Copyright © 2009 by Pearson Education Canada Chapter 13 Standard Setting: Political Issues

Copyright © 2009 by Pearson Education Canada Chapter 13 Standard Setting: Political Issues

Copyright © 2009 by Pearson Education Canada Two Theories of Regulator Behaviour Public Interest Theory –Objective of regulator is to maximize social welfare Interest Group Theory –Regulator takes own interests into account, while balancing demands of investors and managers –Implies conflict between constituencies Standard setters’ emphasis on due process suggests that interest group theory best applies

Copyright © 2009 by Pearson Education Canada Conflict and Compromise Another example of economic consequences –Difficulties faced by IASB in developing IAS 39 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

Copyright © 2009 by Pearson Education Canada 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 »Continued

Copyright © 2009 by Pearson Education Canada Other Comprehensive Income (continued) 2 alternative presentations –Presented with Income Statement Net income from operations xxx Extraordinary itemsxxx Net incomexxx Other comprehensive incomexxx Comprehensive income xxx –Alternative Presentation As part of statement of changes in shareholders’ equity »Continued

Copyright © 2009 by Pearson Education Canada Other Comprehensive Income (continued) Firms’ choice of alternative has information content for investors –Theory in Practice 13.1

Copyright © 2009 by Pearson Education Canada Rules-Based v. Principles-Based Accounting Standards Rules-Based Standards –Lay down detailed rules –Possible to lay down rules for everything? Recall Hobbes, text Section 1.3 Principles-Based Standards –Lay down general principles –Auditor professional judgement relied on to prevent opportunistic manager behaviour when applying the principles

Copyright © 2009 by Pearson Education Canada Criteria for Standard Setting Decision usefulness Reduction of information asymmetry Economic consequences –Benefits > social costs Acceptable to constituencies

Copyright © 2009 by Pearson Education Canada 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 »Continued

Copyright © 2009 by Pearson Education Canada International Integration of Capital Markets (continued) 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 »Continued

Copyright © 2009 by Pearson Education Canada International Integration of Capital Markets (continued) 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) »Continued

Copyright © 2009 by Pearson Education Canada International Integration of Capital Markets (continued) benefits of high quality accounting standards –Better working securities markets –Higher earnings quality –More foreign investment »Continued

Copyright © 2009 by Pearson Education Canada International Integration of Capital Markets (continued) 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?

Copyright © 2009 by Pearson Education Canada Summing Up Information asymmetry is basic reason for financial reporting –Adverse selection –Moral hazard Fundamental problem of financial accounting theory –Best information system to control adverse selection not necessarily the same as best system to control moral hazard –Leads to constituency conflict –Standard setters must mediate this conflict

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