The pros and cons of regulating corporate reporting:A critical review of the arguments Robert Bushman, Wayne R. Landsman Accounting and Business ResearchVol. 40, Iss. 3, 2010

Introduction
There were a series of scandals in the UK in the 90’s which resulted in the collapse of Barings Bank, due to this the Financial Services Authority changed the structure of financial regulation that consolidated regulation responsibilities. The aftermath of the financial crisis of 2007 to 2009 has drawn the financial accounting standard setting into the orbit of political processes focused on restructuring the regulation of the world’s financial markets. The crisis has ignited worldwide debate on issues of systemic risk and the role played by financial regulation in creating exacerbating the crisis. There have been proposals for how to regulate the financial markets and financial institutions should be changed to ease the potential for large scale financial meltdowns in the future. There are many aspects of the financial system under debate, including the alleged role played by financial accounting standards in deepening the trajectory of the crisis. The crisis has forced politicians, regulators and economists to scrutinise financial accounting standards and create pressure for change, which creates an opportune moment to consider how to organise the analysis of efficient regulatory choice. This paper lays out the basic arguments that have been put forth both for and against the regulation of corporate reporting.

2. The Case of Mandatory Disclosure
Here the paper discusses issues related to the nature of disclosure, whether it is a case of choice or formal regulation (voluntary or mandatory).
We are being introduced key theories surrounding above issue and criticism.
First is the public interest theory (helping hand). The simplest way to explain it is that government should get involved and regulate markets to prevent their failure or where already failed, government can help effectively with the recovery by regulation.
Criticism of public interest theory
1) Non-governmental parties’ arrangements mitigating market failures - government intervention is unnecessary.
2) If non-governmental parties unable to come to arrangements, market failures resolved by courts and enforcement of tort rules. In this case if competitors were not able to work together, then there are bodies apart from the government like courts that would enforce rules ensuring fairness and recovery of markets.
3) Capture theory – governments not capable and incompetent, unable to bring the solution. People acting on behalf of governments are seen as selfish agents, whose decisions will be influenced by personal, rather than public interest good and goals.
Next the authors moves on to talk about the theory of disclosure regulation (firm specific forms), where he applies previously discussed arguments.
Is it necessary for regulating disclosures? Question is being asked again. What happens if not?
According to R. Bushman and W. R. Landsman there is a strong believe, that in absence of formal ruling forces of market discipline will very likely create influence for optimal disclosure. This would mean that in certain circumstances companies are more than happy to disclose information voluntarily. However, contained information, when not regulated, may turn out not accurate or extensive enough for certain purposes.
The Authors consider and bring us closer to understanding of an actual need for regulation in regard of disclosure. These are the issues: Market forces putting pressure for disclosing means being open and competitive, attracts investors who believe companies have nothing to hide, If not disclosing voluntarily – hiding bad news or unfavourable information, that lowers share prices/value of the company.
They then explain issues related to misreporting – reputational, legal and contractual penalties. To ensure credibility of reports, even when disclosing them voluntarily, companies should engage professionals (e.g. auditors, credit rating agencies, underwriters).
This brings us to look at the Market wide effects of disclosure (not firm specific only, but collective).
Subject of revealing proprietary information to competition is considered first. Firms may be unwilling to disclose, due to the nature of sensitive information. This may have impact on the allocation of capital and investments, productivity also price competition. Author also talks about over/under production of public information (costly) and disclosing sensitive information about other companies.
There are also benefits noticed by the writer: more accurate assessment by investors, allowing lower the cost of capital and also reduction aggregate expenditures on information.
Next the authors moves on to talk about TREATMENT OF FINANCIAL INSTITUTIONS and the need to disclose additional information in order to measure and manage systemic risk. He then makes a comparison with the situation and types of disclosed information of companies competing for profits.
After, there comes an important issue of DIFFICULTIES IN UNIForMING DISCLOSURE REGULATION FOR ALL COUNTRIES.

