OUTLINE

1
OUTLINE

• CURRENT TOPICS IN FINANCIAL REPORTING
• Revised conceptual framework project
• Securities market efficiency investor
  rationality
• Conservatism
• Manager compensation aspects of corporate
  governance

2
REVISED CONCEPTUAL FRAMEWORK FOR FINANCIAL
REPORTING

• What is a conceptual framework?
• Joint IASB/FASB project to revise
• IASB discussion paper, July, 2006

3
IASB DISCUSSION PAPER, JULY 2006

• Reaffirms decision usefulness
• Hurdle rate for reliability
• Rejects conservative accounting
• Prefers unbiased accounting
• Rejects contracting and motivation of management
  as roles for financial reporting
• Some recognition of stewardship
• Managers outside of reporting system
• Standard setting a process of conflict resolution

4
ACCOUNTING STANDARDS IN CHINA

• Who sets accounting standards in China?

5
SECURITIES MARKET EFFICIENCY AND INVESTOR
RATIONALITY I (N.A. PERSP.)

• Most would agree that securities markets are not
  completely efficient
• Efficient market anomalies in accounting
• Post-announcement drift
• Accruals anomaly
• Efficiency a matter of degree, however
• Most would agree that securities markets are
  close to full efficiency?

6
SECURITIES MARKET EFFICIENCY AND INVESTOR
RATIONALITY II

• Accountants gaining a better understanding of why
  anomalies persist
• Inflation
• Conservative accounting
• Investor sophistication
• Limits to arbitrage
• Cost
• Idiosyncratic risk

7
SECURITIES MARKET EFFICIENCY AND INVESTOR
RATIONALITY III

• A more basic question
• Is average investor behaviour better described by
  rational decision theory or behavioural
  characteristics?
• Brav Heaton, Rev. Fin. Studies (2002)
• Relax assumptions of stationarity and rational
  expectations. Estimation risk created.
• Bayesian learning over time
• Generates return dependencies similar to those
  generated by behavioural characteristics

8
SECURITIES MARKET EFFICIENCY AND INVESTOR
RATIONALITY IV

• Suggests rational decision theory and behavioural
  theories of investor behaviour moving closer
  together
• Bounded rationality?
• Role of financial reporting
• Full disclosure
• Helps overcome investor irrationality, or
• Speeds convergence to new equilibrium

9
HOW EFFICIENT ARE CHINESE CAPITAL MARKETS

• The Economist, Oct. 05, 2006
• Chinas stockmarkets
• Difference in price between A and H shares
• Another efficient market anomaly?

10
Conservatism in Accounting

• Empirical evidence of increased conservatism
• Conceptual framework rejects conservatism as
  biased
• Collision course between practice and standards?
  Probably not
• Some conservative scope in framework
• Unbiased conditional conservatism, ceiling tests
• Hurdle rate for reliability may encourage
  conservative revenue recognition

11
Reasons for Conservatism in Accounting

• Contractual/governance
• Debt covenant hypothesis
• Bonus plan hypothesis
• Legal liability/regulatory
• Few investor lawsuits for understatement errors
• Investor loss results from inability to optimally
  plan consumption over time
• Concave investor utility function generates loss
  asymmetry

12
FINANCIAL STATEMENTS AS A POINT ESTIMATE OF FIRM
VALUE I

• Accountants reporting alternatives
• Report whole distributionnot feasible
• Minimize expected legal liability
• Implies downward bias
• Do liability awards reflect investor utility
  losses?
• Report unbiased estimate of firm value (fair
  value accounting), plus extensive supplemental
  risk information
• Historical cost accounting?

13
FINANCIAL STATEMENTS AS A POINT ESTIMATE OF FIRM
VALUE II

• Conclusion re conservatism
• Accountants will continue to be conservative

14
CORPORATE GOVERNANCE

• Motivation of responsible manager performance
• Managerial labour market
• Manager gets fired?
• Reputation
• Seems to be not enough to motivate. Why?
• Monitoring of manager performance
• Performance measures
• Earnings
• Share price
• - Are managers compensated on the basis of
  earnings and share price in China?

15
SIMILAR STRUCTURE TO CAPITAL MARKETS RESEARCH

• Both have an underlying theory
• Agency theory
• Theory of the rational investment decision
• Both recognize information asymmetry
• Moral hazard
• Adverse selection
• Both have a competing theory
• Power theory (Bebchuck et al)
• Behavioural finance

16
DIFFERENCES FROM CAPITAL MARKETS RESEARCH

• Theory less developed
• Pump dump behaviour
• Empirical evidence more difficult
• Managers outside wealth affects behaviour
• Complicates theory testing

17
WAYS FOR FINANCIAL REPORTING TO MOTIVATE MANAGER
PERFORMANCE I

• Dichotomize earnings
• Net income manager responsible luck
• Conceptual framework rejects
• Not feasible?
• Conditionally conservative accounting?
• Full disclosure
• Helps control earnings management
• Reveals low persistence items

18
WAYS FOR FINANCIAL REPORTING TO MOTIVATE MANAGER
PERFORMANCE II

• An extension of full disclosure
• Effects of past writeoffs on current core
  earnings
• Efficient earnings management
• Accrual reversals discipline earnings management
• Disciplined earnings management can credibly
  reveal persistent earning power

19
WAYS FOR FINANCIAL REPORTING TO MOTIVATE MANAGER
PERFORMANCE III

• Efficient earnings management, cont d.
• To be credible, manager must have longer-run
  decision horizon
• Have recent movements in North America away from
  ESOs to restricted stock lengthened manager
  decision horizon?
• Needs research

20
IMPLICATIONS FOR CHINA I

• Assume want market economy
• Adoption of IASB standards
• Be cautious, high quality standards do not solve
  all reporting problems
• Motivation of responsible manager performance an
  equally important role of financial reporting as
  enabling proper operation of capital markets
• Full disclosure contributes to both markets

21
IMPLICATIONS FOR CHINA II

• Ways to encourage full disclosure
• Regulations and penalties
• Conceptual framework
• Signal
• Accounting profession
• Accounting professors