1. Standard Setting: Political Issues
Geoffrey Jones, Spencer Steckley, John MacFarlane, Joel Zhang, Ellen Truong, Lucy Zhang, Manjeet Warha

2. Agenda Two Theories of Regulation
Conflict and Compromise: An Example of Constituency Conflict
Distribution of the Benefits of Information, Regulation FD
Criteria for Standard Setting
The Regulator’s Information Asymmetry
Case Study: On A Mission For Harmony
Chapter 12 is primarily concerned with the size (net of costs) of the information pie – the larger the pie, whether generated by market forces or regulation or both, the better for society. However, distribution of the benefits of information production between constituencies further complicates standard setting, since constituency interests often conflict. In setting standards, the interests of managers, small investors, large investors and others must be traded off. Value judgements about these tradeoffs are difficult to make
These considerations suggest that standard setting is fundamentally as much a political process as an economic one. And this chapter will dive into how exactly the pie is divided up between the different constiuencies

3. Two Theories of Regulation

4. Public Interest Theory
Regulation is a response to public demand for correction of market failures
The regulator is to have the best interest of society at heart
Problems with this theory
Very complex task of deciding how much regulation
It is very difficult to monitor the
regulators performance
Much less fewer consequences
if the regulator shirks
Public Interest Theory: Regulation is a response to public demand for correction of market failures, the regulator is to have the best interests of society at heart, and the view that regulation should maximize social welfare.

5. Interest Group Theory
The industry operates in the presents of interest groups
Groups will lobby for the regulation or deregulation of the industry
The group that spends the most and its effectiveness will achieve their desired regulations
Each group must take the expenditures of the other groups into account
Interest Group Theory: The industry operates in the presence of a number of interest groups, and these groups will form coalitions or constituencies to protect and promote their interest by lobbying the government.

6. Interest Group Theory - Predictions
To overcome free riding, investors support the creation of standard setting bodies with representatives.
Activities subject to market failure are more likely to be regulated, due to demand from groups adversely affected.
Due process: The legal requirement that the state must respect all of the legal rights that are owed to a person

7. Which Theory of Regulation Applies to Standard Setting?
Public Interest Theory is very difficult to implement.
The choice of accounting standards is better regarded as a conflict between constituencies than as a process of calculation.
Interest Group Theory recognizes the existence of conflicting constituencies.
Interest Group Theory is a much better predictor of new standards than the public interest theory.

8. Conflict and Compromise: An Example of Constituency Conflict

9. IAS 39 Interest groups Development of new standard Jan 2001
Fair value accounting
Financial instrument

10. Banking industry Heavy user of financial instruments
Operation of the economy
European Central Bank
“fair value accounting in the banking sector”
4 general concerns – Nov 2011

11. 4 Concerns Less long term contracts Valuation issue Own credit risk
Conservatism

12. Less long term contracts
Long term loan
Interest rate risk
Bank reduce earning volatility
Reduce long term lending
Reduce investment
Reduce economic growth

13. Valuation issue Less reliable Need well-working market
Need adequate mathematical models
Credit derivative market not developed – 2011
Transparency
Comparability

14. Own credit risk Own debt Credit deteriorates Higher discount rate
Reduced fair value of debt
Recognize gain
Counter intuitive and misleading

15. Conservatism Unrealized gains and losses Prudent bank behaviour
Recognize unrealized losses only
Abandoning conservative accounting
Induce less prudent behaviour
Upset banking regulators

16. Immediate response Reduced volatility by Available for sale -> OCI
Held to maturity -> amortized cost

17. Criticisms 2004 Disguise deteriorating credit risk
Restrictive hedging provision
Earnings volatility

18. Favorites Denmark Mortgage loan Liability hedged by financial assets
If no full fair value option
Earning volatility

19. 2005 EU “carved out” the two issues Macro hedging on portfolio basis
Made it optional
Macro hedging on portfolio basis
Reduce complexity
Full fair value option
Restricted to reducing mismatches only

