Tutorial in Week 12 (based on Week 11 Lecture) beginning 21st May 2018

TOPIC: Voluntary Disclosure

QUESTION ONE

The failure of managers to release bad news is a version of the adverse selection
problem. Such failure indicates that the securities market is not working well.

Required
a. Why might a manager withhold bad news?
b. When will the disclosure principle operate to motivate the manager to report bad
news? Under what conditions is the disclosure principle subject to failure?

a. Managers may withhold bad news when there is low litigation risk from being
discovered to have withheld and :

• Due to career concerns and reputation damage, managers have an

incentive to delay the release of bad news in the hope goods news will
eventually arrive and camouflage/bury he bad news (see expansion of
this point further below)

• To conceal evidence of shirking, if the bad news results from low

manager effort.

• To delay a fall in share price, which possibly affect manager

compensation in a specific year

• To enable insider trading profits.

Note an important constraint on the release of bad news is that litigation risk can motivate
managers to quickly reveal bad news

Career Concerns and Delay in Bad News (extract from Kothari eat al JAR 2009)
Career concerns can motivate managers to withhold bad news and gamble that subsequent corporate
events will allow them to “bury” the bad news. Career concerns broadly encompass the effects of disclosure
on management compensation contemporaneously as well as over a long horizon (Nagar [1999], Nagar,
Nanda, and Wysocki [2003]). The long horizon effects include the impact on the manager’s career (e.g.,
promotion, employment opportunities within and outside the firm, and potential termination) and the
potential loss of postretirement benefits, including directorships. In a formal model linking managers’
career concerns to disclosures, Hermalin and Weisbach [2007, p. 2] assume that “owners seek to assess the
CEO’s ability based on the information available to them, and to replace him if the assessment is too low.”
They conclude that optimal disclosure is less than fully transparent, especially with respect to bad news.
Verrecchia [2001] makes a similar point in his survey of the disclosure literature. In addition to the career-
related costs, managers also incur costs arising from lower bonus payments, a reduction in the quantity of
stock options awarded, and a loss in wealth as a result of the stock price decline following the disclosure of
bad news. Collectively, managers face strong incentives to withhold bad news and gamble that subsequent
events will turn in their favor. This idea is borne out by the survey evidence in Graham, Harvey, and
Rajgopal [2005]. Some CFOs claim that they delay bad news disclosures in the hope that they may never
have to release the bad news if the firm’s status improves before the required information release

b. The disclosure principle will completely eliminate a manager’s incentive to

withhold bad news if the following conditions hold:

• The information can be ranked from good to bad in terms of its

implications for firm value.

• Investors know that the manager has the information.

• There is no cost to the firm of releasing the information.

• Market forces and/or penalties ensure that the information released is

truthful.

• If the information affects variables used for contracting (e.g., share

price or covenant ratios), release of the information does not impose
increased contracting costs on the firm.

Then, the market will interpret failure to disclose as indicating the worst possible
information. To avoid the resulting impact on share price, all but the lowest-type
manager will disclose.

If one or more of the above requirements is violated, the disclosure principle may not
completely eliminate the withholding of bad news. This will be the case when:
 • The information is proprietary. Then, there is a threshold level below
which the news will not be released (Verrecchia (1983)).

• If the market is not sure whether the manager has the information,
there is a threshold below which the news will not be released, even
though it is non-proprietary. The motivation to release non-proprietary
information arises from its effect on firm value (Pae, 2005).

• If release of information may trigger the entry of competitors, the firm

may only disclose a range within which the news lies. In this sense,
disclosure is not truthful (Newman and Sansing (1993)).

• If contracts, such as manager compensation, are based on share price

and if releasing the news will increase the firm’s contracting costs
(e.g., a forecast’s effect on share price may swamp the ability of share
price to reflect manager effort), it may not be in the firm’s interests to
release the information (Dye (1985)).

We may conclude that while the disclosure principle has the potential to motivate full release
of bad news, in practice it is only partially effective due to the number of scenarios where it
breaks down.

QUESTION TWO
On September 15, 2004, the Dow Jones Industrial Index suffered its largest fall in a
month, dropping by 0.8% or 86.8 points. The Standard & Poor's 100, 400, and 500
indices also dropped by similar amounts.

According to media reports, the market declines were triggered by The Coca-Cola
Company and Xilinx Inc. (a large producer of computer logic chips and related
products). These companies announced that sales and profits for the third quarter 2004
would be less than analsyts’ estimates

Required
a. Why did the whole market decline?
b. What market failure does this episode illustrate? Use the concept of externalities
to explain why this is a failure.
a. The market declined because the announcements of lower sales and profits contained
market-wide information. If sales and profits were lower for these two large and
diverse firms, this suggests that many other firms will also suffer from reduced
business activity. As investors bid down the share prices of all firms deemed to be
affected by this reduced activity (including Coca-Cola and Xilinx), the market index
was dragged down.

