A Political Economy of Accounting Standard Setting

A Political Economy of
Accounting Standard Setting




Roland Königsgruber+



July 2007

+ Center for Accounting Research, University of Graz, Universitätsstraße 15 / F3, 8010 Graz, Austria.

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A Political Economy of Accounting Standard Setting





Abstract
In recent years accounting researchers have identified “political” lobbying as a problem
for accounting standard setting. This paper presents a simple model of the political
process to identify situations where companies have incentives to lobby the political
principal instead of participating in the usual due process of accounting standard
setting. Analysis of the model suggests that “political” lobbying is more likely to
happen in the EU than in the US. Furthermore it is suggested that if the relevant
standard setters wish to achieve harmonization of accounting standards between the EU
and the US, European companies have more lobbying leverage than their American
counterparts because there are more European veto players than American ones.

JEL: M48, K20
Keywords: Accounting Standards, Political Lobbying, Harmonization

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A Political Economy of Accounting Standard Setting
1. Introduction
Accounting standard setters have often been criticised for giving undue influence to
individual, mostly corporate, actors and being subject to regulatory capture. A recent addition
to the criticisms voiced is the fear of too much political interference preventing “objective”
accounting standards. This paper identifies public and/or political organizations which have
veto power over accounting standards. It then presents a simple model of the political process
to determine how this veto power influences the standard setting process and to identify
situations where companies and managers have incentives to engage in “political” lobbying of
the accounting standard setter, i.e. to try to influence accounting standards by approaching
political actors instead of participating in the due process of accounting standard setting. The
model is applied to the different institutional frameworks in which accounting standard setting
takes place in the United States and in Europe.
Managers or corporations may wish to retain the ability to conceal unpleasant financial
information or the ability to manage earnings to present constant growth or positive financial
results (e.g., Burgstahler and Dichev, 1997; Burgstahler and Eames, 2003, 2006). In order to
do so they have incentives to exert influence on financial reporting standards. Major
international accounting standard setters follow a due process approach giving companies the
ability to express their views and have them taken into account. However, managers pursuing
one of the objectives mentioned above generally do not wish to express their preferences in
full view of the investing public. Instead, they may use good personal contact to political
decision-makers in order to gain leverage over the standard setter. Former FASB Chairman
Dennis Beresford (2001) states that Congressional intervention in the standard setting process
is taken very seriously by the Board. A point can be made that such activities have a
detrimental effect on the objectivity and unbiasedness of financial information reported
according to standards thus politically influenced (Zeff, 1993, 2002).1
Traditionally, empirical lobbying studies in accounting have taken comment letters sent to the
standard setter as the basis of their analysis (e.g. Watts and Zimmerman, 1978; Deakin, 1989;
Dechow et al., 1996 for lobbying of the in the United States; MacArthur, 1988; Georgiou,

1 Some researchers have suggested that admitting limited competition among accounting standard setters
instead of granting them a monopoly would reduce political interference in the accounting standard setting
process (Benston et al., 2003; Dye and Sunder, 2001; Sunder 2002a, 2002b).
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2002 for lobbying in the United Kingdom; Larson, 1997 for lobbying of the International
Accounting Standards Committee). Georgiou (2004) finds that the use of comment letters is
correlated with the use of other means of lobbying. This gives some justification to the use of
comment letters as a proxy for a company’s overall lobbying posture. However, more
lobbying may go on “behind the scenes” and recent work has begun to use monetary
contributions to politicians as a proxy for political lobbying. Ramanna (2006) finds that firms
that have incentives to lobby against the elimination of pooling as an acceptable accounting
method for business combinations can be linked via political contributions to
Congresspersons who became involved against the Financial Accounting Standards Board
(FASB) proposal on this issue. Johnston and Jones (2006) identify three significant
accounting issues under consideration by the FASB from 1999 to 2000 and find that firms’
political lobbying expenditures are associated with their interest on those issues. Both studies
present evidence of political influence on accounting standards under a private sector standard
setting regime.
The rest of the paper is organized as follows. Section 2 discusses different systems of
accounting regulation and the possibilities they respectively offer for participation in the
regulatory process. Section 3 introduces and analyzes a model of accounting standard setting
in a political context. Section 4 builds on the base model to analyze corporate lobbying.
Section 5 discusses the findings and concludes.
2. Systems of Accounting Regulation
“Political” lobbying in order to influence financial reporting standards has been observed in
many jurisdictions. Zeff (2006) cites instances from the United States, Canada, the UK,
Sweden and international lobbying on IASB standards. However, possibilities for exerting
political influence vary according to country. This paper analyzes the institutional setup in the
United States and in the European Union. Traditionally, studies in comparative international
accounting have distinguished between an Anglo-Saxon or American and a Continental
model of accounting regulation. Whereas the US has a long tradition of standard setting by an
organism belonging to the private sector2 Continental European countries are characterized by
a larger role given to legislation in accounting regulation3. In Germany, the government sets

