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Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 13

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CHAPTER 13

STANDARD SETTING: POLITICAL ISSUES

13.1 Overview

13.2 Two Theories of Regulation

13.2.1 The Public Interest Theory

13.2.2 The Interest Group Theory

13.2.3 Which Theory of Regulation Applies to Standard Setting?

13.3 Conflict and Compromise: An Example of Constituency Conflict

13.4 Distribution of the Benefits of Information: Regulation FD

13.5 Criteria for Standard Setting

13.5.1 Decision Usefulness

13.5.2 Reduction of Information Asymmetry

13.5.3 Economic Consequences of New Standards

13.5.4 Consensus

13.5.5 Summary

13.6 The Regulator’s Information Asymmetry*

13.7 International Integration of Capital Markets

13.7.1 Convergence of Accounting Standards

13.7.2 Effect of Customs and Institutions on Financial Reporting

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13.7.3 Enforcement of Accounting Standards

13.7.4 Benefits of Adopting High Quality Accounting Standards

13.7.5 The relative Quality of IASB and FASB GAAP

13.7.6 Should Standard Setters Compete?

13.7.7 Should the United States Adopt IASB Standards?

13.7.8 Summary of Accounting for International Capital Markets Integration

13.8 Conclusions and Summing Up

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES

1. To Review Two Theories of Regulation

Section 13.2.2 is oriented to the so–called interest group theory of regulation put forth

by Stigler (1971), Posner (1974), Peltzman (1976), and Becker (1983). While this

theory is quite old now, I find it is still relevant and helpful in thinking about the process

of standard setting.

Students readily see the distinction between the two theories based on the discussion

in Section 13.2. However, for instructors who have the time and inclination to cover

regulation in greater depth, the above articles are still worth reading. If assigning one of

them, I recommend Becker (1983).

While my conclusions in the chapter is that the interest group theory reasonably

describes actual standard–setting processes, the public interest theory should not be

discarded since protecting the public interest is, after all, the goal of regulation.

2. To Examine Constituency Conflict in Action

The material in Section 13.3, on the proposal to limit the SEC’s power to direct

accounting standards, provides a vivid example of the power and influence

management can bring to bear. Problem 7 of this chapter provides another example,

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 13

namely the influence of European banks who disliked the prospect of fair value

accounting for financial instruments. Similar conflict with respect to other standards can

easily be found. See, for example, Problem 4 re the furore over the FASB’s standard

123R requiring expensing of employee stock options, Problems 12 and 13 re

Regulation FD, and Problem 15 re Sarbanes–Oxley..

3. To Lay Down Criteria for a Successful Standard

Here, I engage the class in a discussion of the criteria for standard–setting suggested in

Section 13.5, arguing that theoretical correctness is not sufficient for successful

standard.

I then return to the fundamental problem of financial accounting theory introduced in

Section 1.10, pointing out that the constituency conflict that characterizes standard–

setting illustrates how difficult it is to resolve the problem. Hopefully, however, the book

helps the students to see the nature and significance of the problem more clearly.

4. To Introduce Information Asymmetry Between Firm Manager and Regulator

This is an optional section. While it gives an intuitive discussion of issues and some of

the models in this area, it also contains some quite technical material. Nevertheless,

since the focus of this book is on information asymmetry, some coverage is

appropriate. While to date there is relatively little accounting research on regulation

under information asymmetry, this is an area that would benefit from research attention.

The adaptation of a model from Laffont and Tirole (1993) is intended to suggest a

framework within which to think about the effects of information asymmetry between

regulator and manager in an accounting context. The most interesting aspect of the

model of Dessein (2002) is the creation of an intermediate body (the standard setter)

between the regulator (the securities commission) and the manager, which is of obvious

familiarity to accountants.

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5. To Introduce Benefits and Challenges of International Convergence of

Accounting Standards

International convergence of accounting standards is an important topic in financial

reporting these days, and is receiving much research attention. Since adoption of IASB

standards is at least in part a political decision, and is affected by the social, legal, and

political institutions in the countries involved, any discussion of political aspects of

standard setting must now include international standards convergence.

Since current accounting students will be operating increasingly in an international

reporting environment, I suggest concentration on the following points:

• Benefits of international standards convergence. Claimed benefits include lower

financial statement preparation costs, lower network externalities, lower costs of

capital, and increased foreign and domestic investment. By and large, current

research tends to support these claims, although it seems that strong institutions

and enforcement are also necessary if these benefits are to be realized.

• It is unclear whether or not IASB and FASB standards are of equal quality. The

results of Barth, Landsman, Lang, & Williams (2006) and Leuz (2003) provide

conflicting results, for example. However, quality differences will decline as

convergence progresses. A good question for discussion is whether this

convergence will continue, due to current differences in fair value accounting

(e.g., IFRS 9 re business model, and accounting for loan loss provisioning).

• Differences in social, legal, and political institutions across countries create

different contracting and investing environments, which show up as lower

reporting quality than under United States standards, but which actually

represent rational responses to these institutional differences. This is the

message of the Ball, Kothari, & Robin (2000); Ball, Robin & Wu (2003), and

Bushman & Piotroski (2006) papers. The important point is that adoption of IASB

standards by countries does not necessarily mean uniform financial statement

quality across these countries. Rather, investors should interpret foreign financial

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 13

statements taking into account the specific institutional environment of each

country.

• Since the U.S. now accepts financial statements of foreign countries with shares

traded in the U.S. without reconciliation of those statements to U.S. GAAP, this

seems to imply an acceptance of IASB standards as of equal quality to FASB

standards, even though the 2 sets of standards are not completely converged.

However, it now seems unlikely that a “big bang” adoption of IASB standards by

the U.S. is likely (Section 13.7.7).

