1. Copyright © 2009 by Pearson Education Canada 12 - 1 Chapter 12 Standard Setting: Economic Issues

2. Copyright © 2009 by Pearson Education Canada 12 - 2 Chapter 12 Standard Setting: Economic Issues

3. Copyright © 2009 by Pearson Education Canada 12 - 3 12.2 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

4. Copyright © 2009 by Pearson Education Canada 12 - 4 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?

5. Copyright © 2009 by Pearson Education Canada 12 - 5 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

6. Copyright © 2009 by Pearson Education Canada 12 - 6 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

7. Copyright © 2009 by Pearson Education Canada 12 - 7 Regulation in Practice Firms face a mixture of private and regulatory incentives for information production

8. Copyright © 2009 by Pearson Education Canada 12 - 8 12.3 Ways to Characterize Information Production Finer information –Expanded note disclosure –Additional line items Additional information –Current value accounting –MD&A More credible information –Audit

9. Copyright © 2009 by Pearson Education Canada 12 - 9 Private Incentives for Information Production 12.4.1 contractual incentives –Compensation contracts –Debt contracts –Contractual incentives break down if too many parties are involved »Continued

10. Copyright © 2009 by Pearson Education Canada 12 - 10 Private Incentives for Information Production (continued) 12.4.2 market-based incentives –Securities markets Lower cost of capital –Managerial labour markets Higher reputation from full information release –Takeover market »Continued

11. Copyright © 2009 by Pearson Education Canada 12 - 11 Private Incentives for Information Production (continued) 12.4.2, 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

12. Copyright © 2009 by Pearson Education Canada 12 - 12 12.4.3 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

13. Copyright © 2009 by Pearson Education Canada 12 - 13 12.4.3 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

14. Copyright © 2009 by Pearson Education Canada 12 - 14 12.5.1 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

15. Copyright © 2009 by Pearson Education Canada 12 - 15 12.5.1 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

16. Copyright © 2009 by Pearson Education Canada 12 - 16 12.5.2, 12.5.3 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)

17. Copyright © 2009 by Pearson Education Canada 12 - 17 12.5.4 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

18. Copyright © 2009 by Pearson Education Canada 12 - 18 Market Failures in Private Information Production 12.6.1 externalities and free riding 12.6.2 adverse selection –Insider trading –Manager may delay in information release –Regulation FD an attempt to reduce adverse selection 12.6.3 moral hazard –Opportunistic earnings management to disguise shirking

19. Copyright © 2009 by Pearson Education Canada 12 - 19 12.6.4 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

20. Copyright © 2009 by Pearson Education Canada 12 - 20 12.6.5 Summary Market forces motivate much information production Market forces unlikely to generate socially optimal information production due to numerous market failures

21. Copyright © 2009 by Pearson Education Canada 12 - 21 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

22. Copyright © 2009 by Pearson Education Canada 12 - 22 12.7 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

23. Copyright © 2009 by Pearson Education Canada 12 - 23 12.9 The Bottom Line To understand regulation of information production, we must look to political aspects as well as economic