Economic Consequences of Financial Reporting and Disclosure Regulation: A Review and Suggestions for Future Research*

Christian Leuz Graduate School of Business, University of Chicago, European Corporate Governance Institute (ECGI) cleuz@chicagogsb.edu and Peter Wysocki Sloan School of Management, Massachusetts Institute of Technology wysockip@mit.edu Comments Welcomed March 2008 (First version: May 2006) Abstract This paper surveys the theoretical and empirical literature on the economic consequences of financial reporting and disclosure regulation. We integrate theoretical and empirical studies from accounting, economics, finance and law in order to contribute to the cross-fertilization of these fields. We provide an organizing framework that identifies firm-specific (micro-level) and market-wide (macro-level) costs and benefits of firms reporting and disclosure activities and then use this framework to discuss potential costs and benefits of regulating these activities and to organize the key insights from the literature. Our survey highlights important unanswered questions and concludes with numerous suggestions for future research. Keywords: Accounting, Asymmetric information, Capital markets, Institutional economics, International, Mandatory disclosure, Political economy, Regulation, Standards

JEL Classifications: D78; D82; G14; G18; G30; G38; K22; K42; M41; M42

* We wish to thank Andrew Karolyi, Ken Peasnell and seminar participants at New York University, Manchester Business School, 2007 AAA International Accounting Section Conference, 2007 INTACCT Workshop, and 2007 Accounting & Economics Conference in Fribourg for helpful comments and suggestions.

Electronic copy available at: http://ssrn.com/abstract=1105398

1.

Introduction Three recent trends have spurred the debate about financial reporting and disclosure

regulations around the world. First, international financial crises and corporate scandals often bring about securities regulation reforms and greater reporting and disclosure requirements. The Asian Financial Crisis of 1997, the Enron debacle in the U.S., and the recent credit market crisis are but a few important examples. In the aftermath of these events, regulators and policy makers have called for improved corporate transparency, increased scrutiny and often enacted significant changes to accounting and disclosure requirements and regulations. Second, stock exchanges and accounting standards bodies from numerous countries around the world have adopted International Financial Reporting Standards (IFRS) to achieve the stated goal of harmonization and convergence of accounting rules. Third, both the debate about the competitiveness of U.S. capital markets and the increasing internationalization of capital markets highlight securities regulation as a global issue.1 Despite the importance of corporate transparency as a recurring policy issue, there is (i) limited research on the costs and benefits of financial reporting and disclosure regulation, (ii) few attempts to systematically organize the key economic principles of and empirical findings on this type of regulation, and (iii) little guidance on important unanswered questions about the economic consequences of regulating financial reporting and corporate disclosure. This paper reviews the theoretical and empirical literature on the economic consequences of financial reporting and disclosure regulation, with a particular emphasis on recent research advances in the literature. We integrate theoretical and empirical studies from accounting, economics, finance and law in order to contribute to the cross-fertilization of these fields.

See, e.g., the U.S. Chamber of Commerce sponsored report by the Commission on the Regulation of U.S. Capital Markets in the 21st Century (2007).

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Electronic copy available at: http://ssrn.com/abstract=1105398

Moreover, we provide an organizing framework that identifies firm-specific (micro-level) and market-wide (macro-level) costs and benefits of firms reporting and disclosure activities. We then use this framework to discuss the potential costs and benefits of regulating these activities in global capital markets and to organize the key insights from the literature. We highlight

important unanswered questions to provide directions for future research.2 As such, this survey and framework should prove useful to researchers, as well as standards setters, policy makers, and regulators as they debate the economic consequences of past and future regulatory choices. Generally speaking, our survey finds a paucity of evidence on market-wide and aggregate economic and social consequences of reporting and disclosure regulation, rather than the consequences of individual firms accounting and disclosure choices. Until recently, most of the literature focuses on managers voluntary disclosure and financial reporting choices. 3 These studies provide important insights into the nature of the private costs and benefits of voluntary reporting and disclosure choices and, in this sense, provide a micro foundation. However, these studies provide few insights into the overall desirability, economic efficiency or aggregate outcomes of reporting and disclosure regulation. On the other hand, there has been a recent flurry of studies examining international differences in the effects of different regulatory regimes and on the economic consequences of regulatory changes, such as Regulation Fair Disclosure and the Sarbanes-Oxley Act. We synthesize the insights of these studies in our survey. However, there are still many unanswered questions, especially, (i) why disclosure regulation is so pervasive; (ii) the dynamics and (iii) the process of regulation; (iv) the real and macro-economic consequences of disclosure regulation, (v) its complementarities with other regulations, (vi) its
2

Survey papers that review the disclosure literature or the information/asset pricing literatures include Healy and Palepu (2001), Core (2001), Amihud, Mendelson and Pedersen (2005), and Botosan (2006). Our review complements these surveys by highlighting recent research on the regulation of firms financial reporting and disclosure activities. In addition, our review includes numerous new research studies that post-date prior surveys. 3 These recent advances are an impetus for our survey and are reviewed in detail.

optimal form given imperfect enforcement; and (vii) the issue of regulatory competition. We discuss these open questions and conclude our survey with suggestions for future research in these areas. Despite the focus on regulation, this paper should not be understood as advocating the necessity of regulation or reforms to existing regulations. In fact, we highlight the importance of market forces in influencing firms disclosure and reporting choices, both in isolation as well as the interactions with regulatory acts. For instance, we highlight that corporate transparency likely is a joint outcome of market forces and the incentives provided by various rules and regulations (including the quality of their enforcement). We also point to significant complementarities between the elements of a countrys institutional infrastructure. Given these complementarities, we highlight that unilateral changes in disclosure and accounting rules are unlikely to yield the desired outcomes. Similarly, we stress that global diversity in institutional and economic factors may limit the effectiveness of a one-size-fits-all set of global accounting standards and disclosure regulations. Finally, we emphasize that the issue of firms avoidance strategies, which have long been known to seriously impair the effectiveness of regulation, is further compounded by the growing integration of capital markets around the world, which provides firms with alternatives outside their home countries and leads to regulatory competition. Our survey touches issues that are discussed in the economics literature on regulation in general, such as political lobbying and regulatory capture. However, this literature often focuses on the regulation of product-market monopolists and the corresponding impact on consumers (see, e.g., Kahn, 1988; Laffont and Tirole, 1993). Disclosure settings have their own unique economic and regulatory issues where many firms interact with heterogeneous investors in capital markets. To highlight these unique disclosure issues, our framework identifies and

discusses: (i) firm-specific (micro-economic) costs and benefits arising from firms voluntary disclosure activities, (ii) potential (macro-economic) market-wide costs and benefits of firms voluntary disclosure activities, and (iii) aggregate costs and benefits of regulating and enforcing firms financial reporting and disclosure activities in global capital markets. The survey is organized as follows. Section 2 reviews the theoretical literature on the firm-specific costs and benefits of disclosure, the market-wide costs and benefits of financial reporting and disclosure, and costs and benefits of regulating these activities. In section 3, we review empirical studies on firms disclosure choices. Section 4 presents and discusses empirical studies on changes in disclosure regulation and across country comparisons of disclosure regimes. Section 5 discusses new institutional research in accounting as well as recent studies on the adoption of International Financial Reporting Standards (IFRS) as these advances also help our understanding of the economic outcomes of financial reporting and disclosure regulation. Section 6 concludes the paper with an extensive discussion of suggestions for future research. 2. Theory of Corporate Disclosure and Reporting Regulation In this section, we outline the theory of firms disclosure choices and the theory of disclosure regulation. We use a framework that first identifies possible firm-specific (microeconomic) and market-wide (macro-economic) costs and benefits of firms disclosure activities in the absence of regulation. We then overlay the potential effects of disclosure and reporting regulation. Finally, we give some consideration to the question of how to mandate disclosures, i.e., the mechanism and at which level, and how to enforce the rules.

Both firm-specific and market-wide effects are relevant for evaluating the economic consequences of reporting and disclosure regulation. 4 The former are important because the confluence of firm-specific costs and benefits of voluntary disclosures determines whether they are beneficial to the firm, i.e., whether they increase firm value. However, the mere existence of net benefits to voluntary disclosure is not sufficient to justify mandatory disclosure because, in this case, a firm already has incentives to voluntarily provide information (e.g., Ross, 1979). That is, precisely in the situation where the firm-specific benefits exceed the costs, it is not clear that we need any regulation. Unfortunately, debates about disclosure and financial reporting

regulation often incorrectly point to firm-specific (net) benefits of voluntary disclosure choices rather than focus on the aggregate effects of regulation. However, firm-specific effects of disclosure can still be relevant in regulatory debates if (i) they inform us about the nature and form of the costs and benefits, (ii) they tell us how mandated disclosure can differentially affect firms (including potential wealth transfers among firms), and (iii) they help us predict which firms are likely to engage in avoidance strategies or may lobby for or against a proposed regulation given its differential effects on firms. Market-wide effects of firms disclosures (in the absence of regulation) are relevant because they capture costs and benefits that firms may ignore or not fully internalize when making their individual disclosure decisions. Knowledge of these market-wide effects and

externalities provides a basis for identifying the costs and benefits of regulating and enforcing corporate financial reports and disclosures.

We use the term market-wide effects to denote effects that go beyond a single firm. They could affect a group of firms, an entire industry, and/or all firms in the economy.

2.1.

Firm-Specific Benefits of Corporate Disclosures Current theories typically focus on direct capital market outcomes of firms disclosure

activities. These market outcomes include liquidity, cost of capital and firm valuation.5 Arguably, the firm-specific benefit of disclosure best supported by theory is the effect on market liquidity (see also, Verrecchia, 2001). At its core is the insight that information asymmetries among investors introduce adverse selection into share markets. Uninformed or less informed investors have to worry about trading with privately or better informed investors.6 As a result, uninformed investors lower (increase) the price at which they are willing to buy (sell) to protect against the losses from trading with an informed counterparties. The price adjustment reflects the

probability of trading with informed traders and the potential information advantage of these investors. This form of price protection when buying or selling shares introduces a bid-ask spread into secondary share markets.7 Similarly, information asymmetry and adverse selection reduce the number of shares that uninformed investors are willing to trade. Both effects reduce the liquidity of share markets, i.e., the ability of investors to quickly buy or sell shares at low cost and with little price impact. Corporate disclosure can mitigate the adverse selection problem and increase market liquidity by leveling the playing field among investors (Verrecchia, 2001). Its effect is two-fold. First, more information in the public domain makes it harder and more costly for traders to become privately informed. As a result, fewer investors are likely to be privately informed,

Other potential observable outcomes of firms disclosure activities include changes in analyst following and institutional holdings. However, these outcomes are often viewed as indirect measures of access to low cost sources of capital. 6 In essence, an uninformed investor fears that an informed investor is willing to sell (buy) at the market price only because the price is currently too high (too low) relative to the information possessed by the informed trader (e.g., Glosten and Milgrom, 1985). 7 If the counter party is informed with probability one, the market breaks down analogous to the market for lemons in Akerlof (1970).

which reduces the probability of trading with a better informed counter party. Second, more disclosure reduces the uncertainty about firm value, which in turn reduces the potential information advantage that an informed trader might have. Both effects reduce the extent to which uninformed investors need to price protect and hence increase market liquidity. An important question is whether and how these effects map into firm value or the cost of capital. Illiquidity and bid-ask spreads essentially impose (out-of-pocket) trading costs on

investors, for which investors need to be compensated in equilibrium. Thus, the required rate of return of a security increases by its per-period transaction costs (e.g., Constantinides, 1986; Amihud and Mendelson, 1986). In addition, adverse selection can distort investors trading decisions and result in inefficient and hence costly asset allocations for which investors need to be compensated, leading to a higher required rate of return or cost of capital (Garleanu and Pedersen, 2004). Moreover, adverse selection problems and trading costs in secondary markets fold back to the point at which the firm issues shares. Investors anticipate that they face price protection when they sell shares in the future and hence reduce the price at which they are willing to buy shares in the initial securities offering (e.g., Baiman and Verrecchia, 1996; Verrecchia, 2001). As a result, a firm must issue more shares to raise a fixed amount of capital. Thus, information asymmetry also translates into a higher cost of raising capital. In addition, information asymmetry and adverse selection in primary share markets can reduce the offering price and lead to underpricing. Myers and Majluf (1984) show that a firm may be willing to pass up profitable investment opportunities if the firm has to issue new securities to finance the investment and information is asymmetrically distributed managers and outside investors. Rock (1986) presents a model where uninformed investors face a winners

curse and a firm has to underprice its securities to ensure the participation of uninformed investors in the offering.8 Next, there are theories that provide a direct link between disclosure and the cost of capital (or firm value), without reference to market liquidity (and adverse selection costs). For example, Merton (1987) develops a model where (some) investors have incomplete information and are not aware of all firms in the economy. As a result, risk sharing is incomplete and inefficient. Disclosures by these lesser known firms can make investors aware of their existence and enlarge the investor base, which in turn improves risk sharing and lowers the cost of capital. This effect is likely to be less relevant to large firms with a substantial analyst and investor following. Moreover, the investor base effect is susceptible to arbitrage if some investors know which of the stocks are not known by all investors (Merton, 1987; Easley and OHara, 2004). A direct link between disclosure and the cost of capital can also arise from estimation risk (e.g., Brown, 1979; Barry and Brown, 1984 and 1985; Coles, 1988). Estimation risk arises because parameters such as a firms beta factor must be estimated (e.g., based on historical stock returns). For example, Barry and Brown (1985) and Coles et al. (1995) consider an information environment where some firms have longer time-series of returns than others. They find that, in this environment of asymmetric parameter uncertainty, securities with long time-series of returns have lower betas and expected returns than they would without estimation risk. However, they are unable to unambiguously sign the effect for securities with short time-series of returns. Aside from a relatively narrow representation of information, these studies do not provide comparisons across high- and low-information firms in a world with asymmetric parameter uncertainty and hence do not address the question of how firm-specific disclosures can influence

For a survey of IPO literature, see Ljungqvist (2004).

