Presentation on theme: "Standard Setting: Political Issues"— Presentation transcript:
1Standard Setting: Political Issues Geoffrey Jones, Spencer Steckley, John MacFarlane, Joel Zhang, Ellen Truong, Lucy Zhang, Manjeet Warha
2Agenda Two Theories of Regulation Conflict and Compromise: An Example of Constituency ConflictDistribution of the Benefits of Information, Regulation FDCriteria for Standard SettingThe Regulator’s Information AsymmetryCase Study: On A Mission For HarmonyChapter 12 is primarily concerned with the size (net of costs) of the information pie – the larger the pie, whether generated by market forces or regulation or both, the better for society. However, distribution of the benefits of information production between constituencies further complicates standard setting, since constituency interests often conflict. In setting standards, the interests of managers, small investors, large investors and others must be traded off. Value judgements about these tradeoffs are difficult to makeThese considerations suggest that standard setting is fundamentally as much a political process as an economic one. And this chapter will dive into how exactly the pie is divided up between the different constiuencies
4Public Interest Theory Regulation is a response to public demand for correction of market failuresThe regulator is to have the best interest of society at heartProblems with this theoryVery complex task of deciding how much regulationIt is very difficult to monitor theregulators performanceMuch less fewer consequencesif the regulator shirksPublic Interest Theory: Regulation is a response to public demand for correction of market failures, the regulator is to have the best interests of society at heart, and the view that regulation should maximize social welfare.
5Interest Group TheoryThe industry operates in the presents of interest groupsGroups will lobby for the regulation or deregulation of the industryThe group that spends the most and its effectiveness will achieve their desired regulationsEach group must take the expenditures of the other groups into accountInterest Group Theory: The industry operates in the presence of a number of interest groups, and these groups will form coalitions or constituencies to protect and promote their interest by lobbying the government.
6Interest Group Theory - Predictions To overcome free riding, investors support the creation of standard setting bodies with representatives.Activities subject to market failure are more likely to be regulated, due to demand from groups adversely affected.Due process: The legal requirement that the state must respect all of the legal rights that are owed to a person
7Which Theory of Regulation Applies to Standard Setting? Public Interest Theory is very difficult to implement.The choice of accounting standards is better regarded as a conflict between constituencies than as a process of calculation.Interest Group Theory recognizes the existence of conflicting constituencies.Interest Group Theory is a much better predictor of new standards than the public interest theory.
8Conflict and Compromise: An Example of Constituency Conflict
9IAS 39 Interest groups Development of new standard Jan 2001 Fair value accountingFinancial instrument
10Banking industry Heavy user of financial instruments Operation of the economyEuropean Central Bank“fair value accounting in the banking sector”4 general concerns – Nov 2011
114 Concerns Less long term contracts Valuation issue Own credit risk Conservatism
12Less long term contracts Long term loanInterest rate riskBank reduce earning volatilityReduce long term lendingReduce investmentReduce economic growth
13Valuation issue Less reliable Need well-working market Need adequate mathematical modelsCredit derivative market not developed – 2011TransparencyComparability
14Own credit risk Own debt Credit deteriorates Higher discount rate Reduced fair value of debtRecognize gainCounter intuitive and misleading
15Conservatism Unrealized gains and losses Prudent bank behaviour Recognize unrealized losses onlyAbandoning conservative accountingInduce less prudent behaviourUpset banking regulators
16Immediate response Reduced volatility by Available for sale -> OCI Held to maturity -> amortized cost
18Favorites Denmark Mortgage loan Liability hedged by financial assets If no full fair value optionEarning volatility
192005 EU “carved out” the two issues Macro hedging on portfolio basis Made it optionalMacro hedging on portfolio basisReduce complexityFull fair value optionRestricted to reducing mismatches only
202007 Market meltdown IFRS 9 Asset with predictable cash flow Amortized costSmooth out volatility
21EU response Relaxation of fair value Not far enough Delayed introductionBut some companies adapted it anywaysCompetitive advantage
22Bottom line Standards cannot be set in vacuum Must recognize existence of constituency conflictIf constituencies are not satisfiedThey will appeal to the political process
23Distribution of Benefits of Information, Regulation FD
24Issue Distribution of information among interest groups Selective Disclosure – Is a situation when a publicly traded company discloses material information to a single person, or a limited group of people or investors, as opposed to disclosing the information to all investors at the same time.This created an uneven playing field for investors, allowing certain investors to profit from material market moving information before others.
