Chapter 4: The Economics of Financial Reporting Regulation

Financial reporting
unregulated 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 owners Signaling 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 relationship
Potential 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 capital A good reputation with respect to financial reporting will improve a firms ability to raise capital Good reporting would lower a firms cost of capital
Less uncertainty about firms that report more extensively and reliably Less 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 reporting Information 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 market

Less 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 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

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

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

Chapter 4: The Economics of Financial Reporting Regulation

financial reporting
unregulated regulated

political and economic nature of the regulatory process economic consequences of accounting standards