20. 2007 Market meltdown IFRS 9 Asset with predictable cash flow
Amortized cost
Smooth out volatility

21. EU response Relaxation of fair value Not far enough
Delayed introduction
But some companies adapted it anyways
Competitive advantage

22. Bottom line Standards cannot be set in vacuum
Must recognize existence of constituency conflict
If constituencies are not satisfied
They will appeal to the political process

23. Distribution of Benefits of Information, Regulation FD

24. Issue Distribution of information among interest groups
Selective Disclosure – Is a situation when a publicly traded company discloses material information to a single person, or a limited group of people or investors, as opposed to disclosing the information to all investors at the same time.
This created an uneven playing field for investors, allowing certain investors to profit from material market moving information before others.

25. Regulation FD (Fair Disclosure)
The intention of implementing Regulation FD was to put an end to the practice of “Selective Disclosure” of non- public information and to more closely define when insider trading liability arises in connection with a trader’s use of non-public information

26. Regulation FD (Fair Disclosure)
When an issuer, or person acting on its behalf (Public Company), discloses material nonpublic information to certain individuals (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information.
The timing of the required public disclosure depends on whether the selective disclosure was intentional or non- intentional
For intentional selective disclosure, the issuer must make public disclosure at the same time
For a non-intentional disclosure, the issuer must make public disclosure promptly

27. Regulation FD (Fair Disclosure)
Regulation FD fundamentally changed how publicly traded companies communicated with their investors by bringing more transparency and more frequent and timely communications in the market place

28. Criteria for Standard Setting

29. Decision Usefulness Must be of value to investors decision making
Investors may “overuse” financial information because they perceive it as “free”
Must balance cost of producing additional information with benefits gained from it
Must consider other criteria as well

30. Reduction of Information Asymetry
Reduction of Information Asymmetry through additional disclosures required by standards will:
Increase fairness in information distribution to all investors
Improve operation of markets (investors perceive more level playing field)
Reduce estimation risk
“Lemons” phenomenon
Expand market liquidity
Extent of IA for smaller firms is higher because less public information
Standards need to require just as much info from smaller firms than larger ones

31. Economic Consequences of New Standards
Cost imposed on firm & managers to meet standard
Contract rigidities  increased probability of violating debt covenants, managers’ bonuses
Release of proprietary information can reduce competitive advantage
Reduction in managers’ freedom to choose from different accounting policies  cannot use choice of policy to signal inside info

32. Political Aspects of Standard Setting
Standard setters must ensure consensus that all constituents will go along with it
Interest group theory of regulation:
Technical or theoretical correctness does not guarantee success of standard
Interest groups will offer strong resistance until they are satisfied
Due process ensures retractions are minimized
Too many retractions threatens existence of standard setting body

33. Regulator’s Information Asymmetry
Regulators face information asymmetry
Most information in hands of managers
Unable to observe manager’s efforts
As a result:
adverse selection
moral hazard

34. Laffont and Tirole Model
π = pq – C – t
Where:
π is profit - C is cost of producing information
p is cost of capital - t is manager’s total compensation
q is quality
t = X + Ψ (e)
Where:
X is excess contribution for managers who keep inside information
Ψ (e)= manager’s effort aversion
C = (β – e) q
Where:
β is firm-specific inside information
e is information-related effort by managers

35. Laffont and Tirole Model
π = pq – C – t
Managers assumed rational, risk-neutral and effort-averse
Higher q better information for investors  lower cost of capital
C = (β – e) q
Lower β means more inside information  lower C
Components of e:
designing and monitoring of financial reporting systems
dealing with Auditors
costs of signaling
managers could lower the cost of producing information by:
signaling costs
good earnings management
choice of accounting policies
adoption of information technology

36. Laffont and Tirole Model
Model is firm specific
Takes into account how firms have different β and cost of capital
Impact on regulations:
Regulations should be firm-specific – not effective to have general standards for all firms
Regulations should be flexible – business and manager characteristics are different across firms
Reducing inside information will help reduce excess

