Class 2 Slides

Question 1

What are the arguments for regulation of financial reporting?

Answer 1

1. It is in the public’s best interest that regulators provide a “helping hand;” there is the possibility of market failure (e.g., 2008 financial crisis).
2. Creates fairness in the market. The goal of regulation is information symmetry. Also, this protects “the little guy” (small businesses).

Question 2

What market failures support the argument that financial reporting should be regulated?

Answer 2

Financial accounting fraud scandals (Enron, WorldCom); also the 2008 financial crisis support the need for regulation in financial reporting to raise the quality of financial reporting and to protect the public. The competitive nature of capital markets could induce misleading reporting by some companies in the short term. Also, even if firms voluntarily report information, it might not be comparable across firms. In addition, firms are a monopolistic supplier about their own information, which could lead to underproduction of info and monopolistic pricing of this info without regulation.

Question 3

Why does regulation exist?

Answer 3

3 possible explanations:

1. Public interest theory
2. Capture Theory
3. Interest Group Theory

Question 4

What does Public Interest Theory state?

Answer 4

Regulation is a response to public demand for the correction of market failures. The objective of regulators is to maximize social welfare, assuming regulators are benevolent and competent.

Question 5

What does Capture Theory state?

Answer 5

Capture theory questions the public interest theory and contends that regulators are often by captured by those whom they are charged to regulate, and even if the regulator is independent and wants to do good by acting in the public interest, they are generally incompetent and likely to fail. Regulators tend to act in their self-interest and seek to maximize their own wealth and power.

Question 6

What does Interest Group Theory state?

Answer 6

There are a number of conflicting interest groups who will lobby regulators for various amounts and types of regulation. Regulators take their own interests into account, while balancing the demands of investors and managers. The benefits of regulation go to the most effective lobbying constituency.