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Accounting Theory Conceptual Issues In A Political And Economic Environment 9th Edition Harry I. -James L. – Test Bank
- The use of research in accounting results in the field being referred to as an academic discipline.
- The scientific method refers to the formal procedures used to derive the laws and principles that govern scientific disciplines, such as physics and chemistry, and is therefore not used in the published research on accounting.
- An important segment of accounting theory is derived from the research process.
- Deductive reasoning analyzes empirical data to make inferences about a population.
- Hypotheses are conclusions derived from the research process.
- General deductive reasoning is extremely important in accounting theory and policy-making.
- Analytical/deductive research methods are commonly used in accounting research.
- Positive accounting research attempts to explain behavioral relationships in accounting.
- Positive accounting research attempts to describe “what is” and determine how things should be.
- Positive accounting research attempts to be value-free, while normative accounting research is value judgment oriented.
- Only a few examples of inductively derived theories are present in accounting literature.
- Normative theories contain at least one premise stating how things should be.
- A premise stating that accounting reports should be based on historical costs would indicate a normative approach.
- Inductive approaches to accounting theory usually attempt to be descriptive.
- An important difference between deductive and inductive research is that inductive research is sometimes global in content, whereas deductive research is usually particularistic.
- One of the purposes of positive research is to satisfy information demand by managers, auditors, creditors, and standard setters.
- Because deductive research is grounded in real-world phenomena, it can realistically focus on only a small part of the relevant environment.
- Deductive and inductive research are competing approaches and may not be used together.
- Inductive research in accounting can help to shed light on relationships and phenomena existing in the business environment.
- Inductive research can be useful in the accounting policy-making process in which deductive reasoning helps to determine rules that are to be prescribed.
- To be useful, inductive research must be kept value-free.
- The decision-model approach to accounting research is normative.
- Accounting research of two generations ago was purely normative.
- The decision-model approach to accounting research seeks to determine what information users of accounting information want.
- The normative nature of the decision-model approach has led to criticism that this method is non-scientific.
- Empirical research shows that prices of publicly traded securities react slowly and in an erratic manner to new information.
- The efficient-markets hypothesis states that the return of a security is based on its risk.
- Because of the efficient-markets hypothesis, the impetus for increased disclosure with less concern for choice among accounting alternatives has grown stronger.
- Much of the accounting research in the behavioral area uses laboratory subjects in carefully controlled experimental situations.
- An argument against using students as subjects in behavioral research experiments is that they are not representative of the broad population of accounting information users.
- Agency theory studies are always inductive.
- One hypothesis of agency theory is that management attempts to maximize its own welfare by minimizing the various agency costs arising from monitoring and contracting.
- Agency theory holds that management always tries to maximize the value of the firm.
- Information economics research is usually inductive in nature.
- Information economics has relatively recently included agency theory assumptions in its analysis.
- Critical accounting discourages active social roles for accountants.
- Critical accounting research assumes a sharp separation between the researcher and his or her field of investigation.
- Of the research methods discussed in the text, the critical accounting approach is the closest to the standard-setting function.
- Currently accepted alternative depreciation methods illustrate that accounting is closer to an art than a science.
- Because accounting is not very much concerned with the human element, we can expect it to be more precise in its measurement and predictions than are the natural sciences.
- Which of the following examines or tests data, usually from a sample of a population, to make inferences about the population?
- When the premises of a theory are constructed so that they can be tested by statistical inference, they are usually called:
- Judging a theory by observing evidence rather than simply by its internal logic is called:
- Which of the following is not a characteristic of good inductive accounting theory research?
|a.||It must carefully specify the problem that is being examined.|
|b.||It must be based on a hypothesis that is capable of being tested.|
|c.||It must test the entire population under investigation.|
|d.||It must employ the requisite tools of statistical inference.|
- Which of the following types of research can realistically examine only rather narrowly defined questions and problems?
