Lecture 12ACCT 332 Accounting Thought and PracticeStandard Setting IssuesChapters 12-13

Overview of the Scott Book

Objectives for Todays ClassIs regulation necessary?Chapter 12: Can markets settle information production decisions?What factors affect regulation?Chapter 13: What is the regulation process?

Information Production: First Best SolutionInformation as a CommodityDemand: information demanded by decision makersSupply: information supplied by firms, managers, analystsFrom societys perspective, firms should produce information until the marginal social benefit = marginal social cost (first-best solution)Benefit: Allows firms to make better investment decisions, improves capital allocation in the markets, improves the functioning of markets as investors have greater confidence, lower cost of capital for firms, etc. (see below)Cost: Opportunity, proprietary, administrative, enforcement, information processing, information acquisition, compliance, contracting.

Ways to Characterize Information ProductionFiner information (already in FS, but more information is provided to aid investor understanding)Expanded note disclosure, e.g. segment disclosureAdditional line items, e.g. unusual vs. recurring items; operating vs. nonoperating itemsLevels 1/2/3 in fair value reportingAdditional information (unrelated to FS, like CSR)FootnotesManagement CommentaryMore credible informationAuditCEO/CFO certification

Private Incentives for Information ProductionContractual reasonsCompensation contracts: Monitoring of manager effortDebt contracts: Monitoring of debt covenantsFirms going public: Monitoring of perksContractual incentives break down if too many parties are involvedEach contracting party may have different information needs, and there may be conflicts of interestNeed mechanisms to ensure the quality of information (not fraudulent or misstated)

Private Incentives for Information Production (contd)Market-based incentivesSecurities markets: Better disclosureReduces cost of capital lower estimation risk, less concern about adverse selectionLeads to more investor interest, increased market liquidity and higher share pricesManagerial labor marketsBetter reputation from full information releaseTakeover market disciplines poorly performing managers

Another Incentive to Disclose Information- the Disclosure PrincipleThe Disclosure PrincipleMarket knows that the manager has the informationIf the manager does not release the information, the market fears the worst Share price crashesTo avoid this adverse consequence, manager releases the informationThe Disclosure Principle does not always workManagers might not have informationIf the benefit of disclosure is lower than its cost (e.g. high proprietary costs, high political costs like making too much money/having a monopoly), it will not be releasedSometimes managers may want to depress share value (just before ESO grants or for political costs)To discourage competition

Market FailuresWhile the incentives discussed in the previous slides suggest the first-best solution (where marginal benefit = marginal cost) should be attainable, this may not necessarily be the case. Public good nature of informationFirms produce costly information that benefits investors and others (e.g., lenders, competitors), but investors dont pay for those benefits (free riding) Therefore firms may produce less information than is socially desirableThen insiders will have more informationCreates adverse selection and moral hazard problemsBuyers and better firms will withdraw Market failures

The Demand for RegulationIf markets do not work well, then they will demand more information than the manager is willing to provideLeads to demand for regulationBenefits of regulationBetter investment decisionsBetter operation of marketsGreater investor confidenceCosts of regulationDirect costs of setting, applying, and enforcing regulationCosts to firms of releasing proprietary informationReduced accounting flexibility

Two Theories of Regulator BehaviorPublic Interest TheoryObjective of the regulator is to maximize social welfare the regulator acts with the best interest of the society at heartEven if true that regulators aim to maximize social welfare, it would be difficult, if not impossible, to do so due to differences in the interests of members of societyInterest Group TheoryRegulator takes its own interest into account, while balancing demands of investors and managersImplies conflicts among constituenciesStandard setters emphasis on the due process suggests that interest group theory applies

March 2009Interest Group Theory The FASB Example

IFRS Objective of IFRS: To develop, in the public interest, a single set of high quality, understandable, and enforceable global accounting standards to help capital market participants around the world make economic decisions.Consequences of IFRS AdoptionIncreased comparabilityMore foreign investor ownershipMore foreign analysts followingLower cost of capitalMore voluntary disclosure (to cater to the increase in investor interest)Are the benefits equal across countries?

*Several non-adopters use a modified version of IFRS.

IFRS AdoptersIFRS Non-AdoptersCountry NameAdoption DateCountry NameAdoption DateCountry NameCountry NameAustralia12/31/2005Singapore12/31/2003ArgentinaPeruAustria12/31/2005Turkey12/31/2006BangladeshRussiaBelgium12/31/2005Brazil12/31/2010BahrainSaudi ArabiaCyprus12/31/2005Bulgaria12/31/2003CanadaSouth KoreaCzech Republic12/31/2005Chile12/31/2009ChinaKuwaitDenmark12/31/2005United Arab12/31/2003ColombiaTaiwanEstonia12/31/2005Ghana12/31/2007CroatiaThailandFinland12/31/2005Jamaica6/30/2003EgyptTrinidadFrance12/31/2005Qatar12/31/2002IndiaTunisiaGermany12/31/2005Philippines12/31/2005IndonesiaUkraineGreece12/31/2005Poland12/31/2005JapanUSAHong Kong12/31/2005Portugal12/31/2005JordanVietnamHungary12/31/2005Romania12/31/2005KazakhstanZambiaIceland12/31/2005Slovakia12/31/2005KenyaZimbabweIreland12/31/2005Slovenia12/31/2005LebanonItaly12/31/2005South Africa12/31/2005Sri LankaLativa12/31/2005Spain12/31/2005MalaysiaLithuania12/31/2005Sweden12/31/2005MexicoLuxembourg12/31/2005Switzerland12/31/2005MoroccoMalta12/31/2005United Kingdom12/31/2005MauritiusNetherlands12/31/2005Venezuela12/31/2005NamibiaNorway12/31/2005Israel12/31/2008NigeriaNew Zealand12/31/2007Pakistan12/31/2009Oman

Criteria for Standard Setting in a Political EnvironmentDecision usefulnessReduction of information asymmetryEconomic consequencesSensitive to costs, including contracting costs, release of proprietary information, and reduction of signaling opportunitiesAcceptable to constituencies

Presentations Next WeekEach group will have 20 minutes to present their term paper.Pick one group member to come up and draw your group order now.

