Transcript STANDARD SETTING

STANDARD SETTING
Accounting Theory
Lecture 5 – Summer 2004
REGULATION
Benefits of regulation:
– helps reduce information asymmetry
– prevent insider trading – adverse selection
– control managerial opportunism – moral hazard
Will firms voluntarily disclose information?
– reduces moral hazard problem
– signal that they are a high-type firm
SIGNALING THEORY
Akerlof’s market for lemons
High-types want to show they aren't low-types
Signal must be credible to be believed
Cost to high-types < cost to low-types
Irrational for a low-type to issue a costly signal
Examples
Conservative accounting policies
Voluntarily disclosures, earnings forecast, FOFI
IMPLICATIONS
Audits add credibility to financial reports
– enhances reliability
Release non-historic-based information
– more relevant for investors
Benefits to firm:
– improves efficiency of contracting
– reduces cost of capital
MARKET FAILURE
Markets fail because of:
Externalities – cost/benefit not fully in price
Free-riders – use information without payment
=> no incentive to release/pay for information
Information asymmetry, moral hazard, adverse
selection problems
=> management incentive contracts – 2nd best
Hence, a need for standard setting
POLITICAL THEORIES
Objectives of regulation
Maximize social welfare & prevent market
failures
Public interest theory
Central authority looks after society’s needs
Interest group theory
Regulation goes to those who are the most
politically effective in convincing legislators
REGULATORS
CICA recommendations have forces of law
Canada & Ontario Business Corp. Acts
Other regulators
OSC, FASB, SEC, International Accounting
Standards Committee
All characterized by due process
Interest group theory
ACCOUNTING STANDARDS
COMMITTEE
Full time chair, 8 members, 2 full-time CICA
employees
Process
Topic on agenda => research paper by staff
Task force => Statement of Principles
ASC approval => Exposure Draft
Comments received => dropped, re-exposure,
incorporated as recommendation
PROBLEMS
Difficult to know which accounting policy is
right
What are it’s economic consequences?
Difficult to know trade-offs required to reach
political compromise
Decision useful for investors & management?
CRITERIA FOR STANDARDS
Acceptable to both investors & management
Reduce information asymmetry
– efficient markets
– approach first-best contracts
Requires use of professional judgment
Adhere to the conceptual framework
– is harmonization good and/or possible?