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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

Chapter 12

Standard Setting: Economic Issues


Chapter 12 standard setting economic issues

Chapter 12Standard Setting: Economic Issues


12 2 regulation
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
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
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
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
Regulation in Practice

  • Firms face a mixture of private and regulatory incentives for information production


12 3 ways to characterize 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
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
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 continued1
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
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
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
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
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
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
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
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
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
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
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
12.7 How Much Information is Enough? Information?

  • 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
12.9 The Bottom Line Information?

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


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