CHAPTER 13 STANDARD SETTING – POLITICAL ISSUES Presented By: Sara Ahmad, Hussam Khan, Jason King, Tiffany Lau, Megan Murphy, Annie Zhong

Agenda  Introduction  Theories of Regulation  Conflict and Compromise  Benefits of Information  Criteria for Standard Setting  Regulator’s Information Asymmetry  International Integration of Capital Markets  Conclusions

13.1 Overview  The problem of market failure is fundamental.  Information asymmetry  Moral Hazard  Adverse Selection  Unanimity: the amount of information the firm would privately produce

Theories of Regulations  Public Interest Theory  Regulations should maximize social welfare  Interest Group Theory  Protect and promote their interests by lobbying the government

QUESTION  What are the Two Theories of Regulation?

13.2 TWO THEORIES OF REGULATION  The Public Interest Theory  The Interest Group Theory

The Public Interest Theory  Suggests that regulation is a response to public demand for correction of market failures  Regulator has the best interests of society at heart  Regulation is a trade-off between its costs and its social benefits in the form of improved operation of markets  Problems:  Complex task of deciding on the right amount of regulation  Regulator motivation

The Interest Group Theory  Stigler (1971): An industry operates in the presence of a number of interest groups  Those interest groups are the “demanders of regulation”  Becker (1983): Coase theorem  If bargaining costs are too high for parties to contract, an appeal to government to step in is possible  Various interest groups are competing for and against regulation  Outcome depends on which group is relatively most effective in applying pressure on the regulator

The Interest Group Theory Cont’d  Predictions:  Creation of standard-setting bodies  Activities subject to market failure are more likely to be regulated, due to demand from groups adversely affected If management is the source of these market failures, we expect to observe considerable regulation of their information disclosures  Due process Ex. Exposure drafts and board representation

The Public Interest Theory Vs. The Interest Group Theory  The Public Interest Theory  Implementing a new standard requires only that the regulator evaluate its social costs and benefits  No interest group involvement is needed

QUESTION  Which Theory of Regulation Applies to Standard Setting?

Which Theory of Regulation Applies to Standard Setting?  The Interest Group Theory!!!  Market forces cannot always be relied upon to generate the right accounting standards and procedures  Standard-setters can’t calculate the correct accounting standards either  Choice of accounting standards is better regarded as a conflict between constituencies than as a process of calculation  The Interest Group Theory formally recognizes the existence of conflicting constituencies

13.3 AN EXAMPLE OF CONSTITUENCY CONFLICT  IAS 39: “Financial Instruments: Recognition and Measurement”  Issued December 1998 with an effective date January 1, 2001  Proposed fair value accounting for major classes of financial instruments  financial institutions are heavy users of financial instruments and were opposed to fair value accounting

13.3 AN EXAMPLE OF CONSTITUENCY CONFLICT CONT’D  European Central Bank issued a comment in November 2001 entitled “Fair Value Accounting in the Banking Sector”  Short-run, long-run  Reliability of fair values for bank loans  Own credit risk  Conservatism

13.3 AN EXAMPLE OF CONSTITUENCY CONFLICT CONT’D  Regardless, IASB continued with IAS 39 but included provisions to reduce banks’ concerns  Ex. Volatility of reported net income is reduced by inclusion of unrealized gains and losses on available- for-sale financial instruments in other comprehensive income  Disagreements continued, which resulted in the European Union making the fair value option and the strict provisions for hedging “optional”

13.3 AN EXAMPLE OF CONSTITUENCY CONFLICT CONT’D  In response, IASB made several changes to IAS 39 including:  Macro hedging  Backing-off somewhat from the full fair value option  The changes to the fair value option appear to have satisfied the European Union, despite banks’ and regulators’ objections to recording gains on own credit risk. Concerns about hedging remained.

13.3 AN EXAMPLE OF CONSTITUENCY CONFLICT CONT’D  In response to the market meltdowns, the IASB issued IFRS 9 in 2009  Financial assets with a predictable cash flow can be measured at amortized cost, subject to an impairment test, if the firm’s business model is to hold them to collect cash flows from interest and principal payments. However, financial assets without a predictable cash flow, in particular, derivatives, continue to be accounted for at fair value.

13.3 AN EXAMPLE OF CONSTITUENCY CONFLICT CONT’D  BOTTOM LINE: Standards cannot be set in a vacuum. If important constituencies cannot obtain what they want, they will appeal to the political process.

