Arjun, Emily, Kira, Rajesh and Yun
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The problem of market failure is fundamental
Information asymmetry which creates the
demand for information production by firms
also creates a demand for regulation of that
information production.
◦ Problem is caused by unanimity
1.
The Public Interest Theory
2.
The Interest Group Theory

Suggests that regulation is a response to
public demand for correction of market
failures.
◦ The regulator is assumed to have the best interest
of society at heart.
◦ Regulation is viewed as a tradeoffs between its
costs and its social benefits

Problems arise with its implementation
1. Very complex task of deciding on the right amount
of regulation (this is particularly true for a
commodity like information where it is effectively
impossible to please everyone)
2. The other serious problem lies in the motivation of
the regulator

This theory was introduced by Stigler (1971)
◦ Stigler takes the view that an industry operates in the
presence of a number of interest groups
◦ These interest groups are thought of as “demanders of
Regulation”

Becker(1983) application of Coase Theorem
◦ Coase theorem: If bargaining costs are too high for
parties to contract , an appeal to government to step is
impossible.
◦ Becker views interest groups as competing for and
against regulation
 The outcome depends on which group is relatively most
effective in applying pressure on the regulator
◦ Interest groups are assumed to be rational

The theory makes several predictions
1. Creation of standard setting bodies
2. Activities subject to market failure are more likely
to be regulated due to demand from groups
adversely affected
3. Due process
- For example, exposure drafts and board
representation

Interest Group Theory... But why?
◦ Market forces cannot always be relied upon to
generate the right accounting standards and
procedures
◦ Complexities resulting from diverse information
needs and interest of investors and managers make
it effectively impossible for standard setters to
calculate the right accounting standards.
◦ Choice of accounting standards is better regarded
as a conflict between constituencies
***Interest Group Theory formally recognizes the
existence of conflicting constituencies


proposed fair value accounting for major
classes of financial Instruments
Fair value accounting , however has long
been opposed by financial institutions, in
particular the banking industry. Since
financial institutions are heavy users of
financial statements, and are crucial to the
operation of the economy, the view of this
important constituency cannot be ignored

In this regard the European Central Bank
issued a comment in November 2001 entitled
“Fair Value Accounting in the Banking Sector”
The Bank Expressed four general concerns:
◦
◦
◦
◦
1)
2)
3)
4)
Short Run, Long Run
Reliability of Fair Values for Bank Loans
own credit risk
Conservatism
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

A further complication of standard setting is
the distribution of the benefits of information
production among interest groups.
Value judgements about who is entitled to
property rights arise because individual
utilities cannot in general be aggregated into
a social preference ordering.
That is the two theories are intertwined.


Standards should be decision useful, but
should also be useful for other parties, such
as management.
This puts Standard Setters at a conflict
situation since it is difficult to determine the
right solution to satisfy all parties.

There are 4 main criteria:
◦
◦
◦
◦
Decision Usefulness
Reduction of Information Asymmetry:
Economic Consequences of New Standards
The political Aspects of Standard Setting


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
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The success of a new standard is judged by its
decision usefulness.
Difficult to judge beforehand, since market hasn’t
had time to respond to the standard.
Theory of rational investor decision-making can be
used to predict decision usefulness.
However, as mentioned earlier, because accounting
information is a public good, we cannot be sure that
the standard has the greatest decision usefulness will
be the best for society.
Thus a standard could appear decision useful, yet
society would be worse off because the costs of
producing that information were not taken into
account.
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Standard setters should be aware of these forces and
take advantage of them, however market forces alone
are not enough to ensure that the right amount of
information is produced.
This is due to information asymmetry.
Standard setters should use reduction of information
asymmetry in capital and labour markets as another
criteria for new standards.
The public good nature of accounting information
helps in reducing information asymmetry.
Reduction of information asymmetry improves
operations of markets, because it gives investors the
perception of a level playing field.
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
One of the costs of a new standard is the cost
imposed on firms and managers to meet that
standard.
There are also indirect costs associated with new
standards.
The freedom of managers ability to choose from
different standards is another economic
consequence.
Also, some highly competitive industries don’t need
additional standards because competition induces
better discloser.
All these considerations suggest that standard setters
should weigh all the possible economic consequences
of a new standard.


