From Low-Quality Accounting to
Financial Crises: Politics of Disclosure
Regulation along the Economic Cycle
Jeremy Bertomeu
Robert P. Magee
A Model of Disclosure Regulation
• View reporting quality as the outcome of a political
process
– Reporting quality is a function of accounting standards, plus all
the institutional features (auditors, SEC, etc.) that determine the
ability to differentiate successful enterprises from unsuccessful
ones.
– Current standards “depreciate” quickly and must be reset every
period.
– Various parties have differing views on the desirability of
reporting quality, and the quality level is set at that desired by the
median voter.
• How is reporting quality influenced by the state of the
economy? How does it influence the economy?
The Interested Parties
• Each period begins with entrepreneurs receiving a good
project (with probability pt) or a bad project (with probability 1pt). Require a loan to start business.
– The economy (pt) follows a geometric random walk, with a bound at
pt =1.
– Good entrepreneurs prefer high quality reporting, bad entrepreneurs
prefer lower quality reporting (though not necessarily no reporting).
• Banks with a loan of unknown quality from the previous period
may receive information about that loan’s quality and may
have a liquidity shock that requires that the loan be liquidated.
– Banks with bad loans prefer no reporting, banks with good loans
and banks with loans of unknown quality prefer high quality
reporting.
Figure 4
Figure 4
Figure 4
Figure 4
One Scenario
Issues Raised by the Model
• Regulations are endogenous
– “Bad” regulations occur because they are beneficial to a subset
of the economy.
– Economic consequences of regulations should identify these
groups.
• How is standard-setting affected by the economic cycle?
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Volume of standards at different stages of cycle
Agenda setting and management
Process time
Types of standards
• How is pressure exerted on the standard-setting
process?