Chapter 13: Summary
This chapter aims to establish that standard setting is political, not just
economical. This is demonstrated by the fact that information asymmetry (moral hazard
and adverse selection) creates demand for information and because the information that
firms would produce privately will not equal the demand of investors, information
asymmetry creates demand for the regulation of information. Thus, the regulation of
information is a political process.
There are two theories of regulation. Public Interest Theory emphasizes that
regulation should maximize social welfare and that regulation is the result of a
cost/benefit analysis done to determine if the cost to improve the operation of the market
outweighs the amount of increased social welfare. Two problems with public interest
theory are (1) different theories arise regarding how much regulation is optimal, and (2) it
is difficult for the legislature to ensure the regulator is acting in the public’s best interest
and not its own.
These problems lead to the Interest Group Theory, which emphasizes that
individuals form groups to protect their interests in regulation by lobbying. Some interest
groups are demanders of regulation and the legislature is the supplier of regulation. The
legislature is also another interest group that seeks to retain power by “supplying”
regulation to those “demanders” who will help them retain power. The regulatory body
attempts to balance the interests of the different groups. The Interest Group Theory is a
better indication of how regulation is actually made.
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In both the United States and Canada, standard setting is a political process with
many constituencies involved and it involves numerous steps, indicating due process in
the establishment of a new standard.
In Canada, by authorization of the Board of Governors of the CICA, the
Accounting Standards Board (ASB) and the Auditing Standards Board (AuSB) are
permitted to set accounting and auditing standards that are found in the CICA Handbook.
To make it independent from the CICA, the ASB creates standards on its own authority.
A new standard requires the approval of at least 2/3 of the board members to ensure that
it will be more than only marginally acceptable and that the minority will be able to force
a compromise. Membership on the ASB is voluntary and 2/3 of members must also be
members of the CICA. Since the CICA is largely made up of representatives of CA firms,
interest groups other than CA firms are largely underrepresented on ASB. Possible ways
to make standard setting in Canada more representative include having full-time paid
employees of ASB and discontinuing the use of ASB and adopting the GAAP of FASB
in the U.S. or the IASC, internationally.
ASB’s standard setting process is slow, which reduces its ability to respond
quickly to new issues. The Emerging Issues Committee (EIC) increases timeliness by
having the EIC provide a timely review of emerging accounting issues.
The Ontario Securities Commission regulates all securities trading in Ontario,
including the exchanges on which they are traded. The authority of the OSC is given by
the Securities Act. An order made by the OSC may be enforced as would any order or
judgment in a court. The OSC is comprised of commissioners who are selected by the
Lieutenant Governor and appointed for a three-year term. In 1978 the Securities Act
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recognized the CICA Handbook as the appropriate authority for financial reporting
standards.
In the United States the Financial Accounting Standards Board (FASB) was
created in 1973, and it attempts to establish and improve standards for financial
accounting and reporting by focusing on consistency and comparability, updating
standards along with changes in the environment, and improving public understanding of
financial information. The FASB is guided by objectivity in decision-making, the
consideration of constituents’ views, a cost/benefit analysis for new standards,
implementation of changes in a way that minimizes disruption and a review and
amendment of past decisions.
The FASB is the operational component of a three part organizational structure,
which includes the Financial Accounting Foundation (FAF) and the Financial
Accounting Standards Advisory Council (FASAC). The FAF raises funds for all three
groups, appoints FASB and FASAC board members, and reviews FASB performance.
The FASAC acts as a liaison between FASB and the business and economic
communities. The FASB itself is comprised of seven board members who serve for a
maximum of two five-year terms. A 5/7 majority is needed when passing a new
standard.
When setting and reporting standards, there is emphasis on due process. The
process includes the following stages: preliminary evaluation of problems, admission to
the agenda of FASB, early deliberations, tentative resolution, further deliberations, final
resolution, and subsequent review.
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The Securities Exchange Commission (SEC) was founded in 1933 to regulate
the trading of securities in multiple states and securities of certain sizes. It is responsible
for ensuring the FASB provides investors with adequate information.
