Tutorial in Week 2 (based on Week 1 Lecture) beginning 5th March 2018

TOPIC: Objectives of Financial Reporting and Information Asymmetry

The first three tutorial questions are designed to aid your understanding of the concepts of
information asymmetry and to illustrate how these fundamental concepts can be used to explain
a significant amount of economic resource allocation problems and associated
outcome/solutions. You will not be directly examined on bid-ask spreads, private equity and
the pecking-order of finance funds however you are expected to understand the concepts of
information asymmetry. The fourth questions introduces a channel through which accountants
can reduce information asymmetry (accruals). The fifth and sixth questions begin to introduce
possible biases associated with accruals which we will be discussing in subsequent weeks.

Question 1. The bid–ask spread (also bid–offer) is the difference between the prices quoted
for an immediate sale (ask/offer) and an immediate purchase (bid) for shares. The graph
below shows the five day moving average of the daily percentage bid-ask spread1 for two
Australian listed companies: Buru Energy and BHP. Buru Energy is a small oil and gas
exploration firm with exploration rights in Western Australia. BHP is one of the largest
multinational mining companies in the world with major operations in iron ore, petroleum,
coal and copper. Why are these bid-ask spreads different? Are there any economic
consequences from this difference?

1 Bid-ask spread is calculated as: (ASK-BID)/(ASK+BID)/2) x 100. Data is from Bloomberg.

Solution

A significant determination of bid-ask spreads is adverse selection. The argument is that

information asymmetry between the buyer and the seller increases the bid-ask spread—the
difference between the proposed “sell” and “buy” prices. This occurs because potential buyers
or sellers could “lose” on trades with better-informed counterparties. Therefore potential
buyers or sellers to price protect themselves offer a lower (higher) price to compensate for their
losses from an “adverse” transaction.

Thus the spread is determined by the probability of trading with a more informed counter-
party and therefore the magnitude and quality of “public information” about a firm’s stock. The
greater the known information set about a firm the lower the risk of trading with a more
informed counter-party. Therefore the bid-ask spreads is greater for Buru Energy than BHP
(notwithstanding the complexity of BHP) due the greater amount of public information about
BHP than Buru Energy and thus lower the risk of trading with a more informed counter-party.
Given that both BHP and Buru Energy both produce external financial reports why is the public
information set about BHP greater than Buru Energy? This can be because a number of other
information intermediaries produce public information such as analysts and the media. For
example BHP has 20 analysts and Buru Energy has 0. Furthermore Buru Energy is a relatively
new stock compared to BHP implying less time to accumulate an understanding of the firm.
Finally, more investors follow BHP (trading volume of 2,392m versus 152m) implying their
information is impounded into stock price giving rise to lower information asymmetry.

Buru Energy BHP

Principal operations Oil and gas exploration Diversified mining and
exploration
IPO year 2008 1885
Total Assets 2016 A$73m US$118,953m
Analyst coverage (from 0 20
Market Watch)
Trading volume 2017 152m 2,392m

The economic consequences of a high bid-ask spread is that a higher bid-ask gives rise to a
corresponding decrease in market liquidity, securities prices are discounted due to higher
transaction costs ( a higher cost of capital), and some potential investors refrain from
participating in such markets.
Question 2. Compute the magnitude of the sources of financing from debt, equity and
internal funds for Amcor. Why may the company prefer to use internal funds, then debt
and finally equity to fund the project? Hint this is likely to vary as a function of the cost
of funds. Use the concepts of information asymmetry to explain this.

Source $USM Percentage

Internal Funds 286 4.5%
Debt 4,611 73%
Equity (Paid-Up Capital) 1,417 22.5%
Total 6,314

Amcor clearly relies much more on debt than equity. Its debt/equity ratio is very high. Amcor most
likely prefers to use debt as the average cost of debt is lower than equity. Current long-term bond
yields are 2.8%. This is likely to be lower than Amcor’s cost of equity. A typical cost of equity is 8-
12%. The cost of debt can be lower than cost of equity due to the following information asymmetry
reasons

 The cost of debt is lower than the cost of equity because adverse selection costs are
lower for debt offerings than equity offerings. This occurs for two reasons. First, for
debt the nominal face value of payoffs are known and therefore there is lower
information asymmetry (some asymmetry still arises due to credit risk). Second, when
equity is offered, outside investors infer that managers believe the current stock price
is overvalued. This could occur because managers, not wanting to dilute existing
shareholders claim, will issue only overvalued securities. Aware of this, market
participants discount firm value to reflect adverse selection costs.

 Certain types of lenders (especially banks) can be given special access to internal firm
information without having to make this information public. Amcor might have private
information that suggests it will perform well in the future that it can disclose to lenders
(resulting in a lower cost of debt), but which it does not want to make public (e.g. because it
will help competitors).

 It is sometime argued that debt can lower the moral hazard costs of firm management not
always acting in the best interest of shareholders. This is because debt acts as a displinanary
mechanism as the firm is committed to making regular cash payments. Therefore firm
management cannot invest in negative net present value projects due to self-interest motivated
by pet-projects, empire building etc as they need to have a viable future cash flow to meet
commitments to lenders.
Aside from information asymmetry reason debt is attractive as a form of financing because:
 Interest payments are tax deductible, whereas dividend payments are not.

