Chapter 4
The economics of Financial Reporting Regulation

The case for unregulated markets for accounting information

* Support for unregulated marketing all relate to the incentives for a firm to report information about itself to owners and to the capital market. * Agency theory explains why incentives exist for voluntary reporting to owners. * Wider voluntary reporting to the capital market is explained by signaling theory * The arguments supporting unregulated markets for accounting information are largely deductive in nature.

Agency Theory

* Predicts and explains the behavior of parties involved with the firm. * It conceives of the firm itself as a nexus of agency relationship and seeks to understand organizational behavior by examining how parties to agency relationships within the firm maximize their own utility. * One major relationship is between the management group and the owners of the firm. * Managers are hired to administer the firms’ activities. * Owners and Managers may have different goals and may not be in perfect agreement. While owners are interested to maximize return of investment and security prices, managers have a wider range of economic interests and psychological needs. Because of this conflict, owners communicate with managers in such a way as to minimize conflict between the goals of two groups. * Costs relating to monitoring management reduce managers’ compensation. Therefore managers have an incentive to keep the cost low by not being in conflict with owners. * Conflict between owners and managers are mitigated to some extent by financial reporting. Routine financial reporting is one means by which owners can monitor employment contracts with managers. * Agency theory is used to explain the demand for audits. Auditor functions as an independent verifier of financial reports submitted by managers to owners. * Minimizing costs on managers is a big incentive for managers. Good reporting will enhance the reputation of the manager and increase its compensation.

Competitive capital markets and signaling incentives * Signaling theory explains why firms have an incentive to report voluntarily to the capital market. * Firms compete with one another for scarce risk capital. Voluntary disclosure is necessary to compete successfully in the market for risk capital. * The ability of the firm to raise capital will be improved if the firm has a good standing with respect to financial reporting. * Good reporting= low cost of capital. This leads to less investment risk and a lower required rate of return. * Companies that perform well have a strong incentive to report their operating results. Companies pressures would also force other companies to report even of they do not have good results. * Companies with neutral news would be motivated to report their results to avoid being suspected of having poor results. * Bad news firms would need to disclose results to maintain credibility in the capital market. * Economic incentive of reporting any news is at the heart of the signaling theory for voluntary financial reporting. * Information Asymmetry: insiders who know more about a company and its future prospects than outsiders do. * Outsiders will protect themselves by offering a lower price for the company. * Asymmetry can be reduced if the firm voluntarily reports private information about itself that is credible and reduces uncertainty about the firms future prospects.

Theoretical and empirical research on signaling effect of management earnings forecast * There are 2 kinds of voluntary disclosures: 1. The surprise of the income numbers forecast. 2. The surprise attributing to the earnings forecast. * Early adoption is generally interpreted as “good news” whereas late adoption generally indicates “bad news”. This research is focused on standards where a long phrase-in-period is present. * Frantz hypothesizes that where accounting alternatives exist, “good news” is signaled by taking the lower income choice and “bad news” is signaled by taking the higher income alternative.. * One study concluded that the SEC’s prospectus requirements have not significantly affected the quality of services offered for public subscription. * Another study examined voluntary annual reporting prior to the Securities Exchange Act of 1934, which required the 10-K annual report. This was already met on a voluntary basis. * Barton and Waymire found that the quality of financial reporting improves with managers’ incentives to supply higher quality financial information. Only concern is whether higher quality financial reporting lowered investor losses during the 1929 crash. * B and W used a sample and used three factors: transparency, accounting conservatism, and the use of an external audit. * Three of the managerial incentives to supply better financial information in 1929: 1. Leveraging effects: refers to the proportion of debt in the capital structure 2. Presence of alternative uses of financial information: considers information stemming from the firm’s dividend policy 3. The issuance of equity market: refers to undergoing the scrutiny of the equity markets
Overall, B and W found positive correlations between quality of financial reporting and managers incentives to supply financial reporting. One drawback to the result was that the overall quality of financial information at that time was poor. Management incentives to supply higher quality financial information appear to be related to competitive issues rather than to strictly managerial ones.

Arguments in favor of private contracting opportunities

* Anyone who genuinely desires information about a firm can obtain it. * If information were truly desired beyond that which is publicly available and free of charge, private individuals can buy the desired information. * Market forces result in the optimal allocation of resources to the production of information. * An examination of the stock market reveals that people are indeed willing to contract privately for information. * Demand for information is optimally met when market forces determine the production and disclosure of accounting information. * Mandatory disclosure system may not be an effective route for transmission of information to the capital markets.

