Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 1 of 13
CHAPTER HIGHLIGHTS
In recent years, the regulatory nature of accounting policy making has become a prominent topic
in both academic and professional accounting literature. The purpose of this chapter is to expose
students to the two extreme sets of arguments: those that favor free markets, and those that favor
regulatory intervention.
The second part of the chapter explains the political nature of regulatory decision making.
Students should understand the “self-interest” principle in a regulatory environment. The self-
interest principle is applicable to (1) accounting regulators (FASB and the SEC) and (2) the
constituency groups affected by accounting regulation. These latter groups include preparers,
auditors, interpreters, and users of accounting reports.
Finally, “economic consequences” has become a vogue term in accounting literature. Basically,
it refers to the effect of accounting standards and reports upon the decision-making behavior of
preparers and users. Economic consequences can be viewed as part of what is called the political
economy of accounting. Simply put, the argument is that any choice of financial reporting
systems, from laissez faire to complete regulation, makes some people better off and others
worse off. It is thus difficult for standard setting to maintain neutrality.
Finally, Sarbanes-Oxley of 2002 (SOX), by establishing the PCAOB and providing FASB
funding from non-taxpayer accounting support fees, has reduced self-regulation by the
accounting profession. This signals significant changes for several years to come.
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 2 of 13
QUESTIONS
Q-1 What are the arguments favoring regulation of financial reporting?
The arguments for regulation are in two groups: those relating to market failures and those
relating to social goals. It can be argued that private incentives for financial reporting do not
Q-2 What are the arguments against regulation of financial reporting?
The arguments against regulation focus on the incentives to report voluntarily. Agency theory
Q-3 Why is it difficult to evaluate the regulation question?
The free-market position cannot be easily researched (empirically) because the market is
Q-4 Why does accounting information have some features of a public good? What are the
implications for information production in both unregulated and regulated markets?
A public good is one that is characterized by non-rival consumption; that is, it can be consumed
without reducing the opportunity for consumption by others. In one sense, an accounting report
can be read without reducing the information available to subsequent readers. However, the
Q-5 Why can’t optimal regulation be determined? If optimal accounting regulation cannot
be determined, how can a regulatory body such as the SEC or FASB make good
decisions?
Arrow argues (in the Impossibility Theorem) that optimal regulation (resource allocation
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 3 of 13
Q-6 A distinction was made in the chapter between two types of regulation: (a) the
refinement and standardization of financial statements and (b) expanded disclosure.
Why is the distinction important in evaluating the regulation question?
Refinement and standardization is probably more aesthetically pleasing because it is within the
body of the statements themselves and should lead to increased comparability. The emphasis
Q-7 Who pays for accounting regulation and who benefits?
These are important but unanswered questions, at least in terms of accounting research. From a
self-interest viewpoint, auditors and financial intermediaries benefit from regulation because new
Q-8 Can accounting standards and policy making be neutral? In what sense is neutrality
really important?
Neutrality is not possible in the sense that someone benefits from regulation, and someone pays
Q-9 Arrow (1963) warns that public participation and a consensual approach to social
issues can lead to democratic paralysis; that is, to a failure to act due to an inability to
agree on goals or objectives. How did such a situation lead to the demise of the APB
(review Chapter 3)? Why is the FASB faring somewhat better?
The rejection of ARS 1 and ARS 3 by the accounting profession was a failure due to inability to
agree on goals. While the APB did have some successes (pension and income tax allocation, for
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 4 of 13
Q-10 Horngren (1973) argues that accounting policies are a social decision and a matter of
public interest. Evaluate this statement.
The decision to regulate is a social decision because it affects society’s allocation of resources.
Q-11 Horngren (1973) believes that accounting standards must be marketed by regulatory
bodies. By this he means that affected parties need to be sold on the benefits of
standards. How is this concept consistent with the nature of regulation?
Regulatory theories suggest that regulators are motivated to make their constituents happy in
order to enhance the position of the regulator. The essence of Horngren’s position is that the
Q-12 It was suggested many years ago that a court should be created to resolve disputes in
accounting. In what ways does the FASB function as an accounting court? In what
ways is it different?
The due-process nature of regulatory decision making is adapted from the legal system. There is
Q-13 What benefit is the conceptual framework project to the FASB if (a) there is no way of
determining optimal accounting regulation and (b) regulatory decision making is a
political process?
Perhaps the best way of characterizing it is to liken it to the United States Constitution, as
Q-14 What is the relationship between public goods and free riders? Is accounting a public
good?
Free riders are those individuals who capture the benefits of public goods without paying for
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 5 of 13
Q-15 What is Pareto optimality? Why would adherence to it minimize accounting standard
setting?
