306-684 Financial Accounting Seminar 10

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306-684 Financial AccountingSeminar 10

• Standard Setting Economic Issues

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• ACOUNTING REGULATION
• MEDIATING BETWEEN THE INTERESTS OF SHAREHOLDERS
  and MANAGERS

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Rational decisions still required
The possibility of earnings management still
exists
Predicting future cash flows
Not enough information known by outsiders
Bias toward more info
Effort aversion opportunism,
Moderate disclosuresome discretion
Perfect relevance, reliabilitynot practical. Why?
Finding ways to motivate managers (Game Theory)
Finding the appropriate mix of measures
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Fundamental Problem of Financial Accounting Theory

• The two primary objectives of financial reporting
  
• efficient securities markets
• efficient contracting
• How we produce the right
• amount of information?
• Is regulation necessary?
• If so, how much?

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Learning Objectives

• To conceptualize accounting information as a
  commodity for which there is market
• To explain the arguments for private vs.
  regulated markets for a/c information
• To understand the role of accounting standards in
  information production.

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Regulation

• Information as a Commodity
• Demand information demanded by decision makers
• Supply information supplied by firms, managers,
  analysts
• From societys perspective, firms should produce
  information until the marginal social benefit
  marginal social cost

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The Questions

• Can market (i.e., private) forces of demand and
  supply generate the socially optimal amount of
  information production? (cost-benefit analysis)
• If not, can regulation step in to generate
  socially optimal information production?

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Benefits of Information Production

• Improved individual decisions
• Investors
• Managers
• Improved operation of
• Capital markets
• Managerial labour markets

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Costs of Information Production

• Out-of-pocket costs
• Time and effort, info systems
• Proprietary costs
• May reveal information to competitors
• If released, will directly reduce future cash
  flow
• Agency costs, since information to investors may
  reduce contract efficiency

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Ways to Characterise Information Production

• Finer information
• Expanded note disclosure
• Additional line items
• Additional information
• Fair value accounting
• MDA
• More credible information
• audit

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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)
• Contractual incentives break down if too many
  parties are involved

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Private Incentives for Information Production

• Market-based incentives
• Securities markets
• Poor disclosure creates estimation risk, raising
  firms cost of capital
• Managerial labour markets
• Poor disclosure lowers manager reputation and
  reservation utility
• Takeover market

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Securities Market Response to Full Disclosure

• Theory
• Merton (1987)
• Better disclosure leads to more investor interest
• Diamond Verrecchia (1991)
• Better disclosure increases market liquidity and
  share price
• Easley OHara (2004)
• Better disclosure reduces estimation risk
• Lower estimation risk ? higher share price, lower
  cost of capital

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Securities Market Response to Full Disclosure

• Empirical better disclosure ?
• greater analyst following ? more investor
  interest (Lang Lundholm, 1996)
• More institutional ownership, higher share price
  (Healy, Hutton Palepu, 1999)
• Narrower bid-ask spread (Welker, 1995)
• Lower cost of capital (Botosan
• Plumlee, 2002)
• Lower interest cost on debt (Sengupta, 1998)

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The Disclosure Principle

• Market knows manager has the information
• e.g. a forecast
• Manager does not release the information
• Market fears the worse
• Share price crashes
• To avoid, manager releases the information

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The Disclosure Principle

• 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

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• Our stockholders and our owners knew exactly
  what they needed to know
• Jeffrey Skilling,
• former Enron CEO on trial for
• conspiring to defraud shareholders,
• responding to charges that he lied
• to investors

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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)

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Private Information Search

• Investors have incentive to search for
  information
• Complements information production by firms
• Socially wasteful?
• Many investors spend resources to discover same
  information
• Less wasteful if private investor search affects
  cost of capital, thereby improving working of
  markets

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Market Failures in Private Information Production

• Are Private Incentives Sufficient?
• Is Information Market Fully Efficient?
• The answer is NO.

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Market Failures in Private Information Production

• Public good nature of information
• Free rider problem information can be reused
  less incentive for firms to produce
• Private and social value of information not the
  same
• Externalities problem information may benefit
  investors but harm firms and managers, creating
  agency costs

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Market Failures in Private Information Production

• Adverse selection problem
• Insider trading
• Delay in information release
• Moral hazard problem
• Earnings management to disguise shirking

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• ABC Learning Ltd.
• Key managers sell-off of shares prior to
  informing the market.
• Why? Shares held in own company were the basis
  for margin loan
• margin loan called in by bank
• Breach of ASX rules
• Trading suspended
• Fall in value for other shareholders
• Change in rules?

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Market Failures in Private Information Production

• Lack of unanimity between investors and managers
  about amount of information production

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Summary

• Market forces motivate much information
  production
• However, market forces unlikely to generate
  socially optimal information production due to
  numerous market failures
• Therefore, regulations are required

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Can Regulation lead to socially optimal amount of
info production?

• 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

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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

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The Bottom Line

• To understand regulation of information
  production, we must look to political aspects as
  well as economic
• Regulation in accounting -Standard setting
• The regulation of firms external information
  production decisions by some central authority.

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The Bottom Line

• Accounting standards
• IASB, AASB, FASB
• Mandatory information production
• Meets the basic information demand by users
• Voluntary information production depends on the
  market forces

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Conclusions

• Private incentives are not enough to produce
  socially optimal amount of information
• Regulation also cannot generate socially optimal
  information production
• Accounting standard setting should maximize the
  net benefit of regulation (benefit minus cost)