Chapter 12

Standard setting: economic issues

12.1 overview

Standard setting is a form of regulation that is ultimately the responsibility of a countrys goverment
of legislature (we shall use the terms interchangeably). Geverments typically delegate responsibility
for standard setting in accounting to a specific agency, such as the securities commisions described
in section 1.12.5. in turn, these agencies may delegate standard-setting responsibility to semi-
autonomous bodies such as the IASB, AcSB, and FASB. When it is not necessary to distinguish among
them, we will often use the term regulator to refer to these various standard-setting bodies.

Recall that we view the standard setter as a mediator between the conflicting interests of investors
and managers. The fundamental problem (section 1.10) is how to conduct this mediationthat is,
how to combine the financial reporting and efficient contracting roles of accounting information or,
equivalently, how to determine the socially right amount of information.

This raises the question, what is the socially right amount of information? In theory, the economic
answer is straightforward. This is the amount that equates the marginal social benefits of
information to the marginal social costs. We shall call this the first-best amount of information
production.

For many products, market forces are sufficient to drive production close to first-best with little
regulation. However, while there are many market-based incentives for firms to produce
information, first-best production of information is impossible to attain by market forces alone. A
major reason is information asymmetry. Since financial accounting information has characteristics of
a public good, suppliers of information do not always get paid for the information they produce.
Consequently, they will under produce relative to first-best. As a result, information asymmetry,
leading to adverse selection and moral hazard, is greatest than is socially desirable. This market
failure supports arguments for regulation of financial disclousure. However, due to the difficulty of
measuring the complex benefits and costs of information, standard setters are unable to attain first-
best either. Since regulation also has a cost, the question then becomes one of the extent of
standard setting. Too little standard setting results in too much information asymmetry, as just
mentioned. Too much standard setting imposes a greater cost on society than the benefits of lower
information asymmetry.

In past year, many industries were deregulated, giving greater freedom to firms to make their own
private decisions about prices, quantities, and product quality. Deregulation followed from a general
belief that markets were superior to regulation as vehicles for producing goods and services.
Airlines, trucking, financial services, telecommunications, and electric power generation are major
example of deregulation. This belief in markets suggests less regulation in accounting; that is, market
forces can be relied on to motivate firms to produce enough financial information.

However, the Enron and WorldCom debacles (section 1.2) and the 2007-2008 market meltdowns
(section 1.3) have resulted in severe criticism of the stability of unregulated markets. As a result,
regulatin has increased for some industries, such as financial services. Indeed, regulation in
accounting has increased, as evidenced by the Sarbanes-Oxley Act, and new accounting standards,
including financial instruments, derecognition, and consolidation, outline in Chapter 7.

What happens as the extent of information-industry regulation changes? Does increased regulation
smother competition and innovation? Is increased regulation cost-effective? Would deregulation
cause information production to collapse into chaos? At present, the answers to these questions are
not known. However, discussion of the pors and cons of standard setting helps us see the tradeoffs
taht are involved and appreciate the crucial role of information in society.

Accountants shouls not to take the extent of regulation for granted. Regulation is an important
component of the accounting environment, which is constantly changing. This affect much of what
accountants do, their legal obligations, and their legal liabilities.

12.2 regulation of economic activity

There are numerous instances of regulation of economic acivity in our economy. Firms that have a
monopoly, such as electricity distribution, municipal water utilities, and local telephone service, are
common examples. Here, regulation typically takes the form of regulation of rates, price caps, or the
rate of return on invested capital. Public safety is an area subject to frequent regulation as, for
example, in elevator inspection laws, compulsory use of seatbelts, standards for automobile tire
construction, dringking water safety, and fire protection regulations. Communications is another
area that, in many countries, is deemed sufficiently sensitive to attract regulation. Other sets of
regulations affect financial institutions and securities markets. One reason for such regulation arises
from the public-good nature of accounting information (section 5.5), where the regulation tries to
increase information production to compensate for the underproduction that arises for public
goods. This is an example of an externality, where the actions of one party (e.g., underproduction)
affect outside parties. Another reason for regulation is to protect individuals who are at an
information disadvantage due to information asymmetry. If managerial actions and inside
information were freely observable by all, there would be no need to protect individuals from the
consequences of information disadvantage.

Externalities and information asymmetry are thus frequently used to justify regulations to protect
investors. In addition to GAAP, we have insider trading rules, MD&A, executive compensation
disclosures in management proxy circulars, public access to corporate conference calls, regulations
of full disclousure in prospectuses, and laws to regulate accounting professions. As well as protecting
ordinary investors, such regulations are also intended to improve the operataion of capital and
managerial labour markets by enchancing public confidence that these markets work well.

