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

• 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

EMH and Early Rationales (Cont’d)

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.

• 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)

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