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.
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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 foreignbased statements.
The Financial Accounting Standards Board (FASB) acts as the operational part of a threepart 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
Multiple Choice
True / False
Short Answer
Long Answer
Total
8 points
10 points
6 points
30 points
16 points
70 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)
b)
c)
d)
Majority
2/3
60%
Unanimous
2. Which of the following is true of the EIC of the CICA? *
a)
b)
c)
d)
It provides guidance in the absence of a clear accounting standard.
It ignores the political aspects of standard setting.
It consists of highly skilled practising public accountants.
It reduces the timeliness of standard setting.
3. According to public interest theory, the regulatory body answers to:
a)
b)
c)
d)
Ontario Securities Commission
Financial Accounting Standards Board
Board of Governors
Nobody
4. Which of the following alone is sufficient for an accounting standard to be successful? *
a)
b)
c)
d)
It must be decision useful.
It must have no technical weakness.
It must reduce information asymmetry.
It must be accepted by all constituencies.
5. The authority of the OSC is endowed by __________.
a)
b)
c)
d)
Charter of Securities
Board of Governors
The Securities Act
CICA
True / False (2 points each, 6 points total)
1.
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
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
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 Emerging Issues Committee is established by the Accounting Standards Board to provide a
forum for timely review of emerging accounting issues that are likely to receive divergent or
unsatisfactory treatment in practice in the absence of some guidance.
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)
b)
c)
d)
Majority
2/3
60%
Unanimous
2. Which of the following is true of the EIC of the CICA?
a)
b)
c)
d)
It provides guidance in the absence of a clear accounting standard.
It ignores the political aspects of standard setting.
It consists of highly skilled practising public accountants.
It reduces the timeliness of standard setting.
3. According to public interest theory, the regulatory body answers to:
a)
b)
c)
d)
Ontario Securities Commission
Financial Accounting Standards Board
Board of Governors
Nobody
4. Which of the following alone is sufficient for an accounting standard to be successful?
a)
b)
c)
d)
It must be decision useful.
It must have no technical weakness.
It must reduce information asymmetry.
It must be accepted by all constituencies.
5. The authority of the OSC is endowed by __________.
a)
b)
c)
d)
Charter of Securities
Board of Governors
The Securities Act
CICA
True / False (2 points each, 6 points total)
1.
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 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)
1. 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.
2. 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)
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4.
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
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”
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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.
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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