Pareto optimality refers to social situations where the benefit of one group or individual cannot
be improved without hurting other groups or individuals. The problem with applying Pareto
Q-16 How do agency theory and the codificational viewpoint differ in assumptions about the
behavior of individuals?
Under the agency theory view, individuals act in their own best interest. The problem with this
assumption is that it is tautological. The codificational view is more process-oriented than
Q-17 Why does codification presume a democratic setting?
Q-18 The social goals underlying accounting regulation are information symmetry and
comparability. Why are these goals complementary?
These are complementary because we not only want as much comparability between firms as
Q-19 Would a regular quarterly announcement of earnings-per-share which is “good” be an
example of signaling? What about early adoption of a new accounting standard that
would reduce income?
Regular reporting of information such as quarterly announcements of earnings-per-share would
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 6 of 13
Q-20 If accounting were not regulated, we would not be facing the difficult problems that
have arisen as a result of Enron and other corporate auditing failures. Do you agree
with this statement? Explain.
Absolutely not! Enron arose out of pure greed. Enron, WorldCom, and others arose because
individuals tried to “game the system.” The problem would have been as bad – if not worse – if
Q-21 Evaluate Ronen’s financial statement insurance proposal.
Ronen, Joshua (2002). “Policy Reforms in the Aftermath of Accounting Scandals,” Journal of
Accounting and Public Policy 21, no. 3: 281–286.
Q-22 Under financial statement insurance why would the relation between the firm and its
auditor and investors bear a slight resemblance to the relationship between Saddam
Hussein and the weapons inspectors from the United Nations in 2002 and 2003?
The auditors’ role would be somewhat similar to the weapons inspectors and the firm would be
similar to Iraq or, if you like, Saddam Hussein. The financial statement insurance proposal
Q-23 What is due process in financial accounting standard-setting?
Due process refers to the bringing into the process all of those who are affected by it, standard
Q-24 Why do companies, even those with “bad news,” have an incentive to disclose
financial reporting information?
While “bad news” is no fun, it gets everything into the open. Not announcing would certainly
add to the volatility of the security price. Of course one of the problems today is firms trying to
Q-25 Does the ability to swiftly-and at no cost-download music files convert this music from
a private good to a public good?
Yes. Files can be shared at no cost resulting in an inability by the artist and the public to restrict
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 7 of 13
CASES, PROBLEMS, AND WRITING ASSIGNMENTS
1. What is the relationship among agency theory, economic consequences, and
signalling? Explain in depth
There is a close connection between agency theory and economic consequences. An underlying
assumption of agency theory is that the firm is a locus or nexus among competing groups:
management tries to maximize its compensation at a cost to shareholders of money that might
have gone into dividends, bondholders likewise want to get their interest and principal and not be
jeopardized by excessive dividends to shareholders hence debt covenants protecting bondholders
2. Benston (1982, p. 102), in an analysis of corporate social accounting and reporting
(CSAR), says: “The social responsibility of accountants can be expressed by their
forebearing from social responsibility accounting.” However, in a critique of Benston’s
analysis, Schreuder and Ramanathan (1984, p. 414) state:
The comments . . . do not purport to convey the message that there is no value at all in
analyzing the potential of CSAR from a shareholder perspective and proceeding from
the (implicit) assumption of perfect and complete markets. We do, however, wish to
point out that this may not be the most appropriate perspective as (1) CSAR is
addressed toward a more inclusive group of stakeholders and (2) one of its main
objectives is to include in the accounting system those aspects of corporate behavior
that are decidedly not handled well by the market. Therefore, the perspective implied
in Benston’s analysis is of very limited value at best.
Required:
CSAR assumes there is a legitimate interest or “stake” in the corporation beyond the
stockholders’ interests, and that these other stakeholders’ interests are not well served
by traditional financial statements. Therefore, it follows that within a broad political
economy of accounting, CSAR is an important policy-making issue. Critically evaluate
this proposition and indicate your agreement or disagreement and the underlying
reasons for your position.
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 8 of 13
This case is intended to raise serious questions about the “primacy” of the FASB’s primary user
group of investors/creditors. Lip service is paid to the existence of other stakeholders, but with a
3. Discuss the economic consequences issues that are present in each of the following
transaction situations.
SFAS No. 13 allows lease contracts to be set up so that the transaction can usually be
set up as an operating lease rather than a capital lease.
When SFAS No. 19 was passed, medium-sized petroleum exploration firms
campaigned hard to set it aside. SFAS No. 19 would have allowed successful efforts
only, whereas the lobbying firms wanted an unrestricted choice between full costing
and successful efforts.
