Information Asymmetry and Corporate Failures in Accounting - Essay Example

? The information asymmetry, corporate failures in contemporary issue in accounting College: Part A. Accounting system andcorporate failures Efficacy of a firm’s accounting and audit system in minimizing agency conflicts depends on whether the accounting principles are well applied and consistent. The practices of accountants and auditors must be consistent and compliant with the standards and regulations issued by governing authorities and regulators such as the GAAP or the Generally Accepted Accounting Principles and many others. Auditor serves the central role in the accounting system; internal auditor can serve the purpose of ensuring that internal control systems are good and also enhance corporate governance. The internal auditor plays a critical role in reducing agency costs by ensuring and assuring that financial reports prepared by the firm are consistent with regulations and standards as expected by the investors (Ahlawat & Lowe 2004, p. 147). There is often a business relationship between the client and the external audit. The firm contracts the auditor to audit and attest to the firm’s accuracy of the financial statements. Corporate failures and major financial scandals like Enron and WorldCom have resulted from poor accounting system where there were information asymmetry between shareholders, investors as well as other outside parties, and the insider parties mainly the management executives and the internal auditors. There is also a business relationship between the auditor and the shareholders who rely on the financial statements prepared by the auditor. Internal audit function works closely with the management in examining internal controls, detecting fraud and advising them in the appropriate remedial measures in case of fraud detection in the system (Sengupta 1998, p. 462). In the vase of internal audit function and audit committees, these auditors are employed by the firm and are therefore paid by their firms, the interaction between the internal auditors and managers as well as the employees can be potential sources of conflict of interest, which may result in the auditors not being fundamentally objective and also compromising their independence. Internal auditors and the dominant senior managers can work together to ensure that their individual interests override those of the firm. In such cases, the financial reports issued to the investors and shareholders may look consistent with accounting standards and principles while being far from the true position of the company. Role of information in the firms’ corporate governance Information plays an important role in facilitating firms’ corporate governance. One of the important issues of corporate governance is the construction of mechanisms that help in aligning objectives of executives with those of the firm’s shareholders (Hermalin & Weisbach 2008). The firms’ board of directors often find themselves heavily tasked with the role of monitoring and advising executives. These boards comprise of internal directors who are the firm’s senior executives and outside directors. Outside directors are essential in bringing independence to the function while the internal directors help in bringing information about the firm’s activities. These directors being insiders or senior executives in the management can hide information where they detect that such information will be utilized in disciplining or taking away the executives private benefits. Information plays an important role in the selection and construction of corporate governance mechanisms that help in aligning actions of managers and senior executives with shareholders’ interests. Information also helps in reducing contracting costs and in the making of strategic decisions. Information asymmetry The internal audit function and the management generally have more information about the firm’s performance than the firm’s shareholders. This information asymmetry can be detrimental to the firm’s performance (LaFond & Watts 2008, p. 447). The nature of firms’ production and investment decisions influence asymmetry of information between the agent and the principal whereby the agent in this case represent the management and the principal represent the shareholders of the firm and other stakeholders. In firms where monitoring is difficult like in high specificity firms, the large shareholders hardly monitors the firm’s management and there are often agency problems. For instance, there is often asymmetry of information in firm’s R&D projects where managers have more information on the financial implications of the projects than shareholders. There is often conflict of interests between management and shareholders, which can lead to detrimental effects to the firm’s financial performance in case of information asymmetry. Such asymmetry can be a source of corporate financial failure among firms. Extreme asymmetry and distortion in information can allow for accounting fraud where dominant senior managers use their authority and position power to influence accountants and auditors to commit material accounting misstatements, which are distinct from small informational issues that stem from untimely or incomplete financial disclosures in the financial reporting. Outside directors