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Chapter 12

Chapter 12. Standard Setting: Economic Issues. Chapter 12 Standard Setting: Economic Issues. 12.2 Regulation. Information as a Commodity Demand: information demanded by decision makers Supply: information supplied by firms, managers, analysts

michelle-grant
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Chapter 12

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  1. Chapter 12 Standard Setting: Economic Issues

  2. Chapter 12Standard Setting: Economic Issues

  3. 12.2 Regulation • Information as a Commodity • Demand: information demanded by decision makers • Supply: information supplied by firms, managers, analysts • From society’s perspective, firms should produce information until the marginal social benefit = marginal social cost

  4. The Questions • Can market (i.e., private) forces of demand and supply generate the socially optimal amount of information production? • If not, can regulation step in to generate socially optimal information production?

  5. A Useful Distinction • Proprietary information • Information that, if released, will directly reduce cash flows • Non-proprietary information • Information that, if released, will not directly reduce future cash flows

  6. Sources of Regulation in Financial Reporting • Professional accounting bodies • Codes of ethics • Discipline committees • Standard setters • GAAP • Securities commissions • MD&A, executive compensation • Legal system

  7. Regulation in Practice • Firms face a mixture of private and regulatory incentives for information production

  8. 12.3 Ways to Characterize Information Production • Finer information • Expanded note disclosure • Additional line items • Additional information • Current value accounting • MD&A • More credible information • Audit

  9. Private Incentives for Information Production • 12.4.1 contractual incentives • Compensation contracts • Debt contracts • Contractual incentives break down if too many parties are involved • Continued

  10. Private Incentives for Information Production (continued) • 12.4.2 market-based incentives • Securities markets • Lower cost of capital • Managerial labour markets • Higher reputation from full information release • Takeover market • Continued

  11. Private Incentives for Information Production (continued) • 12.4.2, cont’d. theory • Merton (1987) • Better disclosure leads to more investor interest • Diamond and Verrecchia (1991) • Better disclosure increases market liquidity and share price • Easley and O’Hara (2004) • Recall CAPM omits estimation risk • Better disclosure reduces estimation risk • Lower estimation risk → higher share price, lower cost of capital

  12. 12.4.3 Securities Market Response to Full Disclosure • Lang & Lundholm (1996) • Better disclosure  greater analyst following → more investor interest • Healy, Hutton & Palepu (1999) • Better disclosure  more institutional ownership, higher share price • Welker (1995) • Better disclosure  narrower bid-ask spread • Continued

  13. 12.4.3 Securities Market Response to Full Disclosure (continued) • Botosan and Plumlee (2002) • Better disclosure  lower cost of capital • Sengupta (1998) • Better disclosure → lower interest cost • Dechow, Sloan, & Sweeney (1996) • Fall in share price for firms under investigation for poor disclosure

  14. 12.5.1 The Disclosure Principle • Market knows manager has the information • e.g., a forecast • Manager does not release the information • Market fears the worst • Share price crashes • To avoid, manager releases the information • Continued

  15. 12.5.1 The Disclosure Principle (continued) • The disclosure principle does not always work • Verrecchia (1983), Pae (2005), Einhorn (2007) • If information below a threshold, will not be released • Newman & Sansing (1993) • Firm may only release interval information • Dye (1985) • Information may not be released if it reduces contract efficiency

  16. 12.5.2, 12.5.3 Signalling • High type v. low type • High types want to separate from low • Crucial aspect of a signal: • Must be less costly for high types to signal • Financial accounting policy choice as a signal • Healy & Palepu (1993)

  17. 12.5.4 Private Information Search • Investors have incentive to search for information • Complements information production by firms • Socially wasteful? • Many investors expend resources to discover same information • Less wasteful if private investor search affects cost of capital, thereby improving working of markets

  18. Market Failures in Private Information Production • 12.6.1 externalities and free riding • 12.6.2 adverse selection • Insider trading • Manager may delay in information release • Regulation FD an attempt to reduce adverse selection • 12.6.3 moral hazard • Opportunistic earnings management to disguise shirking

  19. 12.6.4 Lack of Unanimity • If markets do not work well, investors will not agree with amount of information produced by manager, even if that amount maximizes firm value • Leads to demand for regulation

  20. 12.6.5 Summary • Market forces motivate much information production • Market forces unlikely to generate socially optimal information production due to numerous market failures

  21. Can Regulation Step In to Produce Socially Best Amount of Information? • Benefits of regulation • Better investment decisions • Better operation of markets • Greater investor confidence • Costs of regulation • Direct costs of setting, applying, and enforcing • Costs to firms of releasing proprietary information • Reduced ability to signal • In view of this difficult cost/benefit tradeoff, likely answer is no

  22. 12.7 How Much Information is Enough? • No one Knows • Numerous market-based reasons why firms want to produce information • But, numerous sources of market failure • Regulation Has a Cost • Regulators do not know socially optimal amount of information either • May tend to ignore costs of regulation

  23. 12.9 The Bottom Line • To understand regulation of information production, we must look to political aspects as well as economic

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