Chapter 4: The Economics of Financial Reporting Regulation

Financial reportingunregulated

regulated

Political and economic nature of the regulatory process

Economic consequences of accounting standards

Unregulated financial reporting

Laissez faire Agency theory explains why incentives exist for voluntary reporting to ownersSignaling theory explains wider voluntary reporting to the capital markets

Agency Theory

Views the firm as a nexus of agency relationships and seeks to understand behavior by examining how parties maximize their own utility

Management-Owner agency relationshipPotential conflict between goals of two groups

Financial reporting may mitigate conflicts

Signaling Theory

Voluntary disclosure is necessary in order to compete successfully in the market for risk capitalA good reputation with respect to financial reporting will improve a firm’s ability to raise capitalGood reporting would lower a firm’s cost of capital

Less uncertainty about firms that report more extensively and reliablyLess investment risk and a lower required rate of return

Signaling Theory

Economic incentive to report (even bad news) is at the heart of the argument for voluntary financial reportingInformation asymmetry between the firm (insiders) and outsiders (investors)

Regulated Financial Reporting

Can be justified on the grounds that it is in the public interest

Possibility of market failure

Possibility that free markets are contrary to social goals

Creates fairness in the marketLess wealth transfers between those who have information and those who do not

Principle behind the insider trading regulations

Possibility: Market Failures

Firm as a monopoly supplier of information

Failure of financial reporting and auditing to prevent frauds and bankruptcies

Public-goods nature of accounting information and financial reporting

Public goods are underproduced in a market economy

Consumers of public goods without paying for them are called free riders (results from an externality)

Possibility: Contrary to Social Goals

Involves a normative judgment about how society should allocate its resources

SEC assumes that the stock market will be fair only if all potential investors have equal access to the same information

Goal is information symmetry

Referred to as fair reporting

The Regulatory Process

Essentially a political activity

Due process is an important ingredientTradition goes back to the Interstate Commerce Commission (ICC), one of 1st federal agencies

Seeks to involve all affected parties in the deliberations

Maintains legitimacy of the regulatory process

Regulatory Behavior

Capture theoryThe group being regulated eventually comes to the regulatory process to promote its own self-interestResult is that the regulatory process is considered captured

Life-cycle theoryArgues a regulatory process goes through several distinct phasesStarts out in the public interest, but later becomes an instrument of protecting the regulated group

Economic Consequences of Accounting Standards

Accounting policyNot simply a matter of economic efficiencyAlso affects income and wealth distribution

FASBConsiders cost-benefit of standardsStandards

• One set for all firms• Compliance costs are disproportionately high for

smaller, nonpublicly traded forms

Chapter 4: The Economics of Financial Reporting Regulation

financial reportingunregulated

regulated

political and economic nature of the regulatory process

economic consequences of accounting standards