BEA3005 Financial Reporting and Analysis – Tutorial 6
ECONOMICS AND POLITICS OF ACCOUNTING REGULATION AND POLICY CHOICE
Review Questions
1. The ‘Market for Lemons’ argument.
Akerlof (1970) created the ‘Market for Lemons’ theory discussing information asymmetry.
Information asymmetry leads to unknowing if a car is a lemon or plum – thus people will not play full value for a plum and only lemons will be sold. Bad cars chase good cars out of the market, and possible solutions are warranties/guaranties, brand names, certification, licensing, government certifications.
2. Financial accounting information is a ‘public good.’
Existing shareholders implicitly pay for the production of financial accounting information but have no way of exacting a share of this payment from new shareholders. This implies that potential investors and stakeholders are free riders on existing information, and subsequently underproduction of information – a form of market failure.
3. Agency Relationship? Agency Cost? Reducing Agency Costs?
Agency Relationship – A consensual relationship where one party (principal grants authority for another party (agent) to act on behalf of the principal.
Agency Costs – Costs associated with the principal/agent relationship arising out of differing interests, and the necessity to control the agents’ behaviour.
4. Financial accounting standards as a result of political process?
Economic incentives associated with accounting principles might motivate an additional element of managerial behaviour. The FASB conducts an elaborate due process procedure prior to issuing an accounting standard. This process provides corporate managers an opportunity to lobby the FASB. What underlies their comments to the board? Again, two possibilities exist. The comments may reflect managers’ assessments of which principles generate the most useful financial statement information. Alternatively, their comments may also reflect, perhaps in a disguised way, how the various accounting principles will affect their wealth.
Some observers believe that the FASB has been overly responsive to the latter arguments. Of course, others believe that the FASB is not sufficiently sensitive to the effects its pronouncements have on individual managers or firms. Thus, accounting standards setting is now widely recognized as a political process in which various parties argue for the selection of the accounting principles that further their own self-interest. Some accountants believe that self-interest arguments have had a negative effect on the usefulness of the information required by some FASB rulings.
5. Bonus Plan hypothesis? Debt Covenant hypothesis? Political Cost hypothesis?
Part of Positive Accounting Theory
Bonus Plan Hypothesis - managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximize their personal compensation as by reporting a high net income, their utility will be maximised through bonuses and incentives.
Debt Covenant Hypothesis - the closer a firm is to compromising their debt covenants, the more likely management is to use accounting policies that shift reported earnings from future periods to the current period. This is because higher net earnings will reduce the probability of technical default on the debts.
Political Cost Hypothesis - the greater the political costs to the firm, the more likely management is to use accounting policies to defer reported earnings from current periods to future periods. This hypothesis brings politics into the choice of accounting policies. Highly profitable firms attract media and consumer attention. This attention can create an increase in taxes and other regulations.
Question 1 – Information Asymmetry
An adverse selection problem can arise from information asymmetry between issuer and buyer of securities.
i. Explain what the adverse selection problem is in this context
See ‘Market for Lemons’ theory. The buyer of the security knows more about his financial position and his future prospects than the lender. The lender cannot be certain that the buyer will not disappear with the funds or take enormous risks. The adverse selection problem here is choosing who to issue securities to and at what price.
ii. How can financial accounting information reduce the adverse selection problems?
Financial information will increase the transparency of a firm and reduce the information gap between buyer and lender. Therefore, it will be easier to screen for good/bad borrowers and reduce the adverse selection problem.
iii. Can financial accounting information remove the problem completely?
It will be impossible to remove the problem completely, as it is impossible to report everything that goes on with the company – both qualitatively and quantitatively. Clearly, there will always be a
iv. What other ways are used to remove the problem of insider information?
Question 2 – Theories of Regulations
What assumptions are made about the motivations of regulators in;
a. The public interest theory of regulation
Regulation is supplied in response to the demand of the public for correction of inefficient or inequitable market practices.
Regulators are assumed to have the best interests of society as a whole at heart, and maximise social welfare, without looking at their own private interests.
b. The capture theory of regulation
Regulation is initially in the best interests of the public, but is often manipulated subsequently to benefit particular social groups (often those most affected by the regulation or dominating the industry/sector).
c. The economic interest theory of regulation
Regulation is made to serve the private interests of particular parties, driven by forces of supply and demand (government supply what interest groups demand).