- The basic set of premises in a theory is also sometimes called all of the following except:
- Empirical research that attempts to determine why particular accounting alternatives are selected by management is an example of:
|c.||positive accounting research.|
- Which of the following statements is not true?
|a.||Inductive and deductive methods can be used together.|
|b.||It is impossible to keep inductive research completely value-free.|
|c.||Inductive approaches to accounting theory usually attempt to be descriptive.|
|d.||Deductive research makes inferences about a population based on tests of data.|
- Which of the following characteristics does not apply to the decision-model approach to research?
|a.||It asks what information is needed for making decisions.|
|b.||It asks what information users want.|
|c.||It concentrates on what information is useful for particular decisions.|
|d.||It has a normative and deductive orientation.|
- Which one of the following statements is true regarding the decision-model approach to research?
|a.||A premise underlying this research approach is that decision-makers may need to be taught how to use information they are unfamiliar with.|
|b.||This approach has become more important with the rise of empirical research in accounting.|
|c.||Some advocates of newer approaches have declared that this approach is too scientific.|
|d.||The decision-model approach does not parallel those of standard-setters because standard-setters must cope with the politics of the regulatory process.|
- Which of the following statements is not true regarding the efficient-markets hypothesis?
|a.||It stems primarily from the discipline of finance.|
|b.||It assumes that market prices of publicly traded securities reflect fully all publicly available information.|
|c.||As a result of this proposition, the impetus for less disclosure with more concern for choice among accounting alternatives has grown stronger.|
|d.||It states that the return of a security is based on its risk.|
- Which of the following statements regarding behavioral research is true?
|a.||It is a normative approach.|
|b.||The main concern of this type of research is how users of accounting information make decisions and what information they need.|
|c.||Many studies have shown that there are no discrepancies between normative decision models and the actual decision process of users.|
|d.||Since behavioral research is positive in approach, it is impossible to reach a conclusion regarding whether or not the usage of accounting data for decision-making purposes could be improved upon.|
- Which of the following statements regarding behavioral research in accounting is not true?
|a.||Much of this research uses laboratory subjects in carefully controlled experimental situations.|
|b.||This approach seeks to understand what accounting information is selected for use and how it is processed.|
|c.||This research has found that published financial statements are not often used for managerial decision-making purposes.|
|d.||The question of how representative student subjects are to the broad population is a problem that pervades virtually all behavioral research that uses student subjects.|
- The roots of behavioral research lie in the field(s) of:
|c.||Psychology and sociology.|
- Agency theory studies are a special case of:
|a.||capital markets research.|
|b.||the decision-model approach.|
- Which of the following is not true regarding agency theory?
|a.||It is also called contracting theory.|
|b.||Its underlying assumption is that individuals act in their own best self-interest.|
|c.||Few agency relationships between parties may be defined or governed by accounting numbers.|
|d.||It is concerned with the various costs of monitoring and enforcing relations among management, owners, creditors, and government.|
- The objective of information theory analysis is:
|a.||to determine how optimal contractual arrangement incentives and risk sharing can be negotiated.|
|b.||to determine appropriate alternatives to accrual accounting.|
|c.||to use inductive research techniques to test hypotheses regarding information usefulness.|
|d.||to find alternatives to agency theory assumptions.|
- Critical accounting:
|a.||developed from two other areas of accounting, behavioral accounting and agency theory.|
|b.||is concerned with the economic rather than social role of accountants.|
|c.||presumes a sharp separation between the researcher and his or her field of investigation.|
|d.||views accounting as having a pivotal role in adjudicating conflicts between the corporation and constituencies such as labor, consumers, and the general public.|
- Which of the following statements is not true regarding critical accounting?
|a.||Critical accountants believe that accounting should more strongly emphasize the attempt to solve broad societal problems.|
|b.||Critical accounting researchers believe that in viewing and investigating reality, they also help to shape that reality.|
|c.||It is the intention of critical accounting researchers to move the field into the mainstream of accounting research by adopting a conflict-based perspective.|
|d.||In critical accounting, there is less emphasis upon historical models and more upon mathematical and statistical models.|
- Which of the following statements is true?