use the information given to make decisions, distorting such information leads to decisions that are based on the wrong information, which may lead to accounting misstatements or frauds (Srinivasan 2005, p. 294). Such frauds are subject to litigation, regulatory and other costs. Inside directors are deemed to be knowledgeable parties in the irregular/fraudulent accounting activities and cannot therefore be relied on by the outside directors to be monitors of the fraudulent accounting activities. In addition, outside directors require incentives to prevent and effectively monitor the perverse activities. Information asymmetry between insiders (management and the audit function) and the outsiders (outside directors and shareholders) leaves the outside directors and the shareholders at an informational disadvantage (Zeckhauser & Pound 1990, p. 152). Examining cases of corporate failures like WorldCom and Enron, one can identify the effect of information asymmetry between outsiders and the insiders. For instance, the in the case of Enron, the company’s management and the audit function used the market-to-market accounting system. This kind of system identifies the amount to be earned from a contract and uses the figure in reporting earnings. Decline in the value of the contracts is adjusted for in the financial statements. This kind of accounting system reports profit, which may be already earned or expected to be earned from a given project. The accounting system can be used to cheat investors and shareholders that the company is making huge profits while it is actually in great debt as was the case for Enron. The shareholders could not understand the situation of the company since they had little information while the firm’s management and the audit function knew that the company was in great debt. Information asymmetry is sometimes driven by the relationships between the internal audit function and the management particularly where the internal audit lacks independence and is not fundamentally objective (Sufi 2007, p. 631). Information asymmetry between firm’s internal audit function and the investors and shareholders create opportunities for corporate failures where financial disclosures are not well observed. In addition, information asymmetry in the case of Enron was a complicated issue, the management used Special-Purpose-Entities or the S.P.Es like oil leases, which were set up between management and outside partnerships whereby the partnerships would borrow money and give to Enron enabling it to access credit from banks though in huge debt (Wittenberg-Moerman 2008, p. 246). Such S.P.Es transactions were not included in the financial statements and thus created information asymmetry between shareholders who relied on the financial statements and the inside parties. This allowed Enron to use various types of S.P.Es, differences in the S.P.Es contracts’ value was made up with the company’s stock. This kind of transactions meant that Enron was selling part of its stock to itself, which is an illegal and a great risk demonstrating lack of objective for the internal audit function and the company’s management executives (Rajan & Reichelstein 2009, p. 210). Information asymmetry between the executives allowed them to sustain such contracts without the knowledge of shareholders and investors. Need for regulations After the major financial scandals that occurred between 2000 and 2002, governments and regulatory authorities have come up with stringent regulations and financial standards to be used in the collapse of Enron, which was barely 8 months after the collapse of WorldCom in United States challenged the regulatory bodies and the governments about the authenticity of audit committees and accounting and auditing firms. U.S. was essentially swift in audit reforms and new regulations for corporate governance. To this regard, Sarbanes Oxley Act was enacted and signed into law in U.S. in 2002, 8 months after the case of Enron bankruptcy. The act has articulately provided the responsibilities of the corporate in the financial reports, the financial disclosures in financial reports, roles and responsibilities of management in the preparation of financial reports and disclosures and the pertaining criminal penalties in case of violation. While this act was enacted in U.S. most of its reforms have diffused to other countries like U.K. and Australia (Rezaee 2011, p. 67). For instance, Europe has become strict on the implementation of EU IFRS to the European countries including the non-charitable organizations (Rezaee 2011, p. 67). U.K. has adopted some of the aspects of the SOX I it accounting regulatory reforms. In 2004, U.K. government decided to strengthen its regulatory system following the major cases of corporate failures that occurred in U.S. FRC’s role was extended to act as single independent regulatory body for the auditing and accounting profession and also in the issuing auditing and accounting standards that should be enforced by firms. Audit reforms have been deemed vital in ensuring and enhancing diligence among audit committees (Jorge 2008, p. 205). The reforms must focus on the best practices and regulations that the audit committees must demonstrated and adhere to in their auditing and accounting profession. The recent corporate failures revealed that