Lecture 2 Regulation of Financial Reporting in Australia AASB

Lecture Overview Review of important concepts (module 1) Financial reporting decisions Impact of information Asymmetry Financial reporting discretion (2.1) Current accounting regulations (2.2) International harmonisation of accounting standards (2.2) Rationale for regulation (2.3)

Review of Important Concepts Financial Reporting Decisions Impact of Information Asymmetry

Scope of Financial Reporting Financial reporting covers more than just financial/company accounting (preparation of financial statements). Although this is an important part of it. Financial reporting also includes disclosures that may or may not be contained in the financial statements Examples of disclosures Environmental disclosures, notes to the accounts regarding the valuation of assets, press releases Disclosures can be financial and non-financial

Financial Reporting Decisions Financial reporting decisions relate to application of the accruals system as well as disclosure related choices Five types of financial reporting decisions Expensing versus Capitalisation of Costs Accounting Methods Accounting Estimates Disclosure versus Recognition Disclosure Policy

Information Asymmetry Occurs when some parties to a business transaction have an information advantage adverse selection one party has knowledge not possessed by the other moral hazard arises when some parties cannot observe all the actions of the other parties to the transaction

Summary: Information Asymmetry Adverse selection (Financial reporting to convert inside info to outside info.) Moral hazard (Accounting to monitor the behaviour of managers)

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

Relevance and Reliability A trade-off Ability of financial reporting to overcome information asymmetry problems depends on its degree of relevance and reliability Regulation of financial reporting can increase (decrease?) relevance and (especially) reliability

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

Financial Reporting Discretion (module 2.1)

Financial Reporting Discretion Accountants and managers have substantial discretion when making financial reporting decisions Decisions impact: Numbers in Financial Statements What information is disclosed Decisions of financial statement users Relates to: Unregulated financial reporting decisions Choices available within regulated financial reporting decisions

Is financial reporting neutral and unbiased? Depends on: Amount of discretion available to managers How managers exercise their available discretion efficient motivations (unbiased) opportunistic motivations (biased) Concept of self interest

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

Are accounting regulations neutral and unbiased? Individuals are involved in the standard setting process scope for self interest to get in the way of “neutral and unbiased” accounting regulations the individuals that will be regulated by the new accounting standards can have an impact on the standard setting process Adverse economic and social consequences must be considered

Current Accounting Regulations (module 2.2)

The Development of Accounting Regulation in Australia Pre World War 2 - close links with the UK Subsequent influences: Development of accounting standards in 1970s ASRB (now AASB) shifted control of accounting regulation from profession to government in 1984 Corporations Law application of AASB standards compulsory continuous disclosure applies

History of Accounting Regulation Three Time Periods: 1. A largely unregulated period (pre 1970) 2. A period of professional regulation non-compliance problems 3. Current period of regulation by legislation (post 1984)

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 http://www.aasb.com.au/ UIG - Urgent Issues Group

International Harmonisation of Accounting Standards (module 2.2 cont.)

Globalisation of business An increasing fact of business Global capital and product markets Impact on financial reporting Need for internationally comparable financial statements?

Advantages of internationally comparable accounting standards Presentation of high quality, transparent and comparable financial information is likely to: reduce investment risk in foreign companies / lower cost of capital encourage cross-border investment and result in better allocation of savings to investments

How to achieve internationally comparable financial statements One set of rules / accounting standards? Where does this leave AASB? If so, who’s rules? International Accounting Standards Board US (FASB/SEC) other Should any variation between countries remain? Adoption versus consistency with global set of standards? IASB is currently embarking on a program of convergence of accounting standards world-wide

International Convergence The IASB “cooperates with national accounting standard setters to achieve convergence in accounting standards throughout the world” The AASB has a specific function “to participate in and contribute to the development of a single set of accounting standards for world-wide use”

AASB Policy of International Convergence and Harmonisation International convergence – “working with other standard-setting bodies to develop new or revised standards that will contribute to the development of a single set of accounting standards for world-wide use” International harmonisation – a process which leads to Australian accounting standards being compatible with IASs

What is Harmonisation ? Harmonisation refers to a process which involves national standard setters adopting or adapting IAS or ensuring their national standards are consistent with IAS AASB has been adapting Australian approved accounting standards to ensure that they are consistent with IAS This is different to simply adopting IAS

AASB Harmonisation Program AASB standards amended to be consistent with, but not identical to IAS involves amending existing standards to conform with existing IAS adopting / adapting existing IAS for areas not currently addressed by standards in Australia harmonise new standards with new / revised IAS

Status of AASB Harmonisation Most of AASBs amended to comply with IAS Difficulties in coming to agreement on certain standards Full harmonisation not always achieved Some awaiting IASB completion of IAS

Newsflash Australia will ADOPT International Accounting Standards from January 2005! First country in the world to make such a statement However, the European Union has stated that it will require all listed companies to prepare consolidated financial statements in accordance with IAS from 2005

Who will benefit from International Convergence? Primarily, large companies Currently to list in the US involves companies preparing either a separate set of accounts using US GAAP or a conversion table which provides a translation of key figures from Australian to US GAAP

Rational for Regulation (module 2.3)

Some Important Questions Should financial reporting be regulated? If so: Who should control the regulatory process? How much regulation is enough?

Arguments for and against regulation markets for information are inefficient and subject to failure investors need protection from misleading information enhanced uniformity / comparability Against: markets for information are efficient regulation leads to decreased relevance of financial reporting

Theories of Regulation Regulation of financial reporting “protects the public” maximisation of social welfare Regulation of financial reporting is controlled by the accounting profession self interest of accountants Regulation of financial reporting is controlled by company managers self interest of all individuals involved

A political process Financial reporting regulations have many economic and social consequences Various interested parties lobby the standard setters (self-interest) Standards are not set in a political vacuum To be discussed more thoroughly next lecture…..

For Tutorials Required reading Self assessment questions Text chapter 2 Text chapter 6, pp. 192 - 195 Optional reading (harmonisation) Selected reading 2.1 Remainder of chapter 6 Self assessment questions Questions 1 - 7 from module 2 Answers in tutorials