High quality corporate reporting has become an important issue for many corporate entities. However, the recommendations to improve it are sometimes questioned on the basis that the marketplace for capital can determine the nature and quality of corporate reporting. It could be argued that additional accounting and disclosure requirements would only distort a market mechanism that already works well and would add costs to the reporting mechanism, with no apparent benefit. On the contrary, it could also be argued that increased disclosure reduces risks and offers a degree of protection to users. However, increased disclosure has several costs to the preparer of financial statements.
Required:
Discuss the relative costs to the preparer and benefits to the users of financial statements of increased disclosure of information in financial statements. (4 marks)
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Costs to Preparers:
i) the cost of developing and disseminating information,
ii) the cost of possible litigation attributable to information disclosure,
iii) the cost of competitive disadvantage attributable to disclosure.
i) The costs of developing and disseminating the information include those of gathering, creating and auditing the information. Additional costs to the preparers include training costs, changes to systems (for example on moving to IFRS), and the more complex and the greater the information provided, the more it will cost the company.
ii) Although litigation costs are known to arise from information disclosure, it does not follow that all information disclosure leads to litigation costs. Cases can arise from insufficient disclosure and misleading disclosure. Only the latter is normally prompted by the presentation of information disclosure. Fuller disclosure could lead to lower costs of litigation as the stock market would have more realistic expectations of the company’s prospects and the discrepancy between the valuation implicit in the market price and the valuation based on a company’s financial statements would be lower. However, litigation costs do not necessarily increase with the extent of the disclosure. Increased disclosure could reduce litigation costs.
iii) Disclosure could weaken a company’s ability to generate future cash flows by aiding its competitors. The effect of disclosure on competitiveness involves benefits as well as costs. Competitive disadvantage could be created if disclosure is made relating to strategies, plans, (for example, planned product development, new market targeting) or information about operations (for example, production-cost figures). There is a significant difference between the purpose of disclosure to users and competitors. The purpose of disclosure to users is to help them to estimate the amount, timing, and certainty of future cash flows. Competitors are not trying to predict a company’s future cash flows, and information of use in that context is not necessarily of use in obtaining competitive advantage. Overlap between information designed to meet users’ needs and information designed to further the purposes of a competitor is often coincidental. Every company that could suffer competitive disadvantage from disclosure could gain competitive advantage from comparable disclosure by competitors. Published figures are often aggregated with little use to competitors.
Companies bargain with suppliers and with customers, and information disclosure could give those parties an advantage in negotiations. In such cases, the advantage would be a cost for the disclosing entity. However, the cost would be offset whenever information disclosure was presented by both parties, each would receive an advantage and a disadvantage.
Benefits to users:
Increased information disclosure benefits users by reducing the likelihood that they will misallocate their capital. This is obviously a direct benefit to individual users of corporate reports. The disclosure reduces the risk of misallocation of capital by enabling users to improve their assessments of a company’s prospects. This creates three important results.
(i) Users use information disclosed to increase their investment returns and by definition support the most profitable companies which are likely to be those that contribute most to economic growth. Thus, an important benefit of information disclosure is that it improves the effectiveness of the investment process.
(ii) The second result lies in the effect on the liquidity of the capital markets. A more liquid market assists the effective allocation of capital by allowing users to reallocate their capital quickly. The degree of information asymmetry between the buyer and seller and the degree of uncertainty of the buyer and the seller will affect the liquidity of the market as lower asymmetry and less uncertainty will increase the number of transactions and make the market more liquid.
(iii) Information disclosure helps users understand the risk of a prospective investment. Without any information, the user has no way of assessing a company’s prospects. Information disclosure helps investors predict a company’s prospects. Getting a better understanding of the true risk could lower the price of capital for the company. It is difficult to prove however that the average cost of capital is lowered by information disclosure, even though it is logically and practically impossible to assess a company’s risk without relevant information. Lower capital costs promote investment, which can stimulate productivity and economic growth.