Standard Setting: Political Issues

Arjun, Emily, Kira, Rajesh and Yun

The problem of market failure is fundamental

Information asymmetry which creates the demand for information production by firms also creates a demand for regulation of that information production.◦ Problem is caused by unanimity

13.1 Overview

1. The Public Interest Theory

2. The Interest Group Theory

13.2:The Two Theories of Regulation

Suggests that regulation is a response to public demand for correction of market failures.◦ The regulator is assumed to have the best

interest of society at heart.◦ Regulation is viewed as a tradeoffs between its

costs and its social benefits

13.2.1: The Public Interest Theory

Problems arise with its implementation1. Very complex task of deciding on the right

amount of regulation (this is particularly true for a commodity like information where it is effectively impossible to please everyone)

2. The other serious problem lies in the motivation of the regulator

13.2.1: The Public Interest Theory

This theory was introduced by Stigler (1971)◦ Stigler takes the view that an industry operates in the

presence of a number of interest groups◦ These interest groups are thought of as “demanders of

Regulation” Becker(1983) application of Coase Theorem

◦ Coase theorem: If bargaining costs are too high for parties to contract , an appeal to government to step is impossible.

◦ Becker views interest groups as competing for and against regulation The outcome depends on which group is relatively most

effective in applying pressure on the regulator◦ Interest groups are assumed to be rational

13.2.2:The Interest Group Theory

The theory makes several predictions1. Creation of standard setting bodies2. Activities subject to market failure are more

likely to be regulated due to demand from groups adversely affected

3. Due process- For example, exposure drafts and board

representation

13.2.2: The Interest Group Theory

Interest Group Theory... But why?◦ Market forces cannot always be relied upon to

generate the right accounting standards and procedures

◦ Complexities resulting from diverse information needs and interest of investors and managers make it effectively impossible for standard setters to calculate the right accounting standards.

◦ Choice of accounting standards is better regarded as a conflict between constituencies

***Interest Group Theory formally recognizes the existence of conflicting constituencies

13.2.3: Which Theory of Regulation Applies to Standard Setting?

Conflict and Compromise: An Example of

Constituency Conflict

proposed fair value accounting for major classes of financial Instruments

Fair value accounting , however has long been opposed by financial institutions, in particular the banking industry. Since financial institutions are heavy users of financial statements, and are crucial to the operation of the economy, the view of this important constituency cannot be ignored

IAS 39 – Financial Instruments: Recognition and Measurement

In this regard the European Central Bank issued a comment in November 2001 entitled “Fair Value Accounting in the Banking Sector” The Bank Expressed four general concerns:◦ 1) Short Run, Long Run ◦ 2) Reliability of Fair Values for Bank Loans ◦ 3) own credit risk ◦ 4) Conservatism

“Fair Value Accounting in the Banking Sector”

13.4: Distributions of the Benefits of Information,

Regulation FD

A further complication of standard setting is the distribution of the benefits of information production among interest groups.

Value judgements about who is entitled to property rights arise because individual utilities cannot in general be aggregated into a social preference ordering.

That is the two theories are intertwined.

Information Regulated FD

Standards should be decision useful, but should also be useful for other parties, such as management.

This puts Standard Setters at a conflict situation since it is difficult to determine the right solution to satisfy all parties.

Criteria for Standard Setting

There are 4 main criteria:◦ Decision Usefulness◦ Reduction of Information Asymmetry:◦ Economic Consequences of New Standards◦ The political Aspects of Standard Setting

Criteria for Standard Setting

The success of a new standard is judged by its decision usefulness.

Difficult to judge beforehand, since market hasn’t had time to respond to the standard.

Theory of rational investor decision-making can be used to predict decision usefulness.

However, as mentioned earlier, because accounting information is a public good, we cannot be sure that the standard has the greatest decision usefulness will be the best for society.

Thus a standard could appear decision useful, yet society would be worse off because the costs of producing that information were not taken into account.

Decision Usefulness

Standard setters should be aware of these forces and take advantage of them, however market forces alone are not enough to ensure that the right amount of information is produced.

This is due to information asymmetry. Standard setters should use reduction of information

asymmetry in capital and labour markets as another criteria for new standards.

The public good nature of accounting information helps in reducing information asymmetry.

Reduction of information asymmetry improves operations of markets, because it gives investors the perception of a level playing field.

Reduction of Information Asymmetry

One of the costs of a new standard is the cost imposed on firms and managers to meet that standard.

