Financial Accounting Theory

Seventh Edition
William R. Scott

Chapter 12
Standard Setting: Economic Issues
Chapter 12 Standard Setting: Economic Issues
 12.2 Regulation

Information as a Commodity
Demand: information demanded by decision makers
Supply: information supplied by firms, managers, analysts, media
From societys perspective, firms should produce information
until the marginal social benefit = marginal social cost
Called first-best information production
But hard (impossible?) to operationalize

>> Continued
 Regulation (continued)

Two incentives for firms to produce information

Private incentives
Market forces motivate firms to produce information
E.g. lower cost of capital if information is of high quality
Regulatory incentives
Information production required by regulation
E.g., audited financial statements, MD&A

In practice, firms face a mixture of private and regulatory

incentives to produce information

>> Continued
 Regulation (continued)

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

>> Continued
 Regulation (continued)

Numerous sources of regulation in financial reporting

Professional accounting bodies
Codes of ethics
Discipline committees
Standard setters
GAAP
Securities commissions
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 increases financial statement credibility
 12.4 First-Best Information Production

Social benefits of information

Better investment decisions
More efficient allocation of scarce capital
Lower cost of capital for firms
Lower estimation risk for investors
Less adverse selection
Securities markets work better
Less moral hazard
Managerial labour markets work better
Reduction of monopoly power
Timely identification of failing firms
Information externalities
>> Continued
 First-Best Information Production (continued)

Social costs of information production

Direct costs of information production
Possible release of proprietary information
Possible increased contracting costs
E.g., greater earnings volatility
 12.5 Market Failures in Information Production

Externalities and free riding

Information as a public good (Section 5.5)
Adverse selection
Insider trading
Manager may delay in information release
Moral hazard
Opportunistic earnings management to disguise shirking
Lack of unanimity
Managers and investors may want different amounts of information
12.6 Contractual Incentives for Information Production

To monitor compliance with contracts

To control shirking
Managerial incentive contracts require performance measures, such as net
income
Jensen & Meckling (1976)
An owner-manager who goes public has increased incentive to shirk
Debt contracts require monitoring of covenants

>> Continued
Contractual Incentives for Information Production
(continued)

The Coase theorem

Specifies conditions under which externalities (which may otherwise
require regulation to control) can be internalized between the
contracting parties, reducing need for regulation
E.g., farmers fences, firms release of information
May break down
Many contracting parties
High bargaining costs
Requires enforcement
 Contractual Incentives for Information
Production (continued)

Conclusion
While contractual incentives result in much
information production, they do not drive first-
best information production
Managers may engage in opportunistic earnings
management to disguise shirking
Contracts break down when many persons
involved

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12.7, 12.8 Market Based Incentives for Information
Production

Markets that provide incentives for firms to release

information
Securities markets
Managerial labour markets
Takeover markets

>> Continued
 Market Based Incentives for Information
Production (continued)
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
 Market Based Incentives for Information
Production (continued)

The disclosure principle (continued)

The disclosure principle does not always work
Verrecchia (1983), Pae (2005), Einhorn (2005, 2007)
If information below or above 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

>> Continued
 Market Based Incentives for Information
Production (continued)
12.8.2 Additional disclosure principle research
(optional section)
Pae (2005). Applies disclosure principle to non-proprietary
information
Suijs (2007). Applies disclosure principle when manager unsure of
investor reaction
Einhorn. (2005). Disclosure principle depends on quality of regulated
disclosure
Newman & Sansing (1993). Firm may only release interval
information

>> Continued

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 Market Based Incentives for Information
Production (continued)
Signalling
High type v. low type
High types want to separate from low
Must be less costly for high types to signal
Some signals relevant to accounting
Audit quality
Forecasts
Capital structure
Dividend policy?
Accounting policy choice
Note: Regulation destroys ability to signal
>> Continued
 Market Based Incentives for Information
Production (continued)

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
 12.9 Are Firms Rewarded for Superior Disclosure?

