1. Standard Setting Economic Issues

2. 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

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

4. 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

5. 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

6. 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

7. 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 )
Better disclosure  narrower bid-ask spread (Wellar 1995)
Better disclosure  lower cost of capital (Botosan & Plumlee 2002)

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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