22420 Chap.1 Why Financial Reports Exist and Who Regulates Them
Why Financial Reports Exist and Who Regulates Them
Three jobs for one set of numbers
The subject opens by asking why accountants exist.
General purpose financial reports serve decision making by investors, lenders and others; they feed contracts such as bonus plans and loan covenants; and they let an agent show stewardship of delegated authority.
Why the choices are regulated
Because managers prepare numbers that also set their pay and their borrowing limits, reported figures can drift toward what management wants to show.
Regulation narrows the menu of policies, and the Corporations Act makes the AASB standards compulsory for the financial report, with ASIC and the ASX acting on it.
Standard setting is political
The lecture closes the topic with research on lobbying against a US rule to expense stock options at fair value: supporters of the blocking bill were more likely to have received donations, and donating firms tended to have larger option expenses.
Standards are negotiated settlements, which is why incentives matter when you read them.
What this chapter covers
- 01
Decision making: the users of general purpose financial reports
- 02
Contracting: principals, agents and the agency problem
- 03
Bonus plans and debt covenants written in accounting numbers
- 04
Stewardship and demonstrating delegated authority
- 05
Earnings management and why policy choice is limited
- 06
AASB, IASB, ASIC and the ASX: generate, mandate, enforce
- 07
Corporations Act sections 296(1) and 334(1)
- 08
Australian adoption of IFRS and Aus-prefixed paragraphs
Worked example · free
How a useful-life estimate moves a chief executive’s bonus
- 1Four-year life: depreciation is $2,000,000 ÷ 4 = $500,000, so profit is $9,000,000 − $500,000 = $8,500,000.
- 1Five-year life: depreciation is $2,000,000 ÷ 5 = $400,000, so profit is $8,600,000, which is $100,000 higher.
- 1Bonus: 2% × ($8,500,000 − $5,000,000) = $70,000 on four years, and 2% × ($8,600,000 − $5,000,000) = $72,000 on five years.
- 1The estimate has to reflect the expected pattern of use and be applied consistently, and auditors and ASIC can challenge a life picked to reach a target.
Key terms
- Agency problem
- The cost that arises when managers act in their own interest after capital providers delegate decisions to them and cannot observe everything they do.
- Debt covenant
- A clause in a loan contract that uses accounting numbers, such as a leverage ratio, to restrict actions that could shift wealth from lenders to shareholders.
- Earnings management
- Choosing accounting policies or estimates so that reported profit shows what management wants rather than an accurate model of the company.
- Stewardship
- Reporting that shows an agent used delegated authority as agreed, such as a bank demonstrating its capital requirements to a regulator.
Why Financial Reports Exist and Who Regulates Them FAQ
Why is accounting regulated at all?
Accounting numbers are used by investors and written into contracts such as bonus plans and loan covenants, while managers who prepare them have their own interests. Regulation limits the policies available, gives users more certainty about how numbers are produced and still leaves some judgement.
Who sets and enforces Australian accounting standards?
The AASB issues Australian standards based on the IASB text, the Corporations Act 2001 requires the financial report to comply with them, ASIC enforces compliance and the ASX enforces its own listing rules for listed companies.
Are Australian standards identical to IFRS?
Most are equivalent. Since 2005 the AASB has adopted IFRS, marking added paragraphs with an Aus prefix, often for not-for-profit entities, and issuing standards in the 1000 series for matters IFRS does not cover.
How do lenders use accounting numbers in contracts?
Loan agreements include clauses based on reported figures, such as leverage or loan-to-value limits and restrictions on dividends. They stop managers acting for shareholders from shifting wealth away from debtholders, and a change in an estimate or a standard can move a company toward breach without any change in its cash.
What does stewardship mean in financial reporting?
Stewardship is reporting that shows an agent used delegated authority as agreed. The lecture’s example is a bank demonstrating its regulatory capital under the Basel Accord; in modern companies much of that role has been taken over by contracts that rely on accounting numbers.
Exam move
Learn the three functions as three short paragraphs you could write from memory, each with one example of who relies on the number. Then draw the regulator map and attach one verb to each body. Finally, practise one contracting calculation, such as a bonus or a covenant ratio, so you can show in numbers why a policy choice matters.
Before the tutorial, open a real annual report and find who supplied the company’s capital and how its executives are paid.
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