Acct Theory- Mod 9 Flashcards
What are the 3 different types of information that can be produced? Describe each.
FINE
Precise or detailed information. EX, a thermometer gives a better temperature than the back of your hand
ADDITIONAL
Expanding on information that exists already. EX. combine a barometer and a thermometer
CREDIBLE
Independently verified information.
What are the two main incentives for a company to disclose financial information?
Contractual incentives
Market Based Incentives
What are the contractual incentives for disclosing financial information?
Lenders want reassurance of repayment
Larger loans usually have formal debt covenants
What are the market-based incentives for disclosing financial information?
Labour market want information on managerial performance
Capital market wants information about a company’s funding sources through share sales and obtaining credit
Takeover market wants information on who is a good takeover target
Why are managers motivated to disclose financial information?
Because if they can show that they are doing a good job, they can demand a higher salary or a better job at a bigger company
How do securities markets respond to increased disclosure? Why do they respond this way?
Positively
Higher quality info= more analysts following
Improved disclosure ratings= improved share price
Better disclosure= lower bid-ask spreads
Lower cost of capital (Borrowing)
What is bid-ask spread?
Difference between what you want to sell your shares at and what someone is willing to pay for them
What is the disclosure principle?
Management perspective: Disclose good news, hide bad news
Investor perspective: No news = bad news
Conclusion: Management has an incentive to release bad news because not saying anything could be worse
What is signalling?
Actions or indicators taken by management that send a hidden message.
Ex: management not buying any shares in the company because it may collapse
Ex: Apple releases rumours to see how the market will react
What are the two ways that managers signal?
Direct disclosure:
Information that directly supports other info.
EX: Reporting high cash flow to support high firm value
Indirect Signals:
Vague info that makes investors connect the dots
Ex: a small or medium company hires a big four accounting firm. This signals they are doing well and likely going to grow
What is the key to signalling?
Management has the choice of disclosing or not disclosing.
Choosing disclosure sends a signal.
What is the “right” amount of financial information to disclose?
Benefits of info should equal the cost to produce it
Unbalanced benefits and costs lead to market failure
What is the main cause of market failure?
Unbalanced benefits and costs (of the information disclosed)
What leads to the benefits and costs of disclosure information becoming unbalanced?
EXTERNALITIES:
Actions taken by other firms that impose costs or benefits on another firm. The imposing firm has no cost or benefit.
FREE RIDING
Firms that receive benefits from an externality
Why do we need regulation that forces financial disclosure?
Otherwise companies would only produce information that benefits them
