The Minimizing Adverse Selection Accounting Essay

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According to article International Financial Reporting Standards written by Ray Ball Feb 2012 accounting in shaped by economic and political forces. It follows that increased worldwide integration of both markets and politics (driven by reductions in communications and information processing costs) makes increased integration of financial reporting standards and practice almost inevitable.

Historically, standardization of the international accounting principles has tended unified national accounting in the US in the early 20th century followed the integration of the national economy. Similarly the present impetus for global accounting standards follows the accelerating integration of the world economy. Without the common accounting standards the cross-border portfolio and direct investment may be distorted, the cross-border monitoring of management by shareholders obstructed, and the cross-border contracting inhibited and the cost of these activities may be needlessly inflated by complex translation (Meeks and Swamm, 2009).

Besides direct there are also many indirect advantages of standardization of accounting and financial statements for investors the higher quality of information regarding financial statements reduces risk of adverse selection and reduces cost of equity capital. According to Watts, 1977; Watts and Zimmerman, 1986 Indirect advantages to investors arise from improving the usefulness of financial statement information in contracting between firms and a variety of parties, notably lenders and managers (Watts, 1977; Watts and Zimmerman, 1986).

Following are the benefits:-

Accurate And Comprehensive

Standardization promise more comprehensive, accurate and timely financial statements and reports. Accurate, comprehensive and standardized financial statements eventually helping investors to make business decisions with less risk of adverse selection. (US GAAP November 2012)

Minimizing Adverse Selection

Investors are able to anticipate financial statement information from other sources. Improved quality of financial statements allows them to compete better with professionals, and hence reduces the risk they are trading with a better-informed professional.

Cost Reduction

By standardization of financial statements and reporting formats no need to reprocess financial statements and information to understand. Eventually this resulting in eliminating of reporcessinf cost. ( IFRS Red Book 2012)

Cross Border integration

Reducing international differences in accounting standards assists to some degree in removing barriers to cross-border acquisitions and divestitures, which in theory will reward investors with increased takeover premiums.

Q 2 ( a)

Accounting standard widely used by

Investors,

Government agencies,

Public,

Management of enterprises,

Managerial accountants,

Internal auditors,

Income tax specialists,

Systems experts,

Controllers,

Management consultants,

Financial vice presidents,

Chief executives.

Q 2 (b)

Internationally accounting standard setting bodies are organizations that have been delegated responsibility for setting standards for accounting and financial reporting. Standards and formats are publically available on their sites and can be acquired by approaching them. Some of the bodies are given below as example

Australia

Australian Accounting Standards Board

Canada

CICA's Accounting Standards Board "AcSB"[1]

India

National Advisory Committee on Accounting Standards (NACAS) with the aide and advice of Institute of Chartered Accountants of India

Q 2 (c)

The objective of General Purpose Financial statement is to provide information about the financial performance, financial position, and cash flows of an entity that is usefull to wide range of users in making economic decisions. Financial statements also show the results of managements stewardship of the resources entrusted to it. Financial status is a reflection performance of entity or any business.

General purpose Financial reporting includes disclosure of expenses occurred and revenue generated by entity during financial period together with equity, assets and liability. The

information will be useful in determining the cost of providing goods and services and the change in the entity's control over resources during the reporting period

Q 2 (d)

One of the main objectives of financial reporting is to satisfy the information needs of a range of users. Qualitative characteristics of financial statements are attributes that enhance their meaningfulness to such users. However, the accounting framework does not leave compliance with these to anyone's whim and fancy. Financial statements and reports must possess specific characteristics; the four primary attributes are understand-ability, relevance ,reliability and comparability.

Understand-ability

While financial statements can be somewhat complicated for the uninitiated to understand, users must be able to understand the information within them. This applies to the format/ layout of the statement, the terms used in the statement and the policies methods and assumptions utilized in preparing the statement.