there is need to review the disclosure requirements and ensure that the requirements are adhered to by the audit committees and the management. Such audit reforms will minimize the information asymmetry between auditors, management and the shareholders and potential investors who suffered heavily following the bankruptcies. The passing of financial services bill in U.K. is expected to give financial services authority more power to enhance regulatory system in the country’s financial system (International Monetary Fund 2003, p. 59). This will protect the investors from major financial scandals and ensure that relevant disclosures are made in the companies’ financial reports. Part B Accounting information and the cost of capital The relationship between accounting information and firm’s cost of capital is a fundamental issue in accounting. Most standard setters often refer to this concept and argue that high quality of accountings standards reduce firms’ cost of capital. More accounting information reduces uncertainty through better disclosure, which in turn results in reduced cost of capital (Lambert et al 2007, p. 385). Cost of capital in this context is defined as the firm’s expected rate of returns on its stock. Though it is unclear the degree to which accounting information and firm disclosures minimize non-diversifiable risks, different models have shown. When we characterize firms’ financial reports as information about their future cash flows, we can easily relate it with the cost of capital. Accounting information affects cost of capital of a firm directly and indirectly (Gebhardt et al 2001, p. 136). Direct effects occur when higher accounting information affects the assessment of future cash flows by market participants rather than the cash flows. Direct effects occur when accounting information affects the real decisions of the firm that in turn affect the expected value of the cash flows. High quality accounting information minimizes variance in firm’s cash flows. Increased disclosures moves cost of capital towards risk-free rate (Lambert et al 2007, p. 388). In the direct effects, high quality accounting information affects cost of capital by enabling a firm to make real decisions, which changes firms’ covariance. Accounting information enables managers to reduce amount of cash flow that firm managers appropriate to themselves, it improves firm price and in general reduce cost of capital. In respect to investment and production decisions, accounting information influences decisions and thus influences expected cash flows. Information quality affects cost of equity by improving the investment efficiency, better information quality allows managers to align firm’s investment opportunities with its investment choices (Berger et al 2005, p. 2). High quality information reduces the parameter uncertainty. Higher information quality increases the weight of firm-specific information. Information disclosures reduce cost of capital of a firm by minimizing the problems arising from adverse-selection between projects or traders. However, this is often possible to detect using small samples, with large samples, the test is hard and the results arrived at are very different since the companies are influenced by various other factors other than information. These factors include changes in tax regulations, economic changes, market’s risk tolerance, age of the firm, firm’s growth rate and changes in other industries that are related to the firm. Investors emphasize on firms’ reported earnings where the quality of the firm’s accounting information is high. Proposed hypothesis Proposition 1: cost of capital in a firm increases the risk-free rate as expected price of a firm and the expected cash flows are well known. The cost of capital approaches zero as information increases (Berger et al 2005, p. 3). Proposition 2: Firm’s cost of capital does not change due to disclosures in the accounting information but rather due to various factors that are complex to understand. This proposition has got nothing specific to the accounting information and it means that any shocks like new regulations, inventions and taxes can affect firm’s expected return rate (Bushee & Christopher 2001, p. 171). Sampling The two propositions are examined using 10 firms; the choice of the sample is based on the need to hold the sample size small to reduce the complexity of firms in terms of the various factors that influence their cost of capital. This study will focus on an information environment where all firms have equal information and compare it with the firms in another context where information is not readily available. The ten firms will be selected from U.K oil industry. to ensure that they are facing equal economic conditions. The study proposes to use Capital asset Pricing Model or the CAPM. The trend in the cost of capital for the 10 firms in the oil industry will be examined and compared for two different periods covering the time before 1980s and after 1990s. Period covered will be 1984 to-1988 and the period 2004 to 2008. The choice of oil industry is based on the fact that there has been an increased disclosure requirement in the industry since 1990s requiring firms to disclose their oil reserves and projects related to their businesses. The selection of the period is focused on