Information Asymmetry and Its Impact on Accounting Practice - Example

Name Tutor Title: Information Asymmetry and Its Impact on Accounting Practice Institution Date Introduction Globalization of trade is continuing to have a deep impact on how business is done. Accounting is one major aspect that is very crucial currently. Globalization has changed companies into international institutions and has also challenged daily national identity, economic life and developed a persistent movement towards business and cultural homogenization. The diversity of Accounting among societies is always reflected in financial statements that are prepared under various accounting standards. In case investors and creditors find it hard to understand financial statements of a given company, they can delay their investment or lending funds to a company in question. It is essential therefore for financial reports to be prepared in a common accounting language that is known internationally. It is also important to note that business globalization, exchanges of foreign currency and the need for combined financial statements are putting great pressure on globalization of accounting standards. A global set of accounting standards can allow a playing ground that is more leveled since balance sheets and income statements ratios can become more consistent among companies that are competing. There are various probable motivations for Firms to adopt conservative financial reporting practices. Researchers have used a number of empirical methods in determining and measuring conservative financial reporting. They have also explained the extent to which the empirical evidence of relationship between conservative financial reporting and information prevails (Ball & Shivakumar, 2005). How conservative financial reporting practices reflects information quality of reporting firms To understand how conservative financial reporting reflects the information quality of reporting firms, it is important to explore the association between the extent of conservatism within accounting policies of a firm and the firm’s cost of equity capital. Conservatism can be described as a selection principle among accounting principles that bring about the optimization of collective reported earnings by slower revenue identification, rapid expense identification, lower asset appraisal and higher liability appraisal. An inverse relationship prevails among conservatism and cost of equity capital, for companies that information asymmetry is huge. Conservatism can have insignificant effect on the cost of equity capital for firms that information asymmetry is low. Conservatism is a normal reaction to information asymmetry. It is assumed that demand for conservative financial reporting normally enhances relative to equilibrium corporate governance reaction aimed at reducing the agency costs that are related with managerial overstatement of assets and income (Basu 1997). Basing on firms in United States, it has been forecasted that conservative financial reporting can develop in response to enhance in information asymmetries within equity markets. Conservatism is also assumed as an equilibrium reaction to mitigate value reduction that arises from the information asymmetries. At equilibrium, information quality and quantity affect prices of assets and illustrates that firms can control their capital cost by affecting the accuracy and quantity of information that is available to investors via choosing market microstructure, accounting standards and corporate disclosure exercises. It therefore implies that management can utilize conservative accounting policy options to signal private information when asymmetric information prevails. It is assumed that managers who have private information that concerns the future earnings of the firm can opt for conservative accounting rules and deliberate disclosure as quality signals. In this case, deliberate adoption of conservative accounting rules is not a signal that is costless because it usually minimizes the quantity of financial slack that prevail to managers, for instance, it can minimize the managers capability to control earnings so that they can attain or beat earnings predictions. High quality firms therefore can manage to incur expenses of a more conservative balance sheet while the lower quality firms cannot and thus will not request to imitate the conservative accounting rules options. At equilibrium, the selection of accounting policy can be utilized to signal private information that is concerned with future earnings since the selection normally relates with the optimal firm plan for deliberate disclosure. Guay and Verrecchia argue that (2007) the optimal disclosure policy for firms means to disclose option of a conservative accounting policy. Firms therefore can find themselves utilizing some arrangement of signals entailing conservative accounting options and direct disclosures. Conservatism financial reporting is also capable of reducing information risks. An inverse relationship exists among conservatism and cost of equity capital. Though the relationship is somehow complicated, the conservative accounting policy options can be applied in communicating management’s private information. Conservatism has been viewed from various perspectives, for instance, an essential body of evidence that shows that financial reporting over time has become more conservative. As far as empirical evidence is concerned, four factors have been identified as those that further influence the extent of conservatism. The four factors include contracting, income taxation, accounting regulation and litigation. The contracting clarification has established the greatest attention and offers a foundation for both pervasive and existence nature of conservative accounting exercises since the conservatism’s exercise pre-dates the litigation, income taxation and controls explanations. The contracting description has obtained the greatest attention thus offering a foundation for the existence and persistent nature of conservative accounting exercises (Artiach, 2009). In its verifiability part, conservatism has been evident in accounting and provides a positive role in contracting competencies with evidence. Conservatism mitigates agency differences thus minimizing the cost of debt and developing corporate governance. Conservative financial reporting is normally observed by management as value adding or a way of providing economic advantage. The financial report is a normal reaction to information asymmetry. Conservative financial reporting can cause constant negative accumulations with more negative average accumulations reflecting more conservative accounting. Minus intervention, accumulations are usually expected to repeat after sometime with functioning income converging to cash flows from operations. This therefore implies that persistence cumulative negative’s accumulations over time need to reflect conservatism unfairness in the accounting system of the firm rather than accumulations’ transitory nature. Focus is always placed on non-operating accumulations rather than aggregate accumulations since aggregate accumulations include operating accumulations that arise from daily business of the firm (Basu, 1997). According to Beatty and Weber (2008), financial reporting can greatly assist