|a.||A paradigm is a shared problem-solving view among members of a science or discipline.|
|b.||In accounting, the shared paradigm has been current valuation.|
|c.||Criticism of historical cost has increased since inflation lessened during the 1980s.|
|d.||It appears that a scientific revolution has occurred in accounting because historical cost is no longer the dominant paradigm.|
- In which of the following research areas do researchers believe that there is not a sharp separation between the researcher and his or her field of investigation?
|c.||Capital markets research|
- Which of the following research areas hypothesizes that management attempts to maximize its own welfare by minimizing costs of monitoring and contracting?
|c.||Capital markets research|
- Which of the following accounting research areas is based on the efficient markets hypothesis?
|a.||The decision-model approach|
|d.||Capital markets research|
- Empirical research is:
|d.||none of the above.|
- In a scientific approach to accounting:
|a.||a great deal of latitude is allowed in measurements.|
|b.||there is a low degree of objectivity.|
|c.||the intention is to provide information useful for either predictive or assessment purposes.|
|d.||the straight-line method of depreciation would always be used.|
- Which of the following accounting research approaches arose as a result of the perceived separation of interests in the modern corporation between management and ownership interests?
|a.||Capital markets research|
- Discuss the differences between each of the following:
|•||Normative vs. descriptive theories|
|•||Inductive vs. deductive reasoning|
|•||Global vs. particularistic theories|
Also identify how these types of approaches relate to one another. (For example: is deductive research normative or descriptive; is it global or particularistic?)
Normative theories contain at least one value judgment, or premise, saying how things should be. Descriptive theories try to find relationships that actually exist and attempt to be value-free. Inductive reasoning examines or tests data, usually a sample from a population, and makes inferences about the population. Deductive reasoning uses logic to derive one or more conclusions from a set of premises. Global theories are all-encompassing in nature, while particularistic theories focus on only a small part of the relevant environment, examining rather narrowly defined questions and problems. Deductive research tends to be normative and global. Inductive approaches are usually descriptive and particularistic.
- A study by Watts and Zimmerman that explored the question of how corporate management responds to new standards proposed by the FASB was discussed in the text. Answer the following questions related to that study.
|a.||What was the hypothesis of the study?|
|b.||Describe the study and discuss its findings.|
|c.||Was the study inductive or deductive? Explain.|
|d.||Discuss the criticisms that have been directed at the study and the implications of those criticisms.|
|a.||Watts and Zimmerman hypothesized that management has more incentive to favor standards that lower reported net income when the firm is subject to political pressures, such as antitrust action or regulation because of their dominant market position.|
|b.||Watts and Zimmerman examined responses to the FASB’s exposure draft requiring general price-level adjusted income calculations in corporate annual reports. They found that the proposal was supported by larger firms that would have lower income as a result of general price-level adjustment. Larger firms that would have higher income using general price-level adjustment tended to be against the proposal. These findings supported their hypothesis.|
|c.||The study was inductive because it tested actual data (responses to the exposure draft) from a sample of firms and made inferences about the relevant population.|
|d.||Solomons stated that Watts and Zimmerman’s evidence is rather flimsy because it involves a relatively small number of firms, a single accounting issue, and a single point in time. He also noted that many of the firms that lobbied in favor of general price-level adjustments were not using already available techniques, such as accelerated depreciation and LIFO, which would have reduced reported income. Also, several large firms that would have had lower general price-level-adjusted income relative to historical cost income lobbied against the proposed standard. This implies that the premise of the study, that large firms would be in favor of standards that decrease income, would be applicable only to a very small handful of very large firms. These criticisms show that empirical research in an area involving human behavior is subject to many interpretations and must be used carefully if inferences relative to the standard-setting process are to be drawn from the research.|
- Are inductive and deductive research mutually exclusive methods? Give examples to support your answer.