Note: An alternative, less satisfactory, answer is that only the share prices of the two
companies in question declined in reaction to the firm-specific information contained
in the announcements. Since these firms are quite large, and are part of the market
index, the decline in their share prices pulled the market index down. The magnitude
and breadth of the market decline seems inconsistent with this argument, however.

b. This episode illustrates the problem of externalities. The information released

by Coca-Cola and Xilinx about their own prospects also contained implicit
information about the prospects of other firms. The 2 companies receive no reward for
this economy-wide information, consequently there is no incentive for them to release
more than a minimum disclosure. For example, perhaps more timely release, more
information about why they felt sales and profits will decline, having their auditors
attest to the information, and/or breaking the sales and profits down by company line
of business or division, would have helped the market to assess the extent to which
other companies would be affected.

QUESTION THREE
Refer to Theory in Practice 12 .3 concerning Canadian Superior Energy, Inc (page 511
of the reading).

Required
a. Obviously, the news of well abandonment was a major factor contributing to
Canadian Superior's share price decline in March. However, other reasons for
the decline can also be suggested. Give two other reasons.
b. What well-known problem of information asymmetry is suggested by the CEO's
sale of stock in January 2004? Explain.
c. Assuming that the market's concerns about the information asymmetry problem
you identified in part b are well founded, what is the likely effect of these
concerns on the share prices of all Canadian oil and gas companies? Why?
d. Suppose that given the CEO's optimism about the ultimate success of the well,
the company believes that its share price is undervalued by the market. Suggest
three credible signals that the company and/or its CEO could give to increase its
share price. Explain why the signals you suggest are credible.

Other suggested reasons for the decline in Canadian Superior’s share price:

 The disclosure principle. The CEO’s refusal to answer questions may have led
investors to conclude he had something to hide.

 The sale of $4.3 million of his shareholdings by the CEO. This sale took place
in January. The market should have largely reacted to it then. However, the
March announcement may have suggested to the market that this insider sale
was more ominous than it had perceived at the time. If so, a further share price
decline would be expected.

 Lawsuits. Concern about unfavourable outcome of the class action lawsuits

would lead to a share price decline.

b. The CEO’s sale of stock in January, 2004, suggests the adverse

selection problem, leading to insider trading. The adverse selection problem occurs
when an individual exploits his/her information advantage over other persons. Here, a
possible explanation of the January stock sale is that the Canadian Superior CEO had
inside information about El Paso’s intention to pull out of the project. Sale of shares
before the market became aware of this

intention constitutes exploitation of this information at the expense of outside

investors.
c. The effect would be to decrease share prices of all Canadian oil and gas
companies. This is an example of an externality. That is, share prices of other firms
are affected by the actions of one firm.

Share prices of all firms are affected because of a pooling effect, which takes place
when investors are unable to discriminate between high and low-type firms. In effect,
oil and gas shares are viewed as lemons, subject to considerable estimation risk.

As a result, investors feel that the market for oil and gas shares is not a level playing
field due to the large amount of inside information in the exploration for oil and gas
and the apparent willingness of at least some insiders to exploit this information.
Consequently, investors will withdraw from the market or reduce the amount they are
willing to pay for all oil and gas shares.

d. Possible signals include:

 Obtain a new partner. A new partner will conduct due diligence about
Canadian Superior’s prospects before investing. This will credibly
signal Canadian Superior’s willingness to subject itself to the
investigations conducted by the potential investors/partners, since it
would not be rational to submit to such an investigation if the company
believed the well’s prospects were poor.

 Raise private financing and complete the well without another partner.
This is a credible signal for the same reasons given in the previous
point.

 Issue public debt, as a signal that management believes that the

probability of the debtholders taking over the firm in the future is low.
Management would not be rational to issue public debt if it felt the
well’s prospects were poor.

 Management could increase its shareholdings, or amend the firm’s

compensation plan to require more share holdings by senior officers.
Increased shareholdings would not be rational if management was
concerned about future firm performance.
  Adopt more conservative accounting policies. This will signal that
future earnings can stand resulting downwards pressure. It would not
be rational to adopt conservative policies if Canadian Superior
management believed this would decrease any earnings-based bonuses
or increase the probability of future debt covenant violation.

 Hire a prestigious auditor. This signal may not be as effective as others

since the auditor may not be experienced in auditing technical details of
oil and gas exploration. However, the auditor may be able to offer
systems advice and implementation, to reduce the likelihood of future
abuses of inside information.

