Session 3 - Lecture 2
Financial markets and accounting
The role and (efficient) functioning of financial markets; The need for accounting given frictions that
hamper an efficient functioning of financial markets (the problem); Accounting choices and their
relation to the aforementioned frictions (the solution).
Financial Markets:
Matching capital to ideas/projects
Frictions in markets:
● Effects:
○ No efficient allocation
■ Too costly so you get less than desired
■ Too costly so you won’t get financed at all - standard supply and demand
doesn’t work for financial market because if a company is willing to pay a
higher interest the bank assumes that they will have a high risk so they don’t
give the loan
○ Complete breakdown
■ Potential of more informed players – Lemon problem
■ When you don’t know the value of something you will always “lose” when
bargaining.
● Sources:
○ Asymmetric information
■ One party knows more than the other
■ Source of information asymmetry: specialization
■ Why specialization: results in efficiency gains by / increase in productivity
■ Problem? The other has no way of knowing whether or not the job is done
right since he/she doesn’t have the same knowledge
○ Misaligned incentives
■ Arises from separation of ownership and control - Agency problem
■ Why? Risk sharing / limited liability / continuity, the company doesn’t stop
existing when the owners stops
1
, ■ Problem? Person in control (agent) has more information about decisions
and financials than the person who has ownership (principal). The agent may
act on his own behalf instead of behalf of the principal and the principal has
limited knowledge of this.
Information asymmetry:
● Ex ante - before the contract is made:
○ Adverse selection – Hidden information
■ The agent knows more about his/her characteristics so the principal has a
hard time determining which characteristics the agent has
■ Insurance, only people who know that they need insurance will buy
insurance. They self-select since they know more about themselves than the
insurance company.
○ Reduce information asymmetry via
■ Accounting
● Ex post - after the contract is made:
○ Moral hazard – Hidden action
■ The agent knows more about his/her actions/motivation so the principal has
a hard time determining whether or not the agent did a good job / worked
hard
■ Limited downward and unlimited upward potential problems
■ The potential of moral hazard makes that people anticipate this and that
leads to fewer efficient transactions
○ Align incentives via
■ Contracting, complete contracts however are impossible, future cannot be
predicted.
■ Monitoring
■ Compensation
Accounting (solution to main frictions):
● Stewardship - contracting role
○ Provide information so that firms can be monitored and that contracts are as efficient
as possible
○ Aims for the alignment of the objectives of the shareholders and the managers
○ Emphasis on reliability and conservatism
○ Best allocation of capital within the firm
● Valuation role
○ Reduce information asymmetry between in- and outsiders (shareholders)
○ Emphasis on relevance and timeliness
○ Best allocation of capital outside of the firm
● Limitations
○ Agent is still involved in preparing the accounting information
■ Need for auditors
2
, ○ There is no perfect alternative
Fields et al. (2001)
“Empirical research on accounting choice"
Accounting choice: decision whose primary purpose is to influence (either in form or substance)
the output of the accounting system in a particular way. Managerial intent is key to this definition of
accounting choice.
Agency costs: generally related to contractual issues such as managerial compensation and debt
covenants. The primary function of which is to alleviate agency costs by better aligning the incentives
of the parties.
Information asymmetries: the relation between (better informed) managers and (less well
informed) investors (e.g. timing, magnitude, and risk of future cash flows).
Externalities affecting non-contracting parties: third-party contractual and non-contractual
relations. By influencing the story told by the accounting numbers, managers hope to influence the
decisions of these third parties.
Earnings management: when managers exercise their discretion over the accounting numbers
with or without restrictions (firm value maximizing or opportunistic). Rational managers would not
engage in earnings management in the absence of expected benefits implying that managers do not
believe that information markets are perfect.
Efficient contracting: suggests that, although financial reporting discretion may allow managers to
increase their compensation, such discretion also improves the alignment of their interests with those
of shareholders. For example, higher accounting earnings that drive higher compensation levels may
also result in higher share values or lower probabilities of bond covenant violations.
Li & Shroff (2010)
"Financial reporting quality and economic growth”
Reporting quality: improves project identification and selection, and lowers the cost of capital,
translating into faster growth. Reporting quality mitigates information uncertainty and therefore
makes decision-making less difficult and decreases agency problems. High information uncertainty
industries grow disproportionally faster in countries with better reporting quality
Three roles of financial reporting in impacting economic performance:
- Used by managers and investors to identify good versus bad projects.
- Can serve as a control mechanism that gives managers incentives to direct resources toward
projects identified as good and away from projects identified as bad.
- Could reduce information uncertainty and lower the cost of both equity and debt capital.
