EVOLUTION

OF
DISCLOSURE
REGULATION
RATIONALES:
PRELUDE TO
A NEW
THEORY

EMH and Early Rationales

Many of the early rationales for
corporate disclosure regulation have a
common theme, that investors and
the stock market in general, cannot
distinguish between efficient and less
efficient firms.

EMH and Early Rationales

(Contd)
Leftwich (1980) lists some of the
reason:
Monopoly control of information by
management
Nave investors
Functional fixation
Meaningless numbers
Diversity of procedures
Lack of objectivity

EMH and Early Rationales

(Contd)

Monopoly control of information by

management
Corporate accounting reports are the
only source of information available to
investors and as a consequence
managers are able to manipulate stock
prices.
EMH:
There are alternative sources of information
Managers cannot systematically mislead the
stock market
Market can discriminate between efficient
and less efficient firms, at least to some
degree

EMH and Early Rationales

(Contd)

Monopoly control of information by

management (Contd)
If management has more information
than is available via other sources but
does not provide the information to the
market, the market cannot discriminate
between efficient and less efficient
market as accurately as it otherwise
might.
Governmentally enforced disclosure
Can only be superior if the costs of
production are less with required disclosure
and/or the social value of the information is
greater than its market value

EMH and Early Rationales

(Contd)
Nave investors
Accounting numbers cannot be
interpreted by investors who do not
have accounting training
In an efficient market, tailoring financial
statements to nave investors does not
increase their wealth of the firms value
For nave investors to diversify their portfolios
to reduce the probability that they will lose.

These investors not necessarily nave

Investors personal trade-of

EMH and Early Rationales

(Contd)
Functional fixation
Individual interpret earnings numbers
the same way regardless of the
accounting procedures used to calculate
them.
Interpretation of functional fixation
hypothesis:
Investors do not discriminate between
earnings calculated using diferent
procedures because it is costly to adjust the
numbers
Efects of changes are publicly disclosed

Investors are irrational

Inconsistent with EMH

EMH and Early Rationales

(Contd)
Meaningless numbers
Because earnings are calculated
using several diferent methods of
valuation, the earnings numbers
are meaningless and stock prices
based on those numbers do not
discriminate between efficient and
less efficient firms.
Given the EMH, evidence is
inconsistent with this criticism.

EMH and Early Rationales

(Contd)
Diversity of procedures
Another reason given for the inability of
the capital market to distinguish
between efficient and less efficient and
is often given in conjunction with the
nave investors criticism.
Managers cannot use diverse
procedures to mislead investors
systematically.

Lack of objectivity
Diferent accountants produce diferent
accounting numbers from the same set
of facts.

EMH and Early Rationales

(Contd)
This issue is an empirical one,
depending on relative costs and
benefits of private production of
information and governmentally
regulated production of information

Rationales from the Economic

Literature
The alleged market failure
Market failure exists when the
quantity or quality of goods
produced in a free market difers
from the supposed social optimum.
Market failures suggest that social
welfare can be improved by
government regulation moving the
private output closer to the social
optimum.

Rationales from the Economic

Literature (Contd)
The alleged market failure
(Contd)
Accounting market failure is alleged
to exist because:
The output of information in accounting
reports in the absence of regulation is
non optimal
The resource allocation resulting from
the market for financial information is
inequitable (unfair) to some groups or
individuals

Rationales from the Economic

Literature (Contd)
The alleged market failure
(Contd)
The public good problem
One persons consumption of it does
not reduce the quantity available for
others to consume
Information in accounting reports is
assumed to be a public and not a
private good.

Rationales from the Economic

Literature (Contd)
The alleged market failure
(Contd)
The public good problem (Contd)
However, the accounting information
has both public and private good
attributes
Consumption of the information by
one investors reduce the ability of
others to use the information and
reap the same rewards.
There is indirect cost to the disclosing
firm if the information has adverse
efects on its competitive position.

Rationales from the Economic

Literature (Contd)
The alleged market failure
(Contd)
The public good problem (Contd)
Market failures comes about if the
private producers can not exclude
non purchasers of the good from
using it or can not perfectly price
discriminate between purchasers
Externalities and free-riding
The managers underproduce
information in the absence of
regulation

Rationales from the Economic

Literature (Contd)
The alleged market failure
(Contd)
The signaling problem (also called
the screening problem)
Information asymmetry
Adverse selection
Moral hazard

Signaling hypothesis: proposition

that signaling motivates corporate
disclosure
Signaling can cause an
overproduction of information in
accounting reports

Rationales from the Economic

Literature (Contd)
The alleged market failure
(Contd)
The speculation problem
Overproduction of information by
individuals outside the firm for
speculation purposes
The private benefits to speculator of
investment are positive, but the
social benefits are zero

Rationales from the Economic

Literature (Contd)
Fallacies in the market failure
rationales
The public good problem
There is evidence that firms provided
accounting reports long before those reports
were required by the law
One contracting costs are admitted, it is no
longer apparent that the public good problem
results in a market failure

Private Incentives for Information

Production
Contractual incentives
Incentive contract
Debt covenant
Firm goes public contract
between owner-manager and the
new investors

Market-based incentive
Managerial labour market
Capital markets
Takeover market

Rationales from the Economic

Literature (Contd)
Fallacies in the market failure
rationales (Contd)
The signaling problem
Also ignores contracting costs
If those costs are same for the individuals and
government, there is no market failures

The speculation problem

Assume zero transaction costs

Rationales from the Economic

Literature (Contd)
Fallacies in the market failure
rationales (Contd)
The existence of a market failure in the
production of information in accounting
reports depends on the costs of private
contracting and production of information
relative to the costs of government
achieving the private level of output
If the governments costs are substantial
it is not apparent that there is any
market failure in the private production of
information in corporate accounting
reports

Rationales from the Economic

Literature (Contd)
The cost of regulation
The direct costs
Direct costs of the SEC and FASB
Costs incurred by the accounting firms
and corporations complying with the
standards and the costs of lobbying on
proposed accounting standards.
Expected increase in losses from
lawsuits against accountants and
corporations
Renegotiating contracts

Rationales from the Economic

Literature (Contd)
The cost of regulation (Contd)
The indirect costs of regulation
Corporate managers change their
financing, investment, and/or
production decisions in a fashion that
imposes costs o firms
Society: higher taxes to pay and lower
returns on corporate equity.

Rationales from the Economic

Literature (Contd)
The stock price efects of
regulation
Benston (1973) find no evidence of
costs or benefits of the securities
acts
Chow (1983): 1933 Securities Act
reduced the wealth of shareholders
of firms that were afected by the
act relative to those firms not
afected by the act
Regulation imposes private and social
costs and little evidence of benefits

Two Important Questions

What is the objective of
disclosure regulation?
Improves welfare?
SEC spends virtually none of its
budget in systematically assessing
the costs and benefits of regulation
Politicians and regulators act in their
own self-interest

Two Important Questions

(Contd)
Why do managers care about
accounting procedures?
Drop the assumption of zero
transaction, information, and
contracting costs.
The dropping of the zero transaction
costs assumption also provided the
opportunity for accounting
procedures to afect the value of the
firm