Module 9: Standard Setting: Economic Issues

Transcription

1 Information is a complex commodity which can be produced by firms at a cost. Financial statements are the major form of information but audits are also considered part of the firm's information production - audit doesn't generate information but does add credibility. Two major constituencies involved in financial reporting (investors and managers) have different interests so best accounting system for reporting to investors is not necessarily the best system for motivating manager performance. Can t easily measure all the benefits and costs of information production to assist in standard setting so this makes the standard setting process both political and economic. Regulation of Economic Activity Financial accounting and reporting is a highly regulated activity. Information asymmetry is a major reason that regulation of information is needed: - to protect ordinary investors - to increase public confidence in the fairness of capital markets Many aspects of firm's information production are regulated - CICA > Handbook; OSC, federal & provincial taxation authorities and corporations acts. Central authority - regulatory bodies such as federal & provincial gov'ts, provincial securities commissions, accounting professions Standard setting - establishment of rules & regulations relating to minimum disclosure requirements, GAAP & GAAS, public company audits Standards - regulations laid down by a central authority DEREGULATION OF INFORMATION PRODUCTION - PART 1 HOW? bodies - overall reduction in standard setting - cancel existing standards - reduce supervision by securities commission & other regulatory - reduce or eliminate requirements for audits Firm would determine what information to release; also the nature & extent of audit. **Need private contractual and market forces to ensure information production is relevant & credible. Potential effect if these forces aren't effective: Market failure - the right amount of information is not being produced and credibly communicated. Ideally the proper amount of information for the firm to produce is that where: the marginal cost of info production = marginal benefits to firm of that production (in form of lower cost of capital) Note: regulation can cause firms to produce the wrong amount of information (ex current cost accounting). Costs of regulation - costs of standard setting bureaucracy and compliance costs Benefits - more & better information production than from private incentives. 1

2 Information owned by firm: Proprietary information - if released, it would adversely affect future cash flows of the firm (ex. planned mergers & acquisitions, divestitures, "secret recipes") Non- proprietary information - information that does not directly affect cash flows (ex. F/S, forecasts, quarterly reports) Private Incentives for Information Production WAYS TO CHARACTERIZE INFO PRODUCTION Quantity of information in an accounting context: Finer information - adds more detail to the F/S. (ex. additional or expanded note disclosure; reporting extra line items in F/S; segmented information) Benefit --> increased ability to discriminate between realizations of the states of nature. Additional information - introduction of information not in the financial statements or footnotes. (ex. marking to market, FOFI) Benefit --> expands upon the set of relevant states of nature. Credibility - credible information is more reliable. - Large audit firm typically is more credible than a small firm (more to lose so will maintain higher standards) - Use of materiality level and precision impacts upon the credibility of the audit. - Greater level of assurance provided -> more credible. - The greater the penalties for mgrs who divulge false info, the higher the credibility assigned to these mgrs disclosures Note: essence of credibility is that the receiver of the info knows that the supplier of info has an incentive to disclose truthfully. CONTRACTUAL INCENTIVES FOR INFO PRODUCTION Info is necessary to monitor compliance with contracts. (1) Incentive contract - contract between the firm and its managers that specifies the basis of managerial remuneration. Information is necessary to monitor mgmt's compliance with these contracts. (2) Debt covenants in debt agreements - there is a need to monitor the firm's adherence to the covenants. (3) Privately owned firm goes public ("contract" between owner-manager & new investors) ---> firm owner is motivated to provide sufficient and credible information to investors in order to maintain/increase share prices (ex. Forecast, more detail in F/S; audit which increases credibility) 2

