IM_CH_04 - Chapter 4: The Economics of Financial Reporting...

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Chapter 4: The Economics of Financial Reporting Regulation Instructor’s Manual 7 th edition Page 1 of 14 C HAPTER H IGHLIGHTS In recent years, the regulatory nature of accounting policy making has become a prominent topic in both academic and professional accounting literature. The purpose of this chapter is to expose students to the two extreme sets of arguments: those that favor free markets, and those that favor regulatory intervention. By looking at both sets of arguments, students should become more sensitive to the regulation issue, and realize that regulation creates both benefits and costs. These benefits and costs are hard to measure, and it is sometimes hard to identify on whom they fall. Most economists believe it is not possible to optimally allocate society’s resources under regulation (Arrow’s Impossibility Theorem). What one is left with, then, is the far less ambitious task of simply assuring that there is a net benefit from regulation (benefits exceed costs). If the text has a philosophical stance on regulation, it leans toward regulation but with the need to justify it more than has occurred in the past. This means carefully assessing the benefits and costs of accounting regulation. The second part of the chapter explains the political nature of regulatory decision making. Students should understand the “self-interest” principle in a regulatory environment. The self- interest principle is applicable to (1) accounting regulators (FASB and the SEC) and (2) the constituency groups affected by accounting regulation. These latter groups include preparers, auditors, interpreters, and users of accounting reports. Traditional self-interest theories of regulation (capture theory and life-cycle theory) seem less applicable to accounting than to other areas. This is probably due to the public-good nature of accounting information compared to private property rights created by conventional regulation (e.g., transportation routes in the airline transportation industry). Finally, “economic consequences” has become a vogue term in accounting literature. Basically, it refers to the effect of accounting standards and reports upon the decision-making behavior of preparers and users. Economic consequences can be viewed as part of what is called the political economy of accounting. Simply put, the argument is that any choice of financial reporting systems, from laissez faire to complete regulation, makes some people better off and others worse off. It is thus difficult for standard setting to maintain neutrality. The FASB indeed has an extremely difficult task requiring exquisite balance: promulgating standards for the benefit of investors and creditors but within the context of benefits (to users) exceeding the costs of providing information. The codificational outlook discussed by Gaa provides a philosophical justification for standard setting by an organization such as the FASB. Finally, Sarbanes-Oxley of 2002 (SOX), by establishing the PCAOB and providing FASB
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IM_CH_04 - Chapter 4: The Economics of Financial Reporting...

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