role of accounting standards with respect to information risk

Significant factors that determine the elements recognized within financial statements are relevance, comparability, and reliability. According to FASB Statement of Concepts No. 5, “recognition criteria, conventions, and rules are means of coping with the uncertainty that surrounds business and economic activities.” (Recognition is the process of formally incorporating an item into the financial statements of an entity (e.g., assets liabilities, revenues, expenses…) Accounting standards likely cannot perfectly reduce this uncertainty to some acceptable level; hence application of accounting standards may be associated with information risk (uncertainty about the true value of the firm).

A body of literature provides evidence that investors demand a premium for information risk (e.g., Easley and O’Hara, 2001; Easley, Hvidkjaer, and O’Hara, 2002). In addition Amidhud (2002) and others document that that investors’ expecting higher market illiquidity will adjust stock prices to reflect higher returns. The recent credit crisis certainly illuminated the extent to which information risk can harm capital markets. Akerlof (1970) models the possibility of a market breakdown when investors cannot ascertain the difference between “good assets” and “lemons”.  In this case of asymmetric information about the value of the firm’s assets investors assess value at an average of the two asset types.  This is initially advantageous to the firm with “lemons” who will want to trade, but rational investors will anticipate that firms with good assets will not want to sell at an average price and will drop out of the market, and such investors will be less willing to trade. In the absence of mitigating conditions (i.e., additional disclosure by firms with “good assets”), the market will consist of a pool of lemons.

The impact of  information risk  on information asymmetry may differ depending upon several factors, including: (i) the levels of private information versus public information (Easley and O’Hara, 2001), (ii) the extent to which the investor has superior information processing skills (Kim and Verrechia, 1994), (iii) the extent to which the investor has incentives to engage in costly information gathering activities (Akerlof, 1970), or (iv) a pre-commitment by the firm  to some level of disclosure (Verrechia, 2001; Kim and Verrecchia, 2001).

The concept of earnings quality relates to information risk relative to the application of accounting standards and the presence/absence of earnings management.  This assignment is limited to the role of accounting standards with respect to information risk.

Exhibit 1 represents one possible depiction, based upon the literature of the channel of information risk to investors and resultant equity and liquidity premia.  Note that firm-specific characteristics can have a direct impact on information asymmetry.  For example, growth firms, firms with relatively high proportions of intangible assets, or research and development intensive firms have greater uncertainty with respect to the value of their assets.

Required readings are two articles that provide background information on earnings quality, information asymmetry and the costs of information risk (relatively lower earnings quality/relatively higher information asymmetry); and two academic articles for two accounting areas (in addition to the required reading discussed above).

Using the knowledge in accounting standard for the two areas of Lease Accounting and Fair Value Measurements, and the information addressed in the readings, discuss the following:

·        Describe the accounting standards for each of the two areas. Be sure to include in your discussion the criteria for balance sheet recognition and whether revenues/expenses, gains/losses are recognized in current period earnings or deferred to AOCI (accumulated other comprehensive income) (if applicable).  

·        Based upon the academic articles, discuss the impact of the accounting standard, if any; on investor valuation of the relevant items (e.g., leased assets/liabilities, financial instruments).

·        Provide a recommendation as to how the standard may be improved, or the extent to which additional disclosure (mandated or voluntary) would further reduce information uncertainty.

·        Discuss strategies that a risk manager might undertake to compensate for accounting application/measurement risk.

Exhibit 1: Information Risk and Capital Market Outcomes