3. Regulation of Accounting Standard-setting

Kothari et al (2009) provides a broad look at the issues related to the regulation of accounting standard settings. It sets out three theories which are public interest theory, capture theory and the ideology theory.
Ideology theory serves as a useful way to discuss the current regulatory issues. It relies on the existence of market failures but goes beyond what public interest theory does as it allows regulator’s actions to be influenced. These people are views as possessing political ideologies and a lot of the time the outcomes are derived from this group of people.
Kothari et al then looks at the ideology theory. It is the theory that a private market for accounting standards would fail. This shows the need for the regulation of standard setting but is aware that the effectiveness of this regulation depends on political ideologues and special interest lobbyists.
The ideology theory see’s the need for the design of a standard setting institution that minimises the effect of political ideologies and special interest lobbyists. Kothari et al view competition among standard setters as a main way to minimise these factors. The existence of competing standards means that the ability to compare between firms is sacrificed but there is also the option that two standard setting regulations could be run simultaneously.
Kothari et al concludes with the decision that there is unlikely to be one set of global accounting rules. This can be backed up with the view that political interference in standard setting provides an insight into which we can see the current developments in the regulation of accounting standard settings.
For example, the FASB and IASB have not yet been able to reach a conclusion on reconsidering the accounting standards for financial institutions and it is known that the two boards are being pulled in different directions by Europe and the US. Europe has also recently said that it will not endorse fast track assessment of IFRS 9 which shows that it has chosen the FASB board over the IASB.
4. Politics and financial reporting regulation in the wake of the financial crisis
According to R. Bushman and W. R. Landsman the meltdown of many important financial institutions and the ensuing economic recession has generated a political thirst for regulatory change that threatens to alter vastly the regulation of financial markets, including the regulation of accounting standard-setting. As the financial crisis unfolded in time, significant pressure was brought to bear on the FASB and IASB to relieve some of the perceived pressure on balance sheets deriving from fair value accounting. Both the IASB and FASB did respond to such political pressure by offering more flexibility in the classification of securities across portfolios, in valuation methodology, and in the split of fair value changes between the income statement and owners’ equity.

The question is whether such political pressure in essence resulted in accounting discretion being exploited to allow regulatory forbearance that delayed intervention by bank regulators in the hope that things would turn around. Accounting discretion can affect regulatory forbearance in several ways. First, it can operate through the channel of capital adequacy requirements. A second channel potentially operates through the market discipline of banks’ risk taking by outside investors. The issue here is that the increase in politically driven discretion granted to financial institutions during the crisis may have weakened market disciplinary forces by reducing bank transparency, making it more difficult for outside investors to assess the underlying risk of banks. In addition, recent proposals by the Financial Stability Forum (FSF, 2009) and the US Treasury (2009) strongly recommend that the FASB and IASB re-evaluate the incurred loss model underlying current loan loss provisioning requirements and consider a range of alternative. However, according to R. Bushman and W. R. Landsman it increases potential for opportunistic accounting behaviour by bank managers, which may degrade the transparency of banks and lead to negative consequences.
According to R. Bushman and W. R. Landsman there are several recent studies empirically addressing the important issues of discretion, bank transparency and market discipline. One of the studies is done by Huizinga and Laeven. Huizinga and Laeven (2009) examine accounting discretion by US banks during the 2007–2008 time frame, documenting that banks used discretion to overstate the value of distressed assets, and that banks with large exposures to mortgage-backed securities provisioned less for bad loans.

5. Recent developments discussed
In the US the SEC has statutory authority to set financial reporting requirements for US firms. The SEC effectively delegated accounting standard-setting to the Financial Accounting Standards Board (FASB). The FASB has issued seven Concepts Statements, in which it develops broad accounting concepts, and 168 Statements of Financial Accounting Standards (SFASs) for financial reporting. It also provided guidance on implementation of standards, including FASB Staff Positions (FSPs) and FASB Interpretations (FINs).
The International Accounting Standards Board (IASB) is an independent standard-setting board that is publicly accountable to a monitoring board of capital market authorities. The IASB issues International Financial Reporting Standards (IFRSs). As result of IFRSs in 2005 the EU required adoption of IFRSs for listed companies.

