Scott Im Ch12

CHAPTER 12 STANDARD SETTING: ECONOMIC ISSUES 12.1

Overview

12.2

Regulation of Economic Activity

12.3

Private Incentives for Information Production 12.3.1 Ways to Characterize Information Production 12.3.2 Contractual Incentives for Information Production 12.3.3 Market-Based Incentives for Information Production 12.3.4 Securities Market Response to Full Disclosure 12.3.5 Other Information Production Incentives 12.3.6 Summary

12.4

Sources of Market Failure 12.4.1 Externalities and Free-Riding 12.4.2 The Adverse Selection Problem 12.4.3 The Moral Hazard Problem 12.4.4 Unanimity 12.4.5 Summary

12.5

How Much Information is Enough?

12.6

Decentralized Regulation

12.7

Conclusions on Standard Setting Related to Economic Issues

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

380

LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1.

To Not Take Regulation for Granted

This is the first of two chapters which consider the role of standard setting in mediating the fundamental problem of financial accounting theory that was defined in Section 1.7. The chapter is complex, somewhat esoteric, and comes late in the course. Consequently, I work particularly hard to “market” the chapter to the students. My minimal objectives are that they do not take the current structure of regulation in financial accounting and reporting for granted, and do not take for granted that increasing financial accounting regulation is necessarily desirable. To enhance their interest, I usually begin with a discussion of what might happen if regulation of financial reporting was eliminated, or substantially reduced, including the effects on the number of jobs in the accounting industry. I bolster the question by reference to recent instances of deregulation in other industries. Also, I usually hand out and discuss an article and issue relating to market failure, such as insider trading or failure to release information, from the financial press. Many of the assignment questions for this chapter contain examples of this type of article. 2.

To Conceptualize Ways in which Firms can Produce Information

Here, I treat information as a commodity, and draw an analogy with the production of more conventional products. The idea is to get the students to think about both the benefits and the costs of information production. Conceptually, one can then think, by analogy with conventional microeconomic analysis, about “how much” information the firm should produce. It is worth pointing out that the definition of the socially best amount of information production in the text is a strictly economic definition (see Note 1 to this text chapter). The definition ignores the distribution of information. However, this question is not avoided—it forms the subject of Chapter 13. Of course, information is a very complex commodity. I discuss briefly the three ways to think about the quantity of information produced that are given in Section 12.3.1.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

3.

Instructor’s Manual

Chapter 12 Page

381

To Review Incentives for Firms to Produce Information

I emphasize the important point that, to a considerable extent, firms want to produce information, without a regulator requiring them to do so. I divide these into contractual and market-based reasons. For contracting, the parties want to produce information so as to improve the efficiency of contracting. With respect to markets, the argument is that production of information can lower cost of capital. At this point, I refer to Canadian Tire Corporation (Section 4.8) and ask if their superior disclosure would increase their share price. The empirical results outlined in Section 12.3.4, in particular the results of Welker (1995) and Botosan and Plumlee (2002), suggest that the market does reward and punish firms’ information production decisions. These empirical results provide encouragement that the market does reward superior information production. 4.

To Appreciate the Extent to which Private Market Forces Limit Market Failure

For this objective, I give intuitive presentations of the disclosure principle and its limitations, and of signalling. With respect to signalling, I assign and discuss the Healy and Palepu (1993) paper. This paper is effective in conveying the nature of signalling costs. I then discuss with the class the signalling potential of accounting policy choice, financial forecasts and audits. With respect to accounting policy choice, one can argue, for example, that a low-type firm that chooses conservative accounting policies will incur costs of possible debt covenant violation that will not be incurred by a high-type firm. For financial forecasts in MD&A and audits I emphasize that the manager must have a choice if accounting products such as these are to have signalling potential. 5.

To Appreciate Sources of Market Failure in Information Production

Externalities and free riding are well-known sources of market failure, which apply to information production. I emphasise that information asymmetry also leads to market failure. It may not be fair to call this failure per se, since it is only failure if evaluated relative to a first best ideal of properly operating markets. However, the important point is that securities and

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

382

managerial labour markets are not capable of completely overcoming the effects of information asymmetry and restoring first-best levels of effort and information production. As a result, incentive contracts are still needed to motivate (second best) manager effort. Nevertheless, a case can be made for regulations to control the effects of information asymmetry by fully disclosing manager compensation, controlling insider trading, and generally promoting full and timely information release. Regulations such as these improve the operation of the managerial labour market, thereby reducing the extent to which (costly) incentive contracts have to take over. 6.

To Appreciate the Cost/Benefit Tradeoff of Regulation

Here, I emphasize the various costs of regulation, since bodies that push for new regulations, including standard setters, rarely refer to costs thereof. With respect to the benefits of regulation, and for a discussion of the pros and cons of regulation generally, Lev’s 1988 paper is consistent with many of the arguments made in this chapter and the next. If time permits, I return to the opening theme and ask again whether regulation in accounting should be decreased, or continue to increase. While it is sometimes hard to get a good discussion going, a variety of views usually emerges. Most students, however, are understandably cautious about deregulation in their chosen career path. 7.