Standard setters must have the ability to
come to a consensus strong enough that
even a party that doesn’t not like it will have
to along with it anyway.
The structure and due process of standardsetting bodies is designed to encourage such
a consensus. However, if the conflict
between parties is severe enough, a party
may even appeal to the political process.

In conclusion, all these criteria show that the
actual process of standard setting is best
described by the interest group theory rather
than the public interest theory.

Textbook comes to a focus on standard
setting
◦ Under ideal conditions accounting and reporting
standards are not needed
◦ Under ideal conditions one can question whether
financial accounting is needed at all
◦ Such conditions do not exist
 Financial accounting becomes much more challenging.


Information asymmetry is a major challenge
Two types:
1. Adverse Selection

Challenge is to convey information from inside to
outside the firm



Improve investor decision-making
Limit the ability of insiders to exploit their
information advantage
Enhancing the operation of capital markets
2. Moral Hazard
 Challenge is to provide an informative measure of
managerial performance.
 enables incentive contracts to motivate manager effort,
protect lenders, and inform the managerial labour market

Investors need decision-relevant information
to help them predict future firm performance
◦ Current Value-Based Information
◦
 Generally the best predictors of future values
 Problems of volatility
 Possible low reliability
Historical Cost Accounting/Conservative
Accounting


Less subject to problems of measuring manager
performance
Current value- and historical cost based
accounting must be traded off

Need for financial reporting to fulfill a dual
role of meeting investors’ information needs
and the needs of efficient contracting
◦ Creates the fundamental problem of financial
accounting theory
◦ Standard setter must then seek a compromise
between conflicting interests
 The structure of standard-setting bodies is designed
to facilitate such a compromise


The need for international accounting
standards will continue to expand
Difficulties in standard setting will increase
◦ New constituencies arise representing different
levels of economic development, business
practices, and cultures

Standard-setting bodies, and investors, will
have to adapt to take these additional
challenges into account.


Canada has long been a strong advocate of
International Accounting Standards(19661975)
Canada was one of the founding member of
the International Accounting Standards
Committee (1973)

CICA’S Accounting Research Committee
expressed commitment to IASC to harmonize
accounting standards
◦ Minimize differences between the International
Accounting Standards and the corresponding
recommendations set in the CICA Handbook

Canadian vs. United States
Standards
◦ Significant issue many Canadian
companies have: US patents or
investors, as well as significant
operations in the US

CICA’S Accounting Research
Committee expressed
commitment to IASC to harmonize
accounting standards
◦ Increased globalization of markets
increases demand for greater
uniformity in the standards

Long term objective: Single set of
high quality standards that will be
internationally accepted

Two recommendations:
1.
2.
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Each of the three standard setters bodies commit to a
continuing program of liaison and mutual involvement
Standard setter committee be established and initiate and
attaining cooperative effort
Top 10 major areas in which there were significant
differences in standards:
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◦
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1) Effects on Changing Prices
2) Business Combination
3) Consolidation and Equity Accounting
4) Foreign- currency translation
5) Income Taxes
6) Earnings per share
7) Post Retirement Benefits
8) Pension Accounting
9) Investments
10) Research and Development
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Significance changes since
1995 to reduce differences in
standards between Canada and
US
However: differences still
remain in the following areas:
◦ Consolidation and Equity
Accounting
◦ Investments
◦ Research and Development Costs
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Canada, Chile, Mexico and US meet annually with
the mission to provide the overall quality and
comparability of accounting standards
To accomplish this mission the committee with
need to:
◦ Promote comparability of accounting standards
◦ Consider existing significant areas of difference in
standards
◦ Develop recommendation on what specific efforts should
be taken to reduced through existing significant
differences
◦ Monitor progress towards the elimination of significant
differences in standards
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Group_E_Chapter_13_Presentation