Copyright © 2009 by Pearson Education Canada Chapter 12 Standard Setting: Economic Issues

Copyright © 2009 by Pearson Education Canada Chapter 12 Standard Setting: Economic Issues

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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?

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada Regulation in Practice Firms face a mixture of private and regulatory incentives for information production

Copyright © 2009 by Pearson Education Canada Ways to Characterize Information Production Finer information –Expanded note disclosure –Additional line items Additional information –Current value accounting –MD&A More credible information –Audit

Copyright © 2009 by Pearson Education Canada Private Incentives for Information Production contractual incentives –Compensation contracts –Debt contracts –Contractual incentives break down if too many parties are involved »Continued

Copyright © 2009 by Pearson Education Canada Private Incentives for Information Production (continued) market-based incentives –Securities markets Lower cost of capital –Managerial labour markets Higher reputation from full information release –Takeover market »Continued

Copyright © 2009 by Pearson Education Canada Private Incentives for Information Production (continued) , 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada , 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)

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada Market Failures in Private Information Production externalities and free riding adverse selection –Insider trading –Manager may delay in information release –Regulation FD an attempt to reduce adverse selection moral hazard –Opportunistic earnings management to disguise shirking

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada Summary Market forces motivate much information production Market forces unlikely to generate socially optimal information production due to numerous market failures

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada The Bottom Line To understand regulation of information production, we must look to political aspects as well as economic