Standard Setting Economic Issues

Class Announcements Assignment #10 due March 31st; available on-line Research Paper Part #4 and bonus due April 3rd Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia Final Exam 7:00pm April 19th, Main Gym, Oland Centre

Class Objectives Information asymmetry is reduced through regulation Information production considerations Standard setting as a form of regulation The costs and justification of regulation

Standard Setting: Regulation Firms are not completely free to control the amount and timing of the information they produce about themselves Information asymmetry used to justify regulation Accounting is a highly regulated area of economic activity Regulation includes: minimum disclosure, GAAP, GAAS, audits The extent of regulation is increasing all the time as more and more accounting standards are promulgated “Standard setting is the regulation of firms external information production decisions by a regulator” (p. 462) The standard setter is a mediator between the conflicting interests of investors and managers

Standard Setting: Information Production Information is a commodity Type Proprietary Non-proprietary Benefits Improved Individual Decisions Investors Managers Improved Operation of Capital markets Managerial labour markets Costs Out-of- Pocket Costs Time & effort, more paperwork Proprietary Costs May reveal information to competitors

Standard Setting: Types of Information Production Finer Information (more detail) Expanded note disclosure Additional line items Additional Information (not necessary inclusions) Fair value accounting supplementary info MD&A More Credible Information Audit Fines/charges

Standard Setting: Securities Market Response Securities market will respond positively to increased disclosure Better disclosure  greater analyst following (Lang & Lundholm 1996) Better disclosure  improved share price (Healy et al. 1999) Better disclosure  more institutional ownership (Healy et al. 1999) Better disclosure  narrower bid-ask spread (Wellar 1995) Better disclosure  lower cost of capital (Botosan & Plumlee 2002)

Standard Setting: Incentives for Information Production Contractual Compensation contracts IPO Market-Based (non-contractual) Securities markets (firm value) Managerial labour markets (Reputation) Takeover market (corporate control) Coarse Theorm Too many parties to negotiate information production efficiently Other Disclosure Principle Signaling Private information Search

Standard Setting: The Disclosure Principle Disclosure principle – manager will release all information good or bad Market knows manager has the information Manager does not release the information market fears the worst To avoid, manager releases the information Problems: Information asymmetry Cost of disclosure Conflict between information desired by investors and information needed for contracting purposes

Standard Setting: Signaling “A signal is an action taken by a high-type manager that would not be rational if that manager was low-type” (p. 475) For signals to be applicable, the manager must have a choice Examples of signaling: Direct disclosure Proportion of equity retained Audit quality Forecast Analysts following Dividend policy Accounting policy choice

Standard Setting: Private Information Prodcution Many investors will be active in seeking out information particularly in the presence of noise traders or securities market(s) inefficiencies Private information search is costly from society’s perspective since more than one investor incurs costs to discover the same information

Standard Setting: Justification Accounting is a public good Market failure supports arguments for regulation Externalities – “an action taken by a firm or individual that impose costs or benefits on the firms or individuals for which the entity creating the externality is not charged or doe not receive revenue.” (p. 464) Free Riding – “is the receipt by a firm or individual of a benefit from an externality” (p. 464) Disclosure Principle - ineffective Information Asymmetry Adverse Selection Problem Insider trading Delay in information release Moral Hazard Problem Earnings management to disguise shirking Lack of unanimity between investors and managers about amount of information production

Standard Setting: Conclusion No one Knows How Much Regulation is Enough (marginal social benefit equals its marginal social cost) Regulation Has a Cost Conclude: Extent of Regulation is a Political Question As Well As An Economic One