Chapter 4
The Economics of Financial
Reporting Regulation
TRUE/FALSE
- Financial reporting for publicly-listed companies in the United States was first regulated in the 1950s.
ANS: F - Congress empowered the Securities and Exchange Commission to regulate financial reporting in the 1930s
ANS: T - The SEC has allowed accounting policy-making power to remain in the private sector.
ANS: T - Arguments supporting unregulated markets are largely inductive in nature.
ANS: F - All of the arguments supporting the case for unregulated markets relate to the incentives for a firm to report information about itself to owners and to the capital market in general.
ANS: T - Empirical tests of the free market position are impossible since we live in a regulated environment.
ANS: T - Agency theory explains that firms have an incentive to report voluntarily to the capital market because they are competing for risk capital.
ANS: F - The major agency relationship is between the management of a firm and a firm’s creditors.
ANS: F - Good financial reporting will lower a firm’s cost of capital.
ANS: T - Only firms that perform well have incentives to report their operating results.
ANS: F - According to signalling theory, firms have an economic incentive to report bad news.
ANS: T - The value of a company can be increased when the firm voluntarily reports private information about itself if the information reduces uncertainty about the firm’s future prospects.
ANS: T - There is usually information symmetry between the firm and outsiders.
ANS: F - Early adoption of new financial accounting standards generally indicates “bad news” whereas late adoption generally indicates “good news.”
ANS: F - The stock market shows that people are willing to contract privately for information about a firm.
ANS: T - An argument in favor of unregulated markets is that because of private opportunities to contract for information, market intervention in the form of mandatory disclosure rules is both unnecessary and undesirable.
ANS: T - An argument supporting accounting regulation is that it is better to force mandatory reporting than to have individuals competing to buy information privately.
ANS: T - An argument supporting accounting regulation is that the production costs of mandatory reporting requirements may be small since most of the basic information is produced as a by-product of internal accounting systems.
ANS: T - Risk in investment can be eliminated by improved accounting and auditing procedures.
ANS: F - Accounting regulation prevents fraud.
ANS: F - Public goods are commodities that once consumed, the opportunity for consumption by others is reduced.
ANS: F - True markets demand for public goods may be determined by the number of consumers that pay for the goods.
ANS: F - An argument supporting regulated markets is that more and better regulation is necessary to raise the quality of financial reporting in order to protect the public from frauds and failures.
ANS: T - An argument supporting regulation is that the only way to increase production of public goods to meet the real demand of the public is through regulatory intervention.
ANS: T - Accounting information is a public good.
ANS: T - Information symmetry exists when potential investors do not all have equal access to the same information.
ANS: F - Pro-regulation arguments as well as arguments for unregulated markets are largely deductively reasoned rather than empirically researched.
ANS: T - There is a tendency for overproduction in unregulated markets.
ANS: F - The Impossibility Theorem implies that once the free market pricing system is abandoned, there is no way of determining aggregate social preferences.
ANS: T - Overproduction of accounting information, or the problem of standards overload, has the greatest effect on large, publicly traded companies.
ANS: F - The present financial disclosure system imposes costs on users rather than the companies themselves.
ANS: F - In setting policy, due process, means that a regulatory agency seeks to involve all affected parties in its deliberations.
ANS: T
MULTIPLE CHOICE
- Which of the following is not an argument supporting unregulated markets?
a.Agency theory
b.Private contracting opportunities
c.Signalling theory
d.Social goals XXXXX - Which of the following concepts provides a framework for analyzing financial reporting incentives between managers and owner?
a.Signalling theory
b.Agency theory XXXXX
c.Information symmetry
d.Private contracting - Which of the following concepts explains why firms have an incentive to report voluntarily to the market even if there were no mandatory reporting requirements.
a.Signalling theory XXXXX
b.Life-cycle theory
c.Information overload
d.Capture theory - Which of the following concept holds that anyone who genuinely desires information about a firm is able to obtain it?
a.Signalling theory
b.Agency theory
c.Information symmetry
d.Private contracting XXXXX - Which of the following concepts holds that voluntary disclosure is necessary in order for a firm to compete successfully in the market for risk capital?
a.Signalling theory XXXXX
b.Agency theory
c.Information symmetry
d.Private contracting - Which of the following is not a possible justification for regulated markets?
a.Possible market failure
b.Natural monopolies
c.The possibility that free markets are contrary to social goals
d.Private contracting opportunities XXXXX - Which of the following has been cited as a reason for alleged low quality of financial reporting, even under regulation?
a.Not enough management flexibility in the choice of accounting policies.
b.Poor accounting and auditing standards XXXXX
c.Laxity by securities analysts
d.All of the above - Goods that possess hard property rights so that non-purchasers are excluded from consuming them are called:
a.Public goods
b.Regulated goods
c.Private goods XXXXX
d.Under produced goods - An externality exists if:
a.A producer of a good is unable to impose production costs on all users of the good. XXXXX
b.True market demand for a good is revealed in the market place.