5.1 Institutional environment: Banking Regulation
R. Bushman and W. R. Landsman introduce us to the Basel Committee. The Basel committee compromises of representatives from worldwide central banks who make aware & supervise the international banking rules. Passed in 1988 the Basel Accords provide a set of minimal requirements for Banks in the countries covered by the Accord. In June 2004 Basel II was extended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks and the economy as a whole face. It rests in three "Pillars" Maintenance of Minimum Capital requirements - this deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Supervisory Review - This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously available. Market Discipline - This requires the bank to make all activities be readily available for investors & creditors by releasing financial information to the public in a timely fashion.
5.2 Fair Value Accounting & the Financial Crisis
In the United States the FASB (Financial Accounting Standards Board) has two primary standards that commission recognition of accounting amount using fair value. SFAS NO. 115. Accounting for certain investments in debt & equity securities - requires recognition at fair value of investments in equity and debt securities classified as held for trading or available for sale. SFAS NO. 113. Accounting for derivative instruments and hedging activities - requires all freestanding derivatives be recognised at fair value.
We are informed by the authors that during the Financial Crisis of 2007-2008 there was a collapse of trading in many markets; it especially hit those who give out mortgages and credit related receivables hard i.e. The Banks. This lead to financial institutions all over the world see their assets plunge in value and consequently having to take large asset write-downs. This brought the FASB & IASB and fair value accounting to the attention of the critics. The following options where made available to the bank regulators to help with the aftermath of the crisis; The Basel Committee could relax regulatory capital requirements meaning banks would not have to sell off assets to remain in line with the regulatory requirements. In certain countries the bank regulators could adjust the way in which regulatory capital is calculated to take into account effects of an SFAS 157 induced liquidity risk. Accounting standard setters are to modify existing accounting standards that relate to fair value to address the liquidity risk premium problems.

5.3 Potential consequences of FAS 115-2 and FAS 124-2
We are then brought to the consequences by the authors. They state although the FSPs issued by the FASB may well have the intended consequence of alleviating pro-cyclicality in severe economic downturns, the FSPs may also have unintentional regulatory consequences e.g. less healthy banks will be those that take advantage of the FSP by assigning a greater share of impairment losses to OCI than more healthy banks. Hence, it is possible that the FSP could result in an increase in total risk because regulatory intervention of weaker banks may be sub optimally delayed.

6. Concluding remarks
In this paper R. Bushman and W. R. Landsman distil essential insights about the regulation of financial reporting from the extant academic literature in accounting, law and economics. R. Bushman and W. R. Landsman lay out the basic arguments for and against the regulation of corporate reporting. Then they apply general arguments about regulation specifically to the theory of disclosure regulation by first discussing the extent to which fundamental forces of market discipline can generate optimal levels of disclosure in the absence of regulation, and then examining where these forces break down to potentially create scope for regulation.
R. Bushman and W. R. Landsman then turn their focus to market-wide effects of regulation of financial disclosure. Although political forces affects regulation of firm-level information, they believe such forces play an even more important role in influencing the structure of financial regulation and accounting standard-setting, particular when accounting information is perceived to affect the stability of the financial markets and banking system. Recent actions by the EC relating to IFRS 9 and the proposed legislation in the US Congress to create a systemic risk council serve to illustrate this point. R. Bushman and W. R. Landsman then discuss in detail the recent fair value debate as a case study of the way in which bank regulatory policy and accounting standard-setting decisions were jointly determined in the midst of financial crisis of 2007-2009.
In conclusion they offer a suggestion for future research: ‘A key direction is to seek a deeper understanding of the consequences of using financial accounting institutions, relative to using alternative regulatory mechanisms’. Also, R. Bushman and W. R. Landsman suggest that research could attempt to exploit the natural experiment provided by the crisis to examine how political pressure was brought to bear on the standard-setters, and to consider alternative structures to better insulate accounting standard- setters from politics.