Decentralized Regulation

Section 1701 of the CICA Handbook, relating to segment reporting, uses the term “management approach” to refer to an interesting and important aspect of that standard. This is its requirement that firms report segment information on a basis consistent with how these segments report internally for management purposes. It strikes me that this requirement illustrates a compromise between regulation and deregulation arguments. That is, it requires that segment information be disclosed, but decentralizes how to disclose it to the internal decision of management. This decentralization should increase decision usefulness to investors while at the same time reducing compliance costs, and even retains some signalling potential since management can reveal inside information

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

383

about its internal organization by the format of its disclosure. Note that the firm may change its internal organization if it regards this information as sufficiently proprietary. If so, the firm’s internal organization is affected by financial reporting considerations, rather than vice versa. That is, Section 1701 may have economic consequences. It will be interesting to see the extent that the management approach shows up in other standards, such as reporting on risk and on financial instruments.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

384

SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1.

The firm’s costs of producing information will depend on the nature of the information produced. For finer information, costs would arise from reporting extra line items in the financial statements, preparing notes to the financial statements, and reporting other supplementary information which expands disclosure within the historical cost framework. For additional information, such as RRA and MD&A, costs are incurred in preparation and disclosure. These costs can be quite high, since the firm goes beyond its historical cost records to prepare the additional information. In both cases, costs could also include proprietary costs arising from release of information to competitors. For example, new entrants may be attracted to the industry. For more credible information, costs would include, for example, fees paid to the auditor. For signals, the cost would depend on the signal. If the firm voluntarily discloses a forecast of next year’s operations, this would be a signal that the firm is confident about its future. The costs of this signal include preparing and presenting the forecast, and the expected costs of any penalties or lawsuits against the firm if the forecast, even if made in good faith, turns out to be materially wrong. Other signals would be the hiring of a prestigious auditor, and presenting more than the minimum amount of financial statement disclosure (the MD&A of Canadian Tire Corporation in Section 4.8.2 is an example). Here, costs include the additional auditing and disclosure costs. It should be noted, however, that signalling costs will be lower for a high-type firm than for a low type. The benefits of information production derive from a feeling by investors that the firm is up-front and candid in revealing information about itself. Again, the Canadian Tire disclosures are an example of this type of reporting. The benefits could show up in a reduction of the firm’s cost of capital, consistent with the

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

385

results of Botosan and Plumlee (2002). Other benefits derive from a reduction of the agency costs of contracting. For example, if a firm agrees to include debt covenants in its borrowing contracts, this will lower the costs of borrowing. The firm should produce information until its incremental cost of information production is equal to its incremental benefits. This amount could differ, however, from the socially best information production, due to externalities and other market failures.

2.

The answer lies in the definition of a signal – an action taken by a manager who possesses good news that would not be rational if that 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 (called mimicking), the expected costs of lawsuits and loss of reputation are much higher than for a good news manager. The market will know this, with the result that forecasts are credible. Thus, if a manager issues a forecast, this is an indirect signal that he/she feels sufficiently optimistic about the future to want to forecast in the first place. If forecasting is made mandatory, then all managers must forecast, regardless of whether they have good or bad news. Then, the ability to use the act of forecasting as an indirect signal that management has good news is lost. The market can no longer use the act of forecasting as a signal to discriminate between the two types of firms. Note: It should be emphasized that the signalling aspect of an indirect signal such as a forecast is distinct from the information about future expected profitability per se that is revealed by the forecast. This latter information remains, of course, if forecasting is mandatory. Also, the signalling aspect of a voluntary forecast does not necessarily imply that forecasts should not be made mandatory. The benefits from the market learning bad news sooner may outweigh the indirect signalling benefits of voluntary forecasting.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

3.

Instructor’s Manual

Chapter 12 Page

386

When a decision is internalized, the decision matters only to the person or

persons making it. It is not necessary for other persons to be concerned with the decision. We saw this phenomenon previously in Section 9.4.2, when we considered an owner renting the firm to the manager for $47.38. The owner did not care about the level of effort exerted by the manager because the owner receives rent of $47.38 regardless of the circumstances. It is only the manager who cares because the level of effort will affect how much firm payoff can be expected after paying the rent. A similar situation applies to contracting in general. The parties to the contract have an incentive to agree on the type of information needed to monitor contract performance, so as to minimize agency costs. The important point is that the provision for information is part of the contract. No external/third-party regulation is needed to motivate its production.

4.

The information content of a direct signal is the information contained in the signal itself. Viewed as a direct signal, the information content of a forecast is that next year’s earnings are expected to be $X. The credibility of such a direct signal derives from an ability of the market to verify, at least probabilistically, the accuracy of the forecast ex post. Then, it is more costly for a manager with an internal forecast less than $X to issue a forecast of $X. For an indirect signal, it is the act of forecasting itself which has information content, as distinct from any information disclosed in the forecast itself. Thus, if a manager issues a forecast, this signals that he/she possesses good news inside information because it would be more costly for a bad news manager to voluntarily go to the cost and effort of issuing a good news forecast. The forecast will likely turn out to be wrong, in which case the manager is subject to loss of reputation and possible litigation.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

5.

(i)

Instructor’s Manual

Chapter 12 Page

387

Securities market. If the manager shirks, this will result in lower earnings,

on average, which would adversely affect the firm’s share price and cost of capital. The manager may be fired or the firm may be the object of a takeover bid. These potential consequences will tend to reduce manager shirking. However, it is unlikely that shirking will be reduced to the point where the manager exerts a first-best effort level. Reasons include: •

There will be periods in which favourable realizations of states of nature produce high profits regardless of shirking.

•

Managers may care less about the consequences of shirking if they are close to retirement.

•

Managers may be able to disguise shirking, at least in the short run, by manipulating real variables such as R&D, by earnings management, or by delaying release of bad news.

