Standard-Setting: Political Issues 306-684 Financial Accounting Seminar 11

Learning Objectives 1 To understand relevant theories put forward to explain regulation 2 To review the history of accounting-politics relationship 3 To discuss/debate what constitutes a “good” accounting standard 4 To assess the impact of globalisation on the standard setting

Recall: Arguments against the necessity of regulation: Contractual incentives for disclosure Market-based incentives for disclosure Arguments for the necessity of regulation: Private incentives are insufficient, due to Market failures Information asymmetry

Recall: We don’t know which set of arguments is more “robust/likely” – can’t be tested as we live in a regulated world So, we don’t know whether increased market failures that might follow from deregulation would be more or less costly to society than the costs of regulation! 2008! – evidence of failure?

Recall: However, information asymmetry ( hence adverse selection and moral hazard problems) is pervasive and is persistent A demand for information from firms also creates a demand for regulation, as firms supply less information than investors demand Thus, regulation increases the amount of information disclosed, even if we don’t know the exact costs v. benefits of that increase

Theories of Regulation: What theories do we have to explain the government intervention in the market for accounting information?

Public Interest Theory Regulation is deemed necessary to protect the public interest, and ensure the adequate provision of accounting information. It is needed to counteract market failure, due to: Information asymmetry Lack of unanimity “public good” nature of accounting information

Public Interest Theory These factors will all lead to the under-supply and over-pricing of accounting information The government is assumed to be a neutral party who intervenes to protect the public interest “first best solution” to maximise social welfare Trade off costs of regulation with social benefit of efficient markets and allocation of scarce resources

Public Interest Theory Problems What is the “right” amount of information and regulation? Impossible to please every constituency! What are the motivations of the regulators? Are they really acting in the public interest?

Interest Group Theory Governments are not neutral: politicians and regulators are also rational and self-interested There are conflicts between interest groups and constituencies e.g. between firms and environmentalists A “second best” solution – regulator maximises own interest while balancing those of constituents (such as managers and investors), including the political authority

Interest Group Theory The larger, more powerful interest groups (able to organize and bear the costs of lobbying) are able to trade votes and other benefits for their desired regulation Consistent with the “political costs” theory of PAT Firms want to minimise their political costs and maximise their political benefits

Theories of Regulation Which theory do think is the better explanation of reality? Public interest or Interest group theory? Interest group theory – more cynical, but more realistic?

The Accounting-Politics Relationship Accounting information is implicated in economic crises (e.g. Enron, Lehman Bros.) Crises create potential for political rewards (govt seen as “White Knight”) Politicians and regulators increase regulation to “solve” problem Accounting profession “self-regulates” to avoid increase in government regulation Consequence – continual increase in accounting regulation!

Historical Examples … 1929 Stockmarket Crash in US Preceded by high reported profits and high firm values Assertion was that these were artificially inflated and over-valued Consequence: formation of SEC in 1934, mandatory requirement that firms provide audited financial statements, prohibition of asset revaluations

Historical Examples … Australia in the 1960s Failure of large land development companies Threat of government intervention Professional bodies produce first accounting standards 1984 – standard setting “taken over” by govt – compliance now mandatory October 1987 Crash – followed by increased regulation

Examples … More recently (2001) US – failure of Enron, WorldCom, Arthur Andersen,etc Consequence: Sarbanes-Oxley [SOX] Australia – failure of HIH Consequence: Ramsay report on auditor independence, Royal Commission, reforms to Corporations Law

2008 Failures of banks – large, small and international eg. Lehman Bros, Fortis, etc. Sub-prime mortgage defaults created bad debts that resulted in banks unwilling and unable to lend to other banks Consequence – unprecedented response by governments to inject capital and to take equity positions in banks

The Big Questions Will regulatory changes prevent future corporate failures of this kind? i.e. will the benefits exceed the costs? What changes to regulations will take place post-2008?

Criteria for Standard Setting Investors’ demands on standard setting They want information to predict future firm performance They want full disclosure, transparency, fair values Managers’ demands on standard setting They want flexibility to control (manage) reported net income They want income to be informative about effort

Criteria for Standard Setting For a successful accounting standard: Decision usefulness Reduce information asymmetry Economic consequences benefit > social cost Acceptable to constituencies

Conflicts and Compromises in Standard Setting Difficulties faced by IASB in developing IAS 39 (AASB 139) illustrate extent of constituency conflict in standard setting Concerns of several constituencies European Central Bank European Union carveout Danish regulators Association of Corporate Treasurers IASB compromises Macro hedging Restrict fair value option

Conflicts and Compromises in Standard Setting Concerns about Fair Value accounting in the banking sector Volatility in fair value, especially to long-term lending Reliability of fair value for bank loans proper market? Mathematical model? Revaluation gain from the deterioration of own credit risk Not conservative accounting practice Result: “carved out” fair value option and strict provision for hedging in IAS 39

Conflicts and Compromises Other comprehensive income Items included Unrealized gains and losses on available-for-sale securities Unrealized gains and losses on cash flow hedges Rationale To secure management constituency’s acceptance of fair value accounting

Example: Other Comprehensive Income (two options for presentation) Presented with Income Statement Net income from operations xxx Extraordinary items xxx Net income xxx Other comprehensive income xxx Comprehensive income xxx Or, Alternative Presentation As part of statement of changes in shareholders’ equity Less transparent, especially if securities markets not fully efficient Firms’ choice of alternative has information content for investors

Rules v Principles Rules-based standards Principles-based standards Lay down detailed rules Possible? Principles-based standards General principles to be applied Auditor professional judgment to prevent opportunistic manager behaviour

International Integration of Capital Markets Increasing adoption of IASB standards Some examples European Union, 2005 China, Japan (partially) Australia, 2005 Canada, from 2011 United States? Allows foreign companies under SEC jurisdiction to report using IASB standards without reconciliation, 2007 Norwalk Agreement to work towards standards convergence

International Integration of Capital Markets Effect of customs and institutions Code law countries Greater influence of families and banks in corporate governance than in common law countries Lower moral hazard problem Shows up as less timely and less conservative reporting, even if country has adopted IASB standards Implication that investors should be aware of local practices and customs when interpreting financial statements, even if country uses IASB standards

International Integration of Capital Markets Role of auditor Even high quality standards must be enforced Protection of small investors Moral hazard problem switches to one between an entrenched controlling interest and small investors Auditor may be under great pressure from controlling interests Some evidence that auditors succumb to this pressure Guedhami & Pittman (2006)

International Integration of Capital Markets Benefits of high quality accounting standards Better working securities markets Higher earnings quality More foreign investment

International Integration of Capital Markets Should standard setters compete? e.g., if firms could choose between IASB & FASB standards Race to the bottom? Race to the top? (Problem 13.7) Firms could signal commitment to high quality reporting by choosing the higher quality standards Do benefits of competition outweigh increased costs of allowing 2 sets of standards?

Conclusions Interest group theory better explains the current accounting regulation Stricter regulation follows each major market failure Accounting standard setting is a political process involves conflicts and compromises International accounting standards should be carefully implemented to be effective