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Accounting Information - Complex Commodity & Information Asymmetry

What is Information?

• It is a COMPLEX commodity

• Investors are demanders/managers the suppliers

o Should we let the rules of supply and demand determine the amount of information provided (no regulation)?

o Should there be regulation to protect investors as market forces fail to ensure investors have adequate information?

o Currently, we have regulation= standard setting

o But how much regulation is required? How much is too much?

• Information impacts not only individual decision making but the efficiency of the market

• Currently we report most assets and liabilities at historical but there has been movement towards more market values- therefore we have a mixed measurement system.

o Investors prefer current values as they are more relevant- they provide the best available indication of future firm performance and investment returns.

o Management prefers not to include unrealized gain/ losses as it increases volatility- and they do not believe this reflect their performance

• So as accountants our role is to manage the expectations of many parties- and to have a critical awareness of the impact of financial reporting on investors, managers and the economy.

? We need to design and implement concepts and standards that best trade off the investor informing and manager performance evaluating roles for accounting information

Information Asymmetry

• When one party has an information advantage over another.

1. Adverse Selection

- “where by one or more parties have an info advantage over others”

- Occurs because insider of the firm (Managers) know more about the current condition and future prospect of the firm than investors

- They can exploit this advantage by managing the info released to investors – often to increase/maintain the value of the stock options they hold i.e. Enron management were selling their stock and telling employees to hold on to theirs.....

- Called Adverse as it reduces an investors ability to make good investment decisions and impairs the functioning of Capital markets

- Example: “Insider Trading” i.e. Martha Stewart- her friend Sam Walker from Imclone knew that an important cancer drug was rejected by the FDA- this was a huge blow to Imclone and once announced it was expected the share price would drop- Martha wasn’t hurt by the decline because she sold her shares before the info became public....therefore information asymmetry!

Clarification: Is all Insider Trading illegal?

• No- Trades by insiders can be legal if reported to the securities exchange commissions within a predetermined time frame.

• This way if it is reported to the public, it can be interpreted as a signal …

• Studies show that the buying and selling by insiders is valuable information. When an insider buys or sells, they may know something the public doesn’t – generally when an exec purchases the co. shares, the co. outperforms the market by approx. 10% over a 12 month period. Conversely when execs sold, co. performed 5-6% below market.

2. Moral Hazard

• Where one or more parties observe their actions but other parties cannot

• Caused by separation of ownership/ control

• Consider, if there were no exams, how hard would you study? How would instructor be able to evaluate effort?

• This is very popular in insurance industry. If car insurance covered 100% of your car- with no cost to you- what would stop you from not leaving it running with the doors open? If you don’t suffer any consequences- why mitigate any loss--- this is why there is a deductible= moral hazard

• I.e. how do shareholders know management is working hard on their behalf since they cannot observe their behaviour on a day to day basis?

• Management net income, like insurance deductables, is usually considered a measure of management performance to control moral hazard- first net income is usually used as an input to management compensation contracts and second it can inform the labour market if a manager shirks and he/ she will suffer a loss on income/ reputation.

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