ADM 4342 – Financial Accounting Theory – Chapter Notes

January 29, 2018

Chapter 13 – Standard Setting: Political Issues

13.2: Two Theories of Regulation

Public Interest Theory

- Regulation is a response to public demand for correction of market failures
- The regulator is assumed to have the best interests of society at heart
- Aims to maximize social welfare – attain a first-best amount of info production
- Regulation is seen as a trade-off between its costs and its social benefits
- Problems
o Very complex task to decide correct amount of regulation
o Due to regulator’s information disadvantage and the complexities o measuring
social costs and benefits, it is difficult for the government to monitor the
regulator’s operations
 Costly and lengthy hearings would be required
 Regulator faces less constraint on shirking since there is no capital market
to help motivate their actions
- Implementing a new standard requires only that the regulator evaluate its social costs
and benefits

Interest Group Theory

- Industry operates in the presence of a number of interest groups
- Various interest groups will lobby the regulator for various amounts and types of
regulation
- Various constituencies are seen as demanders of regulation (for or against)
- Groups are competing for and against regulation
- Outcome depends on which group is relatively most effective in applying pressure
o Pressure is constrained by laws, courts, media, and public opinion
- Groups are assumed rational, and thus will not throw good money after a failing cause
- Predictions of theory:
1. Creation of standard-setting bodies – impossible to organize a group of large and
diverse investors to act as a cohesive interest group and thus investors would
support creation of a standard setting body (cheaper than cost of self-organizing)
2. Activities subject to market failure – market failures increase the potential benefits
of regulation for investors – more likely to be regulation due to the demand of
groups adversely affected
3. Due process – interested groups must have a seat at the table, thus management
will be actively involved in standard development
- Varies during the business cycle – banks supply loans to managers for new projects
o Standard settor chooses standards that balance demands of two parties
 o In a growth market, managers want more reporting quality to highlight
successful projects
o In slow market, managers want less reporting quality to hide bad projects and
banks want less regulation to hide their own losses – but this leads to higher
interests rates and falling ROI … which in turn leads to demand for higher
regulation

Note that it is effectively impossible for standard setters to calculate the right account
standards or to determine the socially right amount of regulation to balance diverse
information needs and costs.

13.4 Distribution of Benefits of Information

- Complication of standard setting is the distribution of the benefits of information
production among interest groups
- You must “enlarge” the information pie AND decide how to distribute it
- You cannot simply add up the losses in utility if benefits are taken from one individual
and compare it with the gains in utility if these benefits are transferred to another
individual and claim the society is better off if the gain is greater than the loss
- Society leaves distributional issues to bargaining, contracting, and market forces
- Regulation FD Example – improved regulation only decreased analysts’’ information
advantage with an unknown benefit to other investors (external to early information
distribution)

13.5 Criteria for Standard Setting

Decision Usefulness
- The more information about future firm performance and information system is, the
stronger will be investor reaction to information produced by the system
- Thus, empirical evidence states that security prices respond to accounting information
(and is therefore useful)
- However, since investors do not directly pay for accounting information, they may
“overuse” it and thus a standard could appear useful, yet society is worse off because
the costs of production the information were not taken into account

Reduction of Information Asymmetry

- Since the use of financial accounting information by one individual does not destroy its
use by another, expanding disclosure by means of standards works toward a fair
distribution of benefits of information to all investors
- The benefits are available directly to those who are willing and able to use the expanded
information, or indirectly to other investors through price-protection mechanism of
efficient markets
- However, the reduction of information asymmetry is costly

Economic Consequences of New Standards

 - Costs are imposed on firms when new standards are set
- Monetary costs, but also costs created by contract rigidities (such as increased risk of
violating debt covenants or increased volatility in manager bonuses)
- Reduction in managers’’ freedom to choose from different accounting policies also
results in a cost as managers can no longer use accounting policy choices (now reduced)
to signal inside information
- Greater degree of competition in an industry, the better the disclosure (even without
regulation)

Consensus
- Standard setters must engineer a consensus strong enough that even a constituency
that does not like a new standard will nevertheless go along with
- Structure and due process aim to encourage consensus

13.6 The Regulator’s Information Asymmetry

- regulators face information asymmetry – much of the information needed by the
regulator is in the hands of firm managers who are, in effect, monopolistic information
producers about their firm
- Regulators are unable to observe manager effort (for shirking)
- If the standard settor follows public interest theory, the socially optimal extent of
standard setting allows for some reduction in earning quality so as to limit the
manager’s ability to receive more compensation than is required
- To the extent that the accountant can reduce the amount of insider information, the
problem of excess manager compensation is reduced
- The optimal regulation is firm specific; therefore the regulator should allow flexibility in
reporting quality (principles approach)
- Dessein Model enhances our understanding of the standard setting process. While its
assumes that the objective of the securities commission is to maximize decision
usefulness of financial reporting to investors, the commission’s decision about the
extent of standard setting takes place in the presence of conflict between regulators
and managers
o Conditions of delegation of standard setting by the commission to an
intermediate body that works with managers (so therefore some bias)
o Supports due process

13.7 International Integration of Capital Markets

- Standards in code law countries are set primarily by governments, hence subject to
more political influence than under common law – as a result, additional constituencies
are represented within the corporate governance structure under code law
- High recognition lag and less conservative accounting suggests that financial reporting in
code law countries is of lower quality than under common law
- Auditing is a key player in the enforcement of accounting standards – with firms who
use larger auditing firms practicing more conservative accounting
- It was concluded that a shift from local GAAP to IASB GAAP can benefit the economies
involved, particularly when the local and IASB GAAP differ significantly, and there is a
strong legal regime to enforce and encourage quality reporting
- There is mixed evidence about the relative quality of IFRS and FASB GAAP, with the
comparability and quality being better in certain areas of each – convergence over time
will lead to optimal standards
- Should standard setters compete – problem is that standards will become weaker as the
setter will want more firms following their standards resulting in a race to the bottom
and an overall decrease in quality of reporting
o HOWEVER, firms wanting to signal their commitment to higher reporting quality
would cause the “easier standards” to lose customers, resulting in a race to the
top
- Read 13.7.8 on page 558 for good summary of this section