instructor manual scott ch.12

Instructor’s Manual—Chapter 12

Copyright © 2009 Pearson Education Canada

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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 Private Incentives for Information Production

12.4.1 Contractual Incentives for Information Production

12.4.2 Market-Based Incentives for Information Production

12.4.3 Securities Market Response to Full Disclosure

12.5 A Closer Look at Market-based Incentives

12.5.1 The Disclosure Principle

12.5.2 Signalling

12.5.3 Financial Policy as a Signal

12.5.4 Private Information Search

12.5.5 Summary

12.6 Sources of Market Failure

12.6.1 Externalities and Free-Riding

12.6.2 The Adverse Selection Problem

12.6.3 The Moral Hazard Problem



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12.6.4 Unanimity

12.6.5 Summary

12.7 How Much Information Is Enough?

12.8 Decentralized Regulation

12.9 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 1.7.

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. To balance the

discussion, 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. 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



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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.

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 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 12.4.3, in particular the results of Welker

(1995) and Botosan and Plumlee (2002), 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.

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, and why such signals are credible. 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



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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.

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

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.

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. Management’s

objections to the costs of the Sarbanes-Oxley Act illustrate an argument that regulation

can be very costly. Problem 11a of Chapter 13 considers these objections, and could be

discussed at this point.



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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

IAS 14 and SFAS 131 relate to what I call decentralized regulation of segment

reporting. Section 1701 of the CICA Handbook uses the term “management approach”

for the same concept. 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

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 will be interesting to see the extent that this approach to regulation shows up in other

standards, such as reporting on risk and on financial instruments. This approach also

appears in IAS 39’s provisions on macro hedging, where, if the firm adopts macro

hedging, it must use this approach internally and report to management on this basis—

see Section 7.3.5.



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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.

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, higher fees paid

to a more prestigious 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 transparent, that is, it 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,



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consistent with empirical results, such as 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 a signal reduced, since the scope for signalling is confined to the

extent the firm goes beyond the minimum requirements of the mandated

forecast.

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.



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3. 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 9.4.2, when we considered an

owner renting the firm to the manager for $51. The owner did not care about the

level of effort exerted by the manager because the owner receives rent of $51

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. If we view forward-looking information and risk disclosure in MD&A

as a direct signal, the information content consists of the firm’s expectations of

future operations and the various risks it sees going forward. The credibility of

such a direct signal derives from the MD&A regulations, which may penalize

firms for misleading or incomplete disclosures. Credibility is further increased by

the prospect of adverse investor reaction should future expectations not be

realized and/or should the firm suffer from risks that had not been disclosed.

For an indirect signal, it is the act of superior disclosure itself, which has

information content beyond the information in the disclosure itself. Superior

disclosure suggests a confident management that knows what its future plans

are and has concrete plans to get there in the face of the various risks it faces.

Such disclosure increases investor confidence in good future firm performance,

even if the news itself reveals unfavourable information such as a poor economic

environment, unfavourable weather, or major risks.



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5. (i) 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 opportunistic (i.e.,

“bad”) 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 available

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.



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6. 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

mixed measurement model 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, relative

to historical cost-based valuation. This information can be produced either as

supplementary information (information approach) or in the financial statements

proper (measurement approach).

(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



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audit fees paid, the number of audit hours, and so on. Hopefully, any

opportunistic 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.

7. a. 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 useful 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 useful 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.



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Other forces derive from regulations, such as legal penalties, regulations

requiring information to be released to all parties simultaneously, 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.

8. a. 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.

• To enable insider trading profits.

• To postpone damage to reputation.

b. 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.

• There is no cost to the firm of releasing the information.

• Market forces and/or penalties ensure that the information released

is truthful.



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• 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.

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. The motivation to release non-

proprietary information arises from its effect on firm value (Pae,

2005).

