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306-684 Financial AccountingSeminar 10Standard Setting: Economic Issues

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ACOUNTING REGULATION:

MEDIATING BETWEEN THE INTERESTS OF

SHAREHOLDERS and MANAGERS

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Not enough information known by

outsiders…

Perfect relevance,

reliability…not practical. Why?

Effort aversion;

opportunism,

Finding ways to motivate managers

(Game Theory)

Finding the appropriate mix

of measures

The possibility of earnings

management still exists

Rational decisions still required

Bias toward

more info

Moderate disclosure…

some discretion

Predicting future

cash flows

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Fundamental Problem of Financial Accounting Theory• The two primary objectives of financial reporting – – efficient securities markets– efficient contracting

• How we produce the “right” amount of information?• Is regulation necessary?

– If so, how much?

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Learning Objectives• To conceptualize accounting

information as a commodity for which there is market;

• To explain the arguments for private vs. regulated markets for a/c information;

• To understand the role of accounting standards in information production.

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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

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The Questions

• Can market (i.e., private) forces of demand and supply generate the socially optimal amount of information production? (cost-benefit analysis)

• If not, can regulation step in to generate socially optimal information production?

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Benefits of Information Production

• Improved individual decisions– Investors– Managers

• Improved operation of– Capital markets– Managerial labour markets

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Costs of Information Production• Out-of-pocket costs

– Time and effort, info systems

• Proprietary costs– May reveal information to

competitors– If released, will directly reduce

future cash flow

• Agency costs, since information to investors may reduce contract efficiency

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Ways to Characterise Information Production• Finer information

– Expanded note disclosure– Additional line items

• Additional information– Fair value accounting– MD&A

• More credible information– audit

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Private Incentives for Information Production

• Contractual incentives– Compensation contracts

• Performance measures need information production (e.g. net income, core earnings)

– Debt contracts• Debt covenants need information

production (e.g. working capital, times-interest-earned, debt-to-equity)

– Contractual incentives break down if too many parties are involved

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Private Incentives for Information Production

• Market-based incentives– Securities markets

• Poor disclosure creates estimation risk, raising firm’s cost of capital

– Managerial labour markets• Poor disclosure lowers

manager reputation and reservation utility

– Takeover market

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Securities Market Response to Full Disclosure• Theory– Merton (1987)

• Better disclosure leads to more investor interest

– Diamond & Verrecchia (1991)• Better disclosure increases market

liquidity and share price

– Easley & O’Hara (2004)• Better disclosure reduces estimation

risk• Lower estimation risk → higher share

price, lower cost of capital

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Securities Market Response to Full Disclosure• Empirical – better disclosure →

– greater analyst following → more investor interest (Lang & Lundholm, 1996)

– More institutional ownership, higher share price (Healy, Hutton & Palepu, 1999)

– Narrower bid-ask spread (Welker, 1995)– Lower cost of capital (Botosan & Plumlee, 2002)– Lower interest cost on debt (Sengupta,

1998)

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The Disclosure Principle

• Market knows manager has the information– e.g. a forecast

• Manager does not release the information

• Market fears the worse– Share price crashes

• To avoid, manager releases the information

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The Disclosure Principle

• 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

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“Our stockholders and our owners knew exactly what they needed to know”

Jeffrey Skilling, former Enron CEO… on trial forconspiring to defraud shareholders,responding to charges that he lied to investors

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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)

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Private Information Search• Investors have incentive

to search for information– Complements information

production by firms– Socially wasteful?

• Many investors spend resources to discover same information

• Less wasteful if private investor search affects cost of capital, thereby improving working of markets

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Market Failures in Private Information Production

Are Private Incentives Sufficient?

Is Information Market Fully Efficient?

The answer is “NO”.

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Market Failures in Private Information Production

• Public good nature of information– Free rider problem – information

can be reused – less incentive for firms to produce

• Private and social value of information not the same– Externalities problem –

information may benefit investors but harm firms and managers, creating agency costs

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Market Failures in Private Information Production

• Adverse selection problem– Insider trading– Delay in information release

• Moral hazard problem– Earnings management to

disguise shirking

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•ABC Learning Ltd.Key managers sell-off of shares prior to

informing the market.Why? Shares held in own company

were the basis for margin loan – margin loan called in by bank• Breach of ASX rules• Trading suspended• Fall in value for other shareholders• Change in rules?

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Market Failures in Private Information Production

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

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Summary

• Market forces motivate much information production

• However, market forces unlikely to generate socially optimal information production due to numerous market failures

• Therefore, regulations are required

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Can Regulation lead to socially optimal amount of info production? • 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

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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

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The Bottom Line

• To understand regulation of information production, we must look to political aspects as well as economic

• Regulation in accounting -Standard setting– The regulation of firms’

external information production decisions by some central authority.

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The Bottom Line

• Accounting standards– IASB, AASB, FASB– Mandatory information

production– Meets the basic information

demand by users

• Voluntary information production depends on the market forces

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Conclusions

• Private incentives are not enough to produce socially optimal amount of information

• Regulation also cannot generate socially optimal information production

• Accounting standard setting should maximize the net benefit of regulation (benefit minus cost)