Inductive and deductive research techniques are not mutually exclusive and are often used together. For example, the inductive method may be used to assess the appropriateness of a set of originally selected premises in a primarily deductive system. Researchers often work backward from the conclusions of other studies by developing new hypotheses that appear to fit the data. They then attempt to test the new hypotheses. Inductive research in accounting can shed light on relationships and phenomena existing in the business environment. This research, in turn, can be useful in the policy-making process in which deductive reasoning helps to determine rules that are to be prescribed.
- Describe the decision-model approach to accounting research and identify the two major decisions embraced by this approach.
The decision-model approach to research asks what information is needed by decision-makers. It does not address what information users want but rather concentrates on what information is useful for a particular decision. Its orientation is normative and deductive. The two major decisions embraced by this approach are: (1) enabling the user to better predict future cash flows; and (2) analyzing the efficiency and effectiveness of management (stewardship) as well as subcategories of both these major types of decisions.
- Answer the following related to behavioral research:
|a.||What is the main concern of behavioral research?|
|b.||How does behavioral research differ from the decision-model approach?|
|c.||What are some of the findings of this research?|
|a.||The main concern of behavioral research is how users of accounting information make decisions and what information they need.|
|b.||This approach is descriptive, whereas the decision-model approach is normative. Also, much of behavioral research uses laboratory subjects in carefully controlled experimental situations.|
|c.||Many behavioral studies have shown discrepancies between normative decision models and the actual decision processes of users. Also, revision of probabilities by decision-makers occurs less than Bayesian decision models indicate is appropriate. Other research has found that there may be a tendency to use published financial statements for managerial decision-making purposes.|
- Answer the following questions regarding agency theory:
|a.||What are the assumptions, focus, and hypothesis of agency theory?|
|b.||How does opportunistic behavior, or moral hazard apply to agency theory?|
|c.||How does an audit of financial statements pertain to agency theory?|
|a.||The underlying assumption of agency theory is that individuals act in their own best self-interest. Another assumption is that the enterprise is the intersection point for many contractual-type relationships that exist among management, owners, creditors, and government. As a result, agency theory is concerned with the various costs of monitoring and enforcing relations among these various groups. One hypothesis of agency theory is that management attempts to maximize its own welfare by minimizing the various agency costs arising from monitoring and contracting.|
|b.||According to agency theory, management will try to maximize its compensation, but must do so within the framework of increasing net income, return on investment, or similar accounting measures. While the main management drive will usually be toward improving performance, management may also attempt to choose accounting rules that maximize income immediately rather than over time in order to maximize its own compensation. In this case, management actions may not always be in the best interest of stockholders. This is called opportunistic behavior or moral hazard.|
|c.||The audit minimizes agency costs, and is an example of efficient contracting. It attempts to give assurances to outsiders, such as owners and creditors, about the governance of the enterprise by management.|
- What is critical accounting, and in what way does it differ from all of the other research areas discussed in the text?
Critical accounting views accounting as having a pivotal role in adjudicating conflicts between the corporation and social constituencies such as labor, consumers, and the general public. It is thus directly concerned with the active social role of accountants. All of the other research areas discussed in the text presume a sharp separation between the researcher and his or her field of investigation. Critical accounting researchers believe that in observing and investigating reality, they also help shape that reality.
- Financial reporting for publicly listed companies in the United States was first regulated in the 1950s.
- Congress empowered the Securities and Exchange Commission (SEC) to regulate financial reporting in the 1930s.
- The SEC has allowed accounting policy-making power to remain in the private sector.
- Arguments supporting unregulated markets are largely inductive in nature.
- All of the arguments supporting the case for unregulated markets relate to the incentives for a firm to report information about itself to owners and to the capital market in general.
- Empirical tests of the free market position are impossible since we live in a regulated environment.
- Agency theory explains that firms have an incentive to report voluntarily to the capital market because they are competing for risk capital.
- The major agency relationship is between the management of a firm and the firm’s creditors.
