Chapter 12: Solutions
Chapter 12: Solutions “Contracting internalizes the problem of information production” •
When decisions are internalized, the decision only matters to the person or persons making it.
•
In contracting in general 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
•
Provision for information is a part of the contract no third party regulation is needed to motivate information production
3. To what extend do security market forces and managerial labor markets forces motivate managers to work hard? That is to operate firm in best interests of the shareholders?Do these forces eliminate need for incentive compensation contracts?
Security Markets •
If a manager neglects its duties will result in lower earnings on average, firms price will suffer and cost of capital
•
Manager may be fired and firm may be subject to takeover bid
•
These factors will reduce manager shirking o But will not be reduced entirely to point where manager gives firstbest effort level
There will be periods where results will produce high profits despite manager shirking
Managers care less of consequences when near retirement
May be able to disguise shirking in short run by manipulating variables like research and development by opportunistic earnings management or delaying the release of bad news
Managerial Labour Market
•
If manager shirks will result in lower earnings will affect managers reputation and will affect their reservation utility he /she can command in an incentive contract
•
Can lead to manager being fired or take over bid
Market forces are subject to moral hazard and adverse selection problems. •
Market may reduce to an extent the need for incentive contract but does not eliminate altogether
•
Financial accounting information and other available information does not provide perfect information about opportunistic manager behavior and shirking
•
Managers may be able to exploit inside information for own benefit and disguise shirking through earning management
4. Information as a commodity, complex. Three ways think of about quantity of information
Finer information •
Additional quantity of information as finer, additional detail is supplied within existing financial reporting framework
•
Expansion and elaboration of information that is already being presented o Examples: additional financial statement lines such as breaking down assets into land buildings and presenting allowance for doubtful accounts as separate item o Presenting interest on long term debt sperated from other interest expense o Expanded note disclosure
Additional information •
Risk disclosures, and expanded segment information
•
Information about fair values for example of financial assets or liabilities impaired loans
•
Information can be produced supplementary information (information approach) or in financial statements (measurements approach)
Creditability •
Information viewed as creditably if it is know that manager has an incentive to reveal it truthfully
•
Credibility enhanced through means of an audit
•
Reputation of the auditor, type of audit engagement ( audit, review, compilation, writeup)
•
Any opportunistic manager can be caught by audit
•
Penalties for false mistleading information enhance crediability
•
Market forces: such as loss of reputation, lower reservation utility resulting from lawsuits
5. Adverse selection problem •
Persons with valuable inside information about firm may take advantage of this information to earn profits at the expense of outside investors
•
May fo this by failing to release information or acting on it before releasing it, can earn profit from inside trading
How can financial accounting information reduce adverse selection problem? •
Reduce the problem through o Full disclosure of useful information in financial statements and notes o Supplementary disclosure of MD&A o Timeliness of disclosure: full disclosure will reduce scope of insider profits to extend the disclosure takes place soon after the inside information in acquired.
Can financial accounting eliminate the problem completely? •
Unlikely to eliminate insider information altogether, too costly
•
Some information is proprietary (R&D, merger and take over plans)
•
Would require continuous disclosure
Other ways to reduce problem of insider information? •
Market forces, if issuer is revealed to be engaged in insider trading or other abuse of insider info, investors estimation risk will increase
•
Issuers cost of capital rises, particular where there publicity
•
Regulations, penalties requiring information to be released
•
Black out periods: when earnings announcement dates
6. Failure to release bad information by managers another adverse selection problem
Why would manager want to withhold bad news? •
Conceal shirking if bad news is a result of low manager effort
•
To delay fall in share price which would increase cost of capital and affect manager compensation
•
Enable insider trading profits
•
To postpone damage to firm reputation
What extend does disclosure principle operate to reduce the incentives of managers to withhold bad news? •
Disclosure principle will eliminate a mangers incentive to without bad news if the following is met: o Information can be ranks from good to bad in terms of its implications for firm value o Investors know that the manager have information o There is not cost to firm from releasing the information o Market forces and penalties ensure the information released is truthful i.e. credible o Information affected variables used for contracting (share price or covenant ratios) release of information does not impose increased contracting costs to firm
Market will interpret failure to disclose, and indicate that worst possible information. To avoid, lowest type of manager will disclose
If one or more violated then disclosure principle may not eliminate withholding of bad news. This will be in case of •
Information is proprietary, threshold where below cannot release
•
When GAAP quality is not too high information goes beyond mandated information disclosure will only be disclosed voluntarily if exceeds threshold
•
If releasing information triggers entry of competitors the firm may disclose a range within which the news lies
•
If contracts such as manager compensation based on share price and releasing the news will increase firms contract costs may not be interest for firm to release
7. September 15, 2004 Dow Jones dropped because coca cola and Xilinx announced that profits will be lower than analyst estimations Why did the whole market decline? •
Declined because announcement of lower sales and profits contained market wide information.