Group Questions40 minutes to complete group questionsAssignment of discussion-leading groups

Week 12 Group QuestionsDiscuss the key issue of the Facebook IPO case.Why would Facebook voluntarily provide a revenue projection before its IPO?Discuss why private incentives for information production may have failed in this example.What regulations should be in place to prevent future incidents like this?

The central theme of this course is to understand how accounting provides information that increases decision usefulness. Weve began with a discussion of why we need accounting due to the information asymmetry problem between firms and investors, we then discussed how investors use information using individual decision theory, and what characteristics of accounting information are desirable under the information perspective and the measurement perspective. After the midterm, we introduced managers into the picture, and discussed their incentives in the accounting process from both a contracting perspective and an opportunistic EM perspective.

Information as a CommodityFirms Incentives to Produce InformationMarket FailuresIs Regulation Needed?

Social benefit of information production: allows firm to make better investor decisions, allows investors to make better capital allocation decisions, improves the functioning of markets as investors have greater confidence, lower cost of capital for firms, one firms information production may help us to learn about other firms, identify failing firms earlier, reduction of monopoly power if it allows potential entrants to identify profitable investment opportunities

Social costs: opportunity costs, proprietary costs, administrative costs, enforcement costs, information processing costs, information acquisition costs, compliance costs, contracting costs **Debt rating agencies, private placements, venture capitalistsUse Alibaba case as example of contractual reasons for information production when a firm goes public.When a firm goes public, the managers risk is now shared with the investors, therefore he has more incentives to shirk, but the investors are aware of this agency cost, so they will bid down the price of the new issue. To prevent this from happening, the managers have incentives to provide more information prior to the IPO

Even without regulation, firms will have private incentives to provide information. *Better disclosure greater analyst following more investor interestBetter disclosure more institutional ownership, higher share priceExample: Groupon (disclose pro-forma earnings, excluding marketing expenses, to push up offer pricesFacebook: to increase IP price recently after sharing information with institutional investors during the road show

Labor market: students bring CV to interviews

Improve ability to raise capital in securities markets, and improve employability/remuneration.**therefore firms may produce less information than is socially desirable- Private information acquisitionManagers better able to hide shirkingSmall investor disadvantaged against the big guysExample of market failure: 2008 fall, the closedown of the market for securities based on mortgageFree riding: tell the stories about the farther and two sons shipping porcelain pots end up having all pots broken because the two sons shirk and free ride; to improve: one rope for each and spank them if they do not work this is the role of regulation *{Example: Shareholders want a high-quality audit to (a) increase the credibility of the financial statements and (b) to detect manager shirking. Managers are mainly interested in the first reason, and thus the audit is of less value to them. Thus shareholders will demand more than the manager is willing to supply.}

{ It is possible that economic costs outweigh the economic benefits}{ Conclusion: Regulation cant be fully explained by economic reasoning also have to look at political aspects}

*Both theories work; the public interest theory can be represented by investors interestRecent changes in the due process of IASBStories about related party transaction rule, IASB , China all companies are related parties*Illustration of interest group theory where House Financial Services subcommittee pushed FASB to change its rule on MTMFinancial firms complained that the current MTM rules were to harsh during the financial crisis, resulting in the writedown of billions of losses.Paul Kanjorski is the head of the House Financial Services committeeThirty-one financial firms and trade groups formed a coalition and spent $27.6 million in the first quarter lobbying Washington about the rule and other issues.In a draft proposal issued in April, FASB changed its rules to say that financial firms could "presume" markets were dysfunctional unless there was ample evidence otherwise. Then they could use internal models to set values, rather than market prices. Their models are not fully disclosed to investors.*These are numbers from just the first quarter of 2009 Kanjorski received 700,000 in contributions from 2007-2009The benefits are not equal across countries:Countries have to train their accountants to use IFRS, as well as enforce the adoption of IFRS (compliance and regulatory costs)

Depends on legal origin (code vs common), differences between domestic GAAP and IFRS, enforcement

For code law countries (where a lot of information shared through private channels), the benefits of adopting IFRS will be a lot greater, as transparency will greatly improve.*Concerns of adoption IFRS in EU: implementation costs and loss of diversity in domestic standards

Decision usefulness: IFRS is more fair-value oriented, and hence more relevantReduce info asymmetry: Higher quality standardsEconomic consequences: Higher investor following, reduce cost of capital*(Refer to Profs official answers) Reg FD says all public companies must disclose information to all investors at the same time. (open conference calls) However, Reg FD only applies to public companies, and so did not apply to Facebook yet.

1)

2) Viewed as being transparent, reducing WACC

3) Benefits of nondisclosure > costs of nondisclosure:

4) Amendments then did not require highlights could mandate that all amendments be highlighted so as to alert investors of them. Only allow open conference calls (whereby any investor can participate and listen in) for firms about to go public as well.