2 See Zeff (2005a, 2005b) for a history of the evolution of accounting standard setting in the US.
3 An overview over international differences in accounting regulation and practice can be found in Nobes and
Parker (2006) or Flower and Ebbers (2002).
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broad principles in accounting via the commercial code while referring to the Grundsätze
ordnungsmässiger Buchführung (GoB), literally the principles of orderly book-keeping, for
situations not covered by the law (Flower and Ebbers, 2002). GoB are determined in a market
for interpretations by the decisions of judges in court, the expertise of practitioners and
publications by academic accountants. This gives companies and managers the opportunity to
influence accounting practice on either the legislative or the interpretative level4. A further
notable difference is in the participation of academic accountants in the development of
accounting rules. Whereas there is traditionally high involvement by accounting academics in
Germany (McLeay et al., 2000), few academics participate in the standard setting process in
the US by submitting comment letters (Tandy and Wilburn, 1996).
A 2001 act by the European Union, known as the IAS regulation, radically altered this
situation for listed companies. The regulation which went into effect in 2005 mandates
consolidated group reporting by companies with securities traded on a stock exchange to
adhere to International Accounting Standards/International Financial Reporting Standards
(IAS/IFRS) as issued by the International Accounting Standards Board (IASB) and endorsed
by the European Union5. Listed companies in the EU henceforth have to apply accounting
standards which are developed by a private organisation operating in a very similar manner to
the US standard setter. However, the political system in which this standard setter is
embedded differs strongly between the two jurisdictions. It will be argued here that despite
the similarities of the immediate process of developing accounting standards the differences
on the political level influence companies’ lobbying incentives and are likely to lead to
different standard setting outcomes.
In the United States, the legislator has endowed the Securities and Exchange Commission
(SEC) with the power to promulgate and enforce financial reporting standards in the
Securities Acts of 1933 and 1934. The SEC in turn has delegated the rule-making power to
organisations of the private sector, since 1973 the Financial Accounting Standards Board.
Since the right to regulate can be removed by the body that granted it accounting regulation
can be seen as a two-level principal-agent relationship between the Congress and the SEC and
between the SEC and the FASB. Both the legislator and the SEC thus have veto power over

4 See McLeay et al. (2000) for a rare study of lobbying in accounting rule development in a Continental
European country.
5 Annual accounts, which in Europe are often linked to tax accounting, still have to be prepared in accordance
with national law in most countries. However, the IAS regulation gives member states of the EU the option to
permit or require IAS/IFRS also for annual accounts and reporting by non-listed companies.
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standards promulgated by the FASB. Horngren (1985) compares this hierarchical relationship
to a private enterprise:
Figure 1: Accounting Standard Setting Hierarchy in the United States
Comparison to Private Business
U.S. Congress
Board of directors
SEC
Chief executive officer
FASB
Key subordinate managers
Users, including
investors, managers, auditors
Customers