In sum, while security market forces may reduce the extent to which an incentive compensation contract is needed, they do not eliminate the need for such contracts, since financial accounting information, or any other information for that matter, does not provide perfect information about manager effort. (ii) Managerial labour market. If the manager shirks, this will result in lower firm earnings, on average, which will adversely affect the manager’s reputation and the reservation utility he/she can command in an incentive contract. Again, this can lead to being fired or the firm being the object of a takeover bid. However, these forces are unlikely to completely eliminate shirking, for the same reasons as given in (i). Thus, like the securities market, the managerial labour market does not operate properly to fully eliminate the need for an incentive compensation contract.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

6.

Instructor’s Manual

Chapter 12 Page

388

Three ways that we can think about the quantity of information are: (i)

Finer information. When we think of an additional quantity of information

as finer, we mean that additional detail is supplied within the existing financial reporting framework. Thus, finer information involves the expansion or elaboration of information that is already being presented. Examples include additional financial statement line items, such as breaking down capital assets into land and buildings; presenting the allowance for doubtful accounts as a separate item; presenting interest on long-term debt separately from other interest expense, and so on. Other examples include the presentation of segment information and expanded note disclosure. In technical terms, the presentation of finer information enables the user to better discriminate between realizations of states of nature. (ii)

Additional information. This involves an expansion of the state space

that is being reported on, rather than just a refinement of the existing space. Thus, RRA financial information involves adding additional states to the existing historical cost system. These additional states include values of proved reserves and rates of production. Other examples of additional information include risk disclosures and expanded segment information. Information about fair values, for example of financial assets and liabilities, impaired loans, and capital assets also represents additional information. This information can be produced either as supplementary information (information perspective) or in the financial statements proper (measurement perspective). (iii)

Credibility of information. A third way to think about the quantity of

information is in terms of its credibility. Information will be viewed by the market as credible if it is known that the manager has an incentive to reveal it truthfully. The credibility of accounting information can be enhanced by means of an audit, for example. We can measure credibility by the reputation of the auditor, the type of audit engagement (statutory audit, review, compilation, write-up, etc.), the

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

389

audit fees paid, the number of audit hours, and so on. Hopefully, any dishonest reporting by the manager will be caught by the auditor. Penalties for false or misleading information also enhance credibility. These also include penalties imposed by market forces, such as loss of reputation and lower reservation utility as well as penalties resulting from lawsuits. The greater the penalties, and the greater the likelihood that they will be applied, the greater the credibility.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

7.

a.

Instructor’s Manual

Chapter 12 Page

390

The adverse selection problem in this context is that persons with

valuable inside information about a firm may take advantage of this information to earn profits at the expense of outside investors. They may do this by failing to release their information or acting on it before releasing it. They can then earn profits from insider trading. b.

Financial accounting information can reduce the problem through: •

Full disclosure of relevant information in the financial statements and notes.

•

Supplementary disclosure such as MD&A.

•

Timeliness of disclosure – full disclosure will reduce the scope for insider profits to the extent the disclosure takes place soon after the inside information is acquired.

c.

It is unlikely that financial accounting information can completely eliminate

the problem. This would be too costly, since some information is proprietary. Also, continuous disclosure of all relevant information would be necessary. d.

Market forces may reduce the problem. If the issuer, or other insider, is

revealed to have engaged in insider trading, the issuer’s cost of capital will rise and reputation will be harmed, particularly if there is media publicity. Other forces derive from regulations, such as legal penalties, and requirements for firms to make immediate public announcements of important events. Note: While not discussed in the text, many public companies have blackout periods surrounding earnings announcement dates, during which employees are not allowed to trade in company stock.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

8.

a.

Instructor’s Manual

Chapter 12 Page

391

Managers may withhold bad news: •

To conceal evidence of shirking, if the bad news results from low manager effort.

•

To delay a fall in share price, which would increase cost of capital and possibly affect manager compensation.

b.

•

To enable insider trading profits.

•

To postpone damage to reputation.

The disclosure principle will completely eliminate a manager’s incentive to

withhold bad news if the following conditions hold: •

The information can be ranked from good to bad in terms of its implications for firm value.

•

Investors know that the manager has the information.

•

The information is non-proprietary–there is no cost to the firm of releasing it.

•

Market forces and/or penalties ensure that the information released is truthful.

•

If the information affects variables used for contracting (e.g., share price or covenant ratios), release of the information does not impose increased contracting costs on the firm.

Then, the market will interpret failure to disclose as indicating the worst possible information. To avoid the resulting impact on share price, all but the lowest-type manager will disclose.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

392

If one or more of the above requirements is violated, the disclosure principle may not completely eliminate the withholding of bad news. This will be the case when: •

The information is proprietary. Then, there is a threshold level below which the news will not be released (Verrecchia (1983)).

•

If the market is not sure whether the manager has the information, there is a threshold below which the news will not be released, even though it is non-proprietary (Penno 1997).

•

If release of information may trigger the entry of competitors, the firm may only disclose a range within which the news lies. In this sense, disclosure is not truthful (Newman and Sansing (1993)).

•

If contracts, such as manager compensation, are based on share price and if releasing the news will increase the firm’s contracting costs (e.g., a forecast’s effect on share price may swamp the ability of share price to reflect manager effort), it may not be in the firm’s interests to release the information (Dye (1985)).

We may conclude that while the disclosure principle has the potential to motivate full release of bad news, in practice it is only partially effective due to the number of scenarios where it breaks down.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

9.

a.

