STANDARD SETTING ECONOMIC ISSUES

Class Announcements

Assignment #10 due March 31st; available on-line Research Paper Part #4 and bonus due April 3rd

Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

Final Exam 7:00pm April 19th, Main Gym, Oland Centre

Class Objectives

1. Information asymmetry is reduced through regulation

2. Information production considerations3. Standard setting as a form of regulation4. The costs and justification of regulation

Standard Setting: Regulation Firms are not completely free to control the

amount and timing of the information they produce about themselves Information asymmetry used to justify regulation

Accounting is a highly regulated area of economic activity Regulation includes: minimum disclosure, GAAP, GAAS,

audits The extent of regulation is increasing all the time

as more and more accounting standards are promulgated

“Standard setting is the regulation of firms external information production decisions by a regulator” (p. 462) The standard setter is a mediator between the

conflicting interests of investors and managers

Standard Setting: Information Production

Information is a commodity Type

Proprietary Non-proprietary

Benefits Improved Individual Decisions

Investors Managers

Improved Operation of Capital markets Managerial labour markets

Costs

Out-of- Pocket Costs Time & effort, more paperwork

Proprietary Costs May reveal information to competitors

Standard Setting: Types of Information Production Finer Information (more detail)

Expanded note disclosure Additional line items

Additional Information (not necessary inclusions) Fair value accounting supplementary info MD&A

More Credible Information Audit Fines/charges

Standard Setting: Securities Market Response

Securities market will respond positively to increased disclosure Better disclosure greater analyst following (Lang

& Lundholm 1996) Better disclosure improved share price (Healy et

al. 1999) Better disclosure more institutional ownership

(Healy et al. 1999) Better disclosure narrower bid-ask spread

(Wellar 1995) Better disclosure lower cost of capital (Botosan

& Plumlee 2002)

Standard Setting: Incentives for Information Production Contractual

Compensation contracts IPO

Market-Based (non-contractual) Securities markets (firm value) Managerial labour markets (Reputation) Takeover market (corporate control) Coarse Theorm

Too many parties to negotiate information production efficiently

Other Disclosure Principle Signaling Private information Search

Standard Setting: The Disclosure Principle

Disclosure principle – manager will release all information good or bad Market knows manager has the information Manager does not release the information market

fears the worst To avoid, manager releases the information

Problems: Information asymmetry Cost of disclosure Conflict between information desired by investors

and information needed for contracting purposes

Standard Setting: Signaling “A signal is an action taken by a high-type

manager that would not be rational if that manager was low-type” (p. 475)

For signals to be applicable, the manager must have a choice

Examples of signaling: Direct disclosure Proportion of equity retained Audit quality Forecast Analysts following Dividend policy Accounting policy choice

Standard Setting: Private Information Prodcution Many investors will be active in seeking

out information particularly in the presence of noise traders or securities market(s) inefficiencies

Private information search is costly from society’s perspective since more than one investor incurs costs to discover the same information

Standard Setting: Justification Accounting is a public good Market failure supports arguments for regulation

Externalities – “an action taken by a firm or individual that impose costs or benefits on the firms or individuals for which the entity creating the externality is not charged or doe not receive revenue.” (p. 464)

Free Riding – “is the receipt by a firm or individual of a benefit from an externality” (p. 464)

Disclosure Principle - ineffective Information Asymmetry

Adverse Selection Problem Insider trading Delay in information release

Moral Hazard Problem Earnings management to disguise shirking

Lack of unanimity between investors and managers about amount of information production

Standard Setting: Conclusion No one Knows How Much Regulation is

Enough (marginal social benefit equals its marginal social cost)

Regulation Has a Cost Conclude: Extent of Regulation is a

Political Question As Well As An Economic One