The institutional setup for standard setting in the European Union is less straightforward. The
IAS regulation stipulates that before IAS/IFRS become applicable in the European Union the
Commission has to decide that they are conducive to the European public good and meet
certain qualitative criteria. In this task the Commission follows a so-called comitology
procedure (e.g., Bergstrom, 2005) and is supported by three newly created bodies. The
European Financial Reporting Advisory Group (EFRAG) represents private-sector interests
and is financed by federations representing business, accountants and auditors, banks and
similar organizations. Its work is reviewed on behalf of the European Commission by the
Standards Advice Review Group (SARG), which is composed of independent accounting
experts appointed by the Commission. The Accounting Regulatory Committee (ARC)
represents member states’ governments and is staffed by civil servants from national
ministries. After a new standard or interpretation is promulgated by the IASB, EFRAG’s
Technical Expert Group (TEG) reviews it and issues an advice on its adoption to the
Commission. SARG reviews this advice within three weeks in order to assess whether it is
well balanced and objective. Taking into account EFRAG’s advice, the Commission prepares
draft regulation to adopt the new standard or interpretation and sends it to the ARC which
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either agrees or recommends rejecting it. If the ARC recommends rejection the Commission
can either return the matter to EFRAG for further review or send it to the Council of Ministers
for a final decision (Brackney and Witmer, 2005). A recent change in the European Union’s
comitology procedures has made the so-called regulatory procedure with scrutiny applicable
to the endorsement process. This means that both the European Parliament and the Council
can overturn an implementing measure of the Commission within three months’ time on the
grounds that the Commission has exceeded its implementing powers or that the draft is not
compatible with the aim or the content of the basic instrument (i.e., the IAS regulation). The
process is illustrated in the following chart:
Figure 2: Endorsement Process for Accounting Standards in the EU
IASB issues
TEG advises
SARG
Commission
standard.
on
assesses
prepares draft
endorsement.
TEG‘s advice.
regulation.
ARC
Parliament
recommends
Adoption
and Council
Draft overturned
adoption/
recommended?
review Comm.
by Parliament
rejction.
Yes
Draft.
or Council? Yes
No
No
Commission returns matter to
IFRS
EFRAG for further review
OR

Assuming that the member states’ governments’ interests are represented (on a civil servant
level) by the Accounting Regulatory Committee and that therefore the Council will not veto a
standard deemed acceptable by the ARC this process gives veto power to three institutions.
First, the European Commission which takes into account EFRAG’s advice but is not bound
to it under applicable comitology procedures. Second, the ARC representing national
governments. And third, the European Parliament whose members are elected by the
population of the European Union.
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Figure 3: Accounting Standard Setting Hierarchy in the European Union
Commission
ARC
Parliament
IASB