In this chapter, our primary concerns are the regulation of minimum disclosure requirements,
generally accepted accounting and auditing standards, and the requirements that public companies
have audits. We will use the term standard setting to donate the establisment of these various rules
and regulations. Note that standard setting involves the regulation of firms external information
production decisions. Thus firms are not completely free to control the amount and timing of much
of the information they produce about themselves. Rather, they must do so under a host of
regulations that we will call standards, laid down by a regulator.

Standard setting is the regulation of firms information production decisions by a regulator.

In cosidering issues of information production, it is helpful to distinguish between two types of

information that a manager may possess. The first type is proprietary information. This is
information that, id released, would directly affect future cash flows of the firm. Example are
technical information about valuable patents, and plans for strategic initiatives such a takeover bids
or mergers. The costs to the manager and firm of releasing proprietary information can be quite
hugh.
The second type is non-proprietary information. This is information that, ir feleased, does not
directly affect firm cash flows. It includes financial statement information, earnings forecasts, details
of new financing, and so on. The audit is also included in non-proprietary information.

12.3 ways to characterize information production

While the term production of information may take some getting used to, we used it for two
reasons. First, we want to think of information as a commodity that can be produced and sold. Then,
it is natural to consider separately the costs and benefits of information, and whetber the socially
right amount is produced.

Second, we want a unified way of thinking about the various ways information production can be
accomplished. Information is a complex commodity. Just what do we mean when we speak of the
quantity of information produced? There are several ways to answer thus question.

First, we can think of finer information. For example, a thermometer that tells you the temperature
in degrees is a finer information system than one that only tells you if the temperature is above or
below freezingthe first thermometer tells you everything that the second one does, and more. It
enables a finner reading of the temperature. In an accounting context, a finer reporting sysstem
adds more detail to the existing financial statements. Example of finer reporting include expanded
note disclosure, additional line items on the financial statements, segment reporting, and so on.

In terms of our decision theory discussions on chapter 3, finer information production means a
better ability to discriminate between realizations of the states of nature. Fir example, in a decision
problem where the relevant set of states of nature is the temperature, a thermometer that tells you
degrees enables better discrimination between different temperature states than one that only tells
you if the temperature is above or below freezing. In accounting, the concept of full disclosure
suggests finer information production. Full disclosure increases the informativeness of the
information system, enabling better discrimination between relevant states of the firm.

Second, we can think of additional information. For example, we might add a barometer to our
thermometer. In an accounting context, additional information means the introduction of new
information systems to report on matters not currently included. Examples would include
informative extensions of current value accounting to additional assets and liabilities, future-
oriented financial information included in MD&A, and expanded disclosure of firm risk. In decision
theory terms, additional information means an expansion of the set of relevant states of nature
upon which the firms performance depends. Thus a thermometer-barometer reports on
atmospheric pressure as well as temperature.

In accounting, reporting on firm risk implies an expansion of relevant states of nature, adding, say,
risky or not risky to the high and low future performance states included in example 3.1. Also, we
argued in section 7.2.2 that fair value accounting improves the ability of net income to report on
manager stewardship. If so, this implies adding good or bad manager performance as additional
relevant states of nature.

A third way to think about information pproduction is in terms of its credibility. The essence of
credibility is taht the receiver knows that the supplier of information has an incentive to disclose
truthfully. In our thermometer example, the purchaser knows that the manufacturer must produce
an accurate product in order to stay in business. Thus, the purchaser accepts the termometer as a
credible representation of the temperature. In accounting context, it is often suggested that a Big
Four audit is more credible than a Non-Big Four audit because a large audit firm has more to lose,
both in terms of reputation and deep pockets; hence it will maintain high audit standards. Also,
the greater the penalties for managers who divulge false information, the more credibility investors
attach to managers disclosures.

In this chapter, we will not need to distinguish these different ways to produce information and will
refer to them all, rather loosely, as information production. Note that however we think of its
production, more information will require higher costs, some of which may be proprietary costs.

12.4 first-best information production

From societys standpoint, the socially right, or first-best, amount of information productio is that
amount that equates the marginal social benefits of information production to the marginal social
costs of information production. This amount of information creates the largest possible pie of
information benefits for society. Any additional production would costs more than the benefits
generated. Similarly, if information production is less than this, society would benefit from
producing more.

Numerous benefits and costs of information production are discussed in this book. Benefits include
better-informed investment decisions (section 3.3.2), possible lower markets due to greater investor
confidence resulting from lower adverse selection and moral hazard (section 4.6.1). other benefits of
information production include reduction of monopoly power due to improved ability of potential
entrants to an industry to identify profitable investment opportunities (section 1.2), timely
identification of failing firms (section 8.4.2), reporting on stewardship (section10.5), and situations
where information released by one firm generates information about others (section 12.9.1).