• As an alternative to IASB adoption, should the SEC accept reporting under IASB

or FASB standards by all companies within its jurisdiction (i.e., including

domestic U.S. companies)? This possibility is of considerable import to Canadian

companies, among others. If adopted, it would lead to a measure of competition

between standard setters, creating interesting possibilities of a race to the

bottom or to the top. Problem 8 of this chapter complements the text discussion

in this regard.

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 13

SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS

1. a. Under the public interest theory, the regulatory body (e.g., the standard

setter) attempts to produce an amount of regulation that maximizes social

welfare, by trading off social benefits and social costs of information production.

Standards for which the social benefits exceed the social costs are socially

b. Because of the difficulties of determining the socially optimal amount of

regulation, the regulatory body under the public interest theory may produce

more or less than this amount.

Under the interest group theory, to maximize its own interests, the regulatory

2. a. Aspects of the structure of standard setting that facilitate conflict

resolution in the process of setting new standards include:

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publishes standards “on its own authority.” Most of these standards

are from the IASB.

b. The reason for supermajority voting, presumably, is to foster a spirit of

compromise and to reduce concerns by any one constituency that others,

3. Benefits of adopting IASB standards:

• Better working domestic capital markets, leading to lower firms’ cost of

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 13

Adoption of IASB standards increases the likelihood of acceptance. This

can lead to increased foreign investment by domestic companies.

Costs of adopting IASB standards:

• Financial reporting is affected by local customs, laws, and other

institutional characteristics. Problems arising from adverse selection and

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• Increased pressure on auditors from influential controlling interests in

firms to bend the standards for their benefit. This strains the auditor’s

ethical responsibilities and can lead to increased possibility of legal

liability.

4. a. Advantages of ESOs as a compensation device, in theory:

• Alignment with shareholder interests. Since the value of ESOs

depends on share price, manager effort to increase share value is

encouraged.

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securities markets are not fully efficient, lowered their costs of

capital.

b. Some negative effects of ESOs in practice:

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d. The actions of the opponents of ESO expensing are most consistent with

the interest group theory of regulation. They are actively lobbying the legislature

to defeat the FASB’s proposed standard.

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Reduction of information asymmetry. Again, this depends on the extent of

securities market efficiency. If markets are fully efficient, there is no reduction

since the market already had the expense information under SFAS 123.

5. a. This sequence of events is most consistent with the interest group theory.

Under the interest group theory, constituencies affected by a proposed

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the FASB and turn standard setting over to a possibly more political body, the

SEC. Presumably, the bank manager constituency feels that the SEC will be

more amenable to its wishes and concerns.

c. Costs of moving standard setting to the SEC:

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• As a bureaucracy in its own right, the costs of setting and

administering accounting standards by the SEC may be greater

than under the FASB.

Benefits of moving standard setting to the SEC:

6. Under the public interest theory of regulation, the standard setter attempts to

maximize social welfare. The standard setter may believe that adopting IASB

standards will improve the operation of domestic capital markets, reducing firms’

costs of capital and attract increased foreign investment.

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The ability of domestic firms to raise capital will be improved if they can tap the

capital markets of other countries. Ability to raise capital will be improved to the

extent that foreign investors are already familiar with IASB standards

7. a. Suggested reasons why banks and insurance companies are concerned

about volatility:

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• Increased probability of violating regulatory capital constraints.

To the extent that financial instruments are fair valued,

shareholders’ equity is more volatile if changes in fair values

are not fully hedged or otherwise offset.

b. Costs of the SEC’s allowing both FASB and IASB standards:

• Possible race to the bottom, whereby each standard setting

body lowers its standards to attract firms to its version of

GAAP. This would lower the amount of useful information to

investors and negatively affect the working of capital markets.

Benefits of the SEC’s allowing both FASB and IASB standards:

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• Easier access to U.S. capital markets by foreign firms. This

would lower their costs of capital due to the liquidity of the

U.S. markets.

• Ability to signal. Firms could signal their commitment to full

disclosure and transparency choosing the highest quality set

of standards.

• Competition may reduce the tendency of standard setters to

over– regulate by mandating more standards than socially

desirable, particularly if the interest group theory of regulation

applies.

c. The carveouts will likely reduce the probability of the SEC accepting IASB

standards. To the extent that a major constituency such as the EU rejects,

8. a. With a race to the top, each standard setting body competes by raising

the quality of its accounting standards in the expectation that firms will choose

high quality standards over low quality standards.

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c. The main difficulty is reduced comparability of foreign and U.S. firm

financial statements. That is, if the SEC accepts IASB standards without

reconciliation, investors’ network externalities increase. Without reconciliation,

and in the absence of full standards convergence, investors must become aware

of differences between two sets of standards. Even with convergence, investors

9. a. The first item represents the increase during the quarter in the fair value of

TD’s available–for–sale securities. These securities are valued at fair value for

balance sheet purposes, and changes in fair value are unrealized, hence

included in other comprehensive income. It seems that TD hedges at least some

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The second item represents the gains realized by TD on sales of its available–

for–sale securities during the quarter. These gains are transferred out of other

comprehensive income to net income.

b. The purpose of other comprehensive income is to reduce the volatility of

reported net income that would result from fair valuing financial assets without

c. An alternative treatment is to include other comprehensive income items

on the income statement, below net income, to arrive at comprehensive income

Scott, Financial Accounting Theory, 7th Edition Instructor’s Solutions Manual Chapter 13

about its effort in managing the firm, and thus wishes to separate them as much

as possible from net income.

d. The earnings measure that generates the highest main diagonal

probabilities of the information system is the most useful for an investment

decision. Arguments in favour of net income as most useful are:

Arguments in favour of other comprehensive income as most useful include: