Chapter 4: The Economics of Financial Reporting Regulation Accounting Theory ( 5th edition) Wolk, Tearney & Dodd Copyright March, 2000 Chapter 4: The Economics of Financial Reporting Regulation Financial reporting unregulated regulated Political and economic nature of the regulatory process Economic consequences of accounting standards Chapter 4: The Economics of Financial Reporting Regulation

Unregulated financial reporting Laissez faire Agency theory explains why incentives exist for voluntary reporting to owners Signaling theory explains wider voluntary reporting to the capital markets

Agency Theory Views the firm as a nexus of agency relationships and seeks to understand behavior by examining how parties maximize their own utility Management-Owner agency relationship Potential conflict between goals of two groups Financial reporting may mitigate conflicts

Signaling Theory Voluntary disclosure is necessary in order to compete successfully in the market for risk capital A good reputation with respect to financial reporting will improve a firm’s ability to raise capital Good reporting would lower a firm’s cost of capital Less uncertainty about firms that report more extensively and reliably Less investment risk and a lower required rate of return

Signaling Theory Economic incentive to report (even bad news) is at the heart of the argument for voluntary financial reporting Information asymmetry between the firm (insiders) and outsiders (investors)

Regulated Financial Reporting Can be justified on the grounds that it is in the public interest Possibility of market failure Possibility that free markets are contrary to social goals Creates fairness in the market Less wealth transfers between those who have information and those who do not Principle behind the insider trading regulations

Possibility: Market Failures Firm as a monopoly supplier of information Failure of financial reporting and auditing to prevent frauds and bankruptcies Public-goods nature of accounting information and financial reporting Public goods are underproduced in a market economy Consumers of public goods without paying for them are called free riders (results from an externality)

Possibility: Contrary to Social Goals Involves a normative judgment about how society should allocate its resources SEC assumes that the stock market will be fair only if all potential investors have equal access to the same information Goal is information symmetry Referred to as fair reporting

The Regulatory Process Essentially a political activity Due process is an important ingredient Tradition goes back to the Interstate Commerce Commission (ICC), one of 1st federal agencies Seeks to involve all affected parties in the deliberations Maintains legitimacy of the regulatory process

Accounting Theory ( 5th edition) Wolk, Tearney & Dodd Copyright March, 2000 Regulatory Behavior Capture theory The group being regulated eventually comes to the regulatory process to promote its own self-interest Result is that the regulatory process is considered captured Life-cycle theory Argues a regulatory process goes through several distinct phases Starts out in the public interest, but later becomes an instrument of protecting the regulated group Capture theory and life-cycle theory have been applied to the regulation of accounting. 1976-78 the US Congress investigated the allegation that accounting regulation had been captured by the Big 8 group of accounting firms. 3 groups affected by accounting regulation Companies: regulation imposes costs on companies; therefore, one can argue that firms will oppose new regulations due to additional costs imposed Auditors: likely to oppose regulation that increases the riskiness of audits and the associated possibility of litigation. Free riders: analysts have a strong demand for more information. They make money by summarizing all the information for sale. Chapter 4: The Economics of Financial Reporting Regulation

Economic Consequences of Accounting Standards Accounting policy Not simply a matter of economic efficiency Also affects income and wealth distribution FASB Considers cost-benefit of standards Standards One set for all firms Compliance costs are disproportionately high for smaller, nonpublicly traded forms

Chapter 4: The Economics of Financial Reporting Regulation Accounting Theory ( 5th edition) Wolk, Tearney & Dodd Copyright March, 2000 Chapter 4: The Economics of Financial Reporting Regulation financial reporting unregulated regulated political and economic nature of the regulatory process economic consequences of accounting standards Chapter 4: The Economics of Financial Reporting Regulation