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