Costs of information production include the direct costs of preparing and releasing information,
possible release of propriatery (section12.3), and possible increased contracting costs resulting, for
example, from greater earnings volatility produced by fair value accounting (section 7.5.2).

For some competitive industries with a large number of firms and customers, such a agriculture and
other commodities, market forces can generate equilibrium production quantities that approximate
first best, with relatively little regulation.

However, the characteristics of information and its various costs and benefits to society are so
complex and varied that market forces alone are unlikely to attain first best.

12.5 market failures in the production of information

We now consider some of the markets failures that prevent first-best information production.

12.5.1 externalities and free-riding

We begin with two definitions:

an externality is an action taken by a firm or individual that imposes costs or benefits on other firms
or individuals for which the entity creating the externally is not charged or does not receive
revenue.

free-riding is the receipt by a firm or individual of a benefit from an externality at little or no cost.

The crucial aspect of externalities and free-riding is taht the costs and benefits of information
produstion as perceived by the firm differ from the costs and benefits to society.
Anilowski, Feng, and Skinner (2007) examined the relationship between managements quarterly
guidance about future earnings and aggregate stock market performance. If, for example, a large
number of managers report that earnings are expected to increase, this creates an externality that
conveys information about about future performance of the economy, which would be quite useful
to investors. If so, we should observe an increase in the stock market index following a lot of good
news expected earnings guidance. The author did find evidence of this effect for bellwether firms,
which are the largest 20 firms in their sample. However, they concluded that for most firms in their
sample, issuance of earnings guidance follows the performance og the economy, rather than
providing information about its future performance. That is, the number and timeliness of forecasts
falls short of what is socially desirable. They suggested that if more firms would issue earnings
guidance sooner, the externality effect would expand, benefiting society through better investment
decisions.

With respect to free-riding, we noted in section 5.5. that, due to the public-good nature of
accounting information, its use by one individual does not destroy it for use by another. Then, other
investors can free-ride on this information. Since all investors will realize this, no one has an
incentive to pay. As a result, it is difficult for the firm to charge for producing accounting
information, in which case it produces less information than is socially desirable.

In sum, the effects of externalities and free-riding are that since the firm cannot generate revenue or
other benefits from all of its information production, it will produce less than it would otherwise.
Thus externalities and free-riding are well-known reasons why market forces do not generate first
best information production. Then, the regulator steps in to try to restore the socially correct
amount of production.

12.5.2 the adverse selection problem

In our context, there are two versions of the adverse selection problem. First, we have the problem
of inside trading, which was introduced in Chapter 4. If opportunities exist for insiders, including
managers, to generate excessive profits by trading on the basis of their insider information, persons
willing to do this will be attracted to the opportunity. Then outside investors will not perceive the
securities market as a level playing field. They reduce the amount they are willing to pay for all
securities, or withdraw from the market completely. In effect, information production is not first-
base since useful information withheld from the market for insiders benefit.

A second version of adverse selection arises when managers who are privy to bad news about the
firms future do not realese that information, thereby avoiding, or at least postponing, the negative
firm consequences. This lack of timeliness also constitutes a failure to produce information.

12.5.3 the moral hazard problem

In section 10.2, we noted the findings of Bushman, Engel, and Smith, which suggested that net
income is not completely informative about effort. A reason is that managers may be able to
disguise shirking, and resulting low profitability, by opportunistic earnings management and/or by
reducing voluntary disclosure. Thus, despite managerial labour markets and incentive contracts,
investors will also be concerned about moral hazard and (bad) earnings management.

The 2007-2008 market meltdowns provide a recent example of moral hazard leading to market
failure. Managers of financial institutions that were too big to fail knew that they would, if
necessary, be rescued by the goverment. Consequently, they had an incentive to take on excessive
risk (a form of shirking), which they disguised by, for example, avoiding consolidation of off balance
sheet entities. This contributed to the severse market failures that are described in section 1.3

12.5.4 unanimity

A characteristic of economies with markets that do not work well is a lack of unanimity, which
derives from the effects of adverse selection and moral hazard just described. If markets work well,
shareholders will be unanimously in favour of the managers maximizing the market value of the
firm. When markets do not work well because of adverse selection and moral hazard, this need not
be the case. Eckern an Wilson (1974) studied this problem with respect to the physical production of
the firmthat is, the types and quantities of products to be producedand showed that the
managers choice of production plan to maximize the market value of the firm would not in general
be approved by all shareholders under certain market conditions.

