copyright © 2009 by pearson education canada 12 - 1 chapter 12 standard setting: economic issues

Copyright © 2009 by Pearson Education Canada12 - 1

Chapter 12 Standard Setting: Economic Issues

Copyright © 2009 by Pearson Education Canada12 - 2

Chapter 12Standard Setting: Economic Issues

Copyright © 2009 by Pearson Education Canada 12 - 3

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

» Continued


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

» Continued


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

» Continued


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

» Continued


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

copyright © 2009 by pearson education canada 12 - 1 chapter 12 standard setting: economic issues

Documents

information production12

disclosure continuedbotosan

disclosure principlemarket

optimal information

better disclosure narrower

securities market response

market liquidity

regulatory incentives