•
If sales profits of such large and diverse firms dropped suggest other firm would also suffer from reduced business activity
•
Investors bid down on the share prices of those companies and the other share prices of all other firms deemed to be affected by the reduced activity also declined
8. Feb 1998, announced that revenues and profits for quarter ending were substantially below analyst expectations, share price fell 23%
Sale of 5 million in 1997 by inside director, including CEO. Implications that inside information about disappointing sales of new product line
What source of market failure is implied? •
Insider trading is implied, a version of adverse selection problem
Effect on investors and liquidity of trading company shares would media reports of insider trading have? •
Investors perceive greater estimation risk
o Investors will withdraw from market, feel that playing field is not level, hence less chance to earn investment o Investors will bid down shares, failure to meet expectations result in lower demand of shares o Liquidity of trading shares will fall o Investors depart the market for shares of company, depth falls o Bidask spread rises from investors perceive greater information asymmetry with insiders due to combination of unmet earning and insider stock sales Suppose management felt share price was undervalued after February announcement. What are signaling that management can engage in to counter public impression? •
Raise private financing. Private financing requires due diligence, company’s willingness to subject itself to investigation conducted by lenders without directly releasing proprietary information about future firm prospects
•
Issue public debt, signal that management belied that probability of debt holders taking over firm is low
•
Increase shareholdings, would reverse the effect of insider sales, although would not be rational, more costly
•
engage higher quality auditor, either by changing auditor or extending scope of the existing audit
•
raise dividend, would not be rational if management worried about future earnings
•
adopt conservative accounting principles, signal that future earning can stand resulting downwards pressure
9. Drop in share price
•
Disclosure principle, CEOs refusal to answer questions may have led investors to conclude they had something to hide
•
Sale of 4.3 million of shareholdings by CEO, because he did in January are announcement was in March, could imply insider trading
•
Lawsuits, concern about unfavorable outcome to class action lawsuits, decline in share price
Problem of information asymmetry related to company Adverse selection problem, leading to insider trading. Occurs when individual exploits his/hers information advantage over other persons. Possible explanation of January stock sale is that CEO has insider information about EL Paso intentions to pull out of project. Sales of Shares before market became aware o this intention constitutions exploitation of this information at expense of outside investors. Affect on oil companies Example of externality, that share prices of other firms are affected by actions of one firm •
Affected because of pooling effect which takes when investor are unable to discriminate between high and low type firms in effect oil and gas shares are viewed as lemons subject to estimation risk
•
Investors feel that market for oil and gas shares is not a level playing field, due to insider information
Possible signals: •
Obtain new partner, partner will conduct due diligence. This will credibly signal company willingness to subject itself to the investigation
•
Raise private financing
•
Issue public debt
•
Management could increase shareholdings
•
Adopt conservative accounting policies
•
Hire prestigious auditor
10. Executive purchase of shares conveyed inside information about future prospects of company
•
purchase of sale credible signal as evidenced by strong market respond
•
investors believed that it would not be rational for executives to buy shares unless they believed company’s had positive future prospects
Market failures •
adverse selections and moral hazard
•
seems that managers adopted accounting policies to overstate earnings comprising interests of debtholders and shareholders
•
attempted to cover up shirking, moral hazard
•
policies constitutes market failure because actual profitability was retained as insider information resulting in overstatement of share prices
Why would management have bought shares if aware of opportunistic management? •
Felt shares were undervalued , earnings management that took place could be interpreted as an attempt to report what management felt was imaxs persistent earning power
•
Management may have been low type, willingly to pay the extra cost to signal high type
•
Management may have wanted to increase motivation to work harder
18. Cost of increased regulation: •
Costs if preparing additional information
•
Reduced opportunity to signal voluntary information release
•
Possible release of proprietary information
•
Regulator may goo too far and impose requirement for which social cost exceed social benefits
Benefits of regulation: •
Reduced estimation risk leading to reduced fears of lemons
•
Reduced risk of market failure due to adverse selction since less inside information
•
Reduced risk of market failure due to moral hazard, since more difficult for manager disguise shirking
Reasons to seek exemption from stricter Canadian regulation
•
Lower costs of preparing information
•
Increased concern about legal liability would require additional disclosures such as probable reserves
•
Company shares may be traded in US which case reserve recognition accounting information may need to be prepared to meet US reporting requirements
•
Company may have something to hide may prefer keeping certain reserve information inside of releasing publicly
•
Managers may have shirked and wish to disguise this to avoid disclosure of additional information such as probable reserves
Chapter 13: questions Public interest theory: the regulatory body (e.g standard setters) attempt to produce an amount of regulation that maximized social welfare by trading off social benefits and social costs of information production •
Standards where social costs exceed social benefits are socially desired
•
Implementation of all such standards by regulatory body produces socially optimal amount of regulation
