Chapter 4:

1. Chapter 4: The Economics of Financial Reporting Regulation

2. Lecture • Financial reporting • unregulated • regulated • Political and economic nature of the regulatory process • Economic consequences of accounting standards

3. Financial Reporting: Unregulated • Agency theory explains why incentives exist for voluntary reporting to owners • Signalling theory explains wider voluntary reporting to the capital markets • Private contracting

4. 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 relationship • Potential conflict between goals of two groups • Financial reporting may mitigate conflicts

5. Signalling Theory • Voluntary disclosure is necessary in order to compete successfully in the market for risk capital • A good reputation with respect to financial reporting will improve a firm’s ability to raise capital • Good reporting would lower a firm’s cost of capital • Less uncertainty about firms that report more extensively and reliably • Less investment risk and a lower required rate of return

6. Signalling Theory • Economic incentive to report (even bad news) is at the heart of the argument for voluntary financial reporting • Information asymmetry between the firm (insiders) and outsiders (investors)

7. Private Contracting for Information • If information were truly desired beyond that which is publicly available and free of charge, private individuals can buy the desired information. • Market forces should result in the optimal allocation of resources to the production of information

8. Financial Reporting: Regulated • 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 market • Less wealth transfers between those who have information and those who do not • Principle behind the insider trading regulations

9. 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)

10. 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

11. Imperfections of Accounting Regulation • a potential over-allocation of social resources to the production of free publicly available accounting information • 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.

12. The Regulatory Process • Essentially a political activity • Due process is an important ingredient • Tradition 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

13. Regulatory Behavior • Capture theory • The group being regulated eventually comes to the regulatory process to promote its own self-interest • Result is that the regulatory process is considered captured • Life-cycle theory • Argues a regulatory process goes through several distinct phases • Starts out in the public interest, but later becomes an instrument of protecting the regulated group

14. Economic Consequences of Accounting Standards • Accounting policy • Not simply a matter of economic efficiency • Also affects income and wealth distribution • FASB • Considers cost-benefit of standards • Standards • One set for all firms • Compliance costs are disproportionately high for smaller, nonpublicly traded forms

15. Lecture Recap • Financial reporting • unregulated • regulated • Political and economic nature of the regulatory process • Economic consequences of accounting standards