Chapter 13

Standard Setting: Political Issues

13 - 1
Copyright © 2009 by Pearson Education Canada
 Chapter 13
Standard Setting: Political Issues

13 - 2
Copyright © 2009 by Pearson Education Canada
 13.2 Two Theories of Regulator
Behaviour
• 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
• Standard setters’ emphasis on due process
suggests that interest group theory best applies

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 13.3 Conflict and Compromise

• 13.3.1 Another example of economic consequences

– Difficulties faced by IASB in developing IAS 39 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

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 13.3.2 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

» Continued

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 13.3.2 Other Comprehensive Income
(continued)

• 2 alternative presentations
– Presented with Income Statement
• Net income from operations xxx
• Extraordinary items xxx
• Net income xxx
• Other comprehensive income xxx
• Comprehensive income xxx
– Alternative Presentation
• As part of statement of changes in shareholders’ equity

» Continued

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 13.3.2 Other Comprehensive Income
(continued)

• Firms’ choice of alternative has information

content for investors
– Theory in Practice 13.1

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 13.4 Rules-Based v. Principles-
Based Accounting Standards
• Rules-Based Standards
– Lay down detailed rules
– Possible to lay down rules for everything?
• Recall Hobbes, text Section 1.3

• Principles-Based Standards
– Lay down general principles
– Auditor professional judgement relied on to prevent
opportunistic manager behaviour when applying the
principles

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 13.5 Criteria for Standard Setting

• Decision usefulness
• Reduction of information asymmetry
• Economic consequences
– Benefits > social costs
• Acceptable to constituencies

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 13.6 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

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 13.6 International Integration of
Capital Markets (continued)
• 13.6.2 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

» Continued

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 13.6 International Integration of
Capital Markets (continued)
• 13.6.3 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)

» Continued

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 13.6 International Integration of
Capital Markets (continued)
• 13.6.4 benefits of high quality accounting
standards
– Better working securities markets
– Higher earnings quality
– More foreign investment

» Continued

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 13.6 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 13.7)
– 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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 13.7 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

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