Interest group theory: regulatory body assumed to maximize its own interests, not publics •
Supplied regulation to those constituencies that more effective in lobbying for it
Implications for amount of regulated information that should be supplied Public interest theory: produce more or less than the socially optimal amount of regulation Under interest group theory: to maximize own interest regulatory body may produce as much as it can will probably go beyond socially optimal amount
2. Aspects of structure setting that facilitate confliction resolution in process of new standards: •
Representation of diverse constituencies of the standard setting body
•
Standard setting bodies structured to be independent of conflict interests, IASB and FASB distinct professional accounting bodies due to foundation base structure
•
Contract with constituencies through due process, includes broad consultation , discussion papers
Super majority vote •
Reason is to foster spirit of compromise and to reduce concerns by any one constituency that others are ganging up on
•
Constituencies affected by new standard are more likely to support it than they would be under simple majority voting
3. Benefits of adopting IASB standards •
Better working capital markets o Leads to lower cost of capital in firm o Investors perceive lower estimation risk increase demand for shares o Lower cost of capital leads to increased investment by domestic firms
•
Companies have access to larger liquid capital markets to the extend of their financial statement accepted in other countries o Can lead to increase foreign investment by domestic companies
•
Increased investor confidence leads to increased supply of capital to economy from domestic and foreign investors
•
Lower financial statement preparation costs since fewer jurisdictions whose reporting requirements must be satisfied
•
Lower network externalities, to extend that other countries use IASB standards o Less costly internationally diversified investors to analyze financial statements
Costs of adopting IASB standards: •
Financial reporting affected by local customs, laws other characteristics o Result in different application across countries of same set of accounting standards
Investors need to be aware of differences to properly interpret compare f/s of different countries
•
Increased constituency conflict in design and implementation of new standards o Arising from additional constituencies and customs o Lead to compromises which may reduce standard quality
•
Enforcement may differ from country to country since no single body like SEC in US to apply interpretation and enforcement of IASB standards
•
Increase pressure on auditors from influential controlling interests in firm to bend standards on their behalf o Strains auditors ethical responsibilities and lead to legal liability
•
Increased agency costs to the extend that new standards encourage small outside investors
11. Justify OSFI permission to charge to retained earnings Under public interest theory of regulation OSFI would approve to charge to retained earnings if they were concerned about Scotia’s loan quality •
OSFI knows failure of major bank or even public concern about banks financial condition would cause significant economic and social harm
•
Wish to minimize this happening
•
Encouraged scotia to provide generous safety cushion for loan losses, for two years scotia reported lower net income
Under interest group theory •
OSFI wants to maximize its power and influence
•
One way to do so is to set accounting standards for financial institutions within its jurisdiction
•
Would increase sphere of influence relative to competition constituencies CICA and OSC
•
Increase power over banks and increase visibility in eyes of investors
How would securities market react to treatment?
•
Would not respond because charge to retained earning did not affect cash flows and is fully disclosed
•
Market might respond negatively, direct charge and specific loan provisions may reveal new information that scotia’s loan quality was less than expected o May reveal inside information that scotia management was concerned that net income would not stand full amount of needed provision o Would cause negative effect to companies shares
•
Market might respond positively because scotia is facing up to problem o Management is taking steps to ensure similar problems will not arise again o Loan quality expected to improve
14. Socially correct amount of information is amount that is equal to marginal social costs and marginal social benefits Cost of Section 404 to shareholders and economy: •
Out of pocket costs to establish, evaluate and audit internal control system
•
Manager time and energy devoted, opportunity costs, threatens productivity of firm
•
Increased risk to senior managers who certify system as required by 404 o Suffer loss reputation, position possible prosecution
•
Reduction in manager incentives to undertake risky projects o If goes wrong increased scrutiny reputation, compensation legal liability
•
Less goo earnings management, since managers fear earnings management of any type lead to bad repute that leaders to suspicion and reputation damage and liability
•
Overspending on corporate governance and internal controls
•
Cost to economy, firms withdraw from capital markets
•
Increases costs to monitor and enforce compliance
Benefits to shareholders and the economy: •
Fewer scandals reducing damage to economy and recession caused by investors losing faith in capital markets
•
Firms enjoy lower cost of capital, increases share prices and productivity
•
Improved corporate governance o If before lower than optimal level o Reduced likelihood of financial reporting failures, more informative earnings report, increased efficiency of compensation controls. Lower agency costs, less influence and power of insiders within firm
•
Less bad earnings management
Principle based approach to regulation •
More feasible providing general rules that are laid by regulator and accounts exercise responsible and ethical judgment
•
Less than rules
•
Auditors and accountants must set aside longer run interests ahead of wishes of clients who want to behave opportunistically
•
Have more legal liability
•
Easier to defend oneself if can shown that clear rule which was followed
Chapter 4: Efficient Securities Market 1. Two firms same size, report results of same net income, one stock rose the other hardly.