betas or expected returns. Moreover, it is not clear that parameter uncertainty for individual firms survives the forces of diversification (e.g., Clarkson et al., 1996). Recently, Jorgensen and Kirschenheiter (2003), Hughes, Liu, and Liu (2007), and Lambert, Leuz and Verrecchia (2007a) re-examine the issue of estimation risk and firms cost of capital. Lambert et al. (2007b) model estimation risk using an information-economics approach where firms disclosures are noisy signals of their future cash flows. They show that the assessed covariances of a firms cash flow with the cash flows of other firms decrease as the quality (or precision) of firm-specific disclosures increases, and that this effect unambiguously moves a firms cost of capital closer to the risk-free rate. This information effect is not diversifiable because it is present for all covariance terms. Only the firm-specific variance term is likely to be diversified in large economies where investors can form portfolios of many stocks. The information effects in Lambert et al. (2007a) are consistent with the CAPM and hence should affect firms betas and the market risk premium.9 In addition to the direct effects on the assessed covariances, corporate disclosures have the potential to change firm value by affecting managers decisions and hence altering the distribution of future cash flows. Many studies in agency theory suggest that more transparency and better corporate governance increases firm value by improving managers decisions or by reducing the amount that managers appropriate for themselves (e.g., Shleifer and Wolfenzon, 2002).10 There can also be an indirect effect on the cost of capital (e.g., Lombardo and Pagano, 2002; Lambert et al., 2007a). For example, Lambert et al. (2007a) demonstrate that, if better
9

Hughes, Liu and Liu (2007) provide a similar model with a more restrictive information structure than Lambert et al. (2007a). As a result, disclosures merely affect the market risk premium but not firms beta factors. See also Yee (2006). Jorgensen and Kirschenheiter (2003) analyze the question of firms ex post incentives to disclose information about firm-specific variances. 10 See also the surveys by Shleifer and Vishny (1997) and Lambert (2001). There are also a number of legal studies that emphasize the role of disclosure in mitigating agency problems (see, for example, Mahoney, 1995 and Ferrell, 2004). As these studies typically discuss the role of regulation, they are reviewed in Section 2.6.

disclosure reduces the amount of managerial appropriation 11 , this effect generally reduces a firms cost of capital. Moreover, better corporate disclosures can improve managers production or investment decisions if investors and firms coordinate with respect to capital allocation via public disclosures and share prices.12 But the directional impact of these effects on the cost of capital is ambiguous (Lambert et al., 2007a). The reason is that the projects that are induced by better disclosures and more outside monitoring could have larger covariances with the cash flows of other firms in the economy and hence be riskier. This example illustrates that disclosure may have first-order effects on agency problems and investment efficiency. However, this line of research is still in its infancy and certainly warrants further investigation. 2.2. Firm-Specific Costs of Corporate Disclosures The direct costs of corporate disclosures, including the preparation, certification and dissemination of accounting reports, are conceptually straightforward. However, as illustrated by the recent debate about the economic consequences of SOX (e.g., Wall Street Journal, 2/10/2004; Ribstein, 2005), these direct costs can be substantial, especially considering the opportunity costs of those involved in the disclosure process. Moreover, fixed disclosure costs lead to economies of scale and can make certain disclosures particularly burdensome for smaller firms. Disclosures can also have indirect costs because information provided to capital market participants can also be used by other parties (e.g., competitors, labor unions, regulators, tax authorities, etc.). For example, detailed information about line-of-business profitability can

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Managerial appropriation of corporate resources can take many forms, such as outright stealing of cash, the use of excess cash for pet projects from which the manager derives some private utility, lavish business trips, or simply excessive compensation. 12 At the same time, disclosures can also have adverse real effects and lead to production distortions. Kanoida et al. (2000) and Sapra (2002) illustrate this in the context of hedge disclosures.

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reveal proprietary information to competitors (e.g., Feltham et al., 1992; Hayes and Lundholm, 1996). The fact that other parties may use public information to the disclosing firms

disadvantage can dampen its disclosure incentives (Verrecchia, 1983; Gal-Or, 1985). However, a competitive threat may not always induce firms to withhold information. For example,

incumbent firms may disclose information to deter entry by competitors. Firms might also share information about market demand to prevent overproduction in the industry (Kirby, 1988). Furthermore, competitors can infer information from the fact that a firm does not make certain disclosures. Thus, the relation between disclosures and proprietary costs is complex and depends on the type of competition threat (e.g., Vives, 1984; Gal-Or, 1986; Verrecchia, 1990; Wagenhofer, 1990; Feltham et al., 1992). A related argument is that more transparency could be costly to existing financing relationships, especially with banks (e.g. Rajan and Zingales, 1998; Leuz and Oberholzer-Gee, 2006). Relationship financing may require some private information flows between a firm and its bank in order to protect relationship-specific investments that make financing arrangements viable where a firm pays above market in good times but in return obtains credit in bad times. If disclosures put outside financiers on a level-playing field, the relationship is unlikely to survive the forces of competition in good times. Thus, firms that have or seek such financing

relationships are likely to be reluctant to provide full disclosure. In summary, there are numerous direct and indirect reporting and disclosure costs, which in turn are likely to make the optimal amount of disclosure specific to each firm. 2.3. Market-Wide Effects and Externalities of Corporate Disclosure An individual firms disclosure can have effects beyond the firm itself. We refer to those effects as market-wide effects. The competitive effects of corporate disclosure discussed in

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Section 2.2 are one example. But the effects of corporate disclosure extend beyond competing firms. An individual firms disclosures may have externalities that benefit non-competing firms in other industries by revealing relevant information about new consumer trends, technological shocks, best operating practices, governance arrangements, etc. This information can be useful to other firms for decision making but it can also help reduce agency problems in other firms. Firms disclosures of operating performance and governance arrangements provide useful benchmarks that help outside investors to evaluate other firms managerial efficiency or potential agency conflicts and in doing so lower the cost of monitoring. While the incremental

contribution of each firms disclosure is likely to be small, these information transfers could carry substantial benefits for the market or the economy as a whole. The real effects of

information transfers and potential governance spillover effects are still largely unexplored. Most of the work has focused on information transfers in capital markets, starting with Foster (1981). Dye (1990) and Admati and Pfleiderer (2000) analyze positive externalities in the form of information transfers and liquidity spillovers in capital markets. As firm values and cash flows are likely to be correlated, the disclosure of one firm is useful to investors in valuing other firms and increases the investors demand for shares in other firms. Lambert et al. (2007a) show that this argument applies to estimation risk. Each firms disclosure has a (small) impact on investors assessed covariances of other firms, which in turn lowers the estimation risk and cost of capital of other firms. Jorgensen and Kirschenheiter (2007) show similar externalities in the context of disclosures about firms sensitivity to a market-wide risk factor. Again, while these effects are likely to be small individually, they could be large across all firms in the market or economy. There is also the argument that firm-specific disclosures have market-wide benefits

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because they eliminate duplicative efforts of information intermediaries and investors and that firms are likely the lowest-cost producer for corporate information (e.g., Coffee, 1984; Easterbrook and Fischel, 1984; Diamond, 1985).13 At the same time, there can be negative effects or costly externalities to firms reporting and misreporting activities. For example, Fishman and Hagerty (1989) show that an increase in disclosure by one firm can attract investors away from other firms (e.g., if processing information is costly). In markets that are not perfectly competitive, this effect lowers the price efficiency of other firms and creates a negative externality. This argument can be extended to apply across markets or countries. If markets that are not perfectly competitive, then high transparency in one capital market can siphon off investors and lower the price efficiency in other capital markets. In addition, a firms disclosures can have effects on the efficiency of risk sharing in a market. Adverse selection can distort market-wide risk sharing because investors with relatively high risk tolerance will hold smaller positions (i.e., bear less risk) than they would otherwise because they anticipate the costs of liquidating larger positions in a market with information asymmetry among traders. This effect leaves more risk to be borne by less risk tolerant investors, leading to a higher market risk premium. Diamond and Verrecchia (1991) illustrate this point in a model with risk-neutral and risk-averse traders, but it also applies to economies with differentially risk averse investors (see also Lambert, Leuz and Verrecchia, 2007b). Finally, an individual firms misreporting activities may have negative spillovers to related firms, governments, and investors. For example, Sidak (2003) argues that fraudulent

13

This idea also relates to Hirshleifer (1971) who argues that private information acquisition for speculative gains in securities markets merely creates wealth transfers and hence the costs of such activities are socially wasteful.

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disclosures and financial reports can send false signals to industry players about new investment opportunities, lead governments to pursue incorrect regulatory policies, and cause capital rationing in the industry. In summary, there are numerous reasons why an individual firms disclosures extend beyond the firm itself. Moreover, the market-wide effects could be large in the aggregate while imposing relatively small costs on the disclosing firm. But as individual firms generally cannot internalize the market-wide benefits of their disclosure activities, even relatively small disclosure costs could deter socially optimal disclosure activities. As with other externalities, the problem is that firms trade off only the private (or firm-specific) costs and benefits only and hence do not provide the socially optimal level of disclosure. As discuss next, there are market and regulatory solutions to this problem. Moreover, it is important to recognize that the social value of disclosure can be greater or less than the private value of disclosure, and as a consequence, firms may provide too much or too little information. 2.4. The Economics of Mandated or Regulated Disclosure As many before us have noted, the existence of (net) benefits to voluntary disclosure is not sufficient to justify mandatory disclosure because firms have incentives to voluntarily provide information if the benefits exceed the costs (e.g., Ross, 1979). The idea of market-based disclosure incentives is best illustrated with the unraveling argument (Grossman and Hart, 1980; Grossman, 1981; Milgrom, 1981). Without corporate disclosures, investors are unable to

distinguish between good and bad firms and therefore offer a price that reflects the average value of all firms. So, firms with an above-average value have an incentive to disclose private information about their true value. Once these firms disclose, investors rationally infer that the average value of all non-disclosing firms is lower and adjust the price to reflect this expectation.

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This reaction in turn triggers the remaining non-disclosing firms with values above the newly set market price to disclose information about their private value, and so on. In the end, all firms (except the worst) disclose their private information about value voluntarily. However, the preceding argument relies on a number of simplifying assumptions. For example, disclosure of private information and its verification must be low cost and investors must know that firms possess private information. Without these assumptions, the described full disclosure equilibrium may not prevail (e.g., Ross, 1979; Verrecchia, 1983; Dye, 1985; Jung and Kwon, 1988). However, even if these assumptions are violated, the general spirit of the

unraveling argument still applies: Firms are expected to voluntarily provide information if there are net benefits to disclosure because they ultimately bear the costs of withholding information. Thus, an economic justification of mandatory disclosure has to show that a market solution is unlikely to produce a socially desirable level of disclosure. Moreover, competition and private contracting can address market failures (Coase, 1960). Thus, a market failure alone is not sufficient to justify regulation. To avoid the Nirvana fallacy, one has to show that a regulatory solution would in fact achieve better outcomes or be cheaper than a market solution (e.g., Stigler, 1971). Regulatory processes are far from perfect and face many problems (e.g., Peltzman et al., 1989). Moreover, firms are likely to be better informed about their cost-benefit tradeoff with respect to disclosure than regulators. The literature commonly appeals to the following arguments to justify the regulation of firms financial reporting and disclosure activities: the existence of externalities, market-wide cost savings from regulation, strict sanctions that are difficult to produce privately and dead-

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weight costs from fraud and agency conflicts that could be mitigated by disclosure.14 We review each of these arguments in favor of disclosure regulation but note that they are related and often combined.15 The first argument is that corporate disclosures create several externalities, which can lead to private over- or underproduction of information. In theory, disclosure regulation can mitigate this problem by mandating the socially optimal level of disclosure. However, in

practice, it is likely to be difficult for regulators to determine the socially optimal level of disclosure and whether markets produce too little or too much information, especially considering that there exist many different positive and negative externalities. Moreover, as mentioned before, market solutions can mitigate the problems created by externalities. For instance, consider the argument that the social value of disclosure exceeds the private value because it mitigates duplicative private information acquisition by investors. As Mahoney

(1995) points out, this argument is not very convincing as a justification for mandating quarterly and annual reports because investors continue to have incentives to acquire private information in the interim. It might still serve as a rationale for mandatory ad-hoc disclosure of material information (e.g., 8-K reports in the U.S.). But even for such timely disclosures, market forces likely limit the extent to which private and social values of information can diverge and hence the degree to which information is overproduced. For instance, prices tend to reveal some of the private information that traders have, which in turn curbs incentives to acquire information privately (Grossman, 1977; Grossman and Stiglitz, 1980). Furthermore, widespread duplication

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These arguments are not specific to the disclosure literature and have been used in many other regulatory contexts. Hermalin and Katz (1993) show in a general bargaining context that there are only three reasons for outside interference with private contracting: (i) the parties are asymmetrically informed ex ante; (ii) there is an externality on a third party; and (iii) the state has access to more remedies than private parties. 15 Much of the debate on mandatory disclosure has taken place in the legal literature, rather than in accounting, finance or economics. See, e.g., Seligman (1983), Coffee (1984), Easterbrock and Fischel (1984), Mahoney (1995).

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and overproduction of information create incentives for specialization where some investors produce reports and other pay for them (e.g., Gonedes, Dopuch and Penman, 1976; Mahoney, 1995). Thus, it is likely an empirical question whether mandatory disclosures create externalities that make them in fact socially desirable. A second argument put forth to justify disclosure regulation is that a mandatory regime serves as a low-cost commitment device (e.g., Mahoney, 1995; Rock, 2002).16 The basic idea can be illustrated in an IPO setting. Given the forces underlying the unraveling argument, firms have strong incentives at the time of the IPO to provide information and other assurances about firm value to investors. However, these incentives may change once the capital has been issued. It is easy to imagine situations after the IPO in which firms have incentives to withhold or manipulate information (e.g., when performance is poor). Thus, a mere promise at the IPO to provide high-quality disclosures in the future is unlikely to be credible. In contrast, disclosure requirements specify which information a firm has to provide and force it to reveal this information in both good and bad times. This commitment can mitigate information

asymmetries and reduce uncertainty, both when going public and in secondary markets (e.g., Verrecchia, 2001). But as noted before, this argument alone is not sufficient to justify a

mandatory disclosure regime because firms would voluntarily seek such commitments if they are beneficial (e.g., Ross, 1979). Thus, we need to argue (or provide evidence) that mandatory disclosure provides commitment at lower costs. Alternatively, we can look for reasons why mangers might not privately seek disclosure commitments even if they are beneficial to the firm. Before we review this third class of arguments, we note that managerial agency problems and a potential reluctance of managers to
16

Again, the idea that law can function as a commitment device is not specific to disclosure regulation. See, e.g., Aghion and Hermalin (1990).

