© 2006 Pearson Education Canada Inc.12-1 CHAPTER 12 Standard Setting: Economic Issues

© 2006 Pearson Education Canada Inc.12-2 Regulation Think of Information as a Commodity – Information produced by firms and demanded by decision makers – Firm’s information production decisions regulated by GAAP

© 2006 Pearson Education Canada Inc.12-3 The “Best” Amount of Information Production (From Society’s Perspective) Firms Should Produce Information Until the Marginal Social Cost = the Marginal Social Benefit Operational? –No, but we can still consider benefits and costs of information production

© 2006 Pearson Education Canada Inc.12-4 Benefits of Information Production Improved Individual Decisions –Investors –Managers Improved Operation of –Capital markets –Managerial labour markets

© 2006 Pearson Education Canada Inc.12-5 Costs of Information Production Out-of-Pocket Costs –Time & effort, more paperwork Proprietary Costs –May reveal information to competitors Agency costs, since information to investors may reduce contract efficiency

© 2006 Pearson Education Canada Inc.12-6 Ways to Characterize Information Production Finer Information –Expanded note disclosure –Additional line items Additional Information –Fair value accounting –MD&A More Credible Information –Audit

© 2006 Pearson Education Canada Inc.12-7 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)

© 2006 Pearson Education Canada Inc.12-8 Private Incentives for Information Production, Cont’d. 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

© 2006 Pearson Education Canada Inc.12-9 Securities Market Response to Full Disclosure 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) Better disclosure reduces estimation risk

© 2006 Pearson Education Canada Inc Securities Market Response to Full Disclosure, Cont’d. Empirical –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 –Botosan and Plumlee (2002) Better disclosure  lower cost of capital –Sengupta (1998) Better disclosure → lower interest cost

© 2006 Pearson Education Canada Inc 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

© 2006 Pearson Education Canada Inc 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, “The Effects of Firms’…,” Accounting Horizons (March, 1993)

© 2006 Pearson Education Canada Inc Market Failures in Private Information Production Contracts Break Down if Too Many Parties –Then, can we rely on market forces to motivate optimal information production?

© 2006 Pearson Education Canada Inc Market Failures in Private Information Production, Cont’d. But, Market Forces May Not Be Completely Effective –Public Good Nature of Information Information can be reused (free rider problem) –Less incentive for firms to produce information Private and social value not the same (externalities) –Information may benefit investors but harm the firm and manager, creating agency costs

© 2006 Pearson Education Canada Inc Market Failures in Private Information Production, Cont’d. But, Market Forces May Not Be Completely Effective, Cont’d. –Adverse Selection Problem Insider trading Delay in information release –Moral Hazard Problem Earnings management to disguise shirking

© 2006 Pearson Education Canada Inc Market Failures in Private Information Production, Cont’d. But, Market Forces May Not Be Completely Effective, Cont’d. –Is The Disclosure Principle Effective? Does market know manager has the information? Cost of disclosure Is disclosure truthful? Conflict between information for investors and for contracting, creating agency costs

© 2006 Pearson Education Canada Inc Market Failures in Private Information Production, Concl. But, Market Forces May Not Be Completely Effective, Concl. –Lack of unanimity between investors and managers about amount of information production

© 2006 Pearson Education Canada Inc The Bottom Line Noone Knows How Much Regulation is Enough –Numerous reasons why firms want to produce information –But, numerous sources of market failure Regulation Has a Cost –Regulators tend to ignore this

© 2006 Pearson Education Canada Inc The Bottom Line, Cont’d. Conclude: Extent of Regulation is a Political Question As Well As An Economic One