Can be explained by the difference in the market’s expectations of earnings. •
The net income of firm that had strong reaction may have been higher than expectations
•
Net income of other may have been lower than expectations
•
Another reason could be quality of earnings o One firm may have used different accounting policies o One may have used declining balance (superior disclosure) other may have used straightline amortization (minimal disclosure) o Ones accounting policies more informative the probabilities of information system higher. A stronger market response
•
Informativness of prices could have been different between the two o One whose share price only slightly changed may have released more information during the year, quarterly reports, forecasts, so the efficient market already build information into the share price
5. Reason why 1992, fourth quarter earnings came in lower •
For whole year Earnings were lower end of analysts forecasts
•
Expected 1992 earnings were already built into the firms share price by the efficient market
•
Actual earnings were lower than expectations would cause share price to fall as investors revised downwards beliefs about firms future
•
GE’s earnings quality may have changed
o Perhaps switched to less informative accounting policies in 1992 o Efficient market did not know until 1992 earnings were released o Could trigger decline in share price •
Noise traders o May have been large supply of GE shares coming to the market due to random factors
•
Downturn in stock market on day or earnings announcement o Would exert pressure on share prices including GE
Higher GE beta, greater downward pressure
CAPM New earning information along with downturn in market lowered investor’s prior expectations of GE future profitability •
Market expectation of P+D fell
•
E(R0 is determined by Rf, B and e(M) none of which is directly affected by new earnings information, the current price P in the denominator or equation must fall to restore E(R) from this equation with E(R)j given by equation
•
Efficient securities market theory suggest that market will see through declining balance policy and will not penalize the firm
•
For resulting lower net income reported
•
There will be no loss in market value
•
For market to see through firm depreciation policy must be disclosed
•
Declining balance method has potential advantages
8.
o Since capital assets are amortized quickly under declining method,, serves as hedge against obsolesce o Conservative policies signs of credible signal that firm future earnings power stand the higher depreciation charges o May cause investors to place higher value on firm so that market price of company’s shares could actually rise, rather than fall as result of conservative policy
Chapter 5: the information approach 5. Why is it desirable to find exact time market first became aware of an item of accounting information if any security price reaction to this information is to be detected? •
Efficient market will react quickly to new information
•
If researcher look for a market reaction even within a few days too early or too late, reaction may not be found even though it may have exisited
Can it be found? •
Exact time can be found sometimes, but not always
•
Earnings announcement, date of publication of earning financial press or dates of conferences announcing current earning are acceptable event dates
•
Exact date on which market became aware of information in financial statement can be difficulty or next to impossible to find
•
Given the dates of new reports, forecasts by officials there are many leaks whereby market learns of information early, then difficult to find
What can researchers do when exact date cannot be located? •
Narrow window which share response is evaluated can be widened
•
35 day window centered around day 0 may be used to capture possibility that market may have learned the earning information a day or two early or late
•
or can monitor over a course of weeks and months leading up to and possibly following the formal information announcement
•
it may be claimed that least there is correlation between abnormal market return and unexpected accounting information
6. Negative ERC possible? Why or why not •
it is possible
•
means firm reported positive unexpected earnings but the abnormal share return to these earnings is negative and vice versa
•
example o cisco reported earning but its share price fell because of other less favourable information that accompanied its reports o Earning news was no longer interpreted as good in the light of additional information
16. Efficient securities market theory to explain rise in share price on May 1, 2001 and then rapid subsequent fall in price •
Initial rise occurred because o Reported earnings exceeded analyst expectations, since analysts earnings expectation forecasts are proxy for investor expectations, investors raised probabilities’ for high future firm performance when earning exceeded actual forecasts o Rise in share price was reinforced by CEO comment that firm is pleased to deliver double digit earnings growth, suggested reasonable persistence in company’s increased earnings
Fall in share price •
Due to markets realization that persistence in company earnings was less than believed due to the one time gain in operating earnings
•
Theory financial statement probably released shortly after and the one time item was disclosed
Was company correct in including the one time gain of 8 million in net income? •
Yes , because it required by IAS 1 to include gains and losses fro sales of assets in net income
•
Went wrong was not to disclose detail of this low persistence item
Persistence •
Is low, inclusion of one time gain lower persistence of operating earnings
•
If one time gain is excluded the company earnings per share were lower than the same quarter during previous year
•
If trend continues even the gain excluded earning will not persist
When decisions are internalized, the decision only matters to the person or persons making it.