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disclose information do not change the above reasoning. To illustrate this point, let us consider a family-owned firm that has delegated day-to-day operations, including disclosure decisions, to a manager. Assume that this firm tries to raise additional capital from outside investors and that the manager promises to periodically disclose certain information to outside investors. Despite this promise, outside investors understand that situations may arise where it is in the managers interest to withhold information (e.g., disclosures that would lead to her dismissal). Anticipating these incentives, outside investors raise the rate of return at which they are willing to provide capital to the firm, which implies that the controlling family ultimately bears the costs of not providing a credible commitment as well as the costs of any residual agency problems. Thus, as stated above, controlling owners have incentives to seek commitments and mitigate managerial agency problems (Jensen and Meckling, 1976). Despite these incentives, a mandatory regime can be beneficial if it is limited to disclosures that almost all firms are willing to provide voluntarily (Ross, 1979). 17 The

requirement saves firms the cost of negotiating disclosures when the result does not vary much across firms and hence the costs of complying with a one-size-fits-all regime are relatively low. Using this reasoning, Mahoney (1995) argues that agency information, i.e., disclosures about related-party transactions, underwriting fees, and self-dealing, has this feature as it addresses agency problems that arise in almost all securities offerings. In contrast, information that

primarily helps investors to project future cash flows and value the firm is likely to be highly firm-specific and hence should be discretionary. Based on this justification, the key issue is to identify disclosures that generate economy-wide cost savings.

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Hermalin and Weisbach (2007) also argue that mandatory disclosure beyond the level chosen voluntarily is likely to reduce social welfare.

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A third and closely related argument is that privately producing a sufficient level of disclosure commitment can be very expensive and in many cases even impossible. The penalties that private contracts can impose are generally quite limited. For instance, in our example of a family-controlled firm, the threat of dismissal or monetary penalties may not be sufficient to ensure that the manager always adheres to the owners disclosure policy. Thus, a mandatory disclosure regime can be beneficial if it offers access to criminal penalties or other remedies that are not available to private contracts. A recent stream of literature argues that controlling shareholders and corporate insiders (e.g., the family in the preceding example) can extract substantial private benefits from firms and thereby effectively expropriate outside investors (e.g., Shleifer and Vishny, 1997; La Porta et al., 2000). As a result, controlling insiders may be reluctant to provide disclosures that limit their ability to consume private benefits. That is, controlling insiders may not seek a disclosure commitment, even when it increases firm value and reduces the cost of capital. But as Jensen and Meckling (1976) argue, outside investors are likely to price protect, so the controlling owners bear the costs of extracting private benefits and providing insufficient disclosures. Besides, even if outsiders do not fully anticipate the level of expropriation, as long as controlling owners value the resources they divert or consume at least as much as outside investors, private benefits simply constitute a wealth transfer and not a social loss. However, it seems plausible that the diversion activities themselves are costly, in which case there are social losses (e.g., Burkhart et al, 1998; Shleifer and Wolfenzon, 2002). Moreover, and perhaps more importantly, controlling insiders are likely to forgo profitable investment opportunities for the sake of private benefits (e.g., Shleifer and Wolfenzon, 2002). This behavior is not socially costly if other firms enter the business and exploit these opportunities. But it can

19

have substantial social costs if other firms cannot exploit these opportunities and they are lost to the economy as whole. Thus, competition and the ability of new entrants to raise capital play an important role for the extent to which the consumption of private benefits has social costs. First, competition likely limits the extent to which controlling insiders can appropriate resources without threatening the survival of the firm. Second, new entrants that intend to exploit the opportunities forgone by the incumbents need ways to credibly commit so that they can raise the necessary capital. Thus, a potential benefit of a mandatory disclosure regime is that it makes it easier for new entrants to commit and hence to raise capital, which in turn increases competition and reduces social losses from private benefits consumption (see also Ferrell, 2004).18 In contrast, the incumbents are likely to oppose such a regime and, more generally, have an incentive to prevent the creation of legal institutions that facilitate commitment, lead to more competition and lower private benefits (Rajan and Zingales, 2003).19 In promoting the development of financial markets, mandatory disclosure can also benefit investors, e.g., in creating new investment opportunities for their savings. Again, incumbent firms would not necessarily create such opportunities as they may make it easier for entrants to raise finance (Rajan and Zingales, 2003). The preceding discussion illustrates that mandatory disclosure can have a number of benefits and be socially desirable. However, to avoid the Nirvana fallacy, it is important to recognize that mandatory disclosure regimes have costs and are not without problems. First, mandatory regimes are costly to design, implement and enforce. Second, incumbent firms have

18

It may also have the direct benefit of making it harder for controlling insiders to consume private benefits and thus of mitigating the root cause of the problem. 19 This incentive exists regardless of whether controlling insiders of incumbent firms consume private benefits or not. But the incentive is likely to be stronger when they do extract such benefits.

20

an incentive to capture the regulatory process, e.g., to implement a system that inhibits, rather than promotes competition, which in turn can create substantial indirect costs (Stigler, 1971). Recognizing these issues, Djankov et al. (2003) propose an enforcement theory of regulation. Their premise is that all strategies to implement a socially desirable policy are imperfect and that optimal institutional design involves a tradeoff between imperfect alternatives.20 A Coasian implementation, which relies heavily on courts and private litigation, can be quite imperfect, especially when weapons are unequal across litigants. For instance, it seems plausible that richer, better connected, and better represented promoters and underwriters have a stronger influence on the course of justice than defrauded, small investors (Shleifer, 2005). One way to address this shortcoming of private orderings with private enforcement is to specify mandatory disclosures because rules limit court discretion.21 As Shleifer (2005) points out, it is easier for a firm to influence a court or judge when there are no specific rules of what needs to be disclosed. This discussion highlights two important points: (i) it can be beneficial to combine public rules and private enforcement (e.g., Hay and Shleifer, 1998) and (ii) the desirability and effectiveness of particular disclosure rules depends also on the chosen enforcement mechanism, which highlights an important complementarity in the institutional framework. We will come back to the issue of complementarities. Another important factor is the level at which disclosure regulation takes place and hence who is the regulator. It is conceivable to create mandatory regimes at the exchange, state, country or supranational level. Each level has its advantages and drawbacks. Regulating at a higher level (e.g., country) generates larger benefits from standardization and exploits network
20

They characterize the problem as a tradeoff between two basic social costs: disorder and dictatorship. Shleifer (2005) explicitly discusses this tradeoff in the context of securities regulation. 21 In a related fashion, Easterbrock and Fischel (1984) and Mahoney (1995) also argue that mandatory disclosure and anti-fraud provisions are complementary.

21

externalities. Regulating at a lower level (e.g., exchange) avoids the problems of a one-size-fitsall approach and allows firms to opt into a particular regime, which in turn creates competition among regulatory regimes. The latter can have benefits and drawbacks for the development and enforcement of mandatory disclosures (e.g., Mahoney, 1997; Romano, 1998 and 2001; Huddart et al., 1999; Rock, 2002; Chemmanur and Fulghieri, 2006). These issues become even more complicated in global securities markets where the regulations of various countries interact with each other but are harder to coordinate. Barth, Clinch and Shibano (1999) explore these issues in the context of accounting harmonization and show that countervailing forces imply that accounting harmonization can have beneficial or deleterious effects on security markets. Generally speaking, however, there is little research on the interaction between financial globalization and countries disclosure regulations. 2.5. Concluding Remarks on the Theory of Financial Reporting and Disclosure Regulation In summary, the potential costs and benefits of disclosure regulation are numerous and complex. Our framework identifies important costs and benefits of firms voluntary disclosure activities, as well as potential costs and benefits of regulating these activities. Our review illustrates that the net effect of disclosure regulation on a market or an economy is largely an empirical question. Moreover, the extant theoretical literature typically analyzes and evaluates disclosure regulation in a static way. However, there are important issues of with respect to the dynamics, process and form of reporting and disclosure regulation, complementarities with other regulations, and regulatory competition that are still unexplored in the theoretical literature. We discuss these issues as directions for future research in Section 6.

22

3.

Empirical Evidence on the Costs and Benefits of Disclosure In this section, we review empirical studies on the potential costs and benefits of firms

information financial reporting and disclosure policies.

We again apply the framework

developed in section 2 to identify possible firm-specific (micro-level) and market-wide (macrolevel) effects of firms disclosure and reporting activities. Our review complements prior

surveys of the empirical disclosure literature by Healy and Palepu (2001) and Core (2001) by focusing in particular on new studies that post-date these surveys. As a first step, we outline how the empirical literature defines and measures the quality of firms disclosures and financial reporting attributes. What is meant by high quality disclosures and financial reports is often ambiguous and difficult to measure. We also highlight the fact that most empirical studies explore the association between firms voluntary disclosure choices and various costs and benefits of these choices across firms in a given sample. These firm-specific effects can be relevant in regulatory debates if: (i) they help us pinpoint key costs and benefits of financial reporting and disclosure, (ii) they inform us about the differential costs and benefits to firms, which in turn helps us understand how uniform reporting requirements may differentially affect firms (including potential wealth transfers among firms), or (iii) they help us predict which firms may take avoidance actions or lobby for or against a proposed regulation given the potential differential effects on firms and wealth transfers between them. In general, however, voluntary disclosure studies cannot provide insights into the overall desirability, economic efficiency, or aggregate outcomes of regulating these disclosures. Therefore, it is also important to review the empirical evidence on the macro-level effects and externalities of firms disclosure choices.

23

3.1.

Measuring Disclosure and the Quality of Accounting Numbers Corporate information can be disseminated through financial reporting (e.g., the annual

report or SEC filings like the 10-K or 10-Q) and through various scheduled and unscheduled disclosures (e.g., press releases, conference calls). Disclosures are often qualitative and narrative in nature which makes objective measurement difficult for empiricists. Moreover, theoretical research provides little guidance on what form, quantity and frequency of disclosure is relevant for various stakeholders. Yet, there seems to be agreement that that timely, relevant, verifiable, reliable, unbiased, comparable and consistent disclosures and financial reports are all desirable properties of corporate disclosures and financial reports (FASB, Statement of Financial Accounting Concepts No. 2). However, many of these properties are in conflict with each other and, as a result, empirical researchers face challenges in identifying and capturing the most important dimensions of high quality corporate information. A widely-used disclosure measure is based on the annual survey of financial analysts rankings of U.S. firms disclosure activities by the Association for Investment Management and Research (AIMR) (e.g., Lang and Lundholm, 1993, 1996; Welker, 1995; Healy, Hutton and Palepu, 1999; and Nagar, Nanda and Wysocki, 2003).22 These rankings arguably capture the usefulness of firms disclosures as perceived by expert users of this information. The disclosure rankings capture a broad range of disclosure activities including annual report information, voluntary disclosures in quarterly reports, and more diffuse disclosures arising from investor relations activities. The limitations of the AIMR rankings are that they are only applicable to a subset of large U.S. firms ranked in the survey during the 1980s and 1990s. Moreover, there are

22

The AIMR has changed its name to CFA Institute. The disclosure ratings were published under the old name (AIMR) and discontinued in the mid 1990s. Academic studies still refer to these ratings as AIMR ratings.

24

questions about potential bias in the rankings based on sell-side analysts objectives in assigning disclosure ratings.23 Other studies use measures of disclosure activities constructed by researchers (e.g., Botosan, 1997; Hail, 2003; Francis, Nanda and Olsson, 2005). These self-constructed measures generally use a check-list of information disclosures in firms annual reports. International studies often rely on the international CIFAR index, which is also constructed from annual report information for large firms across a range of countries and typically averaged at the country level (e.g., La Porta et al, 1998; Hope, 2003; Leuz, Nanda, and Wysocki, 2003), and the Standard and Poors scores of international firms disclosures (e.g., Khanna, Palepu, and Srinivasan, 2004; Doidge et al., 2007a). The limitations of these types of measures are that the selection and coding of the relevant disclosures are subjective, that they generally capture the existence of particular disclosures, rather than their quality, and that the construction of a single index assigns particular weights to the different disclosure items. Moreover, these measures often do not capture other disclosure activities that can complement or substitute for financial report disclosures. Other studies focus on the timing and frequency of firms disclosures such the frequency and precision of management forecasts of earnings (see Hirst, Koonce and Venkataraman, 2008, for a review of the literature), ), and conference calls with analysts (e.g., Tasker, 1998; Frankel, Johnson, and Skinner, 1999; Bushee, Matsumoto, and Miller, 2003). While it is difficult to objectively quantify the information issued with management forecasts and during conference calls, the studies highlight that these disclosure events generally reveal useful qualitative and contextual information to outside investors.

23

There are concerns that the surveyed sell-side analysts simply assign higher ratings to firms with better prospects and financial performance. For example, Lang and Lundholm (1993) find that AIMR disclosure ratings are strongly correlated with past performance. Healy and Palepu (2001) also identify additional limitations of the AIMR data.

25

More recently, studies have made a more direct attempt to measure the quality of accounting information provided to outside investors by analyzing the properties of a firms reported earnings. For instance, research suggests that conservative accounting reports (e.g., Basu, 1997; Ball, Kothari and Robin, 2000), earnings smoothing activities (e.g., Leuz, Nanda and Wysocki, 2003; Francis, LaFond, Olsson and Schipper, 2004; LaFond, Lang, and Skaife, 2007), earnings persistence (e.g., Dechow and Dichev, 2002; Francis, LaFond, Olsson and Schipper, 2004) and the value-relevance of earnings (Collins, Maydew and Weiss, 1997; Francis and Schipper, 1999) can capture important (positive or negative) dimensions of a firms discretionary information quality. In addition, the proxies developed in the earnings management literature also provide ways to measure lower quality earnings (see, for example, Healy and Whalen, 1999, and Dechow and Skinner, 2000). Several papers use these individual proxies or aggregate them to measure accounting quality. For example, Leuz, Nanda and Wysocki (2003) examine four earnings properties that indicate opaque financial reporting and/or earnings management, both of which can limit the usefulness of the accounting information for outside investors. These measures have been used in a variety of contexts and by several other studies (e.g., Bhattacharya, Daouk and Welker, 2003; Lang, Raedy and Yetman, 2003b; Lang, Raedy and Wilson, 2006; Burgstahler et al. 2006). By aggregating across measures or showing similar results for several different measures, these studies attempt to address concerns about measurement error. As with the construction of disclosure indices, there is the question on how to weight the properties and the issue that the relations and tradeoffs between properties are ignored.

