CHAPTER 12 Standard Setting: Economic Issues

CHAPTER 12 Standard Setting: Economic Issues Cory Bettel ∙ Jeff Chang ∙ Danielle Dodd Ryan Gruenspan∙ Victoria Kavanagh ∙ Sally Regenstreif

AGENDA

OVERVIEW Standard Setting: The regulation of firm’s external information production decisions by a regulator.

Standard setting is ultimately the government’s responsibility • Regulators are agencies delegated to set accounting standards (E.g. IASB and FASB) • Act as a mediator between conflicting interests of investors and managers • Ensure the right amount of information is in the financial statements OVERVIEW

Fundamental problem is discerning the socially “right” amount of information • First-Best:Amount that equates marginal benefits to marginal costs • Impossible due to market complexities STANDARD SETTING

Regulation protects individuals who are at an information disadvantage • Occurs due to information asymmetry • Improves markets by enhancing public confidence • Common Examples: • GAAP, IFRS, MD&A, • profession laws, full • disclosure laws, etc. REGULATION OF ECONOMIC ACTIVITY

2 Types of Information: REGULATION OF ECONOMIC ACTIVITY Proprietary Information Non-proprietary Information

“Production” of information used for 2 reasons: • Information is a commodity • Consistent way of thinking about its production • Quantity of information: • Finer information • Additional information • Credibility CHARACTERIZE INFORMATION PRODUCTION

Benefits include: • Better-informed investment decision • Lower costs of capital • Better-working markets • Reduction of monopoly power • Timely recognition of firm failure • Potential information release about other firms • Costs include: • Direct costs of preparation and release • Possible release of proprietary information • Increased contracting costs PROS & CONS OF INFORMATION PRODUCTION

Externality: An action taken by a firm or individual that imposes costs or benefits on others for which the creating entity is not charged or does not receive revenue. MARKET FAILURES IN INFO. PRODUCTION • The perception of these costs and benefits differs between the firm and society Free-riding: The receipt of a firm or individual of a benefit from an externality .

Darrough and Stoughton: monopolies keeps certain information private to deter entry • Reduces proprietary costs, but decreases benefit to society • Lambert, Leuz, and Verrecchia: earnings information released affects other firm’s stock prices • Decreases Beta which decreases cost of capital- but decreases for all firms • Anilosky, Feng and Skinner: firm’s reporting good earnings does not provide an externality about future economic performance • If firms’ reporting became more timely, this could increase EXTERNALITY EXAMPLES

Information has a public-good nature, more than one investor can use it • Investors are able to free-ride • Information must be free • Firms produce less • information than society • would like FREE-RIDING EXAMPLES

Insider trading • Managers trade on inside information • No longer a fair game • Bad news is not released ADVERSE SELECTION PROBLEM

Net income is not fully informative of effort • Mangers disguise shirking and low profits by earnings management or reducing disclosure MORAL HAZARD PROBLEM

If markets work well, shareholders will unanimously be in favour of the manager maximizing the market value of the firm • If markets do not work well, no longer will be unanimous UNANIMITY

Information is required to observe compliance with contracts • Unobservable managerial effort • Financial covenants for firms issuing debt • When a private firm goes public, increased possibility of shirking EXAMPLES OF CONTRACTUAL INCENTIVES

Investors will become aware of shirking • As a result, share prices decline • Management incentive to reduce shirking • Contracts include forecasts • Increase financial reporting • Overall increase in information production JENSEN & MECKLING MODEL

Created by Ronald Coase • Problem of externalities can be internalized • Reduce need for regulation • Illustrated by two farms located side by side THE COASE THEOREM

Two farms: • One raises cattle • One grows crops • Cattle roam into crops, damaging value • Two solutions: • Regulate the two farms – fencing • Farmers bargain COASE THEOREM ILLUSTRATION

Fence costs $100, damage costs $150 • Assume property rights belong to the cattle farmer • Cattle can stray • Crop farmer will put up fence • Assume property rights belong to the crop farmer • Damages repaid by cattle farmer • Cattle farmer will put up fence • The fence replaces the need for regulation COASE THEOREM ILLUSTRATION

Firm information costs $100 to release • Benefit to investor is $150 • .: Firm will release information without regulation COASE THEOREM ILLUSTRATION Benefit to Investors Cost to Firm <

Evaluates manager performance on an ongoing basis • Reputation suffers if information is false, biased • or incomplete • Need for contracts not completely removed • Number of incentives reduced • Example: Manager‘s profit share • Reduced from 35% to 20% • Lower amount of compensation in jeopardy • Risk averse manager more likely to provide information MANAGERIAL LABOUR MARKET

Managers motivated by reputation and wanting to increase firm value • Assume investors cannot diversify against adverse selection & estimation risk • Managers release information due to motivation to strengthen reputation and increase firm value • Market prices of the firms’ shares increase, or equivalently, cost of capital will fall • Higher firm profitability and value • Increased compensation CAPITAL MARKETS

Market for corporate control • If manager does not increase value, subject to takeover bid • Replacement of management • The more aggravated investors are, more likely takeover will happen • Market motivates managers to increase firm value • Information is produced and released TAKEOVER MARKET

Disclosure Principle – managers will release all info, good or bad • Rational investors • Assume the manager will only release favourable info • If managers do not release info, will assume the worst • Therefore, managers should release all info, or risk decreasing firm value • Incentive to keep share price from falling THE DISCLOSURE PRINCIPLE

“Does it always work?” • Verrecchia (1983): managers may not fully disclose at all times • Assumptions: • Disclosures made are truthful • Disclosures have a cost • Investors know managers have info & the cost of disclosure • Investors do not know what the info is THE DISCLOSURE PRINCIPLE

