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Copyright © 2009 by Pearson Education Canada12 - 1
Chapter 12 Standard Setting: Economic Issues
Copyright © 2009 by Pearson Education Canada12 - 2
Chapter 12Standard Setting: Economic Issues
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
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?
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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
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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
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Regulation in Practice
• Firms face a mixture of private and regulatory incentives for information production
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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
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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
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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
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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
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
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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
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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
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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
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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)
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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
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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
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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
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12.6.5 Summary
• Market forces motivate much information production
• Market forces unlikely to generate socially optimal information production due to numerous market failures
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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
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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
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12.9 The Bottom Line
• To understand regulation of information production, we must look to political aspects as well as economic
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