26

Dechow and Dichev (2002) and Francis, LaFond, Olsson and Schipper (2005) model the relation between a firms cash flows and working capital accruals to derive a measure of earnings quality. Subsequent research even suggests that these accruals-based measures can potentially capture a firms overall information quality (e.g., Ecker, Francis, Kim, Olsson, and Schipper, 2006). However, Core, Guay and Verdi (2007), Hribar and Nichols (2007), Liu and Wysocki (2007) and Wysocki (2007) present evidence casts doubt on this claim and even questions the extent to which accruals quality captures a firms earnings quality. There are also related empirical studies that examine and attempt to quantify a firms information environment. While these studies do not directly measure a firms disclosure or reporting activities, they do attempt to capture the information asymmetry among traders in a firms securities. For example, Easley, Hvidkjaer, and OHara (2002) use the probability of informed trade in a firms shares (PIN) as a proxy for information asymmetry among traders. Subsequently, this measure has been used to examine the link with firms disclosure activities, In sum, the existing literature shows that measuring firms financial reporting and disclosure activities is difficult and that commonly used proxies exhibit many problems. Thus, there is clearly a need for more research to improve existing proxies as well as to capture qualitative and narrative disclosures more broadly (see also Core, 2001). 3.2. Benefits of Voluntary Disclosures and High Quality Financial Reports

3.2.1. Liquidity Benefits of Disclosures and Financial Reports As discussed in section 2.1, a possible direct firm-specific benefit of high quality disclosures and financial reports is greater liquidity of a firms securities. Survey evidence suggests that managers believe that such a liquidity benefit exists. Graham, Harvey and

Rajgopal (2005) survey managers from 312 public U.S. firms and find that 44% of managers

27

strongly agree with the statement that voluntarily communicating information increases the overall liquidity of our stock (compared to 17% of managers who strongly disagree with the statement). However, the survey provides no evidence on the economic magnitude of the liquidity benefit nor which types, quantity, frequency, and quality of voluntary disclosures are necessary to achieve a measurable impact on stock liquidity. Other cross-sectional studies attempt to directly quantify the stock market liquidity benefits of greater voluntary disclosure. Welker (1995) tests the liquidity impact of firms voluntary disclosure using AIMR disclosure rankings. He finds that firms in the lowest third of the disclosure rankings have about 50 percent higher bid-ask spreads than firms in the highest third of the rankings. However, his tests for the sensitivity of bid-ask spreads to disclosure policy based on the probability of informed trade activity and probability of information event occurrences are statistically insignificant. Healy, Hutton, and Palepu (1999) also use AIMR rankings to examine a sample of firms that exhibit a voluntary and sustained increase in their disclosures. They find these firms had a significant increase in their liquidity (bid-ask spreads and trading volume) after the perceived increase in their disclosure quality. Recent work by Ng (2007) also suggests that certain information quality attributes are associated with the liquidity of a firms shares and with a firms estimated loading on the liquidity factor suggested by Pastor and Stambaugh, 2003. He finds that management forecast frequency is negatively associated with a firms loading on the liquidity risk factor, whereas accounting earnings attributes such as value relevance and accruals quality are not significantly associated with the loading on the liquidity risk factor. Ng (2007) also provides some evidence that the effect of better information quality in lowering liquidity risk is stronger for firms with less private information.

28

In an international setting, Leuz and Verrecchia (2000) examine a sample of German firms that voluntarily adopt more onerous disclosure requirements by switching from German GAAP to an international reporting regime (i.e., IAS or U.S. GAAP). Leuz and Verrecchia (2000) find that switching firms have smaller bid-ask spreads and higher trading volume following the switch and relative to German GAAP firms, consistent with the notion that a commitment to more disclosure reduce adverse selection in capital markets. These studies show that certain voluntary disclosures and accounting attributes are associated with greater liquidity for a firms shares and suggest that traders require less price protection when buying or selling shares. However, in many instances, the economic significance of the liquidity effects in cross-sectional studies of U.S. firms appears to be small. One issue is that these studies analyze firms disclosures within the rich and stringent U.S. disclosure system where the effects of additional voluntary disclosures are likely to be small (Leuz and Verrecchia, 2000). Moreover, cross-sectional studies may understate the true liquidity impact of voluntary disclosures. For example, firms with non-existent or minimal disclosures do not appear in the samples, but are likely to have such large bid-ask spreads that there is little or no public trading.24 In other words, these extreme cases are often missing from cross-sectional studies, and therefore the results may understate the true magnitude of the liquidity impact of public disclosure in share markets. 3.2.2. Voluntary Disclosure, Accounting Quality and Firms Cost of Capital Another possible benefit of voluntary disclosures and high quality financial reports is that they directly lower a firms cost of capital. As outlined in section 2.1, there are several

24

Consistent with this claim, Bushee and Leuz (2005) document that firms in the OTC markets have extremely low levels of market liquidity and Leuz, Triantis and Wang (2007) show that liquidity essentially vanishes if firms cease to provide public disclosures on a regular basis.

29

mechanisms by which an increase in corporate disclosures can manifest in a lower cost of capital. At present, however, the literature has primarily focused on establishing the link between disclosure and the cost of capital and has provided relatively little evidence on the mechanism. In this section, we review several of the key papers and results without trying to be comprehensive (see also Healy and Palepu, 2001; and Core, 2001). Again, there is survey evidence suggesting that managers perceive a cost of capital benefit from expanded voluntary disclosures. Graham, Harvey and Rajgopal (2005) find that 39% of managers strongly agree with the statement the voluntarily communicating information reduces our cost of capital, while 22% strongly disagree with this statement. However, the economic magnitude of this cost of capital effect cannot be determined from this survey. Moreover, it should be noted that the perceived benefits of disclosure do not apply equally to all firms. Graham et al. (2005) find that the perceived reduction in the cost of capital is greatest for firms with high analyst following.25 Theory suggests that information asymmetry and the adverse selection problems of nondisclosure can flow back to the firms share issuance decision and translate into a higher cost of raising capital. Consistent with this conjecture, research documents a positive link between external capital raising activities and disclosure quantity and quality (e.g., Frankel, McNichols and Wilson, 1995; Healy, Hutton and Palepu, 1999; Lang and Lundholm, 2000). More recently, there are also studies that document more extensive pre-IPO disclosures are associated with lower underpricing (e.g., Schrand and Verrecchia, 2005; Leone, Rock and Willenborg, 2007) Other cross-sectional studies attempt to directly quantify the cost of capital benefits of greater voluntary disclosure. One of the first studies in this vein is Botosan (1997). She creates a
25

They also find that the beneficial impact of voluntary disclosures on a firms P/E (which can be viewed as a rough measure of its cost of equity capital) is much more muted for firms with low analyst following.

30

self-constructed index of voluntary annual report disclosures for a sample of U.S. manufacturing companies and links it to an ex ante imputed cost of capital measure. In her overall sample, she does not find a significant relation between voluntary disclosure and equity cost of capital. However, firms with low analyst following do exhibit the predicted negative relation between disclosure and cost of equity capital. Interestingly, this result is exactly opposite to the survey findings of Graham et al. (2005), which suggest that the disclosure-cost of capital relation is weakest for firms with low analyst following.26 Follow-up research by Botosan and Plumlee (2002) finds a significant negative relation between cost of equity capital and annual report disclosures.27 However, they find contradictory evidence suggesting that the cost of capital is higher for firms with more timely voluntary disclosures, and no association between the cost of capital and firms investor relations activities. Other mixed evidence on the cost of capital outcomes is also presented in Healy, Hutton and Palepu (1999). They find that firms realized stock returns are higher in the years following an improvement in their disclosures. Taken literally, this finding suggests that better disclosure actually increases firms cost of capital. However, it should be noted that realized returns are likely to be a relatively poor proxy for firms cost of capital unless they are measured over very long time periods (e.g., Elton, 1999). In an international context, Hail (2003) examines a sample of Swiss firms where mandated disclosure is low and there is large variation in firms voluntary disclosure policies. He finds that more forthcoming firms enjoy around a 2.5% cost advantage over the least

26

The Merton (1987) model of incomplete information and risk sharing suggests that firms can make investors aware of their existence and enlarge the investor base, which in turn lowers their cost of capital. This effect would seem most pronounced for small firms (e.g., in the OTC markets) and it less relevant for large firms with high analyst following. 27 See also Botosan (2006).

31

forthcoming firms. The considerable magnitude of his findings in a weak disclosure environment is consistent with the idea expressed in Leuz and Verrecchia (2000) that the magnitude of the relation may depend on countries institutional factors. These findings also illustrate the possible interactive effects between firms disclosure policies, institutional factors, and ultimately the impact of disclosure regulation. There is also a growing literature on the link between a firms accounting attributes (such as earnings volatility and accruals quality) and the firms cost of capital. For example, Francis, LaFond, Olsson and Schipper (2004) and Verdi (2006) show that smoother earnings are associated with a lower implied cost of capital. Francis, LaFond, Olsson and Schipper (2005) examine the link between cost of equity capital and the quality of a firms accruals. They find a strong negative relation between their measure of accruals quality and various cost of capital measures including P/E ratios, market betas, and observed stock returns, suggesting that the cost of capital decreases when earnings quality increases. Francis et al. (2005) also create an economy-wide risk factor based on their accruals quality measure. They argue that their stock returns tests support the idea that accruals quality is a systematic, i.e. non-diversifiable, risk factor, over and above beta. Ogneva (2007) also provides evidence that accruals quality seems to be a priced risk factor after controlling for shocks to a firms expected cash flows. However, recent research suggests that the apparent association between accounting attributes and cost of capital is often not robust and also not unambiguous in its interpretation. For example, Core et al. (2007) show that the asset pricing tests in Francis et al. (2005) and Ecker et al. (2006) are not appropriate to determine whether accruals quality is a priced risk factor. When conducting proper (two-stage cross-sectional tests) asset pricing tests, Core et al. (2007) find little evidence that accruals quality is priced as a separate risk factor. In addition,

32

McInnis (2007) finds no relation between smooth earnings and neither average stock returns nor a firms implied cost of capital after adjusting for analysts biases in their earnings forecasts.28 He also shows that the bias in analysts forecasts may also drive the apparent association between accruals quality and a firms implied cost of capital (Francis et al, 2004, and Core, Guay, Verdi, 2007). Furthermore, Nichols (2006) and Liu and Wysocki (2007) show that the Francis et al (2005) findings on the association between accruals quality and cost of capital are not robust after controlling for firms fundamental operating characteristics, suggesting that the accruals quality measure does not properly separate firms reporting activities and the properties of its operating processes. Recent studies also examine the association between cost of debt capital and voluntary disclosures. Sengupta (1998) uses AIMR rankings of firms disclosures to examine the relation between cost of debt and voluntary disclosure. He documents an inverse relation between disclosure and the effective interest cost of raising debt. Miller and Puthenpurackal (2002) also find that U.S. debtholders demand economically significant premiums on bonds for foreign firms that have no prior history of on-going disclosure. Moreover, Zhang (2006) finds that lenders offer lower up-front interest rates to firms that report conservative earnings numbers and that these findings are robust to controlling for numerous of other earnings attributes.29 This evidence contrasts with other studies that claim that conservative earnings properties are not a primary factor in determining cost of (equity) capital (e.g., Francis, LaFond, Olsson and Schipper, 2004).
28

See Easton (2008) for a comprehensive discussion of the theoretical, empirical and methodological issues related to estimating a firms implied cost of capital. 29 Graham, Harvey and Rajgopal (2005) survey managers from 312 public firms and find that 42% of managers strongly agree with the statement that a smooth earnings path is preferred because it achieves or preserves a desired credit rating. This compares with 19% of managers who strongly disagree with this statement. This statement is relevant because 47% of the managers also strongly agree with the statement that a smooth earnings path is preferred because it promotes a reputation for transparent and accurate reporting. In other words, smooth earnings appear to be synonymous with high quality financial reporting and this property appears to be valued by debtholders. However, this is somewhat ironic because the most surveyed managers also stated that smooth earnings fail to clarify true economic performance.

33

However, a major difficulty of tests involving the cost of debt is to control for the specifics of firms debt contracts, in particular the covenants, and their impact on the cost of debt. Overall, the evidence on the cross-sectional relation between a firms voluntary disclosures, accounting attributes and cost of capital is still evolving and hence it is difficult to draw definitive and unambiguous conclusions whether the empirical evidence supports current theories on the link between information quality and cost of capital. The empirical results appear to be sensitive to and can vary across different measures of cost of capital (i.e., realized returns versus ex ante cost of capital proxies), types of firms (i.e., different sizes), with the presence of other intermediaries (i.e., financial analysts), across types of disclosures or earnings attributes (i.e., annual reports versus timely disclosures versus conservative earnings), across types of investors (shareholders versus bondholders), and across different institutional environments (i.e., U.S. versus other markets). Another issue is that voluntary disclosure and reporting studies face a self-selection problem, which makes proper identification and estimating the marginal effects of voluntary disclosures on the cost of capital (and other outcomes such as liquidity) difficult. The fact that many studies do not address this issue may also contribute to the lack of consistent findings (e.g., Leuz and Verrecchia, 2000; Core, 2001; Nikolaev and van Lent, 2005; Larcker and Rusticus, 2005). 3.3. Empirical Evidence on the Firm-Specific Costs of Voluntary Disclosures There is a general paucity of empirical evidence on the direct costs and out of pocket expenses of firms disclosure and reporting choices. It is often difficult to quantify the direct costs especially if they come in the form of opportunity costs such as managerial time. However, the empirical literature suggests that there are fixed costs to information production and 34

dissemination than induce economies of scale in disclosure. Empirical disclosure studies consistently find that larger firms have better average disclosure quality (e.g., Lang and Lundholm, 1993). On the other hand, there is more evidence on the indirect costs of voluntary disclosures. For example, there are a number of empirical studies that examine the effects of proprietary costs on firms voluntary disclosure decisions. 30 Harris (1998) explores the association between product market competition and detailed industry segment disclosures. She finds that profitable operations in less competitive industries are less likely to be reported as industry segments. Berger and Hann (2003) also provide insights into the issue of proprietary costs by examining a change to U.S. reporting requirements for segment disclosures (i.e., the transition from SFAS 14 to SFAS 131). Under SFAS 14, firms were arguably given greater discretion in defining industry segments and therefore hiding segment information. SFAS 131 reduced this flexibility and discretion. Berger and Hann (2003) compare segment disclosures under both standards and find that firms that previously aggregated information under SFAS 14 had higher abnormal profitability and operations with more divergent performance. Leuz (2004) also examines proprietary costs for voluntary disclosures of segment information for a sample of German firms. He finds that firms are less likely to voluntarily disclose segment information if profitability across segments is heterogeneous and the mean profitability reported in the consolidated income statement is less revealing. Together results generally support the existence of variation in proprietary costs across firms and provide evidence that these differential costs influence firms voluntary disclosure choices.

30

Proprietary costs are the costs faced by a firm if it reveals information to outside parties. These costs include the revelation of trade secrets, the disclosure of profitable customers and markets, or the exposure of operating weakness to competing firms, unions, regulators, investors, customers or suppliers.

