Standard Setting: Economic Issues

1
CHAPTER 12

• Standard Setting Economic Issues
• Regulation Information as a Commodity

2
Regulation

• Think of information as a commodity
• Information produced by firms and demanded by
  decision makers
• Firms information production decisions
  regulated by GAAP

3
The Best Amount of Info Production (Societys
Perspective)

• Firms should produce information until the
  marginal social cost the marginal social
  benefit
• Is it operational?

4
Costs Benefits

• BENEFITS
• Improved Individual Decisions
• Investors
• Managers
• Improved Operation of
• Capital markets
• Managerial labor markets

• COSTS
• Out-of- Pocket Costs
• Time effort, more paperwork
• Proprietary Costs
• May reveal information to competitors

5
Ways to Characterize Information Production

• Finer Information
• Expanded note disclosure
• Additional line items
• Additional Information
• Fair value accounting
• FOFI (future oriented financial information)
• More Credible Information
• Audit

6
Private Incentives for Information Production

• Contractual
• Compensation contracts
• Debt contracts
• Market-Based
• Securities markets
• Managerial labour markets
• Reputation

7
The Disclosure Principle

• Market knows manager has the information
• For example, a forecast
• Manager does not release the information
• Market fears the worst
• Share price crashes
• To avoid, manager releases the information

8
Securities Market Response to Full Disclosure

• Theory
• Merton (1987)
• Better disclosure leads to more investor interest
• Diamond and Verrecchia (1991)
• Better disclosure increases market liquidity and
  share price
• Easley and OHara (2004)
• Better disclosure reduces estimation risk

9
Securities Market Response to Full Disclosure,
Contd.

• Empirical
• 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
• Botosan and Plumlee (2002)
• Better disclosure ? lower cost of capital
• Sengupta (1998)
• Better disclosure ? lower interest cost

10
The Disclosure Principle

• Market knows manager has the information
• For example, a forecast
• Manager does not release the information
• Market fears the worst
• Share price crashes
• To avoid, manager releases the information

11
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, The Effects of Firms,
  Accounting Horizons (March, 1993)

12
Problems of Collective Action

• Public goods
• Free riders
• Lets think of examples .

It is essentially the prisoners dilemma
problem all over again
13
Externalities

• Effects from one activity that has consequences
  for another activity but is not reflected in
  market prices
• Similar to the idea of public goods
• Can be positive or negative
• Tragedy of the commons

14
Market Failures in Private Information Production

• Public Good Nature of Information
• Info. can be reused (free rider problem)
• Less incentive for firms to produce info.
• Private and social value not the same
  (externalities)
• Information may benefit investors but harm the
  firm and manager

15
Market Failures in Private Information
Production, Contd

• Contracts break down if too many parties
• Is the disclosure principle effective?
• Does market know manager has the information?
• Cost of disclosure
• Is disclosure truthful?
• Conflict between information for investors and
  for contracting

16
Market Failures in Private Information
Production, Contd

• Markets do not work perfectly
• 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

17
The Bottom Line

• No one knows how much regulation is enough
• Numerous reasons why firms want to produce
  information
• But, numerous sources of market failure
• Regulation has a cost
• Regulators tend to ignore this
• Conclude extent of regulation is a political
  question as well as an economic one

18
End-of-Chapter Material

• Contracting internalizes the problem of
  information production. Explain what this
  statement means.
• Describe the difference between a direct and an
  indirect signal, using a voluntary forecast as an
  example.

Page 404
19
End-of-Chapter Material

• The failure of managers to release bad news is a
  version of the adverse selection problem. Such
  failure indicates that the securities market is
  not working properly.
• Why might a manager withhold bad news?
• To what extent does the disclosure principle
  operate to reduce the incentive of a manager to
  withhold bad news? Explain.

Page 404
20
End-of-Chapter Material

• The failure of managers to release bad news is a
  version of the adverse selection problem. Such
  failure indicates that the securities market is
  not working properly.
• Why might a manager withhold bad news?
• To what extent does the disclosure principle
  operate to reduce the incentive of a manager to
  withhold bad news? Explain.

Page 404