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: • “China’s 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 • Accountant’s reporting alternatives • Report whole distribution—not 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 • Manager’s 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