creditors in monitoring their investment effectively. Creditors can lend capital to companies. The initial concern of creditors after lending the capital is always to make sure that the capital given out is finally returned with interest. To ensure that the capital given out is returned with interest, creditors normally depends on information provided by financial reports. Managers of a firm do not always act on behalf of creditors’ interests. In case the creditors are always expecting that managers of the firm will act at their best interests, there will be no reason for writing complicated debt contracts. It is therefore understood that managers do not often act in the best interests of creditors. Agency differences can prevail among managers and creditors that cause creditors to be concerned with firms’ actions. The actions are widely categorized as firms’ action that enhances the risk or possibility that creditors will not get their investment returned. Common examples incorporates managers enhancing firm leverage by creating cash payouts to shareholders in a form of dividends or purchase of shares, or enhancing the riskiness of assets of the firm via different investment decisions. In many scenarios, creditors may not be concerned with daily payout rules and investment decisions, as managers for financially healthy and the going-concern companies normally expect to maximize the value of the firm. It is also understood that in settings that are characterized by a considerable possibility of distress, managers may develop decisions that are beneficial to shareholders and disadvantageous to creditors. Financial reports therefore can be used by creditors to allocate a right decision particularly in countries that managers cannot be trusted in maximizing the value of the firm. For creditors to efficiently monitor their investments, they need information that permits them to identify when mangers may assume actions that are not in the best interests of creditors. They also need the capability to have a number of decisions rights over the company when such situations come up. Financial reporting normally provides this kind of information that is useful to creditors. Financial reporting is well-suited in offering creditors with dependable information concerning net assets, near-term cash flows, leverage, current-period performance and change in asset riskiness or mix (Smith & Warner, 1979). Conservative financial reporting normally conveys a downward unfairness on reported net importance so as to counteract tendencies of managers to bias net importance upwards. It also commits managers to identify bad information in a timely manner. Creditors therefore normally find it essential to have conservative reporting policies that eliminate timely bad information. Creditors are always concerned about how their investments grow particularly when the financial health of the firm deteriorates. Managers may have asymmetric motivations to be less cooperative with bad information that concerns performance of the firm versus good information. Alternatively managers can be expected to be relatively more cooperative with good information than bad information, regardless of how directive the financial accounting policies are constructed. Therefore, provided that creditors are comparatively more concerned about bad firm performance and that they are expected to be comparatively less cooperative with bad performance of firm, creditors are expected to request for financial accounting reports that elicit from managers timely information concerning bad performance of firms (Bagnoli & Watts, 2005). Though all the firms in United States follow GAAP, it does not mean that all the firms normally demand similar degree of conservatism within their financial reports. The rules of accounting have undergone changes over time to attain the requirements of different market players and contracting parties. Therefore it can easily be assumed that the observed accounting policies conform to weighted average desires of financial statements’ users. The weighting is usually based on the relative significance of particular types of contracting parties, the parties’ capability to get information outside the formal reporting needs, the significance of acknowledgment versus disclosure to different financial statements’ users, lobbying strength and indirect and direct costs of reporting (Guay & Verrecchia, 2007). A company and its contracting parties can contain demands for comparatively larger or lesser conservatism in two ways. First, the judgment within GAAP permits managers to select financial reporting that includes comparatively less or more conservatism. Second, contracting parties and managers can develop adjustments to accounting figures that has been reported within individual contracts so that they can attain their requirements well. Adjustments of financial accounting figures are always viewed in a number of contracting contexts, incorporating managerial bonus plans and debt contracts. Adjustments on reported financial figures are usually developed in a range of other contexts that incorporate reports analysis, tax accounting and firm valuation analysis. Firms can also make for themselves adjustments on reported accounting figures when discussion firm’s performance (Beatty &Weber, 2008). Financial reporting in promising capital markets should rest on a stand. Financial reporting normally ensures that accounting information is adequate, available, timely and easily accessible. firms needs to make sure that financial reports are organized on the basis of good accounting necessities and be developed in away that it comply with the accounting requirements since good financial reports usually reflects the firm’s information quality. Financial information needs to be comparable. Attaining comparability incorporates particular accounting rules that are utilized so that financial statements can be prepared. Understanding the contextual importance of financial information is necessary. These concerns can be addressed through balancing the generally accepted set of accounting standards (Abarbanell & Bernard, 2008). Conservative financial reporting serves a number of roles in impacting the performance of a firm and economy as a whole. Financial accounting information can be utilized by investors and managers in identifying good versus terrible projects. This incorporates the opportunities for enhancing the efficiency of assets in place. It also incorporates the opportunities for new and capable managers and other workers in providing their human capital. Financial accounting information of high quality can function as a corporate management mechanism that provides managers with incentives that moves the resources toward projects that are identified as terrible. The timely loss identification in financial reporting usually forces managers to identify losses early enough and hence develops incentives to select good projects. (Ball & Robin, 2000). Financial reporting always has ability of minimizing information improbability and reducing the external capital’s cost. Better identification and choosing of projects, better investment effectiveness and lower capital’s cost translate into rapid growth. Therefore there is always a positive relationship between financial reporting quality and the