Standard Setting: Political Issues Geoffrey Jones, Spencer Steckley, John MacFarlane, Joel Zhang, Ellen Truong, Lucy Zhang, Manjeet Warha

Agenda Two Theories of Regulation Conflict and Compromise: An Example of Constituency Conflict Distribution of the Benefits of Information, Regulation FD Criteria for Standard Setting The Regulator’s Information Asymmetry Case Study: On A Mission For Harmony Chapter 12 is primarily concerned with the size (net of costs) of the information pie – the larger the pie, whether generated by market forces or regulation or both, the better for society. However, distribution of the benefits of information production between constituencies further complicates standard setting, since constituency interests often conflict. In setting standards, the interests of managers, small investors, large investors and others must be traded off. Value judgements about these tradeoffs are difficult to make These considerations suggest that standard setting is fundamentally as much a political process as an economic one. And this chapter will dive into how exactly the pie is divided up between the different constiuencies

Two Theories of Regulation

Public Interest Theory Regulation is a response to public demand for correction of market failures The regulator is to have the best interest of society at heart Problems with this theory Very complex task of deciding how much regulation It is very difficult to monitor the regulators performance Much less fewer consequences if the regulator shirks Public Interest Theory: Regulation is a response to public demand for correction of market failures, the regulator is to have the best interests of society at heart, and the view that regulation should maximize social welfare.

Interest Group Theory The industry operates in the presents of interest groups Groups will lobby for the regulation or deregulation of the industry The group that spends the most and its effectiveness will achieve their desired regulations Each group must take the expenditures of the other groups into account Interest Group Theory: The industry operates in the presence of a number of interest groups, and these groups will form coalitions or constituencies to protect and promote their interest by lobbying the government.

Interest Group Theory - Predictions To overcome free riding, investors support the creation of standard setting bodies with representatives. Activities subject to market failure are more likely to be regulated, due to demand from groups adversely affected. Due process: The legal requirement that the state must respect all of the legal rights that are owed to a person

Which Theory of Regulation Applies to Standard Setting? Public Interest Theory is very difficult to implement. The choice of accounting standards is better regarded as a conflict between constituencies than as a process of calculation. Interest Group Theory recognizes the existence of conflicting constituencies. Interest Group Theory is a much better predictor of new standards than the public interest theory.

Conflict and Compromise: An Example of Constituency Conflict

IAS 39 Interest groups Development of new standard Jan 2001 Fair value accounting Financial instrument

Banking industry Heavy user of financial instruments Operation of the economy European Central Bank “fair value accounting in the banking sector” 4 general concerns – Nov 2011

4 Concerns Less long term contracts Valuation issue Own credit risk Conservatism

Less long term contracts Long term loan Interest rate risk Bank reduce earning volatility Reduce long term lending Reduce investment Reduce economic growth

Valuation issue Less reliable Need well-working market Need adequate mathematical models Credit derivative market not developed – 2011 Transparency Comparability

Own credit risk Own debt Credit deteriorates Higher discount rate Reduced fair value of debt Recognize gain Counter intuitive and misleading

Conservatism Unrealized gains and losses Prudent bank behaviour Recognize unrealized losses only Abandoning conservative accounting Induce less prudent behaviour Upset banking regulators

Immediate response Reduced volatility by Available for sale -> OCI Held to maturity -> amortized cost

Criticisms 2004 Disguise deteriorating credit risk Restrictive hedging provision Earnings volatility

Favorites Denmark Mortgage loan Liability hedged by financial assets If no full fair value option Earning volatility

2005 EU “carved out” the two issues Macro hedging on portfolio basis Made it optional Macro hedging on portfolio basis Reduce complexity Full fair value option Restricted to reducing mismatches only

2007 Market meltdown IFRS 9 Asset with predictable cash flow Amortized cost Smooth out volatility

EU response Relaxation of fair value Not far enough Delayed introduction But some companies adapted it anyways Competitive advantage

Bottom line Standards cannot be set in vacuum Must recognize existence of constituency conflict If constituencies are not satisfied They will appeal to the political process

Distribution of Benefits of Information, Regulation FD

Issue Distribution of information among interest groups Selective Disclosure – Is a situation when a publicly traded company discloses material information to a single person, or a limited group of people or investors, as opposed to disclosing the information to all investors at the same time. This created an uneven playing field for investors, allowing certain investors to profit from material market moving information before others.

Regulation FD (Fair Disclosure) The intention of implementing Regulation FD was to put an end to the practice of “Selective Disclosure” of non- public information and to more closely define when insider trading liability arises in connection with a trader’s use of non-public information

Regulation FD (Fair Disclosure) When an issuer, or person acting on its behalf (Public Company), discloses material nonpublic information to certain individuals (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information. The timing of the required public disclosure depends on whether the selective disclosure was intentional or non- intentional For intentional selective disclosure, the issuer must make public disclosure at the same time For a non-intentional disclosure, the issuer must make public disclosure promptly

Regulation FD (Fair Disclosure) Regulation FD fundamentally changed how publicly traded companies communicated with their investors by bringing more transparency and more frequent and timely communications in the market place

Criteria for Standard Setting

Decision Usefulness Must be of value to investors decision making Investors may “overuse” financial information because they perceive it as “free” Must balance cost of producing additional information with benefits gained from it Must consider other criteria as well

Reduction of Information Asymetry Reduction of Information Asymmetry through additional disclosures required by standards will: Increase fairness in information distribution to all investors Improve operation of markets (investors perceive more level playing field) Reduce estimation risk “Lemons” phenomenon Expand market liquidity Extent of IA for smaller firms is higher because less public information Standards need to require just as much info from smaller firms than larger ones

