EVOLUTION OF

DISCLOSURE
REGULATION
RATIONALES:
PRELUDE TO A
NEW THEORY
EMH and Early Rationales
• Many of the early rationales for corporate
disclosure regulation have a common
theme, that investors and the stock market
in general, cannot distinguish between
efficient and less efficient firms.
EMH and Early Rationales (Cont’d)
• Leftwich (1980) lists some of the reason:
– Monopoly control of information by
management
– Naïve investors
– Functional fixation
– Meaningless numbers
– Diversity of procedures
– Lack of objectivity
EMH and Early Rationales (Cont’d)
• Monopoly control of information by
management
– Corporate accounting reports are the only
source of information available to investors
and as a consequence managers are able to
manipulate stock prices.
– EMH:
• There are alternative sources of information
• Managers cannot systematically mislead the stock
market
• Market can discriminate between efficient and less
efficient firms, at least to some degree
EMH and Early Rationales (Cont’d)
• Monopoly control of information by
management (Cont’d)
– If management has more information than is
available via other sources but does not
provide the information to the market, the
market cannot discriminate between efficient
and less efficient market as accurately as it
otherwise might.
– Governmentally enforced disclosure
• Can only be superior if the costs of production are
less with required disclosure and/or the social value
of the information is greater than its market value
EMH and Early Rationales (Cont’d)
• Naïve investors
– Accounting numbers cannot be interpreted by
investors who do not have accounting training
– In an efficient market, tailoring financial
statements to naïve investors does not
increase their wealth of the firm’s value
• For naïve investors to diversify their portfolios to
reduce the probability that they will lose.
– These investors not necessarily naïve
• Investor’s personal trade-off
EMH and Early Rationales (Cont’d)
• Functional fixation
– Individual interpret earnings numbers the
same way regardless of the accounting
procedures used to calculate them.
– Interpretation of functional fixation
hypothesis:
• Investors do not discriminate between earnings
calculated using different procedures because it is
costly to adjust the numbers
– Effects of changes are publicly disclosed
• Investors are irrational
– Inconsistent with EMH
EMH and Early Rationales (Cont’d)
• Meaningless numbers
– Because earnings are calculated using
several different methods of valuation,
the earnings numbers are meaningless
and stock prices based on those
numbers do not discriminate between
efficient and less efficient firms.
– Given the EMH, evidence is
inconsistent with this criticism.
EMH and Early Rationales (Cont’d)
• Diversity of procedures
– Another reason given for the inability of the
capital market to distinguish between efficient
and less efficient and is often given in
conjunction with the naïve investors criticism.
– Managers cannot use diverse procedures to
mislead investors systematically.
• Lack of objectivity
– Different accountants produce different
accounting numbers from the same set of
facts.
EMH and Early Rationales (Cont’d)
• This issue is an empirical one, depending
on relative costs and benefits of private
production of information and
governmentally regulated production of
information
Rationales from the Economic Literature

• The alleged market failure

– Market failure exists when the quantity
or quality of goods produced in a free
market differs from the supposed social
optimum.
– Market failures suggest that social
welfare can be improved by government
regulation moving the private output
closer to the social optimum.
Rationales from the Economic Literature
(Cont’d)
• The alleged market failure (Cont’d)
– Accounting market failure is alleged to
exist because:
• The output of information in accounting
reports in the absence of regulation is non
optimal
• The resource allocation resulting from the
market for financial information is inequitable
(“unfair”) to some groups or individuals
Rationales from the Economic Literature
(Cont’d)
• The alleged market failure (Cont’d)
– The public good problem
• One person’s consumption of it does not
reduce the quantity available for others to
consume
• Information in accounting reports is
assumed to be a public and not a private
good.
Rationales from the Economic Literature
(Cont’d)
• The alleged market failure (Cont’d)
– The public good problem (Cont’d)
• However, the accounting information has
both public and private good attributes
– Consumption of the information by one
investors reduce the ability of others to
use the information and reap the same
rewards.
– There is indirect cost to the disclosing firm
if the information has adverse effects on
its competitive position.
Rationales from the Economic Literature
(Cont’d)
• The alleged market failure (Cont’d)
– The public good problem (Cont’d)
• Market failures comes about if the private
producers can not exclude non purchasers
of the good from using it or can not
perfectly price discriminate between
purchasers
– Externalities and free-riding
– The managers “underproduce” information
in the absence of regulation
Rationales from the Economic Literature
(Cont’d)
• The alleged market failure (Cont’d)
– The signaling problem (also called the
“screening” problem)
• Information asymmetry
– Adverse selection
– Moral hazard
• Signaling hypothesis: proposition that
signaling motivates corporate disclosure
– Signaling can cause an overproduction of
information in accounting reports
Rationales from the Economic Literature
(Cont’d)
• The alleged market failure (Cont’d)
– The speculation problem
• Overproduction of information by
individuals outside the firm for speculation
purposes
• The private benefits to speculator of
investment are positive, but the social
benefits are zero
Rationales from the Economic Literature
(Cont’d)
• Fallacies in the market failure rationales
– The public good problem
• There is evidence that firms provided accounting
reports long before those reports were required by the
law
• One contracting costs are admitted, it is no longer
apparent that the public good problem results in a
market failure
Private Incentives for Information Production

• Contractual incentives
– Incentive contract
– Debt covenant
– Firm goes public  contract between
owner-manager and the new investors
• Market-based incentive
– Managerial labour market
– Capital markets
– Takeover market
Rationales from the Economic Literature
(Cont’d)
• Fallacies in the market failure rationales
(Cont’d)
– The signaling problem
• Also ignores contracting costs
• If those costs are same for the individuals and
government, there is no market failures
– The speculation problem
• Assume zero transaction costs
Rationales from the Economic Literature
(Cont’d)
• Fallacies in the market failure rationales
(Cont’d)
– The existence of a market failure in the
production of information in accounting reports
depends on the costs of private contracting and
production of information relative to the costs of
government achieving the private level of
output
– If the government’s costs are substantial  it is
not apparent that there is any market failure in
the private production of information in
corporate accounting reports
Rationales from the Economic Literature
(Cont’d)
• The cost of regulation
– The direct costs
• Direct costs of the SEC and FASB
• Costs incurred by the accounting firms and
corporations complying with the standards
and the costs of lobbying on proposed
accounting standards.
• Expected increase in losses from lawsuits
against accountants and corporations
• Renegotiating contracts
Rationales from the Economic Literature
(Cont’d)
• The cost of regulation (Cont’d)
– The indirect costs of regulation
• Corporate managers change their financing,
investment, and/or production decisions in a
fashion that imposes costs o firms
• Society: higher taxes to pay and lower
returns on corporate equity.
Rationales from the Economic Literature
(Cont’d)
• The stock price effects of regulation
– Benston (1973) find no evidence of costs
or benefits of the securities acts
– Chow (1983): 1933 Securities Act
reduced the wealth of shareholders of
firms that were affected by the act
relative to those firms not affected by the
act
• Regulation imposes private and social costs
and little evidence of benefits
Two Important Questions
• What is the objective of disclosure
regulation?
– Improves welfare?
– SEC spends virtually none of its budget in
systematically assessing the costs and
benefits of regulation
– Politicians and regulators act in their own
self-interest
Two Important Questions (Cont’d)
• Why do managers care about
accounting procedures?
– Drop the assumption of zero transaction,
information, and contracting costs.
– The dropping of the zero transaction
costs assumption also provided the
opportunity for accounting procedures to
affect the value of the firm