The International Accounting Standards Board (IASC) was established in 1973 by
agreement between the accounting bodies of several countries. The objectives of IASC
are to publish worldwide accounting standards in the public and to improve the
harmonization of regulations, accounting standards and procedures. The process is
characterized by due process, and includes the selection of a new topic, an exposure draft
prepared by a steering committee and accepted by 2/3 of members, and a draft
International Accounting Standard that must be accepted by 3/4 of members. The IASC
does not have the power to enforce compliance to their standards and thus adoption is
voluntary; however, there is growing acceptance and use
As is demonstrated by the standard setting processes in Canada, the U.S. and the
international community, the structure of the regulatory bodies is characterized by due
process. That is, many constituencies are represented, there are provisions for hearing
and exposure drafts, and support that is usually above majority rule is needed for a new
standard. This indicates that standard setting is conflict-based, therefore it is based on
interest group theory. The acceptance of a standard depends on the extent to which a
constituency feels its views were heard and considered
The standard setting process is characterised by conflict and compromise. An
example of constituency conflict is the discussion surrounding SFAS 115, a standard that
said some securities must be at fair value; that is, market value if available, otherwise use
present value or other models. To understand the conflict, one should first consider FULL
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marking to market. The banks are against it, because of an increased volatility of earnings
and decreased ability to do earnings management. The U.S. Treasury is against it,
because it thought that banks would be unwilling to lend long-term, decreasing the
amount of credit available in the economy. The Securities Exchange Commission (SEC)
is for it, because it conveys fair value to investors. Therefore, compromises were made
that resulted in the current SFAS 115. Note: This did not eliminate gains trading but
constraints were put on it afterward.
An example of compromise is Comprehensive Income, which is a compromise
between investors’’ needs and managers’ needs. It says that there can be two net incomes,
one that does not include items deemed to be beyond management control, for
compensation purposes, and one that includes items beyond management control, for
investors.
There are two criteria that should be used for standard setting. First, a standard
should show decision usefulness, that is, the new standard should improve the
informative nature of a firm’s information systems, but not to an extent that it outweighs
the extra cost to society. Also, the standard should reduce information asymmetry, that
is, the new standard should create a level playing field regarding who has access to
information.
The economic consequences of standard setting suggest that the cost to firms and
managers to meet the standards must not be too great or it may reduce the extent to which
the public forces information. It is also obvious now that standard setting is political, in
that standard setting is a “balancing act” among constituencies that focuses on due
process.
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Chapter 13: Quiz
Multiple Choice
1) Which of the following is false regarding the public interest theory of regulation?
a) The task of deciding on the right amount of regulation is complex.
b) Public interest theory is a second-best approach to regulation.
c) Regulation is the result of a public demand for correction of market
failures.
d) All of the above
e) None of the above
2) While decision usefulness is a necessary condition for the success of a new
standard it may not be sufficient enough to ensure success because:
a) We cannot be sure that the standard with the greatest decision usefulness
is the best for society.
b) The costs of producing the information may outweigh the benefits.
c) A standard may appear to be decision useful when it is not
d) a and c only
e) a and b only
f) All of the above
3) Which of the following statements in not true regarding the Accounting Standards
Board?
a) New standards require at least two-thirds of the board members approval.
b) At least two-thirds of the board members must be members of the CICA.
c) The Accounting Standards Board publishers accounting standards under
the authority of the CICA.
d) All of the above
e) b and c only
4) Which of the following should you consider if you were to set a new accounting
standard?
a)
b)
c)
d)
e)
The economic consequences of the standard
The decision usefulness of the standard
Whether there is consensus regarding the standard
a and b only
All of the above
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Short Answer
1. What are two problems with the public interest theory of regulation?
2. Which theory of regulation, the public interest theory or the interest group theory,
best represents how regulation really works and why?
3. What is the Emerging Issues Committee? What function does it fulfill?
4. The article below by Grace Hinchman reproduced here from Financial Executives
(September 2001) describes the controversy surrounding accounting for stock
options:
Fasten Seat Belts: Bumpy Ride For Stock Option Accounting
By Grace Hinchman, Financial Executives Magazine
We are about to embark on another round of potent political opposition against
the seemingly mundane process of accounting standards. Stock options accounting is
about to be revisited by the new International Accounting Standards Board (IASB),
the body created to establish global accounting rules.
The IASB is without a full appreciation of the 1994 political firestorm that
resulted in the United States when the Financial Accounting Standards Board
proposed its Exposure Draft 127-C, "Accounting for Stock-Based Compensation."
Beginning in late 1993 and through '94, the FASB was under siege from protests over
this Exposure Draft, which resulted in more opposition than any other change the
board has made since it was founded in 1973.
The political and business opposition was swift, concentrated and complete.
Grassroots letter writing campaigns were organized by a hi-technology business
coalition that included International Business Machines Corp., Apple Computer Inc.,
McDonald's Corp., the National Venture Capital Association, the American
Electronics Association (AEA) and several smaller technology firms. Congressional
oversight hearings were conducted, during which FEI expressed its serious concerns.
Legislation introduced by Sen. Joseph Lieberman, D-Conn., S. 1175, the "Equity
Expansion Act," proposed an alternative approach to stock options that would have
made options exempt from the FASB proposal. There was a similar bill introduced in
the House of Representatives.