•
In contracting in general 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
•
Provision for information is a part of the contract no third party regulation is needed to motivate information production
3. To what extend do security market forces and managerial labor markets forces motivate managers to work hard? That is to operate firm in best interests of the shareholders?Do these forces eliminate need for incentive compensation contracts?
Security Markets •
If a manager neglects its duties will result in lower earnings on average, firms price will suffer and cost of capital
•
Manager may be fired and firm may be subject to takeover bid
•
These factors will reduce manager shirking o But will not be reduced entirely to point where manager gives firstbest effort level
There will be periods where results will produce high profits despite manager shirking
Managers care less of consequences when near retirement
May be able to disguise shirking in short run by manipulating variables like research and development by opportunistic earnings management or delaying the release of bad news
Managerial Labour Market
•
If manager shirks will result in lower earnings will affect managers reputation and will affect their reservation utility he /she can command in an incentive contract
•
Can lead to manager being fired or take over bid
Market forces are subject to moral hazard and adverse selection problems. •
Market may reduce to an extent the need for incentive contract but does not eliminate altogether
•
Financial accounting information and other available information does not provide perfect information about opportunistic manager behavior and shirking
•
Managers may be able to exploit inside information for own benefit and disguise shirking through earning management
4. Information as a commodity, complex. Three ways think of about quantity of information
Finer information •
Additional quantity of information as finer, additional detail is supplied within existing financial reporting framework
•
Expansion and elaboration of information that is already being presented o Examples: additional financial statement lines such as breaking down assets into land buildings and presenting allowance for doubtful accounts as separate item o Presenting interest on long term debt sperated from other interest expense o Expanded note disclosure
Additional information •
Risk disclosures, and expanded segment information
•
Information about fair values for example of financial assets or liabilities impaired loans
•
Information can be produced supplementary information (information approach) or in financial statements (measurements approach)
Creditability •
Information viewed as creditably if it is know that manager has an incentive to reveal it truthfully
•
Credibility enhanced through means of an audit
•
Reputation of the auditor, type of audit engagement ( audit, review, compilation, writeup)
•
Any opportunistic manager can be caught by audit
•
Penalties for false mistleading information enhance crediability
•
Market forces: such as loss of reputation, lower reservation utility resulting from lawsuits
5. Adverse selection problem •
Persons with valuable inside information about firm may take advantage of this information to earn profits at the expense of outside investors
•
May fo this by failing to release information or acting on it before releasing it, can earn profit from inside trading
How can financial accounting information reduce adverse selection problem? •
Reduce the problem through o Full disclosure of useful information in financial statements and notes o Supplementary disclosure of MD&A o Timeliness of disclosure: full disclosure will reduce scope of insider profits to extend the disclosure takes place soon after the inside information in acquired.
Can financial accounting eliminate the problem completely? •
Unlikely to eliminate insider information altogether, too costly
•
Some information is proprietary (R&D, merger and take over plans)
•
Would require continuous disclosure
Other ways to reduce problem of insider information? •
Market forces, if issuer is revealed to be engaged in insider trading or other abuse of insider info, investors estimation risk will increase
•
Issuers cost of capital rises, particular where there publicity
•
Regulations, penalties requiring information to be released
•
Black out periods: when earnings announcement dates
6. Failure to release bad information by managers another adverse selection problem
Why would manager want to withhold bad news? •
Conceal shirking if bad news is a result of low manager effort
•
To delay fall in share price which would increase cost of capital and affect manager compensation
•
Enable insider trading profits
•
To postpone damage to firm reputation
What extend does disclosure principle operate to reduce the incentives of managers to withhold bad news? •
Disclosure principle will eliminate a mangers incentive to without bad news if the following is met: o Information can be ranks from good to bad in terms of its implications for firm value o Investors know that the manager have information o There is not cost to firm from releasing the information o Market forces and penalties ensure the information released is truthful i.e. credible o Information affected variables used for contracting (share price or covenant ratios) release of information does not impose increased contracting costs to firm
Market will interpret failure to disclose, and indicate that worst possible information. To avoid, lowest type of manager will disclose
If one or more violated then disclosure principle may not eliminate withholding of bad news. This will be in case of •
Information is proprietary, threshold where below cannot release
•
When GAAP quality is not too high information goes beyond mandated information disclosure will only be disclosed voluntarily if exceeds threshold
•
If releasing information triggers entry of competitors the firm may disclose a range within which the news lies
•
If contracts such as manager compensation based on share price and releasing the news will increase firms contract costs may not be interest for firm to release
7. September 15, 2004 Dow Jones dropped because coca cola and Xilinx announced that profits will be lower than analyst estimations Why did the whole market decline? •
Declined because announcement of lower sales and profits contained market wide information.