development of a firm and the whole economy. This also implies that financial reporting of reflects the performance of the reporting firm. Thus financial reporting of high quality reflects a positive growth effects. The financial reporting quality is thus determined by reporting motivations and institutions that exists in a country. The differences in institution across nations affect the financial reporting quality and other variables in an economy, including the growth of firms (Aboody & Lev, 1998). Financial reporting system normally plays governance role by limiting managerial diversion. The role of governance in financial accounting is always superior when information improbability and information asymmetric is high. In extreme end, when shareholders are well informed, they may probably want managers to choose the initial best investment project. In the existence of information asymmetry among shareholders and managers, directors are probable to undertake their wellbeing at the expense of debt holders and shareholders. The information asymmetry is expected to be very severe in industries that are featured by high information improbability such as development and research or intense industries that are intangible. Timely loss identification assists in mitigating this type of agency problems by expecting managers to identify losses that are not verifiable in a timely manner (Ahmed & Billings, 2002). A lot of disclosure and less management earnings are other characteristics of financial reports that are of high quality that assists in mitigating information improbability problems and thus always assists in economic growth and in identifying firms that are performing well. Sound financial reporting also assists in mitigating information asymmetry or improbability and reduces the capital’s cost. Industries with higher information asymmetry develop faster with better financial reporting quality. This therefore implies that the variation in growth among industries with high information asymmetry and low information asymmetry is greater in an economy with better accounting quality. The difference is due to the fact that a better financial reporting assists the capital’s flow in industries with high information improbability (Ahmed & Duellman, 2007). Financial reporting quality is indefinable concept in the literature of accounting. Different methods of measuring financial reporting quality have been raised by various researchers. The scarcity of available information in international setting have further complicated the matter. Three corresponding measures of financial reporting quality have been utilized extensively in many literatures. When choosing reporting quality measurements, it is important to concentrate on reported financial accounting information rather than accounting policies that are adopted by a particular country. It has been proved that stated accounting policies can be circumvented by insiders and thus do not reflect real reporting practices of the firm. Therefore in evaluating financial reporting quality of a firm, it is important to rely on what the firm does (Guay W. & Verrecchia, 2006). The first measure of financial quality information is center for international financial analysis and research (CIFAR) appraisal of corporate disclosure levels for leading organizations. The CIFAR score is a disclosure indicator for various nations that rates the yearly reports of approximately three firms in every nation on the omission or inclusion of ninety financial accounting items. This therefore implies that every nation normally gets a score out of ninety, with greater amount showing more disclosure. The score has been utilized in many literatures to get rid of accounting quality at national level. It has been discovered that common law nations that tend to have investor protection institutions that are stronger, have CIFAR scores that are significantly high. The score can be used to capture financial reporting strength by assuming that nations with advanced CIFAR scores have comparatively financial disclosure levels. Therefore, better fiscal disclosure is a structural factor that is related with the reporting surroundings of powerful investor protection nations. The compiled CIFAR score can therefore be used as the initial measure of financial reporting quality (Beaver & Ryan, 2000). The earnings management index is normally used as a second measure of financial reporting. It is usually done by first utilizing financial accounting information from thirty one nations. The four measures of management earnings are then aggregated into a single nation-specific management earnings score. The measures that underlay the management earnings are usually selected to get rid of several management earnings practices such as smooth earnings and increase manipulations. The earnings management are usually planned to be specifically sensitive to discretion and reporting incentives of the firms that managers might utilize in complicating performance of the economy and thus the quality of reported figures. Asymmetric timely loss recognition (TLR) or conditional conservatism is also another measure that can be used in measuring financial reporting quality. Conservatism is always described as the differential verifiability needed for identification of profits versus losses (Barry & Brown, 1985). Conclusion From the discussion it is evident that conservatism financial reporting reflects information quality of a reporting firm. In determining how the information quality is reflected by financial reports, it is essential to explore the relationship between the extent of conservatism within accounting policies of a firm and the firm’s cost of equity capital. Conservatism financial reporting has an inverse relationship with the firm’s cost of equity capital if the information asymmetry is greater. In case the Conservative financial reporting has insignificant effect on the cost of equity capital it implies that the information asymmetry is low. Conservatism financial reporting is always a normal reaction to information asymmetry. It is assumed that demand for conservatism normally enhances as equilibrium corporate governance reaction aimed at reducing the agency costs that are related with managerial overstatement of assets and income. Different methods for measuring conservative financial reporting have been suggested. The first measure of financial quality information that has been suggested is center for international financial analysis and research (CIFAR) appraisal of corporate disclosure levels for leading organizations. Asymmetric timely loss recognition is the second method that is used in measuring conservative financial reporting. Management earnings index is also a method that is used in measuring financial reports. Four factors have been identified as those that further influence the extent of conservatism. The four factors include contracting, income taxation, accounting regulation and litigation. Bibliography Ball R. & Shivakumar L., 2005, Earnings quality in U.K. private firms: comparative loss recognition timeliness, Journal of Accounting & Economics 39, 83-128. Basu, S., 1997, The conservatism principle and the asymmetric timeliness of earnings, Journal of Accounting & Economics 24, 3-37. 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