Question 3. Firms are increasing delisting and being bought out by private equity
firms. Use the concepts of information asymmetry to explain this.

Private equity has come to be used to describe the business of taking a publicly-listed company
into private ownership in order to reform it before selling it again at a hoped-for profit.2 Private
equity firms are known for their extensive use of debt financing to purchase companies, which
they restructure PE funds and devise governance mechanisms that align the interests of the
stakeholders and attempt to resell for a higher value. The fundamental argument for the
emergence of private equity firms is that publicly-listed firms are subject to substantial moral
hazard problems because of the separation of control from ownership. Shareholders in
publicly-listed companies cannot observe the actions of management and in-turn management
may act in their own self-interest such excessive pay, only investing in projects with short-
terms payoffs and empire building. Private equity firms are more closely involved in direct
oversight of company management and in turn there is less information asymmetry and a
reduction of moral hazard problems and in turn an increase in value of the firm.

Distinct from PE another reason for delisting in the US is that excessive US regulation and
litigation of public firms discourages private companies from going public and drives some
public companies off organized exchanges. The regulation was introduced to minimize both
adverse selection and moral hazard problems but the cost of this regulation for some firms is
excessive.

Question 4. Telstra is Australia’s largest telecommunications company. Obtain Telstra’s

2017 Annual Report. Compute the level of accruals for Telstra. Will accruals increase
or decrease information asymmetry. What type of information asymmetry will be
affected?

2
Private equity firms (e.g Blue Sky Venture Capital, Allegro Funds, Quadrant Private Equity and KKR and in
the U.S. the Blackstone group, Kolberg Kravis Roberts) are typically investment funds organized as limited
partnerships whose investors are typically large institutional investors, university endowments, or wealthy
individuals. As discussed by Zimmerman (2015) private equity includes a variety of specialized financial
intermediaries including VC funds, angel investors, private equity pools, and other organizations that raise private
capital and invest in early and later stage start-ups, private companies seeking capital, and public firms looking to
exit the public markets (Gilligan and Wright 2014). VCs and PEs have fundamentally different investment
strategies. VCs invest in start-ups and young high-growth companies, whereas many PEs invest in mature
companies with stable cash flows and few growth options.
 (1) Accruals = Net Profit – Cash flow from operations
(2) ($3,901) = $3,874 - $7,775

Accruals could potentially decrease information asymmetry because they increase the
relevance of the reported performance metric by alleviating timing and matching problems
associated with operating cash flows. Revenue is recognized when it is earned (rather than
when the cash flow occurs) and expenses incurred in generating this revenue are matched to
revenue giving rise to a measure of economic value added. However accruals could potentially
increase information asymmetry as accruals have to be estimated giving rise to both random
errors and biases and they could therefore be unreliable. The biases can arise from both GAAP
principles and measurement rules. To the extent the impact of unreliability is greater than the
increase in relevance then accruals could increase information asymmetry.

Accruals could reduce both adverse selection and moral hazard. Adverse selection is reduced
because a more precise measure of economic value added is produced which can be used to
value the firm. Moral hazard is reduced because a more precise measure of managerial effort
is obtained.

The reconciliation of Telstra’s net profit and net cash flow from operations for 2017 can be
summarised as follows:

$m
Net profit 3,874
Net financial expense 591
Loss (gain) on disposal of assets (684)
Depreciation and amortisation 4,441
Other non-cash items 137
Change in working capital (584)
7,775
Question 5 Review Telstra’s 2017 financial reports. Find an example of the use this
report to reduce moral hazard problems. What is implication of this for the properties
of financial reports (bias and precision)?

In the Remuneration Section of the Report on page 44 it is disclosed that the remuneration of
executives is linked to company performance as measured using various definitions of income
such as EBITDA and Total Income (see extracts below). Therefore the incentives of the
executives are aligned with the incentives of the shareholder which is to maximize the value of
the firms (assuming accounting measures of income reflect firm value). As incentives are
aligned the moral hazard problem of managers acting in their own self-interest at the expense
of shareholders (for example by empire building) may be alleviated.

An implication of this for the properties of financial reports is the application by standard
setters of the conservatism principle in the preparation of financial reports which will give rise
to a bias. It is argued because managers performance is being assessed using financial reports
and they are preparing these reports they will have a self-interest in biasing the reported
performance upward. To guard against this alleged bias gains are not recognized until realized
and losses are recognized when anticipated.
Question 6 Find an example of a conservative financial accounting policy in the
financial reports of Telstra. Will this type of accounting increase or decrease
information asymmetry problems?

An example is on page 92 of Telstra’s financial reports in note to financial statements on

Impairment.

AASB 136 Impairment of Assets requires firms to revalue assets downward if the recoverable
amount is lower than the carrying value. However, firms are not allowed to revalue assets
upwards if the recoverable amount is greater than the carrying value. This asymmetric
treatment of increases versus decreases in recoverable amount is an example conservatism. The
recognition of anticipated losses but not gains.

Whether this increases or decreases information asymmetry depends on whether it increases or

decreases biases in financial reports. To the extent this alleviates a pre-existing/potential
upward bias and results in more neutral financial reports then it could be argued it decreases
financial reports. However to the extent it creates a bias in financial reports impeding the
determination of the value of the firm then it could increase information asymmetry (both
adverse selection and moral hazard). We will be discussing this further in the next two weeks.