Lecture 11 - Economics of Voluntary Disclosure and Regulation Flashcards
What is the ‘best’ amount of information production from society’s perspective?
Until Marginal Social Cost = Marginal Social Benefit
2 benefits of information production.
- Improved individual decisions
- Investors (external reports)
- Managers (SPFR)
- Improved operation of
- Capital markets
- Managerial labour markets
3 costs of information production.
- Out-of-pocket costs:
- Time and effort, info systems
- Proprietary costs
- Release of internal information à gives competitors an advantage
- Agency cost:
- Information to investors may reduce contract efficiency
E.g. FV vs HC à not good at contracting as changes are not due to managers.
3 characteristics of good information.
- Detailed information
- Expanded note disclosure
- Additional line items
- Additional info
- FV accounting
- Management discussion and analysis
- More credible information
Audit (increase precision)
What are the 4 reasons a firm would produce information?
- The disclosure principal
- Contractual incentives
- Market based incentive
- Signalling
What is the disclosure principle?
Assumptions:
- Market knows managers has information
- E.g. a forecast
- Manager choses not to release the information
- Market fears the worst (hiding bad news)
- ↓ Share prices
- Therefore, management will disclose.
Why may the disclosure principle not work? 2 reasons.
Does not work if:
- Only works if the market knows you have the information.
- Non-disclosure à market can assume proprietary cost
- Or news is not sufficiently good to warrant incurring disclosure cots.
Therefore, non-disclosure is not only due to ‘bad news’.
How do contractual incentives create a need for information?
Compensation contracts
- Need information (e.g. net income, core earnings)
Debt contracts
- Banks may require internal information
- Or other
- E.g. working capital, times-interest-earned, debt to equity
Also FS required to ensure firm is not breaching covenant.
How do market based incentives create a need for information?
Securities market:
- Poor disclosure creates adverse selection à increases information risk and decreases capital raised.
Managerial labour markets:
- Poor disclosure lowers manager reputation
What is the market’s response to full disclosure? 3 responses
- Merton (1987)
- Better disclosure leads to more investor interest
- Diamond & Verrecchia (1991)
- Better disclosure increases market liquidity and share price (lowers bid ask spread)
- Easley & O’Hara (2004)
Better disclosure reduces estimation risk
Define signalling.
Why do firms want to participate in it?
Signalling is the intentional effort to differentiate a firm as a high type.
Key aspect:
Signalling must be less costly for ‘high type’ firms.
What are the 3 market failures in private information production?
- Public good
- Externality
- Agency problems: Private benefits of non-disclosure (moral hazard and adverse selection problems)
Why is information being a public good an issue?
Once information is released, there is no way to restrict someone else from receiving the benefit.
- No individual has incentive to pay for it.
- Free rider problem.
Private cost > social cost – proprietary cost to firm
Why is information being an externality an issue?
- Action creates a cost or benefit – however firm does not receive full revenue for this (i.e. private benefit < social benefit)
E.g. BHP financial statements could be used for an indicator for the macro economy (BHP is not compensated for this use)
What are 2 private benefits of non-disclosure?
- Adverse selection problem
- Insider trading
- Delay in information release
- Moral hazard problem
Earnings management used to disguise shirking.
