Why has the role of corporate transparency emerged at the forefront of governance debates? There is a perception that shining a bright light into the dark corners of firms� accounts�via greater transparency�will prevent managers from hiding the consequences of their actions from outside investors. This in turn would limit misbehavior and reduce firms� cost of external financing. Good corporate governance and greater transparency are thus seen as two sides of the same coin.
The four articles in this issue address questions of improving transparency and more. As capital markets continue to develop around the world and exert greater influence on the flow of resources, the role of information available to capital market participants is a natural concern. What factors affect corporate transparency, and how do the underlying information systems affect firm performance?
In the first article, �The Benefits of Transparency: Disclosure Regulation and the Cost of Capital,� Christian Leuz and coauthor Luzi Hail examine the relation between regulations mandating and enforcing public firm-level disclosures and the cost of equity capital in 40 countries. While regulators often allege that increasing corporate transparency benefits firms by lowering their cost of capital, prior empirical support is scarce. Leuz and his colleague take a significant leap forward in filling this gap. They document a meaningful reduction in the cost of equity in countries characterized by relatively tight disclosure requirements and enforcement, particularly in countries where capital markets are not globally integrated.
While corporate disclosure intensity is a key feature of the information environment, the measurement prescribed by accounting standards also is of paramount importance. In recent years, perhaps no accounting reform has been more hotly debated than the initiative of the International Accounting Standards Board and the U.S. Financial Accounting Standards Board to report assets and liabilities on corporate balance sheets at their current (updated) market values (referred to as mark-to-market accounting), which would replace the long-standing use of historical cost accounting. This accounting issue is particularly important for financial institutions�whose balance sheets are most affected�and arguably is one of the most significant policy issues currently facing the financial services industry.
In the second article, �Accounting Reform: The Costs and Benefits of Marking- to-Marke t,� Haresh Sapra and coauthors Guillaume Plantin and Hyun Shin provide an economic analysis of the pros and cons of mark-to-market versus historical cost accounting. In their model, managers� resource allocation decisions are driven by their objective of maximizing accounting earnings. It is not surprising that historical cost accounting, which relies on outdated prices, distorts managers� resource allocation decisions. The novel insight from the model is how the �real effects� of mark-tomarket accounting on managers� decisions induce artificial asset price volatility. This, in turn, leads to suboptimal resource allocation decisions by the managers. These unintended adverse consequences of mark-to-market accounting, previously unrecognized by accounting policymakers, are shown to be most severe when balance sheet accounts are long-lived, illiquid, and senior�characteristics typical of financial institutions. Beyond the immediate implications of the analysis for the mark-to-market accounting debate, a more general policy implication is that in a world of imperfect capital markets, removing one friction (such as increasing accounting transparency) without addressing the other market frictions need not guarantee an increase in welfare. In some circumstances, transparency can lower welfare by inducing suboptimal decisions.
In the third article, �Gambling with House Money: Manipulations in Pension Accounting,� Joshua Rauh and coauthors Daniel Bergstresser and Mihir Desai empirically investigate the manipulation of reported earnings through pension accounting and the associated �real effects� on pension fund investments. Under Generally Accepted Accounting Principles (GAAP), the reported cost of defined benefit pension plans is reduced by the assumed, rather than actual, return on pension fund assets. Hence, current GAAP provides a direct way to boost reported earnings by raising the assumed rate of return on fund assets. Rauh and his coauthors discover that some managers exploit this opportunity. In firms where the rate of return assumption has a more dramatic effect on earnings, return assumptions are more aggressive. Moreover, return assumptions are especially high when managers are �entrenched,� and when there is the most to gain from inflated earnings and stock prices. Such gains may be obtained at times when unmanipulated earnings fall just below critical thresholds or when managers are exercising stock options, engaging in acquisitions, or undertaking secondary equity offerings. In addition, managers appear to tilt fund investments toward equity securities, amplifying risk exposure, to justify the higher expected return assumptions used to inflate reported earnings.
While the first three articles focus on corporate accounting and disclosure regulations and practices, the final article considers the collection and dissemination of firm-specific information by the media. In �Candid Camera: The Role of the Media in Corporate Governance,� Luigi Zingales and coauthors Alexander Dyck and Natalya Volchkova explore the role of the press in the restriction of governance abuses by Russian companies during the period from 1998 to 2002. In contrast to countries where laws and enforcement protect minority shareholders� rights, conventional corporate governance mechanisms were largely ineffective in curbing corporate governance abuses in Russia during this recent period. As a result, Russia provides a rich setting for isolating the governance role of the media. The authors predict that if managers, directors, regulators, politicians, and others who influence the way firms are governed are concerned with reputation, press coverage may limit misbehavior. Zingales and his coauthors found that coverage in the Anglo-American press significantly increased the likelihood that the exposed abuses by Russian companies were corrected. Interestingly, coverage in Russian newspapers with similar credibility, but less global reach, did not have a corresponding beneficial effe c t. The authors conclude that the governance effect of the media mainly operates by increasing the reputational cost of abuse, in this case, among Anglo-American investors.
These four articles illustrate a significant impact of disclosure regulation and enforcement on the cost of equity capital, as well as meaningful effects of accounting rules and media coverage on managerial behavior. It�s fair to say that a strong interest in the quality of information readily available to investors and its economic effects is well founded.
On the research front, much remains to be done�and I expect the faculty of the GSB to take the lead. Please stay tuned.
Abbie J. Smith
Boris and Irene Stern Professor of Accounting at the University of Chicago Graduate School of Business