Lecture 1: Economics of Accounting information Flashcards
What are the primary qualities of information?
The primary qualities of accounting information are RELEVANCE and RELIABILITY.
RELEVANT info. have Predictive value in terms of helping with forecasting the future; have Feedback value to correct or confirm what had been predicted in the past; and is Timely, that is, it is available when needed or in time to have an impact on decision.
RELIABLE info. are Verifiable in that it can be confirmed by an independent party; has Representational Faithfulness by reporting what acting happened; and it also neutral, i.e. unbiased.
What are the problems/limitations of these primary qualities?
- Prediction and feedback can be conflicting objectives for the same piece of information
- Neutrality is hard to achieve since there are strong incentives for both aggressive and conservative reporting
- Always exists a trade-off between relevance and reliability of information. E.g. historical cost info is more reliable but less relevant; FV info is more relevant but less reliable. The most relevant information may require estimation, e.g. estimating value of building, but such estimates are likely subjected to bias of the appraiser thus limiting reliability. On the other hand, best information may be those that become reliable once audit is complete, but waiting for audit to be completed may take so long that it is no longer relevant.
- Extensive use of judgement and estimates, such that there is no one true value; inherent subjectivity is capturing and measuring ‘economic reality.
Quantity of information
There are three different ways we can think about the quantity of information:
1. Finer information, which means additional detail or elaboration about what is already reported within the existing financial reporting framework. Examples include the disaggregation of financial statement line items and presenting segment info and expanded note disclosure.
- Additional information, which means an expansion of what is being reported on. E.g. info about reserves for resources companies; sustainability and other non-financial info; expanded risk disclosures like climate risk.
- Credibility of info. Info will be viewed by the market as credible if it is known that manager has incentive to reveal it truthfully. Credibility enhanced by having it independently audited (audit and audit report are additional info). Penalties for false and misleading info also enhance credibility, e.g. penalties from market forces (reputation) and also costs from fines and lawsuits.
Quantity of info affected by the public good nature of accounting info. Firms are monopoly suppliers of info about themselves, which leads to incentives to undersupply and overcharge in the absence of regulation. This market failure leads to regulation of accounting (Corp Law and Accounting standards) to ensure more socially optimal quantities (also quality) of info are supplied.
– However, Arrow’s Impossibility Theorem states that it is not possible to combine differing preferences of individuals into a social preference ordering that satisfies reasonable conditions—means we will never have one single optimal accounting info set. (impossible to specify the socially ‘right’ amount and types of info)
2016 Semester 1 Exam Q:
Using qualities of accounting info as framework, analyse how this shift to real-time reporting will affect the decision-usefulness of accounting info.
Identify and Explain the primary qualities of accounting info (Relevance and Reliability)
2 marks
Would shift towards real-time financial statements make financial info more useful or less useful?
- Trade off between info relevance and reliability.
- Shift to real-time reporting allows info to become more timely thus improving reliability, however reliability may be compromised as it is likely that in order to provide info on a daily basis, estimations (such as estimating the value of a building asset) are needed.
- Although some accounts may be useful to know on a real-time basis (e.g. daily sales and daily movement in inventory), other accounts like allowance for DD and allowance for loan losses, probs not helpful in terms of decision making to know these amounts on a real-time basis
- Thus trade-off must always be considered and whether the shift to real-time will improve decision usefulness will be dependent on if the improvement in relevance doesn’t cost too much reliability.
What is information asymmetry?
Information asymmetry exists when some parties to a business transaction may have some information advantage over others (Adverse Selection) or when the parties may take actions that are unobservable to others (Moral Hazard)
Tutorial 2 Q3:
An adverse selection problem can arise from info asymmetry b/w an issuer and buyer of shares in company
- Explain the adverse selection problem.
- How can financial accounting info reduce adverse selection problem? Can it eliminate problem completely? Explain
- What other ways to reduce problem of inside info?
Adverse selection (BEFORE transactions) is whereby one or more parties to business transaction/potential transaction, have info advantage over other parties. Adverse Selection in this context is that people with valuable inside info about the firm may take advantage of this info to earn profits at expense of outside investors. May do this by failing to release info or acting on it before releasing it. Can then earn profits from insider trading.
- Financial accounting can reduce the problem through full disclosure of relevant info in the FS and notes; supplementary disclosure like press releases; and also timeliness of disclosure (reduce insider scope for profit to the extent that disclosure takes place soon after insider info is acquired).
