Session 1 - Regulation (Essay)

Question 1

Benefits of Codification

Answer 1

Benefits of codification:
Simplicity
Accurate representation of GAAP
Up-to-date research
Reduce research time
Mitigate noncompliance risk
Real-time updates

Question 2

Policy Making Inputs

Answer 2

Accounting Theory
Political Factors
Economic Conditions

Question 3

Agency Problem

Answer 3

Conflict of interest between the shareholders (principal) and the managers (agent) – “agency problem”: managers’ goals may not be aligned with the goals of shareholders

Question 4

Information Asymmetry

Answer 4

Managers may have an information advantage over the investors

Question 5

Adverse Selection:

Answer 5

“hidden information” / “lemons”

Control through full & timely disclosure

Question 6

Moral hazard (shirking):

Answer 6

“hidden action”

Question 7

Case For Unregulated Financial Reporting (SAP)

Answer 7

1. Agency theory explains why incentives exist for voluntary reporting to owners
2. Signaling theory explains wider voluntary reporting to the capital markets
3. Private contracting

Question 8

Agency Theory

Answer 8

Modern day firms are characterized by separation of ownership and control

• Management-Owner agency relationship
• Potential conflict between goals of two groups
• Goals of managers and owners may not be aligned

Financial reporting may mitigate conflicts

Good reporting will enhance the reputation of a manager and a good reputation should result in higher compensation

Question 9

Signaling Thoery

Answer 9

Voluntary disclosure is necessary in order to compete successfully in the market for capital

Good reporting would lower a firm’s cost of capital

• Less uncertainty about firms that report more extensively and reliably
• Less investment risk and a lower required rate of return

Question 10

Why do managers voluntarily disclose bad news?

Answer 10

• To lower risk of litigation against manager

- Managers have also reputational incentives

Question 11

Private Contracting for Information

Answer 11

If information were truly desired beyond that which is publicly available and free of charge, private individuals can buy the desired information.

Question 12

The Case For Regulated Financial Reporting

Answer 12

• In the Public Interest
  Possibility of market failure: unregulated free markets fail to prevent accounting frauds
• Creates Fairness in the market
  Goal is information symmetry: regulation of insider trading is an application of this philosophy

Regulation is a cost-effective method of getting the required information

One way to increase production of information is through regulation

Question 13

Market Failures

Answer 13

Failure of financial reporting and auditing to prevent frauds and bankruptcies.

Failure of unregulated markets

Question 14

3 Theories of Regulation (PIC)

Answer 14

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

Question 15

Public interest theory

Answer 15

Regulation is a response to public demand for correction of market failures

*assumes that government (regulator) is benevolent and competent

Question 16

Interest Group Theory

Answer 16

• Interest groups will lobby the regulator for various amounts and types of regulation
• Implies conflict between constituencies

*agrees with Capture Theory

Question 17

Capture theory

Answer 17

• Regulators captured/controlled/dominated by regulatee
• Regulators tend to act in self-interest
• skeptical of government intervention as a solution