3 Jensen & Meckling (1976) study found that an owner-mgr of a firm going public has a motivation to increase shirking since this problem is no longer internalised (i.e. new owners will bear their share). Thus, shirking costs owner-mgr less after going public, so will engage in more of it. (Hence agency cost to new owners of firm.) Investors will recognize this and bid down share price. *Audits add credibility to net income in (1); covenant information in (2); info in prospectus/forecasts in (3) CONTRACTS: Contract lays out types and amounts of information required -> facilitates production of the right amount of information. Problems when too many parties are involved: Many contracts with many investors: - high negotiation costs (differing investors require different information) - high cost of providing information One contract with many investors: - extremely time consuming to have all investors agree on the type of information to be provided These contracts are also difficult to enforce. Concept of internalization: No regulation is needed to motivate contracting parties to agree on what info is to be produced under the contract --> parties agree on what and how much info is needed. Since types and amounts of info to be produced under contract are negotiated and agreed to by all contracting parties the right amount of info is produced by definition. Motivation is internal to the contracting parties.'. no external forces such as regulation are required. Can't rely on internalization to motivate info production when there is a large number of parties involved. Different individuals want different types and amounts of info -- > too costly to obtain agreement or prepare tailor made information. Also, too costly to monitor compliance with large number of contracts. MARKET BASED INCENTIVES Non-contractual sources of private info production (market prices provide motivation) (1) Managerial Labour Market puts a market value on managerial services. Mgrs are motivated to maximize the market value of the firm in order to increase their own market value. reduces mgmt tendency to shirk mgr wants to minimize cost of capital -> creates an incentive to release full & credible info to the market (increases investor confidence in firm). (2) Capital Market - if investors find out about any manipulation, this will increase the firm s cost of capital. Adversely affects mgr since it will reduce share price. 3

4 (3) Takeover Market (market for corporate control) - If mgr does not maximize firm value, the firm may be subject to a takeover bid ( -> replace mgr) Formal models that relate info release to an increase in the firms market value (i.e. lower cost of capital): Merton (1987) model if firm can increase set of investors who know about the firm then market value will rise, all other things being equal. Diamond & Verrecchia model (1991) voluntary disclosure reduces info asymmetry b/w the firm and the market, which facilitates trading in its shares. Resulting in crease in market liquidity attracts large investors; share price increases as a result of greater demand. If both securities market & managerial labour market work properly the market forces will motivate mgrs to produce the right amount of info ->> cost of producing info should equal corresponding benefit (lower cost of capital). Relevant information - includes only that information which is cost effective to produce. SECURITIES MARKET RESPONSE TO FULL DISCLOSURE Research results indicate that firms with high quality disclosures enjoy lower costs of debt and equity capital and vice versa. Supports the position that market forces encourage info production. Lang & Lundholm (1996) tested the Merton model. Found that, all other things being equal, the higher the quality of the disclosure (as judged by analysts) the greater the number of analysts following the firm. Suggests that analysts can do a better job when they have more info to work with. Thus, increased analyst attention leads to increased investor attention. Healy, Hutton & Palepu (1999) tested the D&V model. Found that firms with improved disclosure ratings were associated with a significantly improved share price performance in the year following the rating increase, compared to others in the same industry. Welker (1995) investigated effect of disclosure quality on the bid-ask component of market liquidity* and predicted that shares of firms with better disclosure policies would have lower spreads (better disclosure policy implied less investor concern about insider trading and other adverse selection problems.) Found significant negative correlation b/w disclosure quality & bid-ask spread. Botosan (1997) found higher quality disclosure to be significantly associated with lower cost of capital, but only for firms with low analyst following. If a high analyst following, the reports produced by these analysts (who typically access a wider variety of info sources rather than just annual F/S) swamp the effects of voluntary annual report disclosure. Sengupta (1998) found his sample firms on average had a.02% reduction in interest cost for every 1% increase in their disclosure quality. These results strengthened for riskier firms. Appeared that lenders assigned lower credit risk to firms with superior disclosure policies. 4