Instructor’s Manual

Chapter 12 Page

393

The market declined because the announcements of lower sales and

profits contained market-wide information. If sales and profits were lower for these two large and diverse firms, this suggests that many other firms will also suffer from reduced business activity. As investors bid down the share prices of all firms deemed to be affected by this reduced activity (including Coca-Cola and Xilinx), the market index was dragged down. Note: An alternative, less satisfactory, answer is that only the share prices of the 2 companies in question declined in reaction to the firm-specific information contained in the announcements. Since these firms are quite large, and are part of the market index, the decline in their share prices pulled the market index down. The magnitude and breadth of the market decline seems inconsistent with this argument, however. b.

This episode illustrates the problem of externalities. The information

released by Coca-Cola and Xilinx about their own prospects also contained implicit information about the prospects of other firms. The 2 companies receive no reward for this economy-wide information, consequently there is no incentive for them to release more than a minimum disclosure. For example, perhaps more timely release, more information about why they felt sales and profits will decline, having their auditors attest to the information, and/or breaking the sales and profits down by company line of business or division, would have helped the market to assess the extent to which other companies would be affected.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

10.

a.

Instructor’s Manual

Chapter 12 Page

394

The implied market failure is one of insider trading, a version of the

adverse selection problem. b.

The following effects would be expected: •

Some investors will withdraw from the market, since they feel that it Is not a level playing field, hence that there is little chance of earning a return on any investments.

•

Investors will bid down the price of Newbridge’s shares. The failure to meet current earnings expectations will result in lower demand for its shares as investors revise downwards their future earnings expectations. This effect will be increased as investors realize the insider trading reveals inside information about expectations of future profitability by Newbridge’s management.

•

The liquidity of trading in Newbridge’s shares will fall. This is due to two effects. First, as investors depart the market for Newbridge’s shares, depth falls. Second, the bid-ask spread rises as investors perceive greater information asymmetry with respect to Newbridge insiders, due to a combination of unmet earnings expectations and insider stock sales.

c.

Possible signals include: •

Raise private financing. Private capital suppliers will conduct due diligence about future firm prospects before investing. This will signal Newbridge’s willingness to subject itself to the investigations conducted by the lenders.

•

Issue public debt, as a signal that management believes that the probability of the debtholders taking over the firm in the future is low.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

•

Instructor’s Manual

Chapter 12 Page

395

Management could increase their shareholdings. This would, in effect, reverse the earlier insider sales. Increased shareholdings would not be rational (i.e., more costly) if management was concerned about future firm performance.

•

Engage a higher quality auditor, either by changing auditors or by extending the scope of the existing audit.

•

Raise the dividend. This would not be rational if management was worried that future earnings could not be sustained at a level to support the higher dividend.

•

Adopt more conservative accounting policies. This will signal that future earnings can stand resulting downwards pressure. It would not be rational to adopt conservative policies if management believed this would decrease their earnings-based bonuses or increase the probability of future covenant violation.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

11.

a.

Instructor’s Manual

Chapter 12 Page

396

Other suggested reasons for the decline in Canadian Superior’s share

price: • The disclosure principle. The CEO’s refusal to answer questions may have led investors to conclude he had something to hide. • The sale of $4.3 million of his shareholdings by the CEO. This sale took place in January. The market should have largely reacted to it then. However, the March announcement may have suggested to the market that this insider sale was more ominous than it had perceived at the time. If so, a further share price decline would be expected. • Lawsuits. Concern about unfavourable outcome of the class action lawsuits would lead to a share price decline. b.

The CEO’s sale of stock in January, 2004, suggests the adverse

selection problem, leading to insider trading. The adverse selection problem occurs when an individual exploits his/her information advantage over other persons. Here, a possible explanation of the January stock sale is that the Canadian Superior CEO had inside information about El Paso’s intention to pull out of the project. Sale of shares before the market became aware of this intention constitutes exploitation of this information at the expense of outside investors. This is a problem for investors because their ability to make good buy/sell decisions is reduced. As a result, share price does not fully reflect this information. When the inside information becomes publicly known, as it did in March, investors who had continued to hold their Canadian Superior shares, and investors who had bought shares in the interval, suffer severe losses, whereas investors who sold their shares in the interval enjoy excess profits. Note: The CEO’s sale of shares in January reveals some information, since rational investors will ask why the shares were sold (providing the insider sale was promptly reported). Thus, Canadian Superior’s share price following the January sale may at least partially reflect the CEO’s inside information.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

c.

Instructor’s Manual

Chapter 12 Page

397

The effect would be to decrease share prices of all Canadian oil and gas

companies. This is an example of an externality. That is, share prices of other firms are affected by the actions of one firm. Share prices are affected because of a pooling effect, which takes place when investors are unable to discriminate between high and low-type firms. In effect, oil and gas shares are viewed as lemons, subject to considerable estimation risk. As a result, investors feel that the market for oil and gas shares is not a level playing field due to the large amount of inside information in the exploration for oil and gas and the apparent willingness of at least some insiders to exploit this information. Consequently, investors will withdraw from the market or reduce the amount they are willing to pay for all oil and gas shares.

d.

Possible signals include: •

Obtain a new partner. A new partner will conduct due diligence about Canadian Superior’s prospects before investing. This will credibly signal Canadian Superior’s willingness to subject itself to the investigations conducted by the potential investors/partners, since it would not be rational to submit to such an investigation if the company believed the well’s prospects were poor.

•

Raise private financing and complete the well without another partner. This is a credible signal for the same reasons given in the previous point.