• When GAAP quality is not too high, information that goes beyond

mandated information disclosure will only be disclosed voluntarily if

it exceeds a threshold (Einhorn, 2005).

• 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)).



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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.

9. a. 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

two 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.

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

adverse selection problem.

b. Investors will perceive greater estimation risk with respect to Newbridge.

The following effects would be expected:



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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

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 without directly releasing proprietary

information about future firm prospects.

• 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 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.



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• 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.

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.

• 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



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intention constitutes exploitation of this information at the expense of outside

investors.

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.

Share prices of all firms 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.



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• 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.

• 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.

12. a. The executive share purchase conveyed favourable inside information

about the future prospects of the company. Yes, the purchase constituted a

credible signal, as evidenced by the strong market response. Investors believed

that it would not be rational for the Imax executives to buy these shares unless

they believed the company’s future prospects were favourable.

b. The market failures are adverse selection and moral hazard. It seems that

despite their 2004 share purchases, Imax managers adopted accounting policies

to overstate earnings, thereby compromising the interests of debtholders and

shareholders (adverse selection). By overstating earnings, management may

have also been attempting to cover up shirking (moral hazard). These policies



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constitute market failures because information about actual profitability was

retained as inside information, resulting in the overstatement of Imax share price

for several years.

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

this time could be interpreted as an attempt to report what

management felt was Imax’s persistent earning power.

• Management may have been low type (i.e., they expected that

future firm prospects were unfavourable) but were willing to pay the

extra cost to signal high type. Perhaps they had plans to sell the

shares later as share price rose due to the earnings management

and consequent higher reported profits. Perhaps higher share price

would increase their compensation.

• Management may have wanted to increase its motivation to work

hard, to pull the firm out of deteriorating operating performance.

Increased share holdings would supply additional motivation.

13. 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 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



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driving force behind opportunistic 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 reducing estimation risk, increasing public confidence and,

presumably, increasing its share price.

• 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 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, reported net income will be less reliable relative to its

reliability if ESO cost is reported in the notes.

• Compensation contract efficiency. To the extent that expensing



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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.

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

per share dividends. Dividends per share will be 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 and lower estimation risk. 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.

• Investors not fully rational and securities markets less than fully

efficient. To the extent they are not fully rational, investors may not

notice ESO expense disclosure in the notes (e.g., limited attention).

Since ESOs are a valid expense, they may thus overestimate firm



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profitability, leading to overstated share price. 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.

14. 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

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 Jones less after going public, so, other things equal, he will

engage in more of it.

Yes, the amount received for the new share issue will be affected. 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.

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, 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



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profits, so as to credibly inform the new shareholders of his expected level

of future earnings.

15. a. The market failure derives from adverse selection. Investors felt that

managers were engaging in selective disclosure. That is, inside information was

released to certain individuals, such as analysts, who had the opportunity to take

advantage of it before passing it on to the market. This practice increased

estimation risk for ordinary investors, causing them to lower the amount they

were willing to pay for all shares and, in extreme cases, leave the market. In

effect, the market was not working as well as it should.

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

bid-ask spread will be affected. The depth component of market liquidity will fall

as ordinary investors leave the market. The bid-ask spread component will rise

as dealers (who set the spread) and 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 their expense.

Liquidity is important if markets are to work well because:

• Market liquidity (depth) enables large investors to buy and sell large

blocks of shares without affecting the market price. If large investors

cannot do this, their demand for shares will fall, since they will have to pay

more to buy and will receive less if they sell. Lower demand exerts

downward influence on share prices.

• Increased bid-ask spread increases transactions costs for investors,

further lowering demand for shares.

• Lower market liquidity, and lower share prices that follows, increases

firms’ costs of capital, with negative effects on the economy.

c. Sources of costs resulting from Regulation FD:



411

• Potential litigation cost resulting from contravening Regulation FD. Such

contravention could be inadvertent, resulting, say, from a casual comment

by a firm manager to an institutional investor.