capturing the period when oil industry had not faced the current stringent disclosure requirements that were established after 1990s and the period after the disclosure requirements (Verrecchia 2001, p. 144). This has seen increased information quality on the industry to the investors and also to the firm managers enabling them to make better investment decisions. Our sample framework allows us to have more general changes to analyze in the information structures covered by the two periods. Expected results and implications Analyzing the sample suggested using relevant models such as CAPM is expected to demonstrate the trends in the movement of cost of capital for the ten firms in the oil industry. It would be expected that, the trend before 1990s, when U.K. imposed strict disclosure requirements on oil reserves and oil industry will show most the firm’s cost of capital increasing or at least not improving with time. However, the cost of capitals for the firms would be expected to have improved and tending towards risk-free rate for the period after 1990s when disclosures improved the accounting information quality in the firms. Such results would confirm that the companies cost of capital is indeed related to the quality of the accounting information and the subsequent disclosures. As mentioned by (Lambert et al 2007, p. 414), the results would then be supportive to the view that high information quality setting increases the projects expected cash flows and this in turn minimizes the cost of capital while poor information setting results in misaligned capital investments and subsequent high cost of capital (Easley & O’Hara 2004, p. 1583). However, the analysis is done with the assumption that all other factors that affect cost of capital are held constant and only information quality is being changed. This however, forms one of the weak points for our proposed study since it is hard to hold constant factors like economic changes and varying characterization of firms in terms of growth and response to market related risks. Conclusion This study has explored the effects of information asymmetry between firm’s insiders (including management and internal auditors) and the outsiders (including shareholders and potential investors). The study has explored that various issues that makes asymmetry of information disastrous to firms’ performance leading to corporate failures. This study has also explored major corporate failures like Enron and shown how asymmetry of information played a part in the corporate failure. This paper has also explored the relationship between accounting information quality and the cost of capital of a firm and finally proposed a research study and expected results together with its implications (Berger et al 2005, p. 34). References Ahlawat, S & Lowe, J (2004), An Examination of Internal Auditor Objectivity: In-House versus Outsourcing, A Journal Of Practice & Theory, Vol. 23, No. 2, pp. 147-158 Berger, P, Chen, H & Li, F (2005), Firm Specific Information and Cost of Equity, working paper, University of Chicago. Bushee, B & Christopher, F (2001), Corporate disclosure practices, institutional investors, and stock return volatility, Journal of Accounting Research 38(2), 171–202. Easley, D & O’Hara, M (2004), Information and the cost of capital, Journal of Finance, 59(3), 1553-1584. Gebhardt, W, Charles, M & Bhaskaran, S (2001), Toward an implied cost of capital, Journal of Accounting Research, 39(4), 135–176. Hermalin, B & Weisbach, M (2008), Information disclosure and corporate governance. Working Paper. International Monetary Fund (2003). United Kingdom: Financial Sector Assessment Program Technical Notes and ...International Monetary Fund. Jorge, S (2008), Implementing reforms in public sector accounting, Loja Virtual IUC LaFond, R & Watts, R (2008), The information role of conservatism. The Accounting Review 83(3), 447-478. Lambert, R, Leuz, C & Verrecchia, R (2007), Accounting Information, Disclosure, and the Cost of Capital, Journal of Accounting Research, 45(2), 385-420. Rajan, M & Reichelstein, S (2009), Objective versus subjective indicators of managerial Performance, The Accounting Review, 84(6), 209-237. Rezaee, Z (2011), Financial Services Firms: Governance, Regulations, Valuations, Mergers, and ... New Jersey: John Wiley & Sons. Sengupta, P (1998), Corporate disclosure quality and the cost of debit, The Accounting Review, 73(4), 459-474. Srinivasan, S (2005), Consequences of financial reporting failure for outside directors: Evidence from accounting restatements and audit committee members, Journal of Accounting Research, 43, 291-334. Sufi, A (2007). Information asymmetry and financing arrangements: evidence from syndicated Loans, The Journal of Finance, 62(4), 629- 668. Verrecchia, R (2001), Essays on disclosure, Journal of Accounting and Economics, 32(4), 91-180. Wittenberg-Moerman, R (2008), The role of information asymmetry and financial reporting quality in debt trading: evidence from the secondary loan market, Journal of Accounting and Economics, 46(6), 240-260. Zeckhauser, R & Pound, J (1990), Are large shareholders effective monitors? An investigation of share ownership and corporate performance, in R. Hubbard (ed), Asymmetric Information, Corporate Finance and Investment, pp. 149-180, University of Chicago Press. Read More