25Regulation FD (Fair Disclosure) The intention of implementing Regulation FD was to put an end to the practice of “Selective Disclosure” of non- public information and to more closely define when insider trading liability arises in connection with a trader’s use of non-public information
26Regulation FD (Fair Disclosure) When an issuer, or person acting on its behalf (Public Company), discloses material nonpublic information to certain individuals (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of that information.The timing of the required public disclosure depends on whether the selective disclosure was intentional or non- intentionalFor intentional selective disclosure, the issuer must make public disclosure at the same timeFor a non-intentional disclosure, the issuer must make public disclosure promptly
27Regulation FD (Fair Disclosure) Regulation FD fundamentally changed how publicly traded companies communicated with their investors by bringing more transparency and more frequent and timely communications in the market place
29Decision Usefulness Must be of value to investors decision making Investors may “overuse” financial information because they perceive it as “free”Must balance cost of producing additional information with benefits gained from itMust consider other criteria as well
30Reduction of Information Asymetry Reduction of Information Asymmetry through additional disclosures required by standards will:Increase fairness in information distribution to all investorsImprove operation of markets (investors perceive more level playing field)Reduce estimation risk“Lemons” phenomenonExpand market liquidityExtent of IA for smaller firms is higher because less public informationStandards need to require just as much info from smaller firms than larger ones
31Economic Consequences of New Standards Cost imposed on firm & managers to meet standardContract rigidities increased probability of violating debt covenants, managers’ bonusesRelease of proprietary information can reduce competitive advantageReduction in managers’ freedom to choose from different accounting policies cannot use choice of policy to signal inside info
32Political Aspects of Standard Setting Standard setters must ensure consensus that all constituents will go along with itInterest group theory of regulation:Technical or theoretical correctness does not guarantee success of standardInterest groups will offer strong resistance until they are satisfiedDue process ensures retractions are minimizedToo many retractions threatens existence of standard setting body
33Regulator’s Information Asymmetry Regulators face information asymmetryMost information in hands of managersUnable to observe manager’s effortsAs a result:adverse selectionmoral hazard
34Laffont and Tirole Model π = pq – C – tWhere:π is profit - C is cost of producing informationp is cost of capital - t is manager’s total compensationq is qualityt = X + Ψ (e)Where:X is excess contribution for managers who keep inside informationΨ (e)= manager’s effort aversionC = (β – e) qWhere:β is firm-specific inside informatione is information-related effort by managers
35Laffont and Tirole Model π = pq – C – tManagers assumed rational, risk-neutral and effort-averseHigher q better information for investors lower cost of capitalC = (β – e) qLower β means more inside information lower CComponents of e:designing and monitoring of financial reporting systemsdealing with Auditorscosts of signalingmanagers could lower the cost of producing information by:signaling costsgood earnings managementchoice of accounting policiesadoption of information technology
36Laffont and Tirole Model Model is firm specificTakes into account how firms have different β and cost of capitalImpact on regulations:Regulations should be firm-specific – not effective to have general standards for all firmsRegulations should be flexible – business and manager characteristics are different across firmsReducing inside information will help reduce excess
38Origin & Development of International Accounting Standards IASCCICA’s Accounting Research CommitteeHarmonization standards internationallyWork with IASC to minimize:Geoff Starts Here.Canada along with United Kingdom and United States was a member of Accountants International Study Group and a founding member of International Accounting Standards Committee (IASC), established in 1973.CICA’s Accounting Research Committee (predecessor to the Accounting Standards Board) expressed its commitment to the IASC’s objective of harmonizing accounting standards internationallyWillingness to work along with IASC to minimize differences betweenInternational Accounting Standards (IASs) andCorresponding accounting recommendations set out in CICA Handbook.IASsCICA
39CICA Handbook – Section 1501 Summary of Differences covered in this sectionMarch 1985 comparison discontinued & replaced by CICA publication, Financial Reporting in International EnvironmentReintroduced to handbook as appendix to Section 1501Appendix now updated to cover IASs issued up to June 30, : (IAS 1 – IAS 40)Now First-time adoption by Not- for Profit organizationsIn December 1995, commitment to IASC’s objective enshrined in Handbook Section 1501, “International Accounting Standards” Up until April 1981, a brief comparison of IASs with CICA accounting standards, setting out any major differences between two standards, periodically included in that section.Financial Reporting in International Environment which was updated six times between 1985 and 1992.In August 1996, comparison was reintroduced into CICA Handbook, in somewhat greater detail than had previously been provided as an appendix to Section 1501.The appendix has now been updated to cover IASs issued up to June 30, 2000 (IAS 1 to IAS 40)Currently, section 1501 is known as “First-time adoption by Not-for-Profit organizations” referring to the first changeover for these organizations to the international standards.
40Uniformity of U.S. & Canadian Standards With the reduction of options in IASs, compliance with both sets of standards by Canadian entities is unquestionably more difficult than it used to be.Conformity with US standards is also a significant issue in Canada, particularly since many Canadian companies have:US parentsUS InvestorsSignificant operations in the USIncreasing globalization of markets, demand for greater uniformity in standards of two countries was inevitable
41Standard Setting Bodies – Objectives In Aug. 1992, accounting standard-setting bodies of North America:CICA Accounting Standards BoardComisión de Principios de Contabilidad of the Instituto Mexicano de Contadores PúblicosACFASB in USSponsored 1st extensive joint studyNAFTAThey sponsored their first extensive and concerted joint study. It was the initial step in encouraging cooperation for progress in international harmonization among standard-setters in the three countries in the wake of NAFTA.
42Standard Setting Bodies – Objectives Analyze similarities and differences in accounting standards in 3 countriesIdentify areas where progress might be made in harmonizing these standardsProvide users of financial statements with info that would enhance their ability to compare business enterprises in 3 countries.Spencer Starts Here
43Study Group Report – Differences Significant differences in standards among Canada, Chile, Mexico, and United States:Effects of changing pricesBusiness combinationsConsolidation and equity accountingForeign-currency translationIncome taxesEPSPost-retirement benefitsPension accountingInvestmentsR&DWhen 1995 report was issued, the “top 10” major areas in which there were significant differences in standards among four countries were…Business combinations, consolidation and equity method accounting, foreign-currency translation all covered in advanced accounting course.Describe roughly each of these points.
44Study Group- Second Objective Set up a standing committeeresulted in the creation the American Free Trade Agreement Committeefor Cooperation on Financial Reporting MattersConsisted of representatives from all 4 countriesMission of committee was to:improve the overall quality and comparability ofaccounting standardsserve the information needs of users
45Study Group- Second Objective Con’t To accomplish its commitment the committee will act to:promote the comparability of accounting standardsconsider existing significant areas of difference in standardsdevelop recommendations on what specific efforts should be used to reduce existing significant differences in standardsidentify potential significant areas of difference that might be created by proposed standardsconsider work of other standard setters or other organizationsmonitor progress toward elimination of significant differences in standards