- Unlikely that accounting info can completely eliminate problem. This would be too costly since some info is proprietary (decision to disclose needs to consider issues with competitors and competitive edge)
- Other ways to reduce problem could be through market forces. If the issuer is revealed to have engaged in insider trading, then the issuer’s cost of capital (required rate of return on equity and interest rate on debt) will rise and reputation will be harmed.
- Other forces derive from regulations such as legal penalties and requirements for firms to make immediate public announcements of important events.
Tutorial 2 Q2:
Why voluntary forecast of accounting earnings can be signal but mandated forecast cannot.
- Signal is an action by a manager who possess good news that would not be rational if manager possessed bad news.
- A voluntary forecast is a signal because it is less costly for a manager with good news to issue a forecast. If a bad news manager falsely issues a good news forecast, the expected costs of lawsuits and loss of reputation much higher than that for good news manager. The market knows this, that forecasts are credible.
Thus, if manager issues a forecast this is indirect signal that they feel sufficiently optimistic about this future to want to forecast in first place. (high quality firms receive higher payoff when they signal)
Separating equilibrium—outsiders able to accurately distinguish b/w high and low types firms - However, if forecasting is made mandatory, then all managers must forecast, regardless of whether they have good or bad news. This means ability to use forecasting as signal that mgmt. has good news is lost. Market can no longer uses act of forecasting as signal to discriminate between the two types of firms
Pooling equilibrium—both types of firms benefit from signalling and outsiders unable to distinguish
** Note: Doesn’t necessarily mean that forecasts should not be made mandatory—benefits from market learning bad news sooner may outweigh indirect signalling benefits of voluntary forecasting.
Distinguish between discretionary (voluntary) information and mandatory (regulated) information?
Discretionary information is generally managerial accounting info usually produced for internal purposes, since there is no law requiring that it should be provided.
Mandatory information is generally financial and tax accounting info. Usually produced at lowest possible costs to comply with laws of the regulators.
Tutorial 2 Q4b)
Suggest signals management could use to convince market of the under-valuation of company’s shares, explaining why each signal is credible
- Management could increase its shareholdings, or amend the firm’s compensation plan to require more shareholdings by senior mgmt. Increased shareholdings would not be rational if mgmt. was concerned about future firm performance
- Firm could change its auditor to a more prestigious brand name auditor. Credible because it would cost more in audit fees, and higher quality auditor provides confidence in accounting info.
- Raise Debt Financing. Credit because private capital supplies would conduct due diligence about future firm prospects before investing. The firm is willing to subject itself to this investigation. Also, signalling that it believes it has ability to repay debt.
- Increase dividend. Would not be rational if mgmt. was worried that future earnings could not be sustained at level to support higher dividends.
Tutorial 2 Q4c)
Describe cost and benefit to firm from a significantly higher level of allowance for bad debts. Why might they choose to increase the allowance?
- This relates to the concept of conservatism, which is a systematic bias in accounting away from neutrality of information.
- The cost would be immediate FS effect of reducing profit due to the higher allowance because company is recognising a loss before it occurs. (DR Bad Debt expense and CR Allowance for BD)
- The benefit of conservatism is that it is a signal of accounting quality. Signals that firm’s current and future earnings can withstand the resulting downward effect on earnings. Thus firm is trustworthy and credible. It can bear the immediate hit on earnings because it is confident of its future earnings stream.
What is the agency problem?
- Shareholders (principals) employ directors and managers (agents) to conduct business in the interest of owners.
- However, situation of information asymmetry gives rise to agency problems, whereby managers may pursue self-interest to the detriment of shareholders (i.e. there is a conflict of interest).
- Examples include managers’ excessive consumption of employment perks (company cars etc.); empire building (attempting to increase individual’s power and influence—managers more concerned with expanding their business units and the value of assets under their control than they are with implementing ways to benefit shareholders); and also dividend retention.
How to reduce agency problem? i.e. how can agents be induced to act in principals’ best interests?
Increase:
- Monitoring costs—cost of producing and verifying by external audit
- Bonding costs—managerial compensation schemes constructed not only to retain competent mangers but to align mangers’ interest with those of shareholders (e.g. annual salary plus performance bonuses and company shares)
- Residual loss (remaining value is loss to managers)
- Regulation—helps to mediate conflicting interests of investors and managers; also address market failure caused by info asymmetry due to public good nature of accounting info.
