Week 1 - Financial statements & Disclosures Flashcards
Example of informational need of stakeholders and users of fin stt.s - PERFORMANCE measurement vs BALANCE SHEET measurement
PERFORMANCE measurement
- influential in shaping I/S, geared towards 1 SUMMARY MEASURE (“earnings”)
eg. how is company X doing? how much should we pay our CEO?
BALANCE SHEET measurement
- STEWARDSHIP demands for both debt contracting & MGMT CONTROL purposes
eg. if co. X goes bankrupt, how much of my loan can I recoup? how much inventory do we have left and how much should we have?
Equity investors (valuation) + agency problems + effect on acct. rules
- Cash flows are volatile and often -ve
- ACCRUAL acct. adjusts cash flow to represent ECONOMIC PERFORMANCE
- b/c current performance is indicative of future performance -> useful for valuation
eg. buying machine now to generate profit in future years, so spread out cost instead of large -ve CF now - Accruals help make BETTER DECISIONS but much DISCRETION is involved, which can cause agency problems
Agency problems
- due to different INCENTIVES & INFORMATION ASYMMETRY
eg. earnings management such as reporting in double-declining dep. in their favour
Effect on acct. rules
- UNCONDITIONAL CONSERVATISM = co. is always sure that what is reported is VERIFIABLE before being reported, ie. not relying on forecasts but info through auditors, eg.
- CONDITIONAL CONSERVATISM = immediately recognising losses when there’s the possibility but only recognising income when verifiable
ie. threshold for verifiability is reduced for adverse information (more important for outside users to be aware of bad news than good news)
Debt investors + agency problems + effect on acct. rules
- Care about LIQUIDATION values (how much we can salvage), value of firm’s assets, how much cash co. is generating, solvency info from I/S
Agency problems
1. Limit on opportunistic risk-taking
- bad for debt investors if there’s a chance for cash to shrink
2. Flexible demand for more oversight and covenants
Effect on acct. rules
- Rules prefer CONSERVATIVE info and CASH-GENERATING ABILITY (no big accruals)
Positive accounting theory + why not normative accounting theory
- Only one SINGLE set of statements but allow DISCRETION so it can be tailored and satisfy diff. stakeholders, ie. allowing adjustments
eg. if many debt investors, choose acct. rules that better show ability of co. to generate revenue
eg. if many equity investors, choose acct. rules that better represent economic reality - No one set of rules nor ideal standards b/c everyone has their OWN INCENTIVE
- AGENCY THEORY and SELF-INTEREST assumptions play a significant role
eg. intangible asset goodwill reflects economic reality (equity investors) but doesn’t represent salvage value (debt investors)
- Normative acct. theory = how ideal principles and standards SHOULD be (but don’t match reality)
- Supports providing many sets of fin stt.s for each user, but disclosure is very COSTLY
Why disclosure matters - overarching, general idea
To facilitate efficient decision-making
- when INFORMATION ASYMMETRY exists = some agents having more info than others
- which results in reluctance to make decisions
Why disclosure matters - 2 problems that can be caused by INFORMATION ASYMMETRY
*rmb that these 2 roles can conflict
*info is crucial in MARKET ECONOMIES
- ADVERSE SELECTION PROBLEMS
eg. investing in capital markets
- IA leads to adverse outcomes (investors don’t want to invest b/c want to avoid bad firms, hence difficult for firms to raise money)
- disclosure converts inside info to OUTSIDE - MORAL HAZARD PROBLEMS
eg. managerial labour markets
- IA leads to SHIRKING and excessive RISK-TAKING (eg. CEO’s private jet, lavish parties)
- disclosure leads to contract transparency and accountability
eg. pay-for-performance for CEOs as they become INCENTIVISED to make good decisions for good firm performance
4 real effects of disclosure + 3 issues
- Revealing information triggers effects (Leuz and Wysocki, 2016)
Real effects
1. Higher LIQUIDITY
2. Higher MARKET EFFICIENCY (price is more informative)
3. Lower COST OF CAPITAL (investors don’t demand as high return for high risk)
4. Lower RETURN VOLATILITY
Issues
1. Too much public info “crowds out” private info with firms need to make investment decisions
(eg. don’t want other firms stealing your co’s private info that would’ve been the competitive advantage)
2. Proprietary costs
3. Disclosure is COSTLY
Why disclosure matters - firms’ voluntary disclosure + Keynesian beauty contest + UNRAVELLING
- Firms almost always voluntarily disclose so that market perceives them as “good” (beware of the downside)
- Keynesian beauty contest
- your actions are determined not only by own expectations but also accounting OTHERS’ EXPECTATIONS - Unravelling
- in the end, all firms will disclose except the worst, who will rather lower their cost of capital than DISCLOSE of BAD INFO, which will be worse for the firm.
Why disclosure matters - Graham, Harvey and Rajgopal (2005) surveyed CFOs why they were (or not) reporting
- EARNINGS, not cash flows, matter as a measure of ECONOMIC REALITY, to measure ECONOMIC PERFORMANCE
- Meeting BENCHMARKS is important! managers prefer smooth earnings
- CFOs are myopic (short-sighted) just to meet expectations in the SHORT-TERM & willing to change behaviour - Executives are willing to reduce REAL INVESTMENT to improve reporting
- Why (not) disclose: reducing uncertainty, but wary of setting precedences
TEXTUAL disclosures + reference
- beyond financial information; text is used by mgmt to give CONTEXT containing VALUABLE INFO
- has changed dramatically over time; more room {lengthy} for explaining key ACCT. POLICIES and compliance with REGULATIONS (Dyer et al., JAE 2017)
» as important for investors to know the mgmt’s justification on how they’re applying these rules to their decisions, to know if it’s best for their returns, eg. why double-declining depreciation - Tone: POSITIVE tone is associated with POSITIVE RETURNS and predicts future operating performance
- Readability: mgmt might obfuscate bad performance by decreasing readability
- also shows the types of risk a firm is most exposed to if kept mentioning in the press releases/conference calls
ESG disclosures vs financial reporting
*ESG is value relevant and investing in ESG generates positive returns
Alternative info for disclosures: eg. satellite images, phone data, social media data (info is EVERYWHERE)
Benefits: calculating own summary measures using the inputs directly, REAL TIME data, information superiority
- Provides info about the environmental & social impact of a firm
- Why report? Real effects of disclosure, but risk of GREENWASHING
- No SUMMARY MEASURES (difficult for ESG), unlike financial reporting
- what if a co. is very environmentally friendly but socially poor - which is better?
- financial reporting focuses on profitability, liquidity etc. easier to COMPARE firms! - NO ACCRUALS
- co. might have bad ESG rating now from current investments but which lead to better rating in the future -> good, incentivises such investments - Value chain reporting
- ESG disclosures are not only about own firm but throughout the SUPPLY CHAIN - Targets reporting
- Targets hold firms ACCOUNTABLE, not found in financial reporting
