chapter 12 standard setting: economic issues

CHAPTER 12Standard Setting: Economic Issues

Cory Bettel ∙ Jeff Chang ∙ Danielle Dodd

Ryan Gruenspan ∙ Victoria Kavanagh ∙ Sally Regenstreif

AGENDA•Overview12.1

•Regulation of Economic Activity12.2

•Characterizing Information Production12.3

•First-best Information Production12.4

•Market Failures in Info. Production12.5

•Contractual Incentives for Information Production12.6

•Market-based Incentives for Information Production12.7 & 12.8

•Disclosure12.9

•Decentralized Regulation12.10

•How much information is enough?12.11

•Improved Standards in the Future Article 1

OVERVIEWOVERVIEW

REGULATION

INFORMATION PRODUCTION

MARKET FAILURES

CONTRACTUAL INCENTIVES

MARKET-BASED INCENTIVES

DISCLOSURE

DECENTRALIZED REGULATION

HOW MUCH IS ENOUGH ?

FUTURE OF STANDARDS

Standard Setting: The regulation

of firm’s external information

production decisions by a

regulator.

OVERVIEW

• 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

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

STANDARD SETTING

• 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

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

REGULATION OF ECONOMIC ACTIVITY

• 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.

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

REGULATION OF ECONOMIC ACTIVITY

• 2 Types of Information:

Proprietary Information

Non-proprietary Information

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

CHARACTERIZE INFORMATION PRODUCTION

• “Production” of information used for 2 reasons:

1. Information is a commodity2. Consistent way of thinking about its

production

• Quantity of information:• Finer information• Additional information• Credibility

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

PROS & CONS OF 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

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

MARKET FAILURES IN INFO. 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.

Free-riding: The receipt of a firm or individual of a benefit from an externality.

• The perception of these costs and benefits differs between the firm and society

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

EXTERNALITY EXAMPLES• 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

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

FREE-RIDING EXAMPLESOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

ADVERSE SELECTION PROBLEMOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

1. Insider trading• Managers trade on inside information• No longer a fair game

2. Bad news is not released

MORAL HAZARD PROBLEMOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• Net income is not fully informative of effort

• Mangers disguise shirking and low profits by earnings management or reducing disclosure

UNANIMITYOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

EXAMPLES OF CONTRACTUAL INCENTIVESOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

JENSEN & MECKLING MODELOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

THE COASE THEOREMOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• Created by Ronald Coase

• Problem of externalities can be internalized

• Reduce need for regulation

• Illustrated by two farms located side by side

COASE THEOREM ILLUSTRATIONOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• Two farms:

1. One raises cattle

2. One grows crops

• Cattle roam into crops, damaging value

• Two solutions:

1. Regulate the two farms – fencing

2. Farmers bargain


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• Firm information costs $100 to release• Benefit to investor is $150

.: Firm will release information without regulation

Cost to Firm

Benefit to

Investors<

MANAGERIAL LABOUR MARKETOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

CAPITAL MARKETSOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

TAKEOVER MARKETOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

THE DISCLOSURE PRINCIPLEOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• “Does it always work?”

• Verrecchia (1983): managers may not fully disclose at all times

• Assumptions:i. Disclosures made are truthfulii. Disclosures have a costiii. Investors know managers have info

& the cost of disclosureiv. Investors do not know what the info

is


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

PAE (2005)OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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)OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

DISCLOSURE PRINCIPLEOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

SIGNALINGOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

Signaling: An action taken by a high-type manager that would not be rational if that manager was low-type.

• Signal must be less costly for a high-type manager to be credible

• Irrational for low-type to mimic high-type

• Some signals include…

SIGNALSOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

1. Proportion of retained equity• Entrepreneur/manager making an IPO• Too costly for low-type to do

2. Audit quality

• Signals value of new securities issue • High quality auditors are costly for low-type

3. Forecasts • E.g. Canadian Tire’s MD&A• Info disclosure beyond minimum

requirements• Signals confidence in firm’s future, which

adds credibility

SIGNALSOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

4. 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

5. Dividend Policy• High payout ratio = confidence in

future performance

6. Accounting Policy• Increased conservation = greater

confidence

SIGNALINGOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

NOTE: Managers must have choice.

•E.g. if equal audit quality imposed

on all firms, then not available as a

signal

PRIVATE INFORMATION SEARCHOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

THEORY OF SUPERIOR DISCLOSUREOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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)


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• Those opposing the theory include:

1. 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.


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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:

1. Variety of measures of investor risk

2. Difficult to measure cost of capital effectively

DECENTRALIZED REGULATIONOVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

1. 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

2. Standards allowing Fair Value• Decentralized since management is

given a choice• Gives management the ability to signal

through its choice of reporting methods

HOW MUCH INFO IS ENOUGH?OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• Complete Deregulation • Not socially desirable • Uncontrolled impacts of externalities,

adverse selection, and moral hazard would be extremely serious

• Markets would probably cease to function


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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


REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

• 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

THE FUTURE: IMPROVED STANDARDS

• 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

OVERVIEW

REGULATION


MARKET FAILURES



DISCLOSURE



FUTURE OF STANDARDS

chapter 12 standard setting: economic issues

Documents

earnings information

information asymmetry

information disadvantageoccurs

certain information

entryreduces proprietary

costs market failures

direct costs of preparation

good earnings