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 society’s 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, firm’s 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

12 - 13
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

12 - 17
 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 & O’Hara (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 (cont’d)

– 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

12 - 22
 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
• Firm’s persistent earning power is unknown
• Manager’s 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

12 - 23
 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 investor’s 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

12 - 25
 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

12 - 26
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