• Costs of meeting the regulation, such as policies and procedures to

communicate information widely, including conference calls and web page

design and operation.

• The cost of a bureaucracy to enforce the regulation.

• An increase in expected costs of litigation from failure to meet forecasts. If

a 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 forecast

and recommendations, the analyst will bear some of the costs of not

meeting the forecast.

• Increase in private information search costs. To the extent that analysts

spend more time to develop their own firm-specific information, rather than

having it handed to them by the firm, costs of private information search

will increase. That is, several analysts may incur costs to discover the

same information.



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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 by “talking down” the analysts 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, helping to counteract the effects of lower

earnings.

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.

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. The market does not work as well as it might with selective disclosure.

Selective disclosure increases investors’ estimation risk and their perceptions

that the market is not a level playing field. The resulting is a decrease in market

liquidity, with negative effects on share prices, firms’ costs of capital, and the

efficiency of capital allocation in the economy.



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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, the possibility existed. Thus investors do not

regard the market as a level playing field. This causes harm to the 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.

17. a. 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 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 management’s building of a reputation for full disclosure

and/or by increasing audit quality. 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.



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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. Release of this information may

adversely affect future cash flows.

• Legal costs. To the extent the increased disclosure consists of forward-

looking information, failure to meet the disclosed targets may result in

litigation and legal costs.

18. a. 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



415

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

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



416

to responsibly reveal persistent earning power (i.e., “good” earnings

management) and to signal.

• 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.

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.

19. 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

and backdating contracts could occur with any revenue recognition standard

short of waiting until cash was collected.

c. Reasons why a manager would overstate current period revenue:

• The bonus plan and debt covenant hypotheses both predict that a

manager will choose accounting policies to move earnings from future

accounting periods to the current period. This will increase the manager’s

current compensation and reduce the probability of debt covenant

violation. Increasing current period’s revenue, as Mr. Kumar did, could

accomplish both of these objectives.

• To meet investors’ earnings expectations.

The bonus plan and debt covenant explanations seem unlikely to apply here.

Given Mr. Kumar’s brilliance and hard work, his compensation must have



417

reflected this. It is unlikely that a desire to manage earnings so as to obtain

additional compensation, or to cover up shirking, drove the revenue

manipulations. Furthermore, nothing is said to indicate any concerns about

Computer Associates’ debt covenants and, as the question indicates, the

company still operates.

A desire to meet earnings expectations seems the most likely reason. Mr. Kumar

obviously valued his reputation, and must have felt that failure to meet earnings

expectations would tarnish his reputation. He may also have felt that low current

earnings were temporary, and that increased future business would enable the

reversal of the premature revenue recognition to be covered up.

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.

Upon learning of the fraud, implying that in fact Computer Associates had not met

earnings expectations, investors would revise downwards their probabilities of

good future firm performance. They would also increase their perception of

estimation risk. For both reasons, they would bid down the price of Computer

Associates’ shares.

With respect to the operation of securities markets, they would operate less well.

Investors would increase their concerns that if a fraud such as this could occur in

one firm, it could occur in others. In effect, fear of “lemons” becomes greater (i.e.,

pooling). Thus, the increase in estimation risk would spread to all firms. This

would increase firms’ costs of capital, make it more difficult for new firms to enter

the market, and reduce the efficiency of capital allocation in the economy.



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20. a. Costs to firms that issue quarterly earnings forecasts:

• Direct costs of preparing the forecast. However, these costs are likely to

be incurred regardless of discontinuance, to the extent the firm forecasts

for internal use.

• Earnings forecasts may reveal proprietary information of value to

competitors, since they convey management’s expectations about future

operations.

• Issuance of quarterly earnings forecasts may lead to a short-term

manager decision horizon whereby longer-term activities are sacrificed in

order to meet the short-term earnings objectives. Examples include cutting

of R&D and postponing capital expenditures.

