WRS, Xiamen, January 6/07 1 OUTLINE CURRENT TOPICS IN FINANCIAL REPORTING –Revised conceptual framework project –Securities market efficiency & investor rationality –Conservatism –Manager compensation aspects of corporate governance

WRS, Xiamen, January 6/07 2 REVISED CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING What is a conceptual framework? Joint IASB/FASB project to revise –IASB discussion paper, July, 2006

WRS, Xiamen, January 6/07 3 IASB DISCUSSION PAPER, JULY 2006 Reaffirms decision usefulness Hurdle rate for reliability Rejects conservative accounting –Prefers unbiased accounting Rejects contracting and motivation of management as roles for financial reporting –Some recognition of stewardship –Managers “outside” of reporting system –Standard setting a process of conflict resolution

WRS, Xiamen, January 6/07 4 ACCOUNTING STANDARDS IN CHINA Who sets accounting standards in China?

WRS, Xiamen, January 6/07 5 SECURITIES MARKET EFFICIENCY AND INVESTOR RATIONALITY I (N.A. PERSP.) Most would agree that securities markets are not completely efficient Efficient market anomalies in accounting: –Post-announcement drift –Accruals anomaly Efficiency a matter of degree, however Most would agree that securities markets are close to full efficiency?

WRS, Xiamen, January 6/07 6 SECURITIES MARKET EFFICIENCY AND INVESTOR RATIONALITY II Accountants gaining a better understanding of why anomalies persist –Inflation –Conservative accounting –Investor sophistication –Limits to arbitrage Cost Idiosyncratic risk

WRS, Xiamen, January 6/07 7 SECURITIES MARKET EFFICIENCY AND INVESTOR RATIONALITY III A more basic question –Is average investor behaviour better described by rational decision theory or behavioural characteristics? –Brav & Heaton, Rev. Fin. Studies (2002) Relax assumptions of stationarity and rational expectations. Estimation risk created. Bayesian learning over time Generates return dependencies similar to those generated by behavioural characteristics

WRS, Xiamen, January 6/07 8 SECURITIES MARKET EFFICIENCY AND INVESTOR RATIONALITY IV Suggests rational decision theory and behavioural theories of investor behaviour moving closer together Bounded rationality? Role of financial reporting –Full disclosure Helps overcome investor irrationality, or Speeds convergence to new equilibrium

WRS, Xiamen, January 6/07 9 HOW EFFICIENT ARE CHINESE CAPITAL MARKETS The Economist, Oct. 05, 2006: –“China’s stockmarkets” Difference in price between A and H shares Another efficient market anomaly?

WRS, Xiamen, January 6/07 10 Conservatism in Accounting Empirical evidence of increased conservatism Conceptual framework rejects conservatism as biased Collision course between practice and standards? Probably not: –Some conservative scope in framework Unbiased conditional conservatism, ceiling tests Hurdle rate for reliability may encourage conservative revenue recognition

WRS, Xiamen, January 6/07 11 Reasons for Conservatism in Accounting Contractual/governance –Debt covenant hypothesis –Bonus plan hypothesis Legal liability/regulatory –Few investor lawsuits for understatement errors –Investor loss results from inability to optimally plan consumption over time –Concave investor utility function generates loss asymmetry

WRS, Xiamen, January 6/07 12 FINANCIAL STATEMENTS AS A POINT ESTIMATE OF FIRM VALUE I Accountant’s reporting alternatives –Report whole distribution—not feasible –Minimize expected legal liability Implies downward bias Do liability awards reflect investor utility losses? –Report unbiased estimate of firm value (fair value accounting), plus extensive supplemental risk information –Historical cost accounting?

WRS, Xiamen, January 6/07 13 FINANCIAL STATEMENTS AS A POINT ESTIMATE OF FIRM VALUE II Conclusion re conservatism –Accountants will continue to be conservative

WRS, Xiamen, January 6/07 14 CORPORATE GOVERNANCE Motivation of responsible manager performance –Managerial labour market Manager gets fired? Reputation Seems to be not enough to motivate. Why? –Monitoring of manager performance Performance measures –Earnings –Share price - Are managers compensated on the basis of earnings and share price in China?

WRS, Xiamen, January 6/07 15 SIMILAR STRUCTURE TO CAPITAL MARKETS RESEARCH Both have an underlying theory –Agency theory –Theory of the rational investment decision Both recognize information asymmetry –Moral hazard –Adverse selection Both have a competing theory –Power theory (Bebchuck et al) –Behavioural finance

WRS, Xiamen, January 6/07 16 DIFFERENCES FROM CAPITAL MARKETS RESEARCH Theory less developed –“Pump & dump” behaviour Empirical evidence more difficult –Manager’s outside wealth affects behaviour –Complicates theory testing

WRS, Xiamen, January 6/07 17 WAYS FOR FINANCIAL REPORTING TO MOTIVATE MANAGER PERFORMANCE I Dichotomize earnings Net income = manager responsible ± “luck” –Conceptual framework rejects –Not feasible? Conditionally conservative accounting? Full disclosure –Helps control earnings management –Reveals low persistence items

WRS, Xiamen, January 6/07 18 WAYS FOR FINANCIAL REPORTING TO MOTIVATE MANAGER PERFORMANCE II An extension of full disclosure –Effects of past writeoffs on current core earnings Efficient earnings management –Accrual reversals discipline earnings management –Disciplined earnings management can credibly reveal persistent earning power

WRS, Xiamen, January 6/07 19 WAYS FOR FINANCIAL REPORTING TO MOTIVATE MANAGER PERFORMANCE III Efficient earnings management, cont’ d. –To be credible, manager must have longer- run decision horizon –Have recent movements in North America away from ESOs to restricted stock lengthened manager decision horizon? Needs research

WRS, Xiamen, January 6/07 20 IMPLICATIONS FOR CHINA I Assume want market economy Adoption of IASB standards –Be cautious, high quality standards do not solve all reporting problems Motivation of responsible manager performance an equally important role of financial reporting as enabling proper operation of capital markets Full disclosure contributes to both markets

WRS, Xiamen, January 6/07 21 IMPLICATIONS FOR CHINA II Ways to encourage full disclosure –Regulations and penalties –Conceptual framework –Signal –Accounting profession –Accounting professors