chapter 12 standard setting: economic issues. chapter 12 standard setting: economic issues
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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
• From society’s perspective, firms should produce information until the marginal social benefit = marginal social cost
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?
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
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
Regulation in Practice
• Firms face a mixture of private and regulatory incentives for information production
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
Private Incentives for Information Production
• 12.4.1 contractual incentives– Compensation contracts– Debt contracts– Contractual incentives break down if too
many parties are involved
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
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
12.4.3 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
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
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
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
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)
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
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
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
12.6.5 Summary
• Market forces motivate much information production
• Market forces unlikely to generate socially optimal information production due to numerous market failures
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
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
12.9 The Bottom Line• To understand regulation of
information production, we must look to political aspects as well as economic
The End
Thank you
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