Standard Setting: Economic Issues

Standard Setting: Economic Issues

1. Regulation of Economic Activity

   • Protect investors from
     • Externalities
     • Information asymmetry
   • Types of information
     • Proprietary
     • Non-proprietary

2. Ways to characterize information production

   • Finer information
   • Additional information
   • In terms of credibility

3. First-best Information Production

   • Marginal Social Benefits = Marginal Social Cost
   • Benefits
     • Better-informed investment decisions
     • Possible lower cost of capital for the firm
     • Better-working markets
     • Reduction of monopoly power
     • Timely identification of failing firms
     • Reporting on stewardship
     • Generates information about other firms

4. Market Failures

   • Externalities & free-riding
   • Adverse Selection
   • Moral Hazard
   • Unanimity

5. Contractual Incentives for information production

   • The Coase Theorem
   • Firm has private incentives to produce information

6. Market-Based Incentives for Information Production

   • Managerial labour market
     • constantly evaluates manager performance
       • managers who release false, incomplete, or biased information will suffer damage to their reputations
   • Capital Market
     • Managers are motivated by reputation and contracting considerations to increase firm value
       • creates an incentive to release information to the market
   • Takeover Market
     • If the manager does not increase firm value, the firm may be subject to a takeover bid
       • if successful, frequently results in replacement of the manager

7. A Closer Look at Market Based Incentives

   • The disclosure Principle
     • a simple argumnet can be made that suggests that a manager will release information, good or bad.
   • Empirical Disclosure Principle Research
   • Signaling
     • an action taken by a high-type manager that would not be rational if that manager was low type
   • Private Information Search
     • many investors will be active in seeking out information, particulary in the presence of noise traders or securities market inefficiencies

8. Are Firms Rewarded for Superior Disclosure?

   • Theory
     • if a firm reduces information asymmetry about itself through higher quality disclosure, its share price then reflects more information about itself relative to the effects of economy-wide events.
     • If market forces are to motivate superior disclosure, firms should benefit through higher share price and lower cost of capital
   • Emprical test of measures of reporting quality
     • measure of voluntary disclosure had little or no effect on cost of capital over and above other measures of earnings quality.
     • foreign firms that crosslist their shares in the United States face both increased disclosure obligations
   • Is Estimation Risk Diversiable?
     • lower accrual quality implies lower informativeness of earnings, thus higher estimation risk and cost of capital.
     • The greater the degree of estimation risk, the stronger is this effect
     • significant positive relation between PIN and cost of capital, with the relationship stronger for firms with poor information environments
   • Conclusions
     • difficult to argue that firms do not benefit from superior disclosure and reduced estimation risk
     • existence of such benefits is suggested by considerable theory and empirical evidence
     • while much theory and evidence supports benefits of superior disclosure, the sources and extent of these benefits are not yet fully understood.