•
If sales profits of such large and diverse firms dropped suggest other firm would also suffer from reduced business activity
•
Investors bid down on the share prices of those companies and the other share prices of all other firms deemed to be affected by the reduced activity also declined
8. Feb 1998, announced that revenues and profits for quarter ending were substantially below analyst expectations, share price fell 23%
Sale of 5 million in 1997 by inside director, including CEO. Implications that inside information about disappointing sales of new product line
What source of market failure is implied? •
Insider trading is implied, a version of adverse selection problem
Effect on investors and liquidity of trading company shares would media reports of insider trading have? •
Investors perceive greater estimation risk
o Investors will withdraw from market, feel that playing field is not level, hence less chance to earn investment o Investors will bid down shares, failure to meet expectations result in lower demand of shares o Liquidity of trading shares will fall o Investors depart the market for shares of company, depth falls o Bidask spread rises from investors perceive greater information asymmetry with insiders due to combination of unmet earning and insider stock sales Suppose management felt share price was undervalued after February announcement. What are signaling that management can engage in to counter public impression? •
Raise private financing. Private financing requires due diligence, company’s willingness to subject itself to investigation conducted by lenders without directly releasing proprietary information about future firm prospects
•
Issue public debt, signal that management belied that probability of debt holders taking over firm is low
•
Increase shareholdings, would reverse the effect of insider sales, although would not be rational, more costly
•
engage higher quality auditor, either by changing auditor or extending scope of the existing audit
•
raise dividend, would not be rational if management worried about future earnings
•
adopt conservative accounting principles, signal that future earning can stand resulting downwards pressure
9. Drop in share price
•
Disclosure principle, CEOs refusal to answer questions may have led investors to conclude they had something to hide
•
Sale of 4.3 million of shareholdings by CEO, because he did in January are announcement was in March, could imply insider trading
•
Lawsuits, concern about unfavorable outcome to class action lawsuits, decline in share price
Problem of information asymmetry related to company Adverse selection problem, leading to insider trading. Occurs when individual exploits his/hers information advantage over other persons. Possible explanation of January stock sale is that CEO has insider information about EL Paso intentions to pull out of project. Sales of Shares before market became aware o this intention constitutions exploitation of this information at expense of outside investors. Affect on oil companies Example of externality, that share prices of other firms are affected by actions of one firm •
Affected because of pooling effect which takes when investor are unable to discriminate between high and low type firms in effect oil and gas shares are viewed as lemons subject to estimation risk
•
Investors feel that market for oil and gas shares is not a level playing field, due to insider information
Possible signals: •
Obtain new partner, partner will conduct due diligence. This will credibly signal company willingness to subject itself to the investigation
•
Raise private financing
•
Issue public debt
•
Management could increase shareholdings
•
Adopt conservative accounting policies
•
Hire prestigious auditor
10. Executive purchase of shares conveyed inside information about future prospects of company
•
purchase of sale credible signal as evidenced by strong market respond
•
investors believed that it would not be rational for executives to buy shares unless they believed company’s had positive future prospects
Market failures •
adverse selections and moral hazard
•
seems that managers adopted accounting policies to overstate earnings comprising interests of debtholders and shareholders
•
attempted to cover up shirking, moral hazard
•
policies constitutes market failure because actual profitability was retained as insider information resulting in overstatement of share prices
Why would management have bought shares if aware of opportunistic management? •
Felt shares were undervalued , earnings management that took place could be interpreted as an attempt to report what management felt was imaxs persistent earning power
•
Management may have been low type, willingly to pay the extra cost to signal high type
•
Management may have wanted to increase motivation to work harder
18. Cost of increased regulation: •
Costs if preparing additional information
•
Reduced opportunity to signal voluntary information release
•
Possible release of proprietary information
•
Regulator may goo too far and impose requirement for which social cost exceed social benefits
Benefits of regulation: •
Reduced estimation risk leading to reduced fears of lemons
•
Reduced risk of market failure due to adverse selction since less inside information
•
Reduced risk of market failure due to moral hazard, since more difficult for manager disguise shirking
Reasons to seek exemption from stricter Canadian regulation
•
Lower costs of preparing information
•
Increased concern about legal liability would require additional disclosures such as probable reserves
•
Company shares may be traded in US which case reserve recognition accounting information may need to be prepared to meet US reporting requirements
•
Company may have something to hide may prefer keeping certain reserve information inside of releasing publicly
•
Managers may have shirked and wish to disguise this to avoid disclosure of additional information such as probable reserves
Chapter 13: questions Public interest theory: the regulatory body (e.g standard setters) attempt to produce an amount of regulation that maximized social welfare by trading off social benefits and social costs of information production •
Standards where social costs exceed social benefits are socially desired
•
Implementation of all such standards by regulatory body produces socially optimal amount of regulation
Interest group theory: regulatory body assumed to maximize its own interests, not publics •
Supplied regulation to those constituencies that more effective in lobbying for it
Implications for amount of regulated information that should be supplied Public interest theory: produce more or less than the socially optimal amount of regulation Under interest group theory: to maximize own interest regulatory body may produce as much as it can will probably go beyond socially optimal amount
2. Aspects of structure setting that facilitate confliction resolution in process of new standards: •
Representation of diverse constituencies of the standard setting body