35

Other research posits that shareholder litigation provides a disincentive for firms to voluntarily provide forward-looking disclosures. Many early studies find mixed evidence on the effect of litigation on disclosure, especially bad news disclosures (see, for example, Kasznik and Lev, 1995; Skinner, 1997; and Johnson, Kasznik and Nelson, 2001). Field, Lowry and Shu (2005) attempt to reconcile this mixed empirical evidence on the relation between bad news disclosures and litigation. They highlight a possibly endogenous relation between observed litigation outcomes and voluntary management disclosures of bad news. After explicitly modeling the endogeneity in their empirical tests, their results suggest that disclosure potentially deters litigation. Therefore, given the threat of litigation, more forthcoming disclosure can benefit the firm in the sense that it reduces expected litigation costs. On the other hand, managers may also face significant ex post personal costs to disclosing bad news to investors. For example, Kothari, Shu and Wysocki (2007) present evidence consistent with widespread withholding of bad news by managers. They argue that managerial career concerns (broadly-defined) motivate them to accumulate and withhold bad news in the hope that things will turn around and they can bury the bad news. Finally, it is possible that disclosure activities have indirect costs for existing private financing or political relationships. As discussed in Section 2.2, firms with relationship

financing through their banks may be more reluctant in their full disclosure. At present, there is relatively little evidence on these indirect costs of disclosure. One example is the study by Leuz and Oberholzer-Gee (2006), which provides evidence on a tradeoff between transparency and political relationships for a sample of Indonesian firms with close ties to President Suharto.

36

3.4. Market-Wide Impact of Firms Disclosure and Reporting Activities It seems intuitive that one firms disclosures and financial reports should provide information about the prospects of other related firms. Foster (1981) was among the first to empirically show that a firms earnings announcement provides information to investors about other firms in the same industry. Han, Wild and Ramesh (1989) also show that managers voluntary earnings forecast disclosures affect the security prices of firms in the same industry. While other follow-up studies also look at these direct information transfers, the more interesting question for our purposes is the existence and magnitude of market-wide externalities from firms disclosure activities. Recent cases of accounting restatements suggest that not only do restating firms face equity market penalties (arguably related to an increased cost of capital), but such penalties also transfers to the firms competitors (Gleason, Jenkins and Johnson, 2004; and Xu, Najand and Zigenfuss, 2006). Durnev and Mangen (2007) also argue that one firms restatement announcement reveals information about the efficiency of its competitors past investments. Durnev and Mangen argue and present supporting evidence that a firms past misreporting activities affected competitors past investment decisions leading to sub-optimal investment based on the erroneous information. Specifically, when a restatement is announced, investors recognize the competitors past inefficient investment choices and they revise downwards their assessment of the competitors future expected cash flows. Sidak (2003) presents similar arguments in his case study of the Worldcom accounting fraud. He argues that WorldCom's fraudulent disclosure and financial reports had real negative effects on other telecom firms, governments and capital markets. WorldCom's falsified reports and disclosures lead to: (i) the widespread overinvestment in network capacity by other firms, (ii) the formulation of flawed

37

government telecommunication policies, and (ii) the sustained retrenchment of financing sources away from future telecom investment projects. Sadka (2006) also presents similar arguments on the real spillover investment effects of firms misreporting activities.

4.

Evidence on Reporting and Disclosure Regulation In this section, we focus primarily on recent empirical studies that can provide more

direct insights into the aggregate and macro-economic economic consequences of financial reporting and disclosure regulations. We review studies that examine the economic outcomes of changes in regulations, as well as studies that explore international differences in disclosure regulations and firms and investors responses to these differences. As Healy and Palepu (2001) note in their survey, empirical research on disclosure regulation and the economic consequences of (major) regulatory events is rare and most of these studies focus on early U.S. disclosure regulation in the 1930s. To be sure, there is a vast literature on the capital-market consequences of mandated changes of (particular) accounting standards.31 However, these studies examine firms that are already subject to the U.S. disclosure regime and generally focus on individual (accounting) rule changes, rather than broader changes in the disclosure regime. Moreover, much of this literature uses the association between reported accounting numbers and stock returns (or prices) as a way to evaluate particular rules or rule changes. As Holthausen and Watts (2001) point out, there is little theory supporting the

31

See, e.g., the surveys in Watts and Zimmerman (1986), Fields, Lys, and Vincent (2001) and Kothari (2001).

38

association criterion for standard setting and, as a consequence, it is not clear to what extent this literature can guide accounting regulators.32 More recently, there are a number of studies evaluating the economic consequences of major regulatory changes, such as the 1964 Securities Act Amendments, the 1999 Eligibility Rule on the OTC Bulletin Board, and Regulation Fair Disclosure in 2000, and the SarbanesOxley Act of 2002. There is also recent research exploiting international variation in disclosure regulation. In this section, we review these relatively new studies in addition to the early work on disclosure regulation. In following section, we then separately focus on the economic consequences of the introduction of International Financial Reporting Standards (IFRS). 4.1. Studies Evaluating Early U.S. Disclosure Regulation The early empirical literature on disclosure regulation primarily studies the Securities Act of 1933 and the Exchange Act of 1934 and is generally skeptical about the merits of the regulation, e.g., its value to investors. Stigler (1964) and Jarrell (1981) analyze abnormal returns to new issues as a way to gauge whether fewer fraudulent or overpriced securities are brought to the market after the 1933 Act. Both studies find no evidence that, after the 1933 Act, registered securities exhibit larger returns than unregistered securities offered before the Act, questioning the widely held view that unregistered securities offerings in the 1920s were generally overpriced and that investors are better off after the Act. However, both studies also find that the variance of abnormal returns decreases (see also Simon, 1989), suggesting that securities offerings are less risky since the introduction of SEC disclosure regulation. In addition, Jarrell (1981) provides evidence that default rates of registered bonds have decreased after the Act.

32

Barth, Beaver and Landsman (2001) reply to the Holthausen and Watts (2001) critique and provide a defense of the value relevance literature.

39

Benston (1969) finds little evidence of fraud related to financial statements in the period before the Acts of 1933 and 1934. In addition, he documents that there was widespread

voluntary disclosure prior to the Acts. Benston (1973) confirms that there were few abuses in reporting prior to the Act and finds little evidence that the risk of securities has significantly decreased. Finally, Chow (1983) analyzes stock reactions to events related to the passage of the Acts and finds negative abnormal stock returns, which are partly attributable to effects on firms accounting-based debt covenants. This evidence is consistent with the notion that the 1933 Act had significant out-of-pocket costs for firms and that it affected firms investment and financing opportunities by tightening existing covenants. (unintended) effects on financial contracts. All these findings have been heavily debated and repeatedly been challenged (e.g., Friend and Herman, 1964; Seligman, 1983; Coffee, 1984; Easterbrook and Fischel, 1984; Romano, 1998; Fox, 1999). Proponents of mandatory disclosures often point to the result that the variance of abnormal returns of new issues decreases after the imposition of SEC disclosure regulation. They interpret this evidence as supporting the notion that mandatory disclosures improve investors assessment of risky securities (e.g., Seligman, 1983). Critics of disclosure regulation in turn argue that this result likely reflects a selection rather than a treatment effect. They point out that, after the Acts, there is a trend from public debt offerings towards private debt placements, and this trend is more pronounced among relatively risky bonds (Benston, 1969; Jarrell, 1981; Simon, 1989). Thus, it is possible that the Acts have simply shifted riskier securities to less regulated markets. Another issue is that the early studies do not control for changing market conditions over the time period, in particular the onset of the Great Depression. The problem is that all It also highlights that regulation may have

40

exchange-traded firms were affected by the new regulation and hence the studies do not have a natural control group. Recent studies by Daines and Jones (2005) and Mahoney and Mei (2006) address these shortcomings. They examine changes in information asymmetry and market liquidity around the Acts using cross-sectional analyses and private placements to control for time period effects. Both studies document a decline in spreads and an increase in market liquidity but find little evidence that these results are attributable to the imposition of SEC disclosure regulation. The improvements in market liquidity seem to be driven by market-wide trends unrelated to the regulation. 4.2. Studies on Subsequent Extensions of U.S. Disclosure Regulation in the OTC Markets There are several recent studies analyzing the 1964 Securities Act Amendments or the 1999 Eligibility Rule for the OTC Bulletin Board. These two regulatory events essentially extended SEC disclosure regulation to segments of the OTC markets. As such they represent major changes in disclosure regulation. But as these events apply only to a subset of publicly traded firms in the economy, there are natural control groups allowing for tighter research designs than the original introduction of SEC disclosure regulation in the U.S. Ferrell (2003) analyzes the Securities Act Amendments of 1964 which subjected larger OTC securities, many of which later traded on NASDAQ, to the Acts of 1933 and 1934. As the earlier studies, he finds that the imposition of SEC disclosure regulation is associated with a significant reduction in volatility among OTC securities, relative to securities that are already subject to SEC disclosure requirements. This finding is consistent with the notion that

information is more quickly impounded in prices, leading to lower volatility and hence more

41

efficient prices. In addition, he documents that OTC securities exhibit positive abnormal returns during the time period over which passage of the 1964 Amendments became likely. In a concurrent study, Greenstone et al. (2006) also find positive abnormal stock returns to firms affected by the 1964 Securities Acts Amendments. They differentiate between firms that are more or less affected to properly identify the effect of the 1964 Amendments. They document that OTC firms most affected by the imposition of SEC disclosure regulation experience abnormal returns between 11-22% from the time the regulation was proposed to when it went into force, and abnormal returns of about 3.5% in the weeks surrounding firms announcements that they had first come into compliance. The authors attribute the positive market reaction to reduced conflicts of interests between controlling insiders and outside shareholders (Shleifer and Wolfenzon, 2002). Consistent with this explanation, Greenstone et al. (2006) find that OTC firms experience an increase in operating performance relative to unaffected firms. Moreover, Ferrell (2003) and Greenstone et al. (2006) show that there is no difference in abnormal returns subsequent to when the regulation was passed and came into effect, consistent with the notion that securities markets have fully priced the effect of regulation. Improved stock price efficiency, as suggested by the evidence in Ferrell (2003), can be socially beneficial if it results in an improvement in the allocation of capital. Similarly, a reduction in agency costs associated with conflicts of interests between controlling insiders and outside investors, as suggested by Greenstone et al. (2006), can be socially desirable if diversion by insiders and outsider expropriation are inefficient and socially costly (e.g., Shleifer and Wolfenzon 2002). However, at present, there is little empirical evidence on the link between information, stock price efficiency and capital allocation (e.g., Durnev, Morck and Yeung, 2003; Verdi, 2006). The inefficiency of expropriation and whether better institutions spur economic

42

growth is also still debated (e.g., Acemoglu, Johnson, Robinson, 2001 and 2002; Glaeser, La Porta, Lopez-de-Silanes, Shleifer, 2004). Moreover, the overall welfare consequences of the effects in Ferrell (2003) and Greenstone et al. (2006) are unknown because neither study can determine the extent to which shareholders gains resulted from wealth transfers from controlling insiders or other stakeholders in these companies. Thus, more research on the aggregate

consequences of disclosure regulation is clearly warranted. A recent study by Bushee and Leuz (2005) make a small step in this direction. Their study exploits a regulatory act, the so called Eligibility Rule, in the previously unregulated OTC Bulletin Board (OTCBB) in 1999. Prior to the Rule, smaller firms that were not subject to 1964 Securities Act Amendments could be quoted on the OTCBB without filing with the SEC. The Rule eliminates this possibility and forces these firms to comply with the reporting requirements under the Securities Exchange Act of 1934. In analyzing firms that are subject to the Rule and those that should be unaffected but are in the same market, the study is probably the first to provide evidence on externalities from disclosure regulation. They find that OTCBB firms that were already subject to SEC reporting obligations experience positive abnormal returns around key announcements dates of the rule, as well as sustained increases in liquidity. This evidence is consistent with the existence of positive externalities of disclosure regulation, possibly due to liquidity spillovers or to an enhanced reputation of the OTCBB. However, this interpretation hinges crucially on the extent to which firms outside the OTCBB are an appropriate control group against which the externalities can be measured. Illustrating that disclosure regulation has not only benefits, Bushee and Leuz (2005) find that the imposition of SEC disclosure requirements forced over 2,600 firms (or 76% of the market segment) into the less regulated Pink Sheets market, at significant costs in terms of

43

market value and liquidity. This evidence suggests that, for the majority of (smaller) OTCBB firms, the firm-specific costs of SEC disclosure regulation outweigh the benefits. Even firms that were compelled to adopt SEC disclosures to avoid removal from the OTCBB exhibit negative abnormal returns associated with the announcement of the rule change, suggesting that the regulatory change is on balance costly to these firms, which is consistent with the fact that the rule eliminated the prior (and presumably preferred) disclosure strategy of these firms.33 The existence of significant crowding out effects of disclosure regulation in Bushee and Leuz (2005) is consistent with the earlier findings in Jarrell (1981) that firms shifted from public offerings to private placements after the Securities and Exchange Acts. These findings illustrate that it is important to consider the various ways in which firms can respond to the imposition of regulation. For instance, firms can go private, move to an unregulated market, or choose not to go public. Understanding firms potential responses and avoidance strategies is crucial when evaluating the costs and benefits of disclosure regulation and also when designing the rules in the first place. 4.3. Studies on Recent Changes in U.S. Disclosure Regulation Two recent changes in U.S. disclosure regulation, Regulation Fair Disclosure and the Sarbanes-Oxley Act, have led to a flurry of regulatory studies. Regulation FD was adopted by the SEC in October 2000 and was intended to increase confidence and fairness in capital markets by prohibiting managers from selectively releasing material non-public information to market professionals or institutional shareholders, but not to the public at large. Thus, Regulation FD

33

Nevertheless, these firms experience significant increases in liquidity upon compliance, consistent with earlier findings in the literature that increases in the commitment to disclosure manifest in higher liquidity.