A similar result applies to firms production of information. Blazenko and scott (1986) analyzed an
economy where the information market does not work well, due to adverse selection. While the
firm manager was motivated to choose an audit quality that would maximize firm market value
(recall that an audit is a form of information production), all shareholders would prefer a higher-
quality audit. The reason is that from the shareholders perspective, there are two valuable functions
of the audit. One is too add credibility to the firms financial statements, as we have mentioned. This
benefits both shareholders and manager. The other is that the audit provides a form of insurance.
For example, it may force disclosure of information that the manager would prefer not to disclose,
or it may discover inside information that the manager had intended to opportunistically suppress or
distort. This role benefits only the shareholders. Consequently, the audit is of greater value to the
shareholders, who will demand more information than the manager wishesto supply.

We conclude that the market forces are unable to drive first-best information production. Thus
some degree of regulation is to be expected in the information industry. However, due to the variety
and complexity of the social costs and benefits of information, the regulator is unable to implement
first-best either. It seems that some combination market is to work reasonably well.

12.6 contractual incentive for information production

12.6.1 examples of contractual incentives

Despite the inability of regulation and/or market forces to generate first-best information
production, there is a surprising number of incentives whereby firms want to produce information.
One set of incentives arises from the contracts that firms enter into. As we saw in chapter 9,
information is necessary to monitor compliance with contracts. For example, if managerial effort is
unobservable, this leads to an incentive contract, under which the managers compensation is based
on some observable measure of the firms operations, such as net income. Also, an audit adds
credibility to reported net income, so that both the owner and the manager of the firm are willing to
accept reported net income as a measure of current managerial performance.

Similarly, when a firm issues debt, it typically includes covenants in the contract. Information is
needed about the various ratios on which the covenants are based, aso that the firms adherence to
its covenanats can be monitored over the life of the debt issue. Again, an audit adds credibility to
the covenant information.

Another contract-based reason for private information production arises when a privately owned
firm goes public. This was modelled by Jensen and Meckling (1976). The owner-manager of a firm
going public, after selling all or part interest, has a motivation to increase shirking. Prior to the IPO,
the shirking problem was internalizedthe owner-manager bore all the costs. The costs of shirking
are the reduced profit that result. Subsequent to the new issue, the owner-managaer, assuming
he/she continues to manage the firm, does not bear all the coststhe new investors will bear their
proportionate share. Thus, shirking costs the owner-manager less after going public, so he or she will
engage in more of it. Futhermore, the owner-manager now has an incentive to exploit inside
information at the expense of the new investors. Thus the new investors face agency costs of both
moral hazard and adverse selection.

Investors will be aware of these agency costs, however, and will bid down the amount they are
willing to pay for the new issue by their expected amount. To reduce this penalty, the owner-
manager has an incentive to commit to releasing hight quality information. One possibility is to
appoint a prestigious auditor. Another is to adopt (conditionally) conservative accounting, which will
increase contract efficiency by reducing the managers ability to recognize unrealized gains
motivation to adopt such opportunistic actions arises from lack of alignment between manager and
shareholder interest. LaFond and Royehowdhury (2008) reported evidence consistent with this
argument. Based on a large sample of U.S. firms over the period 1994-2004, they reported a
significant negative association between manager stock holdings and conservative financial
reporting, consistent with conservative reporting counteracting the motivation of managers with
low stock holdings (and thus low alignment) to overstategains.

The key point here is that the firm has a private incentive to produce information in all of these
contracting scenatiosno regulator is needed to force information production. The information
production decision is internalized between the contracting parties.

12.6.2 the coase theorem

A key mechanism for the production of information for contracting was developed in a classic paper
by Ronals Coase (1960). Coase showed conditions under which the problem of externalities can be
internalized, thereby reducing the need for regulation. His demonstration has become known as the
Coase theorem.

Coase used an illustration of two farms, side by side. One farmer raises cattle, the other grows crops.
The externality is that the cattle stray into the crops, trampling them and reducing their value. One
solution is regulationfarmers could be required to fence their properties. However, there is an
alternative. Assume that a fence costs $100, and that the demage to crops total $150. Suppose first
that property rights belong to the cattle farmerhe/she has the right to let cattle stray onto the
neighbours field. Then, the crop farmer will erect a fence, since its cost is less than the crop
damage. Alternatively, if the crop farmer has property rights, and thus the right to recover damages
from the cattle farmer, the cattle farmer will erect a fence, since its cost is less than the damages
that would have to paid.

The important point of the Coase theorem is that regardless of how property rights are assigned, the
fence will be built. This is socially desirable since the cost of the fence is less than the damage
without it. In effect, regulation is replaced by bargaining and contracting between the interested
parties.