c.Production of a good equals true market demand.
d.The production of a good is regulated. - The effect of an externality is that:
a.Production of a public good equals market demand.
b.Production of a private good equals market demand.
c.True market demand for public goods may be determined by the number of consumers that pay for the goods.
d.The producer of a public good has a limited incentive to produce it because all consumers cannot be charged for the good. XXXXX - Which of the following is considered a social goal related justification for imposing financial reporting regulation?
a.Information symmetry
b.Comparability
c.A competitive capital market
d.All of the above XXXXX - Which of the following does not apply to a codificational system such as accounting standards?
a.It is pragmatic because maximizing the standards is impossible.
b.Outputs are evaluated on the basis of whether they work correctly.
c.Outputs are evaluated on the basis of whether they provide information to users at a reasonable cost.
d.Outputs are correct in terms of deductive logic. XXXXX - Mandatory public reporting of financial information:
a.Enhances the perceived fairness of the capital market. XXXXX
b.Increases the total cost to society of obtaining the information.
c.Results in costs greater than benefits.
d.Requires companies to generate a lot of information that would not otherwise be produced by its accounting system. - The focus of accounting regulation is on:
a.Mandatory reporting.
b.Improving the quality of reported information. XXXXX
c.Standards overload.
d.Underproduction of accounting information. - Which of the following is not a negative consequence of regulating accounting?
a.A wealth transfer from nonusers to users of accounting information.
b.The imposition of disclosure costs on the users of financial information. XXXXX
c.A potential over-allocation of social resources to the production of free, publicly available accounting information.
d.Benefits are received by the users of free accounting information while nonusers implicitly incur the production costs. - Which of the following is not a reason cited in the text for the failure of the CAP and the APB as regulatory bodies?
a.The SEC did not officially endorse private-sector standard setting until 1973.
b.The CAP and the APB lacked the necessary political structure to ensure their survival.
c.Policy making was exposed to outside influence. XXXXX
d.There appeared to be no due process in the determination of accounting and disclosure rules. - Which of the following theories argues that the group being regulated eventually comes to use the regulatory process to promote its own self-interest?
a.Life-cycle theory XXXXX
b.Agency theory
c.Signalling theory
d.Contracting theory - Life-cycle theory argues that:
a.Regulation eventually becomes an instrument for protecting the information users
b.The regulatory body often protects the regulated group from competition.XXXXX
c.Regulation goes through several phases, but is never in the public interest.
d.Both b & c. - Prior to the FASB, accounting regulation was done primarily by:
a.The SEC
b.The FTC
c.AICPA subcommittees XXXXX
d.Large accounting firms - Which of the following groups is not listed in your text as being affected by accounting regulation?
a.The FASB XXXXX
b.Companies
c.Auditors
d.Free riders - Which of the following is a reason that the FASB should closely watch the lobbying behavior of free rides?
a.Responding to the interests of free riders could lead to an underproduction of accounting information.
b.Free riders claim to be acting in the public interest but actually make the market less competitive.
c.Free riders are not affected by accounting regulation.
d.Free riders do not have the direct economic interests in information production that others have. XXXXX - Which of the following is not true about the FASB?
a.It considers the economic consequences of proposed accounting policies.
b.It has seriously considered the question of the desirability of corporate social responsibility accounting.XXXXX
c.It is sensitive to whether there are sufficient benefits to external users to warrant the imposition of new accounting standards.
d.The FASB has commissioned studies to aid in assessing the effects of proposed standards on firms. - When the FASB considers the effects of an accounting standard:
a.The only costs it considers are auditing costs.
b.It considers benefits primarily in terms of the information needs of the stock market.XXXXX
c.It is not concerned with producer costs.
d.It is primarily concerned with the effects of the standard on small or nonpublicly listed firms. - Democratic paralysis refers to:
a.The tendency of decision making under due process to be extremely slow.XXXXX
b.The inability to achieve a consensus in the regulatory process.
c.The argument that regulation is not a democratic policy.
d.The inability of previous standard setting bodies to develop a conceptual framework. - Which of the following statements is true?
a.The problems of the FASB stem from its limited use of due process.
b.The FASB has not been as successful as its predecessors were.
c.Many studies have found that large accounting firms tend to dominate policy at the FASB.
d.With the implementation of the FASB, the capture theory argument lost much of its validity. XXXXX
ESSAY QUESTIONS
- What are the arguments favoring regulation of financial reporting?
ANSWER: One argument supporting regulation is that it is in the public interest. Without regulation, there is the possibility of failure in the free market system because the firm is a monopoly supplier of information about itself. This situation creates the opportunity for restricted production of information and monopolistic pricing if the market is unregulated. Mandatory disclosure would result in more information and a lower cost to society. It is argued that more and better regulation is necessary to raise the quality of financial reporting in order to protect the public from fraud and failures.