The case for regulated Markets for Accounting information

* 2 reasons are used to defend regulation: 1. The possibility of a failure in the free market system referred to as market failure. 2. The possibilities that free markets are contrary to social goals.
The information that would be available in unregulated markets might not provide enough comparability among firms. A philosophical justification of the standard-setting process-called codification- is based on evolutionary improvement of accounting standards in an open and democratic society.

Market Failures 1. The firm as a monopoly supplier of information * Market failure occurs because the firm is a monopoly supplier of information about itself. * This creates the opportunity for restricted production of information and monopolistic pricing if the market is unregulated. * Mandatory disclosure would result in more information and a lower cost to society than would be achieved in an unregulated market. * Monopoly enjoys economies of scale but the firm could under produce information and change monopolistic prices. * Mandatory public disclosures are a cost-effective method of getting firm specific information to those demanding it. * Production cost of mandatory reporting requirements may be quite small. If this is small, then the social cost associated with mandatory financial reporting requirements may be small. * Mandatory public disclosures could save investors money if the alternative is private contracting.

Failures of financial Reporting and Auditing * This focuses on the low quality of financial reporting, even under regulation. The reasons are: 1) poor accounting and auditing standards. 2) Too much management flexibility in the choice of accounting policies. 3) Laxity by auditors. * Corporate fraud undetected by auditors and corporate failures are cited as evidence that the financial reporting system is failing to protect the public interest. * More and more better regulation is necessary to raise the quality of financial reporting to protect the public from frauds and failures rather than no regulation. * Capitalistic economy relies on a competitive private sector capital market. * Good financial reporting is essential to create investor confidence in the fairness of the capital market. * Good information leads to better investment decisions and capital allocations. * Bad financial reporting questions if companies can really be trusted to report fully and accurately. * Competitive nature of the capitalistic market could even induce misleading reporting during the short term. * Increased regulations of financial reporting may reduce the likelihood of undetected frauds and failures, but it can never totally eliminate them. Any argument favoring expanded regulation must also consider the costs of regulations. There comes a point where the marginal benefits from the regulation are less than the marginal costs.

Accounting as a public good * Public goods are commodities that once produced, can be consumed without reducing the opportunity for consumption by others. This condition exists because of the soft property rights associated with such goods. * Private goods possess hard property rights so that nonpurchasers are excluded from consuming the good. * Public goods are under produced in a free market owing to what called externalities. An externality exists if a producer is unable to internalize production costs on all users of the good. * People who consumer public goods without paying for them are called free riders. * Accounting is a public good. It can freely be passed from person to person; each person can consume the content of the information without restricting it for later users. * There are 2 aspects of regulated financial reporting that can give rise to social value not privately captured: 1) Increased comparability of accounting numbers across firms 2) Increase in the confidence in the securities market. * Both operate to reduce information risk in the capital market and should benefit society through a lower level required return on risky investments. * If accounting is a public good then a company would not have a strong incentive to produce and sell accounting information about itself. * In a free market, the opportunities to contract privately for firm-specific information would be restricted.

Social goals * Society may want to achieve goals that may not be met by a free market. * Social goals are justified by a public-interest argument and inevitably involve a normative judgment about how society should allocate its resources. * One social goal is fairness of the capital market is a public-interest type of argument. It assumes that the stock market will be fair only if all potential investors have equal access to the same information, known as information symmetry. * Another social goal is comparability. Comparability refers to reliability of financial statements when making evaluations using financial statements on an interim basis.

The codificational justification of standard setting * Codification refers to a pragmatic approach to improving accounting standards over time. * Gaa’s places a concern with the underlying rationality of the standard setting process. * Codification is not only rational but also evolutionary that the system is expected to improve over time. It works in a relatively open and democratic society rather than in authoritarian societies. On codificational viewpoints, members of the FASB are expected to have the ability, the opportunity and the desire to make a correct decision on financial accounting. * Accounting standards developed in a codificational view would not necessarily be correct in terms of deductive logic. They would be evaluated on the basis whether they performed their intended function well and if the standards do not work, they should be or at least could be amended. This concept leaves the codification approach being pragmatic. * Codification provides a good idea of what can be expected when democratic societies attempt to resolve difficult distributional problems. However, codification can be viewed as a banal rationalization.

