From Low-Quality Accounting to Financial Crises: Politics of Disclosure Regulation along the Economic Cycle Jeremy Bertomeu Robert P. Magee

A Model of Disclosure Regulation View reporting quality as the outcome of a political process –Reporting quality is a function of accounting standards, plus all the institutional features (auditors, SEC, etc.) that determine the ability to differentiate successful enterprises from unsuccessful ones. –Current standards “depreciate” quickly and must be reset every period. –Various parties have differing views on the desirability of reporting quality, and the quality level is set at that desired by the median voter. How is reporting quality influenced by the state of the economy? How does it influence the economy?

The Interested Parties Each period begins with entrepreneurs receiving a good project (with probability p t ) or a bad project (with probability 1- p t ). Require a loan to start business. –The economy (p t ) follows a geometric random walk, with a bound at p t =1. –Good entrepreneurs prefer high quality reporting, bad entrepreneurs prefer lower quality reporting (though not necessarily no reporting). Banks with a loan of unknown quality from the previous period may receive information about that loan’s quality and may have a liquidity shock that requires that the loan be liquidated. –Banks with bad loans prefer no reporting, banks with good loans and banks with loans of unknown quality prefer high quality reporting.

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One Scenario

Issues Raised by the Model Regulations are endogenous –“Bad” regulations occur because they are beneficial to a subset of the economy. –Economic consequences of regulations should identify these groups. How is standard-setting affected by the economic cycle? –Volume of standards at different stages of cycle –Agenda setting and management –Process time –Types of standards How is pressure exerted on the standard-setting process?