Transcript Standard-Setting: Political Issues 306
Standard-Setting: Political Issues
306-684 Financial Accounting Seminar 11
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Learning Objectives
1 To understand relevant theories put forward to explain regulation 2 To review the history of accounting politics 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
regulation: the necessity of – Contractual incentives for disclosure – Market-based incentives for disclosure • Arguments
for
regulation: the necessity of – 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?
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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?
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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 7
Public Interest Theory
• These factors will all lead to the under supply 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 8
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 self interested • 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 10
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 11
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 14
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 15
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 16
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 17
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 19
Criteria for Standard Setting
• For a successful accounting standard: – Decision usefulness – Reduce information asymmetry – Economic consequences • benefit > social cost – Acceptable to constituencies 20
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 22
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 23
Example: Other Comprehensive Income (two options for presentation)
•
Presented with Income Statement
–
Net income from operations xxx
– – – –
Extraordinary items Net income Other comprehensive income xxx xxx xxx Comprehensive income 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 24
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 27
•
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) 28
•
International Integration of Capital Markets
Benefits of high quality accounting standards
– Better working securities markets – Higher earnings quality – More foreign investment 29
•
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 31