Comparing regulated and unregulated markets * Pro-regulated arguments as well as arguments for unregulated markets are so largely deductively reasoned rather than empirically researched. * One of the arguments for regulation is that firms are monopolistic suppliers of information about themselves. * It may be cheaper for society to require mandatory fee disclosure than to have individual investors privately contracting for the same information and paying monopolistic prices. * On the free market counterargument, firms have an incentive to report information voluntarily about them. Because individuals have alternative investment opportunities, companies are not really able to impose monopolistic prices. * Firms have incentives to report freely in order to attract capital and to lower their cost of capital by being perceived as a good reporting firm. * Where there is a perceived information risk owing to poor quality reporting, investors penalize such companies by requiring a higher rate of return to compensate for the extra risk. * Pro-regulators counter that the competitive nature of the capital market provides an incentive for misleading reporting. Managers of the companies may not pay the penalty for poor or misleading reporting and for this reason may be tempted to manipulate reporting in the short term. * A major problem that has arisen in financial reporting involves the auditing function, which could occur under both regulated and unregulated financial reporting. How to alleviate this pressure is one of the most important issues that the accounting profession faces today. * Another argument against regulation is that information not voluntary disclosed by the firm could be obtained through private contracting. The visibility of private contracting opportunities is questionable because of the public-good nature of accounting information and free-rider problem. * It can be argued that mandatory reporting is desirable on social grounds because it creates fairness in the capital market. The more information that is public, the less wealth transfers between those who have information and those who do not. This information is behind insider-trading regulations. * There is always merit in mandating accounting policies. These policies lead more quickly to better financial reporting among companies. Mandating public reporting enhances the fairness of the capital market and may reduce the total cost to society of acquiring the information. * Costs of regulated information appear to be low while benefits to society are probably substantial. If regulation is preferred, the codification philosophy justifies the process of standard setting. * Much of the economic argument against regulation maintains that there are incentives for voluntary reporting. The focus on accounting regulation is on improving the quality of reported information. * Accounting regulation is mainly concerned with refining and unifying the rules of recognition and measurement used in the preparation of the financial statements. * Accounting regulation requires a theoretical foundation, given that it is mainly the quality of information that is being regulated. * While there is no conclusion set for accounting regulation, personal bias is in favor of accounting regulation because we believe that the benefits exceed the costs.

Imperfections of accounting regulation * Accounting regulation can be justified if there is a market failure or if the free market produces a result incompatible with social goals. * Accounting regulation cannot provide an optimal solution to certain problems of financial reporting. * It is impossible to derive regulatory policies that will knowingly maximize the social welfare. This conclusion is the subject of Arrow’s well-known Impossibility Theorem. * There is no compatible rule in a regulated market, and for this reason it is difficult to evaluate the benefits of accounting regulation. Due to this paradox, it is impossible to know if accounting regulation is producing the optimal quantity and quality of financial reporting. * Public good in regulated markets tend to be overproduced. The reason for overproduction is that demand is higher than it would be in a market situation because public goods supplied under regulation are normally subsidized goods. * Since accounting information had public-good characteristics, there is a very little danger that overproduction of accounting information occurs in a regulated market. * FASB is cognizant of the overproduction problem known as standards overload. * The tendency for overproduction in regulated markets can be avoided only if a pricing system can be imposed on public goods creating nonpurchasers who are effectively excluded from consuming the good. * One means of doing this in accounting might be to file company reports with the SEC and charge users for copies of the information. Through this system there would be an incentive for users not to pass on the information to free riders. * Demand for the information could be determined and production costs could be recovered from the actual users of the accounting information. * The electronic filing at the SEC might be the beginning of a technology that will facilitate the creation of property rights over financial reports enabling the charging of access fees to users. * The present disclosure system imposes costs on companies rather than on users. * The negative consequences of regulating information are 1) a potential over allocation of social resources to the production of freely publicly available accounting information 2) a wealth transfer from nonusers to users of accounting information. * A wealth transfer occurs because users receive the benefits of free accounting information, while nonusers implicitly incur the production costs. * A sole purpose is to keep the institutional process of accounting standard setting as unbiased as possible and to rely on the evolutionary nature of the codificational justification of accounting rule making.

THE REGULATORY PROCESS * Regulation is essentially a political activity and is undertaken in the public interest. * Since social welfare cannot be measured, there are no criteria for determining what policy will maximize the public interest. * The notion of public interest is best understood in a political context and with reference to the particular creation and redistribution of income and wealth being advocated. * Economic self-interest models have been used for analyzing political and regulatory behavior. * In a regulated market, individuals or groups who have any stake in the market will be motivated to lobby for their vested interests, to form coalitions with other parties to further strengthen their influence, and generally to try to influence the political system to their advantage.