•
Standard setting bodies structured to be independent of conflict interests, IASB and FASB distinct professional accounting bodies due to foundation base structure
•
Contract with constituencies through due process, includes broad consultation , discussion papers
Super majority vote •
Reason is to foster spirit of compromise and to reduce concerns by any one constituency that others are ganging up on
•
Constituencies affected by new standard are more likely to support it than they would be under simple majority voting
3. Benefits of adopting IASB standards •
Better working capital markets o Leads to lower cost of capital in firm o Investors perceive lower estimation risk increase demand for shares o Lower cost of capital leads to increased investment by domestic firms
•
Companies have access to larger liquid capital markets to the extend of their financial statement accepted in other countries o Can lead to increase foreign investment by domestic companies
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Increased investor confidence leads to increased supply of capital to economy from domestic and foreign investors
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Lower financial statement preparation costs since fewer jurisdictions whose reporting requirements must be satisfied
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Lower network externalities, to extend that other countries use IASB standards o Less costly internationally diversified investors to analyze financial statements
Costs of adopting IASB standards: •
Financial reporting affected by local customs, laws other characteristics o Result in different application across countries of same set of accounting standards
Investors need to be aware of differences to properly interpret compare f/s of different countries
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Increased constituency conflict in design and implementation of new standards o Arising from additional constituencies and customs o Lead to compromises which may reduce standard quality
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Enforcement may differ from country to country since no single body like SEC in US to apply interpretation and enforcement of IASB standards
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Increase pressure on auditors from influential controlling interests in firm to bend standards on their behalf o Strains auditors ethical responsibilities and lead to legal liability
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Increased agency costs to the extend that new standards encourage small outside investors
11. Justify OSFI permission to charge to retained earnings Under public interest theory of regulation OSFI would approve to charge to retained earnings if they were concerned about Scotia’s loan quality •
OSFI knows failure of major bank or even public concern about banks financial condition would cause significant economic and social harm
•
Wish to minimize this happening
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Encouraged scotia to provide generous safety cushion for loan losses, for two years scotia reported lower net income
Under interest group theory •
OSFI wants to maximize its power and influence
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One way to do so is to set accounting standards for financial institutions within its jurisdiction
•
Would increase sphere of influence relative to competition constituencies CICA and OSC
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Increase power over banks and increase visibility in eyes of investors
How would securities market react to treatment?
•
Would not respond because charge to retained earning did not affect cash flows and is fully disclosed
•
Market might respond negatively, direct charge and specific loan provisions may reveal new information that scotia’s loan quality was less than expected o May reveal inside information that scotia management was concerned that net income would not stand full amount of needed provision o Would cause negative effect to companies shares
•
Market might respond positively because scotia is facing up to problem o Management is taking steps to ensure similar problems will not arise again o Loan quality expected to improve
14. Socially correct amount of information is amount that is equal to marginal social costs and marginal social benefits Cost of Section 404 to shareholders and economy: •
Out of pocket costs to establish, evaluate and audit internal control system
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Manager time and energy devoted, opportunity costs, threatens productivity of firm
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Increased risk to senior managers who certify system as required by 404 o Suffer loss reputation, position possible prosecution
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Reduction in manager incentives to undertake risky projects o If goes wrong increased scrutiny reputation, compensation legal liability
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Less goo earnings management, since managers fear earnings management of any type lead to bad repute that leaders to suspicion and reputation damage and liability
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Overspending on corporate governance and internal controls
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Cost to economy, firms withdraw from capital markets
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Increases costs to monitor and enforce compliance
Benefits to shareholders and the economy: •
Fewer scandals reducing damage to economy and recession caused by investors losing faith in capital markets
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Firms enjoy lower cost of capital, increases share prices and productivity
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Improved corporate governance o If before lower than optimal level o Reduced likelihood of financial reporting failures, more informative earnings report, increased efficiency of compensation controls. Lower agency costs, less influence and power of insiders within firm
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Less bad earnings management
Principle based approach to regulation •
More feasible providing general rules that are laid by regulator and accounts exercise responsible and ethical judgment
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Less than rules
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Auditors and accountants must set aside longer run interests ahead of wishes of clients who want to behave opportunistically
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Have more legal liability
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Easier to defend oneself if can shown that clear rule which was followed
Chapter 4: Efficient Securities Market 1. Two firms same size, report results of same net income, one stock rose the other hardly.