•

Issue public debt, as a signal that management believes that the probability of the debtholders taking over the firm in the future is low. Management would not be rational to issue public debt if it felt the well’s prospects were poor.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

•

Instructor’s Manual

Chapter 12 Page

398

Management could increase its shareholdings, or amend the firm’s compensation plan to require more share holdings by senior officers. Increased shareholdings would not be rational if management was concerned about future firm performance.

•

Adopt more conservative accounting policies. This will signal that future earnings can stand resulting downwards pressure. It would not be rational to adopt conservative policies if Canadian Superior management believed this would decrease any earnings-based bonuses or increase the probability of future debt covenant violation.

Note: Additional signals can also be suggested: •

Hire a prestigious auditor. This signal may not be as effective as others since the auditor may not be experienced in auditing technical details of oil and gas exploration. However, the auditor may be able to offer systems advice and implementation, to reduce the likelihood of future abuses of inside information.

•

Increase dividends and/ or undertake a stock buyback. These signals may not be effective because they could also be consistent with the company having little use for its cash in its own operations.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

12.

a.

Instructor’s Manual

Chapter 12 Page

399

The executive share purchase conveys favourable inside information

about the future prospects of the company. b.

Yes, the purchase constitutes a credible signal, as evidenced by the

strong market response. Investors realize that it would not be rational for the Imax executives to buy these shares unless they believed the company’s future prospects were favourable.

13.

a.

Reasons to voluntarily expense ESOs: •

Signal. The bank may have wished to signal its expectation of increased future profits and/or the low persistence of its problems with loan losses. If it expected its future profitability to be low, it would not be rational to further force down profits by expensing ESOs. Lower profits could affect executive compensation, debt covenants and, for a financial institution, capital adequacy ratios.

•

Low usage of ESOs. The bank may have reduced its usage of ESOs following the financial reporting scandals of the early 2000s, where it appeared that increasing the value of ESOs was a driving force behind manipulation of financial statements. To the extent that ESO use is low, the effect of expensing on reported profits is low.

•

Commitment to openness and transparency in financial reporting. Given the impact on investor confidence of accounting scandals such as Enron and WorldCom, which affected share prices of all firms, TD may have felt that voluntary expensing of ESOs will help to improve its reputation for transparency and full disclosure, thereby increasing public confidence and, presumably, its share price.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

•

Instructor’s Manual

Chapter 12 Page

400

Anticipation of new standard. TD may have felt that it was only a matter of time until ESO expensing became part of GAAP, so it might as well start now.

b.

Costs of a standard requiring ESOs to be expensed: •

Out-of-pocket costs. All firms would have to develop the ability and data needed to estimate ESO fair value, or hire experts to do it for them. Costs would include for estimating the parameters of Black/Scholes or other valuation model, and analyzing past exercise behaviour so as to determine a distribution of times to exercise.

•

Loss of ability to signal. Firms that may wish to signal future expected profitability, transparency, and a commitment to full disclosure would not be able to do this via voluntary ESO expensing.

•

Lower reliability. To the extent that estimates of ESO cost are unreliable, the usefulness of financial reporting will be reduced.

•

Compensation contract efficiency. To the extent that expensing ESOs causes firms to reduce their usage, and to the extent that ESOs are an efficient compensation device, firms will have to substitute other, possibly less efficient, types of compensation to motivate performance. This would increase compensation and/or agency costs. Note: A counterargument is that ESOs were not an efficient compensation device, since they often seem to have motivated dysfunctional manager effort rather than increased effort—see benefits below.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

401

Benefits of a standard requiring ESOs to be expensed: •

Greater relevance. Expensing of ESOs increases the relevance of financial reporting, since lower reported profits anticipate lower future dividends. Dividends are lower because of the dilution of shareholders” interests that results when shares are issued at less than market value.

•

More efficient compensation contracts. Firms may reduce their usage of ESOs since it would now be necessary to record their estimated cost as an expense. To the extent that ESOs encourage dysfunctional manager behaviour, substitution of other more efficient compensation devices will increase productive manager effort and lower compensation costs.

•

Level playing field. Investors will have greater confidence in financial reporting to the extent they perceive standard setters responding to past abuses of ESOs by requiring all firms to report their cost.

•

Securities markets less than fully efficient. To the extent that securities markets are not fully efficient, investors may not notice ESO expense disclosure in the notes (e.g., limited attention), and thus may not realize that lower reported profits are the result of an accounting change, rather than necessarily the result of poor performance. They are more likely to take notice of the expense if it is included in the financial statements proper. This will reduce the cost of any bad decisions such investors may make.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

14.

a.

Instructor’s Manual

Chapter 12 Page

402

Tom Harris will shirk more as a majority shareholder because prior to

going public he bore all the costs (reduction of firm value due to shirking) himself as the owner-manager and suffered the loss in profits alone. That is, the effects of shirking were internalized. Subsequent to the new share issue, he will not bear all the costs – the minority shareholders will bear their proportionate share. Thus, shirking costs Tom Harris less after going public, so, other things equal, he will engage in more of it. b.

Potential investors will be aware of Tom’s increased incentive to shirk after

the share issue and will bid down the amount they are willing to pay for the new issue by their share of expected costs of shirking. c.

Tom Harris will be aware of potential investors’ incentives to bid down the

price of the new issue, so that he will receive less in terms of proceeds from sale of shares to outside shareholders. To avoid this potential loss, he has incentives to convince potential shareholders that he will not engage in excessive shirking. d.