The political nature of regulation * Due process is an important ingredient in the regulatory process. * Due process means that a regulatory agency seeks to involve all affected parties in the deliberations. This means to say that people affected by regulation have an opportunity to have input into the regulatory decision-making process. * Some members of the accounting profession believe that accounting policy setting should be neutral and apolitical. However, accounting policy is inevitably political because of its negotiated nature. * By permitting self-regulation in the private sector, the SEC was shielded from the politics of actually setting accounting policy except when it was expedient to do so. The SEC was in a position to use the private sector as a scapegoat if congress were to challenge the work of the SEC. * The lack of due process, or at least the apparent lack of due process sometimes led to a low level of acceptance by affected parties. * The FASB is functioning much more successfully than did earlier regulatory bodies. Due process has been adopted as standard procedure in debating and developing accounting policy. * In legal system, decision making under the due process is extremely slow, but the achieving of consensus is what gives legitimacy to the regulation. * Arrow’s refer to this tendency as democratic paralysis. * The mechanism of due process is firmly established in the organizational structure of the FASB.

Regulatory behavior * Capture theory and the life-cycle theory of regulation both argue that the group being regulated eventually comes to use the regulatory process to promote its own self-interest. When this occurs, the regulatory process is considered captured. * The life cycle theory of regulation argues that a regulatory agency goes through several distinct phrases. * Although it starts out in the public interest, regulation later becomes an instrument for protecting the regulated group. * It becomes very difficult for a regulatory agency come to see that their interests converge. It becomes very difficult for a regulator to remain truly independent because survival of the regulatory agency itself may depend on how well the policies are accepted by the group being regulated. This behavior by both the regulator and the regulated party is explained by the self-interest theory of political behavior. * Capture theory and the life-cycle theory have been applied to the regulation of accounting. Accounting regulation had been captured by the big eight groups of accounting firms. * Prior to the FASB, accounting regulation was done primarily by AICPA subcommittees, which were undoubtedly heavily influenced by the big eight accounting firms. * With the implementation of the FASB, the capture theory argument lost at least some of its validity.

Behavior of Companies, Auditors and Free Riders

1) Managers * Management of companies can be expected to respond to regulatory proposals that will affect either the companies or itself personally. * All accounting regulation imposes some amount of production costs on firms. * There would be a tendency for management to oppose new disclosures or rules that will impose a cost on the firm. * On the other hand some rules may cause specific firms to increase reported net income. Management could have an incentive to support those new proposals that would positively affect reported income and that might increase its own compensation. * However, large regulated companies supported proposed accounting rules that would lower reported net income.

2) Auditors * Auditors are concerned with the auditing implications of financial reporting rules. * Auditors could be expected to support regulation that reduces the riskiness of audits. * The most serious problem arising from auditor behavior involves capture of auditors by auditees. * This has arisen as a result of large management consulting contracts that auditors have entered into with auditees. * One possible solution to the auditor-auditee problem is the creation of financial statement insurance, which could be paid by the auditee to an outside insurance company. I. The financial statement insurance will cover both insurance payments to shareholders as a result of misrepresentation in financial statements and also auditor fees. II. The insurance carrier would select and pay the auditor. III. Amount of coverage and premiums would be published, with those firms having higher coverage and relatively lower premiums looking best.

3) Free riders * Free riders may also try to influence the outcomes of accounting policy deliberations. * Analysts have a strong motivation to demand new accounting information that they can incorporate into investment research and newsletters. * Analysts can make money simply by summarizing public information for investors who do not have time to sift through it themselves. * Free riders do not have the direct economic interests in information production that management and auditors have. * Responding to such pressure could easily result in an overproduction situation. * It is politically difficult to deal with free riders because they can claim to be acting in the public interest by making the capital market fairer and more competitive through free public reporting. * This argument ignores the question of information production costs and who pays for accounting regulation.

Accounting policy should not serve special-interest groups to the detriment of society as a whole. When regulations are dominated by special interests, its mandate no longer exists because a vested-interest group has captured the regulation process.

Economic Consequences of Accounting Policy * Standard setting often results in benefitting one group at the expense of another. * Accounting policy is not simply a matter of economic efficiency or optimality. It also affects income and wealth distribution, and this is necessarily a social and political issue that transcends accounting. * The economic consequences of proposed accounting policies is defined as “the impact of accounting reports on…business, government, unions, investors and creditors. * The FASB is very sensitive to producer costs and whether there are sufficient benefits to warrant the imposition of new, costly accounting standards. * Corporate responsibility reporting is advocated by those who believe that society as a whole has a legitimate interest in corporate behavior, and that the corporation should be made accountable for its behavior over a wide range of activities. * Research into economic consequences has also focused narrowly on stockholders and managers of firms. * One extensive body of research examines the effects of accounting policies and changes in the stock prices. * Another extensive body of research has investigated whether the choice of accounting methods of management’s preference for certain accounting methods is related to accounting-based contracts. * The main focus is on a very limited aspect of the total social costs and benefits of financial reporting and the regulation of financial reporting.