- Good financial reporting will lower a firm’s cost of capital.
- Only firms that perform well have incentives to report their operating results.
- According to signalling theory, firms have an economic incentive to report bad news.
- The value of a company can be increased when the firm voluntarily reports private information about itself if the information reduces uncertainty about the firm’s future prospects.
- There is usually information symmetry between the firm and outsiders.
- Early adoption of new financial accounting standards generally indicates “bad news” whereas late adoption generally indicates “good news.”
- The stock market shows that people are willing to contract privately for information about a firm.
- An argument in favor of unregulated markets is that because of private opportunities to contract for information, market intervention in the form of mandatory disclosure rules is both unnecessary and undesirable.
- An argument supporting accounting regulation is that it is better to force mandatory reporting than to have individuals competing to buy information privately.
- An argument supporting accounting regulation is that the production costs of mandatory reporting requirements may be small since most of the basic information is produced as a by-product of internal accounting systems.
- Risk in investment can be eliminated by improved accounting and auditing procedures.
- Accounting regulation prevents fraud.
- Public goods are commodities that, once consumed, reduce the opportunity for consumption by others.
- True market demand for public goods may be determined by the number of consumers who pay for the goods.
- An argument supporting regulated markets is that more and better regulation is necessary to raise the quality of financial reporting in order to protect the public from frauds and failures.
- An argument supporting regulation is that the only way to increase production of public goods to meet the real demand of the public is through regulatory intervention.
- Accounting information is a public good.
- Information symmetry exists when potential investors do not all have equal access to the same information.
- Proregulation arguments as well as arguments for unregulated markets are largely deductively reasoned rather than empirically researched.
- There is a tendency for overproduction in unregulated markets.
- The Impossibility Theorem implies that once the free market pricing system is abandoned, and there is no way of determining aggregate social preferences.
- Overproduction of accounting information, or the problem of standards overload, has the greatest effect on large, publicly traded companies.
- The present financial disclosure system imposes costs on users rather than the companies themselves.
- In setting policy, due process means that a regulatory agency seeks to involve all affected parties in its deliberations.
- Sarbanes-Oxley has brought about a separation between auditing and management consulting.
- Which of the following is not an argument supporting unregulated markets?
|b.||Private contracting opportunities|
- Which of the following concepts provides a framework for analyzing financial reporting incentives between managers and owner?
- Which of the following concepts explains why firms have an incentive to report voluntarily to the market even if there were no mandatory reporting requirements?
- Which of the following concepts holds that anyone who genuinely desires information about a firm is able to obtain it?
- Which of the following concepts holds that voluntary disclosure is necessary in order for a firm to compete successfully in the market for risk capital?
- Which of the following is not a possible justification for regulated markets?
|a.||Possible market failure|
|c.||The possibility that free markets are contrary to social goals|
|d.||Private contracting opportunities|
- Which of the following has been cited as a reason for the alleged low quality of financial reporting, even under regulation?
|a.||Not enough management flexibility in the choice of accounting policies|
|b.||Poor accounting and auditing standards|
|c.||Laxity by securities analysts|
|d.||All of the above|
- Goods that possess hard property rights so that non-purchasers are excluded from consuming them are called:
- An externality exists if:
|a.||a producer of a good is unable to impose production costs on all users of the good.|
|b.||true market demand for a good is revealed in the market place.|
|c.||production of a good equals true market demand.|
|d.||the production of a good is regulated.|
- The effect of an externality is that:
|a.||production of a public good equals market demand.|
|b.||production of a private good equals market demand.|
|c.||true market demand for public goods may be determined by the number of consumers that pay for the goods.|
|d.||the producer of a public good has a limited incentive to produce it because all consumers cannot be charged for the good.|
- Which of the following is considered a social goal related justification for imposing financial reporting regulation?
|c.||A competitive capital market|
|d.||All of the above|
- Which of the following does not apply to a codificational system such as accounting standards?