5 Dechow, Sloan & Sweeney (1996) study of firms under investigation for GAAP violations reported an average drop pf 9% in share price on the day the Sec investigation was announced When investors lose faith in a firm s financial reporting, consequences can be severe. Market liquidity ability of investors to quickly buy and sell large quantities of securities at the market price with reasonable trans. costs. Liquidity is comprised of market depth (# of shares that investors are willing to buy or sell at any given price) and bid-ask spread (diff b/w buying price and selling price of a share). Note that info asymmetry reduces market depth, causing investors to leave the market and increases the bid-ask spread. OTHER INFORMATION PRODUCTION INCENTIVES Mechanisms to limit market failure in the production of information: 1. Disclosure Principle - mgr will release all information, both good & bad. (If NO news is released investors assume the worst and share prices drop accordingly...therefore incentive is to release all info). BUT, disclosure principle breaks down in many instances and cannot be relied upon to solve the problem of market failure. Dye (1985) indicates that disclosure principle breaks down if investors do not know if the mgr has the info. Also found that the disclosure principle can break down if there is a conflict b/w info desired by investors & info needed for contracting purposes. Verecchia (1983) assumes that if a disclosure is made, it is truthful; also that the market knows the mgr has the info. Also assumes a cost of disclosure. For a given level of disclosure cost there is a threshold level of disclosure. The lower the disclosure cost, the lower the threshold level of disclosure. If disclosure cost is zero (typically would be for non proprietary info) the disclosure principle comes back into play. If market does not know the mgr has this info, then this limits the preceding point. Penno (1997) found there is a threshold level of forecasted profits below which the mgr would not disclose. Likelihood of disclosure decreases as the mgr s info quality increases. Release of high quality forecasts is considered to be rare, since they will only be disclosed when the forecast is relatively favourable. Conclusion: even for non-proprietary info, the disclosure principle is prone to failure. Newman & Sansing (1993) if a firm discloses imprecise info about its value but does provide an interval within which its value lies, thee is a level of credible disclosure. But the disclosure principle fails in the sense that the firm does not report its value exactly. Failure of disclosure: if investors do not know if the mgr has the info if it is more costly to disclose good news & firm doesn't disclose -> investor doesn't know whether this is due to high costs or whether it really is bad news 5

6 if investors don't think info is truthfully revealed (credible) Audit doesn't always provide sufficient credibility due to the extent of the non-verifiable insider information. if a conflict exists between the info desired by the investors and the info needed for contracting purposes. 2. Signalling - Signals are required to help differentiate between firms of differing quality. Manager needs to credibly reveal the firm s type (stems from underlying quality differences). A signal is an action taken by a high-type mgr that would not be rational if that mgr was a low-type. Direct Disclosure - will be credible if the market can verify the information (e.g. through audit). This is effective for certain types of info only. Hughes (1986) model mgr wants to reveal his/her expectation of firm value and makes a direct disclosure at the beginning of the period. Mgr is motivated to report truthfully so that investors can correctly infer their expectation of firm value. (If mgr discloses a high firm value, but cash flows turn out to be low, investors will assess a high probability that the disclosure was untrue & penalties will be applied.) Indirect Signals Leland & Pyle (1977) show that for an entrepreneur going public, the proportion of equity retained is a signal, since it would not be rational for a bad-news mgr to retain a high equity position. Titman & Trueman (1986); Datar, Feltham & Highers (1991) developed models where audit quality is a signal. A rational mgr would be unlikely to retain a high quality auditor when the firm is a low-type. Examples: proportion of equity retained (private firm going public) audit quality (want high quality..high cost audit) capital structure (issuing new shares reduces C.S.MV -> want different method of raising capital) dividend policy ( want high payment ratio) accounting policy publication of voluntary forecasts For signals to be effective, these options need to be at mgmt discretion..not regulated. Voluntary forecasts - act of presenting the forecast is a signal (even if the forecast isn't realized). Information content is in the act of forecasting (as long as forecast is not fraudulently or carelessly issued). Financial Policy as a Signal: Given that the market forces are subject to a degree of market failure and since noise trading distorts a firm s share price, how can mgr signal the true value of the firm? 6

