1. Standard Setting: Economic Issues
Chapter 12
Standard Setting: Economic Issues

2. Chapter 12 Standard Setting: Economic Issues

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. 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. 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. 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. Regulation in Practice
Firms face a mixture of private and regulatory incentives for information production

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. Private Incentives for Information Production
contractual incentives
Compensation contracts
Debt contracts
Contractual incentives break down if too many parties are involved

10. 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

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. 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

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. 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

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. 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. 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. 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

19. 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. 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. 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. 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. 12.9 The Bottom Line
To understand regulation of information production, we must look to political aspects as well as economic

24. The End Thank you