Steps that Tom could take to convince shareholders that he will not

engage in excessive shirking: •

Tom could hire an auditor, or increase the work done by the current auditor. This will increase the credibility of future reported profits, and help ensure that the effects of shirking, including excessive perquisite consumption, are not hidden by earnings management.

•

Tom could increase the proportion of his compensation that depends on earnings and share price performance, to increase alignment with the new shareholders’ interests.

•

Tom could improve disclosure in the XYZ financial statements, so as to signal a commitment to fully inform outsiders about firm performance and prospects. For example, he could voluntarily issue a forecast of future profits, so as to credibly inform the new shareholders of his expected level of future earnings.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

15.

a.

Instructor’s Manual

Chapter 12 Page

403

The market failure derives from adverse selection. Managers have been

engaging in selective disclosure. That is, inside information is released to certain individuals who have the opportunity to take advantage of it before passing it on to the market. This practice works against the interests of ordinary investors. That is, the securities market is not working properly. Investors will perceive that the market is not a level playing field and will withdraw. As a result of this reduced demand, share prices of all firms will be negatively affected. b.

Market liquidity will be reduced by this practice. Both market depth and the

bid-ask spread will be affected. Market depth will fall as ordinary investors leave the market. The bid-ask spread will rise as investors perceive that inside information is in the hands of a group of analysts and institutional investors who will, presumably, use it for their own advantage at the expense of ordinary investors. c.

One source of increased cost is that the firm may contravene the new

Regulation FD, opening itself up to fines and litigation. Such contravention could be inadvertent, resulting, say, from a casual comment by a firm manager to an institutional investor. Alternatively, since the regulation is new, the firm may not be fully aware of its detailed provisions. As a result, the manager may feel that it is better to say nothing. A second source of increased cost may be an increase in expected costs of litigation. No forecast can be completely accurate. If the firm publicly releases a financial forecast that turns out not to be met, it will likely face litigation or, at the least, a substantial drop on its share price. However, if the forecast had been informally released to, say, an analyst, and allowed to filter into the market through that analyst’s recommendations, it is the analyst who will bear much of the cost of not meeting the forecast. Another cost is the direct cost of disseminating the information to a wider audience. These could include, for example, increased costs of conference calls and web page design.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

d.

Instructor’s Manual

Chapter 12 Page

404

Whether or not the operation of securities markets is improved depends

on the net effect of the factors described above. If inside information is released publicly rather than to a select group, an increased perception of the fairness of the marketplace by ordinary investors will reduce the liquidity problems outlined in b. However, if this effect is counterbalanced by less information available to the market as outlined in c, this will reduce the ability of share prices to reflect real firm prospects and value. Note: Some commentators have claimed that the result of the new regulation will be to create more “surprises” in the marketplace. That is, there will be fewer forecasts issued, so it will be more difficult for the market to form accurate expectations. This will increase share price volatility. Increased volatility, per se, does not mean that the market is operating less properly, however.

16.

a.

The most likely reason is that Air Canada wanted to avoid a large decline

in its stock price if its quarterly report revealed unexpected bad news. By releasing the information early through analysts that were obviously “friendly,” the company may have felt that they would diffuse or water down the bad news. This would reduce share price volatility. An alternate reason is that Air Canada’s management may have felt that releasing the information early, even though it was bad news, would enhance its reputation for full information release on the securities and managerial labour markets. This would favourably affect Air Canada’s cost of capital and management’s reservation utility. b.

One reason why Air Canada’s share price fell is that the market was

reacting to the bad news of lowered earnings forecasts. A second reason is that the selective disclosure had the opposite effect from what Air Canada had expected. By revealing inside information to a select group, investors felt that the market for Air Canada shares was not a level playing field.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

405

The resulting drop in market depth and increase in bid-ask spread lowered share price. A third reason is that the market as a whole may have dropped on those days, pulling Air Canada’s share price down with it. The problem does not give sufficient information to determine the extent to which this was the case. Finally, the market may have anticipated the fines and legal costs that would result if the disclosure violated Canadian securities legislation. c.

Selective disclosure reduces the proper operation of the securities market.

Inside information is disclosed to a select group. This group has an opportunity to profit from the information before releasing it to the investing public. During the period before general release, Air Canada’s share price may not fully reflect the information about the lower earnings forecast. d.

This trade suggests adverse selection. A possible reason for the huge

block sale is that an insider is taking advantage of inside information about expected future earnings of Air Canada. e.

Air Canada should have been charged regardless. The problem is one of

perception. Investors do not know whether or not the selected analysts used the information for personal gain. But, certainly, the possibility existed. Thus investors do not regard the market as a level playing field. This causes harm to the proper operation of the market. Air Canada’s selective disclosure policy, even if the analysts did not personally take advantage of the information, is the source of this harm.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

17.

a.

Instructor’s Manual

Chapter 12 Page

406

Firms can increase the liquidity of their shares by the following policies: •

Voluntary release of information. According to Merton (1987), voluntary information release increases the number of investors who become familiar with the firm. An increased number of investors in the market for the firm’s shares increases market depth, thereby increasing liquidity.

•

Full disclosure. According to Diamond and Verrecchia (1991), high quality disclosure reduces information asymmetry. This reduces the bid-ask spread, thereby increasing liquidity and facilitating trading in the firm’s shares. Empirical evidence consistent with this prediction is reported by Welker (1995).