There are also indirect costs associated with new standards.

The freedom of managers ability to choose from different standards is another economic consequence.

Also, some highly competitive industries don’t need additional standards because competition induces better discloser.

All these considerations suggest that standard setters should weigh all the possible economic consequences of a new standard.

Economic Consequences of New Standards

Standard setters must have the ability to come to a consensus strong enough that even a party that doesn’t not like it will have to along with it anyway.

The structure and due process of standard-setting bodies is designed to encourage such a consensus. However, if the conflict between parties is severe enough, a party may even appeal to the political process.

The political Aspects of Standard Setting

In conclusion, all these criteria show that the actual process of standard setting is best described by the interest group theory rather than the public interest theory.

Criteria for Standard Setting Conclusion

Conclusions & Summing Up

Textbook comes to a focus on standard setting◦ Under ideal conditions accounting and reporting

standards are not needed◦ Under ideal conditions one can question whether

financial accounting is needed at all◦ Such conditions do not exist

Financial accounting becomes much more challenging.

Conclusions & Summing Up

Information asymmetry is a major challenge Two types:

1. Adverse Selection Challenge is to convey information from inside to

outside the firm Improve investor decision-making Limit the ability of insiders to exploit their

information advantage Enhancing the operation of capital markets

Information Asymmetry

2. Moral Hazard Challenge is to provide an informative measure of

managerial performance. enables incentive contracts to motivate manager effort,

protect lenders, and inform the managerial labour market

Information Asymmetry

Investors need decision-relevant information to help them predict future firm performance◦ Current Value-Based Information

Generally the best predictors of future values Problems of volatility Possible low reliability

◦ Historical Cost Accounting/Conservative Accounting Less subject to problems of measuring manager

performance Current value- and historical cost based

accounting must be traded off

Conclusions & Summing Up

Need for financial reporting to fulfill a dual role of meeting investors’ information needs and the needs of efficient contracting◦ Creates the fundamental problem of financial

accounting theory◦ Standard setter must then seek a compromise

between conflicting interests The structure of standard-setting bodies is designed

to facilitate such a compromise

Conclusions & Summing Up

The need for international accounting standards will continue to expand

Difficulties in standard setting will increase◦ New constituencies arise representing different

levels of economic development, business practices, and cultures

Standard-setting bodies, and investors, will have to adapt to take these additional challenges into account.

Conclusions & Summing Up

CASE: ON A MISSION FOR HARMONY

Canada has long been a strong advocate of International Accounting Standards(1966- 1975)

Canada was one of the founding member of the International Accounting Standards Committee (1973)

Canada’s Involvement

CICA’S Accounting Research Committee expressed commitment to IASC to harmonize accounting standards ◦ Minimize differences between the International

Accounting Standards and the corresponding recommendations set in the CICA Handbook

Going Forward

Canadian vs. United States Standards◦ Significant issue many Canadian

companies have: US patents or investors, as well as significant operations in the US

CICA’S Accounting Research Committee expressed commitment to IASC to harmonize accounting standards ◦ Increased globalization of markets

increases demand for greater uniformity in the standards

Long term objective: Single set of high quality standards that will be internationally accepted

Going Forward

Two recommendations: 1. Each of the three standard setters bodies commit to a continuing

program of liaison and mutual involvement 2. Standard setter committee be established and initiate and

attaining cooperative effort

Top 10 major areas in which there were significant differences in standards:◦ 1) Effects on Changing Prices◦ 2) Business Combination ◦ 3) Consolidation and Equity Accounting ◦ 4) Foreign- currency translation◦ 5) Income Taxes◦ 6) Earnings per share ◦ 7) Post Retirement Benefits◦ 8) Pension Accounting ◦ 9) Investments ◦ 10) Research and Development

Report: Financial Reporting in North America(1995)

Significance changes since 1995 to reduce differences in standards between Canada and US

However: differences still remain in the following areas:◦ Consolidation and Equity

Accounting◦ Investments ◦ Research and Development

Costs

Report: Financial Reporting in North America(1995)

Canada, Chile, Mexico and US meet annually with the mission to provide the overall quality and comparability of accounting standards

To accomplish this mission the committee with need to:◦ Promote comparability of accounting standards ◦ Consider existing significant areas of difference in

standards◦ Develop recommendation on what specific efforts

should be taken to reduced through existing significant differences

◦ Monitor progress towards the elimination of significant differences in standards

Report: Significant Differences in GAAP

QUESTIONS?