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CHAPTER 12
STANDARD SETTING: ECONOMIC ISSUES
12.1 Overview
12.2 Regulation of Economic Activity
12.3 Ways to Characterize Information Production
12.4 First–Best Information Production
12.5 Market Failures in the Production of Information
12.5.1 Externalities and Free–Riding
12.5.2 The Adverse Selection Problem
12.5.3 The Moral Hazard Problem
12.5.4 Unanimity
12.6 Contractual Incentives for Information Production
12.6.1 Examples of Contractual Incentives
12.6.2 The Coase Theorem
12.7 Market–Based Incentives for Information Production
12.8 A Closer Look at Market–Based Incentives
12.8.1 The Disclosure Principle
12.8.2 Empirical Disclosure Principle Research*
12.8.3 Signalling
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12.8.4 Private Information Search
12.9 Are Firms Rewarded for Superior Disclosure?
12.9.1 Theory
12.9.2 Empirical Tests of the Effects of Disclosure
12.9.3 Is Estimation Risk Diversifiable?*
12.9.4 Conclusions
12.10 Decentralized Regulation
12.11 How Much Information Is Enough?
12.12 Conclusions on Standard Setting Related to Economic Issues
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
1.10. 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. To balance the
discussion, I usually hand out and discuss an article and issue relating to market failure,
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such as insider trading or failure to release information, from the financial press. The
assignment questions for this chapter contain examples of this type of article.
The 2007–2008 market meltdowns (Section 1.3) provide a more recent source of
discussion of the pros and cons of regulation. On the one hand, severe criticisms arose
concerning the adequacy of regulations of the financial industry and, closer to home,
those pertaining to fair value accounting. We now observe new regulations, some of
which are still in process, to increase regulation of banks and trading of derivatives. We
also observe aeveral new accounting standards (Sections 7.5 and 7.8), some of which
back off from fair value accounting for financial instruments. Whether or not these
regulations will reduce criticisms of accounting standards, and prevent recurrence of the
abuses leading up to the market meltdowns, remains to be seen.
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 Section 12.4). 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.
3. 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
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that production of information can lower cost of capital. The empirical results outlined in
Section 12.9.2 suggest that the stock market does reward and punish firms’ information
production decisions. These empirical results provide encouragement that the market
does reward superior information production.
However, (optional Section 12.9.3) if estimation risk (a major source of how information
production can lead to lower cost of capital) is diversifiable, the benefits of information
production are reduced. The answer to the question of estimation risk diversifiability
seems unclear at the present time.
4. 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
correct 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
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.
5. 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 (Problem 10). 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, and why such signals are credible. With
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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. Thus, regulation to restrict choice, such
as a requirement that all firms issue financial forecasts, reduces signalling potential.
Most students have little trouble in understanding the concept of a signal. If they do
have trouble, it is in understanding why a signal is credible. The reason should be
emphasized when discussing signals.
6. To Appreciate the Cost/Benefit Trade–off 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. Management’s
objections to the costs of the Sarbanes–Oxley Act illustrate an argument that regulation
can be very costly. Problem 15 of Chapter 13 considers these objections, and could be
discussed at this point.
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 professional
accounting students, however, are understandably cautious about deregulation in their
chosen career path.
7. Decentralized Regulation
IFRS 8 and ASC 280–10 (formerly SFAS 131) relate to what I call decentralized
regulation of segment reporting. This concept is also called the “management
approach.” These standards contain a 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
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while at the same time reducing compliance costs, and even retains some signalling
potential since management can reveal inside information 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, decentralized regulation may have economic consequences.
It is interesting to see this decentralized approach to regulation showing up in other
standards, such as flexibility of MD&A disclosures (Section 3.6), designation of hedging
instruments (Section 7.9.2), the fair value option (Section 7.5.3) and the concept in
IFRS 9 of basing the accounting for certain financial instruments on the firm’s business
model (Section 7.5.2).
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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 mixed measurement model 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 additional
information requires numerous estimates and forecasts.
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show up in a reduction of the firm’s cost of capital. 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 (a form of information
production), this will lower the costs of borrowing.
2. 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 in Section 9.2.2, when we considered an
owner renting the firm to the manager for $51. The owner did not care about the
3. (i) Securities market. If the manager shirks, this will result in lower firm
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:
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(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 future incentive contracts. Again,
this can lead to being fired or the firm being the object of a takeover bid.
4. 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
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5. a. The adverse selection problem in this context is that persons with
valuable inside information about a firm may take advantage of this
b. Financial accounting information can reduce the adverse selection
problem through:
c. It is unlikely that financial accounting information can completely eliminate
d. Market forces may reduce the problem. If a firm insider is revealed to
have engaged in insider trading or other abuse of inside information, investors’
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company stock. See the study of Jagolinzer, Larcker, and Taylor (2011) in
Section 4.6.1.
6. a. Managers may withhold bad news:
b. The disclosure principle will motivate the manager to report bad news if
the following conditions hold:
Then, the market will interpret failure to disclose as indicating the worst possible
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:
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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.
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7. Apple’s share price fell because of the executives’ refusal to answer. Investors
knew how important Steve Jobs’ was to the success of Apple, and must have felt
8. The adverse selection problem is a source of market failure in the production of
information since persons who are willing to take advantage of inside information
The moral hazard problem is a source of market failure since managers may
9. a. The market declined because the announcements of lower sales and
profits contained market–wide information. If sales and profits were lower for
b. This episode illustrates a market failure because of the problem of
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consequently there is no incentive for them to release more than a minimum
disclosure. For example, perhaps more timely release, more information about
10. a. Possible signals include:
• Direct disclosure of Patten’s credit granting and collection
procedures, so as to inform the market of their integrity. Direct
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b. Any signal could be recommended, since all are credible. However, they
differ in their costs. Presumably, the lowest cost signal should be recommended,
including proprietary costs. Arguments for and against specific signals include:
• Direct disclosure of credit policies reveals proprietary information
about Patten’s credit–granting procedures. These policies must be
effective if anticipated credit losses are so low. Thus, this
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• Declaring a dividend incurs a cash outflow by Patten. Also, a
dividend may create suspicion in the market that the firm does not
have profitable internal capital projects.
11. a. 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.
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
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c. 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.
d. Possible signals include:
• Obtain a new partner. A new partner will conduct due diligence
about Canadian Superior’s prospects before investing. This will
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12. a. The executive share purchase conveyed favourable inside information
about the future prospects of the company. Yes, the purchase constituted a
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c. Reasons why management bought shares
• They may have felt that Imax shares were undervalued by the
market in 2004. The earnings management that took place during
13. a. The implied market failure is one of insider trading, a version of the
adverse selection problem of information asymmetry.