Chapter 4

The Economics of Financial

Reporting Regulation

TRUE/FALSE

1. Financial reporting for publicly-listed companies in the United States was first
regulated in the 1950s.
ANS: F

2. Congress empowered the Securities and Exchange Commission to regulate

financial reporting in the 1930s
ANS: T

3. The SEC has allowed accounting policy-making power to remain in the private
sector.
ANS: T

4. Arguments supporting unregulated markets are largely inductive in nature.

ANS: F

5. 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

6. Empirical tests of the free market position are impossible since we live in a
regulated environment.
ANS: T

7. Agency theory explains that firms have an incentive to report voluntarily to the
capital market because they are competing for risk capital.
ANS: F

8. The major agency relationship is between the management of a firm and a firm’s
creditors.
ANS: F

9. Good financial reporting will lower a firm’s cost of capital.

ANS: T

10. Only firms that perform well have incentives to report their operating results.
ANS: F
11. According to signalling theory, firms have an economic incentive to report bad
news.
ANS: T

12. 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

13. There is usually information symmetry between the firm and outsiders.
ANS: F

14. Early adoption of new financial accounting standards generally indicates “bad
news” whereas late adoption generally indicates “good news.”
ANS: F

15. The stock market shows that people are willing to contract privately for
information about a firm.
ANS: T

16. 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

17. 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

18. 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

19. Risk in investment can be eliminated by improved accounting and auditing

procedures.
ANS: F

20. Accounting regulation prevents fraud.

ANS: F

21. Public goods are commodities that once consumed, the opportunity for
consumption by others is reduced.
ANS: F
22. True markets demand for public goods may be determined by the number of
consumers that pay for the goods.
ANS: F

23. 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

24. 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

25. Accounting information is a public good.

ANS: T

26. Information symmetry exists when potential investors do not all have equal access
to the same information.
ANS: F

27. Pro-regulation arguments as well as arguments for unregulated markets are largely
deductively reasoned rather than empirically researched.
ANS: T

28. There is a tendency for overproduction in unregulated markets.

ANS: F

29. The Impossibility Theorem implies that once the free market pricing system is
abandoned, there is no way of determining aggregate social preferences.
ANS: T

30. Overproduction of accounting information, or the problem of standards overload,

has the greatest effect on large, publicly traded companies.
ANS: F

31. The present financial disclosure system imposes costs on users rather than the
companies themselves.
ANS: F

32. In setting policy, due process, means that a regulatory agency seeks to involve all
affected parties in its deliberations.
ANS: T
MULTIPLE CHOICE

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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
7. 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

8. 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

9. 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.

10. 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

11. 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

12. 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
13. 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.

14. 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.

15. 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.

16. 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.

17. 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
18. 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.

19. Prior to the FASB, accounting regulation was done primarily by:
a. The SEC
b. The FTC
c. AICPA subcommittees XXXXX
d. Large accounting firms

20. 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

21. 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

22. 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.
23. 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.

24. 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.

25. 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

1. 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.

2. 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.

3. 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.
4. 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.

5. 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.
6. What are the capture theory and the life-cycle theory of regulation, and how do
they apply to the regulation of accounting?

ANSWER: Capture theory and the life-cycle theory of regulation both argue that
the group being regulated eventually comes to use the regulatory process to
promote its own self-interest. When this occurs, the regulatory process is
considered captured. The life-cycle theory of regulation argues that a regulatory
agency starts out in the public interest, but later becomes an instrument for
protecting the regulated group.

From 1976 to 1978, the United States Congress investigated the allegation that
accounting regulation had been captured by the Big Eight group of accounting
firms, who were the predominant auditors of publicly listed corporations. Prior to
the FASB, accounting regulation was done primarily by AICPA subcommittees,
which were undoubtedly heavily influenced by the Big Eight accounting firms.
However, with the implementation of the independent FASB the capture theory
argument lost much of its validity.

Current practices of accounting regulation survived the scrutiny of Congress

partly because capture theory and the life-cycle theory are less applicable to
financial reporting. The number of parties directly affected by accounting
regulation is much larger and more diverse than in traditional regulated industries.
Auditors and other parties affected by accounting regulation, companies that must
comply with regulations, and free riders who use the costless information for
investment analyses have a divergence of interests, which place the accounting
regulator in a more naturally neutral posture than is possible in other regulated
industries.