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Chapter 4—THE ECONOMICS OF FINANCIAL REPORTING REGULATION
TRUE/FALSE
1. Financial reporting for publicly-listed companies in the United States was first regulated in the
1950s.
2. Congress empowered the Securities and Exchange Commission (SEC) to regulate financial
reporting in the 1930s.
3. The SEC has allowed accounting policy-making power to remain in the private sector.
4. Arguments supporting unregulated markets are largely inductive in nature.
5. 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.
6. Empirical tests of the free market position are impossible since we live in a regulated
environment.
7. Agency theory explains that firms have an incentive to report voluntarily to the capital market
because they are competing for risk capital.
8. The major agency relationship is between the management of a firm and the firm's creditors.
9. Good financial reporting will lower a firm's cost of capital.
10. Only firms that perform well have incentives to report their operating results.
11. According to signalling theory, firms have an economic incentive to report bad news.
12. 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.
13. There is usually information symmetry between the firm and outsiders.
14. Early adoption of new financial accounting standards generally indicates "bad news" whereas late
adoption generally indicates "good news."
15. The stock market shows that people are willing to contract privately for information about a firm.
16. 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.
17. An argument supporting accounting regulation is that it is better to force mandatory reporting
than to have individuals competing to buy information privately.
18. 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.
19. Risk in investment can be eliminated by improved accounting and auditing procedures.
20. Accounting regulation prevents fraud.
21. Public goods are commodities that, once consumed, reduce the opportunity for consumption by
others.
Accounting Theory: 8th edition Page 3 of 12
22. True market demand for public goods may be determined by the number of consumers who pay
for the goods.
23. 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.
24. 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.
25. Accounting information is a public good.
26. Information symmetry exists when potential investors do not all have equal access to the same
information.
27. Proregulation arguments as well as arguments for unregulated markets are largely deductively
reasoned rather than empirically researched.
28. There is a tendency for overproduction in unregulated markets.
29. The Impossibility Theorem implies that once the free market pricing system is abandoned, there
is no way of determining aggregate social preferences.
30. Overproduction of accounting information, or the problem of standards overload, has the greatest
effect on large, publicly traded companies.
31. The present financial disclosure system imposes costs on users rather than the companies
themselves.
Accounting Theory: 8th edition Page 4 of 12
32. In setting policy, due process means that a regulatory agency seeks to involve all affected parties
in its deliberations.
33. Sarbanes-Oxley has brought about a separation between auditing and management consulting.
MULTIPLE CHOICE
1. Which of the following is not an argument supporting unregulated markets?
a.
Agency theory
b.
Private contracting opportunities
c.
Signalling theory
d.
Social goals
2. Which of the following concepts provides a framework for analyzing financial reporting
incentives between managers and owner?
a.
Signalling theory
b.
Agency theory
c.
Information symmetry
d.
Private contracting
3. 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?
a.
Signalling theory
b.
Life-cycle theory
c.
Information overload
d.
Capture theory
4. Which of the following concepts holds that anyone who genuinely desires information about a
firm is able to obtain it?
a.
Signalling theory
b.
Agency theory
c.
Information symmetry
d.
Private contracting
5. 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?
a.
Signalling theory
b.
Agency theory
c.
Information symmetry
d.
Private contracting
6. Which of the following is not a possible justification for regulated markets?
a.
Possible market failure
b.
Natural monopolies
c.
The possibility that free markets are contrary to social goals
d.
Private contracting opportunities
7. 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
8. Goods that possess hard property rights so that nonpurchasers are excluded from consuming them
are called:
a.
Public goods.
b.
Regulated goods.
c.
Private goods.
d.
Underproduced goods.
9. 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.
10. 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.
Accounting Theory: 8th edition Page 6 of 12
11. Which of the following is considered a social goal related justification for imposing financial
reporting regulation?
a.
Information symmetry
b.
Comparability
c.
A competitive capital market
d.
All of the above
12. 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.
13. 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.
14. The focus of accounting regulation is on:
a.
Mandatory reporting.
b.
Improving the quality of reported information.
c.
Standards overload.
d.
Underproduction of accounting information.
15. Which of the following is not a negative consequence of regulating accounting?
a.
A wealth transfer from nonusers 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 nonusers implicitly
incur the production costs.
16. 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.
17. Which of the following theories argues that the group being regulated eventually comes to use the
regulatory process to promote its own self-interest?
a.
Life-cycle theory
b.
Agency theory
c.
Signalling theory
d.
Contracting theory
18. Life-cycle 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.
19. Prior to the FASB, accounting regulation was done primarily by:
a.
The SEC.
b.
The FTC.
c.
AICPA subcommittees.
d.
Large accounting firms.
20. Which of the following groups is not listed in your text as being affected by accounting
regulation?
a.
The FASB
b.
Companies
c.
Auditors
d.
Free riders
Accounting Theory: 8th edition Page 8 of 12
21. 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.
22. 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.
23. 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 nonpublicly listed
firms.
24. 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.
25. 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.
Chapter 4—THE ECONOMICS OF FINANCIAL REPORTING REGULATION
ESSAY
1. What are the arguments favoring regulation of financial reporting?
2. What are the arguments against regulation of financial reporting?
3. Discuss the regulation question in terms of determining and meeting the demand for accounting
information. Who pays for and who benefits from accounting information?
4. What is meant by "the paradox of regulation"?
5. What is due process, and how has the political nature of regulation affected the CAP, the APB
and the FASB?
6. What are the capture theory and the life-cycle theory of regulation, and how do they apply to the
regulation of accounting?
7. Describe Ronen's solution to the auditor behavior problem that involves the capture of auditors
by auditees.
8. Discuss Ronen’s solution to the problem of companies “capturing” auditors as a result of
management consulting contracts between auditor and auditee.
9. What do Healy and Palepu propose as a remedy for the auditing process being reduced to a
“complex checklist”?