The motivation for the regulators is to appease the most people in order to gain the most voters/supporters/finances. This results in individuals forming strong similar minded groups ad lobby for preferred regulation.
Question 3 – Economic Consequences
An article entitled “Accounting Rule-Making Board’s Proposal Draws Fire,” by Lee Berton, appeared in The Wall Street Journal on January 5, 1994. It described the concerns of small businesses about a FASB proposal to charge the value of employee stock options to expense. Under current GAAP, there is usually no expense recorded for such options.
According to the article, small businesses felt that this new proposal would hurt them the most, because they use stock option plans instead of high salaries to lure top executives. This enables smaller businesses to compete with larger businesses “for executive talent.”
The article referred to a Coopers & Lybrand survey that found the FASB proposal would reduce reported profits of start-up or high-tech firms by 27%, compared with 3.4% for mature, larger firms.
Craig M. Swanson, vice president of finance for Protocol Systems Inc., a medical equipment maker, was quoted in the article as saying that 200 of their 250 employees receive stock options. However, if the FASB proposal were implemented, he would only give stock options to the top executives. Mr Swanson stated that “without options, talented people won’t want to take the risk of growing with us.”
In addition, the article gave an example of a restaurant chain, Outback Steakhouse Inc., where Robert Merritt, senior vice president and chief financial officer, stated that they use stock options in order to keep their employees “interested in the overall performance of the company.” He insisted that dropping stock options “could make it harder to convince employees that their hard work enhances their own wealth.”
In defence of the proposal, the article quoted FASB chairman Dennis Beresford as saying “We are aware of the concerns of small businesses...But we feel that issuing stock options without any cost gives the issuing company an unfair advantage and is an accounting loophole that needs to be addressed.”
a. What economic consequences might there be if the FASB proposal goes through?
‘The widespread use of non-expensed stock options is generally thought to have led not to economic strength, but to inflated stock-market valuations, excessive executive compensation, accounting frauds, bankruptcies, and the loss of approximately $5 trillion.’ The theory would be to reduce these negative consequences.
If this proposal goes through, it may negatively impact on SME’s
b. Do you agree with Mr Beresford’s reply, despite the possible economic consequences?
Question 4 – Positive Accounting Theory
Following the 1990 Iraqi invasion of Kuwait, the price of crude oil soared, as did retail gasoline prices. This led the major US oil companies to try to hold down their reported earnings.
The oil companies were anxious to avoid a repeat of an earlier episode when crude oil and gasoline prices peaked during the 1970s and earnings soared. At that time, the public outrage was so great that the US Congress imposed an excess profit tax, taxing back several billion dollars of excess profit. Warnings of similar taxes were repeated in 1990.
To limit their 1990 profits, the major oil companies did exercise some price restraint to keep prices at the pump from rising as much as they otherwise would have. They also engaged in a number of accounting practices, such as increased provisions for future environmental costs, increased maintenance, and large provisions for legal liabilities.
a. What pricing and accounting policy choices are predicted by the bonus plan and debt covenant hypotheses of positive accounting theory, in response to increasing crude oil prices?
Bonus Plan – managers choose accounting policy that will increase current year profit (to increase dividends and share price).
Bonus plan predicts these as managers aim to increase profit after tax in current and future years (minimise the taxation over the years) in order to have a higher average dividend/share price.
Debt Covenant – if companies are close to defaulting on debts, they will choose to bring profits forward from future periods to avoid this.
This predicts that companies will aim to provide for future (smaller) profits which can be used to pay interest rather than lose the money on taxation in the current year.
b. Use the political cost hypothesis of positive accounting theory to explain why the major oil companies would be the ones most concerned.
Political Cost – excessive profits attract political/regulatory attention
Large firms in particular will be in the public eye anyway and it will give an excuse for increased scrutiny on profits and subsequently all their other business practices.
c. For a US company, what inventory accounting policy (e.g. FIFO, LIFO, average cost method) would be most effective in holding down profits?
LIFO – the most expensive oil is coming in last and so can be a higher expense against profits.
d. Do you think a strategy of holding down reported profits by means of accounting policy choice is effective in avoiding a backlash?