•

Increase reporting credibility. Increased credibility of reporting can be attained by signalling, for example by increasing audit quality, by an increase in legal liability for sub-standard reporting (e.g., Regulation FD), and by moving to a stock exchange with higher standards. Increased credibility increases the willingness of investors to buy the firm’s shares by decreasing estimation risk and, more generally, decreasing concerns about information asymmetry due to misleading reporting.

b.

Costs of increased disclosure include: •

Out-of-pocket costs to disclose, such as costs of printing, web page design and operation, news conferences and news releases.

•

Proprietary costs, such as release of plans, projections, new inventions, potential acquisitions.

•

Legal costs. To the extent the increased disclosure consists of forwardlooking information, failure to meet the disclosed targets may result in litigation and legal costs.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

18.

a.

Instructor’s Manual

Chapter 12 Page

407

Yes, the disclosure reduction will reduce the market’s ability to evaluate

CIBC’s earnings persistence. This is because the realized gains on the Global Crossing investment, being unusual and non-recurring, are of lower persistence than CIBC’s operating earnings. Burying these realized gains in operations thus removes the market’s ability to separately identify them. b.

It seems that CIBC’s reduction of disclosure violates this requirement. The

realized Global Crossing gains do not typify normal business activities. Furthermore, it seems unlikely that these gains will occur frequently over several years. If CIBC intends to use these gains to smooth earnings, they will occur only once a year, or, at most, quarterly. This strains the definition of “frequently.” Furthermore, while CIBC seems to own a large block of Global Crossing, the number of years over which it can realize these gains will be limited by the term of its hedging contracts whereby it has locked in these gains. The number of years over which these gains can be realized will also be limited by the amount needed to smooth earnings to CIBC’s desired amount. While the total gains seem to be quite large, even a modest drop in operating earnings may cause them to be used up quickly. Thus, it is also questionable whether the bank’s policy meets the “several years” criterion. Note: While not in effect at the time of this episode, Section 1400 of the CICA Handbook (issued in 2003) may also be contravened. This standard asserts that fair presentation includes the provision of sufficient information about significant transactions that their effects on the financial statements can be understood. These requirements of Section 1400 are similar to some of the requirements of the Sarbanes-Oxley Act. c.

The securities market’s reaction will depend on whether it perceives

CIBC’s earnings management to be good or bad. If CIBC uses the gains responsibly to credibly reveal inside information about expected earning power, and/or to reduce the effects of unfavourable state realization on contracts, the market’s reaction will be favourable. If CIBC uses them opportunistically to

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

408

maximize bonuses or to attempt to increase share price by reporting higher earnings than can be sustained, the market’s reaction will be unfavourable. The article reveals both opinions. James Bantis complains that the “quality and transparency” of CIBC’s earnings will be reduced. Other analysts, however, are reported as in favour of CIBC’s move, on the grounds that earnings predictability will be improved. This implies that the market has some faith that CIBC will manage its earnings responsibly. If so, the market reaction will be, on balance, favourable. d.

To the extent that CIBC manages its earnings responsibly, it can be

questioned whether market forces have failed. Credible revelation of inside information about persistent earning power can hardly be regarded as a market failure, for example. However, to the extent that the market is concerned about “bad” earnings management, it does not follow that regulations to require improved disclosure of gains and losses such as those from Global Crossing are necessary: •

Section 1520.03 (o) of the CICA Handbook already requires separate disclosure of unusual and non-recurring events. However, there seems to be room for judgement about just when an item of gain or loss meets these criteria. It is unlikely that CIBC would deliberately defy this section.

•

Regulations have a cost, including the cost of reducing the ability of firms to responsibly reveal persistent earning power (i.e., “good” earnings management).

•

To the extent the market reacts negatively to CIBC’s move, this will penalize the bank through lower share price and higher cost of capital. These costs may well be sufficiently high to preclude most firms from engaging in such practices.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

409

We conclude that only if the benefits of the new regulations, after market forces have done their best to discourage the practice, outweigh the costs would new regulations be desirable.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

410

Additional Problems 12A-1. In November, 1997, Philip Services Corp., a large recycler of scrap metal based in Hamilton, Ontario, floated a share issue on the New York Stock Exchange at U.S. $16.50 per share. In the months that followed, revelations of substantial losses led to several large writedowns on Philip’s books, totalling about $400 million. Matters were made worse by a lack of clear and complete explanations by the company as to what the sources of the losses were. By September, 1998, Philip’s shares were trading at under $2. A lawsuit followed on behalf of the purchasers of the November, 1997 share issue. It claimed that Philip had deliberately engaged in earnings management so as to postpone the market’s knowledge of the impending losses until after the share issue. Accounting policies allegedly used to do this included capitalization of losses at one of Philip’s facilities as employee training costs, inclusion of profits from trading in metals contracts as ordinary revenue, and inflating the carrying values of inventories. Allegations also appeared in the financial media that Philip had revealed inside information to certain analysts. Required a.

Why would managerial labour and capital markets not operate to prevent

the earnings management practices that Philip’s management was accused of? b.

Explain why Philip’s failure to communicate promptly and fully the reasons

for the $400 million of writedowns would contribute to the fall in its share price. c.

Philip’s auditor, Deloitte and Touche, were included as defendants in the

lawsuit, on the grounds that they had allowed the alleged earnings management. Based on the information in the question, what arguments could you make to defend yourself if you were the auditor? d.

If you were a financial accounting regulator, such as a member of the

OSC or the AcSB, what new regulations, if any, would you put into place,

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

411

assuming the charges alleged in the lawsuit have merit, to prevent similar incidents in future?