Threshold levels of disclosure exist • News will be disclosed if info exceeds threshold • Unknown to investors why managers are withholding info • Disclosure principle fails • Reinstated if cost • of disclosure = 0 THE DISCLOSURE PRINCIPLE

Relaxed the assumption that the market knows the manager has info • Still an incentive for voluntary disclosure? • More than one piece of news? • What happens with non-proprietary info? PAE (2005)

Forecast of earnings & cash flows • Costly for firms to develop internally & no cost of release • Investors do not know whether firms have developed them or not • Investors will asses probabilities • Iffirm develops both forecasts, only disclose > threshold • Iffirm has not developed either, disclose nothing PAE (2005)

Though it is a basic & strong argument that firms will release news, it easily breaks down in a number of situations • Therefore, cannot be relied upon that all info will always be released by firms DISCLOSURE PRINCIPLE

Signaling: An action taken by a high-type manager that would not be rational if that manager was low-type. SIGNALING • Signal must be less costly for a high-type manager to be credible • Irrational for low-type to mimic high-type • Some signals include…

Proportion of retained equity • Entrepreneur/manager making an IPO • Too costly for low-type to do • Audit quality • Signals value of new securities issue • High quality auditors are costly for low-type • Forecasts • E.g. Canadian Tire’s MD&A • Info disclosure beyond minimum requirements • Signals confidence in firm’s future, which • adds credibility SIGNALS

Capital Structure • Issuance of new shares causes existing shares to drop in value • High-type firm would likely find other sources of financing • E.g. Bonds, internal financing • Dividend Policy • High payout ratio = confidence in future performance • Accounting Policy • Increased conservation = greater confidence SIGNALS

NOTE: Managers must have choice. SIGNALING • E.g. if equal audit quality imposed on all firms, then not available as a signal

Management onus to release info • Implies investors are passive • Investors may conduct private info searches • If successful, inside info can quickly go public • High cost to society PRIVATE INFORMATION SEARCH

Theory: If market forces motivate superior disclosure levels from firms • Firms should benefit from a lower cost of capital • Decrease exists as increased disclosure reduces investors risk • May also positively affect the firms’ future investment and production decisions THEORY OF SUPERIOR DISCLOSURE

The theory is relatively unproven and many researchers still disagree today • Supporters include: • 1. Lehavy & Sloan (2008): When number of wealthy (Assumed informed) investors holding stock increased, future returns on the stock fell • Less risk as investor estimation risk is minimized THEORY OF SUPERIOR DISCLOSURE

Supporters also include: • 2. Dechow, Sloan & Sweeney (1996): An average drop of 9% in share price on the day that the SEC decides to investigate a firm that has violated GAAP/IFRS • Bad Reporting = Higher Investor Risk • Higher Risk = More volatile earnings (High Cost of Capital) • .: Good Reporting = Stable earnings (Low Cost of Capital) THEORY OF SUPERIOR DISCLOSURE

Those opposing the theory include: • Core, Guay & Verdi (2008): Higher accrual quality does not imply a lower cost of capital • It’s believed that higher accrual quality will signal to users about the organization’s next year of business • This would in tern decrease investor estimation risk and decrease WACC • Core, Guay & Verdi determined that such a connection does not exist. THEORY OF SUPERIOR DISCLOSURE

In conclusion… • Difficult to say that firms and investors do not benefit from higher disclosure from an accounting perspective • Difficult to prove conclusively though, due to: • Variety of measures of investor risk • Difficult to measure cost of capital effectively THEORY OF SUPERIOR DISCLOSURE

Gives management some flexibility in reporting • Reduces comparability across firms • Improves the relevance of reporting • Reliability may be controlled • Since management would have to change a firms internal organization to exploit flexibility DECENTRALIZED REGULATION

Segment Reporting • Useful since relevant information may be buried in consolidated totals • It is harder to disguise poor performance • Regulated by IFRS 8 • Requires reporting externally on same basis as internally • Flexibility results in useful information to investors • The cost of opportunism in segment reporting will be high DECENTRALIZED REGULATION

Standards allowing Fair Value • Decentralized since management is given a choice • Gives management the ability to signal through its choice of reporting methods DECENTRALIZED REGULATION

Complete Regulation is too costly • Direct costs such as • Bureaucracy to establish and administer regulations • Compliance costs to firms • Indirect costs such as • Reduction in mgmt opportunity to signal • Costs of “wrong” amounts of information HOW MUCH INFO IS ENOUGH?

Complete Deregulation • Not socially desirable • Uncontrolled impacts of externalities, adverse selection, and moral hazard would be extremely serious • Markets would probably • cease to function HOW MUCH INFO IS ENOUGH?

Range of regulation is up for debate • Theorem of the second best • We many never know the socially correct extent of regulation • Consider the effects of the Sarbanes-Oxley Act • Showed net positive effect to investors • But reduced utilities of insiders, and lowered the number of firms offering securities • Can’t infer the “social” benefits are positive HOW MUCH INFO IS ENOUGH?

In conclusion… • The extent of standards is a complex and important question for a market economy • Standard setting boils down to a cost-benefit trade-off. • However this trade-off may never be fully known • A method for dealing with this uncertainty is to give firms flexibility in meeting reporting standards HOW MUCH INFO IS ENOUGH?

AcSB has started the Accounting Standards Improvement project • Focused on ensuring statements prepared with best practices • Increased discussion of convergence between IASB and FASB • Would create a “gold standard” for major capital markets • Maintaining converged standards = converged interpretation processes THE FUTURE: IMPROVED STANDARDS

CHAPTER 12 Standard Setting: Economic Issues