• Possible lawsuits if earnings targets are not met.

• Managers may engage in opportunistic earnings management in order to

meet earnings targets. This will harm the firm through lower share price

(and the manager through lower reputation) when the earnings

management is discovered.

b. Benefits to firms that issue quarterly earnings forecasts:

• Lower estimation risk, leading to greater investor confidence, an increase

in the number of investors in the firm’s shares, and lower cost of capital.

This benefit is predicted theoretically by Diamong and Verrecchia (1991),

and Easley and O’Hara (2004).

• Motivation of managers to work hard to meet laid-down earnings targets.



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• Greater analyst following, leading to increased investor interest. Lang and

Lundholm (1996) found that high quality disclosure was accompanied by a

larger number of analysts following the firm. The theoretical model of

Merton (1987) then predicts greater demand for the firm’s shares leading

to lower cost of capital.

• Earnings forecasts have signalling properties, thereby providing a credible

vehicle for managers to communicate their earnings expectations. The

credibility of a forecast derives from the fact that its accuracy can be

readily verified after the fact. Consequently, a low type firm would be

foolish to issue a high type forecast.

c. Reasons why the market penalizes the share price of firms that do not

meet their earnings targets:

• Investors revise downwards their probabilities of good future firm

performance. This downward revision triggers sell decisions, leading to a

decline in share price.

• Investors know that managers have strong incentives to meet earnings

targets, and have a variety of earnings management devices to assist in

meeting them. If the manager cannot find enough earnings management

to do this, the firm’s earnings outlook must be bleak.

• Failure to meet earnings targets may suggest poor management in the

sense that management may not be able to accurately predict the firm’s

future.

Investors must have known that management had the 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 costs of disclosure, outlined in part b. According to Verrecchia



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(1893), Pae (2005), and Einhorn (2005), disclosure costs create a threshold. To

be released voluntarily, information must be sufficiently good news that it

exceeds the threshold. In view of the high costs of failing to meet earnings

forecasts, management must have concluded that no matter how good the

forecasted earnings might be, the costs were sufficiently high that the threshold

was not exceeded.

d. Reasons for use of real variables rather than accruals to manage earnings:

• Managers may be afraid of reputation damage, legal liability, and possible

jail sentences for accrual-based earnings management.

• Accruals reverse. This makes earnings in future years increasingly difficult.

• Short decision horizon. If the manager has a short decision horizon,

he/she may not be concerned about the longer-term consequences of

cutting R&D and marketing costs to meet earnings targets.

• Use of real variables frees up working capital, whereas accruals (except

for possible tax effects) do not affect cash flows.

21. 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

stock market collapse, due to its manufacturing operations such

as industrial and medical equipment. GE’s diversification across

many different activities reduces the force of this argument,

however.

• Estimation risk. GE is such a large and complex firm that it is



421

difficult even for analysts to be familiar with the totality of its

operations, particularly since it had not disclosed much detailed

segment information in the past. Also, it was widely known to

practice earnings management (see Chapter 11, Question 9).

Given numerous financial reporting failures, such as Enron and

WorldCom, investors were unable to be sure that GE was not

using similar tactics.

Reasons why increased disclosure exerts upwards influence on share price:

• Reduced estimation risk, as investors respond the firm’s greater

transparency. Even if the increased disclosures are bad news, the

release of this information will help to counteract any ddirect effects

of the information on share price.

• Signal. Increased disclosure can be interpreted as a signal, since a

company would be less likely to disclose more if the increased

disclosure was of bad news.

b. GE’s SPE disclosures, increased earnings announcement disclosures,

and its early adoption of ESO expensing should help to increase its share price.