|a.||It is pragmatic because maximizing the standards is impossible.|
|b.||Outputs are evaluated on the basis of whether they work correctly.|
|c.||Outputs are evaluated on the basis of whether they provide information to users at a reasonable cost.|
|d.||Outputs are correct in terms of deductive logic.|
- Mandatory public reporting of financial information:
|a.||enhances the perceived fairness of the capital market.|
|b.||increases the total cost to society of obtaining the information.|
|c.||results in costs greater than benefits.|
|d.||requires companies to generate a lot of information that would not otherwise be produced by its accounting system.|
- The focus of accounting regulation is on:
|b.||improving the quality of reported information.|
|d.||underproduction of accounting information.|
- Which of the following is not a negative consequence of regulating accounting?
|a.||A wealth transfer from non-users to users of accounting information.|
|b.||The imposition of disclosure costs on the users of financial information.|
|c.||A potential overallocation of social resources to the production of free, publicly available accounting information.|
|d.||Benefits are received by the users of free accounting information while non-users implicitly incur the production costs.|
- Which of the following is not a reason cited in the text for the failure of the CAP and the APB as regulatory bodies?
|a.||The SEC did not officially endorse private-sector standard setting until 1973.|
|b.||The CAP and the APB lacked the necessary political structure to ensure their survival.|
|c.||Policy making was exposed to outside influence.|
|d.||There appeared to be no due process in the determination of accounting and disclosure rules.|
- Which of the following theories argues that the group being regulated eventually comes to use the regulatory process to promote its own self-interest?
- Lifecycle theory argues that:
|a.||regulation eventually becomes an instrument for protecting the information users.|
|b.||the regulatory body often protects the regulated group from competition.|
|c.||regulation goes through several phases, but is never in the public interest.|
|d.||both b and c.|
- Prior to the FASB, accounting regulation was done primarily by:
|d.||large accounting firms.|
- Which of the following groups is not listed in your text as being affected by accounting regulation?
- Which of the following is a reason that the FASB should closely watch the lobbying behavior of free riders?
|a.||Responding to the interests of free riders could lead to an underproduction of accounting information.|
|b.||Free riders claim to be acting in the public interest but actually make the market less competitive.|
|c.||Free riders are not affected by accounting regulation.|
|d.||Free riders do not have the direct economic interests in information production that others have.|
- Which of the following is not true about the FASB?
|a.||It considers the economic consequences of proposed accounting policies.|
|b.||It has seriously considered the question of the desirability of corporate social responsibility accounting.|
|c.||It is sensitive to whether there are sufficient benefits to external users to warrant the imposition of new accounting standards.|
|d.||The FASB has commissioned studies to aid in assessing the effects of proposed standards on firms.|
- When the FASB considers the effects of an accounting standard:
|a.||the only costs it considers are auditing costs.|
|b.||it considers benefits primarily in terms of the information needs of the stock market.|
|c.||it is not concerned with producer costs.|
|d.||it is primarily concerned with the effects of the standard on small or non-publicly listed firms.|
- Democratic paralysis refers to:
|a.||the tendency of decision making under due process to be extremely slow.|
|b.||the inability to achieve a consensus in the regulatory process.|
|c.||the argument that regulation is not a democratic policy.|
|d.||the inability of previous standard setting bodies to develop a conceptual framework.|
- Which of the following statements is true?
|a.||The problems of the FASB stem from its limited use of due process.|
|b.||The FASB has not been as successful as its predecessors were.|
|c.||Many studies have found that large accounting firms tend to dominate policy at the FASB.|
|d.||With the implementation of the FASB, the capture theory argument lost much of its validity.|
- What are the arguments favoring regulation of financial reporting?
One argument supporting regulation is that it is in the public interest. Without regulation, there is the possibility of failure in the free market system because the firm is a monopoly supplier of information about itself. This situation creates the opportunity for restricted production of information and monopolistic pricing if the market is unregulated. Mandatory disclosure would result in more information and a lower cost to society. It is argued that more and better regulation is necessary to raise the quality of financial reporting in order to protect the public from fraud and failures.
