Financial Accounting Theory

Seventh Edition
William R. Scott

Chapter 13

Standard Setting: Political Issues

Chapter 13 Standard Setting: Political Issues
 13.2 Two Theories of Regulation

Public interest theory

Objective of regulator is to maximize social welfare
Interest group theory
Regulator takes own interests into account, while balancing demands of
investors and managers
Implies conflict between constituencies
Constituencies compete by lobbying the regulator to get what they want, taking
other constituencies lobbying into account
Benefits of regulation go to the most effective lobbying constituency
Standard setters emphasis on due process suggests that interest
group theory best applies
 13.3 Conflict and Compromise

An example of political conflict over accounting standards

Proposal for prudential oversight of accounting principles and standards
that pose systemic risk introduced into U.S. Congress, November, 2009
To create a Financial Services Oversight Council (FSOC) to monitor, modify and
possibly cancel new accounting standards
Proponents: American Bankers Association
Opposed: Investor protection associations, SEC, Chamber of Commerce, AAA
The compromise:
FSOC can only review and comment on new standards
>> Continued
 13.4 Regulation FD

Prohibits selective release of information, to help the little

guys and improve fairness of securities markets
Concerns about Regulation FD
Firms may release less information between earnings announcements,
to lower share price volatility
Increased share price volatility at date of earnings announcement
Did Regulation FD attain its goals?
Mixed empirical evidence, but some evidence of lower analyst
information advantage
SECs goal consistent with public interest theory, but the
concerns are consistent with interest group theory
 13.5 Criteria for Standard Setting

Decision usefulness
Reduction of information asymmetry
Economic consequences
Standard setters should weigh costs as well as benefits
Acceptable to constituencies
delicate balance needed between demands of different
constituenciesdue process
 13.6 The Regulators Information Asymmetry
(optional section)

The Laffont & Tirole model

Firm has inside information, release of which benefits investors and, if
released, lowers firms cost of capital
Release of inside information requires manager to exert effort,
increasing firms compensation expense
Regulator , who must set standards for release of information (public
interest theory), does not know firms actual inside information
Regulator compromises, allowing some inside information to remain
(less benefit to investors), but lowering manager effort (lower
compensation cost to firm)
>> Continued
 The Regulators Information Asymmetry (optional
section, continued)

The Dessein model

A regulator (securities commission) has two options for extent of
standard setting
Set high standards, or set lower standards and allow firm manager some
flexibility in accounting policy choice (i.e., rely on market forces to
motivate information release)
Due to market failures, allowing manager flexibility unlikely to produce
socially most useful accounting policy choice
Regulator faces information asymmetry: it does not know the most useful
accounting policies for the firm, but manager does
If regulator asks manager to communicate these most useful policies,
manager does not reply truthfully, lowering regulators ability to set useful
accounting policies and allowing some earnings management
>> Continued
 The Regulators Information Asymmetry (optional
section, continued)

The Dessein model (continued)

Regulators decision depends on its information about the most useful
accounting policies
If low information, choose flexibility option
Effect of manager earnings management less costly to society than cost of poor
standards
If high information (more likely) choose communication option
Effect of manager earnings management more costly to society than cost of higher
quality standards
If communication option chosen, regulator may further increase decision
usefulness by bringing in an intermediate regulator, if the intermediate
regulator communicates better with management
 13.7 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

Continued
 International Integration of Capital Markets
(continued)

Effects of customs and institutions on financial reporting

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

Continued
 International Integration of Capital Markets
(continued)

Enforcement of accounting standards

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
Role of auditor
Auditor may be under great pressure from controlling interests
Some evidence that auditors succumb to this pressure
Guedhami & Pittman (2006)

Continued
 International Integration of Capital Markets
(continued)

Benefits to countries adopting IASB standards

Byard, Li & Yu (2011)
Adoption of IASB by EU countries followed by improved analyst forecast accuracy
only when IASB and previous domestic GAAP differed substantially, and strong law
enforcement
Landsman, Maydew & Thornock (2012)
Increased information content of earnings following IASB adoption, particularly if
strong law enforcement
Okan, Singer & Yu (2012)
Increased usage of net income in manager compensation contracts only when IASB
and previous domestic GAAP differed significantly
Daske, Hail, Leuz & Verdi (2013)
Better working securities markets following IASB adoption for serious country
adopters but not for label country adopters
>> Continued
International Integration of Capital Markets
(continued)

Benefits to countries adopting IASB standards

(continued)
Conclude: empirical evidence supports benefits to countries
following adoption of IASB standards, but only when
IASB GAAP and previous domestic GAAP differ
significantly and strong investor protection laws

>> Continued

13 - 14
 International Integration of Capital Markets
(continued)

IASB v. FASB standards

Leuz (2003)
Little difference in quality
Barth, Landsman, Lang & Williams (2012)
Some evidence that FASB standards are of higher quality

Mixed evidence of which set of standards is of higher

quality

>> Continued

13 - 15
 International Integration of Capital Markets
(continued)

Should standard setters compete?

E.g., if firms could choose between IASB & FASB standards
Race to the bottom?
Race to the top? (Problem 13.8)
Firms could signal commitment to high quality reporting by choosing the
higher quality standards
Do benefits of competition outweigh increased costs of allowing two sets
of standards?
 International Integration of Capital Markets
(continued)

Should U.S. adopt IASB standards?

2012 SEC Staff Report casts doubt on this possibility
FASB should retain significant influence on standards
Empirical research (slides 13-15) suggests little to gain in terms of reporting quality
from IASB adoption
Lower statement preparation costs for U.S. multinationals
But substantial transition costs, including effects on contracts
Conclude a big bang U.S. adoption unlikely
Note IASB proceeding alone to complete Conceptual Framework
Could make further standards convergence more difficult

13 - 17
 13.8 Summing Up

Information asymmetry is basic reason for financial reporting

Adverse selection
Moral hazard
Fundamental problem of financial accounting theory
Best information system to control adverse selection not necessarily
the same as best system to control moral hazard
Leads to constituency conflict
Standard setters must mediate this conflict