Since abuse of SPEs by Enron was particularly salient in investors’ minds at the

time, increased disclosure of GE’s SPE policies would be effective in reducing

investor estimation risk. Increased earnings announcement disclosures would be

of direct usefulness to investors in predicting GE’s future firm performance, and

would also reduce estimation risk. Also, increased earnings announcement

disclosures and early adoption of ESO expensing would have signalling

properties, since the company would be foolish to adopt these policies if it felt

earnings were going to fall.

c. Increased segment disclosures will certainly 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 segment disclosure, will reduce these concerns.



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Also, SFAS 131 requires segments to be reported on a basis consistent with the

firm’s internal organization. Since this basis is of greatest usefulness to investors,

the increase transparency from increased segment disclosure is maximized.

However, the effect of these transparency increases is reduced by GE’s failure to

report separately the earnings of newly-acquired and previously-acquired

subsidiaries. The problem seems to arise because the persistence of earnings is

likely to differ between them. New subsidiaries may come from diverse industries,

with differing earnings persistence characteristics (for example, 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 report separately

complicates the earnings persistence evaluation of GE’s overall earnings.

The market may wish to evaluate the performance of new subsidiaries relative to

the amount paid for them. If GE has paid too much, for example, the effect will be

to reduce GE’s return on capital. Low returns on capital imply lower future

expected earnings. This reduces the persistence of GE’s current earnings.

GE is known to practice earnings management (see Chapter 11, Question 9,

where GE is suspected of increasing its current reported earnings by buying

profitable subsidiaries during the year). Earnings management is a strategy that

was under great suspicion at the time. To the extent that GE’s earnings do not

distinguish between newly-acquired and established businesses, GE’s ability to

practice earnings management is enhanced.

A reasonable conclusion is that GE’s increased segment disclosures will

decrease investor transparency concerns, but the decrease is less than it would

be if GE had separately reported the operations of newly-acquired and

previously-acquired subsidiaries.



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22. a. Costs of increased regulation:

• Direct costs of preparing the additional information and costs of the

bureaucracy needed to enforce the increased regulation.

• Reduced opportunity to signal by voluntary information release.

• Possible release of proprietary information by oil and gas firms.

• Regulator may go too far and impose requirements for which the

social costs are less than the social benefits.

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.

• Reduced risk of market failure due to adverse selection, since less

inside information.

• Reduced risk of market failure due to moral hazard, since more

difficult for managers to disguise shirking on their efforts to maintain

reserve quantities.

b. Reasons to seek exemption from stricter Canadian regulations:

• Lower costs of preparing the information.

• Increased concern about legal liability under the Canadian

regulations, which require additional disclosures, such as for

probable reserves. These would be more subject to error than

proved reserves.

• Company shares may be traded in the United States, in which case

SFAS 69 information would have to be prepared to meet U. S.

reporting requirements. Meeting Canadian reporting requirements in

addition imposes additional costs.

• Investors may be used to the SFAS 69 information and would be

unable/unwilling to learn how to interpret the more complex



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Canadian regulations. This argument would apply especially if

investors are not fully rational.

• Company may have something to hide, and may prefer keeping

certain reserves information inside instead of releasing it publicly

(adverse selection problem)

• Manager may have shirked and wishes to disguise this by avoiding

disclosure of additional reserves information such as probable

reserves (moral hazard problem).

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

firm that does not release this information will be assumed by sceptical investors

to have very low quality reserves. Releasing additional information required by

the Canadian regulations, such as probable reserves, will prevent or reduce this

effect. This will raise share price.

Signalling theory complements this argument. If the firm releases additional

reserves information, the market will realize the firm is committed to high quality

disclosure. This information should be a credible signal since the market realizes

that violation of disclosure regulations imposes high penalties—witness the case

of Blue Range. Also, reserves disclosures must be audited by an independent

professional (see Chapter 2, Question 24). Consequently, share price will rise.



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Additional Problem

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.

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.



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Suggested Solutions 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:

• 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



427

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.

instructor manual scott ch.12

Documents

quantity of information

distribution of information

private information

marketbased incentives

text chapter

financial policy

economic definition

decentralized regulation