Theory
Akerlof (1970)
Better disclosure reduces estimation risk
Merton (1987)
Better disclosure leads to more investor interest
Diamond and Verrecchia (1991)
Better disclosure increases market liquidity and share price
Lambert, Leuz, & Verrecchia (2007)
Information externality reduces beta risk
Easley & OHara (2004)
Lower estimation risk, higher share price, lower cost of capital

>> Continued
Are Firms Rewarded for Superior Disclosure? (continued)

Some empirical tests of disclosure models

Botosan (1997)
Better disclosure reduces cost of capital when low analyst following
Lehavy & Sloan (2008)
Supports Merton model
Hail & Leuz (2009)
Lower cost of capital for foreign firms crosslisting in USA
Healy, Hutton & Palepu (1999), Welker (1995)
Supports Diamond & Verrecchia model
Sengupta (1998)
Better disclosure associated with lower costs of debt
Continued
 Are Firms Rewarded for Superior Disclosure?
(continued)

Some empirical tests of disclosure models (contd)

Ashbaugh-Skaife, Collins, Kinney, and Lafond (2009)
Internal control deficiencies (i.e., higher estimation risk) associated with higher beta.
Supports Lambert, Leuz & Verrecchia model
Reidl & Serafeim (2011)
More level 3 financial instruments (more subject to manager judgement) associated with
higher beta. Supports Lambert, Leuz & Verrecchia model
Barth, Konchitchki & Landsman (2013)
Lower cost of capital for firms with higher earnings transparency
Kravet & Shevlin (2010)
Higher cost of capital for firms reporting financial statement restatements
>> Continued

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 Are Firms Rewarded for Superior Disclosure?
(continued)

Section 12.9.3 Is estimation risk diversifiable? (optional section)

Recall that estimation risk is risk arising from lack of knowledge about
underlying manager and firm parameters. Sources include:
Firm s true beta is unknown
Firms persistent earning power is unknown
Managers integrity is unknown
Firm may be subject to insider trading (adverse selection problem)
Manager may shirk (moral hazard problem)
To extent these risks are diversifiable, firms incentives to reduce cost
of capital, by increasing reporting quality are reduced
>> Continued

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 Are Firms Rewarded for Superior Disclosure?
(continued)

Note that estimation risk affects mean and variance (risk)

of share return
If higher estimation risk reduces investors expected return,
higher reporting quality increases cost of capital, and vice versa
Akerloff (1970) is seminal reference
However, if number of firm shareholders is sufficiently large that
no investors trading (including insiders) has an effect on share
price (price taking assumption), effect on cost of capital of insider
trading is reduced (Lambert, Leuz & Verrecchia (2012))
>> Continued

12 - 24
 Are Firms Rewarded for Superior Disclosure?
(continued)

Note that estimation risk affects mean and variance (risk) of

share return (continued)
If estimation risk affects variance of share return, it may be
diversified away in a diversified portfolio
However, estimation risk can also affect covariance of return:
if a firm reduces estimation risk through improved disclosure,
covariance of its return with the market, and thus its beta, falls (lower
synchronicity). Lower beta lowers cost of capital. This effect is not
diversifiable (Lambert, Leuz & Verrecchia (2007))

>> Continued

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 Are Firms Rewarded for Superior Disclosure?
(continued)

Conclude:
Much theory and evidence that firms benefit from
superior disclosure through lower cost of capital
Some studies suggest that certain types of estimation
risk may be diversifiable, reducing benefits of superior
disclosure

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Are Firms Rewarded for Superior Disclosure?
(continued)

Evidence that some estimation risk is diversifiable

Core, Guay & Verdi (2008) re accrual quality
Mohamran& Rajgopal (2009) re adverse selection risk

12 - 27
 12.10 Decentralized Regulation

Give management some flexibility in meeting accounting

standards
May improve relevance, while controlling reliability
Examples
Segment reporting
Macro hedging
Fair value option
 12.11 How Much Information is Enough?

No one knows
Theorem of the second best
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
 12.12 The Bottom Line

Benefits and costs of information extremely difficult to measure

in economic terms
Market forces can encourage information production
But, numerous market failures in information production
This creates role for regulation (e.g., GAAP)
But, regulation is costly, and regulators cannot know socially optimal
extent of regulation
To better understand regulation of information production, we
must also look to political aspects of standard setting