A securities industry group objected to part of APB Opinion No. 10, which would have
required that all convertible debt be broken down into debt and equity portions at the
time of issue. The debt portion (bonds payable plus premium or minus discount) would
be booked at the effective rate without the conversion privilege with the equity portion
credited to paid-in capital. The industry group was pleased by APB Opinion No. 14,
which did not break out the equity portion of convertible debt except if detachable
stock warrants were issued. Why was the securities industry group (which represented
investment bankers who floated large loans for industry) unhappy with Opinion No. 10
and pleased with Opinion No. 14?
SFAS No. 87 does not show the full pension obligation or liability in the balance sheet
(although a “minimum” liability may be present).
SFAS No. 96 made it much more difficult to recognize deferred tax assets as opposed
to deferred tax liability (a more even-handed treatment was used in recognizing
deferred tax assets and liabilities in SFAS No. 109, which superceded SFAS No. 96).
The FASB tried to include the cost of stock options as an expense but they were
prevented from doing so by vociferous opposition from the business community,
although it now is going to happen under SFAS No. 123R.
This allows for a “better” measurement of debt-equity ratios from the perspective of
shareholders—less of a problem of violating debt covenants—hence making it easier to pay
dividends. Shareholders thus benefit from the ability to more easily receive dividends, which
can work to the detriment of the firm’s bondholders.
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 9 of 13
Zeff (1978) discusses this situation. It appears that the crux of the problem under the break-out
of debt and equity is that by assigning some of the credit to equity, the resulting lower carrying
value of debt would raise the effective rate of interest (as opposed to no break-out of equity) and
also lower the level of income by either reducing the premium or increasing the discount (as
opposed to no break-out of equity). The securities industry group may therefore have thought
that convertible debt raised through their auspices had a higher cost than, in their opinion, it
really had.
Cash
1,000,000
Discount on bonds 100,000
Bonds
payable
1,000,000
Paid-in
capital
100,000
Interest expense 110,000
Cash
100,000
Discount on
bonds
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 10 of 13
SFAS No. 96 would have had a detrimental effect on debt-equity ratios and would likewise have
resulted in lower income when deferred tax assets were not recognized. Hence it would have
been beneficial for bondholders over stockholders. The lower income which would have
resulted in some cases (where deferred tax assets would not have been recognized) might have
resulted in lower security prices.
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 11 of 13
4. Although a recent study by Barton and Waymire indicates that there are incentives for
higher quality financial information under unregulated financial reporting, why is this
finding not an effective one in support of unregulated financial reporting?
References:
Barton, Jan and G. Waymire (2004). “Investor Protection Under Unregulated Financial
Reporting,” Journal of Accounting and Economics (December 2004), pp. 65-116.
5. Etzioni (2009) argues that the 2008 financial crisis points towards widespread
regulatory capture resulting in special interests benefiting from the capture. Rather
than pursue more or less regulation, Etzioni argues for capture-proof regulations.
Evaluate Etzioni’s proposals.
Etzioni, Amitai (July 2009). “The Capture Theory of Regulations–Revisited,” Society, 319–323.
Etzioni suggests that what is needed is a way to make regulations stronger, more capture-proof.
“This requires, first of all, greatly restricting the role of private money in public life, mainly
through reforming campaign-finance laws. Unless this change is adopted, regulations will
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 12 of 13
CRITICAL THINKING AND ANALYSIS
1. Evaluate the costs and benefits of the accounting standard-setting process (versus an
unregulated environment).
This question spans the entire chapter. Repeating the arguments from the beginning of the
chapter should not be sufficient but it is most likely necessary. Balancing the pros and cons is
probably important. The social goals of improving comparability and increasing information
2. How might the “capture” of auditors by auditees be mitigated?
Capture theory argues that the group being regulated eventually comes to use the regulatory
process to promote its own self interest. One approach to responding to the question would
address the long-term relationship between the audit firm (auditor) and its client (auditee).
Perhaps the relationship with an individual regulatory body (audit firm in this case) could be
periodically changed to restart the clock, so to speak. For example, Brazil requires that public
companies periodically rotate audit firms, not just audit partners. This limits the ability of time
to affect the audit-client relationship, keeping it professional rather than too friendly. What
would be the effect of mandated audit firm rotations every 5-10 years in the USA? The idea of
the cost-benefit should arise. Sarbanes-Oxley of 2002 (SOX) requires audit partner rotations
every five years, not audit firm rotations; will this mitigate the capture?
Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual
Accounting Theory (9
th
edition) Page 13 of 13
3. Ball (2009) evokes the question of responsibility for the rash of accounting scandals in
the 2000s. What actions do you propose to address the problem, if you agree that one
exists?
Ball, Ray (May 2009). “Market and Political/Regulatory Perspectives on the Recent Accounting
Standards,” Journal of Accounting Research, 277–323.