Users of financial statements are assumed to have sufficient knowledge to study the information properly. Understand-ability ensures that a user equipped with the basic knowledge can discern information pertaining to the performance and financial position of an enterprise.

Relevance

Since financial statements are for users to make economic decisions, the information must be relevant to the decisions that those users have to make.  Once all items in a financial statement help users to assess historic or future events, the information in the statement relevant to the users. Whether the information affects the economic decisions of users and the nature of information affect relevance as well. Materiality is one of the assumptions used in financial reporting that contributes to relevance.

Reliability

In the context of accounting, reliable information is free from material error (errors that affect the economic decisions of users) and bias. In other words, a reliable financial statement must fairly and consistently present information about the performance and financial position of an entity. Users must have confidence in the financial statement, without it being misleading or deliberately constructed in a manner that presents the entity in a favorable light. The main thrust of the auditing function

Q 3

Pro-regulation perspective

Accounting information is a public or 'free' good it is available openly for the public and public can use it without paying and can pass it to others. Baldwin and Cave (1999 argue that there are a number of reasons for regulation. One of the best known form of regulation was exercised by US government over the potential growth of monopolies at the turn of the twentieth century - the anti-trust legislation (for example the Sherman and the Clayton Acts). Where monopolies exist it is considered that there has been a market failure because competition does not exist. Therefore, it can be inferred from this that regulation is associated with preserving competition. Thus, it is associated with the ideology of the efficacy of markets and competition, hallmarks of capitalism. In centrally controlled economies many "monopolies" are created (usually as some form of bureaucratic control). However, in other countries it is generally believed that it is necessary to maintain an environment conducive to competition. In Australia the Australian Competition and Consumer Commission (ACCC) is charged to ensure competitiveness and rule against anti-competitive behaviour (ensuring compliance with the Trade Practices Act, 1974). Sometimes "natural" monopolies" arise where there are economies of scale that ensure the market is served at the least cost (for example, many utilities such as water, gas or electricity suppliers) in which case regulation is designed to maintain fair trading.

Following are the four arguments supporting free market perspective

Private economic-based incentives

Market for managers argument

Market for corporate takeovers argument

Market for lemons argument

Private economic-based incentives

Assumed that managers will operate business for own benefit and this is expected by shareholders and debtholders

Therefore in interests of management to enter contracts with shareholders and debtholders to constrain managers' actions

Contracts often based on accounting information

Organisations not producing information will be penalised by higher costs of capital

Organisations best placed to determine what information should be produced

dependant on parties involved and assets in place

Imposing regulation restricting available set of accounting methods decreases efficiency of contracting

Also assumed auditing will take place in absence of regulation-reduces risk to external stakeholders

Market for managers argument

Managers' previous performance impacts on remuneration they can command in future

In absence of regulation assumed managers encouraged to adopt strategies to maximise value of firm (provides favourable view of own performance)

includes providing optimal amount of accounting information

Managerial labour market operates efficiently

Information about past performance known by prospective employers and will be impounded in future salaries

Capital market is efficient

Effective managerial strategies reflected in positive share price movements

Market for corporate takeovers argument

Underperforming organisations will be taken over by another entity with the existing management team subsequently replaced

Therefore managers motivated to maximise firm value

Information produced to minimise cost of capital thereby increasing firm value

assumes managers know marginal cost and marginal benefits of information

Market for lemons argument

No information viewed in the same light as bad information

market may make the assessment that silence implies the organisation has bad news to disclose

Therefore managers motivated to disclose both good and bad news

Evidence that both good and bad news disclosed voluntarily (Skinner 1994)

Assumes the market knows that managers have news to disclose

may not always be a realistic assumption

If knowledge of non-disclosure becomes available later, market expected to react at that stage

Taken together, the various factors just discussed (market for managers, market for corporate takeovers, market for lemons, expectations about self-interest and the resulting use of contracts, and so forth) are considered to provide justification for restricting accounting regulation

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