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

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