CLASS 2: Economic & Political Issues in Standard Setting (STANDARDS…
CLASS 2: Economic & Political Issues in Standard Setting
Info = Commodity
ECONOMICALLY, firms should produce info until:
Marginal Social Benefit = Marginal Social Cost
"first best approximation"
Better investment decisions
Lower cost of capital for firms
Timely identification of failing firsm
Incentives for producing info
(Studies suggest that firms are rewarded for superior disclosure: lower Cost of Capital, more investor interest, higher share price, reduced beta risk)
Private incentives: lower cost of capital if info quality is good
Investors: have incentive to search for info. Socially wasteful, since resources expended to discover same information. WOULD BE LESS WASTEFUL IF investor search affected cost of capital -> improve markets
Public incentive: information required by regulation (FS, MD&A)
: monitor compliance/control shirking, debt covenants, etc. do NOT result in first-best info production (contracts break down when many ppl are involved)
: specifies conditions under which externalities can be internalized (farmers fences, firm release of info). Can be used to reduce need for regulation
Proprietary info: reduces CF if released
Non-proprietary info: doesn't reduce CF if released
Market-based incentives: takeover markets, securitise markets, managerial labour markets
: market knows manager has information. If manager doesn't realse information, market fears the worst and shares crash.
: must be costly (audit quality, cap structure, accounting policy choice, dividends). NOTE: regulation destroys ability to signa.
Sources of Info
Professional acconting bodies
Characteristics of Info
Finer info (expanded note disclosure, more line items)
Additional info (current val accounting, MD&A)
More credible info (audited, etc)
Externalities + free riding
Adverse selection (insider trading, manager delays info release)
Moral hazard (opportunistic earnings management)
Lack of unanimity (investors/managers want diff amounts of info)
DOES IT WORK?
Disparity of penalities is important --> e.g. fraud triangle//likelihood of being caught (class example -- executing people for financial misstatements would likely result in fewer misstatements)
Reputational impact (rotation of auditors/etc) --> how business reacts to legislation is important. E.g.: Enron/PSG@ Arthur Andersen Chicago. Ignoring advice of PSG means you are subject to dismissal BUT when internal regulations were relaxed, Enron happened.
Loss of FS credibility due to inaccuracies in the past, so now ppl look to other sources for info
ON THE OTHER HAND: see example of DOJ/SEC --> relaxed consequences now due to impact of persecution of Enron/lives damaged irrevocably.
what is right/wrong
Expectations for info quality
Policies/frameworks. Represent best practices
Evolve with environment
Create comparability: look to them when we are confused
Set level of expectation for quality
What are they for?
Why do we need?
Resolve conflict, level playing field
helps us find ways to present/create info
Other ppl can take info and build on it (further analysis)
Ex: EBITDA >>> NI for determining credit worthiness
BUT this is a problem since there is no regulation for what EBITDA means
Canadian definition: EBITDA & Marketing --> made them look unfairly better
SHOULD STANDARD SETTERS COMPETE?
Race to the bottom (if competing for customers)
Race to the top (signal commitment to high quality reporting by choosing high quality standards
Fundamental problem of FA theory: best information to control adverse selection is not necessarily the best system to control Moral Hazard. Constituency conflict results, and is mediated by standard setters.
: most companies cannot generate sufficient cash flow, must rely on cap markets.
Increasing integration (adoption of IASB)
Increased effect of customs and institutions on FR: greater influence of banks and in corporate governance, lower moral hazard problem, less timely/less conservative
Investors MUST be aware of local practices and customs when interpreting FS, even with IASB
Auditors under greater pressure from controlling interests to protect smaller investors. Some evidence from studies in 2006/08 suggest auditors succumb to the pressure.
Improved informatino content
Better working securities markets for "serious" adopters
benefits notable when IASB GAAP and domestic GAAP differ greatly AND there are strong investor protection laws
Not sure whether FASB or IASB has better standards
WHY IS IT IMPORTANT?
Ignorance causes wrong dcisions
Determines level of due diligence
Can evaluate risk + Value of additiona info
Signalling + Disclosure
Consequences of severe info Aasymm --> hard to find buyers
HOW TO SAFEGUARD AGAINST IT?
Undersatnd what info is relevant (expert advice)
Penalties (jail time)
e.g. conrad black's delayed penalties --> are they severe enough to counteract the asymmetry?
WHAT IS IT?
1 party has more info than others in a contract, doesn't release all info to others
Witholding info that is material (price fixing of bread by Loblaws)
Impact on decision making can be severe
Selective disclosure problems (people building relationships on faulty assumptions
Obfuscated transparency (too much disclosure, overwhelms the readers)
VOLUME & QUALITY
Inundated w/lots of info. Must be curated/vetterd for trustworthiness (e.g. fake news).
Volume is only going to increase. Need to quality information to determine WHO to believe
E.g.: muddy waters: 1/2 property on balanace sheet were not owned by Sino, audited by EY toronto but EY didn't send auditors --> lots of info on Muddy WAters but was low quality, unreliable
HOW MUCH INFO IS ENOUGH INFO?
NO ONE KNOWS. As many reasons to produce info as there are sources of market failure.
Regulation has a cost: regulators don't know the socially optimal level either. (see: "Theorem of second best")
Benefits + costs of info are hard to measure in economic terms
Contracting + market forces encourage info
market failures exist in info production
Regulation helps reduce market failures BUT is costly
No one knows socially optimal amount of info
Political aspects are important when thinking about role of regulation
Public Interest Theory
: objective of regulator = max social welfare
Interest Group Theory
: regulator takes own interests into account WHILE balancing demands of investors and managers
Implied conflict b/w Constituents
Constituencies compete by lobbying regulators
Benefits of regulation go to most effective lobbying group
Interest Group Theory
best applies due to emphasis on due process
REGULATORS HAVE INFO ASYMMETRY TOO
Firm has insider info BUT release requires manager to exert effort which increases expenses. Regulator does not know firms' actual insider info, so regulator compromises --> allows some information to remain but also lowers manager effort (less benefit to investors AND lower compensation cost)