44

may have changed the degree of information asymmetry between investors. At the same time, it may have changed firms incentives to provide information to the markets in the first place. The evidence on Regulation FD is mixed, but most studies point the existence of costs and benefits arising from the regulation. First, there is considerable evidence that information production by financial analysts changed around Regulation FD. For instance, Gintschel and Markov (2004) show a reduction in the price impact of information disseminated by analysts. Gomes, Gorton and Madureira (2005) document a shift in analyst coverage from smaller to larger firms. Bushee, Matsumoto and Miller (2004), Gintschel and Markov (2004), Eleswarapu, Thompson and Venkataraman (2004) and Chiyachantana, Jiang, Taechapiroontong and Wood (2004) document decreases in effective bid-ask spreads after Regulation FD, consistent with the notion that information asymmetry decreases when selective disclosures are reduced. Similarly, Bailey, Li, Mao and Zhong (2003) document that an increase in trading volume. But there is also conflicting evidence by Straser (2002) and Sidhu, Smith, Whaley, and Willis (2008) suggesting that the adverse selection component of the bid-ask spread has risen after Regulation FD. Jorion, Liu and Shi (2005) also examine the impact on select intermediaries, namely credit rating agencies who can still receive non-public information from companies and these communications are exempt from Regulation FD. Therefore, credit rating agencies have access to confidential information that is arguably not available to equity analysts after Regulation FD. Jorion et al (2005) find that the market impact of announcements of credit rating changes is larger in the post-FD period. This evidence is consistent with the notion that non-uniform regulation can give a strategic advantage to the certain parties. Second, there is also on shifts in firms disclosure policies around Regulation FD. For instance, Heflin, Subramanyam and Zhang (2003) and Bushee, Matsumoto and Miller (2004)

45

provide evidence that firms disclosures remain constant or even increase after Regulation FD. On the other hand, Kothari, Shu and Wysocki (2007) find evidence consistent with Regulation FD leveling the playing field with respect to good news and bad news disclosures and, on average, firms have reduced their withholding of bad news (relative to good news) after the passage of the new disclosure rules. Gomes et al. (2006) provide evidence that larger firms were able to compensate the loss in analyst coverage via other information channels but that small firms could not and as a result face a higher cost of capital. Duarte et al. (2007) also use the cost of capital as a way to assess the net effects of Regulation FD with respect to information asymmetry and information dissemination. They find no change in the cost of capital for AMEX and NYSE firms and a small increase in the cost of capital for NASDAQ firms. In contrast, Chen, Dhaliwal and Xie (2006) find that firms implied cost of capital declines in the post-FD period, the decrease in the cost of capital is mainly due to medium and large firms but is not significant for small firms and that the decrease in the cost of capital is systematically related to firm characteristics indicative of selective disclosure before Regulation FD. Third, Francis, Nanda and Wang (2006) highlight the concern that studies on Regulation FD may reflect concurrent changes in the U.S. information environment that are not related to the regulation. To gauge this concern, they benchmark changes in public information metrics (return volatility, informational efficiency and trading volume) and changes in analyst information metrics (forecast dispersion and accuracy) against concurrent changes for foreign firms that are cross-listed on U.S. markets but exempted from Regulation FD.34 The findings suggest that Regulation FD did not uniquely affect the U.S. information environment, but that it reduced information dissemination through the channel of analyst reports.

34

It should be noted that Gomes et al. (2006) and Chen et al. (2006) also benchmark their results against ADR firms.

46

Finally, there is a recent series of papers evaluating the effects of the Sarbanes-Oxley Act (henceforth SOX), which was passed in 2002 response to a series of corporate scandals. It is probably the most sweeping change to U.S. securities regulation since the Securities and Exchange Acts of 1933 and 1934. Romano (2004) argues that it also represents a significant departure in the approach to securities regulation because SOX prescribes particular corporate practices, rather than just the disclosure of these practices. This aspect sets SOX apart from the regulatory changes that we have previously discussed and makes it a particularly interesting object to study. As with Regulation FD, the evidence is decidedly mixed. Jain et al. (2004) analyze changes in market liquidity and document an improvement in liquidity measures following SOX. Rezaee and Jain (2005) find positive abnormal stock price reactions to events that increased the likelihood of the passage of SOX. Li et al. (2004) document positive abnormal returns to events resolving the uncertainty regarding the contents of SOX regulations. In contrast, Zhang (2007) finds negative cumulative abnormal returns to legislative events leading to the passage of SOX. In examining abnormal returns around legislative events, the latter three studies attempt to shed light on the net costs or benefits of SOX to firms or even the corporate sector. However, a major difficulty in evaluating SOX is that it broadly applies to SECregistered firms and hence to the vast majority of publicly traded firms. As a result, it is difficult to separate the effects of SOX from other contemporaneous events. 35 For instance, foreign equity markets experienced negative abnormal returns around key SOX events as well (e.g., Zhang, 2007), which casts serious doubt that the abnormal returns to legislative events can be solely attributed to SOX.

35

For a discussion of this issue and examples of contemporaneous events, see Leuz (2007).

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Recognizing this issue, Berger et al. (2006) and Litvak (2006) assess the impact of SOX on foreign firms that are cross-listed on U.S. exchanges, relative to U.S. firms and foreign firms, respectively. Berger et al. (2006) find that the value-weighted portfolio of cross-listed foreign firms has a significantly more negative stock price reaction to SOX than the value-weighted U.S. market, suggesting that SOX has been costly to foreign firms. Similarly, Litvak (2006) finds that foreign firms that are subject to SOX react more negatively than either matched cross-listed foreign firms that are not subject to SOX or non-cross-listed foreign firms. Overall, these studies suggest that SOX imposes net costs on foreign firms. However, it is an open question whether or not we can extrapolate the findings for foreign firms to U.S. firms. For instance, it is

conceivable that foreign firms are affected more negatively by the Act if SOX compliance creates contradictions with foreign governance regulation. An alternative way to identify SOX effects is to exploit cross-sectional differences in the way SOX affects firms. For instance, Chhaochharia and Grinstein (2007) provide evidence that firms that have to make more changes to be compliant with the provisions of SOX earn positive abnormal returns around key SOX events compared to firms that are less compliant. However, this result holds only for large firms. Small firms that are less compliant earn negative abnormal returns relative to firms that have to make fewer changes to be compliant, indicating that the costs of SOX outweigh the benefits for smaller firms. The differential effect of SOX on large and small firms is also exploited in Gao, Wu and Zimmerman (2007). They provide evidence on the possible unintended consequences of SOX exemptions for small companies (i.e., firms with public float less than $75 million). They predict and find evidence that the size-based

exemptions provide incentives for firms to remain small leading firms to take real actions that inhibit firm growth, such as investment cuts.

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Hochberg et al. (2007) use lobbying behavior of corporate insiders as a way to identify firms that are more likely to be affected by SOX. They demonstrate that firms whose insiders lobbied against a strict SOX implementation experience significantly positive abnormal returns over the passage of SOX, relative to firms that did not lobby (and hence are deemed less affected). They interpret this result as evidence that SOX improves disclosure and governance of lobbying firms and hence benefits outside shareholders. To support this interpretation, they provide evidence that lobbying firms are not as well governed and more likely to consume more private control benefits at the expense of outsiders. The advantage of using lobbying behavior is that it relies on observable behavior that is directly related to SOX. However, we still need firm characteristics (e.g., about governance) to aid the interpretation and preclude alternative explanations. For instance, without corroborating evidence on the governance structure of

lobbying firms, it is possible that the documented return differential simply reflects that better governed firms are better able to cope with costly regulation and also have more time to lobby. Thus, the interpretation of cross-sectional differences in abnormal SOX returns hinges critically on having convincing a priori predictions on how SOX has differentially affected firms. At this point, the evidence on the net costs or benefits of SOX to firms is inconclusive. An alternative approach to determine whether a regulatory act has been costly or beneficial to firms is to examine their responses to the regulation. For instance, if SOX has been costly to firms, we expect firms to engage in avoidance strategies. There are several papers that follow this path. For instance, Engel, Hayes and Wang (2007) analyze firms going-private decisions around SOX as well as market responses to these decisions. They argue that firms can avoid the costs associated with SOX by going private and that they will do so whenever the costs imposed by SOX outweigh the benefits generated by SOX and the net benefit from being public prior to

49

SOX. Engel et al. (2007) document an increase in Rule 13e-3 transactions after SOX. These transactions allow firms to deregister their securities from the SEC and to go private. They also show that the announcement returns to these transactions are positive and increase for smaller firms after SOX. These results are consistent with the notion that the costs of SOX to firms have increased the incidence of going private and that SOX has larger net costs for smaller firms.. However, as Leuz (2007) points out, the increase in going private activities is unlikely to be attributable to SOX as there are similar going private trends in other countries around the world. Moreover, Leuz, Triantis and Wang (2007) point out that there is a considerable number of public companies that deregister their securities from the SEC, cease to make periodic filings to the SEC, but continue to trade publicly in the Pink Sheets, which do not require SEC registration. Leuz et al. (2007) show that these going dark activities account for the bulk of the recent surge in SEC de-registrations after SOX and that going dark (but not going private) is associated with SOX-related events. They also provide evidence that for many firms cost savings are likely to be the primary reason for going dark, which in turn suggests that SOX imposes substantial costs on firms, particularly smaller ones. However, as with the lobbying evidence presented by Hochberg et al. (2007), the latter interpretation depends crucially on the reason why firms exit the SEC disclosure system after the imposition of SOX. It is also possible that firms go dark in order to avoid the additional scrutiny intended and imposed by SOX. Consistent with this hypothesis, Leuz et al. (2007) provide evidence that, at least for some firms, particularly when governance and investor protection are weak, controlling insiders appear to take their firms dark to protect private control benefits and decrease outside scrutiny. In a similar vein, Hostak, Karaoglu, Lys and Yang (2007) examine the extent to which foreign firms de-list and deregister their ADRs from U.S. exchanges around the passage of SOX.

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Again, the motive could be the costs of complying with SOX or, alternatively, insiders loss of control rents due to the corporate governance mandates of SOX. Consistent with the going dark findings in Leuz et al. (2007), the authors find that the passage of SOX coincides with an increase in voluntary de-listings of foreign ADRs from US stock exchanges. They also present evidence that is more consistent with the hypothesis that foreign firms with weaker corporate governance delist to avoid complying with the corporate governance mandates of SOX than the claim that direct compliance costs drive these decisions. In sum, the empirical findings on the impact of both Regulation FD and SOX are often mixed. However, most studies do point the existence of costs and benefits to firms as well as losers and winners from these regulations. These recent studies on changes in U.S. reporting and disclosure regulations have substantially increased our understanding of how to frame and test the question What are the economic consequences of regulatory changes? But despite these advances, it remains an unresolved question whether the market-wide (or macro-economic) benefits of recent changes to reporting and disclosure regulations exceed their aggregate costs. 4.4. International Evidence on Costs and Benefits of Disclosure Regulation The previous sub-sections summarize empirical studies that examine regulatory changes; typically changes that occurred in the U.S. An alternative approach to studying the economic consequences of regulation is to exploit cross-sectional variation, notably international differences in disclosure and securities regulation, including firms and investors responses to these differences.36

36

There are also studies that examine the effects of changes in countries accounting rules, e.g., on firms cost of capital or market liquidity. We discuss these studies in Section 5.

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Glaeser, Johnson and Shleifer (2001) compare the regulation of financial markets and the associated stock market development in Poland and the Czech Republic in the 1990s. They exploit that securities laws and markets were designed from scratch after the two countries emerged from socialism and point in particular to the role of enforcement and the incentives of the enforcer. Consistent with this notion, Glaeser et al. (2001) find that strict enforcement of securities law and a highly motivated regulator are associated with a rapidly developing stock market in Poland. In the Czech Republic that took a more hands-off approach to regulation, delistings and expropriation were rampant after an initial boom period. La Porta, Lopez-de-Silanes, Shleifer (2006) extend the analysis of securities regulation and financial development to 45 countries. They create a dataset evaluating the strength of countries securities regulation and provide evidence that stricter and better enforced securities regulation is associated with higher financial market development, as measured for example by the size of a countrys equity markets and IPO activity. Building on this dataset, Hail and Leuz (2006) examine international differences in firms cost of equity capital across 40 countries and their association with the quality of countries legal institutions and securities regulation. They show that firms in countries with more extensive disclosure requirements, stronger securities regulation and stricter enforcement mechanisms have a significantly lower cost of capital. They also demonstrate that these cost of capital effects are much smaller for capital markets that are globally more integrated. The latter finding is consistent with economic theory and suggests capital market integration puts an upper bound on the cost of capital benefits from strong disclosure regulation. There are also a number of studies that analyze the joint outcomes of firm-level disclosure choices and countries institutional features. For instance, Chen, Chen and Wei

52

(2003) find that both higher country-level investor protection and higher disclosure and corporate governance ratings contribute to a lower cost of equity capital for Asian firms. However, their findings also suggest that, in emerging markets, strengthening countries investor protection and corporate governance appears to be more important in reducing the cost of equity capital than firms expanding their disclosures. In contrast, Francis, Khurana and Pereira (2005) analyze the link between disclosure and cost of capital for firms from 34 countries and find that more disclosure is associated with a lower cost of capital but firms voluntary disclosure choices appear to operate independently of country-level regulations. Again combining firm-level

choices and country-level institutions, Eleswarapu and Venkataraman (2007) examine U.S. ADRs from 44 countries and find that after controlling for firm-level determinants of trading costs and home country market share, trading costs (i.e., effective spreads and price impact of trades) are lower for stocks from countries with higher judicial efficiency, accounting standards, and political stability. There is also a growing literature on how firms cope with or overcome disadvantages they face in their home markets due to regulatory, institutional, or other constraints that among other things limit their ability to raise capital. For instance, many firms from emerging market economies have sought cross listings in the U.S. and subjected themselves to U.S. securities regulation. That is, firms can opt into a foreign regime and thereby bond themselves to the more onerous disclosure, accounting and governance requirements and stricter enforcement regime of another country, which is called the bonding hypothesis (Coffee, 1999; Stulz, 1999). The problem is that firms in countries with weak institutional frameworks have difficulties in raising external finance because controlling insiders in these environments cannot sufficiently assure outside investors that they will not expropriate them. Outside investors react to this commitment

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problem with price protection, which increases the cost of raising capital. This problem matters more to firms with growth opportunities that require outside finance and, consequently, these firms have an incentive to seek bonding devices that sufficiently reassure outside investors. Coffee (1999) and Stulz (1999) argue that U.S. cross listing makes it harder and more costly for controlling owners and managers to extract private control benefits and to expropriate outside investors. The idea is that U.S. securities laws afford stronger rights to outside investors than those in most other countries and that these rights are more strictly enforced, either via the SEC or private securities litigation. By cross listing in the U.S., foreign firms subject themselves to these laws and their enforcement.37 U.S. cross listing also forces foreign firms to substantially increase their disclosures (via Form 20-F), making it less costly for outsiders to monitor the behavior of controlling insiders. Finally, cross listing may increase the attention by financial analysts and monitoring by sophisticated U.S. capital market participants (e.g., pension funds and institutional investors). Consistent with the bonding hypothesis, recent empirical work by Reese and Weisbach (2002), Lang, Lins and Miller (2003a), Lang, Raedy and Yetman (2003b), Doidge, Karolyi, and Stulz, 2004, Bailey, Karolyi, and Salva (2006), and Hail and Leuz (2006) shows that foreign firms with cross listings in the U.S. raise more external finance, have higher valuations, a lower cost of capital, more analyst following and report higher quality accounting numbers than their foreign counterparts. Similar to the voluntary disclosure literature, cross-listing studies face the issue that firms that choose to cross-list. As a result, firms with cross-listings may be fundamentally different

37

Examples are the Foreign Corrupt Practices Act, Rule 10-b5, SEC enforcement actions and U.S.-style class action suits.

