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• 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
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
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.14. a. Reasons to voluntarily expense ESOs:
• Signal. The bank may have wished to credibly 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
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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
• Lower reliability. To the extent that estimates of ESO cost are
unreliable, reported net income will be less reliable relative to its
reliability if ESO cost is reported in the notes.
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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.
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
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15. a. Tom Jones 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
b. 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 and lower profits, are not hidden by earnings management.
16. a. Firms can increase the liquidity of their shares by the following policies:
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b. Costs of higher quality reporting include:
• Out–of–pocket costs to disclose, such as costs of printing, web page
design and operation, news conferences and news releases.
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17. a. No. Holding the books open past period end and backdating contracts
both misstate accruals. Since accruals reverse, the revenue misstatements
would cancel out over a period of years.
b. No. The revenue misstatements were fraud, not a result of
misinterpretation or misuse of an accounting standard. Holding the books open
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d. The most likely source of market failure is adverse selection. By
keeping information about these revenue manipulations inside (at least until
discovery in 2002), Mr. Kumar postponed the negative consequences that would
have resulted from a failure to meet earnings targets. Given Mr. Kumar’s
18. a. Well–manager firms are likely to prepare quarterly forecasts for internal
use. Investors will know this. According to the disclosure principle, if the firm
b. Costs to firms that issue quarterly earnings forecasts:
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c. It is unclear whether poor share returns around the date of the stopping
announcement are consistent with the authors’ findings.
The firm is losing longer–term investors. This suggests that these investors are
concerned about longer–term performance. Also, poor share returns and
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d. Investors must know that management has earnings forecast information,
since this was released in the past and presumably would be continued for
internal purposes. Consequently, the disclosure principle must have failed due to
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19. a. Reasons for the fall in GE’s share price:
• Systematic risk. Because of the U.S. recession of the early
2000s, the whole market fell, dragging GE’s share price with it.
• Recession. The market may have been concerned that GE
would be particularly affected by recession following from the
Reasons why increased disclosure exerts upwards influence on share price:
• Reduced estimation risk, as investors respond to the firm’s greater
transparency. Even if the increased disclosures are bad news, the
release of this information will help to counteract any direct effects
of the information on share price.
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b. Increased segment disclosures will help to reduce investor concerns.
Since the complexity of GE’s operations, and low transparency of reporting, were
longstanding investor worries, any increase in transparency, such as increased
earnings from acquisition of a well–established business would have greater
persistence than those from acquisition of a business with a new and untested
product). Furthermore, the products and services of previously–acquired
subsidiaries likely have greater, or at least different, persistence than the
average persistence of newly acquired subsidiaries. Consequently, failure to
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general were under great suspicion at this time. To the extent that GE’s earnings
do not distinguish between newly–acquired and established businesses, GE’s
20. a. Costs of increased regulation:
Benefits of increased regulation:
• Reduced estimation risk for investors, leading to reduced fear of
lemons and better operation of capital markets for oil and gas
companies.
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b. Reasons to seek exemption from stricter Canadian regulations:
• Lower costs of preparing the information.
c. The market will realize that an oil and gas firm has inside information
about the types and amounts of its reserves. Under the disclosure principle, a
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Signalling theory complements this argument. If the firm releases additional
reserves information, the market will realize the firm is committed to high quality
21. a. Policies and procedures under which managers can credibly convey
inside information to the Board:
• Appoint financial experts to the Board and to Board committees
such as audit and compensation. The expertise of such directors
gives other outside directors some assurance that relevant
fashion, and help to overcome any tendency for managers to omit
or delay its release. Good news information is less likely to be held
back by management.
• Manager reputation. Information released by a manager that has
developed a reputation for high quality financial reporting is more
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b. Reasons why public financial statements may be more credible to such
directors than information supplied by management
• An audit increases the credibility of financial statements.
c. Outside directors are likely to be more objective and independent of
management than inside directors. As information quality available to Board
22. a. According to contract theory, bondholders are concerned that
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b. The Yankee market requires higher disclosure and corporate governance
c. According to the Diamond and Verrecchia theory, voluntary disclosure
reduces information asymmetry and estimation risk, thereby facilitating trading,
which increases market liquidity. Since the Yankee market is subject to
Additional Problem
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12A-1. 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.
Financial media at the time 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.
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Suggested Solution to Additional Problem
12A-1 a. 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 internally.
However, there are additional requirements that must hold if the disclosure
principle is to explain the information releases:
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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