Chapter 12
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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

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Chapter 12

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Chapter 12

Standard Setting: Economic Issues


Chapter 12Standard 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

      • 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


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