Standard-Setting: Political Issues

1. Standard-Setting: Political Issues 306-684 Financial Accounting Seminar 11

2. 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

3. Recall: • Arguments against the necessity of regulation: • Contractual incentives for disclosure • Market-based incentives for disclosure • Arguments for the necessity of regulation: • Private incentives are insufficient, due to • Market failures • Information asymmetry

4. 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?

5. 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

6. Theories of Regulation: • What theories do we have to explain the government intervention in the market for accounting information?

7. 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

8. 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

9. 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?

10. 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

11. 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

12. 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?

13. 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!

14. 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

15. 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

16. 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

17. 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

18. 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?

19. 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

20. Criteria for Standard Setting • For a successful accounting standard: • Decision usefulness • Reduce information asymmetry • Economic consequences • benefit > social cost • Acceptable to constituencies

21. 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

22. 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

23. 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

24. Example: Other Comprehensive Income (two options for presentation) • Presented with Income Statement • Net income from operations xxx • Extraordinary items xxx • Net income xxx • Other comprehensive income 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

25. 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?

26. 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

27. 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

28. 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)

29. International Integration of Capital Markets • Benefits of high quality accounting standards • Better working securities markets • Higher earnings quality • More foreign investment

30. 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?

31. 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