The description of the respective political processes in accounting regulation in the European
Union and the United States suggests that despite a similar structure of the immediate process
of accounting standard setting – the IASB and the FASB follow an almost identical due
process approach to standard setting – the possibilities for influencing standards are fairly
different in the two regions due to differences in the political environment. In the US a new
standard has to overcome the potential rejection by two veto players: the Securities and
Exchange Commission and the legislator. The SEC can veto any standard or simply refuse to
enforce it. However, the SEC is subject to oversight by Congress and Congress can therefore
undo an SEC veto by legislatively mandating the enforcement of the standard. On the other
hand, Congress also has the ultimate veto power over the standard. There is, at the same time,
a countervailing force working against political mingling in the standard setting process: since
a legislative act requires the consent of both Chambers of Congress and the President a
legislative veto over an accounting standard will only occur if all three agree on it. In the
European Union there are three actors with de facto veto power over accounting standards, the
Commission, the Parliament and the ARC. However, contrary to the US, neither is superior to
the other and can undo its decisions. Furthermore, all three institutions can in principle decide
on a veto on their own without having to reach agreement with other institutions. These facts
suggest that vetoing an accounting standard is easier in Europe than in the United States.
3. A Model of Accounting Standard Setting in a Political Context
This section establishes a simple model of the political process similar to Holburn and
Vanden Bergh (2004) in order to analyze power relations in accounting regulation.
Alternatives in the standard setting process are represented by a single continuous dimension.
This can be thought of, for instance, as the level of discretion that the standard allows or the
level of disclosure required. Not promulgating an accounting standard then also corresponds
to a point on the policy line, and can be interpreted as leaving the incumbent regulation in
place. The sequence of events is such that a private sector accounting standard setter (i.e., the
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FASB or the IASB) promulgates a new standard or a new interpretation subsequent to which
public or political actors with veto power decide whether to accept that standard or to veto it
and thereby reinstate the status quo before issuance of the new standard. All actors involved
in this process are assumed to have single-peaked, linear and symmetrical bliss point
preferences over accounting standards on the single-dimensional policy space. Actor i’s utility
utility is then represented by Ui = –|ŝ – si| where ŝ represents the ultimate outcome of the
standard setting process and si represents actor i’s optimal outcome. Each political or public
body, e.g. the SEC or the European Commission, is assumed to have one single bliss point
preference, independent of its internal composition. Furthermore, complete information is
assumed throughout the analysis, i.e., all actors’ preferences are common knowledge.
ACCOUNTING STANDARD SETTING IN THE UNITED STATES
In the United States, accounting standards are promulgated by the Financial Accounting
Standards FASB. However, the right to develop mandatory standards has been delegated to
the FASB by the Securities and Exchange Commission and the SEC retains veto power over
individual standards and can refuse to apply them. Furthermore, any accounting standard can
be voided of its content by law, which then has higher authority than a SEC decision as well.
Alternatively, the law could theoretically also order the SEC to take back a veto and
acknowledge a given standard. The legislative process is such that passing a bill requires the
consent of the Senate, the House and the President. To keep the model simple and tractable I
abstract from the possibility of Congress to overcome a presidential veto. Then the game is
played as follows: FASB develops and promulgates an accounting standard, the SEC decides
whether to veto it, and the legislator decides whether to override any regulation with a law.
Such a dynamic game is solved by the usual technique of backward induction: the institutions
involved in the legislative process, i.e. the House, the Senate and the President, decide
whether to intervene in the standard setting process by vetoing either the new standard or
potentially by undoing a veto by the SEC. Anticipating this, the SEC will only veto a new
accounting standard if it prefers the incumbent standard to the new one and foresees that its
veto will not be overruled by a legislative act. Under complete information the FASB will in
turn anticipate both the SEC’s and the legislator’s reaction and pass a standard that is as close
as possible to its optimal point on the policy line without being vetoed.
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Figure 4: A Possible Distribution of Preferences over Accounting Standards in the US
Political Core
sF sSEC sS
sH
sP

For illustrative purposes, Figure 4 shows a potential distribution of preferences over
accounting standards. The subscripts F, SEC, S, H, and P denote the FASB, the SEC, the
Senate, the House and the President respectively. Points farther to the left on the policy line
correspond to smaller numerical values in the following analysis. The range between the
extreme preferences on either side of the three actors involved in the legislative process, i.e.
the Senate, the House and the President, is designated as the Political Core. The eventual
outcome in this situation depends on where one the policy line the incumbent standard lies as
this is the fallback that will prevail if a potential new standard gets vetoed. If, for instance, the
incumbent standard lies to the right of the President’s bliss point sP, the FASB can fully
impose its own preferences, ŝ = sF. The SEC will not veto this standard because –|sF – sSEC| >
–|SQ – sSEC| where SQ denotes the status quo, i.e. the incumbent standard. Similarly, the
legislator will not veto the standard because –|sF – sS| > –|SQ – sS| implying that at least the
Senate will not agree to a legislative solution vetoing the new standard and reinstating the
status quo. If, on the other hand, the incumbent standard falls between the Senate’s and the
House’s preferences, the legislators will veto any new standard s if sS – s > SQ – sS as in that
case all three legislative institutions will prefer the incumbent standard to the new one. The
SEC would not veto any standard acceptable to the legislator since any s § SQ is preferred to
the incumbent standard under the preference structure outlined above. Anticipating these veto
strategies the FASB will maximize its utility by setting a standard ŝ = sS – (SQ – sS). We can
generalize these findings by stating the following proposition:
Proposition 1: Under the US accounting regulatory system, the FASB can fully impose its
preferred standard if and only if either both the SEC and at least one of the three legislative
institutions prefer this standard to the incumbent one or if all three legislative institutions
prefer this standard to the incumbent one.
The intuition for this proposition is straightforward: if the SEC prefers the new standard to the
incumbent one it will not veto it and if at least one of the legislative institutions prefers it, no
law will be passed vetoing the standard. Similarly, if all three legislative institutions prefer the
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