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Instructors ManualChapter 12

CHAPTER 12 Standard Setting: Economic Issues 12.1 12.2 12.3 12.4 Overview Regulation of Economic Activity Ways to Characterize Information Production 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 12.8 12.9 How Much Information Is Enough? Decentralized Regulation 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 avoidedit 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. Managements 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, Levs 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 firms 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 39s 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 firms 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 years 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 firms 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 firms 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 firms 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 managers 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 issuers 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 managers 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 nonproprietary 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 firms contracting costs (e.g., a forecasts effect on share price may swamp the ability of share price to reflect manager effort), it may not be in the firms 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 Newbridges 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 Newbridges management.

The liquidity of trading in Newbridges shares will fall. This is due to two effects. First, as investors depart the market for Newbridges 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 Newbridges 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. price:

Other suggested reasons for the decline in Canadian Superiors share

The disclosure principle. The CEOs 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 CEOs 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 Pasos 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 Superiors prospects before investing. This will credibly signal Canadian Superiors 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 wells 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 wells prospects were poor.
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Management could increase its shareholdings, or amend the firms 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 companys 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 Imaxs 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 effortsee 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 Toms 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:
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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 analysts 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 Canadas 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 Canadas cost of capital and managements reservation utility, helping to counteract the effects of lower earnings. b. One reason why Air Canadas 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 Canadas 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 Canadas 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 firms 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 firms shares. Empirical evidence consistent with this prediction is reported by Welker (1995). Increase reporting credibility. Increased credibility of reporting can be attained by managements building of a reputation for full disclosure and/or by increasing audit quality. Increased credibility increases the willingness of investors to buy the firms 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 forwardlooking information, failure to meet the disclosed targets may result in litigation and legal costs.

18.

a.

Yes, the disclosure reduction will reduce the markets ability to evaluate

CIBCs earnings persistence. This is because the realized gains on the Global Crossing investment, being unusual and non-recurring, are of lower persistence than CIBCs operating earnings. Burying these realized gains in operations thus removes the markets ability to separately identify them. b. It seems that CIBCs 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 CIBCs 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 banks 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
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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 markets reaction will depend on whether it perceives

CIBCs 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 markets 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 markets reaction will be unfavourable. The article reveals both opinions. James Bantis complains that the quality and transparency of CIBCs earnings will be reduced. Other analysts, however, are reported as in favour of CIBCs 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
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to responsibly reveal persistent earning power (i.e., good earnings management) and to signal. To the extent the market reacts negatively to CIBCs 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 managers current compensation and reduce the probability of debt covenant violation. Increasing current periods 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. Kumars brilliance and hard work, his compensation must have
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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 managements 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 firms shares, and lower cost of capital. This benefit is predicted theoretically by Diamong and Verrecchia (1991), and Easley and OHara (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 firms 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 firms 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 firms 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 GEs share price: Systematic risk. Because of the U.S. recession of the early 2000s, the whole market fell, dragging GEs 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. GEs 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
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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 firms 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. GEs 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 GEs SPE policies would be effective in reducing investor estimation risk. Increased earnings announcement disclosures would be of direct usefulness to investors in predicting GEs 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 GEs 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 firms 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 GEs 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 GEs 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 GEs return on capital. Low returns on capital imply lower future expected earnings. This reduces the persistence of GEs 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 GEs earnings do not distinguish between newly-acquired and established businesses, GEs ability to practice earnings management is enhanced. A reasonable conclusion is that GEs 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 penaltieswitness 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 firms 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 firms share price accordingly. To avoid this, the manager will release all but the worst possible information. For the disclosure principle to explain DaimlerChryslers 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
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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 DaimlerChryslers 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.

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