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 Chapter 7(ii)
Standard Setting: Political Issues

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 7.2 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

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 7.3 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

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 13.4 Regulation FD
• Prohibits selective release of information, to help the
“little guys,” reduce analyst information advantage, 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

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 7.5 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

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 7.6 International Integration of
Capital Markets
• Increasing adoption of IASB standards
– Some examples
• European Union, 2005
• China, Japan (partially)
• Australia, 2005
• Canada, 2011
• United States?
– Allows foreign companies under SEC jurisdiction to report
using IASB standards without reconciliation, 2007
– Norwalk Agreement to work towards standards convergence
» But convergence may be slowing

» Continued

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 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
– Investors should be aware of local practices and customs
when interpreting financial statements, even if country
uses IASB standards

» Continued

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 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)
– Francis & Wang (2008)

» Continued

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 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

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 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:
(i) IASB GAAP and previous domestic GAAP
differ significantly and
(ii) strong investor protection laws

>> Continued

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 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

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 7.7 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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