Standard-Setting:
Political Issues
306-684 Financial
Accounting
Seminar 11
1
Learning Objectives
1 To understand relevant theories put
forward to explain regulation
2 To review the history of accountingpolitics relationship
3 To discuss/debate what constitutes a
“good” accounting standard
4 To assess the impact of globalisation on
the standard setting
2
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
3
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?
4
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
5
Theories of Regulation:
• What theories do we have to
explain the government
intervention in the market for
accounting information?
6
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
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Public Interest Theory
• These factors will all lead to the undersupply 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
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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?
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Interest Group Theory
• Governments are not neutral: politicians
and regulators are also rational and selfinterested
• 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
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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
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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?
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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!
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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
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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
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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
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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
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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?
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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
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Criteria for Standard Setting
• For a successful accounting standard:
– Decision usefulness
– Reduce information asymmetry
– Economic consequences
• benefit > social cost
– Acceptable to constituencies
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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
21
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
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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
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Example: Other Comprehensive Income
(two options for presentation)
• Presented with Income Statement
–
–
–
–
–
Net income from operations
Extraordinary items
Net income
Other comprehensive income
Comprehensive income
xxx
xxx
xxx
xxx
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
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Rules v Principles
• Rules-based standards
– Lay down detailed rules
– Possible?
• Principles-based standards
– General principles to be applied
– Auditor professional judgment to prevent
opportunistic manager behaviour
– Possible?
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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
26
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
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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)
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International Integration of
Capital Markets
• Benefits of high quality accounting
standards
– Better working securities markets
– Higher earnings quality
– More foreign investment
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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?
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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
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