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
• SEC’s 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
constituencies—due process
 13.6 The Regulator’s Information Asymmetry
(optional section)

• The Laffont & Tirole model

– Firm has inside information, release of which benefits investors and, if
released, lowers firm’s cost of capital
– Release of inside information requires manager to exert effort,
increasing firm’s compensation expense
– Regulator , who must set standards for release of information (public
interest theory), does not know firm’s 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 Regulator’s 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 regulator’s ability to set useful
accounting policies and allowing some earnings management
>> Continued
 The Regulator’s Information Asymmetry (optional
section, continued)

• The Dessein model (continued)

– Regulator’s 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