1. Standard-Setting: Political Issues
Financial Accounting Seminar 11

2. 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

3. 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

4. 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?

5. 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

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

7. 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

8. 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

9. 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?

10. 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

11. 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

12. 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?

13. 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!

14. 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

15. 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

16. 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

17. 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

18. 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?

19. 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

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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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)

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

30. 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?

31. 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