7 Healy & Palepu (1993) suggested several mgr responses to convince the market of inside info w.r.t. value of A/R in F/S. Direct disclosure of firms; credit & collection policies however, could release some proprietary info. Therefore, suggested some indirect signals, including providing a private lender with info about real value of receivables, to engage in hedging strategy (not speculative); mgmt to increase its holding of the company s shares. Common theme mgmt would be foolish to undertake any of these unless it really believed its inside info about asset values. 3. Private Information Search - investors actively seek out information (conduct investigations & analysis; hire financial advisors; copy acts of insiders) From society s perspective, private info search can be quite costly since more than 1 investor incurs costs to discover the same info. (Would be better if firm produced & publicised the info only once, so each investor did not have to rediscover this info.) To the extent investors are successful in their search this info is transferred to the public (i.e. shows up in share prices) Limits ability of insiders to capitalize on inside info --> reduces severity of adverse selection. Unequal distribution of info across investors big players may have more resources to find & analyze info, leaving small investors at a disadvantage (refer back to Beaver s 1989 findings). Leads to suggestions (such as Lev 1988) for regulation to require firms to release info to everyone, thus increasing public confidence in a fair marketplace; contributes to market liquidity. Sources of Market Failure Externalities and free riding are reasons to justify regulation (market isn t producing the socially correct amount of info so regulator is needed.) Externalities - information released by one firm that affects share prices of other firms (ex. release of net income info which may affect general expectations for firms in the same industry; release of proprietary info). Note: externalities make it more difficult to determine social costs & benefits of information. Free riding when use of info by one individual does not destroy its use for another, other investors can take advantage of (i.e. free ride on) this information. (Note: no one has an incentive to pay for this info so the company cannot recover costs of info production.) 3 sources of market failure that indicate regulation may still be needed: 1. Adverse Selection Problem - one person has info advantage and "selects" him/herself into situation to exploit info. (a) Insider Trading If there are opportunities to earn significant profits those mgrs who would be willing to do this will be attracted to the opportunity. (b) Mgrs who know bad news about the firm's future and do not release it in order to postpone damage to their reputation Concerns: * investors are less able to distinguish quality of different securities * ability of takeover market to purge poor mgrs is reduced 7

8 Pooling if market cannot distinguish b/w securities of different qualities, then the market price will reflect the average quality. (Similar effect occurs in the takeover market -> for quality of managers.) 2. Moral Hazard Problem - If managerial effort is unobservable the effort-averse mgr will shirk. * can't observe managerial effort or state realization * finite no. of employment periods (disciplinary effect of market decreases as mgr approaches retirement) To address the moral hazard problem managerial incentive contracts are used. Due to remuneration being based, in part, on net income mgr is motivated to manage earnings to increase remuneration (by influencing accruals or accounting policy changes). This is counter productive to the extent that mgrs are motivated to manage earnings (could result in market failure). 3. Problem of Unanimity - all shareholders do not necessarily support mgr policies. Mgr seeks to maximize firm market value through choice of accounting policies & audit quality...shareholders can have differing views (e.g want accounting policies which are conservative; high quality audit) Blazenko & Scott (1986) demonstrated that in an economy where the info market does not work properly, due to adverse selection, the firm mgr was motivated to choose that audit quality that would maximize firm market value but shareholders would prefer a higher quality audit. DIRECT costs of regulation: direct costs of the bureaucracy compliance costs How Much Information is Enough? INDIRECT costs of regulation: reduction in mgrs' opportunity to signal regulator may not know "correct" amount of information required Use of a central authority to set standards for information production reduces the disagreements of investors (helps address problem of unanimity). Is regulation needed? Still unresolved. Decentralized Regulation There is regulation involved but compliance is decentralized to the internal decisions of management. Improves relevance of reporting (likely will be reported on a basis that is consistent with internal reporting i.e. represents management viewpoint of relevant issues) Less costly (typically firm is already preparing this info internally) Overall: Standard setting is a process of conflict resolution must take economic consequences and politics into account (not just based on theoretical considerations) 8

9 9