Financial Accounting Seminar 10 Standard Setting: Economic Issues

2 ACOUNTING REGULATION: MEDIATING BETWEEN THE INTERESTS OF SHAREHOLDERS and MANAGERS

3 Not enough information known by outsiders… Perfect relevance, reliability…not practical. Why? Effort aversion; opportunism, Finding ways to motivate managers (Game Theory) Finding the appropriate mix of measures The possibility of earnings management still exists Rational decisions still required Bias toward more info Moderate disclosure…som e discretion Predicting future cash flows

4 Fundamental Problem of Financial Accounting Theory The two primary objectives of financial reporting – –efficient securities markets –efficient contracting How we produce the “right” amount of information? Is regulation necessary? –If so, how much?

5 Learning Objectives To conceptualize accounting information as a commodity for which there is market; To explain the arguments for private vs. regulated markets for a/c information; To understand the role of accounting standards in information production.

6 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

7 The Questions Can market (i.e., private) forces of demand and supply generate the socially optimal amount of information production? (cost- benefit analysis) If not, can regulation step in to generate socially optimal information production?

8 Benefits of Information Production Improved individual decisions –Investors –Managers Improved operation of –Capital markets –Managerial labour markets

9 Costs of Information Production Out-of-pocket costs –Time and effort, info systems Proprietary costs –May reveal information to competitors –If released, will directly reduce future cash flow Agency costs, since information to investors may reduce contract efficiency

10 Ways to Characterise Information Production Finer information –Expanded note disclosure –Additional line items Additional information –Fair value accounting –MD&A More credible information –audit

11 Private Incentives for Information Production Contractual incentives –Compensation contracts Performance measures need information production (e.g. net income, core earnings) –Debt contracts Debt covenants need information production (e.g. working capital, times-interest-earned, debt-to-equity) –Contractual incentives break down if too many parties are involved

12 Private Incentives for Information Production Market-based incentives –Securities markets Poor disclosure creates estimation risk, raising firm’s cost of capital –Managerial labour markets Poor disclosure lowers manager reputation and reservation utility –Takeover market

13 Securities Market Response to Full Disclosure Theory –Merton (1987) Better disclosure leads to more investor interest –Diamond & Verrecchia (1991) Better disclosure increases market liquidity and share price –Easley & O’Hara (2004) Better disclosure reduces estimation risk Lower estimation risk → higher share price, lower cost of capital

14 Securities Market Response to Full Disclosure Empirical – better disclosure → –greater analyst following → more investor interest (Lang & Lundholm, 1996) –More institutional ownership, higher share price (Healy, Hutton & Palepu, 1999) –Narrower bid-ask spread (Welker, 1995) –Lower cost of capital (Botosan & Plumlee, 2002) –Lower interest cost on debt (Sengupta, 1998)

15 The Disclosure Principle Market knows manager has the information –e.g. a forecast Manager does not release the information Market fears the worse –Share price crashes To avoid, manager releases the information

16 The Disclosure Principle 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

17 “Our stockholders and our owners knew exactly what they needed to know” Jeffrey Skilling, former Enron CEO… on trial for conspiring to defraud shareholders, responding to charges that he lied to investors

18 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)

19 Private Information Search Investors have incentive to search for information –Complements information production by firms –Socially wasteful? Many investors spend resources to discover same information Less wasteful if private investor search affects cost of capital, thereby improving working of markets

20 Market Failures in Private Information Production Are Private Incentives Sufficient? Is Information Market Fully Efficient? The answer is “NO”.

21 Market Failures in Private Information Production Public good nature of information – Free rider problem – information can be reused – less incentive for firms to produce Private and social value of information not the same – Externalities problem – information may benefit investors but harm firms and managers, creating agency costs

22 Market Failures in Private Information Production Adverse selection problem –Insider trading –Delay in information release Moral hazard problem –Earnings management to disguise shirking

23 ABC Learning Ltd. Key managers sell-off of shares prior to informing the market. Why? Shares held in own company were the basis for margin loan – margin loan called in by bank Breach of ASX rules Trading suspended Fall in value for other shareholders Change in rules?

24 Market Failures in Private Information Production Lack of unanimity between investors and managers about amount of information production

25 Summary Market forces motivate much information production However, market forces unlikely to generate socially optimal information production due to numerous market failures Therefore, regulations are required

26 Can Regulation lead to socially optimal amount of info production? 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

27 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

28 The Bottom Line To understand regulation of information production, we must look to political aspects as well as economic Regulation in accounting - Standard setting –The regulation of firms’ external information production decisions by some central authority.

29 The Bottom Line Accounting standards –IASB, AASB, FASB –Mandatory information production –Meets the basic information demand by users Voluntary information production depends on the market forces

30 Conclusions Private incentives are not enough to produce socially optimal amount of information Regulation also cannot generate socially optimal information production Accounting standard setting should maximize the net benefit of regulation (benefit minus cost)