transparency and intermediaries

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Week 5: T ransparencies and Intermediaries

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8/3/2019 Transparency and Intermediaries

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Week 5: 

Transparencies andIntermediaries

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Information Asymmetry andMarket for Lemons

Akerlof (1970)

The market for used cars

Car A: $ 3,000

Car B: $ 1,600

Car C: $ 200

The sellers know the quality and value but the buyers do not.

What might happen?

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Information Asymmetry andMarket for Lemons cont’ 

Buyers are willing to pay a price no more than the average valueof all used cars if they do not know the quality of each car.

Sellers of good cars would not enter the market because of

anticipating such results; thus only the worst cars are in themarket.

The whole market virtually collapses if the extent of informationasymmetry is serious.

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Information Asymmetry andMarket for Lemons cont’ 

Information asymmetry: the sellers know better about the qualityof products than the buyers

Examples: used car markets, job hunting, stock offerings

Stock prices decline upon the announcements of new shareofferings-- because of information asymmetry, some stocks areovervalued, while others are undervalued-- undervalued firms are reluctant to issue new shares

-- new share offering announcements signal to the market thatthose offering firms are overvalued

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Information Asymmetry andMarket for Lemons cont’ 

Discussion question:

Are there any mechanisms to overcome the problems caused byinformation asymmetry?

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Information Asymmetry andMarket for Lemons cont’ 

Provide guarantees / warranties

e.g., free labor and parts in 2 years after purchasing

Quality assurance / ratings

e.g., credit rating for corporate bonds Signal

e.g., manager-owner retain a large fraction of ownership after IPO; hireprestigious investment banks and accounting firms

Information disclosure

e.g., prospectus, periodical reports, voluntary disclosure

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Information Disclosure and CorporateGovernance

Sunshine is the best disinfectant

To effectively monitor managers, outsiders needinformation about the companye.g., shareholders can reward or penalize managers based onoperating performance disclosed in annual reports

Outside investors also need information to evaluate

securities valuee.g., before the passage of SOX, securities regulations in US aremainly about information disclosure

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Information Disclosure and CorporateGovernance cont’ 

Information disclosure made by public companies

-- mandated disclosure: disclosure required by legislation orregulatory agencies

e.g., prospectus, annual reports, interim reports

-- voluntary disclosure: disclosure above the mandated minimum

e.g., management forecast, analysts‟ presentations and conference

calls, press releases, internet sites, and other corporate reports

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Voluntary Disclosure

Motives for voluntary disclosure

-- Public equity or debt offers are costly because of informationasymmetry. Managers who expect to make capital market transactionshave incentives to provide voluntary disclosuree.g.: firms often increase information disclosures prior to stock offerings

-- Stock-based compensation plans provide incentives for managers toengage in voluntary disclosure

-- Legal actions against managers for inadequate or untimelydisclosures can encourage firms to increase voluntary disclosure

e.g.: firms tend to accelerate the release of unfavorable news

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Voluntary Disclosure cont’ 

Empirical evidence generally supports the notion that voluntarydisclosure is credible

-- management forecasts have comparable credibility to auditedfinancial information

e.g., Positive (negative) stock price reactions to management forecastsof earnings increases (decreases);

Management forecasts are more accurate than analysts‟ forecasts 

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Voluntary Disclosure cont’ 

Consequences of voluntary disclosure

-- improved stock liquidity

e.g., increased analyst rating of disclosure leads to lower bid-ask spread

-- reduced cost of capitale.g., Botosan (1997) finds that for firms with low analyst following, thereis a negative relation between cost of equity capital and the extent oftheir voluntary disclosure

-- increased institutional ownership

-- increased analysts‟ following 

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“More Specifics Would Help Hang Seng Bank”

(Oct 3, 2008, Dow Jones Newswires)

-- Washington Mutual Bank: the 6th largest bank in

the U.S., and the largest savings and loan association

-- It filed for bankruptcy on Sep 26, 2008 amid the

financial crisis-- several local banks in Hong Kong held debt issued byWaMu, and are likely to incur losses because of itsbankruptcy

-- Hang Seng announced that it held WaMu debt but didnot disclose the details; instead, it suggested that theexposure was „immaterial‟ 

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-- the stock price of Hang Seng declined by about

9% on a single day, or the market value is reduced

by about 15 billion, although its exposure to WaMudebt could be a small fraction of its asset base

-- Dah Sing Bank provided detailed information about itsexposure to WaMu, and the stock price declined by

about 9% upon the announcement

-- Both banks experienced a similar magnitude of stockprice decline although WaMu debt is a much smaller

portion of assets in Hang Seng than in Dah Sing

-- The lesson: no disclosure makes people to assumethe worst

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Mandated Disclosure

Annual report

-- it is regulated

-- includes financial statements, footnotes, managementdiscussion and analysis

-- major financial statements: income statement, balance sheet,and cash flow statement

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Mandated Disclosure cont’ 

Regulation of financial reporting

-- financial reporting is regulated by accounting standards

e.g., GAAP (Generally Accepted Accounting Principles), IAS(International Accounting Standards)