13.4 Distribution of the Benefits of Information  Distribution of economic benefits among interest groups are difficult because they involve value judgments of fairness between affected parties  Society leaves the resolution to bargaining, contracting, and/or market forces, with regulation stepping in when these appear to fail

Regulation FD  Prohibits companies from selectively disclosing information  Goals:  Decline in analysts’ information advantage, new information would be released by firms directly to the market  Enhance public confidence in fair a marketplace  Contribute to market liquidity

Decision Usefulness  The more information an information system gives about a firm’s future performance  the stronger the investor reaction to information produced by that system  A new standard is more likely to be successful if it is decision useful  But society may ‘overuse’ the info since they don’t pay for it directly Costs of producing that info weren’t taken into account

Reduction of Information Asymmetry  Market forces operate to motivate managers and investors to produce information  However, market forces alone cannot generate the right amount of information  This is due to information asymmetry  A criterion for new standards should therefore, be the reduction of information asymmetry

Reduction of Information Asymmetry  The reduction of information asymmetry improves the operations of markets  Financial accounting information used by one person does not reduce its usefulness for another  Investors will perceive investing as a more level playing field Estimation risk can be reduced along with the bid-ask spread and market liquidity can be expanded  However, information asymmetry can also have costs

Question  What kind of costs could arise from trying to implement a new standard?

Economic Consequences of New Standards  A new standard imposes costs on the firm to meet that standard  Out of pocket costs  Contract rigidities  The release of proprietary information can reduce competitive advantage  Reduction in manager’s freedom to choose from different accounting policies  Standard setters need to weigh the economic consequences of new standards as an important source of cost that will affect both the need for the standard and willingness to accept it

The Political Aspects of Standard Setting  Standard setters must engineer a consensus strong enough to make even a constituency that doesn’t like the standard, go along with it  The structure and due process of standard setting bodies is designed to encourage such a consensus  The due process may be time consuming but it will help to minimize costly and embarrassing retractions

Summary  Accounting standard setters are guided by decision usefulness and reduction of information asymmetry  These criteria are necessary but not sufficient to ensure successful standard setting  Should also consider the legitimate interests of management and pay attention to due process

13.6 The Regulator’s Information Asymmetry  More recently, the theory of regulation has formally recognized that, like everybody else, the regulator faces information asymmetry  Information in the hands of firm managers  Unable to observe within the firm  Thus, the regulator faces both  Adverse selection problems and  Moral Hazard problems

Laffont and Tirole model  To illustrate how regulation theory may proceed under information asymmetry, we adapt the Laffont and Tirole model (1993) to an accounting context  Consider an economy with information demanded by investors and supplied by managers

Laffont and Tirole model (cont.)  Let “q” be the quality of information released by a firm  Higher q benefits investors, who reward the firm with lower cost of capital “p”  Firms also differ with respect to the amount of insider information, which we denote “ β ”

Laffont and Tirole model (cont.)

 If the inside information being provided is private information, the manager may secure additional compensation (“X”) through opportunistic behaviours such as:  Bad earnings mgmt. (Section 11.6)  Manipulating the value of option awards (8.3)

L-T model formulae

Possible Outcomes Outcome 1: Regulator has all relevant information  Given that the regulator knows β, it can prevent the manager from exploiting this information to generate excess compensation  The regulator has enough information to set q so that the manager earns no excess compensation  Thus, the rational manager will choose e

Possible Outcomes Outcome 2: Information Asymmetry (unknown β )  Regulator can still observe all other components but he or she can no longer observe the ( β – e) component of C  The regulator can no longer prevent the manager from exploiting insider info.  Thus, firm profits now include a deduction for excess manager compensation

General Accounting Conclusions #1: The extent that the accountant can reduce the amount of insider information effectively reduces the excess compensation problem #2: “Optimal” regulation is firm specific. Which supports the adoption of flexibility in accounting

13.7 – International Integration of Capital Markets  Questions:  Are Capital Markets becoming more integrated globally?  Does integration make the markets more efficient?

Convergence of Accounting Standards  Integration of capital markets makes them more efficient which attracts more investors  This also facilitates more efficient contract setting  When evaluating the political landscape you must now consider all aspects of international integration – social, political, legal and economic

Common Accounting Practices  What are some of the benefits of having one set of Accounting Practices internationally?

