1. 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

2. 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

3. 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

4. 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

5. 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)

6. 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

7. 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)

8. 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

9. 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

10. 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.
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

11. 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

12. 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