Another argument in favor of regulation is that accounting information is a public good, and public goods are underproduced in a free market. Underproduction of public goods occurs because producers are not able to impose production costs on all users of the good, and are thus not motivated to meet real demand. The only way in which production can be increased is through regulatory intervention. Intervention in the form of mandatory reporting requirements is considered necessary to ensure that the real demand for accounting information is met.
It is also possible that free markets are contrary to social goals because they may not communicate enough information to the security markets, resulting in insiders having information that is not available to shareholders. In addition, the information that would be available in unregulated markets might not provide enough comparability among firms.
A philosophical justification of the standard-setting process—called codification—is based on evolutionary improvement of accounting standards in an open and democratic society. The goal of the standard-setting process should be to provide the best standards from the societal point of view.
- What are the arguments against regulation of financial reporting?
The arguments supporting unregulated markets for accounting information are based on agency theory, signalling theory, and private contracting opportunities. Agency theory predicts a conflict between owners and managers. Owners are interested in maximizing return on investment and security prices, while managers desire to maximize their total compensation. Because of this potential conflict, owners incur costs monitoring agency contracts with management, and these costs reduce managers’ compensation. Financial reporting is a way to mitigate this conflict to some extent, and allow owners to monitor employment contracts with their managers. Minimizing agency costs is an economic incentive for managers to report accounting results reliably to owners. Good reporting will enhance the reputation of a manager; and a good reputation should result in higher compensation because agency monitoring costs are minimized if owners perceive that accounting reports are reliable.
Signalling theory explains why firms have an incentive to report voluntarily to the capital market: voluntary disclosure is necessary in order for firms to compete successfully in the market for risk capital. Insiders know more about a company and its future prospects than investors do; therefore, investors will protect themselves by offering a lower price for the company. However, the value of the company can be increased if the firm voluntarily reports (signals) private information about itself that is credible and reduces outsider uncertainty.
Another argument against regulation is the presumption that anyone who genuinely desired information about a firm would be able to obtain it by privately contracting for information with the firm itself, with the firm’s owners, or indirectly with information intermediaries, such as stock analysts. If information were desired beyond that which is publicly available and free of charge, private individuals would be able to buy the desired information. In this way, market forces should result in the optimal allocation of resources to the production of information.
- Discuss the regulation question in terms of determining and meeting the demand for accounting information. Who pays for and who benefits from accounting information?
An argument in favor of regulation is that accounting information is a public good, and public goods are underproduced in a free market. Underproduction of public goods occurs because producers are not able to impose production costs on all users of the good, and are thus not motivated to meet real demand. The people who consume public goods without paying for them are called free riders. True market demand for public goods is not revealed in the market place because free riders are able to use the goods at no cost. The only way in which production can be increased is through regulatory intervention. Intervention in the form of mandatory reporting requirements is considered necessary to ensure that the real demand for accounting information is met.
There is another argument that regulated markets result in a tendency for overproduction. This overproduction can be avoided only if a pricing system can be imposed on public goods, creating non-purchasers who are effectively excluded from consuming the good. If accounting information had to be purchased, such as through the SEC’s EDGAR system, there would be incentives for users not to pass on the information to free riders. In this way, real economic demand for information could be determined, and production costs could be recovered from the real users of accounting information. By contrast, the present disclosure system imposes costs on companies rather than on users. One of the negative consequences of regulating accounting is that it results in a wealth transfer from non-users to users of accounting information. A wealth transfer occurs because users receive the benefits of free accounting information while non-users implicitly incur the production costs.
- What is meant by “the paradox of regulation”?