3
Financial markets and accounting
The role and (efficient) functioning of financial markets; The need for accounting given frictions that
hamper an efficient functioning of financial markets (the problem); Accounting choices and their
relation to the aforementioned frictions (the solution).
Financial Markets:
Matching capital to ideas/projects
Frictions in markets:
● Effects:
○ No efficient allocation
■ Too costly so you get less than desired
■ Too costly so you won’t get financed at all - standard supply and demand
doesn’t work for financial market because if a company is willing to pay a
higher interest the bank assumes that they will have a high risk so they don’t
give the loan
○ Complete breakdown
■ Potential of more informed players – Lemon problem
■ When you don’t know the value of something you will always “lose” when
bargaining.
● Sources:
○ Asymmetric information
■ One party knows more than the other
■ Source of information asymmetry: specialization
■ Why specialization: results in efficiency gains by / increase in productivity
■ Problem? The other has no way of knowing whether or not the job is done
right since he/she doesn’t have the same knowledge
○ Misaligned incentives
■ Arises from separation of ownership and control - Agency problem
■ Why? Risk sharing / limited liability / continuity, the company doesn’t stop
existing when the owners stops
1
, ■ Problem? Person in control (agent) has more information about decisions
and financials than the person who has ownership (principal). The agent may
act on his own behalf instead of behalf of the principal and the principal has
limited knowledge of this.
Information asymmetry:
● Ex ante - before the contract is made:
○ Adverse selection – Hidden information
■ The agent knows more about his/her characteristics so the principal has a
hard time determining which characteristics the agent has
■ Insurance, only people who know that they need insurance will buy
insurance. They self-select since they know more about themselves than the
insurance company.
○ Reduce information asymmetry via
■ Accounting
● Ex post - after the contract is made:
○ Moral hazard – Hidden action
■ The agent knows more about his/her actions/motivation so the principal has
a hard time determining whether or not the agent did a good job / worked
hard
■ Limited downward and unlimited upward potential problems
■ The potential of moral hazard makes that people anticipate this and that
leads to fewer efficient transactions
○ Align incentives via
■ Contracting, complete contracts however are impossible, future cannot be
predicted.
■ Monitoring
■ Compensation
Accounting (solution to main frictions):
● Stewardship - contracting role
○ Provide information so that firms can be monitored and that contracts are as efficient
as possible
○ Aims for the alignment of the objectives of the shareholders and the managers
○ Emphasis on reliability and conservatism
○ Best allocation of capital within the firm
● Valuation role
○ Reduce information asymmetry between in- and outsiders (shareholders)
○ Emphasis on relevance and timeliness
○ Best allocation of capital outside of the firm
● Limitations
○ Agent is still involved in preparing the accounting information
■ Need for auditors
2
, ○ There is no perfect alternative
Fields et al. (2001)
“Empirical research on accounting choice"
Accounting choice: decision whose primary purpose is to influence (either in form or substance)
the output of the accounting system in a particular way. Managerial intent is key to this definition of
accounting choice.
Agency costs: generally related to contractual issues such as managerial compensation and debt
covenants. The primary function of which is to alleviate agency costs by better aligning the incentives
of the parties.
Information asymmetries: the relation between (better informed) managers and (less well
informed) investors (e.g. timing, magnitude, and risk of future cash flows).
Externalities affecting non-contracting parties: third-party contractual and non-contractual
relations. By influencing the story told by the accounting numbers, managers hope to influence the
decisions of these third parties.
Earnings management: when managers exercise their discretion over the accounting numbers
with or without restrictions (firm value maximizing or opportunistic). Rational managers would not
engage in earnings management in the absence of expected benefits implying that managers do not
believe that information markets are perfect.
Efficient contracting: suggests that, although financial reporting discretion may allow managers to
increase their compensation, such discretion also improves the alignment of their interests with those
of shareholders. For example, higher accounting earnings that drive higher compensation levels may
also result in higher share values or lower probabilities of bond covenant violations.
Li & Shroff (2010)
"Financial reporting quality and economic growth”
Reporting quality: improves project identification and selection, and lowers the cost of capital,
translating into faster growth. Reporting quality mitigates information uncertainty and therefore
makes decision-making less difficult and decreases agency problems. High information uncertainty
industries grow disproportionally faster in countries with better reporting quality
Three roles of financial reporting in impacting economic performance:
- Used by managers and investors to identify good versus bad projects.
- Can serve as a control mechanism that gives managers incentives to direct resources toward
projects identified as good and away from projects identified as bad.
- Could reduce information uncertainty and lower the cost of both equity and debt capital.
3