37. On a Mission for Harmony

38. Origin & Development of International Accounting Standards
IASC
CICA’s Accounting Research Committee
Harmonization standards internationally
Work with IASC to minimize:
Geoff Starts Here.
Canada along with United Kingdom and United States was a member of Accountants International Study Group and a founding member of International Accounting Standards Committee (IASC), established in 1973.
CICA’s Accounting Research Committee (predecessor to the Accounting Standards Board) expressed its commitment to the IASC’s objective of harmonizing accounting standards internationally
Willingness to work along with IASC to minimize differences between
International Accounting Standards (IASs) and
Corresponding accounting recommendations set out in CICA Handbook.
IASs
CICA

39. CICA Handbook – Section 1501
Summary of Differences covered in this section
March 1985 comparison discontinued & replaced by CICA publication, Financial Reporting in International Environment
Reintroduced to handbook as appendix to Section 1501
Appendix now updated to cover IASs issued up to June 30, : (IAS 1 – IAS 40)
Now First-time adoption by Not- for Profit organizations
In December 1995, commitment to IASC’s objective enshrined in Handbook Section 1501, “International Accounting Standards” Up until April 1981, a brief comparison of IASs with CICA accounting standards, setting out any major differences between two standards, periodically included in that section.
Financial Reporting in International Environment which was updated six times between 1985 and 1992.
In August 1996, comparison was reintroduced into CICA Handbook, in somewhat greater detail than had previously been provided as an appendix to Section 1501.
The appendix has now been updated to cover IASs issued up to June 30, 2000 (IAS 1 to IAS 40)
Currently, section 1501 is known as “First-time adoption by Not-for-Profit organizations” referring to the first changeover for these organizations to the international standards.

40. Uniformity of U.S. & Canadian Standards
With the reduction of options in IASs, compliance with both sets of standards by Canadian entities is unquestionably more difficult than it used to be.
Conformity with US standards is also a significant issue in Canada, particularly since many Canadian companies have:
US parents
US Investors
Significant operations in the US
Increasing globalization of markets, demand for greater uniformity in standards of two countries was inevitable

41. Standard Setting Bodies – Objectives
In Aug. 1992, accounting standard-setting bodies of North America:
CICA Accounting Standards Board
Comisión de Principios de Contabilidad of the Instituto Mexicano de Contadores Públicos AC
FASB in US
Sponsored 1st extensive joint study
NAFTA
They sponsored their first extensive and concerted joint study. It was the initial step in encouraging cooperation for progress in international harmonization among standard-setters in the three countries in the wake of NAFTA.

42. Standard Setting Bodies – Objectives
Analyze similarities and differences in accounting standards in 3 countries
Identify areas where progress might be made in harmonizing these standards
Provide users of financial statements with info that would enhance their ability to compare business enterprises in 3 countries.
Spencer Starts Here

43. Study Group Report – Differences
Significant differences in standards among Canada, Chile, Mexico, and United States:
Effects of changing prices
Business combinations
Consolidation and equity accounting
Foreign-currency translation
Income taxes
EPS
Post-retirement benefits
Pension accounting
Investments
R&D
When 1995 report was issued, the “top 10” major areas in which there were significant differences in standards among four countries were…
Business combinations, consolidation and equity method accounting, foreign-currency translation all covered in advanced accounting course.
Describe roughly each of these points.

44. Study Group- Second Objective
Set up a standing committee
resulted in the creation the American Free Trade Agreement Committee
for Cooperation on Financial Reporting Matters
Consisted of representatives from all 4 countries
Mission of committee was to:
improve the overall quality and comparability of
accounting standards
serve the information needs of users

45. Study Group- Second Objective Con’t
To accomplish its commitment the committee will act to:
promote the comparability of accounting standards
consider existing significant areas of difference in standards
develop recommendations on what specific efforts should be used to reduce existing significant differences in standards
identify potential significant areas of difference that might be created by proposed standards
consider work of other standard setters or other organizations
monitor progress toward elimination of significant differences in standards

46. THANK YOU FOR LISTENING!
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