Can be explained by the difference in the market’s expectations of earnings. •
The net income of firm that had strong reaction may have been higher than expectations
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Net income of other may have been lower than expectations
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Another reason could be quality of earnings o One firm may have used different accounting policies o One may have used declining balance (superior disclosure) other may have used straightline amortization (minimal disclosure) o Ones accounting policies more informative the probabilities of information system higher. A stronger market response
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Informativness of prices could have been different between the two o One whose share price only slightly changed may have released more information during the year, quarterly reports, forecasts, so the efficient market already build information into the share price
5. Reason why 1992, fourth quarter earnings came in lower •
For whole year Earnings were lower end of analysts forecasts
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Expected 1992 earnings were already built into the firms share price by the efficient market
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Actual earnings were lower than expectations would cause share price to fall as investors revised downwards beliefs about firms future
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GE’s earnings quality may have changed
o Perhaps switched to less informative accounting policies in 1992 o Efficient market did not know until 1992 earnings were released o Could trigger decline in share price •
Noise traders o May have been large supply of GE shares coming to the market due to random factors
•
Downturn in stock market on day or earnings announcement o Would exert pressure on share prices including GE
Higher GE beta, greater downward pressure
CAPM New earning information along with downturn in market lowered investor’s prior expectations of GE future profitability •
Market expectation of P+D fell
•
E(R0 is determined by Rf, B and e(M) none of which is directly affected by new earnings information, the current price P in the denominator or equation must fall to restore E(R) from this equation with E(R)j given by equation
•
Efficient securities market theory suggest that market will see through declining balance policy and will not penalize the firm
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For resulting lower net income reported
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There will be no loss in market value
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For market to see through firm depreciation policy must be disclosed
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Declining balance method has potential advantages
8.
o Since capital assets are amortized quickly under declining method,, serves as hedge against obsolesce o Conservative policies signs of credible signal that firm future earnings power stand the higher depreciation charges o May cause investors to place higher value on firm so that market price of company’s shares could actually rise, rather than fall as result of conservative policy
Chapter 5: the information approach 5. Why is it desirable to find exact time market first became aware of an item of accounting information if any security price reaction to this information is to be detected? •
Efficient market will react quickly to new information
•
If researcher look for a market reaction even within a few days too early or too late, reaction may not be found even though it may have exisited
Can it be found? •
Exact time can be found sometimes, but not always
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Earnings announcement, date of publication of earning financial press or dates of conferences announcing current earning are acceptable event dates
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Exact date on which market became aware of information in financial statement can be difficulty or next to impossible to find
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Given the dates of new reports, forecasts by officials there are many leaks whereby market learns of information early, then difficult to find
What can researchers do when exact date cannot be located? •
Narrow window which share response is evaluated can be widened
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35 day window centered around day 0 may be used to capture possibility that market may have learned the earning information a day or two early or late
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or can monitor over a course of weeks and months leading up to and possibly following the formal information announcement
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it may be claimed that least there is correlation between abnormal market return and unexpected accounting information
6. Negative ERC possible? Why or why not •
it is possible
•
means firm reported positive unexpected earnings but the abnormal share return to these earnings is negative and vice versa
•
example o cisco reported earning but its share price fell because of other less favourable information that accompanied its reports o Earning news was no longer interpreted as good in the light of additional information
16. Efficient securities market theory to explain rise in share price on May 1, 2001 and then rapid subsequent fall in price •
Initial rise occurred because o Reported earnings exceeded analyst expectations, since analysts earnings expectation forecasts are proxy for investor expectations, investors raised probabilities’ for high future firm performance when earning exceeded actual forecasts o Rise in share price was reinforced by CEO comment that firm is pleased to deliver double digit earnings growth, suggested reasonable persistence in company’s increased earnings
Fall in share price •
Due to markets realization that persistence in company earnings was less than believed due to the one time gain in operating earnings
•
Theory financial statement probably released shortly after and the one time item was disclosed
Was company correct in including the one time gain of 8 million in net income? •
Yes , because it required by IAS 1 to include gains and losses fro sales of assets in net income
•
Went wrong was not to disclose detail of this low persistence item
Persistence •
Is low, inclusion of one time gain lower persistence of operating earnings
•
If one time gain is excluded the company earnings per share were lower than the same quarter during previous year
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If trend continues even the gain excluded earning will not persist