12A-2. In October, 1999, DaimlerChrysler AG started to give more information to analysts, including production forecasts and earnings outlooks. This increased transparency followed a sharp drop in the firm’s share price following its second quarter, 1999, earnings report, which revealed flat earnings compared to the previous year. Apparently, DaimlerChrysler managers felt that much of the share price decline was a result of investors having been “taken by surprise,” rather than of the flat earnings as such. The article also reported on a recent meeting of DaimlerChrysler managers in Washington, DC. The meeting was “upbeat,” with discussion of plans for several new vehicles and of continued cost cutting progress.

Required a.

Use the disclosure principle to explain why DaimlerChrysler will reveal this

new information. b.

Does the increased disclosure constitute a signal? Explain why or why not.

Suggest ways that DaimlerChrysler management could credibly signal its upbeat information to the market.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

412

Suggested Solutions to Additional Problems 12A-1. a.

Undoubtedly, capital and managerial labour markets operate to reduce the

incidence of earnings management practices as described in the question, since managers will realize that reversal of the accruals will negatively impact future earnings. This negative impact will affect cost of capital and management’s reputation. However, since these markets do not operate completely properly, they do not always prevent such practices. The reason here is adverse selection. It appears that Philip used earnings management to delay release of its inside information. Presumably, management was hoping for a turnaround that would absorb the losses that it knew it had incurred. b.

Consistent with the disclosure principle, Philip’s failure to disclose would be

interpreted by the market as the worst possible news. The disclosure failures, and possible preferential treatment of certain analysts, would increase the market’s perception of estimation risk and, more generally, information asymmetry with respect to Philip, thereby reducing liquidity of trading for Philip’s shares. Both of these effects contribute to a decline in share price. c.

Suggested arguments for the auditor: •

If management failed to disclose inside information to the public, it may also have withheld information from the auditor. If so, the auditor could use this as part of his/her defence.

•

Possibly, at least some of the alleged earnings management practices were within GAAP. Capitalization of employee training costs may be defended on the grounds that they benefit future periods. Also, if Philip engaged in trading of metals future contracts frequently, the definition of extraordinary items in Section 3480 of Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

413

the CICA Handbook could possibly be used to justify that profits on such trading were part of operations. d.

It would be prohibitively costly (i.e., impossible) to completely eliminate the

market failures described. This would require constant monitoring of all firms’ inside information. However, the OSC may be able to reduce the frequency of such failures by: •

Increased penalties for withholding of inside information.

•

Increased required reporting frequency of inside information.

•

The securities commission ultimately has the power to issue financial accounting standards. Either directly, or indirectly by pressure on the Accounting Standards Board, it could require that disclosure of transactions such as trading in metals futures be improved. Note: Fair value accounting for financial instruments, and Section 1400 of the CICA Handbook can be regarded as steps in this direction.

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

12A-2. a.

Instructor’s Manual

Chapter 12 Page

414

The disclosure principle states that if a manager does not release

information that the market knows he/she possesses, the market will fear the worse and bid down the firm’s share price accordingly. To avoid this, the manager will release all but the worst possible information. For the disclosure principle to explain DaimlerChrysler’s release of production and earnings forecasts, the market must know that the firm manager does possess this information. Clearly, this is the case since any well-managed firm will prepare such projections. However, there are additional requirements that must hold if the disclosure principle is to explain the information releases: •

It must not be too costly for DaimlerChrysler to release the information. Here, the main cost would be the proprietary cost of revealing production and earnings plans to competitors. However, the firm must feel that the forecasts are sufficiently “upbeat” that the threshold level of disclosure is attained. That is, beneficial effect on share price exceeds the proprietary costs.

•

The information released must be perceived as credible by the market. Here, credibility is attained because the accuracy of the management forecasts will be verifiable by the market when actual production and earnings are known.

•

According to Dye (1985), the effect on share price of the production and earnings forecasts must not be so strong as to swamp the ability of share price to reveal information about manager effort. If so, the increased contracting costs (resulting from a share price that is less informative about manager effort) may outweigh the benefits to DaimlerChrysler of releasing the information. For example, the “upbeat” forecasts may derive from favourable economic conditions on production, sales, and earnings rather than manager effort. Then, management compensation (if based on

Copyright © 2006 Pearson Education Canada Inc.

Financial Accounting Theory, Fourth Edition

Instructor’s Manual

Chapter 12 Page

415

share price performance) will increase, even though the increased compensation is not a result of manager effort. To avoid this compensation cost, the firm may not release the information despite the favourable effect it would have on share price. In this case, DaimlerChrysler must feel that the favourable information is the result of manager effort, due to plans for several new vehicles and success at cost cutting. Consequently, the share price benefits seem to outweigh the contracting costs. b.

Yes, it constitutes a signal. To be a signal it must be less costly for a firm

with inside knowledge of good prospects to release an upbeat forecast than for a firm without such good prospects to release an upbeat forecast. This is the case for DaimlerChrysler’s increased disclosure since the market will be able to verify the forecast ex post. The expected costs of failing to meet the forecast are lower for a firm with inside knowledge of good prospects. This is what gives the signal its credibility. Other ways that DaimlerChrysler could credibly signal its upbeat information include: •

Management could increase its holdings of company stock.

•

The firm could raise new financing by means of bonds rather than by issuance of shares.

•

The firm could increase its dividend.

•

The firm could adopt more conservative accounting policies.

Copyright © 2006 Pearson Education Canada Inc.