Another argument in favor of regulation is that accounting information is a public good, and public goods are under-produced in a free market. Under-production of public goods occurs because producers are not able to impose production costs on all users of the good, and are thus not motivated to meet real demand. The only way in which production can be increased is through regulatory intervention. Intervention in the form of mandatory reporting requirements is considered necessary to ensure that the real demand for accounting information is met.
It is also possible that free markets are contrary to social goals because they may not communicate enough information to the security markets, resulting in insiders having information that is not available to shareholders. In addition, the information that would be available in unregulated markets might not provide enough comparability among firms.
A philosophical justification of the standard-setting process – called codification – is based on evolutionary improvement of accounting standards in an open and democratic society. The goal of the standard-setting process should be to provide the best standards from the societal point of view. - What are the arguments against regulation of financial reporting?
ANSWER: The arguments supporting unregulated markets for accounting information are based on agency theory, signalling theory, and private contracting opportunities. Agency theory predicts a conflict between owners and managers. Owners are interested in maximizing return on investment and security prices, while manages desire to maximize their total compensation. Because of this potential conflict, owners incur costs monitoring agency contracts with management, and these costs reduce managers’ compensation. Financial reporting is a way to mitigate this conflict to some extent, and allow owners to monitor employment contracts with their managers. Minimizing agency costs is an economic incentive for managers to report accounting results reliably to owners. Good reporting will enhance the reputation of a manager, and a good reputation should result in higher compensation because agency monitoring costs are minimized if owners perceive that accounting reports are reliable.
Signalling theory explains why firms have an incentive to report voluntarily to the capital market: voluntary disclosure is necessary in order for firms to compete successfully in the market for risk capital. Insiders know more about a company and its future prospects than investors do; therefore, investors will protect themselves by offering a lower price for the company. However, the value of the company can be increased if the firm voluntarily reports (signals) private information about itself that is credible and reduces outsider uncertainty.
Another argument against regulation is the presumption that anyone who genuinely desired information about a firm would be able to obtain it by privately contracting for information with the firm itself, with the firm’s owners, or indirectly with information intermediaries, such as stock analysts. If information were desired beyond that which is publicly available and free of charge, private individuals would be able to buy the desired information. In this way, market forces should result in the optimal allocation of resources to the production of information. - Discuss the regulation question in terms of determining and meeting the demand for accounting information. Who pays for and who benefits from accounting information?
ANSWER: An argument in favor of regulation is that accounting information is a public good, and public goods are under-produced in a free market. Under-production of public goods occurs because producers are not able to impose production costs on all users of the good, and are thus not motivated to meet real demand. The people who consume public goods without paying for them are called free riders. True market demand for public goods is not revealed in the market place because free riders are able to use the goods at no cost. The only way in which production can be increased is through regulatory intervention. Intervention in the form of mandatory reporting requirements is considered necessary to ensure that the real demand for accounting information is met.
There is another argument that regulated markets result in a tendency for over-production. This over-production can be avoided only if a pricing system can be imposed on public goods, creating non-purchasers who are effectively excluded from consuming the good. If accounting information had to be purchased, such as through the SECs EDGAR system, there would be incentives for users not to pass on the information to free riders. In this way, real economic demand for information could be determined, and production costs could be recovered from the real users of accounting information. By contrast, the present disclosure system imposes costs on companies rather than on users. One of the negative consequences of regulating accounting is that it results in 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. - What is meant by “the paradox of regulation?”
ANSWER: Arguments favoring regulation are that intervention in the form of mandatory reporting requirements are necessary to ensure that the real demand for accounting information is met and to provide the best standards from the societal point of view. However, economists have concluded that it is impossible to derive regulatory policies that will knowingly maximize the social welfare. Once the free market pricing system is abandoned, there is no way of determining aggregate social preferences. Of the pricing system is working, aggregate social preferences are revealed through supply-demand equilibrium, and resources are allocated according to market prices. There is no comparable rule in a regulated market, so it is impossible to know if accounting regulation is producing the optimal quantity and quality of financial reporting. - What is due process, and how has the political nature of regulation affected the CAP, the APB and the FASB?
ANSWER: Due process means that a regulatory agency seeks to involve all affected parties in its deliberations. Due process is important in maintaining the legitimacy of the regulatory process. The CAP and APB failed as regulatory bodies for at least two reasons:
(1)They had only a weak mandate to regulate financial reporting. Until the issue of ASR 150 in 1973, the SEC did not officially endorse private- sector standard setting.
(2)Their apparent lack of due process sometimes led to a low level of acceptance by affected parties.
From a regulatory viewpoint, the FASB is functioning much more successfully than did the CAP and the APB. Its standards were endorsed by the SEC in ASR 150 and due process has been adopted as standard procedure in debating and developing accounting policy.