Arguments favoring regulation are that intervention in the form of mandatory reporting requirements is necessary to ensure that the real demand for accounting information is met and to provide the best standards from the societal point of view. However, economists have concluded that it is impossible to derive regulatory policies that will knowingly maximize the social welfare. Once the free market pricing system is abandoned, there is no way of determining aggregate social preferences. If the pricing system is working, aggregate social preferences are revealed through supply-demand equilibrium, and resources are allocated according to market prices. There is no comparable rule in a regulated market, so it is impossible to know if accounting regulation is producing the optimal quantity and quality of financial reporting.
- What is due process, and how has the political nature of regulation affected the CAP, the APB, and the FASB?
Due process means that a regulatory agency seeks to involve all affected parties in its deliberations. Due process is important in maintaining the legitimacy of the regulatory process. The CAP and APB failed as regulatory bodies for at least two reasons:
|(1)||They had only a weak mandate to regulate financial reporting. Until the issue of ASR 150 in 1973, the SEC did not officially endorse private-sector standard setting.|
|(2)||Their apparent lack of due process sometimes led to a low level of acceptance by affected parties.|
From a regulatory viewpoint, the FASB is functioning much more successfully than did the CAP and the APB. Its standards were endorsed by the SEC in ASR 150 and due process has been adopted as standard procedure in debating and developing accounting policy.
- What are the capture theory and the lifecycle theory of regulation, and how do they apply to the regulation of accounting?
Capture theory and the lifecycle theory of regulation both argue that the group being regulated eventually comes to use the regulatory process to promote its own self-interest. When this occurs, the regulatory process is considered captured. The lifecycle theory of regulation argues that a regulatory agency starts out in the public interest, but later becomes an instrument for protecting the regulated group.
From 1976 to 1978, the United States Congress investigated the allegation that accounting regulation had been captured by the Big Eight group of accounting firms, who were the predominant auditors of publicly listed corporations. Prior to the FASB, accounting regulation was done primarily by AICPA subcommittees, which were undoubtedly heavily influenced by the Big Eight accounting firms. However, with the implementation of the independent FASB, the capture theory argument lost much of its validity.
Current practices of accounting regulation survived the scrutiny of Congress partly because capture theory and the lifecycle theory are less applicable to financial reporting. The number of parties directly affected by accounting regulation is much larger and more diverse than in traditional regulated industries. Auditors and other parties affected by accounting regulation, companies that must comply with regulations, and free riders who use the costless information for investment analyses have a divergence of interests, which place the accounting regulator in a more naturally neutral posture than is possible in other regulated industries.
- Describe Ronen’s solution to the auditor behavior problem that involves the capture of auditors by auditees.
Ronen suggests the creation of financial statement insurance which would be paid by the auditee to an outside insurance company. This insurance would cover both insurance payments to shareholders as a result of misrepresentation in financial statements and also auditor fees. In turn, the insurance carrier would select and pay the auditor. The amount of coverage and premium would be published, so those firms having higher coverage and relatively lower premiums would look best. The principal–agent relation is changed from firm and auditor to insurance carrier and auditor. If the insurance carrier selects a “low ball” auditor, it increases the risk of having to pay shareholders for sub-par audits.
- Discuss Ronen’s solution to the problem of companies “capturing” auditors as a result of management consulting contracts between auditor and auditee.
Ronen suggests the creation of financial statement insurance which would be paid by the auditee to an outside insurance company. This insurance would cover both insurance payments to the shareholders as a result of misrepresentation in financial statements and also auditor fees. In turn, the insurance carrier would select and pay the auditor. The amount of coverage and premium would be published with those firms having higher coverage and relatively lower premiums looking best. If the insurance carrier selects a low ball auditor, it increases the risk of having to pay shareholders for sub-par audits.
- What do Healy and Palepu propose as a remedy for the auditing process being reduced to a “complex checklist”?
Healy and Palepu argue the auditing process has become a complex “checklist” which insulates the auditor from legal responsibilities for errors in the financial statements. They recommend that auditing firms make a professional judgment regarding the transparency of the financial statements, similarly to what is done by bond rating agencies. The stock exchanges would be involved to oversee the process. This should improve the quality of the information provided, though would likely also increase the cost of audits.