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than their foreign counterparts in ways that are difficult to control or observe. In other words, the documented differences in accounting quality, valuations of these firms and the cost of capital could reflect observed heterogeneity, rather than the decision to cross list per se (e.g., Lang et al., 2003a; Doidge et al., 2004). In addition, there is little direct evidence on the sources of the cross-listing effects. Thus, it is unclear which of the requirements associated with cross listing on U.S. exchanges give rise to the documented effects (e.g., Leuz, 2003). Moreover, it possible that market forces (rather than legal requirements) are responsible for improvements in corporate transparency around U.S. cross listings. For instance, Siegel (2005) raises doubts about the effectiveness of the U.S. legal system and SEC enforcement activities against foreign firms listed on U.S. exchanges and points to reputational effects. However, it should be noted the bonding hypothesis does not claim that all expropriation is deterred. It only maintains that U.S. cross listings provide some additional reassurance to outside investors. The relevant

comparison is therefore either the same firm without a cross listing or similar firms in the same country without cross listings. That said, market forces may be an important factor for the cross listing effects that have been documented by prior work. In fact, it seems like that documented cross-listing effects stem from a combination of legal and market forces (e.g., Leuz, 2006). The cross-listing literature provides a number of insights on the potential costs and benefits of stringent regulations. The results suggest that more demanding regulations and standards can be beneficial to (certain) firms. On the other hand, countries with regulations that are perceived too onerous and hence costly may fail to attract foreign firms. Such claims have recently been made for cross listings on U.S. exchanges after the passage of SOX. Non-U.S. firms are said to prefer cross listings on the London Stock Exchange. While recent research disputes this claim (e.g., Doidge et al., 2007; Piotroski and Srinivasan, 2007), this discussion

55

highlights that it can be important for regulators to consider the consequences of disclosure regulation on firms cross listing behavior and that stringent disclosure regulation can be a double-edged sword. With the globalization of financial markets, firms have ever-increasing options to respond to regulation in their home countries, to attract capital from foreign investors as well as to opt into stricter foreign regulatory regimes. Finally, there are recent studies that suggest that foreign investors seek out firms with higher quality voluntary disclosures and invest more in countries with better disclosure regulations. A number of international studies demonstrate that foreign firms with better

voluntary disclosures attract greater following by U.S. institutional investors (Bradshaw, Bushee, and Miller, 2004) and mutual funds (Aggarwal, Klapper and Wysocki, 2005). Aggarwal et al. (2005) find that reporting quality has investment effects that show up at both the firm and country level and that there are important interactions between the firm-level and country-level decisions. 38 Leuz, Lins, and Warnock (2007) present evidence that firms with governance problems attract significantly less foreign investment (using comprehensive portfolio data of U.S. investors) and that the association between governance and U.S. investment is most pronounced in countries with overall governance weaknesses and poor information flows. While these studies suggest that firms are penalized by foreign investors for poor quality financial reporting, the findings also suggest an important interplay among numerous factors such as corporate governance, voluntary reporting choices, and disclosure rules and regulations.

38

For example, Aggarwal et al. (2005) find that firm-level voluntary disclosure effects are most pronounced for firms that reside in jurisdictions with lower mandated disclosures.

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5.

New Institutional Accounting Research and the Introduction of IFRS A recent and important trend in financial reporting and disclosure regulation is the

increasingly widespread adoption of uniform financial reporting standards by stock exchanges and accounting standards bodies from different countries. These uniform standards are labeled International Financial Reporting Standards (IFRS) and their stated goal is to achieve global harmonization and convergence of financial reporting rules and regulations. This section reviews empirical studies on this major trend in financial reporting regulation. These studies complement the empirical work on disclosure regulation. We also review studies on the relation between reporting quality and countries institutional features because this literature offers important insights to the debate about the economic consequences of IFRS adoption. 5.1. Evidence on the Importance of Countries Institutional Features for Reporting Quality International Financial Reporting Standards (IFRS) are accounting rules issued by the International Accounting Standards Board (IASB). In contrast to local accounting rules

(domestic GAAP) that differ across markets and countries, IFRS are a set of uniform rules that, in theory, apply in the same way to all public companies in markets that adopt the standards. IFRS are principles-based reporting standards that attempt to cover a broad range of economic conditions, transactions, activities or events. Over 100 countries have recently moved to IFRS reporting or decided to require the use of these standards in the near future, and even the U.S. is considering allowing U.S. firms to prepare their financial statements in accordance with IFRS. While the overall impact of IFRS is still to be determined, promoters of IFRS often argue that uniform global standards are obviously superior to disparate, and in many cases competing, standards across markets. However, the optimality of a single set of mandated global financial reporting rules, let alone the specific uniform rules contained in the current IFRS, is not obvious 57

(e.g., Dye and Sunder, 2001). While mandatory uniform rules and regulations may provide aggregate economic benefits, the individual and aggregate costs of uniform global regulations on firms, investors, and other stakeholders are often not recognized nor discussed. In particular, IFRS draw heavily on the current financial reporting regulations of countries and markets that are geared toward outside capital providers. Moreover, these advanced countries have

institutional infrastructures that complement the type of reporting regulations that have developed in these markets. Therefore, it is far from clear that IFRS will be superior or even effective in countries that have different capital-market paradigms and lack the necessary institutional infrastructures to support the effective application and enforcement of the uniform global standards. There is a growing body of evidence that countries legal institutions are important determinants of financial market development, firms capital and ownership structures, dividend policies, and insiders private control benefits. 39 Building on this work, recent international accounting studies investigate the link between countries institutional features and financial reporting outcomes (e.g., reporting quality) as well as the market effects of these outcomes (e.g., with respect to the cost of capital). Specifically, Ball, Kothari, and Robin (2000), Hung (2001), and Leuz, Nanda and Wysocki (2003) highlight that a countrys legal and institutional environment can affect firms financial reporting incentives and hence influence the quality of financial information reported to outside investors. Ball, Kothari, and Robin (2000) analyze firms from seven countries that differ with respect to their governance models and the extent to which they resolve information asymmetries via public disclosure or private communication. They show that firms from common law countries exhibit more timely loss recognition,

39

See surveys by Shleifer and Vishny (1997) and La Porta et al (2000).

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consistent with the role of earnings in these economies. Leuz, Nanda and Wysocki (2003) examine the level of earnings management and the opaqueness of accounting earnings reported by firms from 31 countries. They show that both investor protection laws and the enforcement of these laws are important determinant of reporting quality. More importantly, they show that these investor protection effects persist even after controlling for a countrys accounting rules. A key message of these papers is that mandated accounting rules and regulations cannot be considered in isolation and that these rules may have limited effectiveness without understanding other economic and institutional factors that affect firms reporting incentives (see also Ball, 2001). The results in Ball, Robin, and Wu (2003) further reinforce this conclusion. Ball et al. (2003) examine the properties of four Asian countries that have similar accounting standards as other common law countries (i.e., U.S. or U.K.) but different economic and institutional structures. They find that reported earnings from firms in Hong Kong, Malaysia, Singapore and Thailand have properties similar to code law countries and are less timely than reported earnings from U.S. or U.K. firms. Thus, despite the similarity of the accounting standards, the properties of reported earnings are different and in line with institutional factors.40 The results of the aforementioned studies show that other institutional factors can limit the effectiveness of the accounting standards, leading to lower quality financial reporting. One such factor is a firms ownership structure, which responds to a countrys institutional framework (La Porta, Lopez-de-Silanes, and Shleifer, 1999; Claessens, Djankov, and Lang, 2000; Faccio and Lang, 2002; Denis and McConnell, 2003). Weak protection of minority shareholders rights combined with concentrated ownership appear to lead to significant valuation discounts for firms (e.g., La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2002;
40

Leuz (2003) provides the converse result by examining firms that are trading in Germanys New Market where institutional factors and reporting incentives are largely held constant, but firms accounting standards differ. We review this paper in Section 5.

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Claessens, Djankov, Fan, and Lang, 2002; Lemmon and Lins, 2003). Recent research shows that firms ownership structures also shape insiders reporting incentives and hence the quality of observed financial reporting (e.g., Fan and Wong, 2001; Haw et al., 2004; Ball and Shivakumar, 2005; Burgstahler et al., 2006). These findings again highlight that isolated changes to

disclosure regulations and accounting standards may lead to unexpected or ineffective outcomes if other important institutional arrangements such as firms ownership structures are ignored. Other factors that can affect the financial reporting properties and disclosure outcomes include the enforcement activities of tax authorities and the development of the auditing profession. For example, Guenther and Young (2000) and Haw et al. (2004) suggest that a strong tax enforcement system within a country is associated with higher-quality reported accounting numbers. On the other hand, it is unclear whether tax enforcement leads to financial reporting outcomes, or whether other institutional factors lead to high-quality financial reporting which then has the spillover benefit of greater observed tax compliance (Wysocki, 2003). Francis, Khurana, and Pereira (2003) explore the impact of a developed private-sector auditing profession on reporting outcomes. They find higher average financial reporting and disclosure quality in countries with more developed auditing infrastructures and greater auditing enforcement. The effective implementation of uniform reporting standards can also be limited by political influences within a country which can lead to the misapplication of or exclusion from reporting regulations for particular firms. Watts (1977) and Watts and Zimmerman (1986) discuss the role of political lobbying in development and implementation of accounting rules. Ball (2006) also discusses how political factors may specifically undermine the proper enforcement of IFRS in certain countries. However, there is a paucity of research on the factors that affect the likelihood and implementation of reporting and disclosure regulation in national or

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global capital markets. The forces (including political) that the affect the regulatory process are important and largely unexplored issues in the literature that we discuss in section 6. 5.2 Recent Empirical Studies Examining the Economic Impact of IFRS Adoption The development of uniform international accounting standards is a recent phenomenon and the mandated use of IFRS is still in its infancy. For example, the European Union did not mandate the use of IFRS for public European companies until 2005. As a result, there is still relatively little data on the economic consequences arising from the mandate to use of IFRS. Ball (2006) provides an overview of the issues surrounding the adoption of IFRS and identifies several key issues that may limit the success and effectiveness of mandated IFRS. However, many of these concepts have yet to be tested because mandated use of IFRS is so recent. At present, there are only a few studies that analyze the economic consequences of the introduction of mandatory IFRS reporting. Most studies examine firms voluntary decisions to provide financial reports that conform with high quality international accounting standards. We provide an overview of both types of studies. Soderstrom and Sun (2007) also provide a survey of studies that examines the link between IFRS adoption and the quality of firms accounting numbers. Empirical on the economic consequences of voluntary IFRS adoptions generally analyze direct capital-market effects (such as liquidity or cost of equity capital) or the effects on various market participants (such as the impact on analyst forecast properties or on the holdings of institutional investors). Examples of studies that examine the capital-market effects of voluntary IFRS adoptions include Leuz and Verrecchia, (2000), Barth et al. (2007), Karamanou and Nishiotis, (2005), Cuijpers and Buijink (2005), Daske (2006), Hung and Subramanyam (2007), and Daske, Hail, Leuz, and Verdi (2007a). 61

Leuz and Verrecchia (2000) examine German firms that adopt IAS or U.S. GAAP and find that IAS and U.S. GAAP firms exhibit lower bid-ask spreads, higher turnover, and decrease in spreads and turnover around IAS or U.S. GAAP adoption (compared) to German GAAP firms. Cuijpers and Buijink (2005) use implied cost of capital estimates and do not find significant differences across local GAAP and IFRS firms in the EU. Daske (2006) examines voluntary IAS adoption by German firms and finds that IFRS firms even exhibit a higher cost of equity capital than local GAAP firms. Daske, Hail, Leuz, and Verdi (2007a) show that firms with a serious commitment to adopting IRFS experience larger cost of capital and market liquidity benefits than firms that are simply adopting IFRS as a label. Finally, Karamanou and Nishiotis (2005) examine the short-window announcement returns to IFRS adoptions. However, the caveat to these types of studies is that the short-window market reactions also capture news effects that are potentially associated with the adoption of IFRS (e.g., information about growth opportunities). Therefore, this type of research design may not be appropriate to isolate the effects of IFRS reporting. Focusing on reporting quality, Barth, Landsman and Lang (2007) analyze changes in the properties of reported earnings around the voluntary adoption of IFRS reporting and present evidence that firms reporting quality increases. Hung and Subramanyam (2007) examine a sample of German firms and test for the financial statement effects of adopting IAS between 1998 through 2002. They find that the no difference in the value relevance of accounting numbers with IAS adoption, but there is weak evidence that IAS income exhibits greater conditional conservatism than income reported under German GAAP. There are also a few studies on the reaction of market participants to voluntary IFRS adoptions. Cuijpers and Buijink (2005) find an increase in analyst following around IFRS, but

62

the effect is not robust to controls for self selection. Covrig et al. (2007) document that foreign mutual fund ownership is significantly higher for IFRS adopters compared to local GAAP firms and that the difference in mutual fund holdings increases for firms in poor information environments and with low visibility, suggesting that IFRS reporting can help firms attract foreign institutional investment. In sum, the evidence on voluntary IFRS adoptions is mixed. As discussed with respect to the voluntary disclosure literature, a key challenge for these studies is the fact that firms choose whether and when to adopt IFRS reporting. Therefore, it is difficult to attribute the observed effects to IFRS reporting per se. Moreover, studies on a firms voluntary financial reporting decisions can tell us little about the aggregate impact of mandated IFRS. Thus, we now turn to the few recent studies that examine the economic consequences of the transition to mandatory IFRS reporting. Existing research studies on the transition to

mandatory IFRS reporting generally examine: (i) the stock market reactions to major events before IFRS adoption that affect the likelihood that a jurisdiction (notably the European Union) will adopt mandatory IFRS, or (ii) the observed capital market outcomes after the introduction of mandatory IFRS in a jurisdiction. Studies in the first category use stock market reactions (to events affecting the likelihood of IFRS adoption) to infer whether the shareholders perceive net benefits or net costs to eventual IFRS adoption. The empirical evidence in these studies is generally mixed. First, Comprix et al. (2003) examine the stock returns of European firms on four major event dates in the year 2000 that arguably increased the likelihood that the EU would adopt mandatory reporting under IFRS. They find average negative returns for European stocks on the four major event dates. However, certain type of firms did experience significantly positive abnormal stock returns on certain event

