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Chapter 13

Chapter 13. Standard Setting: Political Issues. Chapter 13 Standard Setting: Political Issues. 13.2 Two Theories of Regulator Behaviour. Public Interest Theory Objective of regulator is to maximize social welfare Interest Group Theory

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Chapter 13

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  1. Chapter 13 Standard Setting: Political Issues

  2. Chapter 13Standard Setting: Political Issues

  3. 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

  4. 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

  5. 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

  6. 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

  7. 13.3.2 Other Comprehensive Income (continued) • Firms’ choice of alternative has information content for investors • Theory in Practice 13.1

  8. 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

  9. 13.5 Criteria for Standard Setting • Decision usefulness • Reduction of information asymmetry • Economic consequences • Benefits > social costs • Acceptable to constituencies

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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?

  15. 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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