-- accounting standards regulate the reporting choices availableto management in presenting the firm‟s financial statements 

-- regulation reduces processing costs for financial statementusers by providing a commonly accepted language thatmanagers can use to communicate with investors

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External Audit

Financial statements in annual reports are usually audited byexternal auditors

-- unintentional errors are possible

-- wrong judgments may occur

-- managers may intentionally misrepresent financial informationto benefit themselves

e.g., manipulate earnings to gain more bonus

-- therefore, auditors play an important governance role

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External Audit cont’ 

Accounting firms:

-- Big International Audit Firms: PWC, Deloitte, Ernst & Young,KPMG… 

-- national or local audit firms

Types of audit opinions

-- Unqualified opinion (clean opinion)

-- Modified opinion

e.g. Qualified opinion

Disclaimer of opinion

Adverse opinion

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External Audit cont’ 

Audit quality: the probability that accounting irregularitiesare discovered and reported by an audit firm

Two determinants

-- auditor ability: the likelihood that a breach isdiscovered by an audit firm

-- auditor independence: the likelihood that an audit firmreports the breach

The chance to discover irregularities depends on theauditor‟s capabilities, the audit procedures employed, the

extent of sampling etc.

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External Audit cont’ 

Factors that affect the independence of auditors

-- competition for audit service

e.g., consent with management

-- non-audit servicee.g., consultancy on taxation issue or IT service

-- tenure

e.g., rotation of partners or accounting firms

-- personal relationshipe.g., former auditor serves as the CFO

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External Audit cont‟ 

Audit quality is on average higher for big audit firms

-- a client‟s economic significance to an auditor affects

auditor independence: a single client is less important to

big auditors than to small auditors-- big auditors provide better training to their staff andthus have greater abilities to discover breaches ofaccounting standards

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External Audit cont’ 

Effectiveness of the audit function: whether the auditadds value for investors and whether auditors‟ actions

are independent of client interest.

-- shareholders consider audited accounting informationto be credible

e.g., stock prices react to earnings announcements

-- providers of capital require companies to appoint anindependent auditor before they will provide funds, evenwithout regulation

e.g., banks may request audited financial information before providingcredit

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External Audit cont’ 

Chen, Su, and Zhao (2000): market reactions to different types ofaudit opinions in China

-- sample firms are divide into two groups, one comprising firmsreceiving clean audit opinions and the other receiving modified

opinions-- market reactions are more negatively to the second group

-- implications: audit opinions are credible and convey newinformation about firm value and governance; thus, audit addsvalue to investors

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Arthur Andersen LLP

Arthur Anderson once was among the big 5 accounting firms inthe world

Before it „voluntarily relinquished‟, it had offices in 84 countries

and 85,000 employees; the income was as large as $9.3 b a year

In early this century, several of its clients were involved inmassive accounting scandals and AA itself was found guilty ofobstructing justice

On August 31, 2002, AA issued a statement that it has voluntarilyrelinquished

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Arthur Andersen LLP cont’ 

-- integrity: gain reputation

e.g., the founder, Arthur Anderson, in the first year (1913) in business,refused to approve a set of questionable books of a railroad;

it resigned all of its clients in the savings and loan industry before the

very accounting tricks AA refused to bless led to a series of massivefailures and several criminal convictions 

-- consistency: tightly control the quality of audit

e.g., „one firm on voice‟, open offices only, no joint accounting firms, in-

house training facilities, consistency in appearance 

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Arthur Andersen LLP cont’ 

Anderson Consulting and conflicts between consulting and auditbusinesses

-- it began as a way to help its clients

-- it became more profitable than audit business in 1970s;

however, the audit side still controls the management

-- one former CEO, Kapnick, suggested a spin-off of theconsultants into a separate firm as a solution; he was rejected byaudit partners and abandoned as a result

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Arthur Andersen LLP cont’ 

-- the audit side set up its own consulting divisions and urged itspartners to increase clients and revenues

-- in April 1997, the audit and consulting sides contested for thecontrol of AA but both failed; later that year, the consulting side

decided to split it off from AA

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Arthur Andersen LLP cont’ 

Causes for AA‟s failure 

-- the stress of growth and revenues over quality

e.g., reluctant to walk away from big clients with questionable accounts

one partner, Carl Bass, was removed from the Enron account at the

request of the client, after he challenged Enron‟s accounting practice -- weakened internal quality control

e.g., Public Review Board made up of outside experts was discontinuedafter the split of the audit and consulting parts

the power of Professional Standards Group (PSG) was severely

diminished after its suggestion to expense stock options was overruledin 1992

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Arthur Andersen LLP cont’ 

-- negligence of independence

e.g., the Independence and Ethics Office did not interfere in the closerelationship between AA‟s auditors and Enron; indeed, the close

relationship with Enron was commended by partners as a model for

other audit clients-- hubris

e.g., AA was confident that it could turn auditors into salespeoplewithout undermining auditor independence;

Even after being involved in a series of accounting scandals before

Enron and Worldcom, it considered each an isolated incident for whichit bore no responsibility instead of reviewing its practice