International Standard Setting  The IASB can now facilitate the process of standardizing accounting procedures with the following benefits:  Reduce Preparation Costs  Lower Costs of Capital  Decreases Network Externalities (reduces the costs for investors since they don’t need to understand multiple types of financial practices)

U.S. Accounting Standards  Should the U.S. be forced to adopt the IASB accounting standards? Why or why not?  Why does the U.S. have the power to keep their own set of accounting standards?

U.S. Accounting Standards (FASB)  Foreign firms and individuals wishing to raise capital in the U.S. are impacted by the difference in financial standards  The IASB is working towards convergence between the two standards, but differences still exist  E.g. in the U.S. R&D is almost always fully expensed under GAAP, however IAS 38 allows firms to capitalize some of these costs

Common Law vs. Code Law  Do you think there is a difference in the orientation of financial statements because of the legal system within a country?

Effects of Customs and Institutions  In a study from 2000 by Ball, Kothari, and Robin, they found that financial statements prepared in countries with common-law systems tended to orient their financial statements more to the benefit of investors  On the other hand, countries with code-law systems had accounting requirements which were set and oriented towards the government  They found that information asymmetry was actually lower in countries with code-law, as banks, unions, and associations were better represented in financial reporting  They concluded that information was more timely in code-law countries and that there was likely less of a recognition lag

Conservatism  Do you think a code-law type system would lead to more conservatism or less?

Conservative Reporting  The study found that firms in code-law countries were less conservative because insiders (banks, government, etc.) had more access to the information and could put pressure on management sooner to correct their actions  However, the study also found that the quality of the financial reports in these countries was lower than in the common-law countries

Quality vs. Quantity  Would you rather have your information in a timely manner or would you prefer that it was easier to interpret?

Quality of Information  A 2003 study by Ball, Robin, and Wu found that some countries adopted practices which had less recognition lag and conservatism (such as in the lower quality code-law countries) even when they used high-quality financial standards  This means that high quality financial accounting standards alone will not by themselves improve financial reporting  And remember, countries and firms still have discretion in how they interpret and apply these standards  E.g. In some countries, businesses are encouraged to smooth their financial statements to prevent or reduce embarrassment to their government

Enforcement  How do you enforce International Accounting Standards so that they contribute to higher-quality financial reporting?

Enforcement of Accounting Standards  IASB themselves do not have formal enforcement power over the countries which choose to adopt their standard  Each country is responsible for enforcing the requirements of the standard on the companies that operate there  Ineffective enforcement of these standards increases the risk for investors and reduces the efficiency of the global markets  Auditing is an important tool in enforcing accounting standards, however corrupt or unethical auditors can significantly impact the effectiveness of the standard

High-Quality Accounting Standards  What are the benefits of High-Quality Accounting Standards?

Benefits of High-Quality Standards  Significantly reduced costs for the organization including preparation costs, capital costs, and legal costs  Increases the efficiency of the markets as there is more correlation between accounting information and share price  Improves the relationship between the organization, government, banks, and investors  Leads to more investment from foreign sources as they are better able to interpret information

Standard Setters  Should standard setters (such as IASB GAAP and U.S. GAAP) be allowed to compete in a particular jurisdiction?

Convergence or Competition?  Instead of having IASB converge with FASB, an alternative would be for standard setters to compete in a given jurisdiction  Competition would encourage standard setters to reduce their requirements in order to attract firms resulting in more risk, higher potential for earnings management, and less market efficiency  However, investor pressures would force companies to produce higher-quality reports or risk losing their funding  Determining the best option is complex, and depends heavily on the country in question, and the current social, legal, and economic environment

Conclusions about International Integration  Differences in financial reporting is not as simple as high vs. low quality  In fact, differences in accounting standards is based heavily on a countries customs, government, institutions, and enforcement in place  As capital markets become more internationally integrated, market efficiency becomes more reliant on international accounting standards to increase information for foreign and domestic investors

13.8 Summing Up  Two major types of information asymmetry  Adverse Selection Managers and insiders know more than outside investors about the state and prospects of the firm Improving investor decision-making  Moral Hazard The effort exerted by a manager is unobservable to shareholders and lenders in all bit the smallest firms Informative measure of managerial performance

Conclusion  Increasing globalization of commerce and securities  Difficulties dealing with standard setting  Standard setting groups and investors

Questions?