Analysis of Information Asymmetry - Literature review Example

?Part- A Introduction Information Asymmetry deals with the access and knowledge of information for parties to any given transaction. Information asymmetry therefore arises when one party to the transaction has better information than the other. Based on this asymmetry, person having specific information therefore may be at advantage as compared to party which is relatively ignorant of this new information. In such a scenario, the overall transaction can go wrong and it is often considered as the market failure also where market is inefficient enough to offer opportunity to everyone to have perfect knowledge. (Xu, Wang, & Han, 2012) Corporations are incorporated as artificial persons with distinction between the ownership and the management of the firm. Owners of the corporations called shareholders therefore remain separate from the active management of the organization and managers manage the organization as custodian of the shareholders. However, this creates issue of agency wherein though managers act as the agents of shareholders, they pursue their own interests. (Sau,2003) The actions of managers therefore are assumed to be in direct conflict with the interests of the shareholders. One of the key reasons for this conflict of interest is the availability and access to information. Since managers are actively involved into the management of any firm therefore they possess relatively superior information as compared to outsiders. This however, can also create corporate failures as shareholders may not be fully aware of the actions of the managers. One way through which both financial and non-financial disclosures can be improved is the effective regulations to make things more transparent.( Baek, Kim, & Kim, 2008) Information asymmetry As discussed above, information asymmetry arises when one party to the transaction has superior or more information as compared to other party to the transaction. This imbalance in the possession of information therefore can make transactions biased and can put one party at a receiving ends due to lack of knowledge and relevant information. Information asymmetry can also occur when one party has the knowledge or information about a good or service while other party doesn’t have the same. ( Walsh, and Seward, 1990) There are different models of information asymmetry under which different assumptions are made. In adverse selection models, it is assumed that one party lacks the understanding and information about a transaction whereas in moral hazards model, ignorant party lacks the information about the performance of a transaction. (Chen, Berger, & Li, 2006). Moral Hazards and Agency Problems Information asymmetry becomes important within organizational context due to agent-principal relationship between the shareholders and managers of the firm. One of the key reasons as to why moral hazards can arise is based upon the notion that if all the actions of employees are not monitored, there are chances that moral hazards may arise. This peculiar situation therefore outlines that shareholders may inherently be in a disadvantageous position because of their inability to monitor the actions of managers in effective and comprehensive manner. (Heath, and Norman, 2004) Shareholders, as principals, engage managers as their agents to run the organization and control and manage the day to day operations of their organizations. It is critical to understand however that the efficiency and effort with which managers must perform their assigned actions remain within their own control. This aspect however, gives rise to hidden actions on the part of the managers and shareholders, as principals cannot monitor the effectiveness and efficiency of these actions due to information asymmetry. As a result of this, until and unless, managers have other motives, he or she is always putting in low level of effort behind his actions. This also creates the issue of moral hazards. (Dobson, 1993) Moral hazards suggest that the managers, as the agents of the shareholders, may act without due care and attention to safeguard the interests of the shareholders. This is only possible because the actions of the managers are hidden from the shareholders. In order to avoid this situation, shareholders often design incentive schemes to tempt managers to act into the best interests of the shareholders. However, the inadequacy of incentive schemes often cannot force managers to act into the best interests of the shareholders.( Cormier, D, et al. 2010) Higher information asymmetry increases the transaction costs for the shareholders thus increasing the rate of returns. This increase in rate of return therefore invariably reduces the equity valuation and result into decrease in wealth of shareholders. (Bowen, 2007) Corporate Failures and Information Asymmetry Corporate failures like Enron and current failure of large banks and financial institutions again raised the question of whether the managers, despite being paid so high, take actions which can effectively safeguard the interests of the shareholders. Various research studies outlined that the presence of information asymmetry has an enormous impact on the overall corporate governance mechanisms of the organization. (Zhang, 2008) Issues such as intensity with which board monitors the overall actions of the managers may decrease with the higher information asymmetry. It has been suggested that board of directors often become less active when the overall environment is noisier and it becomes relatively difficult for external players to verify or audit the projects. (Akhtaruddin & Haron, 2010) This aspect therefore clearly outlines that information asymmetry creates strong disadvantages for a proper implementation of corporate governance mechanisms within the organization. Where such asymmetry is wider, external agents lose their power to actually actively monitor the activities of the managers. It’s critical to understand corporate failures in financial services industry may be relatively different