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dates. In particular, positive stock returns are observed for firms that that are audited by a big five auditor, those located in countries expected to have greater overall improvements in reporting quality from IFRS adoption, and firms located in countries with higher legal levels of enforcement. Second, Armstrong et al. (2007) examine the stock market reaction to 16 events between 2002 and 2005 that affect the likelihood of IFRS adoption in the EU. Armstrong et al. (2007) find a positive market reaction to events that increase the likelihood of IFRS adoption and a negative market reaction to events that decrease the likelihood of IFRS adoption. The study also finds that the stock market reaction is more positive for firms with lower quality pre-IFRS information environments, with higher pre-IFRS information asymmetry, and for firms from common law countries. Finally, Christensen et al. (2007a) examine the market reactions of U.K. stocks to announcements of events related to mandatory IFRS reporting. They find that the average U.K. market reaction is small. Using the degree of similarity with German voluntary IFRS and U.S. GAAP adopters as a proxy for a U.K. firms willingness to adopt IFRS, they find that this proxy is positively (negatively) related to the stock price reaction to news events increase ng (decreasing) the likelihood of mandatory IFRS reporting. They find a similar

association for changes in the implied cost of equity capital. The heterogeneity in the results across firms is consistent with the reporting incentives view. Studies in the second category analyze the post-adoption market effects of mandated IFRS. For example, Platikanova (2007) examines measures of stock market liquidity for firms in four European countries. While she finds heterogeneous changes in the liquidity measures for the four countries after IFRS adoption, she does find that an overall decline the liquidity differences across the countries after the IFRS adoption. Daske, Hail, Leuz and Verdi (2007b) also examine the impact of IFRS adoption in 26 countries on market liquidity, cost of equity

64

capital and Tobins q. They find that, on average, market liquidity and equity valuations increase around the introduction of mandatory IFRS in a country. However, these market benefits exist only in countries with strict enforcement regimes and institutional environments that provide strong reporting incentives. Interestingly, they also find that the capital market effects after mandatory adoption are most pronounced for firms that first voluntarily switched to IFRS before it was actually mandated. Finally, Christensen et al. (2007b) analyze whether IFRS reconciliations provided with the last U.K. GAAP financial statements convey new information to the markets. Overall, the results are consistent with the view that reporting quality is shaped by numerous factors in countries institutional environments which points to the importance of firms reporting incentives and countries enforcement regimes. As more data becomes available, there will undoubtedly be a flood of empirical studies on the outcomes of the mandated adoption of IFRS in countries around the world. At present, however, there is little evidence on the important macro-economic outcomes of changes to mandated financial reporting rules. 6. Conclusions and Suggestions for Future Research This article surveys the literature and highlights recent research advances that add to our understanding of the economic consequences of financial reporting and disclosure regulation. We provide an organizing framework that identifies the firm-specific (micro-level) and marketwide (macro-level) costs and benefits of firms reporting and disclosure activities and then use this framework to discuss the potential costs and benefits of regulating these activities in various forms recognizing the existence of global capital markets. Our framework synthesizes the key insights from theoretical and empirical studies in accounting, economics, finance and law to contribute to the cross-fertilization of ideas from these fields. We particularly highlight the 65

interactions between accounting rules and disclosure requirements with other securities regulations and institutional factors within a country and across markets. Our survey illustrates a general paucity of evidence on market-wide and the aggregate economic and social consequences of reporting and disclosure regulation, rather than the consequences of individual firms accounting and disclosure choices. Until recently, most of the prior literature focuses on managers voluntary disclosure and financial reporting choices, which can provide important micro-economic insights that helps us understand the impact of regulation. However, these studies provide few insights into the overall desirability, economic efficiency or aggregate outcomes of reporting and disclosure regulation. Moreover, even the recent flurry of studies on major regulatory changes in the U.S., notably Regulation Fair Disclosure and the Sarbanes-Oxley Act, focus primarily on the economic consequences to firms, but provide little evidence on aggregate or macro-economic effects, externalities or economic consequences to investors or consumers. The literature also exhibits a heavy emphasis on regulatory changes in the U.S. However, there have also been major changes in reporting and disclosure regulation in other countries, notably in emerging markets and transition economies. Researchers have not fully explored the outcomes and implications of these numerous and major regulatory and enforcement changes in other countries. Furthermore, the introduction of mandatory IFRS reporting around the world provides a unique opportunity to test the impact of a uniform set of reporting rules in diverse economic settings. Finally, areas where there are relatively unregulated markets (like the U.S. OTC markets) offer interesting settings for future studies. Despite the fact that our survey focuses on disclosure and reporting regulation, it does not advocate the necessity of regulation or reforms to existing regulations. Instead, we synthesize

66

the lessons from existing research to highlight the tradeoffs that standards setters, policy makers, and regulators face in evaluating existing or proposed accounting rules and disclosure requirements. We also suggest possible areas of future academic research that could inform them about the economic consequences of financial reporting and disclosure regulation. To conclude the survey, we discuss these suggestions next. As we noted earlier, one finding of our survey is that much of the financial reporting and disclosure literature has focused on managers voluntary disclosure and financial reporting choices. These studies are also frequently cited in the debate on reporting and disclosure regulation. However, they provide few insights into the overall desirability, economic efficiency or aggregate outcomes of reporting and disclosure regulation. Therefore, our suggestions for future research focus on questions and unresolved issues related to the determinants and aggregate outcomes of financial reporting and disclosure regulation. Suggestions for Future Research Our first suggestion is that we need to have a better understanding why disclosure and reporting regulation is so pervasive in advanced economies. Standard economic theory and much of the literature are skeptical about the need for and the benefits of regulation, except perhaps in extreme cases of market failure. Contrasting this view is the observation that, in successful financial markets and economies, firms reporting and disclosure activities are often heavily regulated. Do these markets thrive because of regulation or in spite of it? Opportunities exist to understand this question and to address the apparent disconnect between standard economics and actual regulatory practice. Towards this end, one promising avenue for research is to explore whether standards and regulation play a beneficial role by stabilizing expectations in financial markets, when 67

contracts and information are incomplete and market participants are boundedly rational. For example, reporting regulation may solve coordination problems among market participants by providing a coarse standardized (or default) solution that is widely understood by both suppliers and users of information and applied in many transactions and contracts.41 Financial reporting rules and disclosure regulation in most advanced economies strike us as such a coarse standardized solution. In addition, financial reporting and disclosure regulation may stabilize financial markets by limiting asset bubbles (i.e., periods when firms trade at prices that significantly deviate from fundamental value). Financial bubbles can harm an economy by causing a significant

misallocation of capital. Therefore, during times of technological or financial innovation which often coincide with financial bubbles, mandated reporting and disclosure rules can: (i) limit asymmetric information among market participants, which can contribute to the formation of bubbles (e.g., Brunnermeier, 2003), and (ii) force firms to talk about fundamentals such as verifiable current cash flows, profits, net assets and ownership claims rather than firms aspirations for future success. In other words, seemingly-dated reporting rules and disclosure regulations can capture the cumulative wisdom (and wounds) from previous episodes of hype and exuberance and provide a fundamentals-based reality check for the current generation of market participants who are navigating seemingly new market conditions.42 At present, it is

41

See also the tradeoff between precision and shared understanding in the work on optimal communication by Morris and Shin (2006). 42 For example, the Securities Acts of 1930s were enacted in reaction to the apparent asset bubble and subsequent 1929 market crash. The Securities Acts provided a basis for the SECs ban on upward revaluations of assets reported in firms financial statements (Walker, 1992, and Watts, 2003). This lower of cost or market principle persists today in U.S. accounting standards and arguably reinforces firms incentives to report conservative financial statements (Basu, 1997 and Watts, 2003).

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unclear whether and to what extent disclosure and reporting regulation mitigates asset bubbles and financial crises. If it does, it could explain why regulation often follows financial crises.43 A countervailing concern is that existing regulations are inflexible and fail to adapt to fast-changing and dynamic markets. Inflexible regulations can stifle financial innovation, which in turn can affect whether new technologies and ideas are financed. Therefore, refinements to the theory of disclosure regulation should capture the role and dynamic nature of markets for ideas and capital. More generally, we note that the extant theory of disclosure regulation is mostly static and concerned with the questions of whether and how to regulate. Thus, as a second direction for new research, we propose more work on the dynamics of regulation. For instance, there is little evidence on how the costs and benefits of disclosure regulation differ at different stages of economic development and how the tradeoffs change as economies evolve. The third (and closely related) research suggestion is to generate insights into the process through which financial reporting and disclosure regulations are created and implemented. Factors likely to influence the implementation process include within-country political forces and market and political influences from outside a country. The traditional literature on the economics of regulation (see, e.g., Stigler, 1971; Posner, 1974; Peltzman, 1976) provides significant insights into issues related to special interests and regulatory capture. However, this literature generally focuses on direct government regulation of product-market monopolists. Disclosure requirements in turn are increasingly used as a public policy instrument in lieu of more conventional and direct regulation that restricts or mandates certain behaviors or business practices (e.g., Graham, 2002). Moreover, the markets for financial information are likely to be substantially different from the product markets. However, there is little research on the factors
43

An obvious alternative explanation is that policy makers and regulators must be viewed as acting after financial crises leading to ever increasing regulation.

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that affect the likelihood and implementation of reporting and disclosure regulation in national or global capital markets. Early work by Watts (1977) and Watts and Zimmerman (1978 and 1986) provide useful insights into the political factors that influence adoption of financial reporting and disclosure rules and regulations. However, there has been little follow-on research on these adoption issues.44 Interestingly, there is essentially no research how political intervention affects the implementation of reporting and disclosure regulation. Ball (2006) hypothesizes that

political intervention may undermine the uniform is implementation of IRFS, but this conjecture is yet to be tested. The fourth direction suggests opportunities for more research on the real and macroeconomic outcomes of regulation. This research would go beyond capital market effects and address the real investment, consumption and possibly social outcomes of regulation in an economy. For example, does the existence of regulation (or lack therefore) affect the type, timing and amount of total real investment by companies? Is there a link between transparency of the corporate sector and economic growth? Does mandated disclosure of financial

information by companies feed back into the aggregate consumption decisions of consumers? Does disclosure regulation directly affect allocation outcomes and influence who are the winners and losers in the economy? Research into these matters could capitalize on recent regulatory changes. For example, mandatory adoption of IFRS in many countries around the world could provide insights into aggregate changes in disclosure quality and possible aggregate capital market, investment and consumption effects. Moreover, there is wide variation in the types of firms, the providers of capital, and institutional arrangements across countries that recently adopted IFRS. Future research can also capitalize on this heterogeneity in firms, investors and
44

A few exceptions are Francis (1987), McLeay, Ordelheide and Young (2000), McLeay and Merkl (2004), and Ramanna (2007).

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institutions to help us better understand the differential impact of uniform standards on different stakeholders in different environments. However, it must be noted that the adoption of IFRS in many countries is neither exogenous nor unexpected. Firms, investors and consumers can anticipate the required implementation of IFRS, which may confound attempts to draw direct inferences in this setting. Other recent regulatory changes, e.g., the market reforms in emerging markets, may provide further opportunities. There is also an extensive literature on financial liberalization and economic growth (Levine, 2001). However, in this literature, the role of transparency and disclosure regulation is still largely unexplored. As a fifth direction for future research, we suggest studies to better understand the interactions among elements of the institutional infrastructure within an economy, including both free-market forces and regulation. As an example, there can be complementarities between various elements of a countrys institutional structure. For instance, outside investor protection and public disclosure are likely to be complements in promoting arms length financing arrangements. Similarly, rules typically need complementary enforcement to be effective. Such complementarities imply that changing one element of the institutional structure independently of the other elements is unlikely to yield desired outcomes and hence the desirability of disclosure regulation should not be studied in isolation. 45 Complementarities also imply that countries institutional systems exhibit path dependence, which in turn suggests a role for historical analyses (e.g., Bebchuk and Roe, 1999; Schmidt and Spindler, 2002). At present, however, we have relatively little research into the existence and nature of these institutional interactions. For example, Leuz, Nanda and Wysocki (2003) provide (descriptive) evidence on

45

In the international accounting debate, the notion of complementarities implies that simply introducing IFRS without supporting changes in countries institutional infrastructures is unlikely to improve reporting quality (Ball, 2001).

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the existence of institutional clusters and then show that these clusters can explain crosssectional differences in reporting quality across countries. Another example for interactions among institutional elements is the possibility that seemingly innocuous regulation can interact with existing agency problems leading to surprisingly undesirable outcomes.46 For example, Coates (2007) argues that the introduction of SOX in the U.S. may have interacted with the litigation concerns of managers, directors and auditors, which motivated these parties to over-invest in SOX compliance and internal controls, making the regulation much more costly than expected. Our sixth suggestion for future research highlights the need for more research on the optimal form of regulation given imperfect enforcement, especially with respect to the balance between ex ante regulation to discourage malfeasance versus ex post enforcement to penalize malfeasance. Recent work by Glaeser, Johnson and Shleifer (2001) and Djankov, Glaeser, La Porta, Lopes-de-Silanes and Shleifer (2003) suggests important interactions and tradeoffs between the costs and benefits of an ex ante approach where regulation and standards attempt level the playing field for market participants versus an ex post approach where the terms and outcomes for loss recovery (often through the courts) must be specified. For example, if ex ante regulation fails to specify all contingencies or capture innovations in malfeasance, then parties must often rely on the courts to argue the existence and extent of injuries and penalties. On the other hand, if there are inequalities in the judicial weapons available to litigants or there are agency problems in the court, then regulations can serve to limit the latitude and discretion of the court. As Shleifer (2005) points out as well, there is little research on this central issue of regulation. Furthermore, it is far from clear that the same mix of regulation and enforcement

46

This notion can be viewed as a manifestation of the theory of the second best (Lipsey and Lancaster, 1956).

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should apply in economies with different existing institutional infrastructures or at different economic stages of economic development. Therefore, there are many opportunities to examine the optimal form and implementation of regulation and enforcement across markets and countries. Our seventh and final suggestion calls for future research to understand the interactions among and competition between various markets and regulatory regimes in a global economy. Firms, investors and policy makers in a given market cannot make decisions in isolation without considering the actions and reactions of other players in global and at least partially integrated markets. For example, changes to U.S. GAAP and SEC disclosure rules cannot be contemplated without factoring in the existence of competing IFRS in other markets. Is competition in regulatory regimes (e.g., accounting standards) a wasteful duplication of resources or does it provide choices for firms and investors, which in turn lead to experimentation and learning? Is it a competitive regulatory race to the top or a race to the bottom? There are arguments in both directions for both questions (e.g., Barth, Clinch and Shibano, 1999; Dye and Sunder, 2001; Coffee, 2002), but very little empirical evidence on these matters. Moreover, even if IFRS are adopted by all markets and countries, competition is likely to grow across exchanges and countries along other dimensions: (i) the implementation guidance and interpretation of the board principles-based standards contained in IFRS, (ii) other disclosure requirement outside of mandated financial reports, and (iii) the enforcement of financial reporting standards. Thus, issue of competition across markets and regimes is likely to remain an important topic in the area of reporting and disclosure regulation.

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7.

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