Economic Consequences of New Standards Cost imposed on firm & managers to meet standard Contract rigidities  increased probability of violating debt covenants, managers’ bonuses Release of proprietary information can reduce competitive advantage Reduction in managers’ freedom to choose from different accounting policies  cannot use choice of policy to signal inside info

Political Aspects of Standard Setting Standard setters must ensure consensus that all constituents will go along with it Interest group theory of regulation: Technical or theoretical correctness does not guarantee success of standard Interest groups will offer strong resistance until they are satisfied Due process ensures retractions are minimized Too many retractions threatens existence of standard setting body

Regulator’s Information Asymmetry Regulators face information asymmetry Most information in hands of managers Unable to observe manager’s efforts As a result: adverse selection moral hazard

Laffont and Tirole Model π = pq – C – t Where: π is profit - C is cost of producing information p is cost of capital - t is manager’s total compensation q is quality t = X + Ψ (e) Where: X is excess contribution for managers who keep inside information Ψ (e)= manager’s effort aversion C = (β – e) q Where: β is firm-specific inside information e is information-related effort by managers

Laffont and Tirole Model π = pq – C – t Managers assumed rational, risk-neutral and effort-averse Higher q better information for investors  lower cost of capital C = (β – e) q Lower β means more inside information  lower C Components of e: designing and monitoring of financial reporting systems dealing with Auditors costs of signaling managers could lower the cost of producing information by: signaling costs good earnings management choice of accounting policies adoption of information technology

Laffont and Tirole Model Model is firm specific Takes into account how firms have different β and cost of capital Impact on regulations: Regulations should be firm-specific – not effective to have general standards for all firms Regulations should be flexible – business and manager characteristics are different across firms Reducing inside information will help reduce excess

On a Mission for Harmony

Origin & Development of International Accounting Standards IASC CICA’s Accounting Research Committee Harmonization standards internationally Work with IASC to minimize: Geoff Starts Here. Canada along with United Kingdom and United States was a member of Accountants International Study Group and a founding member of International Accounting Standards Committee (IASC), established in 1973. CICA’s Accounting Research Committee (predecessor to the Accounting Standards Board) expressed its commitment to the IASC’s objective of harmonizing accounting standards internationally Willingness to work along with IASC to minimize differences between International Accounting Standards (IASs) and Corresponding accounting recommendations set out in CICA Handbook. IASs CICA

CICA Handbook – Section 1501 Summary of Differences covered in this section March 1985 comparison discontinued & replaced by CICA publication, Financial Reporting in International Environment Reintroduced to handbook as appendix to Section 1501 Appendix now updated to cover IASs issued up to June 30, 2000: (IAS 1 – IAS 40) Now First-time adoption by Not- for Profit organizations In December 1995, commitment to IASC’s objective enshrined in Handbook Section 1501, “International Accounting Standards” Up until April 1981, a brief comparison of IASs with CICA accounting standards, setting out any major differences between two standards, periodically included in that section. Financial Reporting in International Environment which was updated six times between 1985 and 1992. In August 1996, comparison was reintroduced into CICA Handbook, in somewhat greater detail than had previously been provided as an appendix to Section 1501. The appendix has now been updated to cover IASs issued up to June 30, 2000 (IAS 1 to IAS 40) Currently, section 1501 is known as “First-time adoption by Not-for-Profit organizations” referring to the first changeover for these organizations to the international standards.

Uniformity of U.S. & Canadian Standards With the reduction of options in IASs, compliance with both sets of standards by Canadian entities is unquestionably more difficult than it used to be. Conformity with US standards is also a significant issue in Canada, particularly since many Canadian companies have: US parents US Investors Significant operations in the US Increasing globalization of markets, demand for greater uniformity in standards of two countries was inevitable

Standard Setting Bodies – Objectives In Aug. 1992, accounting standard-setting bodies of North America: CICA Accounting Standards Board Comisión de Principios de Contabilidad of the Instituto Mexicano de Contadores Públicos AC FASB in US Sponsored 1st extensive joint study NAFTA They sponsored their first extensive and concerted joint study. It was the initial step in encouraging cooperation for progress in international harmonization among standard-setters in the three countries in the wake of NAFTA.

Standard Setting Bodies – Objectives Analyze similarities and differences in accounting standards in 3 countries Identify areas where progress might be made in harmonizing these standards Provide users of financial statements with info that would enhance their ability to compare business enterprises in 3 countries. Spencer Starts Here

Study Group Report – Differences Significant differences in standards among Canada, Chile, Mexico, and United States: Effects of changing prices Business combinations Consolidation and equity accounting Foreign-currency translation Income taxes EPS Post-retirement benefits Pension accounting Investments R&D When 1995 report was issued, the “top 10” major areas in which there were significant differences in standards among four countries were… Business combinations, consolidation and equity method accounting, foreign-currency translation all covered in advanced accounting course. Describe roughly each of these points.

Study Group- Second Objective Set up a standing committee resulted in the creation the American Free Trade Agreement Committee for Cooperation on Financial Reporting Matters Consisted of representatives from all 4 countries Mission of committee was to: improve the overall quality and comparability of accounting standards serve the information needs of users

Study Group- Second Objective Con’t To accomplish its commitment the committee will act to: promote the comparability of accounting standards consider existing significant areas of difference in standards develop recommendations on what specific efforts should be used to reduce existing significant differences in standards identify potential significant areas of difference that might be created by proposed standards consider work of other standard setters or other organizations monitor progress toward elimination of significant differences in standards

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