Eager to be responsive to their constituents, several members of the House and
the Senate supported a "Sense of Congress Resolution" introduced by Rep. Anna
Eshoo, D-Calif. and former Sen. Bill Bradley, D-N. J. Although such a measure lacks
statutory authority, it did express congressional concern about the FASB Exposure
Draft. The Senate Resolution was never voted on because the FASB backed down
from its proposal, but there were more than 60 votes in the Senate to support the
Resolution.
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The opposition to the FASB went to such lengths, including organizing a good
old-fashioned labor union rally. During the FASB public hearings in San Jose, Calif.,
more than 4,000 hi-tech employees rallied at a nearby conference center to oppose the
stock options proposal and signed petitions intended for their Congressional
delegations. Led by a marching band, the employees were addressed by state officials
and federal legislators opposing the FASB proposal. The national print media covered
the event and stock options accounting became the hot topic on talk radio shows
throughout San Jose and San Francisco.
Opponents claimed that the proposal to charge stock options against earnings
would cost them, on average, 30 percent of annual earnings, according to a 1994
AEA survey - the inference being that such a fluctuation in earnings would mean the
demise of the "New Economy" engine that was fueling the U. S.' prosperity.
Obviously, no member of Congress wanted to be held responsible for killing the
goose that laid the "New Economy's" golden egg, so congressional opposition
continued to build.
After about eight months of unrelenting political heat, the FASB backed down
from its original Exposure Draft and abandoned its intention to require companies to
report as an annual expense the value of stock options in favor of additional
disclosures. Bowing to political pressure and corporate opposition, former FASB
Chairman Dennis Beresford acknowledged that the threat of congressional
intervention heavily influenced the FASB's decision. James (Jim) Leisenring, thenFASB vice chairman, and a disciple of stock option expensing, emphasized that the
Board had not altered its position that stock options have value, and that their value
can be estimated and included on financial statements, but the threat of Congress
taking this matter into their own hands was a factor to shelve further consideration of
the issue.
Today, Jim Leisenring is a member of the IASB and his strongly held position
that stock options should be charged against earnings has not wavered. In addition,
IASB's Chairman Sir David Tweedie believes that investors are ill served by existing
regulations for stock options. The combination of these two IASB members, coupled
with the hi-technology industry's ability to re-ignite its swift and concentrated
political opposition - as witnessed almost seven years ago - will make the new IASB's
priority agenda indeed a very bumpy ride.
Required
a) List the constituencies named in the article that have an interest in stock-based
compensation accounting.
b) In the article it states that the former FASB chairman Denis Beresford admitted
that the original Exposure Draft regarding stock-based compensation accounting
was abandoned in part because of fears of congressional intervention. Is this fear
justified? Why or why not?
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Answers
Multiple Choice
1) b 2) f 3) c 4) e
Short Answer
1. Two problems with the public interest theory of regulation are:
i.
With a complex commodity such as information it can be a very
complicated task to decide of the right amount of regulation, as it is
virtually impossible to please everyone involved.
ii.
The motivation of the regulatory body is a second problem with the public
interest theory as it may be difficult to prevent the regulatory body from
acting in their own best interests instead of the publics.
2. The interest group theory best represents a real world situation regarding
regulation and would be the best predictor of how regulation really works. This is
because it takes the view that regulators try to maximize their own welfare while
at the same time balancing the demands of various constituencies. This theory
represents real circumstances more clearly than the public interest theory does
because the public interest theory views the regulators as trying to maximize
social welfare and does not account for the fact that regulators have their own
interests and goals that may interfere with the publics interests.
3. The emerging issues committee was established in 1988 by the Accounting
Standards Board it consists of 14 voting members and it provides a forum for
timely review of accounting issues that are likely to receive differing or
inadequate handling in public practice in the absence of some guidance. The
emerging issues committee is able to address issues in a timely manner and this is
important because it could take years for the issue to be put before the Accounting
Standards Board for review.
4.
a)






High Technology Business Coalition
Various delegates in the House of Representatives
Various members of the Senate
Labor unions of hi-tech employers
Various State Officials
Various Federal Legislators
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b) Yes the fear of congressional intervention is warranted by the FASB. Although
intervention in the exception to the rule the FASB has received intervention in the
past with SFAS 19. SFAS 19 was a statement requiring oil and gas companies to
use successful efforts accounting and disallowed full cost accounting. In this
instance the SEC overrode FASB and allowed both methods to be used for
financial reporting. Intervention such as this erodes the publics as well as the
business community’s confidence in the FASB’s ability to be a competent
standard setter.