• Market for lemons argument

Question 12

The free-market perspective - Private economic based incentives

Answer 12

the private economic-based incentives for the organisation to provide information (based on agency theory). Agency costs are expected and the managers will disclose information (make contracts) to calm owners
- Information provided –> stakeholders buy shares.
There are also incentives to have accounting information audited to ensure reliability

Question 13

The free-market perspective - Market for managers argument

Answer 13

If the managers remuneration depends on past performance it implicates providing information. Even in absence of regulations, managers will be encouraged to adopt strategies to maximise the value of their organisation (hence providing financial reports)

Question 14

The free-market perspective - Market for corporate takeovers argument

Answer 14

Works on the assumption that an underperforming organisation will be taken over by another entity that will replace the management team –> managers motivated to maximise firm value.
(The argument assumes that information will minimise costs and that the managers are aware of this)

Question 15

The free-market perspective - Market for lemons argument

Answer 15

Assumes that failure to provide information is viewed in the same light as providing bad information. The silence might be worse than bad news.
(Reputational-effects argument - managers may incur reputational costs it they fail to disclose bad news)

Question 16

The free-market perspective - one issue with the perspective

Answer 16

The theory breaks down when it is applied to a firm with multiple external parties since making so many contracts is not feasible.

Question 17

The pro-regulation perspective - definition

Answer 17

A perspective which prefers regulations, it says that market forces will not work since accounting information is a public good.

Question 18

The pro-regulation perspective - Problem with public good

Answer 18

Accounting information, once available, people can use it without paying and can pass it to others - free riders. Will understate true demand and few people will want to pay –> underproduction of information.

Question 19

The pro-regulation perspective - Arguments for

Answer 19

• Regulation is needed to compensate for the underproduction from the market failure of public goods
• The level playing field argument - everybody should have access to the same information

Question 20

The pro-regulation perspective - one issue with the perspective

Answer 20

Free goods which are regulated gets overproduced, hence too much information provided. Users do not need to pay and overstate their need of information

Question 21

Theories that explain the process of regulation

Answer 21

• Public interest theory
• Capture theory
• Private/economic interest group theory

Question 22

Public Interest Theory

Answer 22

Believes that regulation is initially put in place to benefit society rather than particular investors, and the regulator body (government) is considered to represent all interests

Question 23

Public Interest Theory - Criticism

Answer 23

(Posner) A simplistic perspective of why regulation is introduced, questions the weak image of the economic markets and criticises that regulations is put in place for “the public good”

Question 24

Capture Theory

Answer 24

Means that although regulation might be introduced with the aim of protecting the “public interest”, this aim will not be achieved since the organisations that are subject to the regulation will ultimately come to control the regulator.
The regulated parties seek to “capture” the regulator with intention of ensuring that the regulations will be advantageous”

Question 25

Capture Theory - 5 ways for the regulated to capture the regulator

Answer 25

1. The regulated interest controls the regulation
2. Succeed in coordinating the regulators activities with their activities
3. manages to neutralise or ensure non-performance by the regulator
4. subtle process of interaction with the regulators succeed to get the regulators seeing from their perspective
   5.?

Question 26

Private/economic Interest Group Theory

Answer 26

Assumes that groups will form to protect particular economic interests and not public interest. The groups will try to LOBBY the regulator to direct it into being advantageous for the group (self-interest)

Question 27

Private/economic Interest Group Theory - why can the regulator itself be a interest group?

Answer 27

They are motivated to ensure re-election or maintain a position of power

Question 28

Private/economic Interest Group Theory - Connected to principles of supply and demand

Answer 28

The regulation can be considered as a product (Posner). Those with highest demand get more of the product. Transfer of wealth.