as compared to failures in other sectors of the economy. Though information asymmetry arises in both the cases however, the overall impact of the same on both may be relatively different. Role of Regulations Financial and non-financial disclosures are considered as the most important means available to the management of any organization to actually communicate firm’s performance to outsiders including investors and shareholders. The role of regulations therefore viewed in terms of minimizing the information asymmetry by obtaining more information while at the same time designing mechanism which can force organizations to improve their performance. Regulators therefore can actually force the firms to improve their disclosures and include all information which can effectively affect the decision making process of investors. This would also require to include more of non-financial information such as comprehensive management analysis, directors review etc which not only make managers accountable for their actions but also provide investors a clear and concise information in easy to read and understand formats. Regulations therefore can ensure such information disclosures. (McLaughlin & Safieddine 2008) Improved financial and non-financial disclosures therefore can add more value for shareholders and other outsiders as information will be presented in more transparent and clear manner. Investors therefore can easily assess the risks involved in the investment as well as how the organization is performing. Regulations like SOX and COSO has allowed regulators to increase the rate of compliance with the regulation to improve their disclosures. The argument of improving corporate governance in order to reduce information asymmetry is however faced with important challenge of whether one model of corporate governance can actually fit for all the organizations. Various studies have suggested that important corporate governance mechanisms such as structure of ownership and board of directors are often endogenously defined with each organization taking its own local factors into account. As such regulations may not be effective in ensuring that the managers work in the best interests of the shareholders. (Bartov,and Bodnar, 1996) Conclusion Though research has clearly outlined that one of the key reasons for corporate failures in the information asymmetry however, the resulting implementation of the corporate governance mechanisms may not reduce the information asymmetry. The cost of implementation of the regulation ultimately results into higher costs which further reduces the wealth of the shareholders. However, in order to reduce the corporate failures, it is important that more transparent and complete financial as well as non-financial disclosures should be made. This can however, only be achieved through effective regulation wherein government should impose relevant regulations to improve the disclosure requirements for firms. Part-B Introduction Cost of capital is considered as one of the most important measures against which not only firms evaluate their projects but the overall valuation of a firm is also based upon this. Lower cost of capital indicates that the there is relatively lesser risk involved and thus investors would view it more favorably. Proper and transparent quality accounting information however, can have an impact on cost of capital without actually adjusting other risk variables. Firms engaged in making comprehensive accounting disclosures revealing quality information tend to have lower cost of capital. Literature Review It has been argued that where there is an uncertainty regarding the quality of the information, it is going to affect the firm’s cost of capital. Lambert Leuz &, Verrecchia (2007) suggested that improved accounting information and its proper disclosure reduces the variance in the cash flows of the firms and also results into reduction of the covariance with other firms. This results into low cost of capital and makes it almost closer to the risk free rate of return. As such improved and transparent accounting information provided by the firms not only raises the firm’s price but also reduces the cost of capital for the firm. (Botosan, 1997) It has been outlined both the direct as well as indirect effects of the quality of accounting information and its impact on the cost of capital of the firm.(Sengupta, 1998) One of the key shortcomings of the studies on the subject is based upon the use of small sample size which actually reduces the overall effectiveness of such studies. Berger, Chan & Li (2006) argue that developing a large sample of information quality, the overall relationship can be better established between accounting information and the cost of capital of the firm. Authors argued that cost of equity capital can decreased by 0.4% if the overall quality of the accounting information of the firm improves by 1 standard deviation. Apergis et. Al (2012) evaluated the accounting information by decomposing it into different components such as earnings quality. The empirical findings of the study suggest that there exists a negative relationship between the quality of accounting information and the cost of capital. Higher and improved accounting information however, can erode excess returns because of the low cost of capital resulting due to better and improved accounting information. There are two major and important themes on which existing research is based i.e. how improved accounting information results into low cost of capital through reduction in the variability in cash flows. Secondly, emphasis has been on understanding as to whether the improved financial accounting information actually results into excess rates of returns. It is also critical to understand that standard setters often refer to the fact that quality of accounting information can actually lead to low cost of capital. The overall focus on setting accounting standards therefore is always based upon improving the quality of disclosures made. If accounting standards actually compulsively allow firms to improve its quality of accounting information so that the benefit of the same may be transferred to shareholders. (Francis, et al. 2005) Further, asset pricing models clearly outline the importance of diversification and non-diversifiable risk and its impact on the cost of capital. By improving its accounting information, firms can actually reduce its diversifiable risk and improve its cost of capital. Hypothesis Considering the above literature review, the hypotheses for this research study are: 1. Better accounting information and its disclosure can result into low cost of capital. 