 Increase dividends and/ or undertake a stock buyback. These signals

may not be effective because they could also be consistent with the
company having little use for its cash in its own operations.

QUESTION FOUR

In February 1998, Newbridge Networks Corporation, a telecommunications equipment

maker based in Kanata, Ontario, announced that its revenues and profits for the
quarter ending on February 1, 1998, would be substantially below analysts' estimates.
Its share price immediately fell by 23% on the Toronto and New York stock exchanges.
The sale, in December 1997, of over $5 million of the company's shares by an inside
director of Newbridge was widely reported in the financial media during February
1998. Details of sales by other Newbridge insiders, including its CEO, during previous
months were also reported. The implication of these media reports was that these
persons had taken advantage of inside information about disappointing sales of a new
product line.

Required
a. Which source of market failure is implied by these media reports of insider
trading?

b. What effects on investors, and on the liquidity of Newbridge shares, would media
reports of such insider sales be expected to create?

a. The market failure derives from adverse selection. Investors felt that managers were
engaging in selective disclosure. That is, inside information was released to certain
individuals, such as analysts, who had the opportunity to take advantage of it before
passing it on to the market. This practice increased estimation risk for ordinary
 investors, causing them to lower the amount they were willing to pay for all shares
and, in extreme cases, leave the market. In effect, the market was not working as well
as it should.

b. Market liquidity will be reduced by this practice. Both market depth and the
bid-ask spread will be affected. The depth component of market liquidity will fall as
ordinary investors leave the market. The bid-ask spread component will rise as dealers
(who set the spread) and investors perceive that inside information is in the hands of a
group of analysts and institutional investors who will, presumably, use it for their own
advantage at their expense.

Liquidity is important if markets are to work well because:

 Market liquidity (depth) enables large investors to buy and sell large blocks of
shares without affecting the market price. If large investors cannot do this,
their demand for shares will fall, since they will have to pay

more to buy and will receive less if they sell. Lower demand exerts downward
influence on share prices.

 Increased bid-ask spread increases transactions costs for investors, further

lowering demand for shares.

 Lower market liquidity, and lower share prices that follows, increases firms’
costs of capital, with negative effects on the economy.

QUESTION FIVE

A number of firms, in the US such as BCE Inc., Coca Cola, and McDonald's, have
discontinued their practice of issuing quarterly earnings forecasts, thereby lowering their
disclosure quality. More generally mandated reporting frequency of financial reports
varies across the world where for example in Australia half-year reports are mandated
and in the US quarterly reporting is mandated.

Required
Outline some benefits and costs to firms of issuing quarterly earnings forecasts

Costs to firms that issue quarterly earnings forecasts:

  Direct costs of preparing the forecast. However, these costs are likely to be
incurred regardless of discontinuance, to the extent the firm forecasts for
internal use.

 Earnings forecasts may reveal proprietary information of value to competitors,

since they convey management’s expectations about future operations.

 A reason often given is that the severe negative consequences of not meeting
quarterly targets gives management a short-run focus, distracting it from the
attainment of longer- term goals. Thus, Issuance of quarterly earnings forecasts
may lead to a short-term manager decision horizon whereby longer-term
activities are sacrificed in order to meet the short-term earnings objectives.
Examples include cutting of R&D and postponing capital expenditures.
Consequently, the firm is better off not to issue a forecast in the first place. This
reason for discontinuing quarterly forecast was examined by Chen, Matsumoto,
and Rajgopal (2011 ), who identified a sample of firms that discontinued
quarterly earnings guidance over the period 2000-2006. They reported that
firms that are losing long-term investors are relatively likely to discontinue
quarterly forecasts.

 Possible lawsuits if earnings targets are not met.

 Managers may engage in opportunistic earnings management in order to meet

earnings targets. This will harm the firm through lower share price (and the
manager through lower reputation) when the earnings management is
discovered.

Benefits to firms that issue quarterly earnings forecasts:

 Lower estimation risk, leading to greater investor confidence, an increase in

the number of investors in the firm’s shares, and lower cost of capital. This
benefit is predicted theoretically by Diamong and Verrecchia (1991), and
Easley and O’Hara (2004).

 Motivation of managers to work hard to meet laid-down earnings targets.

 Greater analyst following, leading to increased investor interest. Lang and
Lundholm (1996) found that high quality disclosure was accompanied by a
larger number of analysts following the firm. The theoretical model of Merton
(1987) then predicts greater demand for the firm’s shares leading to lower cost
of capital.

 Earnings forecasts have signalling properties, thereby providing a credible

vehicle for managers to communicate their earnings expectations. The
credibility of a forecast derives from the fact that its accuracy can be readily
verified after the fact. Consequently, a low type firm would be foolish to issue
a high type forecast.