2. The relationship between accounting information and cost of capital is not firm or industry specific. Research Methodology Research methodology will be based upon combining both the qualitative as well as quantitative research methods. Qualitative research will involve a detailed review of the available literature on the chosen topic. A survey methodology will be adapted to critically analyze and explore the existing themes of research on this topic and by using secondary information; a critical effort will be made to understand the link between the two. Quantitative research methods however, will focus on understanding the correlation between the two earnings quality and the cost of capital. Earning manipulation will be reviewed and a correlation and regression analysis will be made to establish link between how the same result into reduction/increase in cost of capital of the firm. Assessment of earnings manipulation will be based upon the evaluation of what accounting methods and estimates are used by the firm to enhance their earnings. Most importantly, focus will be on depreciation, allowances and other methods which can be employed by the management of the firms to show an improved profitability. Sample Collection Considering the overall scope of the research and limitations on the resources available, a smaller sample size of 20 firms listed on London Stock Exchange will be considered for this research. Mid-sized firms having market capitalization of at least 50 million will be considered for this research. Accounting information from last 5 years will be considered and earnings will be evaluated on quarterly basis. 20 firms will be divided into four randomly generated groups based upon industry classification of the firms. Implications of the Research One of the key expectations of this research will be based upon the assumption that the link between accounting information and the cost of capital may be industry specific with firms operating in certain industries showing stronger correlation than the firms operating in different industries. This therefore may suggest that quality of accounting information may vary across different industries and investors may respond differently to the firms operating in different industries. Further, it may also be able to shed light on the manipulation of earnings on an industry wide level to understand as to how firms in different industries manipulate their earnings. Possible Limitations of the study Since the overall scope of this study will be limited and considering the limitations such as time and resources required completing this research on larger scale, researcher expects that these limitations will be significant. Though Research expects to have an uninterrupted access to information available however, without the active support of research supervisor, completing this research may be a limiting factor. Researcher also expects that lack of resources may be one of the potential restrictions on the work. Lack of resources would include funds and time available to conclude this research in timely manner. Conclusion The above research proposal outlined quality of accounting information can result into improved cost of capital. Existing literature clearly outlines the link between accounting information and cost of capital and suggests that firms having better and improved disclosures tend to have better cost of capital. This research study will look into how the quality of accounting information can actually result into better cost of capital for 20 firms listed on London Stock Exchange. References A. Botosan, C. (1997) Disclosure Level and the Cost of Equity Capital. The Accounting Review, 72 (3), p.323-349. Akhtaruddin,M & Haron, H (2010) Board ownership, audit committees’ effectiveness, and corporate voluntary disclosures, Asian Review of Accounting, 18(3), p.245 – 259 Apergis, N. et al. (2012) Accounting Information, the Cost of Capital and Excess Stock Returns: The Role of Earnings Quality-Evidence from Panel Data. International Business Research, 5 (2). Baek, H, Kim, D & Kim, J (2008) Management earnings forecasts and adverse selection cost: good vs bad news forecast, International Journal of Accounting and Information Management, 16 (1), p.62 – 73 Chen, H, Berger, P & Li, F (2006), Firm Specific Information and Cost of Equity EFA Zurich Meetings Cormier, D, et al. (2010) Corporate governance and information asymmetry between managers and investors, Corporate Governance, 10 (5), p.574 – 589 Dobson, J (1993) Moral Hazard, Adverse Selection and Reputation: A Synthesis. 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(1990) On the Efficiency of Internal and External Corporate Control Mechanisms. The Academy of Management Review, 15 (3), p.421-458. R. Francis, J. et al. (2005) Disclosure Incentives and Effects on Cost of Capital around the World. The Accounting Review, 80 (4), p.1125-1162. Sau, L. (2003) Banking, Information, and Financial Instability in Asia. Journal of Post Keynesian Economics, 25 (3), p. 493-513. Sengupta, P. (1998) Corporate Disclosure Quality and the Cost of Debt. The Accounting Review,, 73 (4), p.459-474. Xu, X , Wang, X & Han, N (2012) Accounting conservatism, ultimate ownership and investment efficiency. China Finance Review International, 2(1), p.53 – 77 Zhang, Y. (2008) Information Asymmetry and the Dismissal of Newly Appointed CEOs: An Empirical Investigation. Strategic Management Journa, 29 (8), p.859-872. Read More